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    Managerial economics book Managerial economics book Document Transcript

    • MANAGERIAL ECONOMICS MANAGERIAL ECONOMICS SYLLABUSUnit 1 Managerial economics: Meaning, nature and scope; Economic theory and managerial economic; Managerial economics and business decision making; Role of managerial economics.Unit 2 Demand Analysis: Meaning, types and determinants of demand.Unit 3 Cost Concepts: Cost function and cost output relationship; Economics and diseconomies of scale; Cost control and cost reduction.Unit 4 Production Functions: Pricing and output decisions under competitive conditions; Government control over pricing; Price discrimination; Price discount and differentials.Unit 5 Profit: Measurement of profit; Profit planning and forecasting; Profit maximization; Cost volume profit analysis; Investment analysis.Unit 6 National Income: Business cycle; Inflation and deflation; Balance of payment; Their implications in managerial decision. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS CONTENTS1. NATURE & SCOPE OF MANAGERIAL ECONOMICS2. DEMAND ANALYSIS3. COST CONCEPTS4. PRODUCTION FUNCTION5. PROFIT6. NATIONAL INCOME BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSBABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS LESSON – 1 NATURE & SCOPE OF MANAGERIAL ECONOMICSThe terms Managerial Economics and Business Economics are oftenused interchangeably. However, the terms Managerial Economics hasbecome more popular and seems to displace Business Economics.DECISION-MAKING AND FORWARD PLANNINGThe chief function of a management executive in a business firm isdecision-making and forward planning. Decision-making refers to theprocess of selecting one action from two or more alternative coursesof action. Forward planning on the other hand is arranging plans forthe future. In the functioning of a firm the question of choice arisesbecause the available resources such as capital, land, labour andmanagement, are limited and can be employed in alternative uses. Thedecision-making function thus involves making choices or decisionsthat will provide the most efficient means of attaining anorganisational objectives, for example profit maximization. Once adecision is made about the particular goal to be achieved, plans for thefuture regarding production, pricing, capital, raw materials and labourare prepared. Forward planning thus goes hand in hand withdecision-making. The conditions in which firms work and takedecisions, is characterised with uncertainty. And this uncertainty notonly makes the function of decision-making and forward planningcomplicated but also adds a different dimension to it. If the knowledgeof the future were perfect, plans could be formulated without errorand hence without any need for subsequent revision. In the real world,however, the business manager rarely has complete information aboutthe future sales, costs, profits, capital conditions. etc. Hence, decisionsare made and plans are formulated on the basis of past data, currentinformation and the estimates about future that are predicted asaccurately as possible. While the plans are implemented over time, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmore facts come into the knowledge of the businessman. Inaccordance with these facts the plans may have to be revised, and adifferent course of action needs to be adopted. Managers are thusengaged n a continuous process of decision-making through anuncertain future and the overall problem that they deal with isadjusting to uncertainty. To execute the function of ‘decision-making in an uncertainframe-work’, economic theory can be applied with considerableadvantage. Economic theory deals with a number of concepts andprinciples relating to profit, demand, cost, pricing, production,competition, business cycles and national income, which are aided byallied disciplines like accounting. Statistics and Mathematics also canbe used to solve or at least throw some light upon the problems ofbusiness management. The way economic analysis can be usedtowards solving business problems constitutes the subject matter ofManagerial Economics.DEFINITIONAccording to McNair the Merriam, Managerial Economics consists ofthe use of economic modes of thought to analyse business situations. Spencer and Siegelman have defined Managerial Economics as“the integration of economic theory with business practice for thepurpose of facilitating decision-making and forward planning bymanagement.” The above definitions suggest that Managerial economics is thediscipline, which deals with the application of economic theory tobusiness management. Managerial Economics thus lies on the marginbetween economics and business management and serves as thebridge between the two disciplines. The following Figure 1.1 shows therelationship between economics, business management andmanagerial economics. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSAPPLICATION OF ECONOMICS TO BUSINESS MANAGEMENTThe application of economics to business management or theintegration of economic theory with business practice, as Spencer andSiegelman have put it, has the following aspects : Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions: In economic theory, the technique of analysis is that of model building. This involves making some assumptions and, drawing conclusions on the basis of the assumptions about the behavior of the firms. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a satisfactory explanation of what the firms actually do. Hence, there is need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develop appropriate extensions and reformulation of economic theory. For example, it is usually assumed that firms aim at maximising profits. Based on this, the theory of the firm suggests how much the firm will produce and at what price it would sell. In practice, however, firms do not always aim at maximum profits (as they may think of diversifying or introducing new product etc.) To that extent, the theory of the firm fails to provide a satisfactory explanation of the firm’s actual behavior. Moreover, in actual business BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSlanguage, certain terms like profits and costs have accountingconcepts as distinguished from economic concepts. Inmanagerial economics, an attempt is made to merge theaccounting concepts with the economics, an attempt is made tomerge the accounting concepts with the economic concepts.This helps in a more effective use of financial data related toprofits and costs to suit the needs of decision-making andforward planning.Estimating economic relationships: This involves themeasurement of various types of elasticities of demand such asprice elasticity, income elasticity, cross-elasticity, promotionalelasticity and cost-output relationships. The estimates of theseeconomic relationships are to be used for the purpose offorecasting.Predicting relevant economic quantities: Economic quantitiessuch as profit, demand, production, costs, pricing and capitalare predicated in numerical terms together with theirprobabilities. As the business manager has to work in anenvironment of uncertainty, the future needs to be foreseen sothat in the light of the predicted estimates, decision-making andforward planning may be possible.Using economic quantities in decision-making and forwardplanning: This involves formulating business policies forestablishing future business plans. This nature of economicforecasting indicates the degree of probability of variouspossible outcomes, i.e., losses or gains that will occur as a resultof following each one of the available strategies. Thus, aquantified picture gets set up, that indicates the number ofcourses open, their possible outcomes and the quantifiedprobability of each outcome. Keeping this picture in view, thebusiness manager is able to decide about which strategy shouldbe chosen. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Understanding significant external forces: Applying economic theory to business management also involves understanding the important external forces that constitute the business environment and with which a business must adjust. Business cycles, fluctuations in national income and government policies pertaining to taxation, foreign trade, labour relations, antimonopoly measures, industrial licensing and price controls are typical examples. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies.CHARACTERISTICS OF MANAGERIAL ECONOMICSThere are certain chief characteristics of managerial economics, whichcan help to understand the nature of the subject matter and help in aclear understanding of the following terms: Managerial economics is micro-economic in character. This is because the unit of study is a firm and its problems. Managerial economics does not deal with the entire economy as a unit of study. Managerial economics largely uses that body of economic concepts and principles, which is known as Theory of the Firm or Economics of the Firm. In addition, it also seeks to apply profit theory, which forms part of distribution theories in economics. Managerial economics is concrete and realistic. I avoids difficult abstract issues of economic theory. But it also involves complications ignored in economic theory in order to face the overall situation in which decisions are made. Economic theory ignores the variety of backgrounds and training found in individual firms. Conversely, managerial economics is concerned BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS more with the particular environment that influences decision-making. Managerial economics belongs to normative economics rather than positive economics. Normative economy is the branch of economics in which judgments about the desirability of various policies are made. Positive economics describes how the economy behaves and predicts how it might change. In other words, managerial economics is prescriptive rather than descriptive. It remains confined to descriptive hypothesis. Managerial economics also simplifies the relations among different variables without judging what is desirable or undesirable. For instance, the law of demand states that as price increases, demand goes down or vice-versa but this statement does not imply if the result is desirable or not. Managerial economics, however, is concerned with what decisions ought to be made and hence involves value judgments. This further has two aspects: first, it tells what aims and objectives a firm should pursue; and secondly, how best to achieve these aims in particular situations. Managerial economics, therefore, has been described as normative microeconomics of the firm. Macroeconomics is also useful to managerial economics since it provides an intelligent understanding of the business environment. This understanding enables a business executive to adjust with the external forces that are beyond the management’s control but which play a crucial role in the well being of the firm. The important forces are: business cycles, national income accounting, and economic policies of the government like those relating to taxation foreign trade, anti-monopoly measures and labour relations.DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICSThe difference between managerial economics and economics can beunderstood with the help of the following points: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSManagerial economics involves application of economicprinciples to the problems of a business firm whereas;economics deals with the study of these principles only.Economics ignores the application of economic principles to theproblems of a business firm.Managerial economics is micro-economic in character, however,Economics is both macro-economic and micro-economic.Managerial economics, though micro in character, deals onlywith a firm and has nothing to do with an individual’s economicproblems. But microeconomics as a branch of economics dealswith both economics of the individual as well as economics of afirm.Under microeconomics, the distribution theories, viz., wages,interest and profit, are also dealt with. Managerial economics onthe contrary is mainly concerned with profit theory and does notconsider other distribution theories. Thus, the scope ofeconomics is wider than that of managerial economics.Economic theory assumes economic relationships and buildseconomic models. Managerial economics adopts, modifies andreformulates the economic models to suit the specific conditionsand serves the specific problem solving process. Thus,economics gives the simplified model, whereas managerialeconomics modifies and enlarges it.Economics involves the study of certain assumptions like in thelaw of proportion where it is assumed that “The variable input asapplied, unit by unit is homogeneous or identical in amount andquality”. Managerial economics on the other hand, introducescertain feedbacks. These feedbacks are in the form of objectivesof the firm, multi-product nature of manufacture, behavioralconstraints, environmental aspects, legal constraints, constraintson resource availability, etc. Thus managerial economics,attempts to solve the complexities in real life, which areassumed in economics. this is done with the help of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS mathematics, statistics, econometrics, accounting, operations research, etc.OTHER TERMS FOR MANAGERIAL ECONOMICSCertain other expressions like economic analysis for businessdecisions and economics of business management have also beenused instead of managerial economics but they are not so popular.Sometimes expressions like ‘Economics of the Enterprise’, ‘Theory ofthe Firm’ or ‘Economics of the Firm’ have also been used formanagerial economics. It is, however, not appropriate t use thesesterms because managerial economics, though primarily related to theeconomics of the firm, differs from it in the following respects: First, ‘Economics of the Firm’ deals with the theory of the firm, which is a body of economic principles relating to the firm alone. Managerial economics on the other hand deals with the, application of the same principles to business. Secondly, the term ‘Economics of the firm’ is too simple in its assumptions whereas managerial economics has to reckon with actual business behaviour, which is much more complex.SCOPE OF MANAGERIAL ECONOMICSAs regards the scope of managerial economics, there is no generaluniform pattern. However, the following aspects may be said to beinclusive under managerial economics: Demand analysis and forecasting. Cost and production analysis. Pricing decisions, policies and practices. Profit management. Capital management. These aspects may also be defined as the ‘Subject-Matter ofManagerial Economics’. In recent years, there is a trend towardsintegrations of managerial economics and operations research. Hence, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICStechniques such as linear programming, inventory models and theoryof games have also been regarded as a part of managerial economics.Demand Analysis and ForecastingA business firm is an economic Organisation, which transformsproductive resources into goods that are to be sold in a market. Amajor part of managerial decision-making depends on accurateestimates of demand. This is because before production schedules canbe prepared and resources are employed, a forecast of future sales isessential. This forecast can also guide the management in maintainingor strengthening the market position and enlarging profits. Thedemand analysis helps to identify the various factors influencingdemand for a firm’s product and thus provides guidelines tomanipulate demand. Demand analysis and forecasting, thus, isessential for business planning and occupies a strategic place inmanagerial economics. It comprises of discovering the forcesdetermining sales and their measurement. The chief topics covered inthis are: Demand determinants Demand distinctions Demand forecasting.Cost and Production AnalysisA study of economic costs, combined with the data drawn from thefirm’s accounting records, can yield significant cost estimates. Theseestimates are useful for management decisions. The factors causingvariations in costs must be recognised and thereby should be used fortaking management decisions. This facilitates the management toarrive at cost estimates, which are significant for planning purposes.An element of cost uncertainty exists in this because all the factorsdetermining costs are not always known or controllable. Therefore, itis essential to discover economic costs and measure them for effectiveprofit planning, cost control and sound pricing practices. Production BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSanalysis is narrower in scope than cost analysis. The chief topicscovered under cost and production analysis are: Cost concepts and classifications Cost-output relationships Economics of scale Production functions Cost control.Pricing Decisions, Policies and PracticesPricing is a very important area of managerial economics. In fact priceis the origin of the revenue of a firm. As such the success of a usinessfirm largely depends on the accuracy of price decisions of that firm.The important aspects dealt under area, are as follows: Price determination in various market forms Pricing methods Differential pricing product-line pricing and price forecasting.Profit ManagementBusiness firms are generally organised with the purpose of makingprofits. In the long run, profits provide the chief measure of success.In this connection, an important point worth considering is theelement of uncertainty existing about profits. This uncertainty occursbecause of variations in costs and revenues. These are caused byfactors such as internal and external. If knowledge about the futurewere perfect, profit analysis would have been a very easy task.However, in a world of uncertainty, expectations are not alwaysrealised. Thus profit planning and measurement make up the difficultarea of managerial economics. The important aspects covered underthis area are: Nature and measurement of profit. Profit policies and techniques of profit planning.Capital ManagementAmong the various types and classes of business problems, the mostcomplex and troublesome for the business manager are those relatingto the firm’s capital investments. Capital management implies BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSplanning and control and capital expenditure. In this procedure,relatively large sums are involved and the problems are so complexthat their disposal not only requires considerable time and labour butalso top-level decisions. The main elements dealt with costmanagement are: Cost of capital Rate of return and selection of projects. The various aspects outlined above represent the majoruncertainties, which a business firm has to consider viz., demanduncertainty, cost uncertainty, price uncertainty, profit uncertainty andcapital uncertainty. We can, therefore, conclude that managerialeconomics is mainly concerned with applying economic principles andconcepts to adjust with the various uncertainties faced by a businessfirm.MANAGERIAL ECONOMICS AND OTHER SUBJECTSYet another useful method of explaining the nature and scope ofmanagerial economics is to examine its relationship with othersubjects. The following discussion helps to understand relationshipbetween managerial economics and economics, statistics, mathematics,accounting and operations research.Managerial Economics and EconomicsManagerial economics is defined as a subdivision of economics thatdeals with decision-making. It may be viewed as a special branch ofeconomics bridging the gulf between pure economic theory andmanagerial practice. Economics has two maindivisions-microeconomics and Macroeconomics. Microeconomics hasbeen defined as that branch where the unit of study is an individual ora firm. It is also called “price theory” (or Marshallian economics) and isthe main source of concepts and analytical tools for managerialeconomics. To illustrate, various micro-economic concepts such aselasticity of demand, marginal cost, the short and the long runs, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSvarious market forms, etc., are all of great significance to managerialeconomics. Macroeconomics, on the other hand, is aggregative in characterand has the entire economy as a unit of study. The chief contributionof macroeconomics to managerial economics is in the area offorecasting. The modern theory of income and employment has directimplications for forecasting general business conditions. As theprospects of an individual firm often depend greatly on generalbusiness conditions, individual firm forecasts rely on general businessforecasts. A survey in the U.K. has shown that business economists havefound the following economic concepts quite useful and of frequentapplication: Price elasticity of demand Income elasticity of demand Opportunity cost Multiplier Propensity to consume Marginal revenue product Speculative motive Production function Liquidity preference Business economists have also found the following main areas of economics as useful in their work. Demand theory Theory of firms – price, output and investment decisions Business financing Public finance and fiscal policy Money and banking National income and social accounting Theory of international trade Economies of developing countries. Thus, it is obvious that Managerial Economics is very closelyrelated to Economics. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSManagerial Economics and StatisticsStatistics is important to managerial economics in several ways.Managerial economics calls for the organising quantitative data andderiving a useful measure of appropriate functional relationshipsinvolved in decision-making. For instance, in order to base its pricingdecisions on demand and cost considerations, a firm should havestatistically derived or calculated demand and cost functions.Managerial economics also employs statistical methods forexperimental testing of economic generalisations. The generalisationscan be accepted in practice only when they are checked against thedata from the world of reality and are found valid. Managers do nothave exact information about the variables affecting decisions andhave to deal with the uncertainty of future events. The theory ofprobability, upon which statistics is based, provides logic for dealingwith such uncertainties.Managerial Economics and MathematicsMathematics is yet another important subject closely related tomanagerial economics. This is because managerial economics ismathematical in character, as it involves estimating various economicrelationships, predicting relevant economic quantities and using themin decision-making and forward planning. Knowledge of geometry,trigonometry ad algebra is not only essential but also certainmathematical tools and concepts such as logarithms and exponential,vectors, determinants, matrix, algebra, calculus, differential as well asintegral, are the most commonly used devices. Further, operationsresearch, which is closely related to managerial economics, ismathematical in character. It provides and analyses data ad developsmodels, benefiting from the experiences of experts drawn fromdifferent disciplines, viz., psychology, sociology, statistics andengineering. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSMANAGERIAL ECONOMICS AND ACCOUNTINGManagerial economics is also closely related to accounting, which isconcerned with recording the financial operations of a business firm.In fact, a managerial economist depends chiefly on the accountinginformation as an important source of data required for hisdecision-making purpose. for instance, the profit and loss statementof a firm shows how well the firm has done and whether theinformation it contains can be used by managerial economist to throwsignificant light on the future course of action that is whether the firmshould improve its productivity or close down. Therefore, accountingdata require careful interpretation, reconstruction and adjustmentsbefore they can be used safely and effectively. It is in this context thatthe link between management accounting and managerial economicsdeserves special mention. The main task of management accounting isto provide the sort of data, which managers need if they are to applythe ideas of managerial economics to solve business problemscorrectly. The accounting data should be provided in such a form thatthey fit easily into the concepts and analysis of managerial economics.Managerial Economics and Operations ResearchOperations research is a subject field that emerged during the SecondWorld War and the years thereafter. A good deal of interdisciplinaryresearch was done in the USA. as well as other western countries tosolve the complex operational problems of planning and resourceallocation in defence and basic industries. Several experts likemathematicians, statisticians, engineers and others teamed uptogether and developed models and analytical tools leading to theemergence of this specialised subject. Much of the development oftechniques and concepts, such as linear programming, inventorymodels, game theory, etc., emerged from the working of the operationresearchers. Several problems of managerial economics are solved bythe operation research techniques. These highlight the significant BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSrelationship between managerial economics and operations research.The problems solved by operation research are as follows: Allocation problems: An allocation problem confronts with the issue that men, machines and other resources are scarce, related to the number sand size of the jobs that need to be completed. The examples are production programming and transportation problems. Competitive problems: competitive problems deal with situations where managerial decision-making is to be made in the face of competitive action. That is, one of the factors to be considered is: “What will competitors do if certain steps are taken?” Price reduction, for example, will not lead to increased market share if rivals follow suit. Waiting line problems : Waiting line problems arise when a firm wants to know how many machines it should install in order to ensure that the amount of ‘work-in-progress’ waiting to be machined is neither too small nor too large. Such situations arise when for example, a post office, or a bank wants to know how many cash desks or counter clerks it should employ in order to balance the business lost through long guesses against the cost of installing more equipment or hiring more labour. Inventory problems: Inventory problems deal with the principal question: “What is the optimum level of stocks of raw-materials, components or finished goods for the firm to hold?” The above discussion explains that the managerial economics isclosely related to certain subjects such as economics, statistics,mathematics and accounting. A trained managerial economistcombines concepts and methods from all these subjects by bringingthem together to solve business problems. In particular, operationsresearch and management accounting are getting very close tomanagerial economics.USES OF MANAGERIAL ECONOMICS BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSManagerial economics achieves several objectives. The principalobjectives are as follows: It presents those aspects of traditional economics, which are relevant for business decision-making in real life. For this purpose, it picks from economic theory those concepts, principles and techniques of analysis, which are concerned with the decision-making process. These are adapted or modified in such a way that it enables the manager to take better decisions. Thus, managerial economics attains the objective of building a suitable tool kit from traditional economics. Managerial economics also incorporates useful ideas from other disciplines such as psychology, sociology, etc. If they are found relevant for decision-making. In fact, managerial economics takes the aid of other academic disciplines that are concerned with the business decisions of a manager in view of the various explicit and implicit constraints subject to which resource allocation is to be optimised. It helps in reaching a variety of business decisions even in a complicated environment. Certain examples of such decisions are those decisions concerned with: o The products and services to be produced o The inputs and production techniques to be used o The quantity of output to be produced and the selling prices to be subscribed o The best sizes and locations of new plants o Time of replacing the equipment o Allocation of the available capital Managerial economics helps a manager to become a more competent model builder. Thus, he can pick out the essential relationships, which characterise a situation and leave out the other unwanted details and minor relationships. At the level of the firm, functional specialists or functional departments exist, e.g., finance, marketing, personnel, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS production etc. For these various functional areas, managerial economics serves as an integrating agent by co-ordinating the different areas. It then applies the decisions of each department or specialist, those implications, which are pertaining to other functional areas. Thus managerial economics enables business decision-making to operate not with an inflexible and rigid but with an integrated perspective. This integration is important because the functional departments or specialists often enjoy considerable autonomy and achieve conflicting goals.Managerial economics keeps in mind the interaction between the firm and society and accomplishes the key role of business as an agent in attaining social economic welfare. There is a growing awareness that besides its obligations to shareholders, business enterprise has certain social obligations as well. Managerial economics focuses on these social obligations while taking business decisions. By doing so, it serves as an instrument of furthering the economic welfare of the society through socially oriented business decisions. Thus, it is evident that the applicability and usefulness ofmanagerial economics is obtained by performing the followingactivates: Borrowing and adopting the tool-kit from economic theory. Incorporating relevant ideas from other disciplines to achieve better business decisions. Serving as a catalytic agent in the course of decision-making by different functional departments/specialists at the firm’s level. Accomplishing a social purpose by adjusting business decisions to social obligations.ECONOMIC THEORY AND MANAGERIAL ECONOMICSEconomic theory offers a variety of concepts and analytical tools thatcan assist the manager in the decision-making practices. Problemsolving in business has, however, found that there exists a wide BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdisparity between the economic theory of a firm and actual observedpractice, thus necessitating the use of many skills and be quite usefulto examine two aspects in this regard: The basic tools of managerial economics which it has borrowed from economics, and The nature and extent of gap between the economic theory of the firm and the managerial theory of the firm.Basic Economic Tools in Managerial EconomicsThe most significant contribution of economics to managerialeconomics lies in certain principles, which are basic to the entire rangeof managerial economics. The basic principles may be identified asfollows:1. Opportunity Cost PrincipleThe opportunity cost of a decision means the sacrifice of alternativesrequired by that decision. This can be best understood with the help ofa few illustrations, which are as follows: The opportunity cost of the funds employed in one’s own business is equal to the interest that could be earned on those funds if they were employed in other ventures. The opportunity cost of the time as an entrepreneur devotes to his own business is equal to the salary he could earn by seeking employment. The opportunity cost of using a machine to produce one product is equal to the earnings forgone which would have been possible from other products. The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities. If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is equal to the quantity of Y, which it would have produced. If that machine can produce 10 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS units of X or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y. If no information is provided about quantities produced, except about their prices then the opportunity cost can be computed in terms of the ratio of their respective prices, say Px/Py. The opportunity cost of holding Rs. 500 as cash in hand for one year is equal to the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank. Thus, it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil. For decision-making, opportunity costs are the only relevantcosts. The opportunity cost principle may be stated as under: “The cost involved in any decision consists of the sacrifices ofalternatives required by that decision. If there are no sacrifices, thereis no cost.” Thus in macro sense, the opportunity cost of more guns in aneconomy is less butter. That is the expenditure to national fund forbuying armour has cost the nation of losing an opportunity of buyingmore butter. Similarly, a continued diversion of funds towards defencespending, amounts to a heavy tax on alternative spending required forgrowth and development.2. Incremental PrincipleThe incremental concept is closely related to the marginal costs andmarginal revenues of economic theory. Incremental concept involvestwo important activities which are as follows: Estimating the impact of decision alternatives on costs and revenues. Emphasising the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision. The two basic components of incremental reasoning are as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision. Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.The incremental principle may be stated as under: A decision is obviously a profitable one if: o It increases revenue more than costs o It decreases some costs to a greater extent than it increases other costs o It increases some revenues more than it decreases other revenues o It reduces costs more that revenues. Some businessmen hold the view that to make an overall profit,they must make a profit on every job. Consequently, they refuseorders that do not cover full cost (labour, materials and overhead) plusa provision for profit. Incremental reasoning indicates that this rulemay be inconsistent with profit maximisation in the short run. Arefusal to accept business below full cost may mean rejection of apossibility of adding more to revenue than cost. The relevant cost isnot the full cost but rather the incremental cost. A simple problem willillustrate this point.IIIustrationSuppose a new order is estimated to bring in additional revenue of Rs.5,000. The costs are estimated as under: Labour Rs. 1,500 Material Rs. 2,000 Overhead (Allocated at 120% of labour cost) Rs. 1,800 Selling administrative expenses (Allocated at 20% of labour and material cost) Rs. 700 Total Cost Rs. 6,000 The order at first appears to be unprofitable. However, suppose,if there is idle capacity, which can be, utilised to execute this order BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSthen the order can be accepted. If the order adds only Rs. 500 ofoverhead (that is, the added use of heat, power and light, the addedwear and tear on machinery, the added costs of supervision, and soon), Rs. 1,000 by way of labour cost because some of the idle workersalready on the payroll will be deployed without added pay and no extraselling and administrative cost then the incremental cost of acceptingthe order will be as follows. Labour Rs. 1,500 Material Rs. 2,000 Overhead Rs. 500 Total Incremental Cost Rs. 3,500 While it appeared in the first instance that the order will result ina loss of Rs. 1,000, it now appears that it will lead to an addition of Rs.1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does notmean that the firm should accept all orders at prices, which covermerely their incremental costs. The acceptance of the Rs. 5,000 orderdepends upon the existence of idle capacity and labour that would gounutilised in the absence of more profitable opportunities. Earley’sstudy of “excellently managed” large firms suggests that progressivecorporations do make formal use of incremental analysis. It is,however, impossible to generalise on the use of incremental principle,since the observed behaviour is variable.3. Principle of Time PerspectiveThe economic concepts of the long run and the short run have becomepart of everyday language. Managerial economists are also concernedwith the short-run and long-run effects of decisions on revenues aswell as on costs. The actual problem in decision-making is to maintainthe right balance between the long-run and short-run considerations.A decision may be made on the basis of short-run considerations, butmay in the course of time offer long-run repercussions, which make it BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmore or less profitable than it appeared at first. An illustration willmake this point clear.IIIustrationSuppose there is a firm with temporary idle capacity. An order for5,000 units comes to management’s attention. The customer is willingto pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more.The short-run incremental cost (ignoring the fixed cost) is only Rs.3.00. Therefore, the contribution to overhead and profit is Re. 1.00 perunit (Rs. 5,000 for the lot. However, the long-run repercussions of theorder ought to be taken into account are as follows: If the management commits itself with too much of business at lower prices or with a small contribution, it may not have sufficient capacity to take up business with higher contributions when the opportunity arises. The management may be compelled to consider the question of expansion of capacity and in such cases; even the so-called fixed costs may become variable. If any particular set of customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated. In response, they may opt to patronise manufacturers with more decent views on pricing. The reduction or prices under conditions of excess capacity may adversely affect the image of the company in the minds of its clientele, which will in turn affect its sales. It is, therefore, important to give due consideration to the timeperspective. The principle of time perspective may be stated as under:‘A decision should take into account both the short-run and long-runeffects on revenues and costs and maintain the right balance betweenthe long-run and short-run perspectives.” Haynes, Mote and Paul have cited the case of a printing company.This company pursued the policy of never quoting prices below full BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScost though it often experienced idle capacity and the managementwas fully aware that the incremental cost was far below full cost. Thiswas because the management realised that the long-run repercussionsof pricing below full cost would make up for any short-run gain. Themanagement felt that the reduction in rates for some customers mighthave an undesirable effect on customer goodwill particularly amongregular customers not benefiting from price reductions. It wanted toavoid crating such an “image” of the firm that it exploited the marketwhen demand was favorable but which was willing to negotiate pricesdownward when demand was unfavorable.4. Discounting PrincipleOne of the fundamental ideas in economics is that a rupee tomorrow isworth less than a rupee today. This seems similar to the saying that abird in hand is worth two in the bush. A simple example would makethis point clear. Suppose a person is offered a choice to make betweena gift of Rs. 100 today or Rs. 100 next year. Naturally he will choosethe Rs. 100 today. This is true for two reasons. First, the future is uncertain andthere may be uncertainty in getting Rs. 100 if the present opportunityis not availed of. Secondly, even if he is sure to receive the gift infuture, today’s Rs. 100 can be invested so as to earn interest, say, at 8percent so that. one year after the Rs. 100 of today will become Rs.108 whereas if he does not accept Rs. 100 today, he will get Rs. 100only in the next year. Naturally, he would prefer the first alternativebecause he is likely to gain by Rs. 8 in future. Another way of sayingthe same thing is that the value of Rs. 100 after one year is not equalto the value of Rs. 100 of today but less than that. To find out howmuch money today is equal to Rs. 100 would earn if one decides toinvest the money. Suppose the rate of interest is 8 percent. Then weshall have to discount Rs. 100 at 8 per cent in order to ascertain howmuch money today will become Rs. 100 one year after. The formula is: Rs. 100 V= 1+i BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS where, V = present value i = rate of interest. Now, applying the formula, we get Rs. 100 V= 1+i 100 = 1.08 If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,which will accumulate at 8 per cent after one year. 92.59 x 1.08 = 99.0072 = 1.00 The same reasoning applies to longer periods. A sum of Rs. 100two years from now is worth: Rs. 100 Rs. 100 Rs. 100 V= (1+i)2 = (1.08)2 = 1.1664 Similarly, we can also check by computing how much thecumulative interest will be after two years. The principle involved inthe above discussion is called the discounting principle and is statedas follows: “If a decision affects costs and revenues at future dates, itis necessary to discount those costs and revenues to present valuesbefore a valid comparison of alternatives is possible.”5. Equi-marginal PrincipleThis principle deals with the allocation of the available resource amongthe alternative activities. According to this principle, an input shouldbe allocated in such a way that the value added by the last unit is thesame in all cases. This generalisation is called the equi-marginalprinciple. Suppose a firm has 100 units of labour at its disposal. The firmis engaged in four activities, which need labour services, viz., A, B, C BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSand D. It can enhance any one of these activities by adding morelabour but sacrificing in return the cost of other activities. If the valueof the marginal product is higher in one activity than another, then itshould be assumed that an optimum allocation has not been attained.Hence it would, be profitable to shift labour from low marginal valueactivity to high marginal value activity, thus increasing the total valueof all products taken together. For example, if the values of certaintwo activities are as follows: Value of Marginal Product of labour Activity A = Rs. 20 Activity B = Rs. 30 In this case it will be profitable to shift labour from A to activityB thereby expanding activity B and reducing activity A. The optimumwill be reach when the value of the marginal product is equal in all thefour activities or, when in symbolic terms: VMPLA = VMPLB = VMPLC = VMPLD Where the subscripts indicate labour in respective activities. Certain aspects of the equi-marginal principle need clarifications,which are as follows: First, the values of marginal products are net of incremental costs. In activity B, we may add one unit of labour with an increase in physical output of 100 units. Each unit is worth 50 paise so that the 100 units will sell for Rs. 50. But the increased output consumes raw materials, fuel and other inputs so that variable costs in activity B (not counting the labour cost) are higher. Let us say that the incremental costs are Rs. 30 leaving a net addition of Rs. 20. The value of the marginal product relevant for our purpose is thus Rs. 20. Secondly, if the revenues resulting from the addition of labour are to occur in future, these revenues should be discounted before comparisons in the alternative activities are possible. Activity A may produce revenue immediately but activities B, C BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS and D may take 2, 3 and 5 years respectively. Here the discounting of these revenues will make them equivalent. Thirdly, the measurement of value of the marginal product may have to be corrected if the expansion of an activity requires an alternative reduction in the prices of the output. If activity B represents the production of radios and it is not possible to sell more radios without a reduction in price, it is necessary to make adjustment for the fall in price. Fourthly, the equi-marginal principle may break under sociological pressures. For instance, du to inertia, activities are continued simply because they exist. Similarly, due to their empire building ambitions, managers may keep on expanding activities to fulfil their desire for power. Department, which are already over-budgeted often, use some of their excess resources to build up propaganda machines (public relations offices) to win additional support. Governmental agencies are more prone to bureaucratic self-perpetuation and inertia.Gaps between Theory of the Firm and managerial EconomicsThe theory of the firm is a body of theory, which contains certainassumptions, theorems and conclusions. These theorems deal with theway in which businessmen make decisions about pricing, andproduction under prescribed market conditions. It is concerned withthe study of the optimisation process. For optimality to exist profit must be maximised and this canoccur only when marginal cost equals marginal revenue. Thus, theoptimum position of the firm is that which maximises net revenue.Managerial economics, on the other hand, aims at developing amanagerial theory of the firm and for the purpose it takes the help ofeconomic theory of the firm. However, there are certain difficulties inusing economic theory as an aid to the study of decision-making atthe level of the firm. This is because for the purposes of business BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdecision-making it fails to provide sufficient analytical tools that areuseful to managers. Some of the reasons are as follows: Underlying all economic theory is the assumption that the decision-maker is omniscient and rational or simply that he is an economic man. Thus being omniscient means that he knows the alternatives that are available to him as well as the outcome of any action he chooses. The model of “economic man” however as an omniscient person who is confronted with a compete set of known or probabilistic outcomes is a distorted representation of reality. The typical business decision-maker usually has limited information at his disposal, limited computing ability and a limited number of feasible alternatives involving varying degrees of risk. Further, the net revenue function, which he is expected to maximise, and the marginal cost and marginal revenue functions, which he is expected to equate, require excessive knowledge of information, which is not known and cannot be obtained even by the most careful analysis. Hence, it is absurd to expect a manager to maximise and equalise certain critical functional relationships, which he does not know and cannot find out. In micro-economic theory, the most profitable output is where marginal cost (MC) and marginal revenue (MR) are equal. In Figure 1.2, the most profitable output will be at ON where MR=MC. This is the point at which the slope of the profit function or marginal profit is zero. This is highlighted in Figure 1.3 where the most profitable output will be again at ON. In economic theory, the decision-maker has to identify this unique output level, which maximises profit. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS In real world, however, a complexity often arises, viz., certainresource limitations exist. As a result, it is not possible to attain themaximum output level (ON). In practical terms the maximum outputpossible as a result of resource limitations is, say, OM. Now theproblem before the decision-maker is to find out whether the output,which maximises profit, is OM or some other level of output to the leftof OM. It is obvious that economic theory is of no help for ON level ofoutput because it is not relevant in view of the resource limitations. Amanagerial economist here has to take the aid of linear programming,which enables the manager to optimise or search for the best valueswithin the limits set by inequality conditions. Another central assumption in the economic theory of the firm is that the entrepreneur strives to maximise his residual share, or profit. Several criticisms of this assumption have been made: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSo The theory is ambiguous, as it doesn’t clarify. Whether it is short or long run profit that is to be maximised. For example, in the short run, profits could be maximised by firing all research and development personnel and thereby eliminating considerable immediate expenses. This decision would, however, have a substantial impact on long-run profitability.o Certain questions create some confusion around the concept of profit maximisation. Should the firm seek to maximise the amount of profit or the rate of profit? What is the rate of profit? Is it profit in relation to total capital or profit in relation to shareholders’ equity?o There is no allowance for the existence of “psychic income” (Income other than monetary, power, prestige, or fame), which the entrepreneur might obtain from the firm, quite apart from his monetary income.o The theory does not recognise that under modern conditions, owners and managers are separate and distinct groups of people and the latter may not be motivated to maximise profits.o Under imperfect competition, maximisation is an ambiguous goal, because actions that are optimal for one will depend on the actions of the other firms.o The entrepreneur may not care to receive maximum profits but may simply want to earn “satisfactory profits”. This last point is particularly relevant from the behavioural science standpoint because it introduces a concept of satiation. The notion of satiation plays no role in classical economic theory. To explain business behaviour in terms of this theory, it is necessary to assume that the firm’s goals are not concerned with maximising profit, but with attaining a certain level or rate of profit, holding a certain share of the market or a BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS certain level of sales. Firms would try to satisfy rather than maximise. But according to Simon the satisfying model damages all the conclusions that can be derived concerning resource allocation under perfect competition. It focuses on the fact that the classical theory of the firm is empirically incorrect as a description of the decision-making process. Based on this notion of satiation, it appears that one of the main strengths of classical economic theory has been seriously weakened.Most corporate undertakings involve the investment of funds,which are expect to produce revenues over a number of years.The profit maximisation criterion provides no basis forcomparing alternatives that can promise varying flows ofrevenue and expenditure over time.The practical application of profit maximisation concept alsohas another limitation. It provides no explicit way ofconsidering the risk associated with alternative decisions.Two projects generating similar expected revenues in thefuture and requiring similar outlays might differ vastly asregarding the degree of uncertainty with which the benefitsto be generated. The greater the uncertainty associated withthe benefits, the greater the risk associated with the project.Baumol on the other hand is of the view that firms do notdevote all their energies to maximising profit. Rather acompany will seek to maximise its sales revenue as long as asatisfactory level of profit is maintained. Thus Baumol hassubstituted “Total sales revenue” for profits. Also, twodecision criteria or objectives have been advanced viz., asatisfactory level of profit and the highest sales possible. Inother words, the firm is no longer viewed as working towardsone objective alone. Instead, it is portrayed as aiming atbalancing two competing and non-consistent goals. Baumol’s BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmodel is based on the view that managers’ salaries, theirstatus and other rewards often appear as closely related tothe companies’ size in which they work and is measured bysales revenue rather than their profitability. As such,managers may be more concerned to increased size thanprofits. And the firm’s objective thus becomes salesmaximisation rather than profits maximisation.Empirical studies of pricing behaviour also give results thatdiffer from those of the economic theory of firm as can beseen from the following examples: o Several studies of the pricing practices of business firms have indicated that managers tend to set prices by applying some sort of a standard mark-up on costs. They do not attempt to estimate marginal costs, marginal revenues or demand elasticities, even if these could be accurately measured. o For many firms, prices are more often set to attain, a particular target return on investment, say, 10 per cent, than to maximise short or long-run profits. o There is some evidence that firms experiencing declining market shares in their industry strive more vigorously to increase their sales than do competing firms, which are experiencing steady or increasing market shares.An alternative model to profit maximisation is the concept ofwealth maximisation, which assumes that firms seek tomaximise the present value of expected net revenues over allperiods within the forecasted future.As pointed out by Haynes and Henry, a study of thebehaviour of actual firms shows that their decisions are notcompletely determined by the market. These firms have somefreedom to develop decisions, strategies or rules, whichbecome part of the decision-making system within the firm. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS This gap in economic theory has led to what has come to be known as ‘Behavioural Theory of the Firm’. This theory, however, does not replace the former but rather powerfully supplements it. The behavioural theory represents the firm as an adoptive institution. It learns from experience and has a memory. Organisational behaviour, is embodies into decision rules and standard operating procedures. These may be altered over long run as the firm reacts to “feedback” from experience. However, in the short run, decisions of the organisation are dominated by its rules of thumb and standard methods.CONCLUSIONThe various gaps between the economic theory of the firm and theactual decision-making process at the firm level are many in number.They do, however, stress that economic theory seriously needs majorfixing up and substantial changes are in progress for creating betterand different models. Thus the classical economic concepts like thoseof rational man is undergoing important changes; the notion ofsatisfying is pushing aside the aim of maximisation and newer linesand patterns of thoughts are being developed for finding improvedapplications to managerial decision-making. A strong emphasis is laidon quantitative model building, experimentation and empiricalinvestigation and newer techniques and concepts, such as linearprogramming, game theory, statistical decision-making, etc., arebeing applied to revolutionise the approaches to problem solving inbusiness and economics.MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIESA managerial economist can play a very important role by assisting themanagement in using the increasingly specialised skills andsophisticated techniques, required to solve the difficult problems ofsuccessful decision-making and forward planning. In business BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSconcerns, the importance of the managerial economist is thereforerecognised a lot today. In advanced countries like the USA, largecompanies employ one or more economists. In our country too, bigindustrial houses have understood the need for managerial economists.Such business firms like the Tatas, DCM and Hindustan Lever employeconomists. A managerial economist can contribute todecision-making in business in specific terms. In this connection, twoimportant questions need be considered: 1. What role does he play in business, that is, what particular management problems lend themselves to solution through economic analysis? 2. How can the managerial economist best serve management, that is, what are the responsibilities of a successful managerial economist?Role of a Managerial EconomistOne of the principal objectives of any management in itsdecision-making process is to determine the key factors, which willinfluence the business over the period ahead. In general, these factorscan be divided into two categories: External Internal The external factors lie outside the control of managementbecause they are external to the firm and are said to constitutebusiness environment. The internal factors lie within the scope andoperations of a firm and hence within the control of management, andthey are known as business operations. To illustrate, a business firm isfree to take decisions about what to invest, where to invest, how muchlabour to employ and what to pay for it, how to price its products, andso on. But all these decisions are taken within the framework of aparticular business environment, and the firm’s degree of freedomdepends on such factors as the government’s economic policy, theactions of its competitors and the like. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSEnvironmental Studies of a Business FirmAn analysis and forecast of external factors constituting generalbusiness conditions, for example, prices, national income and output,volume of trade, etc., are of great significance since they affect everybusiness firm. Certain important relevant factors to be considered inthis connection are as follows: The outlook for the national economy, the most important local, regional or worldwide economic trends, the nature of phase of the business cycle that lies immediately ahead. Population shifts and the resultant ups and downs in regional purchasing power. The demand prospects in new as well as established markets. Impact of changes in social behaviour and fashions, i.e., whether they will tend to expand or limit the sales of a company’s products, or possibly make the products obsolete? The areas in which the market and customer opportunities are likely to expand or contract most rapidly. Whether overseas markets expand or contract and the affect of new foreign government legislations on the operation of the overseas plants? Whether the availability and cost of credit tend to increase or decrease buying, and whether money or credit conditions ahead are likely to easy or tight? The prices of raw materials and finished products. Whether the competition will increase or decrease. The main components of the five-year plan, the areas where outlays have been increased and the segments, which have suffered a cut in their outlays. The outlook to government’s economic policies and regulations and changes in defence expenditure, tax rates tariffs and import restrictions. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Whether the Reserve Bank’s decisions will stimulate or depress industrial production and consumer spending and how will these decisions affect the company’s cost, credit, sales and profits. Reasonably accurate data regarding these factors can enable themanagement to chalk out the scope and direction of their ownbusiness plans effectively. It will also help them to determine thetiming of their specific actions. And it is these factors, which presentsome of the areas where a managerial economist can make effectivecontribution. The managerial economist has not only to study theeconomic trends at the micro-level but also must interpret theirrelevance to the particular industry or firm where he works. He has todigest the ever-growing economic literature and advise topmanagement by means of short, business-like practical notes. Inmixed economy like that of India, the managerial economistpragmatically interprets the intentions of controls and evaluates theirimpact. He acts as a bridge between the government and the industry,translating the government’s intentions and transmitting the reactionsof the industry. In fact, the government policies emerge out of theperformance of industry, the expectations of the people and politicalexpediency.Business OperationsA managerial economist can also be helpful to the management inmaking decisions relating to the internal operations of a firm inrespect of such problems as price, rate of operations, investment, expansion or contraction. Certain relevant questions in this context would be as follows: What will be a reasonable sales and profit budget for the next year? What will be the most appropriate production schedules and inventory policies for the next six months? What changes in wage and price policies should be made now? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS How much cash will be available next month and how should it be invested?Specific FunctionsThe managerial economists can play a further role, which can coverthe following specific functions as revealed by a survey pertaining toBrittain conducted by K.J.W. Alexander and Alexander G. Kemp: Sales forecasting. Industrial market research. Economic analysis of competing companies. Pricing problems of industry. Capital projects. Production programmes. Security / Investment analysis and forecasts. Advice on trade and public relations. Advice on primary commodities. Advice on foreign exchange. Economic analysis of agriculture. Analysis of underdeveloped economics. Environmental forecasting. The managerial economist has to gather economic data, analyse allrelevant information about the business environment and prepareposition papers on issues facing the firm and the industry. In the caseof industries prone to rapid theological advances, the manager mayhave to make continuous assessment of tl1e impact of changingtechnology. The manager may need to evaluate the capital budget inthe light of short and long-range financial, profit and marketpotentialities. Very often, he also needs to prepare speeches for thecorporate executives. It is thus clear that in practice, managerialeconomists perform many and various functions. However, of all these,the marketing functions, i.e., sales force listing an industrial market BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSresearch, are the most important. For this purpose, the managers may collect statistical records ofthe sales performance of their own business and those rehiring totheir rivals, carry out analysis of these records and report on trends indemand, their market shares, and the relative efficiency of their retailoutlets. Thus, while carrying out heir functions, the managers mayhave to undertake detailed statistical analysis. There are, of course,differences in the relative importance of· the various functionsperformed from firm to firm and in the degree of sophistication of themethods used in performing these functions. But there is no doubtthat the job of a managerial economist requires alertness and theability to work uriderpressure.Economic IntelligenceBesides these functions involving sophisticated analysis, managerialeconomist may also provide general intelligence service. Thus theeconomist may supply the management with economic information ofgeneral interest such as competitorsprices and products, tax rates, tariff rates, etc.Participating in Public DebatesMany well-known business economists participate in public debates.The government and society alike are seeking their advice and views.Their practical experience in business and industry adds prestige totheir views. Their public recognition enhances their protégé in the .firm itself.Indian ContextIn the Indian context, a managerial economist is expected to performthe following functions: Macro-forecasting for demand and supply. Production planning at macro and micro levels. Capacity planning and product-mix determination. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Economics of various production lines. Economic feasibility of new production lines / processes and projects. Assistance in preparation of overall development plans. Preparation of periodical economic reports bearing on various matters such as the companys product-lines, future growth opportunities, market pricing situation, general business,. and various national/international factors affecting industry and business. Preparing briefs; speeches, articles and papers for top management for various chambers, Committees, Seminars, Conferences, etc Keeping management informed of various national and International Developments on economic/industrial matters. With the adoption of the new economic policy, themacro-economic environment is changing fast and these changeshave tremendous implications for business. The managerialeconomists have to playa much more significant role. They ha1e toconstantly measure the possibilities of translating the rapidly changingeconomic scenario into workable business opportunities. As Indiamarches towards globalisation, the managerial economists will have tointerpret the global economic events and find out how the firm canavail itself of the various export opportunities or of establishing plantsabroad either wholly owned or in association with local partners.Responsibilities of a Managerial EconomistBesides considering the opportunities that lie before a managerialeconomist it is necessary to take into account the services that areexpected by the management. For this, it is necessary for amanagerial economist to thoroughly recognise the responsibilitiesand obligations. A managerial economist can serve the mana¬gementbest by recognising that the main objective of the business, is tomake a profit on its invested capital. Academic training and the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScritical comments from people outside the business may lead amanagerial economist to adopt an apologetic or defensive attitudetowards profits. There should be a strong personal conviction on partof the managerial economist that profits are essential and it isnecessary to help enhance the ability of the firm to make profits.Otherwise it is difficult to succeed in serving management. Most management decisions necessarily concern the future, whichis rather uncertain. It is, therefore, absolutely essential that amanagerial economist recognises his responsibility to makesuccessful forecast. By making the best possible forecasts andthrough constant efforts to improve, a managerial ng, the risksinvolved in uncertainties. This enables the management to· follow amore orderly course of business planning. At times, it is required forthe managerial economist to reassure the management that animportant trend will continue. In other cases, it is necessary to pointout the probabilities of a turning point in some activity of importanceto management. In any case, managerial economist must be willing tomake fairly positive statements about impending economicdevelopments. These can be based upon the best possibleinformation and analysis. The managements confidence in amanagerial economist increases more quickly and thoroughly witha record of successful forecasts, well documented in advance andmodestly evaluated when the actual results become available. A few consequences to the above proposition need also be emphasised here. First, a managerial economist has a major responsibility to alert mana¬gelI1ent at the earliest possible moment in case there is an err6r in his forecast. This will assist the mallagement in making appropriate adjustment in policies and programmes and strengthen his oWn position as a member of the management team by keeplrighis fingers on the economic pulse of the business. Secondly, a managerial economist must establish and maintain BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS many contacts with individuals and data sources: which would not be imme¬diately available to the other members of the management. Extensive familiarity with reference sources and material is essential. It is still more important that the known individuals who are specialists in particular fields have a bearing on tpe managerial economists work. For this purpose, it is required that managerial economist joins professional associations and tak~ active part in them. In fact, one of the best means of determining the quality of a managerial economist is to evaluate his ability to obtain information quickly by personal contacts rather than by lengthy research from either readily available or obscure reference sources. Within any business, there may be a wealth of knowledge and experience but the managerial economist would be really useful ifit is possible pn his part to supplement the existing know-how with additional information and in the quickest possible manner. Again, if a managerial economist is to be really helpful to themanagement in successful decision-making and forward planning, itis necessary" to able to earn full status on the business team.Readiness to take up special assignments, be that in study teams,committees or special projects is another important requirement. Thisis because it is necessary for the managerial economist to wincontinuing support for himself and his professional ideas. Clarity ofexpression and attempting to minimise the use of technicalterminology while communJcating his ideas to management executivesis also an essential role so as to win approval. To conclude, a managerial economist has a very important role toplay by helping management in successful decision-making andforward planning. But to discharge his role successfully, it is necessaryto recognise the relevant responsibilities and obligations. To somebusiness executives, however, a managerial economist is still a luxuryor perhaps even a necessary evil. It is not surprising, therefore, to findthat while tneir status is improving and their impor;ance is gradually BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSrising, managerial economists in certain firms still feel quite insecure.Nevertheless, there is a definite and growing realisation that they cancontribute significantly to the profitable growth of firms and effectivesolution oftMir problems, and this promises them a positive future.REVIEW QUESTIONS 1. What is managerial economics? How does it differ from traditional economics? 2. Discuss the nature and scopeofmanagerial economics. 3. Show the significance of economic analysis in business decisions. 4. Managerial Economics is perspective rather than descriptive in character? Examine this statement. 5. Assess the contribution and limitations of economic analysis to business decision-making. 6. Briefly explain the five principles, which are basic to the entire gamut of managerial economics. 7. Explain the role of marginal analysis in determining optimal solution if managerial economics. How does it compare with break-even analysis? 9.Discuss some of the important economic concepts and techniques that help busirless management. 10.Explain the various functions of a managerial economist. How can he best serve the management? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS LESSON – 2 DEMAND ANALYSISDemand is one of the crucial requirements for the existence of anybusiness firm. Firms are interested in their profit and sales, bothof which depend partially upon the demand for the product. Thedecisions, which management makes with respect to production,advertising, cost allocation, pricing, inventory holdings, etc. callfor an analysis of demand. While how much a firm can producedepends upon its capacity and demand for its products. If there isno demand for a product, its production is unworthy. If demandfalls short of production, one way to balance the two is to createnew demand through more and better advertisements. The morethe future demand for a product, the more inventories the firmwould hold. The larger the demand for a firms product, the higheris the price it can charge. Demand analysis seeks to identify and measure the forces thatdetermine sales. Once this is done the alternative ways ofmanipulating or managing demand can easily be inferred.Although, demand for a finris product reflects what theconsumers buy, this can be influenced through manipulating thefactors on which consumers base their demands. Demand analysisattempts to estiinate the demand for a product in future, whichfurther helps to plan production based on the estimated demand.MEANING OF DEMAND Demand for a good implies the desire of an individual to acquire the product. It also includes willingness and ability of ail individual to pay for the product. For example, a misers desire for and his ability to pay for a car is not demand, for he does not have the necessary will to pay for the car. Similarly, a poor persons desire for· and his willingness to pay for a car is not demand because he lacks the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSnecessary purchasing power. One can also imagine an individual,who possesses both the will and the purchasing power to pay for agood. But this purchasing power is not the demand for that good,this is because he does not have the desire to buy that product.Therefore, demand is successful when there are all the three factors:desire, willingness and ability. It should also be noted that demandfor any goods or services has no meaning unless it is stated withreference to time, price, competing product, consumers incomes,tastes and preferences. This is because demand varies withfluctuations in these factors. For example, the demand for anAmbassador car in India is 40,000 is meaningless unless it is statedthat this was the demand ·in 1976 when an Ambassador cars pricewas around thirty thousand rupees. The price of the competing cars’prices were around the same, a Bajaj scooters price was around fivethousand rupees and petrol price was around three and a half rupeesper litre. In 1977, the demand for Ambassador cars could bedifferent if any of the above factors happened to be different.Furthermore, it should be noted that a product is defined withreference to its particular quality. If its quality changes it can bedeemed as another product. Thus, the demand for any product is thedesire, wi1lihigness and ability to buy the product with reference toa partkular time and given values of variables on which it depends.TYPES OF DEMANDThe demand for various kinds of goods is generally classified on thebasis of kinds of consumers, suppliers of goods, nature of goods,duration of consumption goods, interdependence of demand,period of demand and nature of use of goods (intermediate or final),The major classifications of demand are as follows: Individual and market demand Demand for firms prodtictand industrys products Autonomous and derived demand Demand for durable and non-durable goods BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Short-term and long-term demand Individual and Market DemandThe quantity of a product, which an individual is willing to buy at aparticular price during a specific time period, given his moneyincome, his taste, and prices of other commodities (particularlysubstitutes and complements), is called individuals demand for aproduct. The total quantity, which all comsumers are willing to buyat a given price per time unit, given their money income, taste, andprices of other commodities is known as market demand for thegood. In other words, the market demand for a good is the sum ofthe individual demands of all the c6-nsumers of a product, over atime period at given prices.Demand for Firms Product and Industrys ProductsThe quantity of a firms yield, that can be disposed of at a given priceover a period refers to the demand for firms product. The aggregatedemand for the product of all firms of an industry is known as themarket-demand or demand for industrys product. This distinctionbetween the two kinds of demand is not of much use in a highlycompetitive market since it merely signifies the distinction between asum and its parts. However, where market structure is oligopolistic, adistinction between the demand for firms product and industrysproduct is useful from managerial point of view. The product of eachfirm is so differentiated from the products of the rival firms thatconsumers treat each product different from the other. This givesfirms an opportunity to plan the price of a product, advertise it inorder to capture a larger market share thereby to enhance profits. Forinstance, market of cars, radios, TV sets, refrigerators, scooters,toilet soaps and toothpaste, all belong to this category of markets. In case of monopoly and perfect competition, the distinctionbetween demand for a firms product and industrys product is not ofmuch use from managerial point of view. In case of monopoly, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSindustry is one-firmindustiy andthe demand for firms product is thesame as that of the industry. In case of perfect competition, productsof all firms .of the industry are homogeneous and price for each firmis determined by industry. Firms have little opportunity to plan theprices permissible under local conditions and advertisement by afirm becomes effective for the whole industry. Therefore, conceptualdistinction between demand for films product and industrysproduct is not much use in business decisions making.Autonomous and Derived DemandAn Autonomous demand for a product is one that arisesindependently of the demand for any other good whereas a deriveddemand is one, which is derived from demand of some other good. Tolook more closely at the distinction between the two kinds of demand,consider the demand for commodities, which arise directly from thebiological or physical needs of the human beings, such as demand forfood, clothes and shelter. The demand for these goods is autonomousdemand. Autotnomous demand also arises as a result ofdemonstration effect, rise in income, and increase in population andadvertisement of new produCts. On the other hand, the demand for agood that arises because of the demand for some other good is calledderived demand. For instance, demand for land, fertiliser andagricultural tools and implements are derived demand, since thedemand of goods, depends on the demand of food. Similarly, demandfor steel, bricks, cement etc., is a derived demand because it isderived from the demand for houses and other kind of buildings. [ngeneral, the demand for, producer goods or industrial inputs is aderived one. Besides, demand for complementary goods (whichcomplement the use of other goods) or for supplementary goods(which supplement or provide additional utility from the use of othergoods) is a derived demand. For instance petrol is a complementarygoods for automobiles and a chair is a complement to a table.Consider some examples of supplement goods. Butter is supplement BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSto bread, mattress is supplement to cot and sugar is supplement totea. Therefore, demand for petrol, chair, and sugar would beconsidered as derived demand. The conceptual distinction betweenautonomous demand and derived demand would be useful accordingto the point of view of a bllsinessman to the extent the former canserve as an indicator of the latter.Demand for Durable and Non-durable GoodsDemand is often classified under demand for durable and non-durablegoods. Durable goods are those goods whose total utility is notexhausted in single or short-run use. Such goods can be usedcontinuously over a period of time. Durable goods may be consumergoods as well as producer goods. Durable consumer goods includeclothes, shoes, house furniture, refrigerators, scooters, and cars. Thedurable producer goods include mainly the items under fixed assets,such as building, plant and machinery, office furniture and fixture. Thedurable goods, both consumer and producer goods, may be furtherclassified as semi-durable goods such as, clothes and furniture anddurable goods such as residential and factory buildings and cars. Onthe other harid, non-durable goods are those goods, which can beused only once such as food items and their total utility is exhaustedin a single use. This category of goods can also be grouped undernon-durable consumer and producer goods. All food items such asdrinks, soap, cooking fuel, gas, kerosene, coal and cosmetics fall inthe former category whereas, goods such as raw materials, fuel andpower, finishing materials and packing items come in the lattercategory. The demand for non-durable goods depends largely on theircurrent prices, consumers income and fashion whereas the expectedprice, income and change in technology influence the demand for thedurable good. The demand for durable goods changes over a relativelylonger period. There is another point of distinction between demandsfor durable and non-durable goods. Durable goods create demand for BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSreplacement or substitution of the goods whereas non-durable goodsdo not. Also the demand for non-durable goods increases ordecreases with a fixed or constant rate whereas the demand fordurable goods increases or decreases exponentially, i.e., it maydepend· upon some factors such as obsolescence of machinery, etg.For example, let us suppose that the annual demand for cigarettes in acity is 10 million packets and it increases at the rate of half-a-millionpackets per annum on account of increase in population when otherfactors remain constant. Thus, the total demand for cigarettes in thenext year will be 10.5 million packets and 11 million packets in thenext to next year and so on. This is a linear increase in the demand fora non-durable good like cigarette. Now consider the demand for adurable good, e.g., automobiles. Let us suppose: (i1 the existingnumber of automobiles in a city, in a year is 10,000, (ii) the annualreplacement demand equals 10 per cent of the total demand, and (iii)the annual autonomous increase ·in demand is 1000 automobiles. Assuch, the total annual clemand for automobiles in four subsequentyears is calculated and presented in Table 2.1. Table 2.1: Annual Demand for AutomobilesBeginning Total no. of Replacement Annual Total Annualof the year automobiles demand autonomous demand increase (Stock) demand in , ; demand st 1 year 10,000 - - 10,000 - 2nd year 10,000 1000 1000 12,000 _ 2000 -3id year 12,000 1200 1000 14,200 2200 4th year 14,200 1420 1000 16,620 2420 Stock + Replacement + Autonomous demand = TotalDemand It may be seen from the Table 2.1 that the total demand forautomobiles is increasing at an increasing rate due to accelerationin the replacement demand. Another factor, which might acceleratethe demand for automobiles and such durable goods, is the rate ofobsolescence of this category of goods.Short-term and Long-term Demand BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSShort-term demand refers to the demand for goods that aredemanoed over a short period. In this category fall mostly the fashionconsumer goods, goods of seasonal use and inferior substitutesduring the scarcity period of superior goods. For instance, the demandfor fashion wears is short-term demand though the demand for thegeneric goods such as trousers, shoes and ties continues to remain along¬term demand. Similarly, demand for umbrella, raincoats,gumboots, cold drinks and ice creams is of seasonal nature; Thedemand for such goods lasts till the season lasts. Some goods of thiscategory are demanded for a very short period, i.e., 1-2 week, forexample, new greeting cards, candles and crackers on occasion ofdiwali. Although some goods are used only seasonally but are durable inpature, e.g., electric fans, woollen garments, etc. The demand for suchgoods is of also durable in nature but it is subject to seasonalfluctuations. Sometimes, demand for certain gools suddenly increasesbecause of scarcity of their superior substitutes. For examp1e, whensupply of cooking gas suddenly decreases, demand for kerosene,cooking coal and charcoal increases. In such cases, additional demandis of shGrt¬term nature. The long-term demand, on the hand, refersto the demand, which exists over a long-period. The change inlong-term demand is visible only after a long period. Most genericgoods have long-term demand. For example, demand for consumerand producer goods, durable and non-durable goods, is long-termdemand, though their different varieties or brands may have onlyshort-term demand. Short-term demand depends, by and large, onthe price of commodities, price of their substitutes, current disposableincome of the consumer, their ability to adjust their consumptionpattern and their susceptibility to advertisement of a new product. Thelong-term demand depends on the long-term income trends,availability of better substitutes, sales promotion, and consumer creditfacility. The short-term and lcmg-term concepts of demand are usefulin designing new products for established producers, choice of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSproducts for the new entrepreneurs, in pricing policy and indetermining advertisement expenditure.DETERMIN!NTS OF MARKET DEMANDThe knowledge of the determinants of market demand for a productand the nature of relationship between the demand and itsdeterminants proves very helpful in analysing and estimating demandfor the product. It may be noted at the very outset that a host offactors determines the demand for a product. In general, followingfactors determine market demand for a good: Price of the good- . Price of the related goods-substitutes, complements and supplements Level of consumers income Consumers taste and preference Advertisement of the product Consumers expectations about future price and supply position Demonstration effect and bend-wagon effect’ Consumer-credit facility Population of the country Distribution pattern of national income. These factors also include factors such as off-season discountsand gifts on purchase of a good, level of taxation and general socialand political environment of the country. However, all these factorsare not equally important. Besides, some of them are not quantifiable.For example, consumers preferences, utility, demonstration effectand expectations, are difficult to measure. However, both quantifiableand non-quantifiable determinants of demand for a product will bediscussed.1. Price of the ProductThe price of a product is one of the most important determinants of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdemand in the long run and the only determinant in the short run.The price and quantity demanded are inversely related to each other.The law of demand states that the quantity demanded of a good or aproduct, which its consumers would like to buy per unit of time,increases when its price falls, and decreases when its price increases,provided the other factors remain same. The assumption otherfactors remaining same implies that income of the consumers, pricesof the substitutes and complementary goods, consumers taste andpreference and number of consumers remain unchanged. Theprice-demand relationship assumes a much greater significance in theoligopolistic market in which outcome of price war between a firm andits rivals determines the level of success of the firm. The firms have tobe fully aware of price elasticity of demand for their own products andthat of rival firms goods.2. Price of the Related Goods or ProductsThe demand for a good is also affected by the change in the price ofits related goods. The related goods may be the substitutes orcomplementary goods.SubstitutesTwo goods are said to. be substitutes of each other if a change in priceof one good affects the deinand for the other in the same direction.For instance goods X and Y are considered as substitutes for eachother if a rise in the price of X increase demand for Y, and vice versa.Tea and coffee, hamburgers and hot-dog, alcohol and drugs are someexamples of substitutes in case of consumer goods by definition, therelation between demand for a product and price of its substitute is ofpositive nature. When, price of the substitute of a product (tea) falls (orincrease), the demand for the product falls (or increases). Therelationship of this nature is shown in Figure 2.1 and 2.2. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSComplementary GoodsA good is said to be a complement for another when it complementsthe use of the other or when the two goods are used together in sucha way that their demand changes (increases or decreases)simultaneously. For example, petrol is a complement to car andscooter, butter and jam to bread, milk and sugar to tea and 1 coffee,mattress to cot, etc. Two goods are termed as complementary to eachother -i if an increase in the price of one causes a decrease in demandfor the other. By definition, there is an inverse relation between thedemand for a good and the price of its complement. For instance, anincrease in the price of petrol causes a decrease in the demand for carand other petrol-run vehicles and vice versa while other thingsremaining constant. The nature of relationship between the demand BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSfor a product and the price of its complement is given in Figure 2.2.3. Consumes IncomeIncome is the basic determinant of market demand since itdetermines the purchasing power of a consumer. Therefore, peoplewith higher current disposable income spend a larger amount ongoods and services than those with lower income. Income-demandrelationship is of more varied nature than that between demandand its other determinants. While other determinants of demand,e.g., products own price and the price ohts substitutes, are moresignificant in the short-run, income as a determinant of demand isequally important in both short run and long run. Beforeproceeding further to discuss income-demand relationships, it willbe useful to note that consumer goods of different nature havedifferent kinds of relationship with consumers having differentlevels of income. Hence, the managers need to be fully aware of thekinds of goods they are dealing with and their relationship with theincome of consumers, particularly about the assessment of bothexisting and prospective demand for a product. For the purpose of income-demand analysis, goods and serv:icesmaybe grouped under four broad categories, which ate: (a) essentialconsumer goods, (b) inferior goods, (c) normal goods, and (d) prestigeor luxury goods. To understand all these terms, it is essential tounderstand the relationship between income and different kinds ofgoods. Esscntial Consumcr Goods (ECG): The goods and services of this category are called basic needs and are consumed by all persons of a society such as food-grains, salt, vegetable oils, matches, cooking fuel, a minimum clothing and housing. Quantity demanded for these goods increases with increase in consumers income but only up to certain limit, even though the total expenditure may increase in accordance with the quality of goods consumed, other factors remaining the same. The relationship between goods of this category and consumers BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS income is shown by the curve ECG in Figure 2.3. As the curve shows, consumers demand for essential goods increases only until his income rises to OY2. It tends to saturate beyond this level of income.Inferior goods: Inferior goods are those goods whose demand decreases with the increase in consumers income. For example millet is inferior to wheat and rice; bidi (indigenous cigarette) is inferior to cigarette, coarse, textiles are inferior to refined ones, kerosene is inferior to cooking gas and travelling by bus is inferior to travelling by taxi. The relation between income and demand for an inferior good is shown by the curve IG in Figure 2.3 under the assumption that other determinants of demand remain the same demand for such goods rises only up to a certain level of income, i.e., OY1 and declines as income increases beyond this level. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Normal goods: Normal goods are those goods whose demand increases with increaseiri the consumer income. For example, clothings, household furniture and automobiles. The relation between income and demand for normal goods is shown by the curve NG in Figure 2.3. As the curve shows, demand for such goods increases with the increases in consumer income but at different rates at different levels of income. Demand for normal goods increases rapidly with the increase in the consumers income but slows down with further increase in income. It should be noted froms Figure 2.3 that up to certain level of income (YI) the relation between ¬income and demand for all type of goods is similar. The difference is of only degree. The relation becomes distinctly different beyond YI level of income. Therefore, it is important to view the income-demand relations in the light of the nature of product and the level fconsumers income. Prestige and luxury goods: Prestige goods are those goods, which are consu!TIed mostly by rich section of the society, e.g., precious stones, antiques, rare paintings, luxury cars and such other items of show-bff. Whereas luxury goods include jewellery, costly brands of cosmetics, TV sets, refrigerators, electrical gadgets and cars. Demand for such goods arises beyond a certain level of consumers income, i.e., consumption enters the area of luxury goods. Producers of such goods, while assessing the demand for their goods, should consider the income changes in the richer section of the society and not only the per capita income. The relation between income and demand for such goods is shown by the curve LG in Figure 2.3.4. Consumers taste and preferenceConsumers taste and preference play an important role in BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdetennihing demand for a product. Taste and preference depend,generally, on the changing. life-style, social customs, religious valuesattached to a good, habi of the people, the general levels of living ofthe society and age and sex of the consumers. Change in thesefactors changes consumers taste and preferences. As a result,consumers reduce or give up the consumption of some goods andadd new ones to their consumption pattern. For example, followingthe change in fashion, people switch their consumption pattern fromcheaper, old-fashioned goods to costlier ‘mod’ goods, as long asprice differentials are proportionate with their preferences.Consumers are prepared to pay higher prices for mod goods even iftheir virtual utility is the same as that of old-fashioned goods. Themanufacturers of goods and services that are subject to frequentchange in fashion and style, can take advantage of this situation intwo ways: (i) they can make quick profits by designing new models oftheir goods and popularising them through advertisement, and (ii)they can plan production in abetter way and can even avoidover-productiorlifthey keep an eye on the changing fashions.5. Advertisel11ent ExpenditureAdvertisement costs are incurred with the objective of increasing thedemand for the goods. This is done in the following ways: By informing the potential consumers about the availability of the goods. By showing its superiority to the rival goods. By influencing consumers choice against the rival goods, and By setting fashions and changing tastes. The impact of such effects shifts the demand curve upward to theright. In other words, when other factors remain same, the expenditureon advertisement increases the volume of sales to the same extent.The relation between advertisement outlay and sales is shown inFigure 2.4. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSAssumptionsTherelatiqnship between demand and advertisement cost as shown inFigure 2.4 is based on the following assumptions: Consumers are fairly sensitive and responsive to various modes of advertisement. The rival firms do not react to the advertisements made by a firm. The level of demand has not already reached the saturation point. Advertisement beyond this point will make only marginal impact on demand. Per unit cost of advertisement added to the price does not make the price prohibitive for consumers, as compared particularly to the price of substitutes. Others determinants of demand, e.g., income and tastes, etc., are not operating in the reverse direction. In the absence of these conditions, the advertisement effect onsales may be unpredictable.6. Consumers’ ExpectationsConsumers’ expectations regarding the future prices, income and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSsupply position of goods play an important role in determining thedemand for goods and services in the short run. If consumers expect arise in the price of a storable good, they would buy more of it at itscurrent price with a view to avoiding the possibility of price rise future.On the contrary, if consumers expect a fall in the price of certaingoods, they postpone their purchase with a view to take advantage oflower prices in future, mainly in case of non-essential goods. Thisbehaviour of consumers reduces the current demand for the goodswhose prices are expected to decrease in future. Similarly, an expectedincrease in income increases the demand for a product. For example,announcement of ‘dearness allowance’, bonus and revision of payscale induces increase in current purchases. Besides, if scarcity ofcertain goods is expected by the consumers on account of reportedfall in future production, strikes on a large scale and diversion of civilsupplies towards the military use causes the current demand for suchgoods to increase more if their prices show an upward trend.Consumer demand more for future consumption and profiteersdemand more to make money out of expected scarcity.7. Demonstration EffectWhen new goods or new models of existing ones appear in themarket, rich people buy them first. For instance, when a new model ofcar appears in the market, rich people would mostly be the first buyer,Colour TV sets and VCRs were first seen in the houses of the richfamilies some people buy new goods or new models of goodsbecause they have genuine need for them. Some others do sobecause they want to exhibit their affluence. But once new goodscome in fashion, many households buy them not because they have agenuine need for them but because their neighbors have bought thesame goods. The purchase made by the latter category of the buyersare made out of such feelings as jealousy, competition, equality inthe peer group, social inferiority and the desire to raise their socialstatus. Purchases made on account of these factors are the result of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSwhat economists call demonstration effect or theBand-wagon-effect. These effects have a positive effect on demand.On the contrary, when goods become the thing of common use, somepeople, mostly rich, decrease or give up the consumption of suchgoods. This is known as Snob Effect. It has a negative effecton thedemandfor the related goods.8. Consumer-Gredit FacilityAvailability of credit to the cansumers fram the sellers, banks,relatians and friends encourages the conSumers to buy more thanwhat they would buy in the aosence of credit availability. Therefore,the consumers who can borrow more can consume more than thosewho cannot borrow. Credit facility affects mostly the demand"fordurable goods, particularly those, which require bulk payment at thetime of purchase. The car-loan facility may be one reason why Delhihas more cars than Calcutta, Chennai and Mumbai. Therefore, themanagers who are assessing the prospective demand for their goodsshould take into account the availability of credit to the consumers.9. Population of the CountryThe Jotal domestic demand for a good of mass consumption dependsalso on the size of the population. Therefore, larger the populationlarger will be the demand for a product, when price, per capitaincome, taste and preference are given. With an increase or decreasein the size of population, employment percentage remaining thesame, demand for the product will either increase or decrease.10. Distribution of National IncomeThe level of national income is the basic determinant of the marketdemand for a good. Therefore, pig her the national income higher willbe the demand for all normal goods and services. Apart from this, thedistribution pattern of the national income is also an importantdeterminant for demand of a good. If national income is evenly BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdistributed, market demand for normal goods will be the largest. Ifnational income is unevenly distributed, i.e., if majority of populationbelongs to the lower income groups, market demand for essentialgoods, including inferior ones, will be the largest whereas thedemand for other kinds of goods will be relatively less.REVIEW QUESTIONS 1. Give short note on Demand Analysis. 2. What are the determinants of market demand for a good? How do the changes in the following factors affect the demand for a good? A. Price B. Income C. Price of the substitute D.Advertisement E. Population. Also describe the nature of relationship between demand for a good and these factors (consider one factor at a time assuming other factors to remain constant). 3. Explain different types of determinants of demand. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS LESSON - 3 COST CONCEPTSBusiness decisions are generally taken on the basis of money values ofthe inputs and outputs. The cost production expressed in monetaryterms is an important factor in almost all business decisions, speciallythose pertaining to (a) locating the weak points in productionmanagement; (b), minimising the cost; (c) finding out the optjmumlevel of output; and (d) estimating or projecting the cost of businessoperations. Besides, the term cost has different meanings underdifferent settings and is subject to varying interpretations. It istherefore essential that only relevant concept of costs is used in thebusiness decisions.CONCEPT OF COSTThe concepts of cost, which are relevant to business operations anddecisions, can be grouped, on the basis of their purpose, under twooverlapping categories such as concepts used for accounting purposesand concepts used in economic analysis of business activities.SOME ACCOUNTING CONCEPTS OF COSTOpportunity Cost and Actual CostOpportunity cost is the loss incurred due to the unavoidable situationssuch as scarcity of resources. If resources were unlimited, there wouldbe no need to forego any income yielding opportunity and, therefore,there would be no opportunity cost. Resources are scarce but havealternative uses with different returns, Resource owners who aim atmaximising of income put their scarce resources to their mostproductive use and forego the income expected from the second bestuse of the resources. Thus, the opportunity cost may be defined as theexpected returns from the second best use of the resources foregone BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdue to the scarcity of resources. The opportunity cost is also called thealternative cost. For example, suppose that a person hps a sum of Rs. lOO,OOO for which he has only two alternative uses. He can buy either a printing machine or, alternatively, a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000. If he is a profit maximising investor, he would invest his tnoney in printing machine and forego the expected income from the lathe. The opportunity cost of his income from printing machine is,· the expected income from the lathe machine, i.e., Rs. l5,000. The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost of using resources in thePrinting business is the best opportunity ahdthe expected return from the lathe machine is the second best alternative. In assessing the alternative cost, both explicit and implicit costs are taken into account. Associated with the concept of opportunity cost is the concept of economic rent or economic profit. In our example, economic rent of the printing machine is the excess of its earning over the income expected from the lathe machine (i.e., Rs. 20,000 - Rs. 15,000 = Rs. 5,000). The implication of this concept for a businessman is that investing in printing machine is preferable as long as its economic rent is greater than zero. Also, if firms have knowledge of the economic rent of the various alternative uses of their resources, it will be helpful for them to choose the best Investment A venue. In contrast to opportunity cost, actual costs are those which are actually incurred by the firm in the payment for labour, material, plant, building, machinery, equipments, travelling and transport, advertisement, etc. The total money expenditures, recorded in the books of accounts are, the actual costs, Therefore, the actual cost comes under the accounting concept. Business Costs and Full CostsBusiness.costs include all the expenses, which are incurred to carry BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSout a business. The concept of business costs is similar to the actualor the real costs. Business costs include all the payments andcontractual obligations made by the firm together with the book costof depreciation on plant and equipment. These cost concepts areused for calculating business profits and losses, for filing returns forincome tax and for other legal purposes. The concept of full costs,include business costs, opportunity cost and. normal profit. As statedearlier the oppor¬tunity cost includes the expected earning from thesecond best use of the resources, or the market rate of interest on thetotal money capital and the value of entrepreneurs own services,which are not charged forin the current business. Normal profit is anecessary minimum earning in addition to the opportunity cost, whicha firm must get to remain in its present occupation.Explicit and Implicit or Imputed CostsExplicit costs are those, which fall under actual or business costsentered in the books of accounts. For example, the payments forwages and salaries, materials, licence fee, insurance premium anddepreciation charges etc. These costs involve cash payment and, arerecorded in normal accounting practices. In contrast with these costs,there are other costs, which neither take the form of cash outlays, nordo they appear in the accounting system. Such costs are known asimplicit or imputed costs. Implicit costs may be defined as the earningexpected froin the¬second best alternative use of resources. Forexample, suppose an entrepreneur does not utilise his services in hisown business and works as a manager in ·some other firm on a salarybasis. If he starts his own business, he foregoes his salary as amanager. This loss of salary is the opportunity cost of income from hisbusiness. This is an implicit cost of his business. The cost is implicit,because the entrepreneur suffers the loss, but does not charge it asthe explicit cost of his own business. Implicit costs are not taken intoaccount while calculating the loss or gains of the business, but theyform an important consideration in whether or not a factor would BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSremain in its present occupation. The explicit and implicit coststogether make the economic cost.Out-of-Pocket and Book CostsThe items of expenditure, which involve cash payments or cashtransfers recurring and non-recurring are known as out-of-pocketcosts. All the explicit costs such as wage, rent, interest and transportexpenditure. On the contrary, there are actual business costs, whichdo not involve cash payments, but a provision is made for them in thebooks of account. Thes costs are taken into account while finalisingthe profit and loss accounts. Such expenses are known as book costs.In a way, these are payments that the firm needs to pay itself such asdepreciation allowances and unpaid interest on the businessmansown fund.Fixed and Variable CostsFixed costs are those, which are fixed in volume for a given output.Fixed cost does not vary with variation in the output between zero andany certain level of output. The costs that do not vary for a certainlevel of output are known as fixed cost. The fixed costs include cost ofmanagerial and administrative staff, depreciation of machinery,building and other fixed assets and maintenance of land, etc. Variable costs are those, which vary with the variation in the totaloutput. They are a function of output. Variable costs inclue cost of rawmaterials, running cost on fixed capital, such as fuel, repairs, routinemaintenance expenditure, direct labour charges associated with thelevel of output and the costs of all other inputs that vary with theoutput.Total, Average and Marginal CostsTotal cost represents the value of the total resource requirement forthe production of goods and services. It refers to the total outlays ofmoney expenditure, both explicit and implicit, on the resources usedto produce a given level of output. It includes both fixed and variable BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScosts. The total cost for a given output is given by the cost function. The Average Cost (AC) of a firm is of statistical nature and is notthe actual cost. It is obtained by dividing the total cost (TC) by thetotal output (Q), i.e., TC AC = = average cost Q Marginal cost is the addition to the total cost on account ofproducing an additional unit of the product. Or marginal cost is thecost of marginal unit produced. Given the cost function, it may bedefined as aTC AC= aQ These cost concepts are discussed in further detail in thefollowing section. Total, average and marginal cost concepts are usedin economic analysis of firms producti on activities.Short-run and Long-run CostsShort-run and long-run cost concepts are related to variable and fixedcosts, respectively, and often appear in economic analysi.sinterchangeably. Short-run costs are those costs, which change withthe variation in output, the size of the firm remaining the same. Inother words, short-run costs are the same as variable costs. Long-runcosts, on the other hand, are the costs, which are incurred on thefixed assets like plant, building, machinery, etc. Such costs havelong-run implication in the sense that these are not used up in thesingle batch of production. Long-run costs are, by implication, same as fixed costs. In thelong-run, however, even the fixed costs become variable costs as thesize of the firm or scale of production increases. Broadly speaking, theshort-run costs are those associated with variables in the utilisation offixed plant or other facilities whereas long-run costs are associated BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSwith the changes in the size and type of plant.Incremental Costs and Sunk CostsConceptually, increment natal costs are closely related to the conceptof marginal sot. Whereas marginal cost refers to the cost of themacgmalunit of output, incremental cost refers to the total additionalcost associated with the marginal batch of output. The concept ofincremental cost is based on a specific and factual principle. In the realworld, it is not practicable for lack of perfect divisibility of inputs toemploy factors for each unit of output separately. Besides, in the longrun, firms expand their production; hire more men, materials,machinery, and equipments. The expenditures of this nature are theincremental costs, anq not the marginal cost. Incremental· costs alsoarise owing to the change in product lines, addition or introduction ofa new product, replacement of worn out plan and machinery,replacement of old technique of production with a new one, etc. The sunk costs are those, which cannot be altered, increased or decreased, by varying the rate of output. For example, once it is decided to make incremental investment expenditure and the funds are allocated and spent, all the preceding costs are considered to be the sunk· costs since they accord to the prior commitment and cannot be revised or reversed when there is change in market conditions orchange in business decisions. Historical and Replacement CostsHistorical cost refers to the cost of an asset acquired· in the pastwhereas replacement cost refers to the outlay, which has to be madefor replacing an old asset. These concepts own their sigtlificance tounstable nature of price behaviour. Stable prices over a period of time,other things given, keep historical and replacement costs on par witheach other. Instability in asset prices, however, makes the two costsdiffer from each other. Historical cost of assets is used for accounting purposes, in theassessment of net worth of the firm. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Private and Social Costs We have so far discussed the cost concepts that are related to the working of the firm and those which are used in the cost-benefit analysis of the business decision process. There are, however, certain other costs, which arise due to functioning of the firm but do not normally appear in business decisions. Such costs are neither explicitly borne by the firms. The costs of this category are borne by-the society. Thus, the total cost generated by a firms working may be divided into two categories: • Those paid out or provided for by the firms, • Those not paid or borne by the firm. The costs that are not borne by the firm include use of resoucesfreely available and the disutility created in the process of production.The costs of the former category are known as private costs and of thelatter category are known as external or social costs. A few examplesof social cost are: Mathura Oil Refinery discharging its wastage in theYamuna River causes water pollution. Mills and factories located in citycause air pollution by emitting smoke. Similarly, plying cars, buses,trucks, etc., cause both air and noise pollution; Such pollutions causetremendous health hazards, which involve health cost to the society asit whole These costs are termed external costs from the firms point ofview and social cost from the societys point of view. The relevance ofthe social costs lies in understandipg the overall impact of firmsworking on the society as a whole and in working out the social cost ofprivate gains. A further distinction between private cost and social costtherefore, requires discussion. Private costs are those, which are actually incurred or providedby an individual or a firm on the purchase of goods and services fromthe market. For a firm, all the actual costs both explicit and implicitare private costs. Private costs are the internalised cost that isincorporated in the firms total cost of production. Social costs, on thehand refer to the total cost for the societyon account of production ofa commodity. Social cost can be the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSprivate cost or the external cost. It includes the cost of resources forwhich the firm is not compelled to pay a price such as rivers and lakes,the public, utility services like roadways and drainage system, the costin the form of disutility created in through air, water and noisepollution. This category is generally assumed to be equal to totalprivate and public expenditures. The private and public expenditures,however, serve only as an indicator of public disutility. They do notgive exact measure of the public disutility or the social costs.COST-OUTPUT RELATIONSThe previous section discussed the variou cost concepts, which help inthe business decisions. The following section contains the discussionof the behaviour of costs in relation to the change in output. This is, infact, the theory of production cost. Cost-output relations play an importai)t role in businessdecisions relating to cost minirnisalioil"OfprofiHnaximisation andoptimisation of output. Cost-output relations are specified through acost function expressed as T(C) = f(Q) (1) where, TC = total cost Q = quantity produced Cost functions depend on production function andmarket-supply function of inputs. Production function specifies thetechnical relationship between the input, and the output. Productionfunction of a firm combined with the supply function of inputs orprices of inputs determines the cost function of the firm. Precisely,cost function is a function derived from the production function andthe market supply function. Depending on whether short or long-runis considered for the production, there are two kinds of cost functions:such as short-run cost-function and long-run cost function.Cost-output relations in relation to the changing level of output will bediscussed here u.nder both kinds of cost-functions. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSShort-run Cost Output RelationsThe basic analytical cost concepts used in the analysis of costbehaviour are total average and marginal costs. The totalcost (TC) isdefined as the actual cost that must be incurred to produce a givenquantity of output. The short-run TC is composed of two majorelements: total fixed cost (TFC) and total variable cost (TVC). That is,in the short-run, TC = TFC + TVC (2) As mentioned earlier, TFC (i.e" the ·cost·of plant, building,equipment, etc.) remains fixed in the short-run, where as TVC varieswith the variation in the output. For a given quantity of output (Q), the average total cost, (AC),average fixed cost (AFC) and, average var!able cost (AVC) can bedefined as follows: TC TFC + TVC AC = = Q Q TFC AFC = Q TVC AVC = Qand AC = AFC +AVC (3)Marginal cost (MC) is defined as the change in the total cost divided bythe change in the total output, i.e., ∆TC aTC MC = or ∆Q aQ (4) Since ∆TC = ∆TFC + ∆TVC and, in the short-run, ∆TFC = 0, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICStherefore, ∆TC=∆TVC Furthermore, under marginality concept, where ∆Q = 1,MC = ∆TVC.Cost Function and Cost-output RelationsThe concepts AC, AFC and AVC give only a static relationship betweencost and output in the sense that they are related to a given output.These cost concepts do not tell us anything about cost behaviour, i.e.,how AC, A VC and AFC behave when output changes. This can beunderstood better with a cost function of empirical nature. Suppose the cost function (I) is specified as TC = a + bQ - CQ2 + dQ3 (5) (where a = TFC and b, c and d are variable-cost parameters) And also the cost function is empirically estimated as TC = 10 + 6Q - 0.9Q2 + 0.05Q3 (6) and TVC = 6Q - 0.9Q2 + 0.05Q3 (7) The TC and TVC, based on equations (6) and (7), respectively, havebeen calculated for Q = I to 16 and is presented in Table 3.1. The TFC,TVC and TC have been graphically presented in Figure 3.1. As thefigure shows, TFC remains fixed for the whole range of output, andhghce, takes the form of a horizontal line, i.e., TFC. The TVCcurveshows that the total variable cost first increases atai decreasing rateand then at an increasing rate with the increase it the total output. Therate of increase can be obtained from the slope of TVC curve. Thepattemof change in the TVC stems directly from the law of increasingand diminishing returns to the variable inputs. As output increases,larger quantities of variable inputs are required to produce the samequantity of output due to diminishing returns. This causes asubsequent increase in the variable cost for producing the sameoutput. The following Table 3.1 shows the cost output relationship. Table 3.1: Cost Output Relations Q FC TVC TC AFC AVC AC MC BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS (I) (2) (3) (4) (5) (6) (7) (8) 0 10 0.0 10.00 - - - - I 10 5.15 15.15 10.00 5.15 15.15 5.15 2 10 8.80 18.80 5:00 4.40 9.40 3.65 3 10 11.25 21.25 3.33 3.75 7.08 2.45 4 10 12.80 22.80 2.50 3.20 5.70 1.55 5 10 13.75 23.75 2.00 2.75 4.75 0.95 6 10 14.40 24.40 1.67 2.40 4.07 0.65 7 10 15.05 25.05 1.43 2.15 3.58 0.65 8 10 16.00 26.00 1.25 2.00 3.25 0.95 9 10 17.55 27.55 1.11 1.95 3.06 1.55 10 10 20.00 30.00 1.00 2.00 3.00 2.45 11 10 23.65 33.65 0.90 2.15 3.05 3.65 12 10 28,80 38.80 0.83 2.40 3.23 5.15 13 10 35.75 45.75 0.77 2.75 3.52 6.95 14 10 44.80 54.80 0.71 3.20 3.91 9.05 15 10 56.25 66.25 0.67 3.75 4.42 11.45 16 10 70.40 80.40 0.62 4.40 5.02 14.15 From equations (6) and (7), we may derive the behaviouralequations for AFC, AVC and AC. Let us first consider AFC.Average Fixed Cost (AFC)As already mentioned, the costs that remain fixed for a certain level ofoutput make the total fixed cost in the short-run. The fixed cost isrepresented by the constant term a in equation (6). We know that TFC (8) AFC = Q Substituting 10 for TFC in equation (8), we get 10 (9) AFC = Q Equation (9) expresses the behaviour of AFC in relation tochange in Q. The behaviour of AFC for Q from 1 to 16 is given inTable 3.1 (col. 5) and is presented graphically by the AFC curve in theFigure 3.1. The AFC curve is a rectangular hyperbola. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Average Variable Cost (AVC) As defined above, TVC AVC = Q Given the TVC function in equation 7, we may express AVC asfollows: 6Q-0.9Q2+0.05Q3 = 6- 0.9Q+0.05Q3 AVC = Q (10) Having derived the A VC function (equation 10), we may easilyobtain the behaviour of A VC in response to change in Q. Thebehaviour of A VC for Q from I to 16 is given in Table 3.1 (co 1. 6),and is graphically presented in Figure 3.2 by the A VC curve.Critical Value of A VCFrom equation (10), we may compute the critical value or Q in respectof A Vc. The critical value of Q (in respect of A VC) is that value of Q BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSat which A VCis minimum. The Ave will be minimum when itsdecreasing rate of change is equal to zero. This can be accomplishedby differentiating equation (10) and setting it equal to zero. Thus,critical value of Q can be obtained as aAVC Q= aQ = 0.9+0.10Q=0 (11) Q= 9 Thus, the critical value of Q=9. This can be verified from Table3.1Average Cost (AC)The average cost in defined as TC AC = Q Substituting equation (6) for TC in above equation, we get 10+6Q-09Q2+0.05Q3 (12a) AC = Q 10 = Q + 6-0.9Q+0.05Q2 The equation (l2a) gives the behaviour of AC in response tochange in Q. The behaviour of AC for Q from I to 16 is given in Table3.1 and graphically presented in Figure 3.2 by the AC-curve. Note thatAC-curve is U-shaped.From equation (12a), we may easily obtain the critical value of Q inrespect of AC. Here, the critical valuepf Q in respect of AC is one atwhich AC is minimum. This can be obtained by differentiating equation BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS(l2a) and setting it equal to zero. This, critical vallie of Q in respect ofAC is given by aAC 10 = - 0.9 + 0.1Q = 0 aQ Q2 (12b) This equation takes the form of a quadratic equation as -10 – 0.9Q2 + 0.1Q3 = 0 or, Q3 – 9Q2 = 100 = 0 By solving equation (12b), we get Q = 10 Thus, the critical value of output in respect of AC is 10. That is,AC reaches its minimum at Q = 10. This can be verified from Table.3.1 shows short-run cost curves.Marginal Cost (MC)The concept of marginal cost (MC) is particularly useful in economicanalysis. MC is technically the first derivative of TC function. That is, aTC BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS MC = aQ Given the TC function as in equation (6), the MC function can beobtained as aTC aQ = 6-1.8Q+0.15Q2 (13) Equation (13) represents the behaviour of MC. The behaviour ofMC for Q from 1 to 16 computed as MC = TCn - TCn- i is given inTable 3.1 (col. 8) and graphically presented by MC-curve in Figure3.2. The critical value of Q in respect of MC is 6 or 7. It can be seenfrom Table 3.1. One method of solving quadratic equation is to factorise it andfind the solution. Thus, Q3 – 9Q2 – 100 = 0 (Q – 10) (Q2 + Q + 10) = 0 For this to hold, one of the terms must be equal to zero, Suppose (Q2 + Q + 10) = 0 Then, Q – 10 = 0 and Q = 10.COST CURVES AND THE LAWS OF DIMINISHING RETURNSWe now return to the laws of variable proportions and explain itthrough the .cost curves. Figures 3.1 and 3.2 clearly bring out theshort-term laws of production, i.e., the laws of diminishing returns.Let us recall the law: it states that when more and more units of avariable input are applied to those inputs which are held constant, thereturns from the marginal units of the variable input may initiallyincrease but will eventually decrease. The same law can also beinterpreted in terms of decreasing and increasing costs. The law canthen be stated as, if more and more units of a variable inputs areapplied to the given amount of a fixed input, the marginal costinitially decreases, but eventually increases. Both interpretations of the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSlaw yield the same information: one in terms of marginal productivityof the variable input, and the other, in terms of the marginal cost. Theformer is expressed through production function and the latterthrough a cost function. Figure 3.2 represents the short-run laws of returns in terms ofcost of production. As the figure shows, in the initial stage ofproduction, both AFC and AVC are declining because of internaleconomies. Since AC = AFC + AVC, AC is also declining, this showsthe operation of the law of increasing returns. But beyond a certainlevel of output (i.e., 9 units in out example), while AFC continues tofall, AVC starts increasing because of a faster increase in the TVC.Consequently, the rate of fall in AC decreases. The AC reaches itsminimum when output increases to 10 units. Beyond this level ofoutput, AC starts increasing which shows that the law of diminishingreturns comes in operation. The MC, curve represents the pattern ofchange in both the TVC and TC curves due to change in output. Adownward trend in the MC shows increasing marginal productivity ofthe variable input mainly due to internal economy resulting fromincrease in production. Similarly, an upward trend in the MC showsincrease in TVC, on the one hand, and decreasing marginalproductivity of the variable input, on the other.SOME IMPORTANT COST RELATIONSHIPSSome important relationships between costs used in analysing theshort-run cost behaviour may now be summed up as follows: As long as AFC and AVC fall, AC also falls because AC = AFC +AVC. When AFC falls but A VC increases, change in AC depends on the rate of change in AFC and AVC then any of the following happens: ifthereisdecrease in AFC and increase in A VC, AC falls, if the decrease on AFC is equal to increase in Ave, AC remains BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS constant, and if the d~crease in AFC is less than increase in A VC, AC increases. The relationship between AC and MC is of varied nature. It may be described as follows: When MC falls, AC follows, over a certain range of initial output. When MCis failing, the rate of fall in MC is greater than that of AC This is because in case of MC the decreasing marginal cost is attributed, : to a single marginal unit while; in case of AC, the decreasing marginal cost is distributed overall the entire output. Therefore, AC decreases at a lower rate than MC. Similarly, when MC increase, AC also increases but at a lower rate fbr the reason given inthe above point. There is however a range of output over which this relationship does not exist. For example, compare the behaviour of MC and AC over the range of output frbm 6 units to 10 units (see Figure 3.2). Over this range of ~utput, MC begins to increase while AC continues to decrease. The reason for this can be seen in Table. 3.1. When MC starts increasing, it increases at a relatively lower rate, which is sufficient only to reduce the rate of decrease in AC, i.e., not sufficient to push the AC up. That is why AC continues to fall over some range of output even, if MC falls. MC iJ1tetsects AC at its minimum point. This is simply a mathematical relationship between MC and AC curves when both of them are obtained from the same TC function. In simple words, when AC is at its minimum, then it is neither increasing nor decreasing it is constant. When AC is constant, AC = MC.Optimum Output in Short-runAn optimum level of output is the one, which can be produced at a BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSminimum or least average cost, given the required technology isavailable. Here, the leastt¬cost combination of inputs can beunderstood with the help of isoquants and isocosts. The least-costcombination of inputs also indicates the optimum level of output atgiven investment and factor prices. The AC and MC cost Curves canalso be used to find the optimum level of output, given the size of theplant in the short-run. The point of intersection between AC and MCcurves deterinines the minimum level of AC. At this level of output AC= MC. Production beloW or beyond thislevelwill be in optimal. Ifproduction is less than 10 units (Figure 3.2) it will leave some scopefor reducing AC by producing more, because MC < AC. Similarly, ifproduction is greater than 10 units, reducing output can reduce AC.Thus, the cost curves can be useful in finding the optimum level ofoutput. It may be noted here that optimum level of output is notnecessarily the maximum profit output. Profits cannot be knownunless the revenue curves of firms are known.Long-run Cost-output RelationsBy definition, in the long-run, all the inputs become variable. Thevariability of inputs is based on the assumption that, in the long run,supply of all the inputs, including those held constant in the short-run,becomes elastic. The firms are, therefore, in a position to expand thescale of their production by hiring a larger quantity of all the inputs.The long-run cost-output relations, therefore, imply the relationshipbetween the changing scale of the firm and the total output;conversely in the short-run this relationship is essentially one betweenthe total output and, the variable cost (labour). To understand thelong-run cost¬output relations (lnd to derive long-run cost curves itwill be helpful to imagine that a long run is composed of a series ofshort-run production decisions. As a corollary of this, long-run costcurves are composed of a series of short-run cost curves. We may nowderive the long-run cost curves and study their relationship withoutput. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSLong-run Total Cost Curve (LTC)In order to draw the long-run total cost curve, let us begin with ashort-run situation. Suppose that a firm having only one-plant has itsshort-mn total cost curve as given-by STCl in panel (a) of Figure 3.3.In this example if the firm decides to add two more plants to its sizeover time, one after the other then in accordance two more short-runtotal cost curves are added to STCl in the manner shown by STC2 andSTC3 in Figure 3.3 (a):. The LTC can now be drawn through theminimum points of STCl, STC2 and STC3 as shown by the LTC curvecorresponding to each STC.Long-run Average Cost Curve (LAC)Combining the short-run average cost curves (SACs) derives thelong-run average cost curve (LAC). Note that there is one SACassociated with each STC. Given the STC1 STC2, and STC3 curves inpanel (a) of Figure 3.3, there are three corresponding SAC curves asgiven by SAC1 SAC2 arid SAC3 curves in panel (b) of Figure 3.3. Thus,the firm has a series of SAC curves, each having a bottom pointshowing the minimum SAC. For instance, C1Q1 is the minimum ACwhen the firm has only one plant. The AC decreases to C2Q2 when thesecond plant is added and then rises to C3Q3after the inclusion of thethird plant. The LAC carl be drawn through the bottom of SAC1 SAC2and SAC3 as shown in Figure·3.3 (b) The LAC curve is also known as‘Envelope Curve or Planning Curve as it serves as a guide to theentrepreneur in his planning to expand production. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The SAC curves can be derived from the data given in the STCschedule, from STC function or straightaway from the LTC-curve.Similarly, LAC can be derived from LTC-schedule, LTC function orfrom LTC-curve. The relationship between LTC and output, andbetween LAC and output can now be easily derived. It is obvious. fromthe LTC that the long-run cost-output relationship is similar to theshort-run cost-output relationship. With the subsequent increase inthe output, LTC first increases at a decreasing rate, and then at anincreasing rate. As a result, LAC initially decreases until the optimumutilisation of the second plant and then it begins to increase. Fromthese relations are drawn the laws of returns to scale. When the scaleof the firm expands, unit cost of production initially decreases, but itultimately increases as shown in Figure 3.3 (b). BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSLong-run Marginal Cost CurveThe long-run marginal, cost curve (LMC) is derived from the short-runmarginal cost curves (SMCs). The derivation of LMC is illustrated inFigure 3.4 in which SAC3and LAC arethe same asin Figure 3.3(b). Toderive the LMC3, consider the points of tangency between SAC3 and theLAC, i.e., points A, Band C. In the long-run production planning, thesepoints determine the output levels at the different levels of production.For example, if we draw perpendiculars from points A, Band C to theX-axis, the corresponding output levels will be OQ1 OQ2 and OQ3 Theperpendicular AQ1 intersects the SMC1 at point M. It means that atoutput BQ2, LMC, is MQ1. If output increases to OQ2, LMC rises to BQ2.Similarly, CQ3 measures the LMC at output OQ3. A curve drawn throughpoints M3B and N, as shown by the LMC, represents the behaviour ofthe marginal cost in the long run. This curve is known as the long-runmarginal cost curve, LMC. It shows the trends in the marginal cost inresponse to the change in the scale of production. Some important inferences may be drawn from Figure 3.4. TheLMC must be equal to SMC for the output at which the correspondingSAC is tangent to the LAC. At the point of tangency, LAC = SAC. Forall other levels of output (considering each SAC separately), SAC >LAC. Similarly, for all levels of outout corresponding to LAC = SAC,the LMC = SMC. For all other levels output, i:he LMC is either greateror less than the SMC. Another important point to notice is that theLMC intersects LAC when the latter is at its minimum, i.e., point B.There, is one and only one short-run plant size whose minimum SACcoincides with the minimum LAC. This point is B where, SAC2 = SMC2= LAC = LMC.Optimum Plant Size and Long-run Cost CurvesThe short-run cost curves are helpful in showing how a firm candecide on the optimum utilisation of the plant-which is the fixedfactor; or how it can determine the least-cost output level. Long-run BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScost curves, on the other hand, can be used to show how themanagement can decide on the optimum size of the firm. An Optimumsize of a firm is the one, which ensures the most efficient utilisation ofresources. Given the state: of technology overtime, there is technicallya unique size of the firm and lever of output associated with the leastcost Concept. This uriique size of the firm can be obtained with thehelp of LAC and LMCIn Figur 3.4 the optimum size consists of twoplants, which produce OQ2 units of a produd, at minimum long-runaverage cost (LAC) of BQ2. The downtrend in the LAC ihdicates that until output reaches thelevel of OQ2, the firm is of non-optimal size. Similarly, expansion ofthe firm beyond production capacity OQ2 causes a rise in SMC as wellas LAC. It follows that given the technology, a firm trying to mini miseits average cost over time must choose a plant which gives minimumLAC where SAC = SMC = LAC = LMC. This size of plant assures mostefficient utilisation of the resource. Any change in output level, i.e.,increase or decrease, will make the firm enter the area of in optimality.ECONOMIES AND DISECONOMIES OF SCALEScale of enterprise or size of plant means the amount of investment inrelatively fixed factors of production (plant and fixed equipment).Costs of production are generally lower in larger plants than in the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSsmaller ones. This is so because there are a number of economies oflarge-scale production.Economies of ScaleMarshall classified the economies of large-scale production into twotypes: 1. ExternalEconomies 2. Internal Economies External Economies are those, which are available to all the firmsin an industry, for example, the construction of a railway line in acertain region, which would reduce transport cost for all the firms, thediscovery of a new machine, which can be purchased by all the firms,the emergence of repair industries, rise of industries utilisingby-products, and the establishment of special technical schools fortraining skilled labour and research institutes, etc. These economiesarise from the expansion in the size of an industry involving anincrease in the number and size of the firms engaged in it. Internal Ecnomies are the economies, which are available to aparticular firm and give it an advantage over other firms engaged inthe industry. Internal economies arise from the expansion of the sizeof a particular firm. From the managerial point of view, internaleconomies are more important as they can be affected by managerialdecisions of an individual firm to change its size or scale.Types of Internal EconomiesThere are various types of internal economies such as labour,technical, managerial, marketing and so on. We will discuss the typesof internal economies in detail in the following section: Labour Economies: If an firm decides to expand its scale of output, it will be possible for it to reduce the labour costs per unit by practising division of labour. Economies of division of labour arise due to increase in the skill of workers, and the saving of time involved in changing from one operation to the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSother. Again, in many cases, a large firm may find it economicalto have a number of operations performed mechanically ratherthan manuaily. These economies will be of great use in firmswhere the product is complex and the manufacturing processescan be sub-divided.Technical Economies: These are economies derived from theuse of sub¬size machines and such scientific processes likethose which can be carried out in large production units. A smallestablishment cannot afford to use such machines andprocesses, because their use would bring a saving only whenthey are used intensively. On the other hand, their use will bequite uneconomical if they were to lie idle over a considerablepart of the time. For example, a large electroplating plant costsa great deal to keep it in operation. Therefore, the cost per unitwill be low only if the output is large. Similarly, a machine thatfacilitates the pressing out a side of a motorcar will take a weekor more to be put ready for operation to produce a particulardesign. The greater the output of cars of this particular designsthe lower the cost per unit of getting the machine ready foroperation. Similarly, if a dye is made to produce a particularmodel of cars, the cost of dye per unit of cars will depend uponthe output of the cars. Very often large firms may find iteconomical to produce or manufacture parts and componentsfor their products rather than buy them from outside sources.For example, Hind Cycles, unlike small mariufacturers, producedparts and components themselves. Moreover, large firms mayfind it profitable to utilise their by-products and waste products.For example, Tata use the smoke from their furnaces tomanufacture coal tar, naphthalene, etc. A small firms output ofsmoke would not be large enough to justifY setting up the .equipment necessary to do so.Managerial Economies: When the size of the fern increases, theefficiency of the management usually increases because there BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS can be greater specialisationin managerial staff. In a large firm, experts can be appointed to look after the various sections or divisions of the business, such as purchasing, sales, production, financing, personnel, etc. But a small firm cannot provide full-time employm·entto these experts naturally, the various aspects of the business have to be looked after by few people only who may not necessarily be experts. Moreover, a large firm can afford to set up data processing and mechanised accounting, etc., whereas small firms cannot afford to do so. Marketing Economies: A large firm can secure economies in its purchasing and sales. It can purchase its requirements in bulk and thereby get better terms. It usually receives prompt deliveries, careful attention and special facilities from its suppliers. This is sometimes due to the fact that a large buyer can exert more pressure·, at times compulsive in nature, for specially favoured treatment. It can also get concessions from transport agencies. Moreover, it can appoint expert buyers and expert salesmen. Finally, a large firm can spread its advertising cost over bigger output because advertising costs do not rise in proportion to a rise in sales. Economies of Vertical integration: A large firm may decide to have vertical integration by combining a number of stages of production. This¬integration has the advantage that the flow of goods through various stages in production processes is more readily controlled. Steady supplies of raw materials, on the one hand, and steady outlets for these raw materials, on the other, make production planning more certain and less subject to erratic and unpredictable changes. Vertical integration may also facilitate cost control, as most of the costs become controllable costs for the enterprise. Transport costs may also be reduced by planning transportation in such a way that cross hauling is reduced to the minimum.Financial Economies: A large firm can offer better security and is, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS therefore, in a position to secure better and easier credit facilities both from its suppliers and its bankers. Due to a better image, it enjoys easier access to the capital market. Economies of Risk-spreading: The larger the size of the business, the greater is the scope for spreading of risks through diversification. Diversi¬fication is possible.on two lines as follows: o Diversification of Output: If there are many products, the loss in the sale of one product may be covered by the profits from others. By diversification, the firm avoids what may be called putting all eggs in the same basket. For example, Vickers Ltd., make aircrafts, ships, armaments, food-processing plant, rubber, plastics, paints, instruments arid a wide range of other products. Many of the larger firms have taken to diversification. ITC diversified to include marine products and hotel business in its operations. o Diversification of Markets: The larger producer is glenerally in a position to sell his goods in many different and even far-off places. By depending upon one market, he runs the risk of heavy loss if sales in that market decline for one reason or the other.Sargant Florence and Economies of ScaleSargant Florence has attributed the economies of scale the threeprinciples, which are in operation in a large-sized business, namely,the principle of bulk transactions, the principle of massed reserves,and the principle of multiples. Principle of Bulk Transactions: This principle implies that the cost of dealing with a large batch is often no greater than the cost of dealing with a small batch, for example, the cost of placing an order, large or small; availability of discounts on bulk orders, or annual purchase contracts; economies in the use orlarge containers such as tanks or trucks of special design, for a BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS container holding, say, twice as much as the other one, does not cost double the amount. • Principle of Massed Reserves: A large firm has a number of departments or sections and its overall demand for services, say, transport services, is likely to be fairly large. But it is unlikely that all departments will make heavy demands of the particular service at the saine time. Thus the firm can afford to have its own transport fleet and fully utilise it and thereby ultimately reduce its costs. The larger the firm, the greater are the advantages. Principle of Multiples: This principle was first raised by Babbage in 1832 and has also been referred to as Balancing of Processes. The principle can be better explained through an example. Suppose a manufacturing, operation involves three processes, first in which a machine (:an make 30 units a week; second in which an automatic machine can make 1,000 units per week; and a third in which a semi-automatic machine can make 400 units per week. Unles~ the output of the plant is some common multiple of 30,1,000 anti 400, one or more of the processes will have unutilised capacity. Their LCM is 6,000 and, therefore, to best utilise all the machines the plant size must be of at least 6,000 units or any of its multiples.Economies of Scale and Empirical EvidenceAccording to the surveys conducted by the Pre-investment SurveyGroup (FAG) and later on by the NCAER, it has been pf()Ved that inpaper industry, profitability decreases with lower scaly of operationsand bigger plants beneht from economies of scale. The report of thePre-investment Survey Group (FAG) reveals that the manufacturingcost of writing and printing paper would fall from Rs. 1,489 in a100-tonne per day plant to Rs. 1,238 in a 200-tonne per day plantand further to Rs. 1,104 in a 300-tonne per day plant. The followingTable 3.2 further shows the capital cost of raw materials andoperating cost per tonne of paper according to the size of the unit, as BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSestimated by the NCAER. Table 3.2: Paper Industry: Investment and Other Costs of Paper Mills according to Size Size Tonnes Fixed Cost of raw Operating per day) investment cost ma terials per cost per tonne . per tonne tonne of paper of paper 100 • 4,473 324 1,307 200 4,070 263 1,116 250 3,945 258 1,056 Another study of cement industry by the Economic and ScientificResearch undation-shows that the per unit of capacity capital 4,473investment of a 3,000 tonne per day (TPD) capacity cement plantislower than the plants of 50 TPD size. Thus a single cement plantproducing 3,200 TPD requires 46 per cent less capital investment than8 plants of 400 TPD productions would. As regards cost of production,a 800 TPD plant has a 15 per cent cost advantage over a 400 TPDplant. The difference between the cost of production of a tonne ofcement by a 3,000 TPD plant and of a50 TPD plant is as high as Rs.100 per tonne. In fact, there has been a perceptible increase in thesize of cement plants in India. For example, the 600 tonnes per daycapacity cement plants during the early 1960s gave way with their sizegoing up to 1,200 tonnes per day. The latest preference is for 3,200tonnes per day capacity plants. A significant policy implication ofeconomics of scale is that in order to earn a reasonable return and atthe same time ensure a fair deal to the consumers, the industry shouldgo in for larger plants and expand the existing plants to .the optimumlevel.The 6/10 RuleA useful rule that seeks to measure economies of scale is the 6/1 0rule. According to this rule, if we want to double the volume of acontainer, the material needed to make it will have to be increased by6/10, i.e., 60 per cent. A proofofthe6/l0 rule is easy and can be given BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICShere with its advantage. Let us begin with the volume of a containerand the material required to make it. Suppose the container is of theshape of a Gube with its side. The volume of the container then is: Vo = ao x ao x ao = ao3 Now, to find out the area of material needed, we know that the 2container will have six equal square faces, each of area an so, thearea of total material needed IS: Mo = 6 x ao2 = 6ao2 Suppose now, that the containers dimension increases from an toall the volume of the container will then increase to al3 and the areaof t~e material needed will increase to 6a12. Thus, for two containers of dimensions an and al the ratio of theareas of material needed will be: M1 6a1/2 a1/2 M0 = 6a0/2 = a0The corresponding ratio of the volumes will be: V1 a1/3 a1/3 V0 = a0/3 = a0From the above, it follows that: M1 a1/2 a1/3.2/3 V 1 2/3 = M0 = a0/2 = a0 V0 Now, if we double the volume, i.e., if V1 V1 = 2V0 or =2 V0Then, M1 V1 2/3 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS M0 = V0 = (20) 2/3 = 1.59 M1 = 1.59 M0 In other words, doubling the volume requires 59 per centincrease in material. This is rouJded off as 60 per cent, which is thesame as 6/1O. It may be added that, if in place of a cubical container,we had taken the example of a spherical or a rectangular or acylindricai or for that matter a conical container, we would have aijivedat the same relationship, viz., M1 V12/3 = M0 V0 The 6/10 rule is of great practical significance. Its significance canwell be realised if we visualise, for example, blast furnaces as boxescontaining the ingredients needed to produce iron, or tankers as largeboxes containing oil.Minimum Economic Capacity (MEC) SchemeSmall size firms do not enjoy economies of scale. As such, inpursuance of governments policy to encourage minimum efficientcapacity in industrial und~i1akings, the Government of India hasintroduced MEC Scheme to petrochemical industries, for example,Naphtha / Gas Cracker (3 to 4 lakhs tonnes), Bopp Film (56,000tonnes), Polyster Film (5,000 tonnes), Polyster Filament Yam (25,000tonnes), Acrylic Fibre (20,000 tonnes), MEG (One lakh tonnes), PTA(2lakh tonnes), etc.World SdaleWith re·cent trends towards globalisation of industries in India, theconcept of "World Scale" has emerged. The term World Scale refers tothat scale or size of the enterprise, which is large enough to enable thefirm to reap various large-scale economies so as to competesuccessfully on the world basis with global rivals. Thus RelianceIndustries Limited has recently announced to build a world scalepolyester facility at Hnzira and a cracker project with capacity BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSexpanding from earlier 40,000 tonnes·to the world scale of 7,50,000tonnes per annum.Diseconomies of ScaleEconomies of increasing size do not continue indefinitely. After acertain point, any further expansion of the size leads to diseconomiesof scale. For example, after the division of labour has reached its mostefficient point, further increase in the number of workers will lead to aduplication of workers. There will be too many workers per machinefor really efficient production. Moreover, the problem of co-ordinationof different processes may become difficult. There may be divergenceof views concerning policy problems among specialists inmanagementand reconciliation may be difficult to arrive. Decision-making processbecomes slow resulting in missed opportunities. There may be toomuch of formality, too many individuals between the managers andworkers, and supervision may become difficult. The managementproblems thus get out of hand with consequent adverse effects onmanagerial efficiency. The limit of scale economics is also often explained in terms ofthe possible loss of control and consequent inefficiency. With thegrowth in the size of the firm, the control by those at the topbecomes weaker. Adding one more hierarchical level removes thesuperior further away from the subordinates. Again, as the firmexpands, the incidence of wrong judgements increases and errors injudgement become costly. Last be not the least, is the limitation where the larger the plant,the larger is the attendant risks of loss from technological changes astechnologies are changing fast in modern times.Diseconomies of Scale and Empirical EvidenceLarge petro-chemical plants achieve economies in both full usage andin utilisation of a wider range ofby-products, which would otherwise, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSbe wasted. But above 5,00,000 tonnes, diseconomies of scale sets inbecause of the following occurrences: The plant becomes so large that on-site fabrication of some parts is required which is much more expensive; Starting up costs are much higher, more capital is tied up and delays in commissioning can be extremely expensive; and The technical limit to compressor size has been reached. There is, however, no substantial evidence of diseconomies oflarge-scale production. In the final analysis, however, a significanttest of efficiency is survival. If small firms tend to disappear and largeones survive, as in the automobile industry, we must conclude thatsmall firms are relatively inefficient. If small firms survive and largeones tend to disappear as in the textile industry, then large firms arerelatively inefficient. In reality, we find that in most industries, firmsof very different sizes tend to survive. Hence, it can be concluded thatusually there is no significant advantage or disadvantage to size overa very wide range of outputs. It may mean, of course, that thebusinessman in his planning decisions determines that beyond acertain size, plants do have higher costs and, therefore, does notbuild them. Somewhat surprisingly, some Indian entrepreneurs have beenperceptive enough to attempt to derive the advantages of both largeand small-scale enterprises. In the late sixties, the Jay Engineering Co.Ltd. evolved a strategy of blending large units with small enterprisesto obtain the best of both worlds. It manufactures its Usha fans inthree different plants (Calcutta, Hyderabad and Agra), with each plantmanu facturing the same or a similar range of products. Each unit isautonomous and is free to take operational decisions except in highlystrategic areas. Within each unit, the work-force is kept small to carryout vital operations such as forgoing, blanking, notching and finalassembly. The rest of the work is sub-contracted to neighbouringsmall-scale units, which over a period or time have become almost BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSintegral parts of each plant. Loans for the purchase of machinery arealso advanced and technical know-how and sometimes-eve training isprovided to these ancillary units. Payments are made promptly. The whole system operates likefamilies within a larger family. Managers in the US, who are alwaysquick in innovating, have also begun adopting this blended systemduring the past few years. General Motors encourages the creation ofacluster of independent enterprises in an area, with adequate autonomygranted to the companys area chief to encourage their growth anddevelopm.ent. Consequently, though a giant in the automobileindustry, General Motors enjoys a large number of the privileges thatacerue to small units and also reaps the special benefits accruing tolarge business firms.Economies of ScopeThis concept is of recent development and is different from theconcept of economies of scale. Here, the cost efficiency in productionprocess is brought out by variety rather than volume, that is, the costadvantages follow from variety of output, for example, productdiversification within the given scale of plant as against increase involume of production or scale 6f output. A firm can add new andnewer products if the size of plant and type of technology make itpossible. Here, the firm will enjoy scope-economies instead of scaleeconomies.COST CONTROL AND COST REDUCTIONCost ControlThe long-run prosperity of a firm depends upon its ability to eamsustaid profits. Profit depends upon the difference between the sellingprice and the cost of production. Very often, the selling price is notwithin the control of a firm but many costs are under its control. Thefirm should therefore aim at doing whatever is done at the minimumcost. In fact, cost control is ail essential element for the successfuloperation of a business, Cost control by management means a search BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSfor better and more economical ways of completing each operation. Ineffect, cost control would mean a reduction in the percentage of costsand, in turn, an increase in the percentage of profits. Naturally, costcontrol is and will continue to be of perpetual concern to the industry. Cost control has two aspects such as a reduction in specificexpenses and a more efficient use of every rupee spent. For example,if sales can be increased with the same amount of expenditure, say,on advertising and saTesmen, the cost as a percentage of sales is cutdown. In practice, cost control will ultimately be achieved by lookinginto both these aspects and it is impossible to assess the contribution,which each has made to the overall savings. Potential savings inindividual businesses will, however, vary between wide extremesdepending upon the levels of efficiency already achieved before costcontrols are introduced. It is useful to bear in mind the following rules covering cost control activities: It is easier to keep costs down than it is to bring costs down. The amount of effort put into cost control tends to increase when business is bad and decrease when business is good. There is more profit in cost control when business is. good than when I business is bad. Therefore, one should not be slack when conditions are good. Cost control helps a firm to improve its profitability andcompetitiveness. Profits may be drastically reduced despite a large andincreasing sales volume in the absence of cost control. A big salesvolume does not necessarily mean a big profit. On the other hand, itmay create a false sense of prosperity while in reality; increasing costsare eating up profits. Profit is in danger-when good merchant¬disingand cost control do not go hand in hand. Cost control may also help afirm in reducing its costs and thus reduce its prices. A reduction inprices of a firm would lead to an increase in its competitiveness. Theaspect is of particular relevance to Indian conditions because of highcosts, India is being priced out of the world markets. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSTools of Cost ControlFollowing ar.e the tools that are used for the cost control: Standard Costs and Budgets: The technique of standard, costinghas been developed to establish standards of performance forproducing gvuus and services. These standards serve "as a goal for theattainment and as basis of comparison with actual costs in checkingperformance. The analysis of variance between actual and standardcosts will: (i) help fix the responsibility for non-standard performanceand (ii) focus attention on areas in which cost improvement should besought by pinpointing the source of loss and inefficiency. Theprinciple here is that or controlling by exception. Instead ofattempting to follow a mass of cost data, the attention of thoseresponsible for cost control is concentrated on significant variancesfrom the standard. If effective action is to be taken, the cause andresponsibility of a variance, as well as its amount, must be established. The prime objective of standard costs is to generate greater cost consciousness and help in cost control by directing attention to specific areas where action is needed. To those who are immediately concerned, variances wou1d indicate whether any action is required on their part. It must be noted that Costs are controlled at the points where they are incurred and at the time of occurrence of events, and At the same time they may be uncontrolled at some points. It is, therefore, necessary to understand the difference betweencontrollable and uncontrollable costs. The variances may also becontrollable and uncontrollable. For example, if the material costvariance is due to rise in prices, it is not within the control of theproduction manager. But if the variance is due to greater usage,control action is certainly possible on his part. The highermanagement can also deCide whether or not they should intervene inthe matter. Sometimes, variances may be so significant that acomplete reapRraisal of the standard costs themselves may be needed. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS For example, if the variances are always favourable, it may pointto the fact that the standards have not been properly fixed. Standardcosting can also provide the means for actual and standard costcomparison by type of expense, by departments or cost centres. Yieldsand spoilage can be compared with the standard allowance for loss.Labour operations and overheads also can be checked for efficiency.Flexible budgets constitute yet another effective technique of costcontrol, especially control of factory overheads. Flexible budgets, alsoknown as variable budgets; provide a basis for determining costs thatare anticipated at various levels of activity. It provides a flexiblestandard for comparing the costs of an actual volume of activity withthe cost that should be or should have been. The variances can thenbe analysed and necessary action can be taken in the matter. Table 3.3gives a specimen flexible budget. Table 3.3: Finishing Department, Modern Manufacturing Co. Standard hours of direct labour 35,000 40,000 45,000Labour cost hour at Rs. 3 per Rs. 1,05,000 Rs. 1,20,000 Rs. 1,35,000Other variable costs 17500 20.000 22,500Semi-variable costs 9,250 10,000 10,250Fixed costs 50,000 50,000 50,000Total Rs.l,81,75Q Rs. 2,00,000 Rs.2,17,750 The scientific establishment of standards of performance throughstandard costs and budgets has not only provided better cost controlbut has led to cost reduction in a number of companies. This hasbeen the case especiilIIy in companies where standards were tied towage-incentive plans and improyement in control is part of a generalprogramme of better management. The above table shows threebudgets, one each for 35,000, 40,000 and 45,000 standard hours ofwork. In practice, one may come across 50 or more cost items in the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSbudget and not just four as shown in the table.Ratio AnalysisRatIo is a statistical yardstick that provides a measure of therelationship betweeri two figures. This relationship may be expressedas a rate (costs per rupee of sales), as a per cent (cost of sales as apercentage of sales), or as a quotient (sales as a certain number oftime the inventory). Ratios are commonly used in the analysis ofoperations because the use of absolute figures might be misleading.Ratios provide standards of comparison for appraising theperformance of a business firm. They can be used for cost controlpurposes in two ways: A businessman may compare his firms ratios for the period under scrutiny with similar ratios of the previous periods. Such a comparison would help him identify areas that need his attention. • The businessman can compare his ratios with the standard ratios in his jndustry. Standard ratios are averages of the results achieved by thousands, of firms in the same line of business.If these comparisons reveal any significant differences,thtYmanagement call analyse the reasons for these differences andcan take appropriate action to remove the causeS responsible forincrease in costs. Some of the most commonly used ratios for costcorrtparisons are given below: • Not profits/sales. Gross profits/sales. Net profits/total assets. Sales/totaLassets. • Production costs/costs of sales. Selling Costs/costs of sales. Admiriistration costs/costs of sales. Sahes/iriventory or inventory turnover. Material costs/prod1, Jction costs. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Labour costs/production costs. Overhead/prqduction costs. Value Analysis: Value analysis is an approach to cost saving thatdeals with product design. Here, before making or buying anyequipment or materials, a study is made of the purpose to which thesethings serve. Would other lower-cost designs work as well? Couldanother less costly item fill the need? Will less expensive material, dothe job? Can scrap be reduced by changing the design or the type ofraw materiaJ? Are the sellers costs as low as they ought to be?Suppliers of alternative materIals can provide the ample data to makethe appropriate choice. Of course, absorbing and reviewing the datawill need some time. Thus the objective of value analysis is theidentification of such costs in a product that do not in any mannercontribute to its specifications or functional value. Hence, valueanalysis is the process of reducing the cost of the prescribed functionwithout sacrificing the required standard of performance. Theemphasis is, first, on identificatiqn of the required function and,secondly, on determination of the best way to perform it at a lowercost. This novel method of cost reduction is not yet seriously exploited,in our country. Value analysis is a supplementary device in addition tothe con~entional cost reduction methods. Value analysis is closely related to value engineering, thoughthey are not identical. Value analysis refers to the work thatpurchasing department does in-this direction whereas valueengineering usually refers to what engineers are doing in this area.The purchasing department raises questions and consults theengineering department and even the vendor companys department.Value analysis thus requires wholehearted co-operation of not only thefirms expertise in design, purchase, production and costing but alsothat of the vendor and other company expertise, if necessary. Someexamples of savings through value analysis are given below: Discarding tailored products where standard components can do. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Dispensing with facilities not specified or not required by the customer, for example, doing away with headphone in a radio set. Use ofnewly-deyeloped, better and cheaper materials in place of traditional materials. Taking the specific case of TV industry, there are variouscomponents of cost, which can be questioned. The various items areas under: Whether to have vertical holding chassis or the chassis should be tied down horizontally. In case, chassis is held vertically, additional expenditure in terms of holding clamps is required. Whether to have plastic cabinet or wooden cabinet. Whether to have two speakers or one speaker. Whether to have sliding switches or stationary switches. Whether to have PVC back cover or wooden back cover. Whether to have costly knobs or cheaper knobs. Whether to have moulded mask or extruded plask. Whether to have Electronic Tuner or Turret Tuner. Whether to have digital operating unit or noble operating unit. Cost control is applicable only to such costs, which can bealtered by the management on their own initiative. It may be noted inthis context that, by and large, non-controllable costs exceed far morethan controllable ones thereby restricting the scope of profitimpfoyement through cost, control. Of course, attempts may be madeto convert an uncontrollable cost into a controllable one. Verticalcombinations to secure control over sources of supply provide anexample. So also instead of buying a component, a firm may decide tomake the conversion possible.AREAS OF COST CONTROLFolloviing are the areas where the cost can be controlled:1. Materials BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSThere area number of ways that help in reducing the cost ofmatenals.Ifbuying is done properly, a firm avails itself of quantity discounts.While buying from a particular source, in addition to the cost ofmaterials, consideration should be given to freight charges. In somecases, lower prices of materials may be offset by higher freiight to thefirms godown. Whiie buying, one may attempt to buy from thecheapbt source by inviting bids. At times, it may be possible to havemore economical substitutes for raw materials that the firm is using.Many a times, improvell1ent in product design may lead to reductionin material usage. It is desirable to concentrate attention on the areaswhere saving potential is the highest. Another area, which needs examination in this respect, iswhether to make or buy components from outside source. Very oftenfirm may find it advantageous to manufacture certain parts andcomponents in ones own factory rather than buying them. Yet inmany cases there are specific advantages in purchasing spares andcomponents from outside because suppliers may deliver goods at lowcost with high quality. For example, Ford and Chrysler of the US AutoIndustry purchase their components from outside source. But GeneralMotors could not do so because the firm has its own departments forhandling the process of production. This type of firm is referred asvertically integrated firm where it owns the various aspects of makingseIling and delivering a product Hind Cycles, which has now beentaken over by the Government, manufactures all its components. Butmanu¬facturers of Hero and Avon Cycles purchased most of theircomponents from outside source and successfully competed with HindCycles. Continuous Research and Development (R & D) may also lead toa reduction in raw material costs. For example, Asian Paints made highsavings in costs of raw materials by its phenomenal success onResearch and Development front, by manufacturing synthetic resinsfor captive consumption. Total materials consumed as a ratio of valueof production fell from 67.66 per cent in 1973 to 60-67 per cent in BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS1977. General Motors have reduced the weight of their cars to makethem more fuel-efficient. Better utilisation of materials may also savethe cost of materials by avoiding wastes in storing, handling andprocessing. Some of the factors, responsible for excessive wastage ofmaterials are: lack of laid down requirements for raw materials, badprocess planning, rejects due to faulty materials or poor workmanship,lack of proper tools, jigs and fixtures, poor quality of materials, loosepacking, careless and negligent handling and careless storage. Exploration of the possibilities of the use of standardised partsand components and the utilisation of waste and by-products, mayalso lead to a significant reduction in the cost of materials. Inventory control is yet another area for reducing materialscost. Thro inventory control, it is possible to maintain theinvestment in inventories at lowest amount consistent with theproduction and the sales requirements of firm. The cost of carryinginventories ranges from 15 to 20 per cent per annum account ofinterest on capital, insurance, storage and handling charges, spillabreakage, physical deterioration, pilferage and obsolescence. Again50 per cent the gross working capital may be locked up ininventories. Some important ways of reducing inventories are: Improved production planning. Having dependable sources of supplies, which can ensure prompt deliver of materials at short notice. Elimination of slow-moving stocks and dropping of obsolete items. Improved flow of part and materials leading to increased machine utilisation and shorter manufacturing cycles. Packaging constitutes a significant proportion of raw materials(9 to 24 per cent) and of the total manufacturing expenses (7 to 22per cent). Firm should mal attempts to reduce the packaging costs tothe minimum. For example, instead discarding containers that the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmaterials come in it may be used for shipping tl goods and thus, thepackaging cost can be saved. The manufacturing firms such; cars andmotor bikes may request its customers to return the containers inwhic are goods were sent so that they could be used in future. This isbecause packin of such goods as well as the materials used forpacking is very expensive.2. LabourReduction in wages for reducing labour costs is out of question. Onthe other hand, wages might have to be increased to provideincentives to workers. Yet there is good scope for reduction in thewage cost per unit. A reduction in labour costs is possible by properselection and training, improvement in productivity and by automation,where possible. A study by cn (Confederation of Indian Industry)showed that Hero Cycles improved their productivity per employee by6.4 per cent. Purolators were able to increase their productivity by100 per cent. Work· study might result in a lot of savings by reducingovertime and idle time and providing better workloads. Labourproductivity might increase if frequent change of tools is avoided.Improvement in working conditions may reduce absenteeism and thusreduce costs per unit. Scrutiny of overtime may reveal substantialscope for savings. All efforts must be made to redllce wastage of human effort.Wastage of human effort may be due to lack of co-ordination amongvarious departments by having more workers thannecessary, ·under-utilisation of existing manpower, shortage ofmaterials, improper scheduling, absenteeism, poor methods and poormorale. For example, Metal Box adopted a Voluntary SeveranceScheme in 1975¬76 to reduce their work force by 950 workers afterthey faced a huge operating loss ofRs. 2.4 crores. General Motorseliminated 14,000 white-collar jobs through attrition to reduce cost.Japans big 5 steel producers announced substantial retrenchmentprogrammes and workers co-operated with the management.Attempts must be made to secure co-operation of employees in cost BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSreduction by inviting suggestions from them. These suggestionsshould be carefully examined and implemented if found satisfactory.Hindustan Lever has a suggestion box scheme and employees whocome out with good suggestions receive awards. These suggestionsmay either lead to savings or improve safety and work convenJence.The basic idea is to motivate workers and make them perceive workingin the firm as a participative endeavour.3. OverheadsFactory overheads may be reduced by proper selection of equipment,effective utilisation of space and .equipment, proper maintenance ofequipment and reduction in power cost, lighting cost, etc. Forexample, fluorescent lighting can reduce lighting cost. Faulty designsmay lead to excessive use of materials or multiplicity of components,waste of steam, electricity, gas, lubricants, etc. A British team invitedby the Government of India to report on standards of fuel efficiency inIndian industry found that fuel wastages might be as high as anaverage of 25 per cent. Keeping them in check even in the face ofincreasing sales may reduce overhead costs per unit. For example,Metal Box maintained their fixed costs in 1976-77 even when therewas an increase in sales of over 18 per cent. Taking advantage of truck or wagonloads may reducetransportation cost. Careful planning of movements may also savetransportation cost. Another point to be examined is whether it wouldbe economical to use ones own transport or hire a transport. Forreasons of economy, many transport companies hire trucks rather thanowning them. This is because purchase and maintemince of trucks canbe more expensive. By chartering vehicles the problems ofmaintenance is left to the owner who in turn Cuts cost for the firm.Thus by keeping a smaller work force on rolls and by introducing acontract rate linked to a safe delivery schedule it is possible to ensurespeedy point-to-point delivery of goods. Many firms now prefer to useprivate taxis rather than have their own staff cars. Reduction of wastes in general can also reduce manufacturing BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScosts considerably. Of course, a certain amount of waste and spoilageis unavoidable because employees do make mistakes, machines do getout of order and sometimes raw materials are faulty. However,attempts can be made to reduce these mistakes and faulty handling tothe minimum. The normal figure for the waste and spoilage dependsupon the complexity of the product, the age of the manufacturingplant, and the skill and experience of the workers. Once normalwastage is found out, production reports must be watched carefully tofind out whether the wastages are excessive. Wastes can be reducedconsiderably by educating operators in the causes and cures of thewastes. Bad debt losses can be reduced considerably by selectingcustomers carefully, and keeping an eye on the receivables.Concentrating on areas and media can reduce advertising costs, whichgive the best results. Selling costs can be controlled by improving the supervision andtraining of salesmen, rearrangement of sales territories, replantingsalesmens routes and calls and redirecting of the sales efforts, toachieve a more economic product mix. It may be possible to saveselling costs by the use of warehouses, making bulk shipments to thewarehouses and giving faster deliveries to the customers.Centralisation, reduction, clerical and accounting work may also lead tocost savings. A look at the telephone bills and the communication costin general may also reveal areas for substantial savings. For example atelegram may be sent in place of a trunk call.(a) Cost ReductionThe Institute of Cost and Works Accounts of London has defined costreduction as "the achievement of real and permanent reductions in theunit costs of goods manufactured or services rendered withoutimpairing their suitability for the use intended". Thus, cost reduction isconfined to savings in the cost of manufacture, administration,distribution and selling by eliminating wasteful and unnecessaryelements from the product design and from the techniques andpractices carried out in coilOection with cost reduction? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS(b) Cost Contro/and Cost ReductionAccording to the Institute of Cost and Works Accounts, London, "costcontrol, as generally practised, lacks the dynamic approach to manyfactors affecting costs, which determine the need of cost reduction."For example, under cost control, the tendency is to accept standardsonce they are fixed and leave them unchallenged over a period. In costreduction, on the other hand, standards must be constantlychallenged for improvement. And there is no phase of business, whichis exempted from the cost reduction. Products, processes, proceduresand personnel are subjected to continuous scrutiny to see where andhow they can be reduced in cost. To achieve success in cost reduction, the management must beconvinced of the need for cost reduction. The formulation of a detailedand co-ordinated plan of cost reduction demands a systematicapproach to the problem. The first step would be the institution of aCost Reduction Committee consisting of all the departmental heads tolocate the areas of potential savings and to determine the priorities.The Committee should review progress and assign responsibilities toappropriate personnel. Every business operation should be approachedin the belief that it is a potential source of economy and may benefitfrom a completely new appraisal. Often, it may be possible to dispenseentirely with routines, which, by tradition, have come to be regardedas a permanent feature of concern. Cost reduction is just as muchconcerned with the stoppage of unnecessary activity as with thecurtailing of expenditure. It is imperative that the cost ofadministering any scheme of cost reduction must be kept withinreasonable limits. What is reasonable must be determined in all casesfrom the relationship between the expenditure and the savings, whichresult from it.Essentials for the Success of a Cost Reduction ProgrammeFollowing are the some of the points that firms should take care in BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSorder to achieve success in the cost reduction programme: Every individual within the firm should recognise· hisresponsibility. The co-operation of every individual requires a carefuldissemination of the objectives and interest of the employees in theachievement of the firms goals. Employee resistance to change should be minimised by disseminating complete information about the proposed changes and convincing the emplcyees that the changes are concerned with the problems faced by the firm and that they would ultimately benefit. Efforts should be concentrated in the areas where the savings are likely to be the maximum. Cost reduction efforts should be continuously maintained. There should be periodic meetings with the employees to review the progress made towards cost reduction.(c) Factors Hampering Cost Control in IndiaThe cost of raw material and other intermediate products is generallyhigh. In many cases: the cost of raw materials is substantially higherthan their international prices, which makes it difficult for the Indianfirms to compete in foreign markets. The sharp rise in oil prices inrecent years also gave a severe push to the cost of raw materials withpetrochemical base. Shortages of raw materials are a usualphenomenon. With a view to insuring against these shortages,manufacturers keep larger inventories, which result in increase in theircosts. This occurs especially in case of imported raw materials. Wagesare always being linked to cost of living. There are wage boards foralmost every industry and management has little control on wage rates. Overheads are also higher in India due to the following reasons: The size of the plant is very often uneconomic due to the Governments desire to prevent concentration of economic power. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS However, there is now a marked change in the policy. In 1986, the Government announced that 65 industries would be started with minimum economic capacity so as to make Indias products competitive. This process got a boost after the new Industrial Policy was announced in July 1991. There is under-utilisation of capacities due to lack of raw materials and power shortage. However a manufacturer can exceed his capacity by improving the techniques of production process. Even after making improvements, a manufacturer lacks the way to completely minimise the possibilities of increase in the overheads. Machinery and equipment obtained under tied credits usually cost 30 to 40 per cent more than what it wouid cost if purchased in the open market. There are delays in the issue of licences and by the time licences are issued, cost of equipment goes up. The number of industries subject to licensing has now been drastically reduced. Increase in administered prices for many items crucial to the industrial production by the Government from time to time also pushes up costs. Finally, there is what lis called by businessmen as unseen overheads in the nature of demands for illegitl gratification by various Government officials at different administrative levels. There are indirect taxes, which also tend to raise the overallcosts of production in India. Excise duties and saies taxes alsoheighten the impact of indirect taxes on the cost of production. Indiais perhaps the only country where basic raw materials carry heavyexcise duties. According to an estimate by Mr. S. Moolgaokar,Chairman, TELCO, as much as Rs. 25 crores of working capital islocked up in inventories and work-in-progress with TELCO and itssuppliers solely due to the present tax structure. Until recent times the Indian industrialists operated in a sheltered BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdomestic market. They were protected against foreign competition byimport controls and against domestic competition due to industriallicensing. So long as this sellers market prevailed competition amongsellers was absent and there was no ¬compelling reason for theindustrialists to pay any attention to cost reduction. Costconsciousness was thus by and large absent in India. The price fixationfor products under price control ensured that the rise in costs wasfully reflected in the prices. This made it possible for the industrialiststo pass on any increase in costs to the consumers. However, now withthe advent of recession tendencies, and liberalisation in licensingpolicies, the Indian industrialist is compelled to pay greater attentionto cost reduction and cost control. APPENDIX - ICalculation of VariancesThe difference between the standard cost and the comparable actual,cost for the same element and for the same period is known as costvariance. The total of the variances consequently represents thedifference between the actual profits and the standard profits, i.e., theprofits that ought to have been made. The variances are said to befavourable or credit Variances when the actual performance exceedsthe standard performance or the actual costs are lower than thestandard costs. On the other hand, the variances are unfavourableordebit variances when the actual, performance falls short of thestandard performance or the actual costs exceed the standard costs. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSAll variances must state the direction of the variance as well as theamoUnt. Calculation of cost variances is an important feature ofstandard costing. The formulae for calculating the various variancesare given below:Material Cost Variance (Actual Quantity x Actual Price) - (Standard Quanity x Standard Price)or, (AQ x AP) - (SQ x SP)Material Price Variance (Actual Price - Standard Price) x Actual Quantityor, (AP - SP) x AQMaterial Usage or Quantity Variance (Actual Quantity - Standard Quantity) x Standard Priceor, (AQ - SQ) x SP Material usage variance can be further sub-divided into (i) Mixvariance and (ii) Yield variance. When the process uses severaldifferent materials that are supposed to be combined in a standardproportion, mix variance shows the effeclofvariations from thestandard proportion. The formula for calculating the mix variance is: (Actual Quantity - Standard Proportion) x Standard Price Yield variance shows the loss due to the actual loss being more orless than the standard loss. The formula for calculating the yieldvariance is: (Actual Loss - Standard Loss) x Average Standard Input PriceLabour CostVariance (Actual Hours x Actual Rate)-(Standard Hours x Standard Rate)or, (AH x AR) - (SH x SR)Labour Rate (Price) Variance (Actual Rate - Standard Rate) x Actual Number of Hoursor, (AR- SR) x AH BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSOverhead Efficiency VarianceThe object is to test the efficiency achieved from the actualproduction. The variance is thus, analogous in nature to the labourefficiency variance. The formula for calculation of the variance is: (Actual Hours - Standard Hours for Actual Production) x Standard Overhead Rateor, (AH - SH) x SOlt Cost control ultimately depends on action, which is based onvariances. However, these actions can be taken only by people whohave the appropriate authority. It is, therefore, futile to presentvariances to a person if those variances are related to matters, whichfall outside his guthority. Such variances are called uncontrollablewhereas those relating to matters within his authority ilre termed ascontrollable variance. APPENDIX IICost Control Drive in Coal India Limited (Cll)CIL closed in 1984-85 with a provisionally estimated profit of Rs. 20pro res after fully discharging its depreciation and loan repaymentobligations. The company had to initiate a series of stringent measuresto achieve the profit figure, the thrust being on controlling costs. Fourspecific areas chosen include: salary and wages, administrationexpenditure, stores and realisation of dues. In 1983-84, the incidenceof salary and wages being what it was, the cost of manpower, pertonne of coal worked out to Rs. 97.04. In 1984-85, the rise wascontained at 88 paisa and the cost of manpower per tonne came to Rs.97.92.This was despite the fact that there was a rise of 51 points inthe consumer price index. And then factors would have justifledan BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSincrease of Rs. 6.44 in the cost of manpower per tonne of coal but itwas contained at 88 paisa. The CIL Chairman pointed out that a major effort was made toensure gainful redeployment of manpower through persuasion andmotivation and at times even by force: Empowered teams of seniorexecutives were sent to interview people and persuade them to acceptjobs that would suit them. Local redeployment was insisted uponalthough in some places non-availability of residential accommodationcaused a problem. Secondly, increase of manpower was controlled verystrictly. Instructions were issued to subsidiary companies that no newappointment was to be made without Director of Finance and theChairman approving it. Thirdly, a drastic reduction was made inovertime allowance and for achieving this objective even threat ofsacking had to be administered. In the sphere of administration expenditure, the thrust was oncutting down the expenses on account of travelling allowance.However, cost control measures were most effective in the sphere ofstores management. The system of fortress checks, introduced in1984-85 resulted in straight saving of Rs. 30 crores. CILs profit in1984-85 would have been about Rs. 80 crores, ,if only there was anappropriate system of pricing.PRICE DISCOUNTS AND DIFFERENTIALSDistributors DiscountsDistributors discounts are the price reductions that systematicallymake the net price vary according to buyers position in the chain ofdistribution. They are called so because these discounts are given tovarious distributors in the trade channel, for example, wholesalefactors, dealers and retailers. For the same reason, they are also calledas trade channel discounts. As these discoUnts create differentialprices for different customers on the basis of marketing functionsperformed by them for example, whether they are wholesalers or BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSretailers, they are also called as functional discounts. However, it mustbe pointed out that the special discounts may also be given to personsother than distributors and not, associated with distribution function.For example, special discounts may be given to manufacturers whoincorporate the product in their own product. Tyres and tubes sold; tocycle manufactUrers for use in their bicycles, is a typical example.Special prices may be charged to members of the same industry; forexample, one company may exchange petroleum with anothercompany at a special price. Again, special prices may be quoted toCentral and State Governments and to the Universities; for example,Remington typewriters, Godrej safes, etc., are sold at low prices tothese places.Forms of Distributors DiscountsDistributors discounts take different forms determined mainly by theconsent of all the business firms in an industry. Nevertheless, at timesfirms may have to decide about the form in which discount is to beoffered. There are mainly three forms: Different net prices for different distributor levels. Net prices are rarely used for quoting differential prices to distributors. Manufacturers give them to certaii1iliithorised dealers. The simplicity of this method enables some savings in invoicing and accounting. A uniform list price modified by a structure of discounts, each rate applicable to a different level of distributor, List prices with discounts are more common. This method makes it easy to deal with diverse trade channels. It also facilitates cyclical and seasonal adjustments in prices by merely varying the discounts. This may also help in keeping actual prices a secret, not only among distributors but also from competitors· and customers secret, not only among distributors but also from competitors and customers. A single discount combined with different supplementary BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS discounts to different levels of distributors. For example, 5 per cent to regional distributors. Thus, the chief advantage of the prices with discounts is greaterflexibility. Further, this method helps the manufacturers to exercisegreater control over the realised margin of different categories ofdistributors. But real control is achieved only when such discounts arecoupled with resale price maintenance. A supplementary discountgives the manufacturers, a picture of the entire trade channel structure.These discounts may be intended to reflect distributors cost atdifferent stages and competition between different kinds ofdistributors. The supplementary discounts are very descriptive innature while their accounting is expensive. Distributors discountsdiffer widely in industries. They also differ among the various businessfirms within industry.How to Determine Distributors DiscountsThe economic function of distributors discounts is to induce differentcategories of distributors to perform their respective marketingfunctions. As such, to build up a discount structure on soundeconomic lines, it is essential to know the services to be performed bythe distributors, distributors operating costs, discount structure ofcompetitors, effects of discounts on distributor population, cost ofselling to different channels and opportunities for marketsegmentation. Services to be performed by the distributors at different levels: The main objective of the manufacturer is to get the distributor function performed most econoiIlically and effectively. For this purpose, he may decide upon the various types of services to be performed by the various types of distributors. The larger is the number of services to be performed by the distributor concerned, the larger is the discount allowed to him, and. vice versa. For example, a sewing machine manufacturer might de£idethat the dealer will only display the various models of the machine manufactured by the firm and settle the terms of sale. The BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdelivery and servicing of the machines may be given to onedistributor in the city. Naturally, in such a cast the discount givento the dealer will be lower than in the case where he has to stockthe commodity and provide after-sales services as well.Distributors’ operating costs: Trade discounts should naturallycover the operllting costs and the normal profits of thedistributors. In case of high margins, distributers would beinduced to make extra selling efforts. If margins do not covercosts, the distributors concerned would not be interested inpushing up the sale of the product. Sometimes distributorsbelonging to the same category by name may be performingwidely diflcling functions, Their operating cost is, therefore,determined by the funel ions they perform, For example, if adistributor is required to warehouse and ship the goods as andwhen required by the actual users, he would require greaterdiscounts than a distributor who receives the consignments intruckloads and merely reships them to the different actual userswithout having to warehouse them. Even when distributors arepcrforming identical services, operating costsmay differ amongindividual distrihutors depending upon variations in theiroperating efficiency. In such cases, the manufacturer has todetermine as to whose costs will he try to cover through tradediscounts. There are two possible alternatives: (I) the costs or themost efficient two-thirds of the dealers plus normal profits, or (2)an estimate of his own cost of performing the distributionfunction. This is very oncn used when the manufacturer is alreadyengaged in some sort or distribution runction.Competitor’s discount structure: The discounts granted bycompetitors arc usellII guides in framing the structure ofdiscounts. Their relevance becomes still greater when it isrealised that distributors discounts are given in order to scek thedealers sales assist~nce in a, competitive market. In quite a goodnumber of trades, discount rates are fixed by custom and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmanufacturers have no option but to fall in line. In manyindustries, the actual discounts granted by rival sellers vary. Insuch a case, the manufacturer has to decide whether he should beguided by the higher or the lower discounts. In case the productof the manufacturer is at some disadvantage in consumeracceptance, he may decide to allow larger margins than those ofhis competitors. The success of the policy, however, woulddepend upon the following conditions: (a) whether this highmargin of discount merely, compensates for the low turnover andwhether the distributor gets any real economic in~entive? (b)Whether the discount margin will be adequate to induce thedistributor to push the product? (c) How much influence does thedistributor have in pushing a particular brand over that of thecompetitor? (d) Whether the dealer has scope for profitablemarket segmentation and personal price discrimination? And (e)Whether competitor are likely to meet the wider discount margivarying their own? Thus, in general, the success of a particular disscheme requires that the consumers are considerably indifferentto bl have great confidence in the distributor and themanufacturers IT share is so small that large competitors will notfeel compelled to cI their own wider margins. A related question is:should a lower p~i, offered to dealers who handle a certain brandexclusively? Naturall exclusive dealer in general will get a higherdiscount in addition to price advantage arising from quantitydiscounts.Effect of discounts on distributors population: Very often, Idiscounts may be allowed to encourage the entry of newdistribute push up the sales of a new product line. Similarly,smaller discounts In allowed when the number of distributors hasto be restricted.Costs of selling to different channels: There is asaving inoverheat selling to retailers as compared to consumers and· towholesalel compared to retailers and the regular system of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS discounts has somethil do with this saving in overheads. Opportunities for market segmentation: Trade channel discounts C2 used to achieve profitable market segmentation. In some industries market is divided into several fairly distinct sub-markets, each havin own peculiar competitive and demand characteristics. For example, il tyre market, the following sub-markets may be distinguished: o Original equipment market characterised by skill and bargai strength ofthe buyers and by big cyclicaJ fluctuations in demand. o Individual consumer replacement. Market characterise by unskilled buying, brand preferences, and cyclical stability. o Commercial operators replacement market characterised by I buyers who are price-wise and quality-wise, for example, munic transport undertakings. o Government sale in market characterised by large orders, foil bids and publication of successful bidders price. o Export market characterised by international competition. Each one of these sub-markets .has different elasticity of,demand. There! The need to charge different prices in each marketsegment arises from difference in the elasticities of demand in thesesubmarkets. The disc (structure can be so devised as to produce therelevant differential prices suitable for each market segment. Forexample, in the case of original equipment market, price has littleinfluence on the total number of tyres purchased because the price ofthe tyrespaid by automobile manufacturers would form very smallpercentage of the wholesale price of the car, say, less than 5 per cent.As such, no feasible reduction in tyre prices would affect cat pricesenough to increase perceptibly the demand for cars and hence of tyres.Very often, while pricing a product which is to be used as acomponent of the finished product of another manufacturer, e.g.,pricing of spark plugs or tyres, their manufacturers may be influencedby such considerations as earning prestige through associating the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScomponent with the finished product, getting replacement business ifthe product is used as a component with some well-known product,etc. Hence, while selling the component product to the manufacturerof finished product; lower prices and for that purpose higherdiscounts may be allowed. In case of individual consumer replacementmarket, i.e., where buyers are consumers demanding the product forreplacement. The level of price affects the timing of the demandwithin fairly regroups limits set by the age of the product, say tyre.Here because of brand preferences, buyers responsiveness to pricedifferences is lower than in other markets where buyers knowledge isgreater. Another pricing problem relating to individual consumerreplacement market arises because the manufacturer has to decidewhether to allow high discounts as to permit dealers tomake-individual concessions to customers. Here, a dealer can chargefull price from some customers who are averse to shopping andbargaining but quite substantially lower prices to more careful and·bargaining type of customers. Thus, allowing high discounts to dealersprovides them sufficient leeway to charge higher or lower prices fromtheir own customers according to their demand elasticity. It isnormally appropriate to allow the dealer large discounts and therebyconsiderable latitude where the unit cost of the article is high, whereservice concessions and trade-ins are provided to the customers byway of veiled price concessions and where the customer is not tiedstrictly to the dealer by continuity of service or by customer relations. A related pricing problem of the manufacturer is to decidewhether different distributor margins should be fixed for high-qualityhigh-price commodities, on the one hand, and low-quality low-priceproducts, on the other. The manufacturer has to consider whether heis to concentrate more on high quality or on low quality products inview of their respective profitability. Market segmentation achievedthrough differential distributors discounts enables building big plantsto reap economies of size. Manufacturers have sometimes built bigger BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSplants and to work them to full capacity, they have taken up privatelabel business (manufacturing _ goods to order with private andexclusive brarids), allowing greater discounts till their own brandbecomes sufficiently popular and its demand increases sufficiently towork the big plant fully. If so, they can discontinue the private labelbusiness.Distributors demand elasticity higher than that of consumers:Distributors demand for the competing brand of differentmanufacturers is more elastic than the corresponding demand of finalconsumers. The distributor is generally more capable of judging priceand quality than ultimate consumers who have insufficient knowledgeof the competing brands, and apprehend that a low price may besynonymous with inferior quality. The consumer finds it difficult tochoose between different competing brands, and he often allowshimself to be guided by the retailers. It may be safely asserted thateven the smallest difference in price may cause a dealer to switchover from one brand to another whereas an even greater price changemight not cause any reaction on the ultimate consumers. It is,therefore, of decisive importance to the manufacturers that theysecure the goodwill of the distributors. In. fact, the distributorspotential selling power is great and the manufacturers should try togain their promotional support. However, in the case of a few highly advertised branded products,which occupy a firms position in the minds of the consumers,distributors have to be content with very small margins. For example,the retailers margin in a 5-kilo Dalda tin comes to 1.5 per cent only.It would be better for a manufacturer to adopt a standard discountpolicy. With latitude in discount policy, there is much danger ofconfusion, inequity, loss of goodwill and loss of sales. It may also benoted that distributor discounts do not matter much in industrialgoods.Quantity Discounts BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSQuantity discounts are price reductions related to the quantitiespurchased. Quantity discounts may take several forms and may berelated to the size of the order being measured in terms of physicalunits of a particular commodity. This is practicable where thecommodities are homogeneous or identical in nature, or where theymay be measured in terms of truckloads. However, this method is notpossible in case of heterogeneous commodities, which are hard to addin terms of physical units, or truckloads. Drug industry and textileindustry offers examples of this type. Here, quantity discounts arebased upon the rupee value of the quantity ordered. Rupee becomes acommon denominator of value. Quantity discounts based on physical units become importantwhere the cost of packing is a significant factor and orders of less thanstandard quantities, say, less than a case of 6 pressure cookers, mayinvolve higher packing charges per cooker. Since the space remainsunutilised, the quantity discounts may be employed to induce full-casepurchasing. In some cases, sellers may clearly mention that packingcharges will be the same whether you purchase a full case or less thana full case. Here also, the buyer may like to go for a full case and inessence avail himself of the quantity discounts. Discounts based onphysical units are less likely to be distorted by changes in prices. In some cases, to prompt large orders, it may he specified thatorders up to a certain size will not be entitled to any discount. Butbeyond this size, the customer would be entitled to a discount for hisextra purchases over and above the minimum size. The discount ratesmay vary with successive slabs of quantities ordered. Alternatively,discount may be allowed on the entire purchases provided they exceeda certain minimum. In some cases, quantity discounts mflY be basedon the cumulative purchases made during the particular period,usually at year or a. season, e.g., Diwali discounts may be given on thebasis of cumulative purchases made during the Diwali season spreadover September to November. This is different from quantity BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdiscounts based upon individual lots ordered at a time. ThesediscountS ensure customer loyalty and discourage purchasing fromseveral competitors simultaneously, but the limitation of cumulativediscounts is that, they do not tackle the problem of high cost ofservicing small orders, because, buyers get no incentive to order forbigger lots and to avoid hand-to-mouth purchasing. Buyers may beinclined to place larger orders towards the end of the discount periodto qualify for higher discounts. This may disrupt the productionschedule of the manufacture . The following genital conclusions can be reached: • Individual order size is a better basis than cumulative purchases made during a particular period. Discounts based on the quantity of individual commodities ordered have advantages over those based on the total size of mixed commodities ordered. Physical units are preferable to rupee value as a measure of order size on which to base quantity discounts.Objectives of Quantity DiscountsOne important objective of quuntity discountS is to reduce thenumber of small orders and thereby avoid the high cost of servicingthem. Quantity discounts can facilitate economic size orders in threeways: A given set of customers is encouraged tbbuy the same quantity batiste bigger lots. The customers may be induced to give the seller a larger: ihare of their total requirements by giving preference over, competitors. Small size purchasers may be discouraged and bigger size customers may be attracted. Quantity discount system enables the dealer to reap economiesof buying in lager lots. These economies may enable the dealer tocharge lowler prices from the customers thereby benefiting the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScustomers. Finally, lower prices to customers may increase thedemand for the commodities, which in turn may enable the dealer topurchase larger quantities, reaping still greater discounts, and themanufacturer to reap economies of large-scale production, Theadvantages to the manufacturer, dealer and customer are as suchcircular. In fact, in many cases discounts become a matter of tradecustom. A noted disadvantage of quantity discounts is that dealers mayoften find it cheaper to purchase from wholesalers availingthemselves of these quantity , discounts than from the manufacturerdirectly. This is because the wholesalers may pass on some of theirdiscounts to the dealers. This may ultimately affect the image of themanufacturer in the minds of the dealers. Again, if the seller becomesdependent upon a few buyers, they may be able to dictate, hispolicies ap.d practices. But if his product is sufficiently differentiatedor his service is unique, he may find it possible and worthwhile topursue an independent discount policy. Quantity discounts are mostuseful in the marketing of materials and Applies but are rarely usedfor marketing equipment and components. Quantity discounts have attracted the attention of the Monopoliesand Restrictive Trade Practices Commission. The Commissionconceded the claim of Reckitt and Coleman of India Ltd., that it wasentitled to gateway under Section, 38(1) (h) of tlie Act in respect ofdiscounts given on larger orders. It was held that the Company’s pricestructure did not directly or indirectly restricts competition to anymaterial degree. However, some time later, the Commission extnictedan assutance from the five manufacturers of grinding wheels thatthey would give up the practice of discounts based on the quantity.Their practice of pricing on ‘slab’ Basis was alleged to give advantageto buyers of larger quantities compared to Players of smallerquantities.Cash Discounts BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSCash discounts are price reductions based on promptness of payment.An example of discount can be "2 per yent off if paid in ten days, fullinvoice price in 30 days." In practice, the size of cash discount mayvary widely. Cash discount is a convenient device to identify andovercome bad credit risks. In certain trades where credit risk is high,cash discount would be high. If a buyer decides to purchase goods oncredit, this reflects his weak bargaining position, and he has to pay ahigher price by forgoing the cash discount. There is another way tolook at cash dis.counts. Though cash discounts encourage promptpayment, yet allowing of cash discount also involves certain costs. These costs have to be compared with the cost of carrying theaccount, viz., locking up of working capital, expense of operating acredit and collection department- and risk of bad debts andalternative ways of attaining prompt settlements. By promptcollections, manufacturers reduce their working capital requirementsand thus save their interest costs. However, allowing discounts mayinvolve paying 36.5 per cent in order to save 15 per cent. Thus it isthe reduction in collection expenses and in risks rather than savingson interest, which should be the guiding consideration for cash·discounts. The main point of distinction between cash discounts andquantity discounts is that the former are price reductions based onpromptness ·of payment whereas the latter are price reductionsdepending on the quantities purchased (physical units or rupee valueof the quantity purchased). As such, cash discounts induce promptpayments or collections whereas quantity discounts induce buying inlarge quantities.Time DifferentialsCharging different prices on the basis of time is another kind of pricediscrimination. Here the objective of the seller is to take advantage ofthe fact that buyer demand elasticity varies over time. Two broadtypes of time differentials may be distinguished: Clock-time differentials, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Calendar-time differentials. Clock-time Differentials: When different prices are charged forthe sMne service or commodity at different times within a 24 hoursperiod, the price differentials are known as clock-time differentials.The common examples of these are the differences between the dayand night rates on trunk calls, differences between morning andregular shows in cinema houses, and different tates charged forelectricity sold to industrial users during peak load hours (day time)and off¬peak load hours. In the case of telephone services, day timingis the period of more inelastic demand and the night time is the moreelastic demand period. Two conditions, which make the clock-timedifferentials profitable are as follows: Buyers must have a definite and strong preference for purchasing at certain timings over others giving rise to significant differences in demand elasticity. The product or service must be non-storable either wholly or in parts, i.e., the buyer must consume the entire product at one time when and for which he pays. In case the product is storable, it will be purchased at lower rates to be used later when needed making price differential a losing proposition. Calendar-time Differentials: Here price differences are basedon a period longer than 24 hours; for example, seasonal pricevariations in the case of winter clothings, or betel accommodation athill and tourist stations. Here, the objective is also to exploit the timepreferences of the buyers.Geographical Price DifferentialsGeographical price differentials refer to price differentials based onbuyers location. The objective here again is to minimise thedifferences in transport costs due to the varying distances betweenthe locations of the plants and the customers. There are various typesof geographical price differential, which are explained below: FOB factory pricing: It implies that the buyer pays all the freight BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSand is responsible for the risks occurring during transport exceptthose that are assumed by the carrier. The advantages of FOB factorypricing are as follows: It assures u uniform net price on nIl shipments regardless of where they go. No risk is assumed by the seller. The seller is not responsible for delay in carriage. Postage stamp pricing: Postage stamp pric1rg means chargingthe same delivered price for all destinations irrespective of buyerslocation. The quoted price naturally includes the estimated averagetransportation costs. In effect, these prices become discriminatory,that the short distance buyers have to pay more for transportationthan the actual costs involved while long distance buyers have to payless than the actual costs of transporting goods. Postage stamppricing is most Hnmonly employed for goods of popular brands andhaving nation wide distribution. The basic idea is to maintain auniform retail price at all places. This common retail price can also beadvertised throughout the country. Bata footwears provide the bestexample of postage stamp pricing other examples are Usha sewingmachines and fans, radios, pressure cookers, typewriters, drugs andmedicines, newspapers and magazines, etc., Postage stamp pricing is most suitable in case of products wheretransportation costs are significant. It can also be used with advantageby manufacturers to avoid the disadvantage of location being far awayfrom the main customers who if charged on the basis of actual costsmight have to pay much more and hence refrain from purchasing. Thisadvantage is particularly striking in the case of products involving hightransportation costs. This pricing gives a manufacturer access to allmarkets regardless of his location. Market access is particularlyimportant when products of the rivals are substantially the same. Zone pricing: Under zone pricing, the seller divides the countryinto zones and regions and charges the same delivered price within BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSeach zone, but different prices between different zones. For example,Parle Company has divided the country into 9 zones, the intra-regionalprice differentials ranging between 5 and 15 per cent approximately.Generally speaking, zone pricing is preferred where the transportationcost on goods is too high to permit their sale throughout the countryat uniform price. The more significant the transportation costs, thegreater the number of zones and smaller their size. Conversely, forproduct involving lower transportation costs, zones are generally fewbut big in size. In India, zone pricing has been widely used invanaspatiand sugar industries.Basing point pricing a basing point price consists of a factory priceplus transportation charges calculated with reference to a particularbasing point. Under this system, the delivered price may be computedby using either single basing point or multiple basing points. In thesingle basing point system, all sellers (irrespective of the locations)quote delivered prices, which arc the sum of the basing point priceand cost of transport from the basing point to the particular point ofdelivery. Thus, the delivered prices quoted by all sellers for a givenpoint of delivey are uniform regardless of the point from whichdelivery is made. In the multiple point pricing system, two or moreproducing centres are selected as basing points, and the seller thenquotes a delivered price equal to the factory price plus transportationcosts from the basing point nearest to the buyer. Rasing-point pricinghas been widely used in the USA, especially in the steel industry whereat first the single basing-point system known as Pitts burgh plus wasemployed. It was followed by mulliple basing point pricing whenPittsburgh plus was declared illegal.Consumer Category Price DifferentialsPrice discrimination is frequently practised according to consumercategories in the case of public utilities, for examples, electricity,transportation, etc. Electricity firms quote different rates forresidential consumers and industrial consumers. The rates may also BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdiffer for domestic power, light and fan. Railways also chargedifferently from children to adults. They also charge differently -ondifferent classes of goods and different classes of passengers.Personal Price DiscriminationPrice concessions are commonly made to individuals at times forpersonal considerations. For instance, special prices may be given tocompanies own employees, shareholders or personal acquaintances.These special prices may take several forms such as additionalservices free of cost, leniency in fixation of prices for used goods inexchange of new ones and extending credit, interest-free credit.REVIEW QUESTIONS 1. Explain with illustration the distinction between the following: A. Fixed cost and variable costs B. Acquisition cost and opportunity cost. 2. What is opportunity cost? Give some examples. How are these costs relevant for managerial decisions? 3. When MC changes, AC changes (a) at the sane rate, (b) as a higher rate, or (c) at a lower rate? Illustrate your answer with the help of diagrams. 4. Explain the relationship between marginal cost, average cost, and total cost. 5. Distinguish between the following: A. Marginal cost rind incremental cost; B. Business cost and full cost; C. Actual cost and imputed cost; D. Private cost and social cost of private business. 6. Discuss the various economies or scale. Also discuss Sargent Florences principles in this regard. 7. "Economics of scale may be either external or internal; they may be technical, managerial, financial or risk-bearing." Elucidate. 8. Discuss the various economies of scale. Do they result in monopolies? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS9. What are the advantages and limitations of large-scale production?10.State the importance of cost control in profit planning and discuss the various areas of cost control.11.Distinguish between cost control and cost reduction. What are the essentials for the succcss of a cost reduction programmc? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS LESSON – 4 PRODUCTION FUNCTIONThe term "production function" refers to the relationship betweeninputs used and outputs produced by a firm. The terms "factors ofproduction" and "resources" are used interchangeably with the term"inputs". The relationship is purely physical or technological incharacter and therefore it ignores the prices of inputs and outputs.The study of the production function is aimed at achieving themaximum output. This can be done with a given set of resources orinputs, and with a given state of technology. The production functioncan be expressed in the form of a schedule. Table 4.1 shows twoinputs viz; labour [X], i.e., number of workers, and capital [Y], i;e., sizeof machine in terms of horsepower, and one output (Q), i.e., thenumber of tonnes of iron produced with the various combinations ofinputs. Table 4.1: Production Function Capital (Y) - Size of machines (in horse power) 250 1,000 1,500 2,000 Labour (X) 1 2 20 32 26 (Number of 2 4 48 58 88 workers) 3 8 88 110 100 4 12 110 120 110 5 32 120 124 120 6 58 124 126 124 7 88 126 128 128 8 100 126 130 130 9 110 126 130 132 10 104 124 130 134 The production function can also be stated in a form of an eqation: Q = f (X1, X2, etc.), Where Q = A function ofthedesired output as a result of utili singthe quantity of two or more inputs Xl = units of labour, X2 = units of machinery. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Some factors of production are assumed to be fixed (i.e., notvarying with changes in output); and hence are not included in theequation. The production function is estimated by the method of leastsquares. In economic theory, we are concerned with three types ofproduction functions, viz., Production function with one variable input. Production function with two variable inputs. Production function with all variable inputs.PROPUCTION FUNCTION WITH ONE VARIABLE INPUTIn economics, the production function with one variable input isexplained with the help ofLaw of Variable Proportions, which is asfollows:Law of Variable ProportionsThe law of variable proportion is one of the fundamental laws ofeconomics. It is also known as the Law of Diminishing MarginalReturns or the Law of Diminishing Marginal Productivity. This Law ofvariable proportion shows the input-outPut relationship or productionfunction with one variable factor, i.e., a factor, which can be changed,while other factors of production are kept constant. This is explainedwith the help of the following example: Suppose a farmer has 20 acres of land to cultivate. The land hassome fixed investment, Le., capital in the form of a tube well,farmhouse and farm maehinery. The amount of land and capital issupposed to be fixed factors of production. However, the farmer canvary the number of workers employed on its land. Labour is thus thevariable factor of production. The change in the number of workerswill change the output. The point worth noting here is that the law does not state thateach and every increase in the amount of the variable factor that isemployed in the production process will yield diminishing marginal BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSreturns. It is, however, possible that preliminary increases in theamount of a variable factor may yield increasing marginal returns.While increasing the amount of the variable factor, a point will " bereached though, where the; marginal increases in total output or themarginal retums will begin declining.Assumptions for Law of Variable ProportionsThe law of variable proportions functions is based on followingassumptions: Constant technology: The technology is assumed to be constant because technological changes will result into rise of marginal and average product. Snort-run: The law operates in the short-run because it is here that some factors are fixed and others are variable. In the long-run, all factors are variable. Homogeneous input: The variable input employed is homogeneous or identical in amount and quality. Use of varying amount of variable factor: It is possible to use various amounts of a variable factor on the fixed factors of production.Three Stages of ProductionA graphic description of the production function is shown in followingfigure 4.1. The total, marginal and average product curves in Figure4.1, demonstrates the law of variable proportions. The figure alsoshows three stages of production associated with law of variableproportions. The total product curve is divided info three segmentspopularly known as three stages of production, which are as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSStage IThe figure 4.1 shows stage 1 as the segment from the origin topointX2. Here, total product (TP) rises at an increasing rate. At thispoint, the marginal product (MP) of X equals its average product (AP).X2 is, also the point at which the average product is maximised. In thisstage, the production function is characterised first by increasingmarginal returns from the origin to point X1and then by diminishingmarginal returns, from X1to X2. It should not be assumed that in stage1, only increasing marginal returns take place. Because increasingreturns may occur until a certain point, and thereafter diminishingreturns may take place. Stage I should not therefore be identified withincreasing marginal returns only. Here, both AP and MP increase. Inthis stage, a firm can move towards optimum combination of factorsof production and increasing returns, by adding more and morevariable units to fixed factors.Stage IIThe stage II is depicted by the figure in the range from X2 to X3. Inothcr words, stage II begins where the average product of the variablefactor is maximised. It continues till the point at which total product ismaximised and marginal product is zero. Here, TP rises at diminishingrate. This stage is thus, called the stage of diminishing returns, where BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSa firm decides its level of production.Stage IIIFinally, we have stage III, which is depicted by the area beyond X3where the total product curve starts decreasing. Here, too muchvariable input is being used as related to the available fixed inputs andthus variable inputs are overutilized. The efficiency of both variableinputs and fixed inputs decline through out this stage. In this range,the marginal product of the variable factor is negative. It starts fromthe point where MP is nil and TP is maximum and covers the wholerange of negative marginal productivity. The following Table 4.2shows the various stages. Table 4.2: Stages of Production Total Physical Product Marginal Physical Average Physical Product ProductStage IIncreasing at an Increases, reaches its Increases and reachesincreasing rate maxiIhum and then its maximum declines till MR = APStage IIIncreases at diminishing Is diminishing and Starts diminishingrate till it reaches becomes equal tomaximumStage III zeroStarts declining Becomes negative Continues to decline From this stage-wise description of the production function wecan reach two conclusions, which are as follows:Stage II is RationalOnly stage II is rational and denotes the relevant range-within which arationai firm should operate. In Stage I, it is profitable for the fiim tokeep on increasing the use of labour and in Stage, III, MP is negativeand hence it is inadvisable to use additional labour. The firm, therefore,has a strong incentive to expand through Stage I into Stage II. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSStages I and /II are IrrationalStages I and III are described as irrational stages. They are called sobecause management, if it is to maxi mise profits will neverintentionally apply the variable to the fixed factors in any combination,which will yield a total product falling in either of these two stages.PRODUCTION FUNCTION WITH TWO VARIABLE INPUTSTo understand a production function with two variable inputs, it isnecessary to explain what is an Isoquant.IsoquantsAn isoquant is also known as an iso-product curve, equal productcurve or a production indifferent curve. These curves show thevarious combinations of two variable inputs resulting in the same levelof output. Table 4.3 shows how different pairs of labour and capitalresult in the same output. Table 4.3: Different Pairs of Labour and Capital Labour Capital Output (Units) (Units) (Units) I 5 10 2 3 10 3 2 10 4 1 10 5 0 10 It is evident that output is the same either when 4 units oflabour with 1 unit of capital or 5 units of labour with 0 units of capitalare employed. This relationship, when shown graphically results in anisoquant. Thus, by graphing a production function with two variableinputs, one can derive the isoquant that helps in tracing all the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScombinations of the two factors of production that yield the sameoutput. Thus, an isoquant can be defined as "the curve passingthrough the plotted points representing all the combinations of thetwo factors of production, which will produce the given output." Figure4.2 depicts a typical isoquant digram in which by an upwardmovement to the right, one can obtain higher levels of outputs, usinglarger quantities of output. For each level of output, there will bedifferent isoquant. When the whole array of isoquants is representedon a graph, it is called isoquant map.Substitutability of InputsAn important assumption regarding the isoquant diagram is that theinputs can be substituted for each other. For example a particularcombination of X and Y results in output quantity of 600 units. Bymoving along the isoquant 600, one finds other quantities of theinputs resulting in the same output. Let us suppose that X representslabour and Y represents machinery. If the quantity of the labour (X) isreduced, the quantity of machinery (Y) must be increased in order toproduce the same output. The following Figure 4.2 shows a typicalisoquant. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSMarginal Rate of Technical Substitution (MRTS)The slope of the isoquant has a technical name; Marginal Rate ofTechnical Substitution (MRTS) or sometimes, the marginal rate ofsubstitution in prodtltioti.) Thus, in terms of inputs of capitalservices K and Labour L. MRTS = aK/dL MRTS is similar to MRS, I.e., Marginal Rate of Substitution, (whichis slope, of an indifference curve).Types of IsoquantsIsoquants assume different shapes depending upon the degree ofsubstitutability of inputs under consideration. Based on this thetypes of isoquants can be enlisted as follows: Linear Isoquants: In the case of linearisoquants, there is perfect substitutability of inputs. For example, a given output say 100 units can be produced by using only capital or only labour or by a number of combinations of labour and capital, say 1 unit of labour and 5 units of capital, or 2 units of labour and 3 units of capital, and so on. Likewise, a giyen power plant that is equipped to burn either oil or gas, for producing various amounts of electric power can do so by burning either gas or oil, or varying amounts of each. Gas and oil are perfect substitutes here. Hence, the isoquants are straight lines. The following Figure 4.3 shows the isoquant for oil and gas. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSRight Angle Isoquant: When there is completenon-substitutability between the inputs (or strictcomplimentarily) then the isoquant curves take the form of rightangle isoquants. For example, exactly two wheels and one frameare required to produce a bicycle and in no way can wheels besubstituted for frames or vice-versa. Likewise, two wheels andone chassis (The rectangular, steel frame, supported on springsand attached to the axles, that holds thepody and motor of anautomotive vehicle) are required for acooter. This is also knownas Leontief Isoquant or Input-output isoquant. The followingFigure 4.4 shows the isoquant for chasis and wheels.Convex Isoquant: This form of isoquants assumessubstitutability of inputs but the substitutability is not perfect.For example, in Figure. 4.5 a shirt can be made with relativelysmall amount of labour (L1) and a large amount of cloth (C1). Thesame shirt can be as well made with less cloth (C2), if more,labour (L2) is used because the tailor will have to cut the clothmore carefully and reduce wastage. Finally, the shirt can bemade with still less cloth (C3) but the tailor must take extremepains" so that JabourinpiJt requirement increases to C3. So, whilea relatively small addition of labour from L1 to L2 allows theinput of cloth to be reduced from C1 to C2, a very large increasein labour from L2 to L3 is needed to obtain a small reduction in BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS cloth from C2 to C3. Thus the substitutability of labour for cloth diminishes from L1 to L2 to L3. The following Figure 4.5 shows isoquant for cloth and labour.Main Properties of IsoquantsAll the above-mentioned isoquants are featured with some commonproperties, which are as follows: An isoquant is downward sloping to the right, i.e., negatively inclined. This implies that for the same level of output, the quantity of one variable will have to be reduced in order to increase the quantity of other variable. A higher isoquant represents larger output. Jhat is, with the same quantity, of one input and larger quantity of the other input, larger output will be produced. No two isoquants intersect or touch each other. If two isoqua~tsinter.seCt or touch each other, this would mean that there will be a common point the Two curves; and this would imply that the same amount of two inputs could produce two different levels of output (i.e., 400 and 500 units), which is absurd. Isoquant is convex to the origin. This means that its slope declines from left to right along the curve. In other words, when we go on increasing the quantity of one input say labour by reducing that quantity of other input say capital, we see that BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS less units of capital are sacrificed for the additional units of labour.PRODUCTION FUNCTIONS WITH ALL VARIABLE INPUTSA closely related question in production .economics is how aproportionate increase in all the input factors will affect totalproduction. This is the question of returns to scale, which brings tomind three possible situations: If the proportional increase in all inputs is equal to the proportional increase in output, returns to scale are constant. For instance, if a simultaneous doubling of all inputs results in a doubling of production then returns to scale are constant. The following figure 4.6 shows a constant rate to scale. If the proportional increase in output is larger than that of the inputs, then we have increasing returns to scale. The following Figure 4.7 shows increasing returns to scale. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS If output increases less than proprotionally with input increase, we have decreasing returns to scale. The following Figure 4.8 shows decreasing returns to scale. The most typical situation is for a productin function to havefirst increasing then decreasing returns to scale is shown in Figure 4.9. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The increasing returns to scale attribute to specialisation. Asoutput increases, specialised labour can be used and efficient,large-scale machinery can be employed in the production process.However beyond some scale of operations further gains fromspecialisation are limited, and co-ordination problems may begin toincrease costs substantially. When co-ordination price is more thanoffset additional benefits of specialisation, decreasing returns to scalebegin.Returns to Scale and Returns to an InputTwo important features of production functions are returns to scaleand returns to input, which are explained as follows: Returns to scale: These describe the impact on the output whenthe same proportion increases each input rate. If output increases by alarger percentage than the increase in each input then there areincreasing returns to scale. Conversely, if output increases by asmaller percentage, there are diminishing returns to scale and if itincreases by the same proportions there are constant returns to scale. Returns to input: These describe the impact on the outputwhen only one input is varied, holding all others constant. Thesereturns may be increasing, diminishing, or constant.Optimal Input Combinations BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS From the overall discussion so far itisobvious that productionfunction, has a pure physical or technological character. However, itdoes not tell which input combinations are optimal. For that purpose,one has to take into account the input prices. The following Figure4.10 shows the iscost curves.Isocost CurvesIn this connection, one has to consider yet another but importantdiagram consisting of isocost curves. Here also, the axes representquantities of the inputs X and Y. Suppose that the prices of the inputsare given, and there are no quantity discounts for the firm to get largerquantities at lower prices. The next step will be to plot the variousquantities of X and Y which may be obtained from the given monetaryoutlays. Figure 4.10 shows the resulting isocost curyes, which arestraight lines under the assumption made here. One isocost showingthe quantities of X and Y that can be purchased for Rs. 1,000 andanother isocost curve showing the quantities of X and Y which can bepurchased for an expenditure of Rs. 2,000 and so on. Now we can easily superimpose the isocost diagram on theisoquant diagram (as the axes in both the cases represent the samevariables). With the help of Figure 4.11, it can be ascertained that themaximum output for a given outlay, is say Rs. 2,000. The isoquant BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICStangent represents this maximum output, which is possible with thisoutlay, to the isocost curve. The optimum combination of inputs isrepresented by point E, the point of tangency. At this point, themarginal rate6f substitution (MRS, sometimes known as the rate oftechnical substitution), between the inputs is equal to the ratiobetween the prices of the inputs. Likewise, in order to mini mise the cost for a given output, onemay again refer to the isoquant and isocost curves in Figure 4.11. Inthis case one moves along the isoquant representing the desiredoutput. It should be clear that the minimum cost for this input isrepresented by isocost line tangent to the isoquant.Firms Expansion PathA firms expansion path is defined by the cost-minimisingcombination of several inputs for each output level. Thus the linerepresenting least cost combination for different levels of output iscalled firms expansion path or the scale line shown by line ABC inFigure 4.12. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSMEASUREMENT OF PRODUCTION FUNCTIONSeveral types of mathematical functions are commonly used formeasuring production function but in applied research, four types areused extensively. These are linear functions, power functions,quadratic functions and cubic functions.(1) Linear FunctionA linear production function is expressed as follows: Total product: Y = a + bX, where Y = output and X = input. Fromthis function, equation for average product will be Y/X=a/X+b The equation for the marginal product will be Y/X = b(2) Power FunctionA power function expresses output, Y, as a function of input X in theform: Y = aXb Some important distinctive properties of such power functions are: The exponents are the elasticities of production. Thus, in the above function, the exponent b represents the elasticity of production. The equation is linear in the logarithms, that is, it can be written BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS as: log Y = log a + b log X When the power function is expressed in logarithmic form as above,the coefficient represents the elasticity of production. If one input is increased while all others are held constant, marginal product will decline.(3) Quadratic ProductionFunctionThe production function may be quadratic and is expressed as follows: Y = a + bX = cX2 Where the dependent variable, Y, represents total output and theindependent variable, X, denotes input. The small letters areparameters and their probable values are determined by a statisticalanalysis ofthe data. The distinctive properties of the quadratic production function areas follows: The minus sign in the last term denotes diminishing marginal returns. The equation allows for decreasing marginal product but not for both inerellsing and decreasing marginal products. The elasticity of production is not constant at all points along the curve as in a power function, but declineswiih input magnitude. The equaItion never allows fotan increasing marginal product When X = 0, Y = a, this means that there is some output even when no variable input is applied. The quadratic equation has only one bend as compared with a linear equation, which has no bends.(4) Cubic Production FunctionThe cubic production [unction is expressed as follows: Y = a -I- bX -I- cX2 – dX3 Some important distinctivc properties of a cubic productionfunction arc as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS It allows for both increasing and decreasing marginal productivity. The elasticity of production varies at each point along the curve. Marginal productivity decreases at an increasing rate in the later stages.PRODUCTION FUNCTION AND EMPIRICAL STUDIESThe measurement of production function dates back to a centurywhen certain r pioneer studies were made in the field of agriculture.And though economic concepts and statistical techniques have nowadvanced a lot, its major work is still in agriculture.Cobb-Douglas FunctionA very popular production function, which deserves special mention, isthe Cobb¬I Douglas function. It relates output in Americanmanufacturing industries from 1899 to 1922 to labour and capitalinputs, taking the form. P = bLaC1 - a Where, P = Total output L=Index of employment of labour in manufacturing C = Index of fixed capital in manufacturing. The exponents ‘a’ and ‘1 – a’ are the elasticity of productionthat is, ‘a’ and ‘1- a’ measure the percentage rexsponse of output topercentage changes in labour and capital respectively. The functionestimated for the USA by Cobb and Douglas is: P = 1.01L.75C25 R2 = .94.09 This production function shows that a 1 per cent change inlabour input, with the capital remaining constant, is associated with a0.75 per cent change in output. Similarly, a 1 per cent change incapital, with the labour remaining constant, is associated with a 0.25per cent change in output. The coefficient of determination (R2) meansthat 94 per cent of the variations on the dependent variable (P) were BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSaccounted for, by the variations in the independent variables (L and C). An inportant point to note is that the Cobb-Douglas functionindicates constant returns to scale. That is, if factors of production areeach increased by 1 per cent, the output will increase by 1 per cent. Inother words, one can assume constant avberage and marginalproduction costs for the US industries during the period. The followingFigure 4.13 shows the graph of Cobb-Douglas production.Criticism The production function ordianrily discussed in economics is a rigorously developed micro-economic concept. However, Douglas and his colleagues, estimated production function for nation’s economies for manufacturing sectors and even for industries. Thus they “transferred” strictly micro- economic concept to a macro-econornic setting, without sufficiently justifying their act on logical economic grounds. Therefore, the result of their studies, in the form of equations which they derived, may be incorrect, and hence the interpretations based on their equations are uncertain. The production function of economic theory assumes that the quantities of inputs used are those that are actually used in production. Therefore no variable input is ever redundant. In the Douglas studies however, only labour was measured by the quantity actually used in production, while capital was measured BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS by the capital investment, i.e., the quantity available for production. Therefore, with the possible exception of the years in which full employment and prosperity prevailed and industry made reasonably fuil use of the available inputs, the measure of capital employed was not theoretically correct one. If annual capital input always remained as a constant proportion of total capital investment, then only the elasticity would be the same. In spite of this criticism, the Cobb-Douglas type of production function has been found useful for interpreting economic results, since the elasticity of production; is given directly by the exponents when the data are in original form, or by the regression coefficients when the data are in logarithmic form.MANAGERIAL USE OF PRODUCTION FUNCTIONS Though production functions may seem to be highly abstract andunrealistic, in fact, they are both logical and useful. If the price of afactor of production declines whereas that of another goes up, theformer is likely to substitute the latter. The usefulness of theproduction function can be explained with the help of an example,dairy economists are interested in minimising the cost of feeding cowsin milk production. Taking a cow as a single firm, and grain androughage as inputs, the question arises: What proportion of grain androughage would be economical in feeding the cow? In the past, therehas been some tendency to prescribe a fixed ratio, but economicanalysis suggests that the optimal ratio depends on the inptlt prices.For instance, if we draw isoquantsrelating various quantities of grainand roughage, to various levels of milk output and then superimposeisocost curves on the isoquant diagram, the optimum point of largestoutput for a given outlay or of minimum outlay for a givenoutput-would depend on the prices of the factors of production, and itwould change as these prices change. The dairy farmer can use suchanalysis for increasing the return from his expenditure on feeds. Certain economists have focused especially on the application of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICStheir findings. For instance, Earl Heady and his associates havedeveloped a mechaniclIl device known as Pork Postulator, whichfacilitates the farmer to determine the most profitable ration forfeeding pigs under different price conditions. Production functions thus are not just theoretical and futiledevices. They can also be used as aids in decision-making becausethey can give guidance in two directions regarding: Obtainfng the maximum output from a given set of inputs Obtaining a given output from the minimum aggregation of inputs Of course, in more complex problems, with larger numbers ofinputs and outputs, the mathematics of optimisation becomescomplicated. But recently, the development of linear programming hasmade it possible to handle these complex problems. The use ofcomplex production functions in managerial decisiull making is goingto be further facilitated with the development of electrollic computers.DERIVING INPUT COMBINATIONS FROMPRODUCTION FUNCTIONGiven a production function for a certain output, one can derive all thecombinations of the factors of production that will yield the sameoutput. This can be illustrated as follows:IIIustrationSuppose the production function is: 0= 0.196 H 0.880 N 1.815 Where, 0= output oftransformers in terms of kilovolt-ampere (kVA) produced H = average hours worked per day N = number of men. Now, to derive the input combinations for an output level of1,200 kVA, we will have to set the above equation equal to 1,200: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 1,200 = 0.196 H 0.880 N 1.815 Then, substituting any value of H (or N) in the equation, we canobtain the associated value of N (or H). We compute below the numberof hours required (H) for an output of 1,200 kVA, if 38 men areemployed. 1,200 = 0.196 H 0.880 N 1.815 log 1,200 = log 0.196 + 0.880 log H + 1.815 log N = log 1,200 = log 0.196+ 0.880 log H + 1.815 log 38 In the same way, we can derive the value of H, if N is 40, 42, 44and so on, if the desired output level is 1,200 KVA. We can also derivevarious combinations ofH and N for other levels, say, 1,300 KVA or1,400 KVA.PRICE AND OUTPUT DECISION UNDERVARIOUS MARKET SITUATIONSTo understand the concept of market and its various conditions, it isnecessary to study the thcory orthe firm. This is discussed as follows:The Theory of the FirmThe basic, assumptions of the theory of the linn are as follows: The objective of a firm is to maximise net revenue in the face of given prices and technologically determined production function. A price incrcase far a product raises its supply, whereas prices increase for a factor reduccs its demand. The theory or lhe firm deals with the role of business firms in the resource allocation process. It uses aggregation as a tactic and attempts to specify total market supply and demand curves. The firm operates with perfect knowledge of all relevant variable involved in making a decision and it acts rationally while doing so. Originally the theory assumed that the firm is operating within a perfectly competitive market. But it has now been extended to cover other market situutions. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The theory has been criticised in the context that profitmaximisation is not the only objective of a firm. It has been suggestedthat long-run survival is the primary motive of an entrepreneur.Though the importance of profit has not been denied, manyeconomists have argued that profit maximisation should be replacedwith a gonl of makll1g satisfactory profits. However, there is a generalagreement that the theory or the firm explains at a general level, theway in which resources are alloclIted by the price system, when profitis the main criterion used by the firms. From the viewpoint of price analysis, it is very important forbusiness management to gain a proper understanding of the natureand process of competition in the modem industrial society. Themanagement should undcrstllnd the rationale of the free enterprisesystem within which its own business decisions have to be made andthe purpose and limitations of that system. Next it musl hnve fullknowledge of the markets and market situations in which its ownbusiness operates. It should be aware of the policies appropriate tothose market situations. The management should also have anunderstanding of the competitive process and the way variablesinvolved in the process such as price; product innovnt ion andpromotional activity may be manipulated in enlarging the firmsmarket share. The firms having monopoly power should be familiarwith the nature and llie purpose of the law relating to monopoly andrestrictive practices. The management must also be alert and shouldbe able to recognise when market conditions change. Experiencedexecutiv.es cannot gain the intimate knowledge of the ways or llicircompetitors. Consequently it is necessary to obtain, an understandingof the nature of competition, which can provide an insight into theprobable behaviour pnlllllls of the competitors. To study how pricesare determined the types of market situations need to be studied areas follows: Perfect competition. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Imperfect competition o Monopoly and monopsony o Monopolistic competition o Oligopoly and oligopsony.PURE AND PERFECT COMPETITIONPerfect competition is a market situation where large number ofbuyers and scllns operate freely and commodity sells at a uniformprice. In such a situation no seller or buyer has any influence on themarket price. In this market, a firm is the price taker and industry isthe price maker.Main FeaturesThe main features of perfect competition are as follows: There are a large number of buyers and sellers. Each seller must be small and the quantity supplied by any ne seller must be so insignificant that no increase or decrease in his output can appreciably affect the total supply and the market price. So also, each buyer must be small and the quantity bought by any of the buyers should be so insignificant that no increase or decrease in his purchases can· appreciably affect the total demand and the price. As a result, each seller will accept the market price as it is. So also each buyer will regard the price as determined by forces beyond his control. Each competitor offers a homogenous product, i.e. the products are similar to ach other in terms of quality, size, design and colour. Thus one product could be substituted for the other if the price is lower. Again, the commodity dealt in must be supplied in quantity. There is no obstacle with regard to entry or exit of the firms. When these aforesaid three conditions arc fulfilled there is a market condition that can be defined as a pure competitive market. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The market iil which the commodity is bought and sold is well organised and trading is continuous. Therefore, buyers and sellers are well informed about the price of the commodities. There are many competitors (whether buyers or sellers), each acting independently. There must be no restraint upon the independence of any seller or buyer, either by custom, contract, collusion, and fear of reprisals by the competitors, or by the imposition of government control. The market price is flexible over a period of time. In other words, it rises or falls constantly in response to the changing conditions of supply and demand. All the firms have equal access to production technologies and techniques. There are no patents, proprietary designs or special skills that allow an individual firm to do the job better than its competitors. Firms also have equal access to all their inputs, which are available on similar terms. Thus, perfect competition in an extreme case and is rarely to befound. Actual competition always departs from the ideal of perfectionPerfect competition is a mere concept, a standard by which to measurethe varying degrees of imperfect competition. Sometimes, a distinction is made between perfect competitionand pure I competition. But the line of distinction drawn between thetwo is very fine. That is why many economists have preferred to usethe two terms synonymously. Hence, from managerial viewpoint, theredoes not seem to be any difference between the two. The underlyingpresumption in a free competition (close to perfect cmpetition) is thatit social interest interest unless the contrary can be proved.Competition safeguards the consumer against exploitation byproviding the buyer with alternatives, and makes it unnecessary for thestate to intervene by regulating process and production in order toprotect him. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSDetermination of PriceThe forces of demand and supply determine prices under perfectcompetition. The equilibrium price is obtained at the intersection ofdemand and supply curves as shown in following Figure 4.14. Theequilibrium price will change only with changes in forces of demandand supply.Price and Quantity VariabilityResponses to a cnange in demand or to a change in supply may beprimarily in price or quantity. If the demand is highly elastic,consumers will respond readily to price changes by dropping out ofthe market when prices are lowereda little. As a result, most of theadjustments to changes in supply (an increase leading to a reductionin price and a decrease leading to an increase.in price) would be thosein quantity purchased, if the demand is highly elastic. If the demand isinelastic, the adjustments will take place primarily in price. Similarly, ifsellers respond readily by greatly increasing their offerings on slightincreases in price or by heavy withdrawals in slight price drops, theadjustments to changes in demand willbe largely in quantityexchanged. If sellers are quite responsive to, price in their offerihgs (ifsupply is very inelastic), the adjustments to changes in demand, willtake place largely through shifts in price. In view of the aboveexplanation, we may state thefollowing rules: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS If demand rises then price goes up and vice versa. For example, in Figure. 4.15, the demand curve shifts. upwards, to the right from DD to D’D’ whereas the supply curve remains the same. As a result, the price goes up from OP to OP1. Thus, the sales increase from OQ to OQ1. If supply rises then the price decreases and vice versa. For example, in Figure. 4.16, the supply curve shifts downward to the right from SS to S’S’ while the demand curve remains unchanged. The result is that price falls from OP to OP1. Dul the sales increase from OQ to OQ1. The following Figures 4.15 and 4.16 shows shift in demand curve and shift in supply curve due to increase in price, respectively. Given a shin in the demand curve the following can occur: Price will rise less or falllcss if the supply curve is elastic (flat) Price will rise more or fall more if the supply curve is inelastic (steep) If the rise in price is more than the rise in sales will be less If the rise in price is less than the rise in sales will be more For example, in Figure 4.17, the demand eurve shifts from DD to D’D’. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The supply curve S"S" is steep. Another supply curve SS israther flat. Both the supply curves cut the original demand curve atpoint E giving the equilibrium prices as OP. The flat supply curve SScuts the new demand curve DD at E2 giving the equilibrium price asOP2, which is less than OP1 and more than OP. In the same way the following will occur when there is a shift in the supply curve o The price will rise less or fall less if demand curve is elastic o The price will rise more or fall more if demand curve is inelastic. For example, in Figure 4.18, SS is the original supply curve, SSis the new supply curve, DD is the steep demand curve (indicatingrelatively inelastic demand) and D”D” is the flat curve intersecting thesupply curve at point E. After the shift in the supply curve, however,the SS cuts the DD curve at point E giving OP as the equilibriumprice. But the SS curve cuts the D"D" curve at point E giving theequilibrium price as OP which is higher than OP. If both demand and supply increase, sales are bound to increase but the price mayor may not increase. In this case there case can be two possibilities o Price will rise if the amount, which will be demandedattheold price exceeds the supply, which will be BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS made at that old price as shown in Figure 4.19. o But the price will fall if the amount, which will be supplied at the old price, is more than the amount demanded currently at that price as shown in Figure 4.20. In other words, if at the old price, new demand exceeds the new supply, the price will rise but if the new demand is less than the new supply, the price will fall. An increase in demand with a simultaneous decrease in supplywill raise price and increase sales if the new demand price for the oldequilibrium amount is higher than its new supply price. Similarly, theprice will rise and sales will dimfnish if the new supply price for theold amount is higher than itsnew demandGOVERNMENT INTERVENTION IN PRICE FIXINGQuite often the government interferes with the normal process of pricedetermination by fixing prices either above the equilibrium level orbelow it. In order to make these attempts by the government aboutartificial price fixation successful, government intervention is requiredwith the forces of supply or demand or both, through elaborateadministrative regulations.Difficulties in Price FixingThe government has to face several difficulties while fixing prices dueto certain reasons. There can be elaborated as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Attempts to fix prices above an equilibrium level are illustrated by minimum wage legislation and price support policies. When the Government undertakes the activity of fixing a minimum price say, Rs. 375 per quintal for wheat much above the equilibrium price say, Rs. 300 per quintal, consumers restrict their consumption of wheat (postpone their purchases at all levels). Conversely, farmers are encouraged to increase their production under the incentive of higher prices. This results in disequilibrium between the demand and supply. As such, there are only two ways to maintain prices at a high level: o The government can buy large quantities to absorb the difference between the quantity supplied and quantity demanded. o The government can ask the farmers to limit their output. The government also tries to set maximum prices below the equilibrium level. This is illustrated by the price control on sugar, on steel and a number of othcr commodities. Let us assume that the equilibrium price of sugar is Rs. 10.00 per kilo but price has been controlled at Rs. 7.00. The suppliers would hold back their supplies and this would leave a large body of unsatisficd consumers. The problem would arise as to who should get a sharclof the limited supply of sugar. There would be long queues for the available supply. In short, lots of difficulties would arise. The government would have t.o adopt both-or either of the following measures: o Introduction of rationing o Payment of subsidey to sugar producers to neutralise the effects of low prices and to encourage them to produce more. In this way, the Government would substitute ration cards forthe rationing mechanism of a free-market system and it wouldsubstitute subsidies for the price incentive of a free market thefollowing Figure 4.21 and 4.22 shows the demand for wheat and sugar, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSrespectively.Effect of Time Upon SupplyEconomists find it important to discuss the way in which supplychanges in the course of time. The reason why such a study isnecessary lies in the technical conditions of production, i.e., it alwaystakes time to make those adjustmcllts ill the size and organisation ofa factory, which are necessary for greater production. For the purposeof analysis in this connection, it is usual to follow the method ofanalysis used by Marshall. Marshall suggested three periods of timenamely market period, short period and long period. Marshallconsidered the market period as being only a single day or few days.The fundamental feature of the market period is that it is supposed tobe so short that supplies of the commodity in question will be limitedto the existing stocks or at the most to the supplies in sight.Graphically, the supply curve will be vertical, i.e., the supply remainsfixed irrespective of the price. The market period supply curve is not applicable in all cases. lt isparticularly important in the case of perishable goods, which aredifficult or impossible to store, and in case of demand, which issubject to short-run fluctuations. Marshall defined short period as "a period long enough for thesupplies of a commodity to be altered by increase or decrease incurrent output but not long enough for the fixed equipment to bechanged to produce a larger or a smaller output." In other words; the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSshort-run cost curve remains the same. Here, the supply curve wouldbe a slopmg lme, moving upward Irom left to right thereby indicatingthat as price goes up, supply increases. In the long period, as defined by Marshall, there is time to build additional plants or clear more land for crops; or alternatively, old machines and factories can be closed down. A firm producing at overtime rates or by using standby equipment will usually plan to increase output by buying new plants and machinery. It will do so when provided that it thinks the increased demand will be maintained. The long-period supply curve will, therefore, tend to have a flatter slope than the short¬run supply curve indicating thereby that given a price increase, the supply tends lo be larger than in the short-run period.EQUILIBRIUM AND TIMEThe following discussion now concentrates on how price would bedetermined in different time periods, given a change in demand. In the market period, an upward shift in the demand curve would result in an immediate rise in price, as there will be no increase in supply. This will be followed by greater production during the short period and a fall in the price as firms increase their output. Later, as more capital equipment is installed the output would increase still further and prices would again drop. Conversely, a downward shift in the demand curve would not immediately affect the quantity supplies but the price would drop sharply, followed by some recovery as the firms reduce output in the short period. In the long period, firms would see more profitable uses for their plants and would decide not to replace capital output as it wears out. This would reduce equipment still further and permit some BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS recovery in price. Illustration To take an example, in Figure 4.23 DD shows the demand for fish whereas SS, SS, and S"S" represent the market-period, short-period and long-period supply curves respectively. Suppose the demand for fish in the market shifts to DD.Now, supply of fish cannot be increased immediately and hencemarket or momentary equilibrium is established at price OP”. In the short run, however, fish supply can be increased by amore intensive use of the existing equipment, viz., boats and nets andby working for longer hours. As a result, the price drops to OP". In thelong run, supply can be fully adjusted to meet the demand conditions.New fishermen would be attracted (entry of new firms), new boats;nets and other equipment would be produced and employed in service.As a result, supply would increase further and the long-runequilibrium would take place at a still lower price OP".The Firm in Pure Competition In pure competition, the firm has to accept the given market price.At this given price, it can sell all the products, which it desires but atany higherprice, it cannot sell anything. If the market price is below its BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScost, it has to either take the loss or withdraw from the market. As aresult, any single firm in a purely competitive situation has to adjustits production and sales policies to the given market price. However,the market prices arc determined through the mutual consent of allthe individual competitive buyers and sellers together. But anyindividual firm has no control over the price. Since a purelycompetitive seller has no control over the price at which he sells, hisaverage marginal revenue schedule is infinitely elastic. In perfectcompetition, marginal revenue is equal to the average re.xenue,because every unit is sold at the same market price, irrespective of thequantity sold. Graphically, a horizontal line at the market pricerepresents it. As expansion of sales does not require any reduction inthe price at all; the greater the quantity sold, the larger is the revenue.Under ordinary circumstances, the owner· of a linn will not questionwhether to produce or not to produce. Rather he will have to decidewhether it will be bettcr to producc, say, 10,000 units or 11,000 units.In order to answer this question, hc will compare thc incremental costand tIll incremental revenue resulting (iom thc altcrnative courses ofaction. To express in technical terms, the maximum profit (or theminimum loss) position can be attained by in.creasing output so longas the marginal revenue continues to exceed the marginal cost. Whenmarginal cost is above the marginal revenue, an increase in outputwould reduce profits and it would be better to decrease the output. Ifthe amount of marginal rcvenuc is greater than the marginal cost, itwould be beneficial to increase the output. Thus, profit is maximised,or the loss is minimised, by increasing the output just up to the pointa.t which marginal cost equals marginal revenue.Output Decisions and Consumer InterestsAn entrepreneur will expand his output so long as the addition to hiscost is less than the worth of the incrcase in output price to theconsumers. In this respect, the entreprencur acts consistently with theinterests of the consumers though his purpose is merely to maximise BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICShis own profits. This rcquires continuing the hiring of additional workers andbuying additional raw materials so long as the wage paid for thelabour and the price paid for the matcrials is less than the amount thatevery unit of output will add to his revenues. In this rcspect, theentrepreneur acts in harmony with the interests of the sellers of labourand raw materials though his purpose is to maximise his own profits.A consistcney with the consumer preferences is also maintained inbidding for the additional units of input for his firm. Without being inthe least a philanthropist, the purely competitive entrepreneur seekingto maximise profits provides a very cffective service in helping theallocation of resources in consistence with consumer preferences andwith the interests"of resource owners.The Firm and Shutdown PointThe amount that a particular firm offers for scale in the short-run atdifferent prices for its product depends upon the cost conditions ofthe firm. In case there is any price that is lower than the lowestvariable cost per unit, the firm will have to be shut down. It would notbe useful to operate even in the short run at a price lower than this,sincc variablc costs are not covered. It is not held, however, that in theshort run, the average total costs play no role in the output decisionsof the prbfit-.seeking entrepreneur. This is because the fixed costs,which are a component of the average total costs, would remainunaffected by the decision to shut down.The Decision to Operate at Loss or Shut downThe above discussion shows that in the short run any firm may decideto operate at a loss but try to minimise it. However, the question maywell arise: Why should a firm operate at all when it is suffering losses,and why should it not.shut down? The explanation to the abovequestion lies in the fixed costs, which a firm has to incur any way. Inthe short-run, certain costs, for example, rent, interest, etc., are fixed.They continue to exist whether the firm operates or not. Even if the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSfirm shuts down, it cannot avoid these costs in the short-run. If, forexample, these fixed costs are Rs. 1,000 per month, the firm will losethis amount every· month even if it decides to cease operations. Under these circumstances, it will be clearly beneficial to the firm tocontinue operating if it can cover its variable costs and still havesomething left to contribute towards its irreducible Rs. 1,000 everymonth. Thus, supposing till price is Rs. 40, output is 70 units and theaverage variable cost is Rs. 35, the firms receipts would be Rs. 800.Total variable cost will be Rs. 2,450 and the finll would be left with Rs.350 to meet part of its fixed costs. The net .loss to be suffered wouldbe RS.650 only. If the firm were to close down, its loss would havebeen Rs. 1,000; hence it would decide to operate even at a lossbecause by so doing, its losses would be less than they would havebeen in the case of firms shutdown. If, however, the price comes down to Rs. 35 only and theaverage variabe cost is Rs. 35, the sales receipts would just cover totalvariable cost, leaving nothing towards covering the finns fixed costs.Hence, the firm would be indifferent and perhaps decide to shut down.If price is below the average variable cost (Rs. 35), the firm would failto recover even its variable costs and would certainly shut down. Toconclude, therefore, the shutdown point is whcre AVC=AR.Consequences of Pure CompetitionThe consequences of pure competition can be enlisted as follows: If the market price is below the cost of production of a particular produccr, he can do nothing but to take a loss (in the short run). If tbe price remains below his cost of production for a sufficiently long period, he has no alternative but to go out of business. A firm can increase its profits by selling more units. Products subject to a competitive market situation, face a greater degree of price instability than is the case with BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS differentiated products. No useful purpose is served by advertising. When products sold by individual sellers are identical, advertising by anyone seller would have a negligible effect on the demand for his product.Equilibrium of IndustryThe short-term and long-term adjustment processes can be clearlyidentified by understanding the concept of equilibrium of an industry.These are explained as follow.Meaning of IndustryThe term industries are sometimes used in a broad sense so as toinclude all the producers of a similar type of commodity such asvanaspati industry or cigarette industry. It is sometimes used in anarrow sense to include only the producers of commodities, which areidentical from the point of view of purchasers such as wheat or moreprecisely still a particular grade of wheat. In a purely competitiveindustry, however, the commodity is uniform and there is no productdifferentiation, even in the slightest way. As such, under perfectcompetition, an industry may be said to consist of all firms producinga uniform commodity. It may be further added that a firm, whichproduces more than one product, may be said to participate in morethan one industry. Strictly speaking, different brands of cigarettes maybe regarded as different commodities because there are set consumerpreferences for one brand over another. Yet, these consumerpreferences are so slight that for many purposes all the standardbrands may be regarded as one commodity and the industry as awhole, for example, the cigarette industry. Of course, the industry issaid to be characterised by product differentiation as different brandshave different characteristics to attract consumers.Adjustment Process Towards Long-run Equilibrium in IndustryAn industry is said to be in equilibrium when there is no tendency onthe part of the firms within the industry to leave it or on the part of the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSfirms outside; to enter the industry. Long-run adjustments in anindustry take place through the entry or withdrawal of firms. These areadjustments that take place over a time period I.ong enough to permitsuch a shifting of firms and of relatively fixed productive agents usedby the firms. An industry is said to be in equilibrium when there is noadvantage to any productive agent in moving into or out of theindustry, or when there is no incentive for entrepreneurs to inaugurateor withdraw firrtls from the industry. Firms will move into or drop out of the .inqustry until expectationsof profits and losses have been roughly eliminated or until it is nolonger possible for anyone to better his position by moving into or outof the industry in question. Under pure competition, this equilibriumwill be reached when price is almost equal to the lowest cost on thetypical firms total unit cost curve. Under competition, the price cannotstay higher for long; and withdrawal of firms will keep it from stayinglower for a long period.Survival of the FittestAt any given time, there may be firms of varying sizes and efficiency inan industry, possibly some making profits and others incurring losses.Ellt so long as industry is open for anyone to enter freely, an excess ofprice over the attainable average total costs will encourage the entry ofnew firms. As such new firms move in, they compete with existingfirms and the most inefficient firms are eliminated. In the long-run,therefore, only those firms will remain in the industry, which have thelowest average total costs, as low as those, which would be incurredby new enterprises in optimal scale adjustments. If a long-runequilibrium position is linally attained, there might still be manydifferences between firms but the lowest average total costs of allfirms would be the same. For instance, some entrcpr.eneurs may bemore efficient than others, some firms may be located near marketsand may be paying higher rents whereas others are more distant andmay be paying lower rents. Again, some firms may be small with closepersonal supervision and hence with greater efficiency whereas others BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmay be large and with mass production methods, In view of thesedifferences, the firms may not be having identical or similar costcurves. Still, each firm must produce at an average cost as low as thatof its competitors. In other words, though there may be differencesbetween firms, these may be balanced by balancing advantages anddisadvantages giving rise to uniformity of minimum average totalcosts. To illustrate, two manufacturers of cotton textiles may bedifferently located; one may qave the advantage of nearness to buyersbut the disadvantage of higher rent. The other may be located awayfrom the buyers and as such may have the advantage of lower rent butthe disadvantage of higher transport costs. Here the advantages anddisadvantages may balance so that the two firms have the same lowestaverage costs. Another example is that of one firm having a moreefficient manager than the other. Here the efficient firm may have theadvantage of higher productivity but disadvantage of higher salarypayments as compared to the less efficient firm. On balance, the twofirms may have the same lowest average costs. In an industry adjustments towards long-run equilibrium do notnecessarily I take place smoothly. In fact, too many firms may enter· aprofitable industry. Thus, by the time they are turning out finishedproducts, market price may drop below costs. As a result, firms maystart withdrawing from the industry so much so that too many firmswithdraw with opposite effects. This is most likely to occur whereinitial investments are relatively small or where given fixed equipmentcan be utilised in other industries. This is because these conditionsfacilitate quick entry as well as withdrawal. Agriculture provides anexample of this type where the same fixed assets can be utilisedalternatively as, for example, either for producing wheat or cotton, juteor rice.Restrictions on Firms Entry and Withdrawal BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSFree entryof new firms is usually restricted through Financial or technical barriers to entry into costly and complex techno¬logical processes; Government intervention and legal restrictions; and Collusion among producers on prices, market shares, tendering, etc. Until 1991, the Indian economy was regulated by numerousGovernment decisions on wages, price, size and scope of production,industrial relations, foreign exchange, etc. Due to these Governmentregulations, hardly any industry was free to decide on its scale andmethods of production, wage policies retrenchment, equipment etc.Again, the Indian industrialist operated in a completely shelteredmarket. He was protected against external (foreign) competition byimport and exchange controls. The requirement of a licence beforestarting a large-scale unit further protected him from internal (Indian)competition. Thus, entry and withdrawal of firms was highly restrictedin Indian conditions. However, now the entrepreneurs are free todecide about the industry they want to establish and its size except ina limited number of industries, which are still subject to Governmentregulation.VARIANTS OF PERFECT COMPETITION1. Effective or Workable CompetitionCompetition among the sellers, even though it may not be perfect, canbe regarded as effective if it offers real alternatives to consumers thatare sufficient to compel sellers to vary quality, service and pricesubstantially with a view to attract buyers.The prerequisites of effective competition are as follows: Ready substitution of one product for another. General availability of essential information about a1ternati (its significance lies in that buyers cannot influence the behaviour of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS the sellers unless alternatives are known) Presence of several sellers, each of them possessing the capacity to survive and grow Preservation of conditions which keep alive the basis or potential competition from others Substantial independence of action that is each selIn must be able and willing constantly to reconsider his policy and to modify it in the light or changing conditions of demand and supply. Effective competition cannot be expected in fields where sellersare so few ill number, capital requirements so large, and the pressureof fixed charges so strong that price warfare, or its threat of will leadalmost inevitably to collusive (deceitful) understanding among themembers of the trade of. the industry concerned. In brief, competitionis said to be effective whenever it operates over time to providealternatives to buyers and to afford them substantial protectionagainst exploitation. The concept of effective competition, thoughless definite, is more realistic and relevant than that of perfectcompetition.2. Potential CompetitionPotential competition may restrain producers from overcharging thoseto whom they sell or from underpaying those from whom they buy.The essential precondition for potential competition is thepreservation of freedom to enter or to leave the market. The exclusiveownership of scarce resource, the heavy investment required for entryinto many fields, the fixed character of much of the existingequipment, high costs of transportation, restrictive tariffs, exclusivefranchises, and patent rights constantly operate to destroy the hasis ofpotential competition. Science, invention and the development oftechnology constantly operate to keep this potentiality alive. Potentialcompetition, insofar as its basis continues, may compensate in partfor the shortcomings of the, lack of perfect competition. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSKey Lessons of Perfect Competition of ManagersThe key lessons of perfect competition or competitiveness formanagers in highly competitive market environment are as under: It is important to enter a growing market as far ahead of the competitors as possiblc. Smart managers should take advantage well before the competitors enter the market when supply is low and price is high. This requires entrepreneurial skill to take a risk. A firm, which is earning an economic profit (distinguished from norm.al profit), cannot afford to be complacent or unprepared for increasing cOlllpditioll hccausc cconomic profit will eventually attract new entrants encouraging mare production and enhancing supply, drive prices down down and reduce economic profits. Here, it is impossible for a firm in a pcrkclly compclitive market to compete based on product differentiation. Therefore, the only way that it can earn or maintain profit in the face of added supply and lower prices is to keep its costs as low as possible. The lesson that one can learn from understanding the perfectly competitive model is that a firm is to be amongst the lowest cost producer to ensure its survival.PRICE AND OUTPUT DECISIONS UNDER MONOPOLYMonopolistic market situation allows an individual seller or groups ofsellers, which arc acting as a unit, to exercise direct control over price.Similarly, any such control on the part of buyers is called amonopsonistic market situation. The monopo.listic and monopsonisticmarket situations may be distinguished according to the nature andextent of the deviation from the perfect competition. A usefulclassification Can be: (i) monopoly and monopsony; (ii) monopolisticcompetition; and (iii) oligopoly and oligopsony. However, in thischapter, the discussion is confineclto monopoly only.Main Features of MonopolyThe essential features of monopoly are as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Single seller: There is only one producer or firm of a commodity in the market. This is because there remains no distinction between an industry and a firm in a monopolistic market. Here, the firm itself becomes the industry and thus has full control over supply of the commodity. The monopolist may be an individual, a firm or a group of firms or even Government itself. There are many buyers of the commodities produced by a monopolist, against a single seller. No close substitutes of the commodity: The commodity sold by the monopolist has no close substitutes. This implies that the cross-elasticity of demand between the monopofist"s product or commodity is very low. Though substitutes of products are· available but they are not close substitutes. Difficult entry of a new firm: The monopolist controls the market situation in such a way that it every new firm finds it to be very difficult to enter the monopoly market and also to compete with the monopolistic firm to produce either the homogeneous or identical product. This makes the monopolist, the price maker himself. Negatively sloped demand curve: The demand curve of a monopolist firm is negatively sloped, which means that a monopolist can sell more products only at a lower price and not at a higher price. Keeping in mind the features of a monopoly, it can be said thatthe monopolist is in a position to set the price himself and also enjoysthe market power. The strength of a monopolist lies in his power to raise his priceswithout the fear to loose his customers. However, the extent to whichhe can raise depends on the elasticity of demand for his particularproduct. This, in turn, depends on the extent to which substitutes forhis products are available. In most cases, there is an endless series ofclosely competing substitutes. Therefore, exclusive monopolies likerailways or telephones also consider the possible competition by BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSalternative services. In this case, any increase in the rates by railways,may lead to their substitution by motor transport and of telephonecalls by telegrams. In fact, it is very difficult to draw a line betweenwhat is and what is not a monopoly. The truth is that there is acontinuous shift between competition and monopoly, just as there isbetween light and darkness, or between health and sickness. Even in those industries, which appear to be monopolised at anytime, monopoly has a constant tendency to break down. First, therehave been shifts in consumer demand. Secondly, inventions maydevelop numerous substitutes for the monopolists product. Thirdly,the monopolist may suffer from lack of stimulus to efficiency providedby competition. He may not devote attention to the improvement ofhis product. In addition, new competitors may arise to fill the gap.Finally, the Government may intervene.Causes of Monopoly The government may grant a licence to any particular person or persons for operating public utilities such as gas company, an electricity undertaking, etc. In public utility services, economies of scale are so prominent that it seems almost unbelievable to have several firms performing the same service again. In such a case, the Government may reserve the right of foreign trade related to any commodity for itself or may give the right to any other person. In all these cases, the statutory grant of special privileges by the State creates the condition of monopoly. The use of certain scarce raw materials, patent rights, special methods of production or specialised skill, might also give a producer monopoly power. For example, Hoechst, held a monopoly for some time in oral medicines for diabetes because they were the first to find out the methods of reducing blood sugar by an oral dose. Monopoly also arises where the minimum efficient scale of operations is very large. For example, it is so for making some BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS chemicals In fact, monopoly tends to arise in industries characterised by decreasing long-run costs. Ignorance, laziness and injustice on the part of the buyers may create monopoly in favour of a particular producer.Revenue and Cost of MonopolistsThe revenue and costs of monopolistic firm can be understood withthe following explanations: Average Revenue: By raising the prices slightly, a monopolist can sell less, but there will be some buyers of his product. He can increase his sales only by reducing his price. In this situation, his average revenue (demand curve) will slope downwards to the right. Such a change in AR curve shows that larger quantities can be sold at lower prices whereas smaller quantities can be sold at higher prices. Marginal Revenue and the Sale Value of the Incremental Output: In the market situation of pure competition, both marginal revenue and the sale value of the incremental output are identical. But this is not in the case of monopolly. A monopolist needs to reduce his prices, to sell additional units of his commodities. This reduction in price will apply both to old as well as· new customers. Lei us assume that a shirt manufacturer retails his shirts at Rs. 40 per unit. Total sales are 1,000 shirts. To sell 1,100 shirts, he reduces his price to Rs. 38. The sale value of the additional output will be Rs. 3,800 where as the marginal revenue will be Rs. 1,800 only. Thus, under monopoly conditions marginal revenue will always be less than the sale value of the additional output. However, after a stage, the marginal revenue may even become negative.Adjustments under MonopolyA firm under this market situation can choose to sell many units at alower price or fewer units at a higher price. For maximisation of profit BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSor minirnisation of loss, a monopolistic firm would minimise or reducethe use of inputs and outputs to the level at which the marginalrevenue equals the marginal cost. However, there is a significantdifference between a purely competitive firm and a monopoly. Thedifference lies in the fact that for a purely competitive firm, marginalrevenue equals the average revenue while in a monopolistic firm,marginal revenue is less than the average revenue. Therefore, amonopolist in purely competitive firm can only produce up to the pointwhere average revenue equals the marginal cost. This can beunderstood with the help of the Figures 4.24 and 4.25 are givefl below: With reference to these figures, under perfect competition,output would be OQP (Figure 4.24) as MR curve or the horizontal ARcurve, interesects the MC curve at point Ep. Butunder monopoly, MR =MC at a point Em corresponding to output OQm (Figure 4.24), whichis less than OQP. Under monopoly, the MR curve is not equal to ARcurve, but lies below it. Thus, the monopolists output will be lower,and the use of productive services is also less than it that in the caseof pure comprtition, where adjustments are made to suit consumerspreferences. In other words, in ll1uximising the profits, themonopolist does not take into consideration the interests of theconsumers and the resource owners. It is the total profit that guidesthe monopolist in his price and output policy. The total profit iscalculated by multiplying the profit per unit by the number of units BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSsold. By using the process of trial uilci error with di fferent levels ofprice and output, a monopolist fixes a price-output combination thatyields him the highest total profit.Disadvantages of Monopoly Under monopolistic condition, a monopolist exercises the market power by restricting supplies. By doing so, he is likely to become richer than he would have been if he had no market power. He also docs this even at the expense of those who consume his products. In a monopolistic situation, a consumer choice is restricted. A consumer depends on the monopolist’s decisions on the mutters related to price, and the amount the direction of research and development in the industry, the services offered, etc. Under monopoly, there is a complete absence of competition, which means that there will be no prcssure on the monopolist firm to be economical and to keep its costs down. By keeping its prices higher, a monopolist tends to wastc its cost or production. This is a biggest drawback of a monopolistic tinn. By exercising the monopolistic power, a monopolist is likely to misalloeate the resources from societys point of view. As the monopolist restricts output, his output becomes too small. He employs too little of societys resources. As aresult, of this, too much of these resources are used into the production of the goods with low consumer preferences. Thus, resources are mislilioclited or wasted. A firm enjoying monopoly position in a strategic sector is a big a risk for an economy. For example, any failure related to the power engineering facilities of a firm, is a hindrance for an economy, In one BHEL, a firm is full ofrisk, as any natural or man made causes, which may lead to slow¬down or stoppage of production is a severe setback to the economy. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSLong-run Considerations and Price Policies of a MonopolistIn deciding the current price policy, monopolists commonly take intoaccount some long-run considerations, which may lead to a moremoderate price policy than would be followed by a firm taking intoaccount short-term factors only: Price elasticity of demand: The ability to increase profits by restricting supplies is the criterion of monopoly or market power. In this respect, the more elastic the demalld for the products, the weaker is the position or Ihc monopolist. But there will always be a price, above which the demand is so elastic that it will not cost anything to the monopolist to incur the loss related to less sales by raising the prices higher. In the long-run, consumer receptiveness to price may be much greater than in the short run. Thererore, an intelligent monopolist must consider this factor before exercising monopolistic power. If a monopolists prices are held at high lewis, consumers may stop utilising that commodity. This will result in decreased consumption. On the other hand, if the prices remain lower over extended periods, the consumers will get used to that product, more people will be interested in it and those already consuming it may increase their consumption as well. Potential competition from new tirms: If a firm is very well established, exercise strong and exclusive control over essential raw materials, possess indispensable patents, and licensing regulations, it may pursue extremely high price policies without great concern for the competition that these prices may attract. If, on the other hand, its controls over firms are not so strong, it depends primarily on unfair competition and uncclillin manipulation, then the fear of potential competition may become an important factor to modify the monopolists policies. State of public opinion: Public hostility to unfair practices and exploitHI ion may appear in many forms like consumer boycotts, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS both formal and informal, and legal restrictions and controls. Hostile public opinion is wry important to be ignored irrespective of the form in which it is. Many times it may temper the behaviour of the monopolist seeking to maximise his profits. If a monopolist is cautious, he needs not to work against publicinterest. This is because the monopolists, being big concerns canenjoy the economies of large¬scale production. They are in a betterposition to maintain regular and satisfactory supplies. They can alsoavail the benefits of large-scale buying ar1d selling. In fact they canoperate a better level of efficiency. If they restrain themselves and donot exploit the consumers, they may not only build up a good imagein the market. By doing this, they are also likely to avoid potentialcompetition and Government interference.Differenco between Monopoly and Pure CompetitionThe salient points of difference between monopoly and perfectcompetition are as follows: Under perfect competition, there are a large number of sellers or firms whercns in monopoly, there is a single seller or firm. Under perfect competition, the individual seller has no control over the market pries whereas under monopoly, the seller is in a position to nlllnipulnte the output in order to control the prices. Under perfect competition, the commodity produced by the firms is homogeneous in nature whereas there is no close substitute of the commodities produced by monopoly. Under perfect competition, a firm is a price taker and not a price maker whereas in monopoly a firm is a price maker. Under perfect competition, there is free entry and exit of the firms in the market whereas monopoly this is not so. Under perfect competition, firms get only normal profits in the long period whercas in monopoly, there is the possibility of super-normal profits to take place. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Under perfect competition, there is no possibility of price discrimination whereas in monopoly, price discrimination is possible.MONOPSONYIt is a market situation in which there is single buyer to buy thecommodities but there may be many sellers to sell the identical orhomogeneous commodity.Features of MonopsonyThe essential features of monopsony are as follows: There is only onc buyer or the goods or services. Rivalry from buyers, who offer the close substitutes of the product, is so remote to make it insignificant. As a result, the buyer is in a position to determine the price, which he pays for the goods or commodities. Actual causes closely approximating monopsony are rare. An,example, approximating monopsony is that of Indian Railways inrelation to the wagon industry. Monopsony may also arise whereresources are immobile. If for reason, workers are unable to move toother localities or other firms within same area, their existingemployer has, in effect, a inonopsony position over them.Costs of MonopsonistsThe monopsonist must choose between paying higher wages that willenable him to employ more workers or limiting his working force tothe analler number workers, who can be employed at lower wages.This means that when additional worker is added to the labour force,an employer has to bear both, I wage of the new worker and also thetotal increase in the wages to be paid to t old employees at the newrate. Thus, in monopsonistic market situation, margir expenditure ofeach input level exceeds average expenditure (Table I aild Figu 4.26).Suppose a tailor employs six workers at Rs. 500 per month. To have I BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSadditional worker, he must pay Rs. 550 per month to each worker. Ifhe employs the seventh worker, his total costs, thus, will increase byRs. 850. To represent the position graphically, two curves are needed,one to show the average expenditur and the other to show themarginal expenditure. The marginal expenditure (ME) is consistentlyhigher than the average expenditure (AE) and the slope of thl marginalexpenditure cutve is steeper than that of the average expenditurecurve. The following Table 4.4 shows the cost of a monopsonistic firmhiring workers. Table 4.4: Cost of a monopsonistic firm hiring workers ---- Workers -- -- ..•. _. _.- .. ~- .... - .- Averange - _Marginal .. ~. Total Expenditure Expenditure Expenditure per Worker (TE) (ME) (AE) (Rs.) (Rs.) (Rs.) BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 6 500 3,000 - 7 550 3,850 850 8 600 4,800 950 9 650 5,850 1,050 10 700 7,000 1, 150 11 750 8,250 1,250Price DiscriminationPrice discrimination, may be defined as the practice by a seller ofcharging different prices to thL: samc buyer or to different buyers forthe same commodity or service without corresponding difference inthe cost. It is also known as differential pricing. Differences in ratesare somewhat related to the in costs. For example, it may cost less toserve one class of customers than another to sell in large quantitiesthan in smaller lots. !frates or prices are proportional to cost, somebuyers will pay more and others less, but this will not take place inprice discrimination. In such a situation, charging uniform price willamount to discriminat ion. There arc three classes of pricediscrimination, which are as follows: First-degree discrimination: The seller charges, the same buyer a different price, for euch unit bought. For exumple, prices that are determined by bargaining with individual customers or prices, which are quoted for tenders floated by government authorities. Second degree discrimination: The seller charges different prices for blocks of units, instead of, for individual units. For example, different rates charged by an ekctrieity undertaking for light and fan, for domestic power and for industrial use. Third degree discrimination: The seller segregates buyers according to income, geographic location, individual tastes, kinds of uses for the product, etc. and charges different prices BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS to each group or market despite of charging equivalent costs from them. If the demand elasticities among different buyers are unequal, it will be profitable for the seller to put the buyer into separate classes according to elasticity and thereby, to charge each class a different price. It is also referred as market segmentation and involves dividing the total market into homogeneous sub-groups according to some economic criterion, usually the demand elasticity.Conditions for Price Discrimination The conditions for price discrimination arc as follows: Multiple demand elasticities: There must be difference in demand elasticities among buyers due to differences in income, location, available alternatives, tastes, etc. Market segmentation: The seller must be able to divide the total market by separating the buyers into groups or sub-markets according to elasticity. Market sealing: The seller must be able to prevent any significant resale of goods from the lower to the higher price sub-market. Any resale by buyers among the sub-markets will, beyond minimum critical levels, neutralisc the effect of different prices.Market SegmentationHaynes, Mote and Paul have identified certain criteria according towhich market segmentation is practised. These criteria are givenbelow: Segmentation by income and wealth: This can be understood by considering an example, in which the doctors separate patients with high incomes from patients with low incomes. The fact that doctors treatment is a direct personal service prevents its resale. Segmentation by quantity of purchase: Traders often distinguish between large and small purchasers, offering quantity BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS discounts to large purchasers. The big buyers because of their bargaining power are able to extract special quantity discounts. However, if the quantity discounts are in proportion to the marginal costs of selling to big and small buyers, they will not be counted in price discrimination. Segmentation by social or professional status of the customer: Special prices may be quoted to Central and State Governments or to Universities. Students are given concessions in cinema tickets, railway fare and bus travel. Professional journals usually carry lower student subscription rates. Faculty members or teachers are also sometimes offered books at special discounts. Segmentation by geography: This can be understood by considering an example. For example, business houses, which are sold abroad at prices, lower than the domestic price. Segmentation by time of purchase: Reduced rates are often quoted during festival seasons such as dussehra, diwali, etc. off-season discounts are also popuinr in case of fans, refrigerators, etc. Segmentation by preferences for brand names and other sales promotion devices: Some firms sell the same type of product under different branp names at, different prices. In this case, ignorance on the part of consumer regarding similarity in the quality of products prevents a large-scale of customcrs to shift from one brand to another. Market segmentation also ensures, the manufactures, a certain degree of flexibility in pricing. Apart from this is also to be ensured that it should remain present in every segment of market. For example, Hindustan Lever supplies liril to satisfy the top-end of Ihe market, lifebuoy to the lowest end and lux to the middle¬end.ObjectivesThe objectives of pricc discrimination are as follows: To adjust the consumers surplus in such a way that it accrues BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS to the producer and not to the consumer. To dispose of occasional or irregula surpluses. To develop a new market. To make the maximum and proper use of the unutilised capacity. To earn monopoly profits. To enter into or retain report markets. To destroy or to forestall competition or to make the competition amenable to Ihc wishes of the seller adopting price discrimination. It may be called predatory or discriminatory competition. The test of perdition of intent. To raise the future sales. Quoting lower rates in the present develop in future a taste for the similar commodities producecl by the same manufacturer. For example, Readers Digest sells childrens edition at lower rates. This develops the taste of children towards the magazine and they are expected to continue purchasing it even when they become adults.Single Monopoly Price Vs. Price DiscriminationTo examine the policy of price discrimination, is more useful ratherthan to charge a single monopoly price. This can be done in followingways: First of all, a discriminating monopolist can increase his profits by charging different prices to different buyers or groups of buyers rather than to charge a single price to all the buyers. Secondly, the policy of price discrimination is in the interests of the consumers as well. Bigger output is made available to a large number of customers. This is of special significance in the case of public utility services. The larger the consumption of these services, the greater is the economic welfare. Moreover, the consumers may be charged according to their ability to pay, which is quite fair and reasonable. Finally, the policy of price discrimination enables better BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS utilisation of capacity, preventing waste of social resources. This can be understood with the help of following Table 4.5. Table 4.5: Costs, Prices and Sales of a Monopolist Price Sales Total Cost (Rs.) (Rs.) (Rs.) 9.00 100 1,400 8.00 200 1,750 7.00 300 2,050 6.00 400 2,300 5.00 500 2,500 4.00 700 3,000 3.00 1,000 3,400 2.50 1,400 4,100 2.00 2,000 5,000 1.50 2,800 6,400 1.00 3,600 8,000 The above Table gives the number of units, a monopolist can sellat various prices and the total cost involved in producing them.Answer the following questions related to the table. How much should the monopolist prodllce find what price should be charge, if he sells his entire output at a single price? How much profit will he earn? How much should be produced if the monopolist fixes II discriminatory price, dividing his customers into separate groups according to their ability to pay and charging maximum prices from each group? How much will be the profit, which the monopolist will earn? Will the monopolist be better off if he charges a single price or discriminating prices and by how much? Will it be in the interest of the consumers if the monopolist charges discriminating prices? Explain. Will the policy of price discrimination enable better utilisation of capacity as compared to a single price? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS How much maximum profit would the monopolist earn if he is allowed price discrimination but cannot charge more than RS.2? Would it make any difference to capacity utilisation and availability of supply the consumers?SolutionIf the monopolist sells the output at a single price, he will choose thatprice, which will yield the largest profit, He will, therefore, produce400 units and charge Rs. 6. The maximum profit he will earn is Rs.100. This will be clear from the following Table 4.6: Table 4.6: Monopolist Selling at a Single Price Price Sales Total Total Profit or (Rs.) (Uuits) Revenue Cost Loss (Rs.) (Rs.) (Rs.) 9.00 100 1,600 1,400 -500 8.00 200 2,100 1,750 -150 7.00 300 2,400 2,050 50 6.00 400 2,500 2,300 100 5.00 500 2,SOO 2,500 0 4.00 700 3,000 3,000 -200 3.00 1,000 3,500 3,400 -400 2.50 1,400 4,000 4,100 -600 2.00 2,000 4,200 5,000 -1.000 1.50 2,800 3,600 6,400 -2,200 1.00 3.600 8,000 -4,400 If the monopolist discriminates, dividing his customers into groups according to their ability to pay and charging different prices from each group, the results would be as given in the following Table 4.7: Table 4.7: Monopolist Selling at Discriminatory Prices Price Sales Sales in Revenue Total Total Profit or (Rs.) (Units) each from each Revenue Cost Loss Catego category (Rs.) (Rs.) (Rs.) (units) (Rs.) 1 2 ry 3 4 5 6 7 9.00 100 100 900 900 1,400 -500 8.00 200 100 800 1,600 1,750 -150 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 7.00 300 100 700 2,100 2,050 " 50 6.00 400 100 600 2,400 2,300 1000 5.00 500 200 500 2,500 2,500 -200 4.00 700 300 800 2,800 3,000 -400 3.00 1,000 400 900 3,000 3,400 -600 2.50 1,400 600 1,000 3,500 4,100 -1,000 2.00 2,000 800 1,200 4,000 5,000 -2,200 1.50 2,800 800 1,200 4,200 6,400 4,400 1.00 3,600 800 3,600 .8,000 Here, the prices, sales and total costs are the same as they werein Table 4.5. But the monopolist divides his customers into separategroups and charges different prices from each group. The basis ofdividing the customers is as follows: When price is Rs. 9 per unit, 100 units are sold, when the price isRs. 8 per unit, 200 units are sold. This means that 100 units can besold for Rs. 9 per unit and another 100 for Rs. 9 per unit. Similarly, bycharging Rs. 7 per unit, the monopolist can sell another 100 units. Inthis way, other categories have also been formed as shown in column3. Column 4 gives revenue from each category, which is calculated bymultiplying the figures of column 3 with the corresponding figures ofcolumn 1. Column 5 gives tot21 revenue obtained by selling goods tovarious categories of the customers. Column 6 gives total cost andcolumn 7 gives profit or loss. In this situation, a. discriminating monopolist will also seek themaximum profit, which cen be obtained by creating a category ofcustomers and charging Rs. 9 from those on the top class and Rs. 2from those in the bottom of the category. With such a differential pricestructure, the monopolist will sell 2,000 units and earn a maximumprofit of Rs. 2,400. The monopolist will be better off by Rs. 2,300 by charging the discriminating prices he will earn as much as Rs. 2,400 as against a maximum of Rs. 100 by charging the single price of Rs. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 6. The policy of discriminating prices is in the interest of the customers as well. Larger output of 2,000 units, is beneficial to a larger number of customers. Moreover, each customer is charged according to his ability to pay. Therefore, the policy is fair as well as reasonable. The policy of price discrimination will enable better utilisation of capacity. Assuming the monopolist has a capacity to produce 3,600 units, he would operate at a level of 2,000 units which is much closer to full capacity as against the level of 400 units, where the monopolist will operate if he chmges the single price of Rs. 6. If the maximum price that can be charged is Rs. 2, the monopolist will earn a maximum profit of Rs. 200 by practising price discrimination as shown in the following Table 4.8. Table 4.8.: A Regulated Monopolist Discriminating in Price but Charging not more than Rs. 3 Price Sales Sales in Revenue Total Total Profit or (Rs.) (Units) each from Revenue Cost Loss Category each (Rs.) (Rs.) (Rs.) (units) category (Rs.) 1 2 3 4 5 6 7 3.00 1,000 1,000 3,000 3,000 3,400 -400 2.50 1,400 400 1,000 4,100 4,100 -100 2.00 2,000 600 1,200 5,200 5,000 200 1.50 2,800 800 1,200 6,400 6,400 0 1.00 3,600 800 800 7,200 8,000 -800 But capacity utilisation and availability of supplies will remainunaltered. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS APPENDIX 1Price Discrimination - Diagrammatic ExpositionA diagrammatic exposition of the theory of price discrimination isshown below. Figure 4.27 presents the diagram of price discriminateadopted in traditional economic theory. Let us suppose that the market for a product consists of twosegments, one with a more elastic demand curve than the other D1shows the demand in the more elastic segment and D2 shows thedemand in the less elastic segment. MR. and MR2 represent thecorresponding marginal revenue curves. The total marginal, revenuecllrve MRT adds together the quantities in both market segments ateach marginal revenue. Thus MRT = MR1+ MR2. On the cost side, thediagram shows a marginal cost curve MC, which alone is relevant. Itmay be noted that only one I marginal cost curw exists because itmakes no difference from the cost point of view whethcr the productssell in market segment 1 or market segment 2, since the product isthe same. As usual, profit will be maximised where marginal revenue iscquallo marginal cost. Such equality exists at point E in the diagram BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSwhere the total margimil revel1lie curve (MRT) intersects thell1argin::d cost curve (MC). A horizontal line drawn from this point ofintersection E, back to the Y-axis cuts the two marginal revenuecurves MR, and MR2 at points F and G respectively. These rointsdetermine the quantities to be sold in each market segment and theprices which shall prevail in each market segment. For this purposeone should first draw a perpendicular line frolll point F on X-axis,showing OX, as the quantity in market segment 1. Agai by extendingthis perpendicular line upward to meet the demand curve 0" one gets p.as the price for this market segment. Similarly, frol1l point drawingthe perpendicular to X-axis and thereafter extending it to the demandc.urve D2, we get OX2 as·the quantity to be sold and P2 as the price tobe charged in market segment 2. The quantity sold in market segment1 (OXI) plus the quantity sold in market segment 2 (OX2) exhausts thetotal quantity OQ (i.e., OX1 + OX2 = OQ). Further, the price PI is lowerthan the price P2 thus indicating that the price in the more elasticmarket segment (DI) shall be less than the price in the less elasticmarket segment (D2). The two prices PI and P2 provide differentmargins of contribution to profit. It should also be noted that (hesolution equates the marginal revenue in each segment (i.e., X2G =X.F) besides equating the total marginal revenue to marginal cost atpoint F. If MR. was greater than MR2, the firm could increase profits bytransferring units of product from market segment 2 to-marketsegments I. This is an illustration of the equi-marginal principle. Ifeither MR1 or MR2 were greater than me, an expansion of outputwould be profitable. Optimisation thus requires that MR1 = MR2 = Me. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS APPENDIX 2Measures of Monopoly PowerSeveral economistS have given different measures of monopoly power.These are discussed below: Lerners measure: According to Lerner, the difference betweenprice dnd marginal cost, measures the gegree of monopoly power. Inother words, a sellers monopoly power depends upon his ability tosell the commodity at a price above its marginal cost. A perfectlycompetitive seller enjoys no monopoly power and in his case: Price = Marginal cost (or P - MC = 0). But as monopoly po~er emerges, P - MC becomes greater thanzero and as the power increases, the gap between price and MCincreases. Thus, the degree or index of monopoly power can bemeasured as being equal to: MC P= P For instance, if price is Rs. 20 and marginal cost is Rs.12, the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdegree of monopoly power is 20-12 = 0.4 20 Lerner also relates the monopoly power to price-elasticity ofdemand. Accordingly, higher the price-elasticity of demand, smaller isthe degree of monopoly power. Also, the degree of monopoly power isthe reciprocal of the price-elasticity of demand. That is, if elasticity is2, the degree of monopoly is V*. Bains measure: Bain measures degree of monopoly power in terms of supernormal profits. The supernormal profits are equal to (P - AC) Q, where P = Price, AC = average cost, and Q is output. Rotbscbilds measure: Rothschilos defines degree of monopoly power, in terms of the proportion of the slopes of the firms and industry demand curves, i.e., Slope of the firm’s demand curvedegree of monopoly power Slope of the industry’s demand curve= Triffins measure: Trimn measures degree of monopoly power in terms of price cross-elasticity of demand. Price cross-elasticity of demand means the extent of substitution between the products of two firms when one of them changes the price of its product. If cross-elasticity of demand is zero, this implies that the firm has an absolute monopoly power. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSREVIEW QUESTIONS 1. Define a production function. Explain and illustrate isoquants and isocost curves. 2. Explain the nature mid managerial uses of production function. 3. Discuss the equilibrium of the organisation with the technique of isoquants. 4. Distinguish between production function and cost function. How would you develop the production function? What are its uses? 5. What are the main features of pure competition? How does an organisation adjust its policies to a purely competitive situation? 6. What is the short-down point? Explain why a organisation suffering losses still decides to operate and not shut down. 7. Explain the following propositions: A. If demand rises, price goes up. B. If supply rises, price goes down. C. If both demand and supply increase, sales is bound to BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS increase but price mayor may not.8. Explain the possible effect of an increase in demand with a simultaneous decrease in supply on sales and price.9. Explain the effects of government intervention in price fixation. What steps are necessary to make this intervention effective?10. How does a company determiae the prices of its products? Examine in this connection the validity of the theory that long-period price is equal to cost.11. Explain very short period, short period and long period situations in a market. Show price equilibrium under very short and iong periods.12. What is meant by price discrimination? What are its objectives? Is price discrimination anti-social?13. What does differential pricing mean? Discuss the various types of geographical price differentials and explain how they are determined.14. Comment on the various types of discounts and the effects of each on sales.15. How does the equilibrium of the organisation under perfect competition differ from that of a monopolist? Is it true that in the long run II perfectly competitive organisation earns no super-normal profits?16. Explain and illustrate the conditions for the establishment of organisations equilibrium under perfect competition.17. Examine the weaknesses of the traditional theory of pricing from the point of view of an individual organisation. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS LESSON - 5 PROFITMEANNINGProfit means different things to different people. The word ‘profit’ hasdifferent meanings to business, accountants, tax collectors workersand economists. In a general sense, profit is regarded as income of theequity shareholders. Similarly wages getting accumulated of a labor,rent accruing to the owners of any land or building and interestgetting due to the investors of capital of a business, are a kind ofprofit for labours, land owners and investors. To an account, profitmeans the excess of revenue over all paid out costs including bothmanufacturing and overhead expenses. It is much similar to net profit.In accountancy, profit or business income means profit of a businessincluding its non allowance expenses. In economic, Profit is calledpure profit, which may be defined as a residual left after all contractualcosts have been met, including the transfer costs of managementinsurable risks, depreciation and payment to shareholders, sufficientto maintain investment at its current level. Therefore pure profit canbe calculated with the help of following formula. Pure Profit = Total Revenue - (explicit costs + implicit costs).Economic or pure profit also makes provision for insurable risks,depreciation and necessary minimum payments to shareholders toprevent them from withdrawing their capital. Pure profit is consideredto be a short – term phenomenon. It does not exist in the long run,especially under perfectly conditions. Because of this, they may eitherbe positive or negative for a single firm in a single year. The concept of economic profit differs from that of accountingprofit Economic profit takes into account also the implicit or imputedcosts. The implicit cost is also called opportunity cost. If anentrepreneur uses his labor in his own business, he foregoes hisincome or salary, which he might have earned by working as amanager in another firm. Similarly, by using assets like and building BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSand his own business, he foregoes the market rent, which might haveearned otherwise. All these foregone incomes such as interest, salaryand rent, are called opportunity costs or transfer costs. Accountingprofit does not consider the opportunity cost.THEORIES OF PROFIT AND SOURCES OF PROFITThere are various theories of profit, given by several economists,which are as follows:Walker’s Theory of: Profit as Rent of AbilityThis theory is pounded by F.A. Walker. According to F.A. Walker, “Profitis the rent of exceptional abilities that an entrepreneur may possessover others. Rent is the difference between the yields of the least andthe most efficient entrepreneurs. In formulating this theory, Walkerassumed a state of perfect completion in which all firms are presumedto possess equal managerial ability each firm receives only the wageswhich in Walker view forms no part of pure profit. Hen consideredwages of management as ordinary wages thus, under perfectlycompetitive conditions, there would be no pure profit and all firmswould earn only wages, which is known as normal profit.Clark’s Dynamic TheoryThis theory is propounded by J.B. Clark According to him, “profits arisein a dynamic economy and not in static economy.”A static economy and the firms under it, has the following features: Absolute freedom of completion Population and capital are stationary Production process remains unchanged over time. Homogeneous goods Factors of production enjoy freedom of mobility but do not move because their marginal product in very industry is the same. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS There is no uncertainly and risk. If there is any risk, It is insurable All firms make only normal profitA dynamic economy is characterized by the following features: Increase in population Increase In capital Improvement in production techniques. Changes in the forms of business organization The major function of entrepreneurs or managers in a dynamiceconomic is to take the advantage of all of the above features andpromote their business by expanding their sales and reducing theircosts of production. According to J.B. Clark, “Profit is an elusive sum, whichentrepreneurs grasp but cannot hold. It slips through their fingers andbestows itself on all members of the society”. This result in rise indemand for factors pf production and therefore rises in factor pricesand subsequent rise in the cost of production. On the other hand,because of rise in cost of production and the subsequent fall in sellingprice of the commodities, the profit disappears. Disappearing of profitdoes not mean that profit arise in dynamic economy once only, but itmeans that the managers take the advantage of the changes takingplace in the economy and thereby making profits.Howley’s Risk Theory of ProfitThe risk theory pf profit is propounded by F.B. Hawley’s in 1893. Riskin business may arise due to obsolescence of a product, sudden fall inprices, non-availability of certain materials, introduction of a bettersubstitute by a competitor and risks due to fire, war, etc. Hawley’sconsidered risk taking as an inevitable element of production andthose who take risk are more likely to earn larger profits. According toHawley, Profit is simply the price paid by society assuming business BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSrisks. In his opinion in excess of predetermined risk. They also look fora return in excess of the wags for bearing risk is that the assumptionof risk is irrelevant and gives to trouble and anxiety. According toHawley, Profit consists of two part, which are as follows:- One Part represents compensation for actual or average loss supplementing the various classes of risk. The other part represents a penalty to suffer the consequences of being exposed to risk in the entrepreneurial activities. Hawley believed that profits arise from factor ownership as longas ownership involves risk. According to Hawle’y an entrepreneur hasto assume risk to earn more and more profit. In case of absence ofrisks, an entrepreneur would cease to be an entrepreneur and wouldnot receive any profit. In this theory, profits arise out of uninsuredrisks. The amount of reward cannot be determined, until theuncertainly ends with the sale of entrepreneur products profit in hisopinion is a residue and therefore. Hawley theory is also called aresidential theory of Profit.Knight’s Theory of ProfitThis theory of profit is propounded by frank H. Knight who treatedprofit as a residual return because of uncertainly, and not because ofrisk bearing. Knight made a distinction between risk and uncertainlyby dividing risk into two categories, calculable and non-calculablerisks. They are explained as below:- Calculable risks are those, the prodigality of occurrence of which van be calculated on the basis of available data. For example risk, due to fire theft accidents etc. are calculable and such risks are insurable. Incalculable risks are those the probability of occurrence of which cannot be calculated. For Instance there may be a certain elements of cost, which may not be accurately calculable and the strategies of the competitors may not be precisely assessable. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS These risk are called includable risks. The risk element of such incalculable costs is also insurable. It is in the area of uncertainly which makes decision-making acrucial function for an entrepreneur. If his decisions prove to be right,the entrepreneur makes profit, Thus according to knight profit arisesfrom the decisions taken and implemented under the conditions ofuncertainly. The profits may arises as a result of decision related to thestate of market such as decision, which increase the degree ofmonopoly, decisions regarding holding of stocks that give rise towindfall gains and the decisions taken to introduce new techniquesor innovations.Schumpeter’s Innovation Theory of ProfitJoseph A. Schumpeter developed the innovation theory of Profit.According to Joseph A. Schumpeter, factors like emergence of Interestand profits, recurrence of trade cycles only supplement the distinctprocess of economic development to explain the phenomenon ofeconomic development and profit, Schumpeter starts from the state ofa stationary equilibrium, which is characterized by the equilibrium inall the spheres. Under these conditions stationary equilibrium, thetotal receipts from the business are exactly equal to the cost. Thismeans that there will be no profit. The profit can be earned only byintroducing innovations in manufacturing technique and the methodsof supplying the goods innovations may include the following activities. Introduction of a new commodity or a new quality of goods. Introduction of a new method of production. Introduction of a new market. Finding the new sources of raw material Organizing the industry in an innovative manner with the new techniques. The factor prices tend to increase while the supply of factorsremains the same. As a result, cost of production increase. On theother hand with other firms adopting innovations, supply of goods and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSservices increases resulting in a fall in their prices. Thus, on one hand,cost per unit of output goes up and on the other revenue per unitdecrease. Finally, a stage comes when there is no difference betweencosts and receipts. As a result there are no profits at all. Here,economy has reached a state of equilibrium, but there is the possibilityof existence of profits. Such profits are in the nature of Quasi-rentarising due to some special characteristics of productive services.Furthermore, where profits arise due to factors such as patents, trusts,etc. they will be in the nature of monopoly revenue rather thanentrepreneurial profits.MONOPLOY PROFITMonopoly is a market situation in which there is a single seller of acommodity without a close substitute. Monopoly may arise due toeconomies of scale, sole ownership of raw materials, legal sanction,protection, mergers and take–overs. A monopolist may earn pureprofit, which is also called monopoly profit in the case of a monopoly,and maintain it in the long run by using its monopoly powers.Monopoly powers are as follows:- Powers to control supply and price. Powers to prevent the entry of competitors by reducing the prices. The Monopoly powers help a monopoly firm to make pure profitor monopoly profit. In such cases, monopoly is the source of pureprofit.PROBLEMS IN PROFIT MEASURMENTAccounting profit is the difference between all explicit costs andeconomic profit or subtracting the difference of explicit and implicitcosts from revenue. Once profit is defined, it is easier for a firm tomeasure the profit for a given period. The problems regarding themeasurement of profits are as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The choice between the two concepts of profits, to be given preference while using. The determination of the various costs to be included in the implicit and explicit costs. The solutions to these problems are as follows:- The use of a profit concept depends on the purpose of measuring profit. According concept of profit is used when the purpose is to produce a profit figure for any of the following. o The shareholders, to inform them of progress of the firm o Financiers and creditors, who would be interested in the firm’s progress o The Managers to assess their own performance o For computation of tax-liability. To measure accounting profit for these purposes, necessaryrevenue and cost data are, in general, obtained from the firm books ofaccount. It must, however, be noted that accounting profit maypresent an overstatement or understand of actual profit, if it is basedon illogical allocation of revnues and costs to a given accountingperiod. On the other hand, if the objective is to measure true profit, theconcept of economic profit should be used. However true profitabilityof any investment or business has been completely done. But then thelife of a business firm is unending therefore , true profit can bemeasured only in terms of maximum amount that can be distributedas dividends without harming the earning power of the firm. Thisconcept of business income is however, unattainable and therefore, isof little practical use. It helps in income measurement even frombusinessman point of view. From the above discussion, it is clear that,for all practical purpose, profits have to be measured on the basis ofaccounting concept. But measuring even the accounting profit is notan easy task. The main problem is to decide as to what should be andwhat should not be included in the cost one might feel that profit and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSloss accounts and balance sheet of the firms provide all the necessarydata to measure accounting profit there are, however three specificitems of cost and revenue which cause problems, such as depreciation,capital gains and losses and current vs. historical costs. Theseproblems are related to measurement and may arise because of thedifferences between economists and accountants view on these items.The concept of current costs can be used understood from thefollowing description.CURRENT vs. HISTORICAL COSTSMeaning of Historical CostsThe income statements are prepared in terms of Historical costs andnot in terms of current price. Historical costs is the purchase price ofany asset ands includes the following. Money spent in the acquisition of the asset including transportation costs as well as the insurance cost. Costs of installation such as wages paid for erection of machinery and the amount spent on repairs at the time of installation. The reasons for using historical costs for calculatingdepreciation rather than current costs are as follows:- Historical costs produce more accurate measurement of Income. Historical costs are easily determined and more objective than the values based on the use of current value on asset. Accountants also record historical costs and consider them to be more relevant, The accountants approach ignores certain important changes in earnings and looses of the firms, which may be any of the following: o The value of asset pretended in the books of accounts is understand at the time of inflation and overstated at the time of deflation. o Depreciation is understated during deflation. The historical cost recorded in the books of account does not BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS reflect these changes in values of assets and profits. This problem becomes more critical in case of inventories and stock. The problem is how to evaluate the value of inventory and the stocks.Methods of Inventory ValuationThere are three popular methods of Inventory valuation, first in firstout (FIFO), last in fist out (LIFO) and weighted average cost (WAC) Under FIFO method, material is taken out of stock for furtherprocessing in the order in which they are acquired. The stocks,therefore, appear in firms balance sheet at their actual cost price. Thismethod overstates profits at the time of rising prices. Under LIFO method, the stock purchased most recently becomethe costs of the raw material in the current production under WACmethod, the weighted average of the costs of materials purchased atdifferent prices and different point of time is calculated to evaluate theinventory. All these methods have their own disadvantages and do notreflect the true profit of the business. So the problem of evaluatinginventories to yield a true profit remains unsolved.Problems is Measuring DepreciationEconomists consider depreciation as capital consumption. For them,there are two distinct ways of charging depreciation either byassuming the value of depreciation of equipment to its opportunitycost or to its replacement cost that will produce comparable earning. Opportunity cost of equipment is the most profitable alternateuse of that is foregone by putting it to its present use. The problem isto measure the opportunity cost. One method of measuring theopportunity cost. One method of measuring the opportunity cost, assuggested by Joel Dean, is to measure the fall in value during a year.By using this method cannot be applied when capital equipment hasno alternative use, like a hydropower project In such cases, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSreplacement cost is an appropriate measure of depreciation. Underthis method, the cost of the new asset and the residual value of theold asset are taken as the depreciation of the asset. But depreciation isrecorded only at the time of replacement of an asset. This method isused in public utility concerns like railway, electricity companies. Toaccountants, depreciation is an allocation of under expenditure overtime. Such allocation or charging depreciation is made underunrealistic assumptions such as stable prices and a given rate ofobsolescence. There are different methods of charging depreciation,which are of utmost importance. The use of different levels of profitreported by the accountants. It will be clearer after considering thefollowing example: Suppose a firm purchases a machine for Rs.10,000/- with an estimated life of 10 yrs. The firm can apply any ofthe following four methods of charging depreciation and the amountof depreciation for the given example by using the different methodsis as follows: Straight Balance Method Annuity Method Sum-of the years digit approaches Under the straight – line method, the amount of depreciationremains the same throughout the life of the asset. Depreciation iscalculated according to a fixed percentage on the original cost. Theamount and rate of depreciation is calculated as under: Historical cost-residual value Amount of depreciation = Economic life of the asset Rate of depreciation = Amount of depreciation x 100/Historical cost Residual value is the realizable value of an asset at the end of itseconomic life. Keeping in view the above example, the amount ofdepreciation will be 10,000/10 = Rs. 1,000. It will be same for eachyear. The rate of depreciation will be 1000 x 100/10,000 = 10 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Under the reducing balance method, depreciation is charged at aconstant rate or percent of annually written down values of themachine or any equipment. Assuming a depreciation rate of 20 percent, the amount of depreciation for different years will be calculatedas under :Amount of Depreciation = Historical value x rate of depreciation /100 But the amount of depreciation for the first year will be deductedfrom the successive years. Therefore Rs. 2000 in the first year, Rs.1600 in the second year, Rs. 1280 in the third year, and so on.Under annuity method, rate of depreciation is fixed and is calculatedas under:-d = (C + Cr )/n, where n is the total number of years of capital, C isthe total capital and r is the interest rate. The amount of depreciationin this method is calculated with the help of annuity table. Finally under sum-or-the year’s digits approach, the total yearsof equipment life are aggregated. Depreciation is then charged at therate of the ratio of the last years digits to the total of the years. Withrespect to the given example, the aggregated years of the equipment’slife’s will be 1+ 2 + 3 +... +10 = 55. Depreciation in the 1st year willbe 10,000 x 10/55 = Rs. 1818.18, in the 2nd year it will be 1,000 x9/55 = Rs. 1636.36 and in 3rd year it will be 10,000 x 8/55 = Rs.1454.54, and so on. These four methods of depreciation results indifferent methods of depreciation and subsequently different levels ofprofit.TREATMENT OF CAPITAL GAINS AND LOSSESCapital gains and losses arc regardea as windfalls. Fluctuation in thestock market prices is one of the most common sources of wind Ellis.According to Dean, capital losses are, greater than capital gains in aprogressive society. Many of the capital losses arc of insurable natureand the excess becomes the capital gain. Profit is also affeckd by the way capital gains and losses are treated BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSin accounting. According to Dean, "a sound accounting policy to followconcerning windfalls is never to record them until they are turned intocash by a purchase or sale of assets, since it is never clear until thenexactly how large they are". But, in practice, some firms do not recordcapital gains until it is realised in money terms, but they do write offcapital losses from the current profit. The use of different policiesresult in different profits. But an economist is not concerned with theaccounting practice or principle, which is followed in recording thepast events. An economist is concerned mainly with what happens infuture. According to an economist, the management should be awareof the approximate magnitude of such windfalls before they areaccepted by the accountants. This would be helpful in taking the rightdecision with respect of those assets, which are affected by the use ofpolicies given by the economists.PROFIT MAXIMISATION AS BUSINESS OBJECTIVEProfit maximisation is the most important assumption, which helpsthe economists to introduce the price and production theories. Thetraditional economic theory assumes that the profit maximisation isthe only objective of business firms. According to this theory, profitsmust be earned by business to provide for its own survival, coverageof risks, growth and expansion. It is a necessary motivating force andit is in terms of profits that the efficiency of a business is measured. Itforms the basis of conventional price theory. Profit maximisation isregarded as the most reasonable and analytically the most productivebusiness objective. The profit maximisation assumption in this theory helps inpredicting the behaviour of business firms and also the behaviour ofprice and out pet under different market conditions. No alternativehypothesis or assumption explains and predicts the behaviour of firmsbetter than the profit maximisation assumption. According to thistheory, total profit is the difference between total revenue and totalcost and is calculated as below: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS TP = -TR – TC (1) where, TR = total revenue TC = total cost The total cost includes fixed cost and variable cost. The cost,which remains same at different levels or output, is called fixed cost.The sum of all t~ose costs, which vary directly with the level of output,is called variable cost. In context with the profit maximisationobjective, the total profit or the difference between total· cost andtotal profit is to be maximised. There are two conditions that must befulfilled for TR- TC to be maximum. These conditions are divided intotwo categories, which are necessary or first order condition andsecondary or supplementary condition. These conditions are explainedas below: The necessary or the first order condition states that marginal revenue (MR) must be equal to marginal cost (MC). Marginal revenue is the revenue obtained from the production and sale of one additional unit of output. Marginal cost is the cost arising due to the production of one additional unit of output. The secondary or the second order condition states that the first order condition must show the decreasing MR and rising MC. The secondary condition is fulfilled only when both the MC is rising as well as the MR is decreasing. This condition is illustrated by point P2 in Figure 5.1. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Let us suppose that the total revenue and total cost functions are,respectively given as below: TR = TC = f (Q) where, Q = quantity produced and sold. Substituting total revenue and total cost functions In Equation(I), profit function can be written as below: TP = f(Q)TR - f(Q)TC (2) With the help of equation (2), The first order condition and thesecondary. Condition can be understood easily.First-order Condition The first-order condition of maximising a function is that the firstderivative of the profit function must be equal to zero. Bydifferentiating the total profit function and equating it to zero, thefollowing equation is obtained: aTP aTR aTC = - =0 aQ aQ aQ (3) This condition holds only when aTR aTC BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS aQ = aQ In Equation (3), the term aTR/aQ is the slope of the totalrevenue curve, which is equal to the marginal revenue (MR). Similarly,the term aTC/aQ is the slope of the total cost curve, which is equalto the marginal cost (MC). Thus, the first-order condition for profitmaximisation can be stated as: MR=MC The first-order condition is also called necessary condition, as itis so important that its non-fulfilment results in non-occurrence ofthe secondary condition and thereby the profit maximisationobjective is not attained.Second-order ConditionThe second-order condition of profit maxirnisation requires that thefirst order condition is satisfied under rising MC and decreasing MR.This condition is illustrated in Fig. I. The MC and MR curves are theusual marginal cost and marginal revenue curves, respectively. MC andMR curves intersect at two points, PI and P2. Thus, the first ordercondition is satisfied at both the points but mathematically, thesecond order condition requires that its second derivative of the profitfunction is negative. When second derivative of profit function isnegative, it shows that the total profit curve has bent downward afterreaching the highest point on the profit scale. The second derivative ofthe total profit function is given as: a2TR a2TP a2TR a2TC aQ2 = aQ2 = aQ2 - aQ2 <0 (4)But it requires: a2TR a2TC BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS aQ2 - aQ2 <0 a2TR a2TC aQ2 < aQ2 <0 Since & TR/aQ2 is the slope of MR and & a2 TC/aQ2 is the slope ofMC, the second-order condition can also be written as: Slope of MR < Slope of MC. It implies that MC curve mustintersect the MR curve. To conclude, profit is maximised where boththe first and second order conditions are satisfied. Example It is known that: TR = P.Q where, (5) P = Price of a single quantity and Q = Total quantity.Suppose price (P) function is given as P = 100 – 2Q (6)Then TR = (100 – 2Q) QOr, TR = 100Q – 2Q2 (7)And also suppose that the total cost function as given as TC = 10 + 0.5Q2 (8) Applying the first order condition of profit maximisation andfinding the profit maximising output. It is known that profit ismaximum where: MR – MCor, aTR aTC aQ = aQ (9)Putting the values of Equation (7) and (8) in (9) aTR aTC BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS MR = aQ < aQ = 100 – 4Qand aTC MC = =Q aQThus, profit is maximum where MR = MC 100 – 4Q = Q 5Q = 100 Q = 20 The output 20 satisfies the second order condition also. Thesecond order condition requires that: a2TR a2TC < <0 aQ2 aQ2 In order words, the second-order condition requires that aMR aMC - <0 Q Q Or a(100 – 40) a(Q) aQ - aQ <0 - 4 – 1 <0 Thus, the second-order condition is also satisfied at output 20.CONTROVERSY OVER PROFIT MAXIMISATION OBJECTIVE:THEORY vs. PRACTICEAccording to the traditional theory, profit maximisation is the soleobjective of a business firm. In practice, however, firms have beenfound to be pursuing objectivies other than profit maximisation. For BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSthe large business firms, pursuing goals other thon profitmaximisation is the distinction between the ownership andmanagement. The separntion of manllgement from the ownershipgives managers an opportunity to set goals for the firms other thanprotit maximisation. Large firms pursue goals such as salesmaximisalioll, mllximisulioll of lilllllagcrial utility function,maximisation of firms growth rate, making a target profit, retainingmarket share, building up the net worth of the firm, etc. Secondly,traditionnl theory assumes perfect knowledge about current murketconditions and the future developments in the business environmentof the firm. Thus a business firm is fully aware of its demand and costfunctions in both short and long runs. The market conditions (Ireassumed to be certain. On the contrary, it is also recognised that thefirms do not possess the perfect knowledge of their costs, revenue,and their environment. They operate in the world of uncertainty. Mostof the price and output decisions are based on probabilities. Finally, the marginality principle in which MC and MR are same hasbeen found to be absent in the decision-making process of thebusiness firms. Hall and Hitch have found, in their study of pricingpractices in UK, that the firms do not pursue the objective of profitmaximisation and that they do not use the marginal principle ofequalising MR and MC in their price and output decisions. Most firmsaim at long-run profit maximisation. In the short-run, they set theprice of their product on the basis of average cost principle to coveraverage cost and its components, average variable cost and averagefixed cost. It also takes into account normal profit usually 10 per cent. Gordon,a famous economist, has concluded that the real business world ismuch more complex than the one which is based on hypothesis andassumptions. The extreme complexity of the real business world andever-changing conditions makes it difficult for a business firm to useits past experience in order to forecast demand, price and costs. Theaverage-cost principle of Rricing is widely used by the firms and the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmarginal costs and marginal revenu~ are ignored. On the basis ofmany such studies, it can be said that the pricing practices are relatedto pricing theories.THE FAVOUR OF PROFIT MAXIMISATIONThe arguments against the profit-maximisation assumption, however,should not mean that pricing theory is not related to the actual pricingpolicy of the business firms. Many economists has strongly supportedthe profit maximisation objective and the marginal principle of pricingand output decisions. The empirical and theoretical policies supportthe marginal rule of pricing in the following way: In two empirical studies of 110 business firms, J.S.Earley hasconcluded that the firms do apply the marginal rules in their pricingand output decisions. Fritz Maclup has argued that empirical studiesby Hall and Hitch, and Lester do not provide conclusive evidenceagainst the marginal rule and these studies have their ownweaknesses. He further argued that there has been a misundestandingregarding the purpose of traditional theory. The traditional theoryexplains market mechanism, resource allocation through pricemechanism and has a predictive valu. The significance of marginalrules in actual pricing system of firms could not be considcredbecausc of lack of communication between the busincssmcn and theresearchers as they use different terminology like MR, Me andclasticitics. Also, Maclup is of the opinion that the practices of settingprice equal to the average variable cost plus a profit margin, is notinequitable with the marginal rule of pricing.ARGUMENTS IN FAVOUR OF PROFIT MAXIMISATION HYPOTHESISThe traditional theory supports the profit maximisation hypothesisalso on the following grounds: Profit is essential for survival of a business: 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 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS conditions and the level of competitior. Profit is the biggest incentive for work. It is the driving force behind the business enterprise. It encourages a man to work to do the best of his ability and capacity. Making a profit is a necessary condition for the survival of the firm. Once the firms are able to make profit, they try to maximise it. Achieving other objectives depends on the ability of a business to make profit: Many other objectives of business are maximisation of managerial utility function, maximisation of long-run growth, maximisation of sales revenue. The achievement of such alternative objectives depends wholly or partly on the primary objective of making profit. Profit maximisation objective has a greater predicting power: As comparcd to other business objectives, profit maximistion assumption has been found 10 be good in predicting ccrtain aspects relatcd to a business. Friedman supports this by saying that the profit maxilllisation is considered to be good only if it predicts the business behaviour and the business trends correctly. Profit is a more reliable measure of efficiency of a business: 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. The recent trend shows a growing dependence on the internal finance in the indlstrially advanced countries. In fact, in developed countries, internal sources of finance contribute more than three-fourths or lotal linance. Keeping this in mind, it can be said that profit maximisation is a more valid business objective.Alternative objectives of Business FirmsThe traditional theory does not distinguish between owners andmanagers interests. The recent theories of firm, which arc also calledmanagerial and behavioural theories of firm, assume owners and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmanagers to be separate entities in large corporations with differentgoals and motivation. Berle and Means were the two economists, whopointed out the distinction between the ownership and themanagement, which is also known as Berle-Means-Galbraith (BMG)hypothesis. The B-M-G hypothesis states the following: The owners controlled business firms have higher profit rates than manager controlled business firms, and The managers have no in::entive for profit maximisation. The managers of large corporations, instead of maximising profits, set goals for themselves that helps in controlling the owners also. In this section, some important alternative objectives of business firms, especially of large business corporations are also discussed.Baumols Hypothesis of Sales Revenue MaximisationAccording to Baumol, "maximisation of sales revenue is an alternativeto profit¬maximisation objective". The reason behind this objective isto clearly distinct ownership and management in large business firms.This distinction helps the managers to set their goals other than profitmaximisation goal. Under this situation, managers maxi mise theirown utility function. According to Baumol, the most reasonable factorin managers utility functions is maximisation of the sales revenue. The factors, which help in explaining these goals by themanagers, are following: Salary and other earnings of managers are more closely related to seals revenue than to profits. Banks and financial corporations look at sales revenue while financing the corporation. Trend in sale revenue is a good indicator of the performance of the business firm. It also helps in handling the personnel problems. Increasing sales revenue helps in enhancing the prestige of managers while profits go to the owners. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Managers find profit maximisation a difficult objective to fulfil consistently over tillle and at the same level. Profits may fluctuate with changing conditions. Growing sales strengthen competitive spirit of the business firm in the nlilrkd and vice versa. So far as cmpirical validity of sales revenue maximisationobjective is concerned, realistic evidences are unsatisfying. Mostempirical studies are, in fact, based on inadequate data because thenecessary data is mostly not available. If total cost lilllction intersectsthe total revenue function (TR) function before it reaches its highestpoint, Baumols theory fails. It is also argued that, in the long run,sales maximisation and profit maximisation objective can be mergedinto one. In the long rnll, sales maximisation lends to yield onlynormal levels of profit, which turns out to be the maximum undercompetitive conditions. Thus, profit maximisation is not inequitab!cwith sales maximisation objective.MARRISs HYPOTHESIS OF MAXIMISATION OF FIRMS GHOWTH RATEAccording to Robin Marris, managers maximise firms growth ratesubject to managerial and financial constraints. Marris defines firmsbalanced growth rate (G) as follows: G = Gd = Gc where, Jd = growth rate of dcmand for firms product. Gc = growth rate of capital supply to the firm. In simple words, a firms growth rate is considered to bebalanced when demand for its product and supply of capital to thefirm increase at the same rate. The two growth rates according toMarris, are translated into two utility functions such as: Manager’s ut i I ity function BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Owner’s utility function The manager’s utility function (Um) and owners utility function(Uo) may be specified as follows: Um = f (salary, powcr, job security, prestige, status) and Un = f (output, capital, market-share, profit, public esteem). Owners utility function (Vo) implies growth of demand for firmsproducts and supply of capital. Therefore, maximisation of Uo mcansmaximisation of demand for a firms products or growth of supply ofcapital. According to Marris, by maximising these variables, managersmaximise both their utility function and that of the owners. The,managers can do so because most of the variables such as salarics,status, job security, power, etc., appearing in their own utility functionand those appearing in the utility function of the owners such as profit,capital market, share, etc. are positively and strongly correlated withthe size of the firm. These variables depend on the maximisation ofthe growth rate of the firms. The managers, therefore, seek tomaximise a steady growth rate. Marriss theory, though more accurateand sophisticated than Baumols sales revenue maximisation, has itsown weaknesses. It fails to deal satisfactorily with the marketcondition of oligopolistic interdependence. Another seriousshortcoming is that it ignores price determination, which is the mainconcern of profit maximisatioll hypothesis. In tbe opinion of manyeconomists, Marriss model too, does not seriously challenge the profitmaximisation hypothesis.Williamsons Hypothesis of Maximisation of Managerial UtilityFunctionLike Baulmol and Marris, Willamson argues that managers are verycareful in pursuing the objectives other than profit maximisation. Themanagers seek to maxi mise their own utility function subject to aminimum level of profit. Managers utility function (U) is expressedbelow: V = f(S, M, ID) BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS where, S = additional expenditure on staff M = Managerial emoluments ID = Discretionary investments According to Williamsons hypothesis, managers maximise theirutility function subject to a satisfactory profit. A minimum profit isnecessary to satisfy the shareholders and also to secure the job ofmanagers. The utility fU1ctions which managers seek to maximise,include both quantifiable variables like salary and slack earnings antinon-quantitative variable such as prestige power, status, job security,professional excellence, etc. The non-quantifiable variables areexpressed in order to make them work effectively in terms of ex; ensepreference defined as satisfaction derived out of certain types ofexpenditures. Like other alternative hypotheses, Williamsons theorytoo suffers from certain weaknesses. His model fails to deal with theproblem of oligopolistic interdependcncc, Willinmsolis theory is saidto hold only where rivalry between firms is not strong. In case there isslrong rivalry, profit maximisation is claimed to be a more appropriatehypothesis. Thus, Williamson’s managerial utility function too does notoffer a more satisfactory hypothesis than profit maximisation.Cyert-March Hypothesis of Satisfying BehaviourCyert-March hypothesis is an extension of Simons hypothesis offirms satisfying behaviour. Simon had argued that the real businessworld is full of uncertainly liS accurate and adequate data are notreadily available, If data are available, managers have little time andability to process them, Managers alsc work under a number ofconstraints. Under such conditions it is not possible for the firms toact in terms of consistency assumed under profit maximisationhypothesis. Nor do the firms seek to maximise sales and growth.Instead they seek to achieve a satisfactory profit or a satisfactorygrowth and so on. This behaviour of business firms is termed assatisfaction behaviour. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Cyert and March added that, apart from dealing with uncertainty,managers need to satisfy a variety of groups of people such asmanagerial staff, labour, shareholders, customers, financiers, inputsuppliers, accountants, lawyers, etc. All these groups have confiictinginterests in the business firms. The managers responsibility is tosatisfy all of them. According to the Cyert-March, "firms behaviour issatisfying behaviour, which implies satisfying various interest groupsby sacrificing firms interest or objectives." The basic assumption ofsatisfying behaviour is that a firm is an association of different groupsrelated to various activities of the firms such as shareholders,managers, workers, input supplier, customers, bankers, tax authorities,and so on. All these groups have some expectations from the firm,which are needed to be satisfied by the business firms. In order toclear up the conflicting interests and goals, managers fonn anobjective level of the firm by taking into consideration goals such asproduction, sales and market, inventory and profit. These goals and objective level are set on the basis of themanagers past experience and their assessment of the future marketconditions. The objective level is also modified and revised on thebasis of achievements and changing business environment. But thebehaviouraI theory has been criticised on the following grounds: Though the behavioural theory deals with the activities of the business firms, it does not explain the firms behaviour under dynamic conditions in the long run. It cannot be used to predict the firms activities in the future. This theory does not deal with the equilibrium of the business industry. This theory fails to deal with interdependecne or the linns and its impact on linns behaviour.ROTHSCHILDs HYPOTHESIS OF LONG-RUN SURVIVAL AND MARKETSHARE GOALSRothschild suggested another alternative objective and alternative to BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSprofit maximisation to a business firm. Accordingto Rothschild, theprimary goal of the firm is long-run survival. Some other economistshave suggested that attainment and retention of a market shareconstantly, is an additional objective of the business firms. Themanagers, therefore, seek to secure their market share and long-runsurvival. The firms may seek to maxi mise their profit in the long runthough it is not certain.Entry-prevention and Risk-avoidancelAnother alternative objective of firms as suggested by someeconomists is to prevent the entry of new business firms into theindustry. The motive behind entry prevention may be any of thefollowing: Profit maximisation in the long run. Securing a constant market share. Avoidance of risk caused by the unpredictable behaviour of new firms. The evidence related to the firms to maximise their profits in thelong run, is not certain. Some economists argue that if management iskept separate from the ownership, the possibility of profitmaximisation is reduced. This means that only those firms with theobjective of profit maximisation can survive in the long run. Abusiness firm can achieve all other subsidiary goals easily bymaximising its profits. The motive of business firms behindentry-prevention is also to secure a constant share in the market.Securing constant market share also favours the main objective ofbusiness firms of profit maximisation.A Reasonable Profit TargetA business firm has variolls objectives to achieve. The survival of afirmdepends on the profit it can make. So, whatever the goal of thefirm may be, it has to be a profitable firm. The other goals of a BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSbusiness firm can be sales revenue maximisation, maximisation offirms growth, maximisation of managers’ utility function, long-runsurvival, market share or entry-prevention. In technical sensc,maximisation of profit, as a business objective, may not soundpractical , but profit has to be there in the objective function of thefirms for its survival. The firms may differ on the level of profit andthe extent to which it is to be achieved by various firms. Some firmsset standard profit as their objective, while some of them may settarget profit and some reasonable profit as their objective to beachieved. A reasonable profit, as a business objective, is the mostcommon objective. The policy question related to setting standard orcriteria for reasonable profits are as follows: Why do modem corporations aim at a reasonable profit rather than attempting to maximise profit? What are the criteria for a reasonable profit? How should reasonable profits be determined? Following are the suggestions as given by various economists toanswer the above policy questions: 1. Preventing entry of competitors: Under imperfect market conditions, profit maximisation generally leads to a high pure profit, which attracts competitors, especially ill case of a weak monopoly. Therefore, the firms adopt a pricing and a profit policy that assures them a reasonable profit. At the same time, it also keeps the potential competitors away. 2. Maintaining a good public image: It is often necessary for large corporations to project and maintain a good public image. This is because if public opinion turns against it and government officials start questioning the profit figures, firms may find it difficult to work smoothly. So most firms set their prices lower than that to earn the maximum profit but higher enough to ensure a reasonable profit. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 3. Restraining trade union demands: High profits make trade unions feel that they have a share in the high profit and therefore they demand for wage-hike. Wage-hike may interrupt the firm’s objective of maximising profit. Any delay in profit is sometimes used as a weapon against trade union activities. 4. Maintaining customer goodwill: Customers goodwill plays a significant role in maintaining and promoting demand for the product of a firm. Customers goodwill depends on Jhe quality of the product and its fair price to a large extent. Firms aiming at bcllcr profit prospects in the long run, give up their short-run profit maximisation objective in favour of a reasonable profit. 5. Other factors: The other factors that interrupts the profit maximisation objective include the following: A. Managerial utility function, which is preferable for, profits maximisation to firms. B. Friendly relations between executive levels within the firm. C. Maintaining internal control over management by restricting firms size and profit.Standards of Reasonable ProfitsStandards of reasonable profits are determined when a firm choosesto make only reasonable profits rather than to maximise its profit. Thequestions that arise in this regard are as follows: What form of profit standards should be used? How should reasonable profits be determined? These questions can be understood after going through thefollowing explanatory points.FORMS OF PROFIT STANDARDSProfit standards is determined in terms of the following: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Aggregate money terms Percentage of sales, and Percentage return on investment. All these standards are determined for each product separately.Among all the fonns of profit standards, the total net profit of the firmis more common than other standards. But when the purpose is todiscourage the competitors, then the target rate of return oninvestment is the appropriate profit standard, provided the cost curvesof competitors are similar. The profit standard in terms of ratio tosales is not an appropriate standard because this ratio varies widelyfrom linn to firm, evens irthey nil hove the snme return on capitalinvested. These differences are following: Vertieal integration of production process Intensity of mechanisation Capital structure TurnoverSETTING THE PROFIT STANDARDThe following arc the important criteria that are considered whileselling the standards for a reasonable profit. Capital-attracting standard: An important criterion of profit standard is that it must be high enough to attract external capital such as debt and equity. For example, if the firms stocks are sold in the market at 5 times their current earnings, it is necessary for a firm to earn a profit of 20 per cent of the total investment But there are certain problems associated with this criterion, which are as follows: Capital structure of the firms such as the proportions of bonds, equity and preference shares, which affects the cost of capital and thereby the rate of profit. If the profit standard is based on current or long run average cost of capital or not. The problem in this case arises as it BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS may also vary widely from company to company. Plough-back standard: This standard is appropriate in case company depends on its own sources for financing its growth. This standard involves the aggregate profit that provides for an adequate plough-back for financing a desired growth of the company without resorting to the capital market. This standard of profit is used when liquidity is to be maintained by a firm and a debt is to be avoided as per the profit policy of the firm. This standard is socially less acceptable than capital attracting standard. From societys point of view, it is more desirable that all carnings are distributed to stockholders and they should decide the further investment pattern. This is based on a belicf that an individual is the best judge of his resource use and the market forces allocate funds more efficiently, On the other hand, retained eamings, which are under the control or the managemcnt are likely to be wasted on low-earning projects within a business firm. But to choose the most suitable policy among marketing and management the abilities of the management and outside investors are to be considered. This helps in estimating the earnings prospects of a firm. Normal earnings standard: Another important criterion for setting standard of reasonable profit is the normal earnings of firms of an industry over a period. This serves as a valid criterion of reasonable profit, provided it should take into consider the following points: o Attracting external capital o Discouraging growth of competition o Keeping stockholders satisfied. When average of normal earnings of a group of firms is used,then only comparable firms are chosen. However, none of thesestandards of profits is perfect. A standard should, therefore be chosen BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSafter giving due consideration to the existing marke conditions andpublic attitudes. Different standards arc used for different purposesbecause no single criterion satisfies all conditions of the customers.PROFIT AS CONTROL MEASUREAn important aspect of profit is its use in measuring and controllingperfonnances of the individuals of the large business firms.Researches have concluded that the business individuab of middle andhigh ranks often deviate from profit objective and try 10 maximisetheir own utility functions. They give importance to job security,personal ambitions for promotion, larger perks, etc. But this oftenconflicts with firms profit-making objective. The reasons for conflictsas given by Keith Powlson are as follows: More energy is spent in expanding sales volume and product lines than in raising profitability. Subordinates spend too much time and money doing jobs perfectly regardless of its cost and usefulness. Individuals depend more to the needs of job security in the absence of any reward. In order to control the conllicts and directing the individualstowards the profit objective, the top management usesdecentralisation and control-by-profit techniques. Decentralisation isachieved by changing over from functional division of businessactivities such as production branch, sales division, purchasedepartment, etc. to a system of commodity wise division. By doing so,managerial responsibilities are fixed in terms of profit. Under thegeneral policy framework, managers enjoy self-sufficiency in theiroperations. They are allotted a certain amount to spend and a profittarget to be achieved by the particular division. Profit is then-themeasure of performance of each individual, not of the sales or quality.This kind of reorganisation of management helps in assessingprofit-performance of every individual. The two important problemsthat arise in the determination of profits are as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Either the profit goals are set in terms of total net profit for the divisions or they should be restricted to their share in the total net profit. Determination of divisional profits when there is a vertical integration. The most appropriate profit standard of divisional performance is calculated by deducting current expenses from revenue of the firm. Profit is essential for survival of a business. In the absence ofprofits, the organisations will use up their own capital and close down.It also helps in replacing obsolete machinery and equipment and thusensures the continuity of a business.ConclusionProfit maximisation is the most popular hypothesis in economicanalysis, but there are many other important objectives, which are notto be avoided by any firm. Modem business firms pursue multipleobjectives. The economists consider a number of alternative objectivesof business firms. The main factor behind the multiplicity of theobjectives, especially in case of large business firms, is the separationof management from the- ownership. Moreover, profit maximisatjonhypothesis is based on time. The empirical evidence against thishypothesis is not conclU3ive and unambiguous. The alternativehypotheses are also not so strong to repiace the profit maximisationhypothesis. In addition to it, profit maximisation hypothesis has agreater explanatory and predictive power than any of the alternativehypotheses. Therefore, profil maximisation hypothesis still fornls thebasis of firms behaviour.PROFIT PLANNING AND FORECASTINGA business is considered to be sound if it includes consistency inearning profit while considering the various risks as well. A firm isfaced with a number of untertainties. 1bese uncertainties are in-terms of nature of consumer needs, the diverse nature of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScompetition, the uncontrollable nature of most elements of cost andthe continuous technological developments. The uncertainty about thepattern and extent of consumer demand for a particular productincreases the degree of risk faced by the firm. The nature ofcompetition is related to either product, price or to bothsimultaneously. Prodoct competition is more important till theproduct reaches the stage of maturity. Price competition begins a fierthe product is established and reaches the maurity stage. During thegrowth stage, the risk of obsolescence of a product and shortening ofthe product life cycle is more. The degree of risk involved in productcompetition is greater than in price competition. When the prices risecontinuously, no firm can be certain of its internal cost structure. Thisis because it does not have any control over the prices of rawmaterials or the wages to be paid to the individuals. In course of time,continuous technological improvements may make productioncompletely obsolete. If an improved process is available, a firm canrestrict its risk by neglecting its fixed investment. If it does not havean access to the improved processes, it may have to go out ofbusiness. Unless a firm is prepared to face the uncertainties, as aresult of risk element, its profits will be changed. To plan for profits, athorough understanding of the relationship of cost, price and volumeis ext~emely helpful to business individuals. The most importantmethod of determining the cost-volume¬profit relationship isbreak-even analysis, also known as cost-volume-profit (C-V-P)analysis. Break-even analysis involves the study of revenues and costsof a firm in relation to its volume of sales. It also includes thedetermination of that volume at which the firms costs and revenueswill be equal. The break-even point (BEP) may be defined as that levelof sales at which total revenue is equal to the total costs and the netincome is zero. This is known as no-profit no-loss point. The mainobjective of the break-even analysis is not simply to find out the BEP,but to develop an understanding between the relationships of cost,price and volume. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS DETERMINATION OF THE BREAK-EVEN POINTIt may be determined either in terms of physical units or in moneyterms. This method is convenient for a firm producing singleprdducts only. The break-even volume is the number of units of theproduct, which must be sold to earn revenue. This revenue should beenough to cover all expenses, both fixed and variable. The sellingprice of all units covers not only its variable cost but also leaves amargin called contribution )l1argin to contribute towards the fixedcosts. The break-even point is reached when sufficient number ofunits has been sold so that the total contribution margin of the unitssold is equal to the fixed costs. The formula for calculating thebreak-even point is: Fixed costs BEP = contribution margin per unitWhere the contribution margin is: selling price Variable costs per unit.Example 1: Suppose the fixed costs of a Factory are Rs. 10,000 peryenr, the variable costs are Rs. 2.00 per unit and the selling price is Rs.4.00 per unit. The break~even point would be: Rs. 10,000 BEP = = 5,000 units (4-2) In other words, the company would not make any loss or profit at asales volume of 5,000 units as shown below: Sales RS.20,000 Cost of goods sold: Variable cost @ Rs 10,000 Rs.2.00 Fixed costs Rs. 10,000 Rs.20,OOO Net Profit Nil Solution. Multi-product firms are not in a position to measure thebreak-even point in terms of any common unit of product. It isconvenient for them to determine their break-even point in terms of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICStotal rupee sales. The break-even point is the point where thecontribution margin is equal to the fixed costs. The contributionmargin is expressed as a ratio to sales. For example, if the sales is Rs.200 and the variable costs of these sales is Rs. 140, the contributionmargin, ratio is (200 - 140)/200 or 0.3. The formula for calculating the break-even point is: Fixed costs BEP = contribution margin ratio Example 2: Sales Rs. 10,000 Variable costs Rs. 6,000 Fixed costs RS. 3,000 With the help of given information, calculate net profit. Solution. The contribution margin ratio is (10,000-6,000)/10,000 = 0.4 Fixed costs BEP = contribution margin ratio 3,000 = Rs. 7 500 0.4 Sales value Rs.7,500 Less: Variable costs Rs.4,500 (0.6 x 7,500) Fixed costs Rs.3,000 Net profit Nil Example 3: Sales were Rs. 15,000 producing a profit of Rs. 400 ina week. In the next week, sales amount to Rs. 19,000 producing aprofit of Rs. 1,200. Find out the BEP.Solution. Increase in sales 19,000 - 15,000 = Rs. 4,000 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Increase in profit 1,200 - 400 = Rs. 800 Increase in variable costs 4,000 - 800 = Rs. 3,200 Over sales of Rs. 4,000, variable costs are Rs. 3,200. Hence VC per rupee of sale is 3,200 + 4,000 = 0.80. Fixed costs will be as under: Variable cost 15,000 x 0.80 12,000 Profit 400 VC + Profit 12,400 Sales value 15,000 Fixed cost 2,600 S–V 15,000 – 12,000 3,000 = S = 15,000 = 15,000 = 0.2 FC Now, BEP = Contribution margin ratio 2,600 = = Rs. 13,000 0.2Break-even Point as a Percentage of Full Capacity Full capacity can be defined as the maximum possible volumeattainable with the firms existing fixed equipment, operating policiesand practices. Break-even point is usually expressed as a percentageof full capacity. Considering the example I, the full capacity of the firmis 10,000 units; the break-even point at 5,000 units can be expressedas 50 per cent of full capacity.Multi-product Manufacturer and Break-even Analysis Most manufacturers produce more than one type of product. Thedeter¬mination of BEP in such cases is a little complicated and isillustrated below: Example 4: A manufacturer makes and sells tables, lamps and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSchairs. The cost accounting department and the sales department havesupplied the following data: ~ Product VC % of rupee Selling Price Per unit Sales volume Rs. Rs. Tables 40 30 20 Lamps 50 40 30 Chairs 70 50 50 Capacity of the firm is Rs. 1,50,000 of total sales value. Annual fixed cost - Rs. 20,000 Calculate (1) BEP and (2) Profit if firm works at 50 per cent of capacity. Solution. The contribution towards fixed cost in each case is: . Table Rs. 10 Lamps Rs. 10 Chairs Rs. 20 Now, these contributions are to be converted into percentages ofselling prices, the formula to be applied is: Selling price - VC Contribution percentage = Selling price x 100 Thus, the contribution percentage for individual items is: 40 - 30 1 Table ---x 100 = - xl 00 = 25 per cent 40 4 50 - 40 1 ---x 100 = - xl 00 = 20 per cent 50 5 70 - 50 2 ---x 100 = -x 100 = 28.57 per cent 70 7 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Now, we multiply the contribution percentage of each of the products by the percentage of sales volume for that particular product and add the figures obtained. This gives the total contribution per rupee of sales volume for tables, lamps and chairs. This is done as follows: Contribution % of Sales Tables 25.00 % X 20 % = 5.00 % Lamps 20.00 % X 30 % = 6.00 % Chairs 28.57 % X 50%= 14.28%· 25.28 % say 25 % -- This 25 per cent is the total contribution per rupee of overall sales given the present product sales mix. The calculations required in the question are as follows: 1. BEP: The BEP orthe firm is calculated as under: Fixed costs 20,000 BEP = = Rs. 80,000 Contribution marginper unit 25% 2. Profit: Calculation of profit or loss at various volumes can also be made easily. If the firm produces at 80 per cent of capacity, the profit will be calculated as under: Profit = Total revenue - Total costs = 80% of (1,50,000) - Fixed costs - Variable costs = 1,20,000 - 20,000 - 75% of (1,20,000) = 1,20,000 - 20,000 - 90,000 = Rs. 10,000Break-even Charts Break-even analysis is very commonly presented by means of breakeven charts. Break-even charts are also known as profit-graphs. A BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSbreak-even chart prepared on the basis of example 1 above is given inFigure 5.2. In this figure, units of product are shown on the horizontalaxis OX while revenues and costs are shown on the vertical axis OY.The fixed costs of Rs. 10,000 are shown by a straight line parallel tothe horizontal axis. Variable costs are then plotted over and above thefixed costs. The resultant line is the total cost line, combining bothvariable and fixed costs. There is no variable cost line in the graph.The vertical distance between the fixed cost and th~ total cost linesrepresents variable costs. The total cost at any point is the SU!TI of Rs.10,000 plus Rs. 2.00 per unit of variable cost multiplied by thenumber of units sold at that point. Total revenue at any point is theunit price of Rs. 4.00 multiplied by the number of units sold. Thebreak-even point corresponds to the point of intersection of the totalrevenue and the total cost lines. A perpendicular from the BEP to thehorizontal axis shows the break-even point in units of the product.Dropping a perpendicular from BEP to the vertical axis shows thebreak-even sales value in rupees. The firm would suffer a loss at anypoint below the BEP. Total costs are more than total revenue. Abovethe BEP, total revenue exceeds total costs and the firm makes profits.Since profit or loss occurs between costs and revenue lines, the spacebetween them is known as the profit zone, which is to the right of theBEP, and the loss zone, which is to the len of the BEP. The followingFigure 5.2 shows Break-even Chart. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The break-even chart remains where the BEP is measured interms of sales value rather than in physical units. The only differenceis that the volume on the X-axis is measured in terms of sales value.In that case, a perpendicular frqm the point BEP to either axis wouldshow the break-even rupee sales value. The same type of chart couldbe used to depict the BEP in relation to full capacity. In this case thehorizontal axis would represent the percentage of full capacity, insteadof physical units or the sale value.Break-even Chart-A VariationThe break-even chart is a variation of the traditional break-even graph.This graph is prepared with the variable cost line instead of fixed costline, starting at the zero axis. On it is superimposed the total cost, theline which includes the fixed cost and is, therefore, parallel to thevariable cost line. This graph is as much useful as the contribution tofixed cost and profit. It is more deafly shown below in the Figure 5.3. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSProfit-Volume AnalysisIt is very similar to the break-even analysis and is based on therelationship of profits to sales volume. The profit-volume graph showsthe relationship ofa firms profit to its volume. Total profit or loss ismeasured on the vertical axis above the X-axis and the loss below it.The volume is measured on the X-axis, which is drawn at the point ofZero-Profit. Volume is usually expressed in tenns of percentage offull capacity. The maximum loss, which occurs at zero sales volume, isequal to the fixed cost and is shown on the vertical axis below theX-axis. The maximum profit is earned when the firm works at fullcapacity. The point of maximum profit is shown on the vertical axisabove the X-axis. The two points of maximum loss and the maximumprofit are joined by a line, which is known as the profit line, also calledPN line. The profit line can also be established by detennining theprofit at any two points within the given range of volume and drawinga straight line through these points. The point, at which the profit lineintersects the X-axis, is the break-even point. The space between theX-axis and the profit line shows the profit zone, which is to the rightof BEP, and the loss zone, which is to the left of BEP. The usefulness ofthe graph lise in the fact that it shows the profit or loss earned by thefirm by working at different levels of its full capacity. The following BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSFigure 5.4 shows the profit volume analysis.Assumptions 1. All costs are either variable or fixed over the entire range of the volume of production. But in practice, this assumption may not hold well over the entire range of production. 2. All revenue is variable in nature. This assumption may Lot be valid in all cases such as the case where lower prices are charged to large customers. 3. The volume of sales and the volume of production are equal. The total products, produced by the firm, are sold and here is no change in the closing inventory. In practice, sales and production volumes may differ significantly. However, these assumptions are not so unrealistic so as to weaken the validity of the break-even analysis. 4. In the case of multi-product firms, the product-mix shoulu be stable. Fora multi-product firm, the BEP is determined by dividing total fixed costs by an average ratio of variable profit, also called contribution tosales. If each product has the same contribution ratio, the BEP is not affected by changes in the product-mix. However, if different products have different contribution ratios,shift in the product-mix may cause a shift in the break-even point. In BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSreal life, the assumption of stable product-mix is somewhat unrealistic.Managerial Uses of Break-even AnalysisTo the management, the utility of break-even analysis lies in the factthat it presents a picture of the profit struture of a business firm.Break-even analysis not only highlights the areas of economic strengthand weaknesses in the firm but also sharpens the focus on certaInleverages which cun be opernted upon to enhance its profitability.Through brenk-even analysis, it is possible for the management toexamine the profit structure of a business firm to the possible changesin business conditions. For example, sales prospects, changes in Custstructure, etc. Through break-even analysis, it is possible to usemanagerial actions to maintain and enhance profitability of the firm.The break-even analysis can be used for the following purposes: Safety margin Volume needed to attaintarget profit Change in price Change in price Expansion of capacity Effect of alternative prices Drop or add decision Make or buy decision Choosing promotion-mix Equipment selection Improving profit performance Production planningSafety MarginThe break-even chart helps the management to know the profitsgenerated at the various levels of sales. But while deciding the volumeat which the firm would operate, apart from the demand, themanagement should consider the safety margin associated with theproposed volume. The safety margin refers to the extent to which thefirm can afford a decline in sales before it starts occurring losses. The BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSformula to determine the safety margin is: (Sales – BEP) x 100 Safety Margin = Sales Example 5: Assume that our sales in Example 1 are 8,000 units. (8,000-5,000) x 100 Safety Margin = 8,000 = 37.5% Before incurring a loss, a business firm can afford to loose salesup to 37.5 per cent of the present level. A decreasing safety marginindicates that the firms resistance capacity to avoid losses hasbecome poorer. A margin of safety can also be negative. A negativesafety margin is the percentage increase in sales necessary to reachthe BEP in order to avoid losses. Thus, it reveals the minimum extentof effort in terms of sales expected by the management. Suppose inthe same example sales are us low as 4,000 units. The safety marginwould be: (4,000-5,000) x 100 Safety Margin = ¬4,000 = 25% In other words, the management must strive to increase sales at least by 25 per cent to avoid losses.Volume Needed to Attain Target ProfitBreak-even analysis is also utilised for determining the volume ofsales, necessary to achieve a target profit. The formula for target salesvolume is: Fixed costs + Target profit Target Sales Volume = ¬Contribution margin per unit . Example 6: Continuing with the same example, if the desired profitis Rs. 6,000, the target sales volume would be calculated as follows: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 10,000 + 6,000 2 = 8000 unitsChange in PriceThe management is also faced with a problem whether to reduce theprices or not. The management will have to consider a number ofpoints before taking a decision related to the change in the prices. Areduction in price results in a reduction in the contribution margin aswell. This means that the volume of sales will have to be increased tomaintain the previous level of profit. The higher the reduction in thecontribution margin, the higher will be the increase in sales needed tomaintain the previous level of profit. However, reduction in prices maynot always lead to an equal increase in the sales volume, which isaffected by the elasticity of demand. But the information aboutelasticity of demand may not be easily available. Break¬even analysishelps the management to know the required sales volume to maintainthe previous level of profit. On the basis of this knowledge andexperience, it becomes much easier for -the management to judgewhether the required increase it sales will be feasible or not. Theformula to determine the new sales volume to maintain the same levelof profit, given a reduction in price, would be as under: FC + P Qn = ¬SPn - VC where Qn = New volume of sales FC = Fixed cost P = Profit SPn = New selling price VC = Variable cost per unit (n denotes new) Example 6(a): Continuing with the same example 6, if we proposea reduction of 10 per cent in price from Rs. 4.00 to Rs. 3.60, the newsales volume needed to maintain the previous profit ofRs. 6,000 willbe: 10, 000 + 6,000 16, 000 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 3.60 – 2.00 = 1.60 = 10,000 units This shows that there is an increase of 2,000 units or 25 per centin sales. The management can also easily decide whether this increasein sales volume is profitable for t~e business firm or not. If a firm proposes the price increase, the question to be consideredis by how much the sales volume should decline before profitableeffect of the price increase gets eliminated. Example 6(b): If the firm in example 6 considers an increase inprice by 12Y2per cent to Rs. 4.50, the new volume to maintain the oldprofit would be: 10, 000 + 6,000 16, 000 Q2= = = 6,400 units 4.50 – 2.00 2.50 In other words, if the fall in sales, due to an increase in price, wereless than 1,600 units or 20 per cent, it would be profitable for the firmto increase the price. But if the decline were more than 1,600 units,the proposed price increase would reduce the profit.Change in Costs Break-even analysis helps to analyse the changes in variablecost and fixed cost, which are explained as follows. Change in variable cost: An increase in variable costs leads to areduction in the contribution margin. In such a situation, a firmdetermines the total sales volume needed to maintain the prescntprofits withcut any increase in price. A firm also determines the pricelhut should be set to maintain the present level of profit without anychange in sales volume. The formulae to determine the new quantityor the new selling price, given a change in variable costs, are: 1. The new quantity will be: FC +P Qn = SP - VC n BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 2. The new selling price will be: SPn = SP + (VCn- VC) Example 6(c): Continuing with the example 6, if variable cost increases from Rs. 2 to Rs. 2.50 per unit. 10, 000 + 6,000 15, 000 Q2= = = 10,667 units 4 – 2.50 1.50 SPn = 4 + (2.50 - 2) = Rs. 4.50 Change in fixed cost: An increase in fixed costs of a firm iscaused either by external circumstances such as an increase inproperty taxes or by a managerial decision such as an increase inexecutive salaries. In both the cases, the affect is to raise thebreak-even point of the firm, while keeping the prices unchanged. Thesame determination is undertaken by the firm regarding the salesvolume while keeping the profit level same as before. The formulae todetermine the new quantity or the new price, given a change in fixedcosts, would be: 1. FCn – FC Qn= Q + SP - VC 2. FCn – FC SPn = SP + Q Example 6 (d): Continuing with the same example 6, if fixedcost increases from Rs. 10,000 to Rs. 15,000.Expansion of CapacityThe management may also be interested in knowing whether toexpand production capacity or not, through the installation equipment.Though even analysis, it wuuld be possible to examine the various BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSapplkutions of this proposal or installation of the additionalequipment. The following example illustrates the points involved. Example 7: A textile mill is considering a proposal to increaseits investment in fixed assets. If it decides to do so, fixed expenseswill go up by Rs. 5,00,000 per year without affecting the percentage ofvariable expenses. With the present plant, the maximum production isestimated at an amount, which would enable the company to makeannual sales of Rs. 60,00,000. The increased production with theadditional plant would permit the company to make annual sales of Rs.80,00,000. The relevant cost, sales and profit data for 1997 are: Sales Rs. 50,00,000 Costs and expenses: Fixed Rs. 15,00,000 Variable Rs. 32,00,000 Rs. 47,00,000 Net profit Rs. 3,00,000 There are a number of points involved in the decision onexpansion of capacity. The information regarding the expansion ofcapacity is as follows: Existing Plant Expanded Plant Capacity 0% 100 % 0% 100 % Rs. (in Lakhs) Rs. (in Lakhs) Sales - 60 - 80 Fixed costs 15 15 20 20 Variable costs - 38.4 - 51.2 Profit (Loss) (15) 6.6 (20) 8.8 The expansion of capacity, to enable the firm so as to expand itssales potential from Rs. 60,00,000 to Rs. 80,00,000, will increasethe maximum profit potential of the firm from Rs. 6,60,000 to Rs.8,80,000. But there are certain risks involved. Answer the followingon the basis of above information: 1. How will the expansion of the firms capacity will affect the break-even point? 2. What would be the sales volume required to maintain the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS present profit with the increased fixed costs? Solution. It is evident that the break-even point of the firm wouldbe pushed up from Rs. 41, 66,667 to Rs. 55, 55,556. This means thatif the sales remain at the present level, the firm would operate at aloss. The minimum sales volume needed to maintain the present profitwould be Rs. 63,88,889, i.e., an increase of about 28 per cent there isanother aspect. To earn the maximum profit possible at the presentsales capacity, i.e., Rs. 6,60,000 with the increase in fixed costs, theminimum sales volume needed would be Rs. 73,88,889, i.e., anincrease of 48 per cent. So the decision on the question of expandingcapacity hinges on the possibilities of expanding sales by the variouspercentages indicated above. The fact that the present sales volume is20 per cent less than the maximum possible sales volume of theexisting plant may be an indication that if may be difficult to expandsales. Another way of presenting the same infonnation is theprofit-volume chart. On the assumption that production efficiency andprices will remain unchanged, the profit-volume chart can help inpresenting the following: The break-even points before and after expansion, and At what capacity utilisation, the profit will be the same as at 100 percent capacity utilisation before expansion. The following Figure 5.5. shows the profit volume chart. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS In order to arrive at the data to plot on the figure, the sales, costand profit at either 100 per cent or nil capacity for both existing andexpanded plants should be calculated: As can be seen from Figure 5.4, the break-even point for both theplants lies above 70 per cent capacity utilisation. The capacityutilisation of the expanded plant, which gives the same profit as 100per cent capacity utilisation of the existing plant, can be easily found.At 92 per cent of capacity utilisation, the expanded plant will give aprofit of Rs. 6,60,000.Effect of Alternative PricesThe break-even chart can be modified to show the profit position atdifTerent price levels under assumed conditions of demand and costs.Figure 5.5 shows the pr,ofit position at alternative prices for the firmin example 1. As can be seen from the figure, the break-even pointbecomes lower as the price increases. But it is not necessary that theprofit potential at higher prices may actually be achieved by the firm.A price of Rs. 4 per unit with a demand at 7,000 units will give ahigher profit than a price of Rs. 5 with a demand at 4,000 units. It isnot desirable for a firm to take every price into consideration. Theanalyst, while choosing a trial price, relies largely upon theirexperience and judgement. Customary price is one such price. Thefollowing Figure 5.6 shows the effect of BEP in alternative prices. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSDrop or Add DecisionAn economist takes the decisions regarding the following: Addition of a new product keeping in consideration, its cslimated revenue and cost. Deletion of a product from the product-line keeping in consideration, its consequent effects on revenue and cost. Break-even analysis is also useful in taking decisions related toproduct planning. It can be understood with the help of followingexample: Example 8: The following are the present cost and output data of amanufacturer: Product PrLe Variable costs % of (Rs.) Per unit sales (Rs.) Book-cases 60 40 30 Tables 100 60 20 Beds 200 120 50 Total fixed costs per year: Rs. 75,000 Sales last year: Rs. 2,50,000. The manufacturer is considering whether to drop the line of taolesand replace it with cabinets. If this drop-and-add decision is taken, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSthe cost and output data would be as follows: Product Price Variable costs % of sales (Rs.) Per unit (Rs.) Book-cases 60 40 50 Tables 160 60 10 Beds 200 120 40 Total fixed cost per year: Rs. 75,000 Sales this year: Rs. 2,60,000. On the basis of ubove informntion delermine if the change worthundertaking by the business firm? Solution. On the basis of the information given in the question, theprofit on the present product line is computed as follows: Rs. 60 - 40 x 30% = 0.10 60 Rs. 100 - 60 x 20% = 0.08 100 Rs. 200 - 120 x 50% = 0.20/0.38 200 Thus, the contribution ratio is 0.38, by adding 0.10, 0.08 and 0.20. Total contribution = Rs. 2,50,000 x 0.38 = Rs. 95,000. Profit = Rs. 95,000 - Rs. 75,000 = Rs. 20,000. Profit on the proposed product line would be as under: Rs. 60 - 40 x 50% = 0.17 60 Rs. 160 - 60 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 160 x 10% = 0.06 Rs. 200 - 120 x 40% = 0.16 200 Thus, the contribution ratio is 0.39. Total contribution = Rs. 2,60,000 x 0.39 = Rs. 1,01,400. Profit = Rs. 1, 01,400 - 75,000 - Rs. 26,400. Hence the proposed change is worth undertaking.Make or Buy DecisionMany business firms may opt to produce certain components oringredients, which are part of there finished products, or purchasingthem from outside suppliers. For instance, an automobilemanufacturer can make spark plugs or buy them. Break¬even analysiscan enable the manufacturer to decide whether to make or buy. Withthe help of following example, this can be easily understood: Example 9: A manufacturer of sc.ooters buys certaincomponents at Rs. 8 each. In case he makes it himself, his fixed andvariable costs would be Rs. 10,000 and Rs. 3 per componentrespectively. Should the manufacturer make or buy the component? If the manufacturer needs more than 2,000 components per year,to make or produce the components is more profitable than to buy.There are some special considerations, which helps in choosing thebest option, are as follows: Solution. This can be detennined after calculating break-evenpoint of the manufacturers firm, The break-even point is as follows: Fixed costs BEP = Purchse price – Variable Cost 10,000 = 8-3 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS 10,000 = = 2,000 5 Quality: By manufacturing a certain part of the product itself, the firm is able to exercise control over quality. This may also lead to reduction in assembly costs and increase in consumer goodwill. This helps in enhancing the future sales. The outside suppliers may also possess a highly specialised knowledge, which may outshine the know-how of the firm. In this situation a firm, a firm may feel that it cannot match with the quality assured by outsiders. Here, a firm is advisable to buy the high quality products from other firms so as to avoid the loss due to poor quality. This could also result in fewer sales. Assurance of supply: By producing a product itself, a firm may secure the advantage of co-ordinating the flow of parts more effectively. Sometimes, the suppliers are unable to meet the demand or make deliveries within the required time period. So, this is also an advantage for the firm to produce high quality products and to give its best for the betterment of society. Defence against monopoly: A firm can also manufacture parts to protect itself against a monopoly in supply. If a firm produces some of it products itself, the other firms are less likely to overcharge or dictate thelT: in any respect. So producing a part of the product is also beneficial for a firm.Choosing Promotion-mixSellers often use several methods of sales promotion, such aspersonal selling, advertising, etc. But the proportion of all thesemethods in the promotion mix varies from seller to seller. A retailshop may have to consider whether or not to employ a certain number,say, five additional salesmen. Similarly, a manufacturer may have todecide if he should spend an additional sum of Rs. 20,000 on BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSadvertising his product or not. Break-even analysis enables him totake appropriate decisions by showing how the additional fixed costsinfluence the break-even points. This can be explained with the helpof the following illustration: Example 10: A manufacturer sells his product at Rs. 5 each.Variable costs are Rs. 2 per unit and the fixed costs amount to Rs.60,000. Find the following: 1. The break-even point. 2. The profit if the firm sells 30,000 units. 3. The BEP if the firm spends Rs. 3,000 on advertising. 4. The sale of manufacturer to make a profit of Rs. 30,000 after spending Rs. 3,000 for advertisement. Solution: Tle calculations are as follows: FC BEP = SP - VC 60,000 = = 20,000 units 5-2 Profit = Total revenue - Fixed cost - Variable cost = (5 x 30,000) - 60,000 - (2 x 30,000) = 1,50,000 - 60,000 - 60,000 = Rs.30,000 If the firm spends Rs. 3,000 on advertising, fixed costs wouldrIse by Rs. 3,000, i.e., Rs. 63,000. Hence, BEP would be: FC BEP = SP - VC 63,000 = = 21,000 units 5-2 The formula for finding out the volume of sales· necessary toachieve the age! Profit is: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Fixed cost + Target profit Target sales volume = Contribution margin 63,000 + 30,000 = 3 93,000 = = 31,000 units 3Equipment SelectionBreak-even analysis can also be used to compare different wayso(doing jobs. For instance, use of simple machines, is usually best forsmall quantities. But when bigger quantities are to be produced, fasterbut usually costlier machines are to be employed. Sometimes, a choiceis to be made in between three or more methods, depending upon themost economical one. The following example explains how todetermine these ranges. Example 11: A manufacturer has to choose from amongst threemachines for his factory. The conditions, which he wants to be fulfilledregarding the three machines, are as follows: 1. An automatic machine which will add Rs. 20,000 a year to his fixed costs but the variable costs per unit will be only 40 p. 2. A semi-automatic machine which will add Rs. 8,000 a year to his fixed costs but variable cost$ per unit will be Rs. 2 and 3. A hand-operated machine which will add only Rs. 2,000 a year to his fixed costs but will cause variable costs per unit of Rs. 4. Calculate the range of output over which automatic,semi-automatic and hand-operated machines would be mosteconomical. How would you choose between hand-operated andautomatic machines, supposing the semi automatic machine does notexist?Solution. The cost formulae for the three machines would be, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Machine Cost formula Automatic Rs. 20,000 + 0.40 S Semi-automatic Rs. 8,000 + 2.00 S Hand-operated Rs. 2,000 + 4.00 S Now setting pairs of equations to each other, and solving themto final the Value of S: 1. Automatic vs. Semi- Nutomatie Rs. 20,000 + 0. 40S = Rs. 8,000 + 2S or, 1.60S = 12,000 12000 or, S = = 7,500 units 1.60 2. Semi-automatic vs. Hand-operated: Rs. 8,000 + 2.00S = Rs. 2,000 + 4S or, 2S = 6,000 or, 8 = 3,000 units Thus, up to 3,000 units, hand-operated machine is to be used.The semi¬automatic machine is to be used over the range of 3,000 -7,500 units. Beyond 7,500 units, automatic machine should be used. If, however,the choice is to be made between hand-operated and automaticmachines, the former; is to be used up to 5,000 units and, thereafter,the latter would be more economical. This is calculated as under: 2,000 + 48 = Rs. 20,000 + 0.40 or, 3.60S = 18,000 or, 8 = 5,000 units.IMPROVING PROFIT PERFORMANCEThere are four specific ways in which profit performance of a businesscan be improved, which are as follows: Increasing the volume of sales: Considering the example I, the present volume of sales is 8,000 units and the maximum production capacity 10,000 units. If the sales are increased to BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS the maximum production capacity, there will be an increase in variable expenses only. The profit will increase from, Rs.6,000 to Rs. 10,000. It will be seen that though the increase in sales volume has been only to the extent of 25 per cent, profit has increased by 67 per cent. Increasing the seIling price: An increase in the price increases the contribution margin and reduces the break-even point. Continuing with Example I, if the selling price is increased by 10 per cent, the profit will increase from Rs. 6,000 to Rs. 9,200 showing an increase of more than ¬50 per cent. Reducing the variable expenses per unit: If the variable expenses are reduced by 10 per cent to Rs. 1.80, the profit will increase from Rs. 6,000 to Rs. 7,600 at the present volume of sales. This increase is more than 25 per cent, which is more than the percentage reduction in variable expenses. In cost-volume-profit relationship, the higher proportionate increase in profit than the change in selling price or the volume of sales or the variable expenses is called the leverage effect. At times, it is not possible to increase the prices, but to increase the volume of sales and to reduce the variable expenses is possible. Reducing the fixed cost: A reduction in fixed costs, without a change in variable expenses and the selling price, would lead to an equal change in the profits. For example, if the fixed expenses are reduced from Rs. 10,000 to Rs. 9,000 in the above illustration, profit will increase from Rs. 6,000 to Rs. 7,000. As a change in the fixed costs does not change the contribution margin per unit, there is no leverage effect.Production planningBreak-even analysis can also help in production is planning so as to BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSgive maximum contribution towards profit and fixed costs. This willbe clearly understood from-the following illustration: Example 12: The management of Swadeshi Cotton Mills, Kanpur,is interested in finding out the quantities of cloth X and Y forproduction in a week in order to maximiese profits. The total hoursrequired to produce 100 metres of each cloth are 20 and 25respectively. The total hours available per week are 9,600. Themaximum possible sales of cloth X and Y for one week as estimatedare: X = 30,000 metres, Y for 40,000 metres. The following table shows, the variable costs and selling price per metre: - Pcr mctrc Particulars Cloth X Cloth Y Variable cost Rs.2.00 RS.3.00 Selling price RS.2.60 RS.3.80 The total expenses for one week are estimatcd at Rs. 21,400. Findout the production plan, which the, company should follow. Howmuch profit shall be earned by following this production plan?Solution. The contributions of Cloth X and Yare Re. 0.60 and Re. 0.80per metre respectively, which are calculated by subtracting variablecost of each from selling price. Hence, priority should be gi~en to theproduction of cloth Y as it contributes more towards meeting the fixedcost. The maximum of cloth Y that can be sold is 40,000 metres,which would require 10,000 hours. However, the total hours availableare 9,600. Hence, the maximum of cloth Y that can be produced is38,400 metres (9,600 x 4). The production plan to be followed isgiven below: _._-- X Cloth Nil Cloth Y 38,400 metres This plan shall provide profits as shown below:Total Revenue = Rs. 38,400 x 3.80 = Rs. 1,45,920 BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSTotal cost: Variable cost = Rs. 38,400 x 3 = Rs. 1,15,200 Fixed cost 21,400 1,36,600 Net porfit Rs. 9,320Policy Guidelines Originating from Break-even AnalysisThere are certain useful conclusions in terms of policy guidelines,which may be drawn from break-even analysis as a result of the effectof changing conditions on a firms operations, policies and actions. Ahigh BEP indicates the weakness regarding the profit position of thefirm. To reduce the BEI therefore, the selling price should be increased,variable and fixed costs should be reduced. If the variable costs perunit asre large (Business 8 in Example 13), an increase in selling priceor a reduction in variable costs would be morc eLective. Whether it ismore desirable to raise prices or practicable to cut down variable costs,depends upon competitive market conditions, the elasticity of demandfor firms product and the efficiency of its operations. When thecOi.lribution margin rer unit is comparatively large (Business A inExample 13), the firm is advised to lower the BEP by reducing the levelof fixed costs. The higher the contribution margin, the higher is the survival ofbusiness or vice-versa. Business A with a higher contribution margincan survive even if the prices drop to 50 paise per unit. Business Bwith a lower contribution margin will have to close down itsoperations if prices drop to 50 paise. In a period of boom, whcn boththe prices as well as sales rise, a firm with a higher percentage offixed costs to sales earns higher profits as compared to a businesswith a higher percentage of variable expenses to sales. On the otherhand, in a period of depression, when both the prices as well as salesdecrease, the business with a higher percentage of fixed costs tosales suffers greater losses than the business with a higher BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSpercentage of variable expenses. Example 13: The following example of two businesses, A and B,illustrates some of the points contained in the text above. Business A Business B Selling price per unit Re. 1.00 Re.I.OO Variable cost per unit Re.0.20 Re.0.60 Fixed costs per year RS.5,000 Rs.2,500 With the help of above infonnation, find which of the businessesamong A and B is profitable for the business firm to suspendoperations? Give explanations to support your answer. Solution. The break-even point of both the businesses is 6,250units or Rs. 6,250. If the sales are 10 pefcent above the BEP, businessA gains Rs. 500 while business B gains only Rs. 250. If the sales arebelow the BEP, say 5,000 units, business A loses Rs. 1,000 andbusiness B loses only. Rs. 500. If the market collapses and the prices also go down to50 paise per unit and sales drop to, say, 3,000, business A suffers aloss of Rs. 4, 100 while business B suffers a loss of only Rs. 2.500(the amount of fixed expenses only ns it would find it unprofitable tocontinue operntions). But one signifiennt point is that whilc businessA can continue to operate and contribute 30 paise per unit, soldtowards fixed expenses. Business B will find it profitable to suspendoperations.Limitation of Break-even AnalysisThere arc some important limitations of break-even analysis, whicharc to be kept in mind while using break-even analysis. Theselimitations are as follows: When break-even analysis is based on accounting data, it may suffer from various limitations of such data, such as negligence towards imputed costs, arbitrary depreciation estimates and inappropriate allocation of overhead costs. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSBreak-even analysis, therefore, can be sound and useful onlyif the firm in question maintains a good accounting systemand uses proper managerial accounting techniques andprocedures. The figures must also be adequate and sound. Ifbreak-even analysis is based on past data, the same should beadjusted for changes in wages and price of raw materials.Break-even analysis is static in character. It is based on theassumption of given relationship between costs and revenues.On the one hand and input, on the other. Costs and revenuesmay change over time making the projection, based on pastdata wrong. Therefore, break-even analysis is more usefulonly in situations relatively stable while it does not workeffectively in volatile, erratic and widely changing ones.Costs in a particular period may not be caused entirely by theoutput in that period. For example, maintenance expensesmay be the result of past output or a preparation for futureoutput. It may therefore, be difficult to relate them to aparticular period.Selling costs are especially difficult to handle in break-evenanalysis. This is because changes in selling costs are a causeand not a result of changes in output and sales.A straight-line total revenue curve prcsumcs that any quantityshould be sold at onc price only. This implies a horizonwldemand curve and is true only under conditions of perfectcompetition. The situation of perfect ~ competition is rare inreal world, which restricts the application of many total revenuecurves.A basic assumption in break-even analysis is that thecost-revenue-volume relationship is linear. This is realistic onlyover narrow ranges of output. For example, this type of analysisis worthwhile in deciding if the selling price should be 50 or 60paise, volume should be attempted at 80 per cent of capacity BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS rather than 85 per cent, advertising expenditure should total Rs. 1,00,000 or Rs. 1,15,000 or the product should be put in a package costing 70 paise rather than 90 paise. Break-even analysis is not an effective tool for long-range use and its use should be restricted to the short run only. The break-even analysis should better be limited to the budget period of the firm, which is usually the· calendar year. The area included in the break-even analysis should be limited if too many products, departments and plants are taken together and graphed on a single break-even chart: it will be difficult for the fim1 to distinguish between the good and bad performances of the business firm. Break-even analysis assumes that profits arc a function of output ignoring the fact that they arc also caused by other factors such as technological change, improved management, changes in the scale of the fixed factors of production and so on. To conclude, it can be said that break-even analysis is a device,simple, easy to understand and inexpensive and is there fore, usefulto management. Its usefulness varies from a firm to another firm andalso among industries. Industries suffering from frequent andunpredictable changes in input prices, rapid technological changesand constant shifts in product mix will not benefit much frombreak-even analysis. Finally, break-even analysis should be viewed asa guide to decision-making and not as a substitute for judgement,logical thinking.PROFIT FORECASTINGProfit planning cannot be done without proper profit forecasting.Profit forecasting means projection of future earnings afterconsidering all the factors affecting the siz.e of business profits, suchas firms pricing policies, costing policies, depreciation policy, and soon. A thorough study including a proper estimation of both economicas well as non-economic variables may be necessary for a firm to BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSproject its sales volume, costs and subsequently the profits in future. According to joel Dean, a famous cconomist, there are threeapproaches to profit forecasting, which are as follows: Spot Projection: Spot projection includes projecting the profit and loss statement of a business firm for a specified future period. Projecting of profit land loss statement means forecasting each important element separately. Forecasts are made about sales volume, prices and costs of producing the expected sales. The prediction of profits of a firm is subject to wide margins of error, from forecasting revenues to the inter-relation of the various components of the income statement. Brcak-even analysis: It helps in identifying functional relations of both revenues and costs to output rate, kecping in consideration the way in which output is related to the prolits. It also helps in doing so by relating profits fo output directly by th.e usual data used in break-even analysis. Environmcntal analysis: It helps in relating the companys profits to key variabk, in the economic environment such as the general business activity and the general price level. These variables are not considered by a business firm. All those factors that control profits move in regular and relatedpatterns such as the rate of output, prices, wages, material costs andefficiency, which are all inter-related by their connections with thenational markets and also by their interactions in business activity.Theories of business cycles are based on the hypothesis, which isshown by the national values of production, employment, wages andprices during any fluctuation in business activities. There is no clearpattern in detailed analysis. These patterns helps in increasing thepossibility that the profits of a business firm, can be forecast directly BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSby finding a relation to key variables. The need is to find a directfunctional relation between profits of a business firm and activities atnational level that shows statistical signi ticance. In practice, these three approaches need not be mutually exclusive.Theses approaches can also be used jointly for maximum information.In projecting the profit and lo.ss statement, the functional relationscan be used, arising out of the ratio of cost to output and to its otherdeterminants. In the same way, by measuring the impact of outsideeconomic forces upon the firms profit helps in facilitating good spotguesses. It can also enhance the accuracy of break-even analysis.REVIEW QUESTIONS 1. Distinguish between the following concepts or profit: A. Accounting profit and economic profit. B. Normal profit and monopoly profit. C. Pure profit and opportunity cost. 2. Examine critically profit maximisation as the objective of business firms. What are the alternative objectives of business firms? 3. Explain the first and second order conditions of profit maximisation. 4. Profit maximisation is theoretically the most sound but practically unattainable objective of business firms. Do your agree with this statement? Give reasons for your answer. 5. Explain how profit is used as a control measure. What problems are associated with the use of profit figures as a control measure? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS LESSON NO-6 NATIONAL INCOMENational income is the final outcome of total economic activities of anation. Economic activities generate two kinds of flow in a moderneconomy namely, product-flow and money-flow. Product-flow refersto flow of goods and services from producers to final consumers.Money flow refers to flow of money in exchange of goods and services.In this exchange of goods and services, money income is generated inthe form of wages, rent, interest and profits, which is known as factorearning. Based on these two kinds of flows, national income is definedin terms of: Product flow Money flowDEFINITION OF NATIONAL INCOMENational Income in Terms of Product FlowNational income is the sum of money value of goods and servicesgenerated from total economic activities of a nation. Economicactivities result into production of goods and services and make netaddition to the national stock of capital. These together constitute thenational income of closed economy. Closed economy refers to aneconomy, which has no economic transactions with the rest of theworld. I lowcvcr, in an opcn ecollomy, natiollul incomc ulso includesthe net results of its transactions with the rest of the world, i.e.,exports less imports. Economic activities should be distinguished from thenon-economic activities from national income point of view. Broadlyspeaking, economic activities include all human activities, whichcreate goods and services that can be valued at market price.Economic activities include production by farmers (whether forhousehold consumption or for market), production by firms in BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSindustrial sector, production of goods and scrvices by thc govcfl1mentcntcrpriscs, and services produced by business intermediaries(wholesaler and retailcr), banks and other financial organisations,universities, colleges and hospitals. On the other hand, non¬economicactivities arc those activities, which produce goods and serviccs thatdo 110t have economic value. The non-economic activities includespiritual, psychological, social and political services, hobbies, serviceto selr serviccs of housewives services of members of family to othermcmbers and cxchangc of mutual services between neighbours.National Income in Terms of Money FlowWhile economic activities generate flow of goods and services, on theother hand, they also generate money-flow in the form of f~lctorpayments such as, wages, interest, rent, prolits and earnings ofself-employed. Thus, national insome can also be obtained by addingthe factor earnings after adjusting the sum for indirect taxes, andsubsidies. The national income thus obtained is known as nationalincome at factor cost. The concept of national income is linked to the society as a whole.However, it differs fundamentally from the concept of private income.Conceptually, national income refers to the money value of the finalgoods and services resulting from all economic activities of a country.However, this is 110t true for the private income in addition, there arecertain receipts of money or of goods and services that are notordinarily included in private incomes but are included in the nationalincomes and vice versa. National income includes items such asemployers contribution to the social security and welfare funds for thebenefit of employees, profits of public enterprises and servIces ofowner occupied houses. However, it excludes the interest onwar-loans, social security benefits and pensions. Instead, these itemsare included in the private incomes. The national income is therefore,not merely an aggregation of the private incomes. However, anestimate of national income can be obtain by summing up the privateincomes after making necessary adjustment for the items excluded BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSfrom the national income.MEASURES OF NATIONAL INCOMEThe various measures of national income are as follows:Gross National Product (GNP)There are several measures of national income used in the analysis ofnational income. GNP is the most important and widely used measureof national income. GNP is defined as the value of final goods andservices produced during a specific period, usually one ycar, plus thediflcrence between foreign receipts and" pnyment. The GNP so definedis identical to the concept of Gross National Income (GNl), Thus, GNP= GNI. The difference between the two is that while GNP is estimatedon the basis of product-flows, the GNI is estimated on the basis ofmoney flows.Net National Product (NNP)Net National Product (NNP) is the total market value of all final goodsand services produced by citizens of an economy during a givenperiod of time minus depreciation, i.e., Gross Nationnl Product lessdepreciation. NNP = GNP - Depreciation Depreciation is that part of total productive assets, which is usedto replace the capital worn out in the process of creating GNP. Inother words, while producing goods and services including capitalgoods, a part of total stock of capital is used up. This part of capitalthat is used up is termed as depreciation. An estimated value ofdepreciation is deducted from the GNP to arrive at NNP. The NNP, as defined above, gives the measure of net outputavailable for consumptionhy the society (including consumers,producers and the government), NNP is the real measure of thenational income. In other words, NNP is same as the national incomeat factor cost. It should be noted that NNP is measured at marketprices including direct taxes. However, indirect taxes are not included BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSin the actual cost of production. Therefore, to obtain real nationalincome, indirect taxes are deducted from the NNP. Thus, National income = NNP - Indirect taxes National income: Some accounting relationships Relations at market price GNP = GNI o Gross Domestic Product (GDP) = GNP less net income from abroad o NNP = GNP less depreciation o NDP (Net Domestic Product) == NNP less net income from abroad Relations at factor cost o GNP at factor cost = GNP at market price less net indirect taxes. o NNP at factor cost = NNP at market price less net indirect taxes o NDP at factor cost = NNP at market price less net income from ahroad o NOP at factor cost = NDP at market price less net indirect taxes o NOP at factor cost = GOP at market price less depreciationMethods of Measuring National IncomeFor mcasuring the national income, the national economy is viewed asfollows: The national economy is considered as an aggregate of producing units combining different sectors such as agriculture, mining, manufacturing and trade and commerce. The whole national economy is viewed as a combination of individuals and household owning different kinds of factors of production, which they use themselves or sell-their factor services to make their livelihood. National economy is also viewed as a collection of consuming, saving and investing units (individuals, households and government). BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS The above notions of a national economy helps to measurenational Income by following three different methods: Net output method Factor-income method Expenditure method These methods are followed in measuring national income in a‘closed economy,Net Output MethodThis is also called as net product method or value-added method. Thismethod is used when whole national economy is considered as anaggregate of producing units. In its standard form, this methodconsists of three stages: 1. Measurement of gross value of domestic output in the various branches of production: 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 varics from country to country deyending on (i) the nature of domestic activities, (ii) their significance in aggregate economic activities and (iii) availability ofrecjuisite data. For example, in USA, about seventy-one divisions and sub-divisions are used to classify the national output, in Canada and Netherlands, classification ranges from a dozen to a score and in Russia, only half-a-dozen divisions are used. According to the CSO publication, If fleen sub-categories are currently used in India. After the output is classified under the various categories the value of gross output is is computed in two alternative ways by: A. Multiplying the output of each earegory of acctor by their respective market price and adding them together. B. Collecting data regarding the gross sales and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS changes in inventories from the account of the manufacturing firms to compute the value of GDP. If there arc gaps in data then some estimates are made to fill the gaps.2. Estimation of cost of materials and services used arid depreciation of physical assets: The next step in estimating the net national income is to estimate (he 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 morc difficult task is to estimate depreciation since it involves both conceptual and statistical problems. For this reason, many countries adopt faclor¬income method for estimating their national income. However, countries adopting net-product method find some means to calculate the deductible cost. The costs are estimated either in absolute terms (where input data are adequately available) or as an overall ratio of input to the total output. The general practice in estimatmg depreciation is to follow the usual business practice of depreciation accounting. Traditionally, depreciation is calcul¬ated at some percentage of capital, permissible under the tax-laws. In some estimates of national income, the estimators have deviated from the traditional practice and have instead estimated depreciation as some ratio of the currenL output of final goods. FoI1owing a suitable method, deductible costs including depreciation are estimated for each sector. The cost estimates are then deducted from the sectoral gross output to ohtain the net sectoral products. The net sectoral products are then added together. The total thus obtained is taken to be· the measure of net nationa I products or national income BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS by product method.3. Deduction of these costs and depreciation from gross value to obtain the net value of domestic product: Net value of domestic product is often called the value added or income product. Income product is equal to the sum of wages, salaries, supplementary labour incomes, interest, profits, and net rent paid or accrued.Factor-Income MethodThis method is also known as income method and factor-sharemethod. factor¬income method is used when national economy isconsiderl:d as a combination of factor-owners and users. Under thismethod, the national income is calculated by adding up all the inconlcsaccruing to the basic factors of production used in producing thenational product. Factors of production are c1assi ficd as land, labour,capital and organisation. Accordingly, National income = Rent + Wages + Interest + Profits However, it is conceptually very difficult in a modern economy tomake a distinction between earnings from land and capital andbetween the (;arnings from ordinary labour and organisational effortsincluding entrepreneurship. Therefore, for estimating national incomefactors of production arc broadly grouped as labour lInd capital.Accordingly, national income is supposed to originate from twoprimary factors, viz., labour and capital. However, in some activities,labour and capital are jointly supplied and it is difficult to separatelabour and capital from the total earnings of the supplier. Suchincomes are termed as mixed incomes. Thus, the total factor-incomesare grouped under three categories: Labour incomes Capital income Mixed incomes. Labour Income: Labour incomes included in the national income have five components: BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Wages and salaries paid to the residents of the country including bonus, commission and social security payments. Supplementary labour incomes including employers contribution to social security and employees welfare funds and direct pension payments to retired employees. Supplementary labour incomes in kind such as free health, education, food, clothing and accommodation. Compensations in kind in the form of domestic sr-rvants and other free of¬cost services provided to the employees arc included in labour income. Bonuses, pensions, service grants are not included in labour income as they are regarded as transfer payments. Certain other categories of income such as incomes from incidental jobs, gratuities and tips are ignored because of non-availability of data. Capital Incomes: According to Studenski, capital incomes include following Incomes: Dividends excluding inter-corporate dividends Undistributed profits of corporation before-tax Interests on bonds, mortgages and savings deposits (excluding interests on bonds and on consumer credit) Interest. earned by insurance companies and credited to the insurance policy reserves Net interest paid by commercial banks Net rents from land and buildings including imputed net rents on owner¬occupied dwellings Royalties Profits of government enterprises. The data for the first two incomes is obtained from the firmsaccounts submitted for taxation purposes. There exist difference in BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdefinition of profit for national accounting purposes and taxationpurposes. Therefore, it is necessary to make some adjm.ments in theincome-tax data for obtaining these incomes. The income-tax dataadjustments generally pertain to (i) Excessive allowance ofdepreciation made by tax authorities, (ii) Elimination of capital gainsand losses since these do not reflect the changes in current income,and (iii) Elimination of under 0, overvaluation of ir:ventories onbook-value, Mixed Income: Mixed incomes include income from (a) fanning (b)sole proprietorship (not included ,Ilnder profit or capital income) (c)other professions such as legal and l.ledical practices, consultancyservices, trading and transporting. Mixed income also includesincomes of those who earn their living through various sources suchas wages, rent on own property and interest on own capital. All the three kinds of incomes, viz., labour incomes, capitalincomes and Inixed incomes added together give the measure ofnational income by factor¬income method.Expendit4re MethodThe expenditure method, is also known as final product method. Thismethod is used when national economy is viewed as a collection ofspending units. It measures national income at the final expenditurestages. In other words, this method measures final expenditure onGDP at market prices at the stage of disposal of GDP during anaccounting year. In estimating the total national expenditure, any ofthe following two methods are followed: First method: Undcr this mcthod all the 111011;y cxpcnditurc III IIlllrkc( prkc arc computed and added up to arrive at 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) payment? to the non-pro;it-making institutions and charitable organisations like schools, hospitals and orphanage, and (d) private savings. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Second Method: Under this method the value of all the products finally disposed of are computed and added up to arrive at the total national expenditure. Under the second method, the following items are considered Private consumer goods and services Private investment goods Public goods and services Net investment from aboard. This method is extensively used because the requisite da!J requiredby this method can be collected with greater ease and accuracy.Treatment of Net Income from Abroad Net Factor Income From Abroad (NFIA); We have so far discussed the methods of measuring national income of a closed economy. However, most modem economics are open economy. These open economics exchange goods and services with rest of the world. In this exchange of goods and services, som: nations make net income through foreign trade through exports while some lose their income to the foreign nations through imports. These incomes are called as Net Factor Income from Abroa:d (NFIA). The net earnings or losses in foreign trade affect the national income. Therefore, in measuring national income the net results of external transactions are adjusted to the total national income arrived through any of the three methods. The total income from abroad is added and net losses to the foreigners are deducted from the total national income. All the exports of merchandise and of services such as, shipping, insurance, banking, tourism and gifts are added to the national income. On the contrary, all the imports of the corresponding items are deducted from the value of national output to arrive at the approximate measure of national income. Net Investment From Abroad: Net investment from abroad refers to the di ITerllliee between investment a nation made abroad and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS the in vcst· mcnt 111nde h~, thc rc~t or Ill( world ill Ihnt 1If1liOIl. Thi1 ill,~tll"I1I~ <I mldeu (0 the llIt i01l1l1 i Ilcume clllcullllcd II lieI addillg or deduct illg N I: 1.. from it.Choice of MethodsAs discussed above, there are standard methods of measuring thenational incOJ11I.: such as net output method, factor-income methodand expenditure method. 111 the I three methods would give thesame measure of national income, provided rcquisitc data for eachmethod arc adequately available. Therefore, any of the three methodscan be adopted to measure the national income. However, not all themethods arc suitable for all economies and purposes. Hence, theproblem of choice of method anses. The two main considerations on the basis of which a particularmethod is chosen are: The purpose of national income analysis Availability of necessary data. If objective is to analyse the net output, then the net outputmethod would be more suitable. In case, objective is to analyse thefactor-income distribution then, suitable method would be incomemethod. If objective at hand is to find out the expenditure pattern ofthe national income then the expenditure method is more suitable.However, availability of adequate and appropriate data is relativelymore important considerations in"selecting a method of estimatingnational income. However, the most common method is the net output methodbecause of the following reasons: It requires classification of economic activities and output, which is much easier to classifY than the income or expenditure. The most common practice is to collect and organise the national illcom!.; data by the division of economic activities. Therefore, easy availability of data on economic activities is the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS main reason for the popularity of the .output method. However, it should he borne in mind that no single method cangive an accurate measure of national income. This is because nocountrys statistical system provides the total data requirements for aparticular method. The usual practice is therefore, to combine two or more methodsto measure the national income. The combination of methods againdepends on the nature of required data and the sectoral breakdown ofthe available data.Measurement of National Income in IndiaIn India, a systematic measurement of national income was firstattempted in 1949. Earlier, some individuals and institutions mademany attempts. Dadabhi Narojoji made the earliest estimate ofIndias national income in 1876 for the year 1867-68. Since then,mostly the economists and the government authurities made manyattempts to estimate Indias national income. These estimates differ in coverage, concepts and methodology andthey are not comparable. Besides, earlier estimates were made mostlyfor one year, only some estimates covered a period of 3-4 years. Itwas therefore, not possible to construct a consistent series of nationalincome and assess the pcrforniance of the economy over a period oftime. It was only in 1949 that National Income Committee (NIC) wasappointed with PC. Mahalanobis, as its Chairman and D.R. Gadgil andV.K.R.V. Rao as its members. The NIC not only highlighted thelimitations of the statistical system that existed at that time but alsosuggested ways and means to improve data collectiol1 systems. Onthe recommendation of the Committee, the Directorate of NationalSample Survey was set up to collect additional data required forestimating national income. Besides, the NIC estimated countrysnational income for the period from 1948-49 to 1950-52. In itsestimates, NIC also provided the methodology for estimating nationalincome, which was followed until 1967. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS After the NIC, the task of estimating national income was takenover by the Central Statistical Organisation (CSO). Until 1967, the CSOfollowed the methodology laid down by the NIC. Thereafter, the CSOadopted a relatively improved methodology and procedure, which hadbecome possible due to increased availability of data. Theimprovements pertain mainly to the industrial classification of theactivities. The CSO publishes its estimates in its publication Estimatesof National Income.MethodologyCurrently, output and income methods are used by the CSO toestimate national income of our country. The output method is usedfor agriculture and manufacturing sectors, i.e., the commodityproducing sectors. Income method is used for the service sec(orsincluding trade, commerce, transport and governmeni services. In itsconventional series of national income statistics from 1950-51 to1966-67, the fSO had categorised the income in 13 sectors. However,in the revised series, it had adopted the following 15 break-ups of thenational economy for estimating the national income. (i) Agriculture (ii) Forestry and logging (iii) rishing. (iv) Mining andquarrying (v) Large-scale manufacturing (vi) Small-scalemanufacturing (vii) Construction (viii) Electricity, gas and water supply(ix) Transport and communication (x) Real estate and dwellings (xi)Public Administration and Defence (xii) Other services and (xiii)External transactions. The national income is estimated at bothconstant ar.d current prices.Growth and Composition of Indias NaConallncomeThe following Tables present the growth and change in composition ofIndias national income, both at factor cost and current prices. Table.6.1 presents the decennial trends in national income aggregates likeGDP, GNP, NDP, NNP, Net¬factor income from abroad, capitalconsumption and indirect tax and subsidies. Table 6.2 presents the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSchange in the composition of national income classified under fivebroad categories. Table 6.3 presents the decennial annual averagegrowth rate of GNP and GDP at constant prices. It can be seen fromTable 6.2 that the composition of Indias national income has changedconsiderably over the past four decades. The share of ~griculture hasdeclined from 55.8% in GDP in 1950¬51 to 31.3% in 1994-95 and thatof industrial sector increased from 15.26 to 27.5 % during th; sameperiod. Table 6.1: National Income Aggregates-1960-61 to 1994-95 (Decennial) (At current prices) (Rs. Crores) NationalA Income 1960-61 1970-71 1980-81 1990-91 1992-93 Aggregates (At F:actor C Jst) Gross1 Domestic 15,254 39,708 1,22,427 4,27,600 6,27,600 Prodllct (GDP Fixed Capital 940 2,921 12,087 71,5692. Consumption 51,884 Net 14,314 35,787 1,10,340 5,56,3443. Domestic 4,20,775 Product (NDP) = (1-2) Net Factor -72 -284 345 -114094. Income from 06,833 Abroad Contd.... Indirect5. Taxes 947 3,455 13,586 58,205 77,653 Less Subsideis Gross 6,16,5046. National 15,182 39,424 122,772 4,65,827 Product (GNP) = (1 + 4) BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Net National 14,242 36,503 1,10,685 5,44,9357. Profit (NNP) 4,13,943 = (6-2) GDP (at 16,201 43,163 1,36,013 705,5668. market 5,30,865 prices) = (1+5) GNP (at 16,129 42,879 1,36,358 9,31,0169. Market 5,24,032 price) = (8 + 3) NDP (at 15,261 40,292 1,23,926 6,63,99710. Market 4,78,981 price) = (8 – 2) NNP (at 15,189 39,958 1,24,271 6,22,58811. market 4,72,148 price) = (9 – 2)Source : CMIE, Basic Statistics Relating to Indian Economy, Aug 1994Table 13.3Table 6.2: Change in Composition of National Income (GDP) (Atcurrent prices) (Rs. Crores)Sectors Sectors 1960- 1970- 1980 1990 1994-95 - - at 61 71 1980-81 81 91 prices Agricuitural and 31.3 1. Allied sectors 45.8 45.2 38.1 31.8 Manufacturing 20.7 21.9 25.9 27.5 2. and Mining, etc. 28.8 Transport, 12.1 13.2 16.7 19.0 3. Trade and 19.6 Communication Finance and 11.9 10.0 8.8 11.1 4. Real Estate 8.3 Community and 5. Personal 9.4 9.7 10.5 11.6 11.1 Services Commodity 58.8 6. Sector (1 + 2) 66.5 67.1 64.0 60.5 Non-commodity 33.5 32.9 36.0 42.2 7. Sector (3 + 4 + 39.5 5) BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS All Sectors 100.0 100.0 100.0 100.0 8. 100.0 Tavie 6.3: Annual Average Growth Rate of GNP and GDP (ATCurrent Prices)(% share in GDP) Period GNP (%) GDP (%)1950-51 to 1960-61 4.08 4.091960-61 to 1970-71 3.74 3.781970-71 to 1980-81 3.47 3.341980-81 to 1990-91 5.57 5.761990-91 to 1994,-95 3:95 4.081950-51 to 1994-95 4.04 4.07 -- -----------Inflation and DeflationThe term inflation is used in many senses and it is difficult to give agenerally accepted, precise and scientific definition of the term.Popularly, inflation refers 1O a rise in price level. Kemmerer states,"Inflation is too much money and deposit currency that is too muchcurrency in relation to the physical volume of business being done."This is what Coulburn also means when he defines inflation as, "Toomuch money chasing too few goods". According to T.E. Gregory,inflation is "abnormal increase in the quantity of money". The implication in these definitions is that prices rise due to anincrease in the volume of money as compared to the supply of goods.This is the quantity approach to the rise in the price level. However, itshould be noted that prices may rise due to other factors also such asrise in wages and profits. Besides, there can be an inflationarypressure on prices without actually rising of the prices.Keynesian DefinitionKl:YlH:S rdales inl1ation to a price level that comes into existenceafter the stage of full employment. While, the quantity approachemphasises the volume of money to be responsible for rise in theprice level. Keynes distinguishes between two types of rise in prices (a) BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSrise in prices accompanied by increase in production (h) rise in pricesnot accompanied by incrl:ase in production. If an economy is workingat a low level, with a large number of unemployed men andunutilised resources then expansion of money or some other. factorsleading to an increase in demand will result not only in a rise in theprice level but also rise in the volume of goods and services in aneconomy. This will continue until all unemployed men tindemployment arid capital and other resources are more fully utilised,i.e., the stage of full employment. Beyond this stage, however, anyincrease in the volume of money or rise in demand will lead to a risein prices but lIO corresponding rise in production or employment. Keynes states that the initial rise in prices up to the stage of fullemployment is a good thing far the country since there is an increasein. output and employment. Reflation or partial inflation is used todesignate such a rise in the price level. The rise in prices aller thestage of full employment is bad far the country since there is nocorresponding increase in production or employment. Inflation isused to express such a rise in the price level. Therefore, inllationrefersto a rise in the price level after full employment has been attained.( According to Keynes, "inflation" can be applied to anunderdeveloped country like India where unemployment of men andresources exist side by side with inflationary rise in prices. This isdue to the existence of bottlenecks, such as limited amount of capital,machinery, transport facilities and absence of technical know-how.As a result of these bottlenecks and shortages, a rise in the pricelevel may not lead to increase output beyond a certain stage, eventhough the country may not have reached the stage of fullemployment. We can distinguish between three kinds of inflation onthe basis of their causes, viz., demand-pull, cost-push and sectoralinflation. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSDemand-pull InflationThe most common cal;lse for inflation is the pressure of ever-risingdemand on a stagnant or less rapidly increasing supply of goods andservices. The expansion in aggregate demand may be due to rapidlyincreasing private investment or expanding government expenditurefor war or economic development. At a time whe.n demand isexpanding and exerting pressure on pricescattempts are made toexpand production. However, this may not be possible either due tonon¬availability o(uqemployed resources or shortages of transport,power, capital and equipment. Expansion in aggregate demand, afterthe level of full employment, results into rf~e in the price level. In adeveloping economy I ike India, resources are used for growth, forcreating fixed assets and production of consumer goods. Necessarily,large expenditure will create. large money income and large demandbut without a corresponding increase in supply of real output. We should emphasise here the role played by deficit financing andincrease in money supply on the level of prices in a developingCOU1Hry. Ollen. the government of a developing country resorts todeficit spending Lo finance economic development i.e., borrowingfrom the central bunk und cOllllllercial banks, which, in turn, leads toincrease in money supply in the country. This exerts a strong pressureon the level of prices. An increase in" foreign demand for the exportsof a country may also raise the price level in a country. Expansion inforeign demand aM consequent expansion in exports will raise incomeof the people. This will push up demand for goods and services withina country. In case the additional money income is used to buy importsor is hoarded then it will not have inflationary effect in the country.Thus, inflationary pressure is built by increasing aggregate demand inexcess of the available resources. The increase in aggregate demandcan be due to increase in government expenditure or increase inprivate investment and private consumption or release of pent updemand of consumers immediately after a war or increase in exportsand so on. Deficit financing and increase in money supply further BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSaggregate the situation by boosting demand still further. In all thesecases, inflation is the result of demand-pull factors. It must beemphasised here that demand-pull inflation cannot be sustainedunless there is increase in money supply.Cost-push InflationIn certain circumstances, prices are pushed up by wage increases,forced upon the economy by labour leaders under the threat of strike.Costs can also be raised by manufacturers through a system of fixinga higher margin of profit. The common man generally blamesprofiteers, speculators, hoards and others for pushing up the costsand prices. Again, the government is responsible for raising the costsby imposing new taxes and continuously raising the tax rates ofexisting commodity. Therefore, rising rates of commodity taxes, in asellers market, will enable the producers to raise the prices by the fullamount of taxes. Under conditions of rising prices, business andindustrial units find it easy to pass on the burden of higher wages tothe consumers by raising the prices. 1 II us, rise in wages; profitmargin and taxation are responsible for cost-push inflation. In periods when wages, prices and aggregate demand are all risingand creating an inflationary situation, it is d-ifficult to find out activeand passive factor. In many cases, it is neither demand-pull inflationnor cOSt-push inflation, but it is a combination of both. However, it ispossible and often useful to separate the dominant factors. Ifaggregate de~and is responsible for the inflationary situation, it maypersist so long as excess demand persists and in the extreme case, itmay develop into hyperint1alion cwn thoug.h (osl-push fOtlS nl".nhslllt. t)11 the other hand, cost-push inllation cannot pcrsist for long,unless thcrc is increase ill aggrcg:llc <lClll:1I(1. I r illf1ntillll iscOlllrolled lilnllip"l1llllli(lilry IIIll! 1i""111 Ill,lli",h, aimcd atcontrolling aggregate dCllland then we have demand-pull inllation. Unthc other hand, if wages and prices continue to rise even whcndemand ceases to grow, we have cost-push int1ation. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSSectoral Demand Shift Theory of InflationUnder dcmand-pull inflation, we have shown how expansion inaggregatc demand without a proportionate increase in the supply ofgoods and services leads to an inflationary situation. However, it is notnecessary to have a general increase in demand to bring aboutinflationary pressure. Sometimes, the increase in demand may beconfined to some sector of the economy and this increase in demandand the consequent rise in the price in a particular sector may spreadto other sectors Suppose the demand for agricultural goods risesbecause of inadequate supplies of these goods. There would be aconsequent rise in the price of agricultural goods. Thus, the rise inprices spreads to all other sectors in the economy, through rise in theprices of raw materials and wages. The rise in prices in the agriculturalsector may push up prices in the industrial sector. Therefore, theinflationary rise in the price level is due to sectoral shifts in demand. The "sectoral demand" emphasises the fact that prices are highlyflexible upwards but relatively rigid downwards, for example, theremay be rise in prices in the agricultural sector where there is scarcitywhereas price stability in the industrial sector where there .. is anexcess supply. However, in course of time, prices all over the economywill assume an upward trend. The "sectoral demand" is also useful toexplain the simultaneous existence of inflation and recession, i.e.,inflation in some sectors and recession in certain other sectors.Industries coming under inflationary pressure will experiencepersistent rise in price but industries suffering from recession may notexperience a fall in the price level. Modern economists have coined theword "Stagflation" to refer to this situation in which stagnation insome sectors of the economy is present while other sectors aresubject to a highly inflationary situation.Other Classifications of Inflation Open Inflation: Inflation is said to be open when prices rise without any interruption. It may ultimately end into BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS hyper-inflation. Suppressed inflation: Suppressed inflation refers to a situation in which price level is not allowed to rise with the use of price controls and rationing, even though conditions exist for rise in the price levcl. The price level may rise when the control measures are lifted. Suppressed inflation results in (a) postponement of present demand to a future date (b) diversion of demand from one kind of goods to another, i.e., from those goods which are subject to price control. and rationing to those whose prices are uncontrolled and non-rationed. Suppressed inflation has many dangers. First, it creates administrative problems of controls and rationing. Secondly, it leads to corruption of the price control administration and risc of hlack IIlarkcls. Thirdly. it CHllses 1I1leCOIIOlllic diversion of productive resources from essential goods industries whose prices are· tixed or controllable to those . industries whose products are less essential but prices are uncontrollable. Creeping, Running and Galloping Inflation: In the initial stage of rise in the price level, prices may be rising slowly and this is referred as creeping inflation. In course of time, the rise in the price level becomes more marked and alarming. This is referred as running inflation. Ho.vcver, when the rise in the price level is staggering and extremely rapid, it is often referred to as galloping inflation or hyper-inflation, which a country should avoid at all costs.Consequences of Inflation on Production and EmploymentInflation affects both production and distribution of income in acountry. Inflationary rise in prices may not affect adversely theproduction of national income. When all aV2.ilabk men and materialsare employed then the stock of real wealth in the form of land and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSbuilding is not diminished and the total real income or output availablefor distribution between the different sections of people remains thesame. However, in course of time when inflation has gone beyond acertain limit, it may lead to reduction in production and increase inunemployment due to the following reasons: Firms may find it profitable to hoard rather than produce and sell Agriculturists may refuse to sell their surplus stocks in the hope of getting higher prices Production may be interrupted by bitter labour strikes. Therefore, beyond a certain stage, surplus stocks accumulate,profits decline and invcstmcnt. prodllClillll and incomc rail andlIncmpl()ymcnlll·i~ls.On Distribution of IncomeIt is true that in times of general rise in the price level, if all groups ofprices, such as agricultural prices, industrial prices, prices of minerals,wages, rent and profit rise in the same direction and by the sameextent, there will be no net effect on any section of people in thecommunity. For example, if the prices of goods and services, which aworker quys rises by 50 per cent and if the wage of the worker alsorises by 50 per cent then there is no change in the real income of theworker, i:e., his standard of living will remain constant. However, inpractice, all prices do not move in same direction and- by sainepercentage. Hence, some classes of reople in the community areaffected more favourably than others. This is explained as follows: Producing Classes: All producers, traders and specu!.ators gain during inflation because of the emergence of windfall profits. The prices of goods rise at a far greater rate than costs of production whereas BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS wages, interest rates and insurance premium are all mere or less fixed. Besides, the producers keep such assets, as commodities, real estate, etc., whose prices rise much more than the general level of prices. Thus, the producing and trading classes gain enormously during an inflationary period. However, farmers may gain only if their output is maintained or increased. Fixed Income Groups: Inflation is very severe on those who arc living on past savings, fixed rents, pensions and other fixed income groups called as the middle classes. Those persons who are working in government and private concerns find their money incomes more or less fixed while the prices of the goods and services, which they buy are rising very rapidly. Those with absolui~ly fixed incomes derived from interest and rent-known as the renter class, realise that their money income is absolutely worthless and their past savings have insignificant value in front of high prices. In fact, the worst sufferers in inflation are the middle classes who are considered as the backbone of any stable society. Working Classe~: During inflation, the working classes also suffer, firstly because wages do not rise as much as the prices of those commodities and services, which the workers buy. Secondly, there is also time lag between rise in th~.price level and wages. However, these days, many groups of workers are organised in trade unions and their wages rise simultaneously with rise, in the cost of living. Therefore, it can be presumed that organised workers may not suffer· much during inflation. However, there are many grOlIl)S of workers who arc not organised for example, the agricultural labourers, who find no way of pushing up their wages in the face of rising prices and cost of living. Inflation, lilus, brings shi fts in the distribution of incomc hctwccndi !Tcrellt sections of people. The producing classes such as BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSagriculturists, manufacturers and traders gain at the expense ofsalaried and working classes. The rich become richer and the poorbecomes poorer. Thus, there is a transfer of income from poor to richclasses. Inflation, therefore, is unjust. Besides, those who are hard hitby inflation are the young, old, widows and-small savers, i.e., all thosewho are unable to protect themselves. But the most unfortunate thingis that monetary arid fiscal authorities which are entrusted with thetask of maintaining price stability are often responsible for creatinginhltionary conditions, for example, a country at war resorts toprinting of currency notes as one of the methods of financing war.Similarly, the government of a developing economy may resort todeficit financing as . one of the methods of financing developmentprojects; In these cases, inflationary finance, like taxation, brings inadditional revenue to the public authorities. However, taxation cannotdestroy an economy except in rare cases by eliminating whole groupsof people. Inflation, on the other hand, can destroy fixed incomegroup, pauperise the middle classes and destroy the very foundationsof an economy. No wonder inflation has been termed as "a species oftaxation, cruellest of all" and "open robbery". Inflation, particularly thehyperinflation of the German type, will therefore endanger the veryfow(jations of the existing social and economic system. It will create asense of frustration distrust, injustice and discontent and may forcepeople to revolt against the government. It is, therefore, "economicallyunsound, politically dangerous and morally indefensible". Therefore, itshould be avoided and even if it occurs it should be controlled.Control of InflationInflation should be controlled in the beginning stage, otherwise it wiiltake the shape of hyper-inflation which will completely run thecountry. The different methods used to control inflation are known asanti-inflationary measures. These measures attempt mainly atreducing aggregate demand for goods and services on the basicassumption that inflationary rise in prices is due to an excess of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdemand over a given supply of goods and services. Anti-inflationarymeasures are of four types: Monetary policy Fiscal policy Price controlnnd mtioning Other methodsMonetary PolicyIt is the policy of the central bank of the country, which is thesupreme monetary and banking authority in a country. The centralbank may use such methods as the bank rate, open marketoperations, the reserve ratio and selective controls in order tocontrol the credit creation operation of commercial banks and thusrestrict the amounts of bank deposits in the country. this is knownas tight money policy. . Monetary policy to control inflation isbased on the assumption that a rise in prices is due to a largerdemand for goods and services, which is the direct result ofexpansion of bank credit. To the extent this is true, the centralbanks policy wi}1 be successful.Fiscal PolicyIt is the policy of a government with regard to taxation, expenditureand public borrowing. It has a very important influence on businessand economic activity. Taxes determine the size or the volume ofdisposable income in the hands of the public. The proper tax policyto control inflation will avoid tax cuts, introduce new taxes and raisethe rates of existing taxes. The purpose being to reduce the volumeof purchasing power in the hands of the public and thus reducestheir demand. A precisely similar effect will be achieved if voluntaryor compulsory savings are increased. Savings will reduce currentdemand for goods and thus reduce the inflationary rise in prices. As an anti-inflationary measure, government expenditureshould be reduced. This .indicates that demand for goods and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSservices will be further reduced. This policy of increasing publicrevenue through taxation and decreasing public expenditure isknown as surplus budgeting. However, there is one importantdifficulty is this policy. It may be easy to increase revenue in times ofinflation when people have more money ineome !:Jut difficult toreduce public expenditure. During war as well as during a period ofdevelopment expenditure it is absolutely impossible to reduce theplanned expenditure. If the government has already taken up ascheme or a group of schemes, it is ruinous to give them up in themiddle.; Therefore, public expenditure cannot be used as ananti-inflationary measure. Lastly, public debt, i.e., the debt of thegovernment may be managed in such a way that the supply ofmoney in the country may be controlled. The government shouldavoid paying back any of its previous loans during inflation so as toprevent an increase in the circulation of moneY: Moreover, ifthegovernment manages to get a surplus budget it should be used tocancel public debt held by the central bank. The result will beanti-inflationary since money taken from the public and commercialbanks is being cancelled out and is removed from circulation. But theproblem is how to get abudgct surplus, vhich is extremely difficult,if not impossible.Price Control and RationingThis is the most important and effective method available during warparticularly oecause both monetary and fiscal policies are more or lessuseless during this period. Price control implies the establishment tolegal upper limits beyond which prices of particular goods should notrisco The purpose of rationing, on the other hand, is to distribute thegoods in short supply in an equitable manner among all people,irrespective of their wealth and social status. Price control andrationing g.enerally go together. The chief objection behind use of thismethod to fight inflation is that they restrict the freedom of theconsumers and thus limit their welfare. Besides, its success dependson administrative efficiency, which in many underdeveloped countries BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSis very low.Other Methods Another important anti-inflationary device is to increase the supply of goods through either increased production or imports. Production may be increased by shifting factors of production from the production of less inflation sensitive goods, which are in comparative abundance to the production -of those goods which are in short supply and which are inflation-sensitive~ Moreover, shortage of goods internally may be relieved through imports of inflation sensitive goods, either on credit or in exchange for export of luxury goods and other non-essentials. A word may be added about the measures to control cost-push inflation. It is suggested that wages, salaries and profit margins should be controlled and fixed through a system of income freeze. Business units may particularly welcome wage freeze. However, wage freeze is not so easy or just, unless trade unions agree to the proposal and there is also freezing of prices. At the same time, the Government should not raise the rates of commodity taxes. Thus, it is difficult to control cost push inflation through controlling wages and other incomes. The best method is to bring a rapid increase in production, which will automatically check prices and wages also.Inflation in an: Underdeveloped EconomyBasically, inflation is supposed to occur after reaching the stage of fullemployment, for till that stage is reached an increase in effectivedemand and price level will,be fr)lowed by an increase in output,income and employment. It is after the stage of fuli employment whenall men are employed that a rise in the price level will not beaccompanied by an increase in production and employment. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSTheoret.ically, therefore, it is not possible to imagine an inflationarysituation existing side by side with full employment. It is in thiscontext that the question of inflation in an under developed countrylike India, which has both widespread unemployment andunderemployment is raised.Bottleneck InflationIt is interesting to observe that Keynes himself visualised thepossibility of an inflationary situation even before full employ·.lent wasreached. Such: a situation can arise even in advanced countries, ifthere are difficulties in perfect Glasticity of supply of goods andservices. It is possible that full employment is not reached but eventhen, there is no scope for increased production. The factorsresponsible for imperfect ela<;ticity of supply are law of diminishingreturns, absence of homogeneous factors and unemployed resources,which cannot be used to increase production. All these factors arelumped together and are known as bottlenecks. As monetary demandincreases with the increase in money supply, supply of goods does notincrease in proportion, due to imperfect elasticity. The difficulties orhandicaps, which prevent supply from increasing in the face of risingdemand, are known as bottlenecks. The result is that the cost ofproduction is pushed up and price level is raised. Apart from these,other bottlenecks are as follows: Market imperfections in underdeveloped countries, such as imperfect knowledge on the part of producers and consumers, mobility of factors, divisibility of factors and lack of specialisation. All these are responsible f9r inefficient use of resources. There is, thus, imperfect elasticity of supply in an underdevelopeJ country. Underdeveloped countries face shortage of technical labour, capital, equipment and transport and power facilities. Therefore, these countries are unable to grow becauserofthese.bottlenecks. Unemployment and underemployment are extensively present in an underdeveloped country. The existence of unemployment in BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS the advanced country helps increase output, whenever there is increased demand. However, this is not so in a country like India with a large magnitude of disguised unemployment and open unemployment. According to or.V.K.R.V. Rao, disguised unemployment is not so resrollsive to an increase in effective demand. Underdeveloped countries generally have II high mnrginul propensity to consume. or.Rao believes that this factor prevents an increase in the supply of goods and services. For instance, in the field of agriculture, increased production may be _ consumed at home ~nd, therefor;-:, less may be forthcoming to the market. A special feature of underdeveloped countries is that a large volume of primary production is exported. Therefore, the supply available for home consumption is reduced. The problem of inflationary rise in prices i~ worsened whenever the income earned from exports is spent on domestiC goods and not on imports. Since World War II, many of the underdeveloped countries have started resorting to extensive borrowing from the banks and deficit fi.nrmcing with the idea of speed ing up economic develop!nent. For one thing, much of this expenditure is on social and ccor:omic overheads, such as education, transport and powcr and on capital goods industries such as development of iron and steel industry. This implies that there is an increase in the production of consumption goods. Therefore, the volume of purchasing power with the general public is increased, resulting in increased demand for consumption goods. All these factors explain the existence of inflationary pressure in allunderdeveloped country, even though the stage of full employmenthas not been reached. The existence of bottlenecks such as· shortageof technical know-how and scarcity of capital equipment hasworsened the various problems related to underdeveloped countries. It BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSis, therefore, correct to use th~ concept of inflation even inunderdeveloped countries, provided we remember the existence ofspecial bottlenecks.DeflationI I prices an; abnormally high, it is indeed desirable to have a fall inprices. Such a fall in the price level is good for the community, as itwill not lead to a fall in the level of production or employment. Theprocess designed to reverse the inllationary trend in prices, withoutcreating unemployment, is generally known as disinflation. But ifprices fall from the level of full employment, then income andemployment will be adversely affected and this situation is termed asdeflation. The foll0wing Figure 6.1. shows if the price level continuesto rise even after the stage of full employment has been reached, it iscnlled intlntiol. Decline in prkt level as a result of anti-inl1ationarymeasures is known as disinflation. If prices litll below 11111OlllploYlIltlll. lho ~illlr,lil11 i~ ~nlhd 11011,,111111. Whllt11IC111lhlll IIIII,II~ excess demand over the avai lable supply.uel1l1tion implies dcticiency of dcmand to lift what is supplied. Whileinflation means rise in money incomes, deflation stands for fall inmoney incomes. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSEffects of DeflationThe following are the adverse effects of deflation: On production: Deflation has an adverse effect on the level of production, business activity and employment. During deflation, prices fall due contracting demand for goods and services. Fall in price results in losses and sometimes forcing many firms to go into liquidation. In the face of declining demand for goods, firms arc forced to close down either completely or leave part of their plants idle. Thus, production of income is curtailed and unemployment is increased. 111is is a serious defect of deflation, as compared to inflation in which normally there may not be an adverse effect on production and employment. On distribution: Deflation adversely affects distribution of income too. In the first place, producers, merchants and speculators lose badly during this period because price~ of their goods fall at a far greater rate than their costs, most of which tend to be fixed or sticky. Besides, most of these people are debtors who use borrowed funds in their businesses. They have to repay their debts in money, which has now more value because of deflation. For some debtors, who do not have adequate means to repay their loans had to go into liquidation. Deflation implies fall in price level or rise in the value of money: All those who have fixed incomes will be far better off because their money income is fixed. In other words, the fixed income groups will enjoy a rise in their real income. Therefore, it is assumed that salaried persons and wage C<llners wi II bcnefit by denatioll. Ilowcvcr, this is not completely true since there is increasing unemployment. Therefore, only those who are successful in keeping their jobs will be able to gain from the rise in the value of money. As a matter of fact, during deflation, there is great suffering and mystery all round and millions of families are literally thrown onto the streets to make their living through BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS begging. The only group of people who may really gain is that small minority, known as the renter class who get their income by way of fixed interest and rents.Methods of ControlAnti-deflation measures are the opposite of those, which are used tocombat inflation. Monetary policy aimed at controlling deflationconsists of using the discount rate, open-market operations and otherweapons of control available to the central bank of a country to raisevolume of credit of commercial banks. This policy is known as cheapmoney policy. This is based on an idea that with the increase in thevolume of credit, there will be an increase in investment, productionand employment. However, monetary policy is basically weak, for itassumes that the volume of credit can be expanded by the centralbank. This may not be so, because even when commercial banks areprepared to lend more to businesses to enable them to expand theirinvestment, the latter may not be willing to do so for fear of possiblefailure of their investments. Fiscal policy to fight deflation is known as deficit financing, i.e.,expenditure in excess of tax revenues. On one hand governmentattempts to reduce the level of taxation to provide large amount ofpurchasing power with the public. While, on the other hand, thegovernment increases its expenditure on public work programmessuch as irrigation, construction of roads and railways. By thisprogramme government will (:I) provide employment for those whomay be thrown out of employment in the private sector, (b) add teinational wealth, and (c) counteract the deficiency of private demandfor goods and services. The budget deficit can be financed throughborrowing from the public of their idle cash balances or banks. Thebasic idea of fiscal policy is to expand demand for goods or tocounteract the decline in private demand. Therefore, fiscal policy is themost important policy for economic stabilisation. Other measures to control deflation include price support BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSprogrammes, i.e., to prevent prices from falling beyond certain levelsand lowering wage and other costs to bring adjustment between priceand cost of production. Price support programme has beenextensively used in the USA in recent years but it is very difficult tocarry it through. The government will have to fix the prices belowwhich the commodities will not be sold and undertake to buy thesurplus stocks" It is difficult for the government to secure thenecessary funds for such transactions as well as to devise ways andmeans to dispose of the surplus stocks in other countries. Therefore,the best solution for deflation is to have a ready programme of publicworks to be implemented as and when unemployment makes itsappearance.Compariso!between Inflation and DeflationInflation is rise in prices unaccompanied by increase in employment,while deflation is fall in prices accompanied by increasingunemployment. Inflation distorts the distribution of income betweendifferent groups of people in the country in such an unjust mannerthat the rich gain at the expense of the poor. Deflation, on the otherhand, reduces national income through contraction of production andincreas~ in unemployment. Inflation is unjust and demoralising. Deflation, on the other hand,inflicts on the people the harsh punishment of general unemployment.There exist factories and mills on one hand and workers ready to;ork on the other hand, however, the whole team remaining idle, onthe other. Inflation at least implies that all factors are employed insome way or the other. There is one more reason why deflation isworse than inflation. Inflation can be controlled except occasionally itgets out of control. However, deflation, if once started, injects somuch pessimism into businessmen and bankers that it is highlydifficult to control. However, there is nothing to choose between thetwo and the proper objective should be to aim at economicstabilisation at the level of full employment. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSInflationary and Deflationary GapsKeynes developed the concept of inflationary gap. InfliJtionary gaprefers to, "excess of anticipated expenditures over the availahle outputal base pril.c.~." Inflationary gap occurs when there is an excess ofdemand over available supplies. Let us take a simple and hypotheticalexample to illustrate the eme~gence of inflationary gap. During a period of war, the volume of money expenditure in acountry increases, because or" the governments expenditure on thearmed forces and armaments. Increased government expenditureresulting in increased income with the community will lead toincreased consumption expenditure and investment. The disposableincome of the community, which constitutes aggregate demand forgoods and services, is as follows: (Rs. Crores)1. National income received during a given year: 20,0002. Taxes paid to the government: 5,0003. Gross disposable income (I -2): 15,0004. Saving by the community at 10% oft,e income: 1,5005. Net disposable income with the community: 13,500 The net disposable income with the people represents aggregatedemand for goods and services ofa community. As against theaggregate demand, the aggregate supply comes from gross nationalproduct. However, not all output is available for the community. Thegovernment diverts some resources such as food grains, cloth, for warpurposes, then the total output available for civilian consumption isless than the gross national pro,duct (GNP). For instance, (Rs. CIJres)1. National product (real income): 20,0002. Appropriated for war purposes: 8,0003. Available for civilian consumption: 12,000 Now the net disposable income, which the community will like to BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSspend is Rs. 13,500 crores but the available output for civilianconsumption is only Rs. 12,000 crores. There is excess of demandoVer available supply ~) tne extent of Rs. 1,500 crores, which isreferred to as the inflationary gap. The basic fact is that so long as theamount of disposable income with the people and the volume ofgoods and services available for them are the same, there will be pricestability; but whcn thL~ forillcr is Illore thnllthe lillieI, nn i1t1llllinllllrylJ.lIp willllppc;r :lld IIIl price level will rise; il~ 011 Ihe olher hUlld.the volume of goods llnd services is InrgN 111111 lht VI""I1I Illdhl".lld"ll 1111111111, "dI1lllllilllllll, gllp ill illlIlll, Though Keynes assoeialed un inflationary gap with war, we cunIlso spcak of inflationary gap during periods of economicdevelopment Since 1951, India has undertaken economicdevelopment, financed partly through created money. As a result,there has been enormous increase in money expenditure andmoney income but without a corresponding increase in the volumeof consumptioll goods (part of the increase in production has beenin capital goods). Besides, there is a ~ time interval or gap betweeninvestment and output of goods and services. Naturally, there isexcess demand resulting in inflationary pressure on the generalprice level. Inflationary gap can be illustrated by using theKeynesian concepts of aggregate demand and aggregate supply,The following Figure 6.2 shows the inflationary gap. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS In Figure 6.2, the horizontal axis represents volunie of incomeand the vertical axis represents volume of total expenditure (C + I+ G). The 450 vertical axis represents equilibrium line of Y = E andline C + I + G represents the total expenditure. At point E, theeconomy is in equilibrium because at E the supply of goods andservices or real income (OY) is equal to the demand for them at EY.Therefore, OY is regarded as equilibrium income as well as fullemployment income at current prices.Suppose, the Government increases its expenditure either for war ordevelop¬ment purposes, by an amount equal to EA. Then the newaggregate demand is shifted upwards and beco~es C + l + G. C of-l -- G is parallel to C + r + G line by the amount MEA. The realoutput (or income)remains constant at OY but the mOlletary demandfor this output is not EY but Y A, there is, thus. an excess of demandand equal. to.EA. EA, therefore, represents inflationary gap, which isresponsible for pushing up the price level.Wiping out Inflationary GapThe inflationary gap can be wiped out in various ways. Essentially, itstarts with additional expenditure by the government, which in turncalls for additional expenditure by the community. Through economyin government expenditure, the excess of aggregate demand can bereduced. However, this is not always possible in practice, asgovernment expenditure cannot be cut down during wartime or periodof economic devdopment. To remove this inflationary gap. variousmtlhods can be adopted, such as: There cun be a rise ill voluntary saving by the community. The government may use the tax system to mop up the surplus purchasing power with people; this will reduce C + I by the same amount as the increase in government expenditure. The output of goods and services may be increased so as to absorb the excess demand. In Figure 6.2, such an increase in real BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS income should be YY1• But, as mentioned already, there is no scope for such an increase in real income, as the economy is already at full employment level.Deflationary Gap Deflationary gap is the opposite of inflationary gap. If the volumeof goods and services is larger than the aggregate demand for them, adeflationary gap will arise. Deflationary gap arises when the C + I of-G line is pushed down to C + I + G. The decline in demand may bebecause of reduction in government expenditure or decline in privateinvestment or fall in private consumption demand. This is shown inFigure 6.3. OY, = Volume of real income available for the community As regards wiping out the deflationary gap, the government shouldincrease its expenditures or help to raise the expenditure of thegeneral public. The government can raise its own expenditure byinvesting in public works and financing them by borrowing from banks.The expenditure of the community C + I can be raised by reducinglaxes and other incentives. If the C + j + G is raised to the originallevel then the deflationary gap will disappear.StagflationInflationary gap occurs when aggregate demands exceeds the availablesupply and deflationary gap occurs when aggregate demand is lessthan the available supply. These are two opposite situations. However, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSwe may show how deflationary forces follow inflation, which has notbeen controlled. For instance, when inflation goes unchecked forsometimes and priCes reach very high levels, aggregate demandcontracts and slumps follows. Consumption demand (C) declinesbecause of high price levels. The middle and lower income groupshave to curtail th<f" consumption of many of the goods. Increase inprivate investment (I) does not take place because investors are afraidof future and there is decline in consumer demand at the height ofinflation. In fact, the decline in consumer demand and privateinvestment will reinforce each other and create a deflationary situation.Further, un excessive rise in the price level will affect exportsadversely and thus create a slu1np in the export industries as well. It is,thus, possible to visualise a situation in which inflationary anddeflationary pressures are present simultaneously. The existence of aneconomic recession at the height of inflation has been called asstagflation (stagnation + inflation).Trade Cycles Wesley C. Mitchell, a noted American authority 011 business cycles,wrote: "Business cycles are a species of fluctuations in the economicactivities of organised communities." The adjective ,business restrictsthe concept to fluctuations in the activities, which are systematicallyconducted on commercial basis. The noun cycles bars outfluctuations, which do not recur with a measure of regularity. Mitchellhas, thus, described all the important features of a business cycleadmirably. According to him, features of trade cycle are: It occurs only in organised communities, which are money economies. Refers to fluctuations or changes in business conditions. Implies regular and periodical changes in business and economic activities. According to Keynes, "A trade cycle is composed of periods of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSgood trade characterised by rising prices and low unemploymentpercentage, alternating with periods of bad trade characterised byfalling prices and high unemployment percentage. "Characteristics of Trade CyclesFrom the above definition, it should ,be clear that trade cy~les isrhythmic fluctuations of the economy, that is, periods of prosperityfollowed by periods of depression. However, the waves of prosperityand depression need not always be of the same length and amplitude.Further, trade cycles varied tremendously in magnitude. Whde somehave smaller cyclical fluctuations in economic activity, others havegreat intensity of fluctuations. Expansion in some cycles reaches thefull employment level and stays there. However, in some cycles, thepeak is reached even before full employment. Sometimes, the cyclicalfluctuations may be prolonged for one reason or the other. The American Economic Association emphasised the followingimportant characteristics of trade cycle: Prices IInd production gencrnlly risc 01 1111 togctht.r, Till C:ll:ptl(l i~ agricultllre, where during 1I dowllwlIrd phllsc or business ey(k~, ",h,1 prices are falling. (he agricullurists may tend to produce more, so liS to onset the loss of lillling prices 11I1l1 thus 11I1I1IIlH11I tht SilIlI: 11"c1 <If income. The total output and employment Jluctuate by a larger percentage in durable and capital goods industries than in non-durable and consumption goods industries. Large changes in total output, employment and the price level are normally accompanied by large changes in currency, credit and velocity of circulation of Illoney. Prices of manufactures are comparatively rigid while prices of agricultural goods are normally flexible. Profits fluctuate by a much larger percentage than other types of income. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Industries are so inter-connected that fluctuations in one will be passed on to others also, Thus, cyclical fluctuations affect all industries. Cyclical fluctuations tend to be international, in the sense that prosperity and depression spread from one country to another through foreign trade,Phases of a Trade CycleEvery trade cycle is characterised by two main phases namely, theupward phase and the downward phase ofthe trade cycle. These twophases further have four or five different sub-phases, such asdepression, recovery, full employment, boom and recession. Inmonetary terminology, the same phases . correspond to depression,deflation, full employment, disinflation and deflation. The following Figure 6.4 shows· the different stages· of a tradecycle. FE represents the full employment line-it may be taken as thedividing line. Above this line, there is business prosperity and boomand below this line, there is business depression. As a trade eycle is acontinuous phenomenon, it is essential to break it som~where. It iscustomary to start at the lowest point of the upward " phase, namely,the depression. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSDepression: During depression, the level of economic activity isextremely low. The price level is low, profit margins do not exist,firms incur losses and unemployment is high. Interests, wages andprofits are all low. While all sections in the economy suffer, somesuffer more than others do. For instance, the producers ofagricultural goods suffer badly because the prices of agriculturalgoods fall the most during depression. This is due to inability of thefarmers to adjust their output according to the market demilnd,which is low. The worst hits are the working classes that sufferheavily because of unemployment. The depression is thus, a periodof great suffering, low income and unemployment.The phase of recovery: Depression gives place to recovery. There isrevival of business and economic activity. There is greater demandfor goods and services and consequently there is greater production.Prices, wages, interests and profits all start rising. Employmentincreases and so docs the national income. There is increase ininvestment, bank loans and advances, velocity of circulation ofmoney due to more brisk tnide. Through multiplier and accelerationeffects, the economy is proceeding upward steadily and rapidly. Theprocess of revival and recovery becomes cumulative. Increased BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSreceipts result in increased expenditure causing further incrcasc inn:ceipts. which in turn, rcsult in further increased expendllure andso on. The wave of recovery once initi"ted soon begins to feed uponitself.The phase of full employment: The cumulative process of recoverycontinues until the economy reaches full employment. Fullemployment implies that all the available men arc employed. Theeconomy has reached the optimum level of economic activity.During this phase, there is an all¬round economic stability referringto stability of output, wages, prices and income. Wages, interestsand profits are high, output is highest with the given technologyand employment is maximum. There may be small percentage ofunemployment, but it is not of an involuntary type but of voluntaryand frictional type. The period of full employment has become theusual goal of most national economic policies.The phase of boom or inflation: The phase of recovery frequentlyends not in a stable state of full employment o~ prosperity butfurther leads to a boom or inflation. Beyond the stage of fullemployment, the rise in investment results in increas~d pressure forthe available men and materials and rise in wages and prices.During this period, there is hectic activity going on everywhere inthe economy such as new buildings come up, new factories arecommissioned and many new trades are started. In a matter ofweeks or months, full employment paves the way for overiiJlIemployment, i.e., a peculiar situation in which there are more jobsthan the available workers. Money wage rise, profits increase andinterest rates go up. The demand for bank credit increases andthere is all round optimism. At the same time, bottlen~.cks begin toappear in the economy. Factors of production, particularly rawmaterials and labour becon~e scarce, commanding higher pricesand wages and thereby distort the cost calculations of theentrepreneurs. They now realise that they have overstepped themark and become overcautious. Their over-optimism paves way for BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS their pessimism. Generally, the failure ·01 a firm or bank bursts boom and lead to recession. Recession: The entrepreneurs realise their mistakes and find that many of tht: ventures started in the rosy anticipation of the boom are not profitable. The over oplimism of the boom gives way to pessimism characterised by feelings of hesitation, doubt and fear. Fresh enterprises are postponed for some remote future date and those in hand are abandoned. Credit is suddenly curtailed sharply as the banks are afraid of failure. Business l:xrnnsion stars. order~; : 1re cancelled and workers are laid off. Liquidity preference suddenly rises and people pref~r to hoard rather thail invest Building activity slows down and unemployment appears in construction· industries. Unemployment spreads to other sectors also because the multiplier effect begins to work in the downward direction. Uncmployment leads to fall in income, expenditure, prices, profits and industrial and trade activities. Panic prevai l~" in the stock market and the prices of shares fall rapidly., Once business and economic activity start declining, it becomes almost difficult to stop this decline and finally ,ends in a hopeless depression. We have described the various phases of a trade cycle, but weshould note, that all these phases rarely display smoothness andregularity. The movement at times may be irregular in such a mannerthat one phase may not easily follow the other. Nor is the length ofeach phase by any means always defined. Thus it is quite likely that astate of fairly stable business depression may lead to recovery or itmay decline to further recession, as was tlie case with England in1929. Similarly, a recovery may turn into a recession withoutallo/ing for either full employment or even boom, as witnessed inthe United States in J 937. Sometimes, the depression may beunstable and recover very rapid. So, alsc at times prosperity phasemay be fairly stable as was the case during the period between 1924and 1929. Some of the important features of various phases of a trade cycle BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSshould be 0 emphasised here. They are important when we have toevaluate the worth of different trade cycle theories. The process of revival is generally very gradual but once it picks up, it becomes rapid. The boom period of the trade cycle is marked by high level of business activity. The crash of the boom is always sudden and sharp. The downward trend of the trade cycle is rather very rapid. The depression period is prolonged and is painful because of widespread unemployment.Trade Cycle TheoriesThe complex phenomenon of a trade cycle has received the gr,eatestattention from economist and there arc number of theories Oil tradecyclc. The following theories on trade cycle are as follows: Monctary llnd Non-monctary Thcorics: Trade cycle theories can he classified into monetary lInd nOIHllOnctnry theories. The forllel llllphasbls monetary factors as thc main cause for, while the Ialler elllphnsis 1l1l!1¬IlIllmlllr) Ihe!ll),:-I, :-IllllI ll:lllilllillll llllltllllllIIS. psylllhlgy II hIlSIIll~~llhll and innovations as, thc main cause for the recurrence or econOllllC fluctuations. Climatic Theory: The climatic theory is one of the oldest theories of tradc cycle. The climatic theory, also known as the sunspot theory because the spots that appear, on the face of the sun largely influence climatic conditions. A bad climate causes the failure of harvests, which in turn lead:i to depression in business conditions because of a fall in the incomc of" farmers and consequent fall in their demand for the products of industries, A good climate, on the contrary, has quite the opposite effect on trade and industry. The variations of climate are said to be so BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSregular that periods of good harvest are followed by periods ofbad Ones and consequently booms and slumps follow eachother just as the days and nights, This theory has beendiscarded in modern times. While it is difficult to deny the factthat the prospects of agriculture affect the pwspects ofindustries, it is not easy to correlate such a complexphenomenon of trade cycle exclusively with the climaticconditions. If the theory has to be correct, then it should acceptth"t trade cycles are less important in non-agricultural areas andwhen a nation becomes more completely industrialised, tradecycles would disappear or at least diminish in importance. This,however, is not the case; in fact, it is advanced countries, whichseem to suffer most from the trade cycles.Psychological Theory: Pigou attempted to explain the tradecycle with reference to the feeling of optimism and pessimismamong businessmen and bankers. Businessmen have theirmoods. Sometimes they feel depressed and at· other times, theyare jubilant and optimistic. Despair, hopelessness as well asoptimism are catching in nature. When 0ne businessman ispessimistic, he passes it on to the others, similarly,. optimismspreads from OIlC to another. Thus. lIccording 10 thepsychological thcory. industrial l1uctuations are thc outCOIllCof" the waves or oplilllisl)/ among businessmen. Optimismresults in prosperity and - pessimism in recession anddepression. There is an element of truth in the psychologicaltheory in the sense that psychological waves of optimism andpessimism do play an imp()rtant role ill trade cycles. Butbusincss con !1dcncc or abSCIll"C of it is often the result ratherthan the cause-ofbusiness conditions. Further, the theory does/lot explain satisfactorily how depression starts or a recoverybegins.Over-Investment Theory of Von Hayek and Others: Prof.VonHayek in his books "Monetary Theory and the Trade Cycle" and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS "Prices and Production", has developed theory of business cycles in terms of monetary over-investment and consequent over-production. According to him. there is a "natural" or equilibrium rate of interest at which the demand for loanable funds is equal to the supply of funds through voluntary saving. At the same time, there is also market rate of interest based on demand for and supply of loanable funds in the market. According to Hayeks thesis as long as the market rate of interest is same as the natural rate of interest. there will hc stahility ill husillcss cOlldiliolls alld allY dispilrity bctwcen the two will lead to busincss Iluctuations. For instance, a fall in the market rate of interest below the natural rate wililcad to more investment and, therclore, an upward swing in business activity. On the other hand, a rise in the market rate of interest over the natural rate of interest will lead to a fall in investment and, therefore, a downward swing in business activity. Now, the market rate of interest may fall below the natural rate ofinterest because money supply increase in excess of demand for thesame. The banks lending to entrepreneurs; through whom it eventuallyreaches the consumers bring about this increase in supply of money.The increased money supply is made available to the entrepreneurs bylowering the market rate of interest. There is a spurt of investmentactivity. More capital intensive methods of production are adopted.The demand for capital goods naturally increases and accordingly theirprices go up. As a direct consequence of this rise in the prices ofcapital goods there is a diversion of resources from the production ofconsumption goods to the production of capital goods resulting in thereduction of the supply of consumer goods. But this situation cannotcontinue for long, for increase in the production of capital goods andhigher prices for them will result in larger income for the factorowners who, in turn, can normally be expected to increase theirconsumption of goods. The demand for consumption goods will alsorise and their prices too will go up. There will now be a competition BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSbetween capital goods industries and consumption goods industriesfor scarce resources. Naturally, the prices ofJactor series will go up,raising the cost of production of capital goods industries. The profitmargins of capital goods industries will, therefore, becomeunattractivc. At the same time the banking system decides to reducethe rate of credit expansion by mising the market rate of interestabove the equilibrium rate, causing illvt~;tment to (all abruptly. Thus,on the one hand, investment is unattractive because of lower yield,and on the other, investment is made more expensive because ofhigher rate of interest. The business expansion and boom broughtabout by IbW market rate of interest and heavy investment activitycrashes when the banking system puts a stop to additiorlal lending tofirms by raising the rate of interest. Investment and production willdecline and depression will rise. Hayek(basic thesis can now be summarised as follows. Alternatingstages of prosperity and depression are due to lengthening andshortening processes of production brought about by a change in themoney supply, which causes a change in the market rate of interestaway from the natural rate of interest. The lengthening of the processof production is brought about by increase in moncy supply, whichcauses the market rate of interest to fall below the natural rate ofinterest. Shortening of the process of production is brought about by aLleel ine in the supply of bank money, which raises the market rate ofinterest above the natural rate of interest. Therefore, the failure of thebanking system to keep the supply of money constant is responsiblefor business cycles. Therefore, to control cyclical fluctuations, Hayekssolution is simple, i.e., to keep constant supply of bank money,making allowance for such increases or decreases in the velocity ofcirculation of money.Weaknesses of Hayeks ApproachAccording to Von Hayek, a low rate of interest and large bank lendingto entrepreneurs result into expansion of investment and productionwhereas a high rate of interest puts a stop to this expansion and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSbrings about a depression. Hayeks theory is, therefore, referred to asmonetary over-investment theory of business cycles. The basicweakness of Hayeks approach is its emphasis on the rate of interestand complete neglect of real factors such as technological changesand innovations inCJuencing the volume of investment. Further,according to Hayek, the sole cause for change in the volume ofinvestment is the change in the market rate of interest relative to theequilibrium rate of interest. A lower market rate of interest in relationto equilibrium rate of interest induces entrepreneurs to adopt more :capital-intensivep;1ethods of production, i.e., to change thecapital-output ratio. Hayek~;however, does not mention howinvestment is related to consumer demand. Further more, theimportance given to the rate of interest by Hayek as the cause ofchange in the volume of investment is also questioned. Keynes hasshown that the rate of interest is not an important factor fordetermining the volume of investment. Finally, critics do not accept Hayeks rcmedy. to the problem ofbusiness cyclcs. Hayck suggests that the volume of money supplyshould be kept neutral, so that business fluctuations may becontrolled. I r moncy supply is nol nClllml, investment will be eitherencouraged (expansion of money) or cliscouraged (contraction ofmoney supply) and as a result there will be business fluctuations. Thisis based on the old quantity theory of money, which does notcommand general accepta1ce .. Moreover, a change in the volume ofinvestment is not responsible for business fluctuations whereasinvestment financed by involuntary savings or expansion of bankcredit is to be blamed for fluctuation.Non-monetary Over-investment TheorySome economists like Arthur Spiethofr and D.H. Robertson have alsosubscribed to the over-investment theory but in a modified form.Their approach is based on the assumption that Says law of markets,which oenies the possibility of over¬production, is valid in a barter BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSeconomy but not valid to a money economy in which transactions arenot direct but indirect through money. Spiethoff believes that over-investment is a basic cause of businessslump but this is not due to low rate of interest or to expansion ofmoney supply, as Von Hayek has asserted. According to Spiethoff,over-investment and over-production in one sector may be passed onto others. For instance, during a business depression there is excesscapacity of durable capital goods. There will be no investment in theseor other related industries. When business recovery starts, capitalgoods industries start expanding, and with that other industries thatserve capital goods industries also expand. For example, expansion ofiron and steel industry will lead to expansion of coal, mining,manganese and transportation. When these industries expand, incomewill increase and consequently demand for consumption goqds willalso increase. The upswing continues till the investment in allindustries has reached the optimum point and in certain lines ofproduction, there is even over-investment. This leads to the crash ofboom conditions. D.H. Robertson believes that over-investment in some industries isthe result of indivisibilities and this imbalance is worsened by thebanking system, which brings in more money. In his opinion, thecourse of economic progress is not generally smooth and as a malleIof (act, some degree of fluctuations may be necessary. The realproblem, however, is that the desirable fluctuations may createexcessive responses creating unstable conditions in the economy.Robertson believes that part of this excessive response is due toexistence of indivisibility in certain investments. He cites the exampleof a railway company that faced the problem of congestion on a singletmck, wanted to go 101 a double track. Ill, introduction of,i secondtrack would create excess capacity but the additlull:l1 traffic Illa) nothe slIrticiclll 10 f,dly IItiiisc lill secolld traele Ilo",(ver. lilc rnilll:IYcompany has 110 allcllwlivL hut 10 inlltlducc Ihe Sll(lIHI lllll.k.IIlSllllllIS h"il~ lumpy in many hcavy capital-intensive industries BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSresult in exceSs capacity. Besides such investmcnts arctime-consuming because they have long gcst<ltiull periods, i.e., timegap between the decision to undertake the project and the timeproject is commissioned. Two problems are created as a result of suchinvestment. Firstly, undertaking heavy investment in excessive ofcurrent demand would lead to blockage of capital and undertakingsmaller investment that would be insufficient to meet the currentdemand. Secondly, in a competitive system, many entrepreneurs maygo in for investments with long gestation periods that rt:sult intoover-investment, over-production and glut of goods in the market. While over-investment and over-production ale results ofindivisibilities. they are encouraged by monetary factors. For instance,the banking system may plJCC additional volume of money at thedisposal of entrepreneurs and thus increase the already existing stateof imbalance. Increase in money supply will cause prices to rise,thereby misleading their appraisal of prospective profits. This pricerise encourages entrepreneurs to further over-investment. Thus, D.H.Robertson successfully combines real and monetary factors to explainbusiness cycks. Over¬investment theory has definite merit in thesense that the business boom is identified by too much investment ingeneral or particular industries. TIllS IS largely true. However, the realweakness of the theory is its failure to exp~ain revival from a businessdepr~ssion.Over-Saving or Under-Consumption TheoryThis is one of the earliest theories of trade cycle and has been statedin different forms at different times. Such "Yell-known names asMalthus, Marx and Hobson are associated with this theory. Accordingto this theory, in free capitalist society rich people have large incomesbut they are unable to spend all their incomes and hence they saveautomatically. These savings are usually invested in industry andhence they increase the volume of goods produced. At the same time,the majority of people in the country have low incomes and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSconsequently have low propensity to consume. Thus, consumption isnot increasing correspondingly to production. As a result, the marketis flooded with goods and will be followed bY,depression unless pricesfall to a very low level in order to allow the goods to be carried oll themarket. The fundamental idea of the under-consumption theory isbased upon the conflict, which arises from the double effect, thatsaving has on consumption and production. It is the decrease in thedemand lor and the increase in t.he supply of consumer goods as aresjlt of saving which seems to create under-consumption andover-production. Like all other theories of trade cycles, this theory too is not freefrom defects. It does not explain complete trade cycle. It is pointed outthat the theory concentrates too much on over-saving and its relatedevils and too little on the others. It considers savings automaticallylinding their way into investments while in reality this is not so. Theavailability of savings does not guide entrepreneurs in t!lt.:irinvestment policies. Thus, a mere increase in savings is insufficient toexplain occurrence of a boom.Hawtroys Monetary TheoryHawtrey regards trade cycle as a purely monetary phenomenon.According to him, non-monetary factors like wars, earthquakes,strikes and crop failures may cause partial and temporary depressionin particular sectors of an economy. However, these non-monetaryfactors cannot cause full and permanent depression involving generalunemployment of the factors of production in a trade cycle. On theother hand, changes in the flow of money are the exclusive andsufficient cause of changes in trade cycle. In Hawtreys opinion, thebasic cause of trade cycle is the expansion and contraction of moneyin a country. According to Hawtrey, changes in the volume of moneyare brought about by changes in the rate of interest. For instance, ifbanks reduce their rate of interest, producers and traders will beinduced to borrow more from banks so as to expand their business.Borrowing from banks will lead to more bank money and rise in the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSprice level and business activity. On the other hand, if banks raisetheir rate of interest, producers and traders will reduce theirborrowing from banks. This will reduce the price level and businessactivity. Thus, in Hawtreys analysis, changes in interest rates lead tochanges in borrowing from banks and, therefore, changes in thesupply of money. Changes in the supply of money lead to changes inJusiness activity.Trade Cycle in Just Inflation and Deflationf-Iawtrey argues that the trade cycle is nothing but small-scale replicaof an outright money inflation and deflation. The upward phase of atrade cycle, such as revival, prosperity and boom is brought about byan expansion of money and bank credit and also by increase incirculation of money supply. On the other hand, the downward swingof money supply is nothing but a monetary denatibn. Expansion of bank loans is made possibk by fall in rute of interest,which induces the merchants to increase their stocks since banksgrants loan more liberally. Therefore, merchants begin to place moreorders and increase production by employing more resources. There isgreater demand for factors of production all round and consequentlyhigher income and employment leading to further increased demandof goods. In course of time, a cumulative upward trend is set inmotion. As the volume of business expands and factors of productionarc rendered fully employed, prices rise further and further induceupward business expansion. resulting in inflationary conditions orboom conditions. However, the boom crashes when the balkingauthorities suspend their policy of credit expansion.Why the Boom Crashes Suddenly?The banks suspend credit and call on the borrowers to return theloans, cither because banks have reached the maximum point beyondwhich they cannot givc any more loans or they are afraid that thephase of business expansion has reached a saturation point and hencea downward trend may set in the immediate future. Now the sudden BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSsuspension of credit facilities by the banks comes as a shock toentrepreneurs and merchants. Until now entrepreneurs and merchantswere enjoying liberal policy of the banks and now, contrary to theirexpectations, they receive sudden notices of immediate call-back ofloans to dispose of their stocks at any price in order to repay bankloans. This general desire of businessmen to dispose of their stockswill definitely depress the market and bring down the prices. Withevery fall in prices, the desire to dispose of the stocks as quickly aspossible wi!! lead to confusion and collapse of the market. Marginaland average fimls may even go into liq-uidation, thus worsening theposition still further and making the banks extremely nervous. Bankswill proceed to further contraction and like the period of expansion, itwill become cumulative. Producers curtail output and consumersincome and outlays decrease and contraction spirals in a downwarddirection, until it touches the lowest level possible.How the revival takes place?When the economy is working at the level of depression, the rate ofinterest is low and the bank,....: have large cash reserves. On one hand,low interest rates make it profitable to borrow and invest. On theother hand, large cash reserves induce banks to lend. This starts thephase of revival, which because of its cumulative character, leads toprosperity and boom conditions. This, according to Hawtrey, theinherently unstable nature of the modem monetary and credit systemis the mother or economic fluctuations. This monetary explanation ofthe trade cycle has received powerful support from Milton Freidman,who says, "In every deep depression, monetary factors playa criticairole~" According to Freidman, there is a direct relation between thevolume of money supply and the level or business activity in a country.If the money supply increases at a rate faster than the economys realoutput of goods and services, prices will decline and the economy isbound to contract. Thus, there is direct relation between the level ofincome and economic activity, on the one side and the volume ofmoney supply on the other. If the economy has to be stable, monetary BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSexpansi9n and contraction has to be avoided.Weaknesses of the Monetary ExpansionThe weakness of monetary expansion is as follows: Finance is the soul of commerce and trade in modern times and the banking system plays quite an important part in financing trade activities. However, it is correct to say that banks cause business crises. Hawtreys theory would have been all right in those days when the gold standard was universal and when the volume of money supply was fixed to gold reserves. Currency and credit could expand only when gold reserves increases. These days, gold standard does not exist clnd, therefore, Hawtreys theory is really weak. Borrowing and investment will not depend upon the rate of interest, as Hawtrey believes. A high rate of interest will not deter people· from borrowing for investment, and a low rate of interest will always induce people to borrow and invest. Expansion and contraction of money alone cannot explain prosperity and depression. According to Hawtrey, expansion and boon! are the result of expansion of bank credit, but it is pointed out that the mere expansion of bank credit by itself cannot initiate a boom. Further, according to Hawtrey, a depression is marked by contraction of bank loans and advances but actually, the contraction of bank credit is the ·result of depression. . Lowering of interest rate and willingness of banks to - give loans and advances cannot be a -sufficient reason to stimulate the economy to revive. Businessmen will not borrow and invest unless they are convinced that the economy will definitcly I"cvivc 1I11d il will he prnntllbk to bOlrnw Hnt! invest. In recenl years, lhe technique It tinlllll:ing has been changing BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS illlLl practically all finns, both big and small, havc becn resorting to the policy or ploughing back of profits. The conclusion, which follows, is that the banking system can accentuate a boom or a depression but it cannot originate one. In other words, expansion and contraction of bank credit can be a supplementary cause but not the main cause of trade cycles.Keynes Theory of Trade CyclesKeynes never worked out a pure theory of trade cycles, though hemade significant contributions to the trade cycle theory. Keynes states,"The trade cycle can be described and ana lysed in terms of thefluctuations of the marginal efficiency of capital relatively to the rate ofinterest." According to Keynes, the level of income and employment ina capitalist economy depends upon effective demand, comprising oftotal consumption and investment expenditure. Changes in totalexpenditure will imply changes in effective demand and will lead tochanges fn income and employment in the country. Therefore, in theKeynesian system fluctuations in total expt(nditure are responsible forfluctuations in business activity. Now, according to Keynes,consumption expenditure is relatively stable, and consequently it isthe fluctuations in the volume of investment that are responsible forchanges in the level of employment, income and output. Investment depends up0l) two factors: (a) marginal efficiency ofcapital, and (b) the rate of interest. Investment is carried on up to thepoint where the marginal efficiency of capital (the profitability ofcapital) is equal to the rate of interest (i.e., the cost of borrowingcapital). Keynes argues that the rate of interest will depend upon theliquidity preference of the people in the country and the quantity ofmoney available. In the short period, the rate of interest will be stableand hence it is not responsible for causing cyclical fluctuations intrade cycles. According to Keynes the fluctuations in the marginalefficiency of capital are the fundamental cause of fluctuation in tradecycles. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSThe following Figure 6.5 shows how trade cycle depends upon themarginal efficiency of capital, which according to Keynes, is the villainof the piece. The substance of Keynes theory is that an initialinvestment outlay will generate multiplc amount of income andemployment under the int1uence of the multiplier and accelerationeffects. On the other hand, co;ntraction of investment will similarlylead to multiple contractions of incom~and employment. But whether afresh investment will be Lindertaken will depend upon the marginalefficiency of capital. We can explain these pOint$ a little moreelaborately.How Recovery Starts?Let us start at the bottom of a depression. At this point, the marginalefficiency of capital will be high due to exhaustion of accumulatedstocks and necessity to replace capital goods. At the same time, therate of interest may be low because of large cash balances withcommercial banks or due to fall in the public liquidity preference. As aresult, the entrepreneurs may borrow fu~ds from banks and makefresh investments. Under the impact of the multiplier an<iacceleration effects, the process of increased investment andemployment gets an upward trend. There is heavy economic activityeverywhere in the primary, secondary and tertiary sectors of the BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSeconomic system. This sudden shoot in investment activity gives riseto boom and as long as it lasts, the economic situution appears veryeasy and bright.How the Boom Crashes?The boom conditions thcmselves contain the very seeds;of their owndestruction. Very soon goods are accumulated beyond theexpectations of entrepreneurs and competition among them todispose their accumulated stocks bring crash in prices. While theprices of finished goods are declining, their costs of productioncontinuously rise because factors of production are bceoming scarceand hence are commanding hi,!~her prices. The· marginal efficiency ofcapital is sandwiched between rising costs of production-on the oneside and falling prices of finished goods :In the other. The marginalefficiency of capital, therefore, collapses and brings about a crash inthe investment market.Ineffectiveness of the Rate of InterestKeynes believes that the rate of interest could have prevented thecollapse of the marginal efficiency of the capital and revives theconfidence among the entrepreneurs, by exerting its pressure toreduce cost. Uut then, the rate of interest is very high, like all otherprices and wages. The rate of interest goes up due to a rise in theliquidity preference of the people. The marginal efficiency of capitalfalls below the current rate of interest and thus, the decline ofinvestment is aggravated. Keynes believes that at this stage areduction in the rate of interest is neither easy nor adequate torestore confidence and revive investment. In Keynes theory of tradecycles, the margina~ efficiency of capital has great significance thanthe rate of interest. In fact, it disturbs the equilibrium of the economyand thereby causes fluctuations in the economy. The other factor thatoccupies an equally important place in Keynes theory is the"investment multiplier". However, for the active operation ofinvestment multiplier, the cycle needs to be milder in magnitude than BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSwhat it actually is. Weaknesses of the Keynesian AnalysisKeynes theory of the trade cycle has been regarded as quiteconvincing since it explains cbm:ctly the cumulative processes, bothin the upswing as well as in the downswing. Besides, Keynesadvocacy of fiscal policy to bring about business stability has beenwidely used. However, critics have found some weaknesses in theKeynesian analysis. First, according to Keynes, marginal efficiency ofcapital is the most important factor that guides the investmentdecisions of the entreprencurs. However, this important factordepends on entrepreneurs anticipation of future prospects thatfurther depend upon the psychology of investors. If. such a .case,Keynes theory of trade cycles approaches close to Pigouspsychological theory. Secondly, in Keynes theory, the rate of interestplays a minor role. Keynes expresses the opinion that sizeable fall inthe rate of interest can do something to. revive the confidence amongthe entrepreneurs by exerting pressure on the cost of production.However, Keynes himself has pointed out that this has beensufficiently proved to be correct that the rate of interest does nothave any influence on investment. Thirdly, his theory does not throwlight on the periodicity aspect of the trade cycle. Finally, some critics like Hazlitt have pointed out that Keynesconcept of the rate of interest does not tally with actual marketconditions. For instance, according to Keynes, in a period of recessionand depre~sion, the rate of ir:erest ought to be high because ofstrong liquidity preference but precisely during this period, the rate ofinterest is low. Likewise during boom conditions, the rate of interestought to be lower because of the weak liquidity preference among thepeople instead it is high.Hicks Theory of Trade CyclesIn his book "A Contribution to the Theory of the Trade Cycle," Hicks BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICShas developed a theory mainly by combining the principles of themultipiier and acceleration, which he has borrowed from Keynes andhas combined the concepts of autonomous and induced investment, adistinction originally made by Roy Harrod. The multiplier is related tothe autonomous investment of the Government. The accelerationprinciple is based on induced investment. The above Figure 6.6 shows the influence of the two types ofinvestment on the level of income and cyclical fluctuations. Thehorizontal axis represents the number of years and the vertical axisrepresents the level of economic activity. Line AA represents theprogress of autonomous investment over thc years and it slantsupward at a uniform rate to indicate that autonomous investmentgrows over time at a constant rate. Line EE represents the income (oroutput) corresponding to the aUlononious investment line AA·. EE ISat a higher level than AI" because it rerresents the eomhinedinnllellce of mllitiplkr flnd flccelerrllioll effects n.~ n resultor ,lulollOlllllUS illvestl:lellt (AA ), III fact, the distallce bC1WLCil A/lIlld EE will depend upon the combined inlluence of the multiplier andacceleration effects. Finally, line FF represents the level of fullemployment.The Process of Cyclical Fluctuation BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSSuppose the economy is at point P in the Figure 6,6 and at this .point,a certain invention is introduced. As a result, there is burst ofautonomous investment, which may be short-lived. But the inducedinvestment will push output and employment upward along the pathmarked PP1, away from the EE line. Th,e upward trend touches fullemployment ceiling at PI and cannot ~ise further. At the most, theexpansion can "creep along" the ceiling but only for a limited time.When the path has encountered the edling, it must bounce off from itand begin to move in a downward direction. According to Hicks, this downward swing is predictable. Theinitial burst of autonomous investment is short-lived and after a stagc,it will fall to the usual level. But the induced investment, which was theresult of the initial autonomous investment and the initial increase inoutput, would continue and push ahead on path PP1• But the inducedinvestment is not sufficient to support a growth of output along thepath FF but it is sufficient to support an output which expands alongthe equilibrium path EE, Output, therefore, will bounce back from FFtowards EE. The downward swing is gradual along the path P2RRI and rapid along P2RR2. At first, the downward swing may appear. to be gradual but, in practice, it will be rapid. The reason is that once the decline in output is initiated, it gathers momentum and tends to proceed at a fast rdte. Hicks give a monetary explanation to this phenomenon. As the downward movement starts, it becomes increasingly di fficult to sell goods and consequently the burden of fixed cost becomcs oppressive. Therefore, firm after firm becomes bankrupt and liquidity preference records a sudden and abrupt rise and reacts most adversely on credit situation. At [he same time the stringent conditions in the credit market, forces business activity to fall to the lowest ebb and thereby aggravate the situation. Thus, Hicks theory of trade cycles makes use of multiplier and acceleration principles, which are combined, to the fluctuations of autonomous and induced BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSinvestment. It is induced investment, which is finally rcsponsibleJorthe upward push and downward swing of output and income ofprices and employment.Schumpeters Innovations TheoryJoseph Schumpeter has propounded a trade cycle theory in terms ofinnovations. An innovation can be regarding new product or newmethod of production, such as new machinery, new method oforganisation of factors of production, opening of a new market forthe product and development of new source of raw materials. Inother words, an innovation is anything that is introduced by a firm oran industry to change the supply or demand conditions. Aninnovation may be sufficient to cause changes in expectations ofentrepreneurs and their economic and business calculations. Thesechanges may cause the cost of production to change rapidly andcontinuously and may shift the demand curve continuously in such amanner that the final stage . becomes indeterminate. Any innovation,thus, causes disequilibrium in the economic system, making itnecessary for the economic system to readjust itself at some newequilibrium position. Thus, Schumpeter explains the un-rhythmicmovements of an economy by reference to innovations.The Effect of InnovationsSuppose we start with an economy, which is functioning at fullemployment level. Suppose an innovation in the form of a newproduct has been introduced. The new industry will need to have newplant and equipment. Since the economy is already working at fullemployment level, the new plant and equipment required by the newindustry can be acquired only by withdrawing labour and otherresources from old industries. As a result of higher cost of factor ofproduction, the old industries will experience both an increase intheir cost of production as well as j~crease in their output. Thepromoters of the new product will have to attract all f(!ctors ofproduction by offering higher rewarqs and the necessary finance BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSmay ,:i: me out of additional bank loans. Since the factors ofproduction, both in the new ;tld the old industries, are getting highermoney remuneration therefore, they will ,~( nand more goods andservices and consequently will push up prices, Thus,ill <::IS<:Uucmanu [or anu the simultaneous decreased supply of the old goodswill ~ It:"h upward the prices of these goods. However, it is notnecessary that the in case in the demand alld costs of all industriesshould nec~ssarily be equal. The i l_: industries, whose demand forproducts rises more rapidly than production ~ lHS, will reap abnormalprofits and consequently will expand, To the extent the l (1,1involved in such expansion is financed by hank credit therefore. the id1:qi"":1r III":nlll "11 Irk"l <111.1 ,1;1.1 i .. : Illtgllilkd.The Process of Rising PricesWhen the new product introduced in the mark~, becomescommercially successful and brings in profit for promoters, the rivalcompeting firms quickly introduce similar products and imitations.The production of many competing varieties of products sets inmotion expansion in many related industries. Therefore, resulting intoa period of cumulative prosperity.The Process of Falling PricesThe deflationary effect follows when the novelty of the innovation islost with the production of so many competing varieties or brands ofthe S3me product. Abnormal profits are competed away. Some of thefirms may even incur losses and close down their businesses, thuslayoff labour and other agents of production. Therrfore, the demandfor goods is reduced. A similar deflationary effect is experienced whcnthe innovating firms return their bank loans out of their profits andthus reduce the volume of money supply in the economy. The "viciouscircle of deflation" is generated in this manner.CriticismFirst, Schumpeters theory is based upon two assumptions regarding BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSfull employments of rfsources in the economic system and financingof innovation by means of bank loans. If an economy is working belowfull employment, the introduction of an innovation need not causediversion of factors of production from older industries and thuscause prices of goods to go up or their supply to iecline. Again,innovation is generally financed by the promoter themselves andhence, resort to bank .finance does not arise at all. Secondly,innovation.s may be regarded as one cause for business fluctuationsbut not the only cause, as there are many other causes also. As Hayekcorrectly points out, innovations alone cannot explain thephenomenon of trade cycles without a substantive monetaryexplanation. We have described man; theories of business cycles andthere are many morc. Therefore, none of the theories provides acomplete explanation of the causes of trade cycles. The reason for thisis that the trade cycle is not the result of anyone single factor but isdue to multiplicity of factors, of which sometimes one and sometimesanother becomes dominant.Control of Trade CyclesThc trade cycle, which implies fluctuations in business activity, is notbeneficial to allY seetioll of a community. The period of expansion isaccompanied by large profits to producers and speculators but itbrings loss to lixcd income groups. The period of depression is one ofacute unemployment, poverty, suffering and misery to the poor and ofdistress to the busin(;ss dass(;s as a .result of exlensive hlltlk lIlIdfirms failures. Thus all sections of people in a country, especially theworking classes, are interested in preventing and avoid ing busihesscycles .. On/ of the 1110st important objectives of economic policy isthe elimination of cyclical fluctuations and attainment of stability atthe level of full employment. This has been, in fact, the main objectiveof both monetary and fiscal policies. We have already explained theuse of monetary policy and fiscal policy as well as direct control, tocheck inflations and deflations. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS There is no full proof method for solving the problem of trade cycles.Karl Marx considered trade cycles as inevitable in a capitalist systemand the only rational method to solve the problem was to throw itoverboard and introduce a socialist economy. Like every business firmprepares its annual balance sheet of transactions with a view to knowits assets and liabilities, every nation carrying out economictransactions with foreign countries prepares its Balance of Payment(BOP) Accounts periodically with a view to know stock of its assets andliabilities and its receipts from and payments to the rest of the world.THE BALANCE OF PAYMENTDefinitionThe balance of paYlllent is defined as a systematic record of alleconomic transactions between the residents of a country andreside~ts of foreign countries during a certain period of time.Although the above definition of balance of payments is quiterevealing certain terms used in the definition may require someclarification. The terms systematic record does not refer to anyparticular system. However, the system generally adopted is doubleentry book-keeping system. Economic transactions include all suchtransactions that involve the transfer of title or ownership. While sometransactions involve physical transfer of goods, services, assets andmoney along with the transfer of tille while other transactions do notinvolve transfer of title. For example, suppose that a subsidiarycompany of a foreign undertaking is operating in India and makingprofit. This company may pay all its profits as dividend to theshareholders abroad, or it may, alterilatively reinvest its profit in Indiainstead of paying dividends to its parent company abroad. Both kindsof transactions arc recorded in the balance of payments accounts. ThetrnnsllI 01 titk is important thlln lht: physi,l:lllrlnstl~r orrCSlHlr:cs. The term residcnts rcfcr to the nationals of thc rcportingcountry, Tourists. diplllllllt~;, IIlililmy Icr:lllllllcl, 11llIlHlmry "lid BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSllligrnllll) IVllrllI,~ 111111 Iii, "n,,"·I,,n of foreign companiesoperating in the reporting clHllltr) do not rail in till category orresidents, Thc timc period for balance of payments is not speci ficallydelincd. it can be of any period, The generally period is one financialyear of calendar.PurposeThe balance of payment serves a very useful purpose as it yieldsnecessary information for the future policy formulation in regard todomestic monetary and fiscal pulicies and foreign trade policy. Following are the important uses of balance of payments: It provides useful data for the economic analysis of countrys weakness and strength as a partner in the international trade. By comparing the statements contained in the balance of payments for several successive years, one can find out whether international economic position of the country is improving or deteriorating. In case it is deteriorating, necessary corrective measures can be taken. It reveals the changes in the composition and magnitude of foreign trade. The changes that curb ~conomic well-being of a country are taken care by the government. It also pwvides indications of future repercussions based on countries past trade performances. I f balance of payments shows continuous and large deficits over time then it indicates growing international indebtedness, which ultimately leads to financial bankruptcy. Similarly. a continuous large-scalc surplus in the balance of payments, particularly wht:n its magnitude goes beyond the absorption capacity of the country indicates impending dangers of inflation. Detailed balance of payments accounts also reveal weak and strong points in the countrys foreign trade rdationsund thereby BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS invite gove.-I1ll1cnt attention to the need for corrective measures against the weak spots.Balance of Payments AccountsThe economic transactions between a country and the rest oCtheworld may be grouped under two broad categories: 1. Current transactions: Current transactions pertain to export and import of goods and services that change the current level of consumption in the country or bring a change in the current level of national income. 2. Capital transactions: Capital transactions arc those transactions, which increase or decrease counlrys Iota I stock of capital, instead of affecting the current level of consumption or national income. In other words, current transactions arc flow transactions. In accordance with the two kinds of transactions, balance of payments account is divided into two major accounts: A. Current account B. Capital accountsCurrent AccountThe items, which are entered in the current account of balance ofpayments, are listed in the Table. 6.4 -in the order of their importance.The categories of items presented in the table were published by theIMf and are currently followed in India. In the credit column valuesreceivable are entered and in debt column values payable ar.e entered.The net balance shows the excess of credit over the debit for eachitem, can be negative (-) or positive (+). The items listed in currentaccount can be further grouped into visible and invisible items.Merchandise trade, i.e:, export and imports of goods, fall under thevisible items. Rest all other items in the current account-payment andreceipt for the services, such as banking, insurance and shipping aretermed as invisible. Sometimes another category, i.e., un-requiredtransfer, is created to give a separate treatment to the items like gifts, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdonations, military aid, and technical assistance. These are differentfrom other invisible items since they involve unilateral transfers. The net balance on the visible items, i.e., the excess ofmerchandise exports (Xg) over the merchandise imports (Mg) is calledas balance of trade. If Xg < Mg it is unfavourable. The overall balanceon the Current Account is known as Balance on Current Account. TheBalance on the Current Account either surplus or deficit is carriedover to the Capital Account. . Table 6.4: Balance of Pa}ments Current Account Transactions Credit Debit Net Balance I. Merchandise Export. Import - 2. Foreign travel Earnings Payments - 3. Transportation Earnings Payments - 4. Insurance Receipts Payments - (premium) 5. Investment Dividend Dividends - Income 6. Government Receipts Payments - Cr;:rchase and sales of goods and services) 7. Miscellaneous* Receipts Payments - Current Account - Payments Surplus (+) Balance Deficit (-) * Includes motion picture royalties, telephones and telegraph services, consultancy fees, etc.Capital AccountAs mentioned earlier, the items entered in the capital account ofbalance of payments are those items, which affect the existing stock ofcapital of the country. The broad categories of capital account itemsare: (a) short-term capital movements; (b) long-term capitalmovements; and (c) changes in the gold and exchange reserves.Short-term capital movements include (i) purchase of short¬term BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSsecurities such as treasury. bills, commercial bills and acceptance bills,etc.; (ii) speculative purchase of foreign currency; and (iii) cashbalances held by foreigners for suchfeasons as fear of war and politicalinstability. An item of short-term capital results often from the netbalances (positive or negative) in the Cljrrent Account. Long-termcapital movements include: (i) direct investment in shares, bonds, realestate and physical assets such as plant, building and equipments, inwhich investors hold a controlling power; (ii) portfolio investmentsincluding all other stocks and bonds such as government securities,securities of firms which do not entitle the holder with a controllingpower; and (iii) amortisation of capital, i.e., repurchase and resale ofsecurities carlier sold to or purchased from the foreigners. Directexport or import of capital goods fall under the category of directinvestment. It should be noted that export of capital is a debit itemwhereas export of merchandise is a credit item. Export of goods resultin inflow of foreign currency, which is an addition to the circular flowof money income, whereas export of capital results in outflow offoreign exchange which, amounts to withdrawal from the foreignexchange reserves. Geld and foreign exchange reserves make the thirdmajor category of items in the capital account. Gofd and foreignexchange reserves are maintained to stabilise the exchange rate of thehome currency and to make payments to the creditors in case thereexists payment deficits on all other accounts.Balance of Payments is always in BalancesThe balance of payments accounting is based on the double-entrybook-keeping system in which both sides of a transaction, i.e.,receipts and payments are recorded. For example, exports involveouttlow of goods and inflow of foreign currency. Similarly, imports involve inflo of goods and outflow of foreign currency. Both, inflowand outflow are recorded in this system. International borrowing andlending give rise to credit to the lender and debit to the borrower.Both are recorded in the balance of paymcnts. However, donations,gifts, aids and assistance are unilateral transfers and do not involve BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICStransfer of an equivalent value. In regard to these items, there is onlycredit and no debit since they are non¬refundable. Yet, the receivingcountry is debited to keep the record of non¬refundable amounts anddonator is credited for the record purposes. Such entries haveinformation value for non-economic purposes. Besides, thesetransactions reduce the deficit in the current account of the reportingcountry. Since in this system of balance of payments accountinginternational transactions are entered on both debit and credit sides.Balance of payments always balances from the accounting point ofview.Disequilibrium in Balance of PaymentsWe have noted above that the balance-of payments is always inbalances from accounting point of view. Besides, in the accountingprocedure, a deficit in the current account is offset by a surplus incapital account resulting from either borrowing from abroad orrunning down the gold and foreign exchange reserves. Similarly, a surplus in the current account is 011set by 1Imlltdling Jllicit in capital account resulting from loans llnd gills todebtor country or by dcpklion (), its gold and foreign exchangereserves. In this sense also. lhe 11,lIallce (!I JlllYIJl!:lltS 1IlwlI)srcnlllills In hllllllll:C:. As :.udl. tbert slllluid hc 1I11 qUC.Slll)11 11disequilibrium in the balance of payments. However, disequilibriumin lhe balall!:l: of payments does arise because total receipts duringthe reference pl:riod need 1I0t be necessarily equal to the totalpayments. When total receipts do not m<lleh with total payment ofthe accounting period, this is a position of disequilibrium in thebalance of payments. The final balance of payments position isobtained in the manner described below. For assessing the over-all balance of payments position, the totalreceipt and total payments arising out of transfer of goods andservices and long-run capital movements are taken into account. Allthe transactions are regrouped into autonomous and induced BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICStransactions. Autonomous transactions take place on their own allaccount of peoples desire to consumc morl: or to makc a larger profit.For example, export and imports of items in current account areundcrtaken with a view to, make profit or consume more goods.Another autonomous item in the current account is gift or donations.They are voluntary and deliberate. In the capital account, export andimport of long-term capital are autonomous transactions. In addition,the short-term capital movements motivated by the desireto invest abroad for higher return fall in the category of autonomoustransactions. Thus. all exports and imports of goods and services,long-term and short-term capital movements motivated by the desireto earn higher returns abroad or to givegi fts and donation are the autonomous transactions. Exports andimports take place irrespective of other trans~ctions included in thebalance of payments accounts. !-!ence, these are autonomoustransactions. If exports (Xg) equal imports (Mg) in value, there will beno other transaction. However, if Xg is less than Mg, it leadsto short-run capital movements, e.g., international borrowing orlending. Such international borrowings or lending are not undertakenfor their own sake, but for making payment for the deficit in thebalance of trade. Hence, these are called induced transactions. Theyinvolve accommodating capital flows. On the other hand, the short-term capital movemcnts viz., goldmovemenls it and accommodating capital movements on accounts ofthc autonomous transactions are induced transactions. Thesetransactions lead to reduction in the <, gold and foreign exchangereserves of the country.In the assessment of balance of payments position only autonomoustransactions are taken into account. The total receipt and paymentsresulting from the autonomous transaction determine the deficit orsurplus in the balance of payments. I f total receipts and payments arcunequal, the balance of payments is in disequilibrium. I I the totalpayments exceed the lotal receipts, the balance or payment shows BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdeficit. On the contrary, if receipts from autonomous transactionsexceed the payments for autonomous transactions, the balance ofpayments is in surplus. Naturally, if both are equal, there is neitherdeficit nor surplus, and the balance of payments is i~1 equilibrium.From the policy point of view, the depletion in the gold and foreignexchange reserves is generally taken as an indicator of balance ofpayments running into deficit, which is a matter of concern for thegovernment. However, if reserves are plentiful and the governmenthas adopted a deliberate policy to run it down, then the deficit in thebalance of payments is not an in he?lthy sign for the economy. Besides,the disequilibrium of surplus nature except the one that might causeinf1ation is not a serious matter as the disequilibrium of deficit nature.We will be therefore, concerned here mainly with the deficit kind ofdisequilibrium in the balance of payments.Causes and Kinds of BOP DisequilibriumThe deficit kind of disequilibrium in the balance of payments ariseswhen a countrys autonomous payments exceed its autonomousreceipts. The autonomous payments arise out of imports of goods andservices and export of capital. Similarly, autonomous receipts resultfrom the merchandise exports and import of capital. It may thereforebe said that disequilibrium of deficit nature arises when total importsexceed total exports. However, imports and exports do not determinethemselves. The volume and value of imports and exports aredetermined by a host of other factors. As regards the determinants ofimports, the total import of country depends upon three factor: (i)internal demand for foreign goods, which largely depends on the totalpurchasing power of the residents of the importing country, (ii) theprices of imports and their domestic substitutes, and (iii) peoplespreference for foreign goods. Similarly, the total export of a countrydepends on (i) foreign demand for its goods and services, (ii)competitiveness of its price and quality, and (iii) exportable surplus. Under static conditions, these factors remain constant. Therefore,equilibrium in the balance of payments, once achieved, remains stable. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSHowever, under dynamic conditions, factors that determine importsand exports keep changing, sometimes gradually but often violentlyand unexpectedly. The changes differ in their duration and intensityfrom country to country and from time to time. The changes, whichoccur as a result of disturbances ,in the domestic economy and abroad,create conditions for dis-equilibrium in the balance of payment.Causes of Disequilibrium and the Associated Nature ofImbalances Price Changes and Disequilibrium: The first and the major cause of dis¬equilibrium in the balance of payment is the change in the price level. Price changes may be inflationary or deflationary. Deflation normally causes surplus in the balance of payment. The balance of payments surplus does no! cause a serious concern from the countrys point of view. It may, however lead to wasteful expenditure and mal-allocation of resources. On he C1ther hand, inflrtionary changes in prices causes deficits in the balance of payments. The balance of payments deficit result in increased indebtedness, depletion of gold reserves. loss of employment. and disfort:ons in the domestic economy and causes other economic problems in the deficit countries. Therefore, we will discuss only the impact of inflationary price changes on the balance of payments position. Inflation causes a change in the relative prices of imports and exports. While exchange rate remains same, inflation causes increase in imports because domestic prices become relatively higher than the impo;L prices. On the other hand, inflation leads to decrease in exports because of decrease in foreign demand due to increase in domestic prices. The increase in imports depends also 011 price-elasticity of demand for imports in the home market and decrease in the exports depends on the price-elasticity of foreign demand for home-products. In case price-elasticity of imports and exports is not equal to zero, BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSimports are bound to exceed the exports. As a result, there willbe a deficit in the balance of payments. If inflationary conditionsperpetuate, it will produce long-run disequilibrium. If the size ofdeficit is large and disequilibrium is inflexible, it is termed as afundamental disequjJibrium. The price changes or fluctuationsmay be local, confined to one or few countries or it may beglobal as it happened in the ec:(/y 1930s. If price fluctuationstake the form of business cycle, most countries face depressionand inflation almost simultaneously. Since economic size of thenations differs, their imports are affected in varying degrees.Deficits and surpluses in the balance of payment vary frommoderate to large. The countries with higher marginalpropensity to import accumulate larger deficits duringinflationary phase of trade cycle and a moderate deficit or evensurplus, during depression. Such disequilibrium is known as;;cyclical disequilibrium. This is however only a theoreticalpossibility. Since little is known about the marginal propensitiesto import, any generalisation would be unwise.Structural Changes and Dis-equilihriull1: Structural changes, inaneconomy arc caused by factors, such liS, (i) depletion orthecheap natural resources (ii) change in technology with which acountry is 110t in a position to keep pace, i.e., technology lagand, (iii) change ill consulllers !lIsle IInd preference. Suchchanges incapacitate exporting countries and they lind itdifficult ,10 face competition in the intnnational market, duetoeither high cost of production or lack of foreign demand. Toquote the examples from P.T. ,Ellsworth the gradual exhaustionof better coal in Great Britain resulted in increased cost of coalproduction despi!e improvement in technology. This factorcombined with labour problem converted Great Britain from anet coal-exporting nation to a net-importing one.All such changes bring change in demand and supply conditions. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS If size of foreign trade is fairly large, then the balance of payments is adversely affected. The ultimate result is disequilibrium in the balance of paym~nts. It is called structural disequilibrium. The structural disequilibrium may also originate from thc discovery of new resources, which may invite foreign capital in a large measure. The large-scale capital inflow may turn th~ balance of payments deficit into a surplus. Other Factors: In addition to the fundamental factors responsible for disequilibrium in the balance of payments, there are certain other factors, which may cause temporal disequilibrium, Some of them are as follows: Disturbances or crop failure particularly in the countries, producing primary goods, for examplc, India. Rapid growth in population leading to large-scale imports of food materials. Ambitious developmen! projects requiring heavy imports of technology, equipmenCs,machinery and technical know-how. Demonstration-effect of advanced countries on the consumption patternof less developed countries.Balance of Payments AdjustmentsThe short-term and small deficits in the balance of payments are quitelikely to cmcrge in wide range of international transactions. Thesecleficits do not call for immediate corrective actions. More importantly,irregular short-term changes in the domestic economic policies with aview toremove the short-term deficit in the balance of payments maydo morc harms than good to the economy. Since these changes causedislocations in the process of reallocation of resources and short-Icrm lluctUlItiolls in the cconomy, Therefore, short-term del1dts ofsnHllkr magnitude :lrc ,not II Ill:ltler or serious COlleCIll Ior thepolicy-nlllkers. 11()rn·l. const:lllt delicil or 1:l1p.(1 111:1p"llillllkh:,,~ n wide 1:1111<1 or IClII(lInie nlld 11Itlili.nl implil:alions, i BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSconstant delicil indicates country turning inlo an ltlIIIII h(IIII ,( ordepiction of its lim:ign exchange lint! gold resnves. These countrieslos~ tillir international liquidity and credibility. This situation oftenleads to compromiSe with economic and political independence ofthese countries. India faced a similar situation in July 1990. Therefore,a country facing constant large deficits in ih balance of payments isforced to adopt corrective measures, such as changes in its internaleconomic policies for wiping out the deficits, or at leasl to bring it l(l•• manageable size. It is a widely accepted view that the conditionsfor an automatic corrcctive mcchanism visualised under gold standard,bascd on international price¬mechanism do not exist. Therefore, thegovernment has no option but to intervene . ~ with the marketconditions of demand and supply with the policy measures available (0them. It should be borne in mind that policy-mix in this regard mayvary from country to country and from time to time depending on theprevailing economic conditions.Measures used to Correct Deficits in Balance of PaymentsThe various measures used to correct deficits in balance ofpayments are as follows: Indirect measures to correct adverse BOP: Under free trade system, the deficits in the balance of payments arise either due to greater aggregate domestic demand for goods and services than the total domestic supply of goods and services or domestic prices are significantly higher than the foreign prices. Thus, the deficit may be removed either by increasing domestic production at an internationally comparable cost of production or by reducing excess demand orby using the two methods simultaneously. It may be very difficult to increase the output in the short-run, specially when a country is close to full-employment or when there ~re other limiting factors to its industrial growth. Thcrcforl.:, thl.: only way to rcducl.: ddicil is I to reduce the demand for foreign goods. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS Income and Expenditure Policies: Here we discuss how reduction in . income can lead to reduction in demand and how it helps reducing the deficit in the balance of payments. The t.vo policy tools to change disposable income are monetary llnd fiscal policies. Monetary policy operates on the demand for and supply of money while fiscal policy operates on the disppsable income of the people. The working and efficacy on these policies as i,nstruments of solving balance of payment problem is described below.Monetary PolicyThe instruments of mon~tary policy include discount 01" bank ratepolicy, open market operations, statutory reserve ratios and selectivecredit controls. Of these, first two instruments are adopted in thecontext of balance of payment policy. This however should not meanthat other instruments are not relevant. The government is free tochoose any or all of these instruments amI adopt them simultttneously. To solve the problem of deficit in the balance of payments, a tightmaney policy or dear money.p6Iicy is ,idoptl:d. Under dear moneypolicy, central Ilwlll:lary Clulil()ritics raise "[ilc discount rate.Consequently, under nonna1 conditions, the demand for institutionalfunds for investment decreases. With the fall in investment andthrough its multiplier effect, income of the people decreases. lflnarginal propensity to consume is greater than zero, demand forgoods and services decreases. The decrease in demand also implies asimultaneous decrease in imports while other things remain same.This is how a tight money policy corrects deficit in balance ofpayments. The effcacy of tig:,t money policy is however doubtful underfollowing conditions: (i) when rates of returns are much higher thanthe increased bank rate due to inflationary conditions, (ii) wheninvestors have already affected their investment in anticipation ofincrease in the rate of interest. The tight money policy is then BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScombined with open market operation, i.e., sale of government bondsand securities. These two instruments together help to reduce demandfor capital and other goods. Therefore, if all goes well then the deficitin the balance of payments is bound to decrease.Fiscal PolicyFiscal policy as a tool of income regulation includes vanatlon intaxation and public expenditure. Taxation reduces householddisposable income. Direct taxes directly transfer the houseilOldincome to the public reserves while indirectlaxes serve the samepurpose through increased prices of the taxed commodities. Directtaxes reduce personal savings directly in a greater amount whileindirect taxe~ do it in a relatively smaller amount. Taxation reducesthe disposable income ofthe household and thereby the aggregatedemand including the demand for imports. Taxation also helps tocurtail investment by taxing capital at progressive rates. The g~veinmeht can reduce income and demand also by adoptingthe policy of surplus budgding in which the government keeps itsexpenditure less than its revenue. Ll~:>tion reduces disposableincome of household and public expenditure increases householdsincome and their purchasing power. However, multiplier effect ofpublic expenditure is greater by one than the multiolier effect oftaxation. Therefore, while adopting surplus-budget policy dueconsideration should be given to this fact. To account for this fact, itis necessary that surplus is so largi.: that the total cumulative effectof taxati?n on disposable income exceeds the effect of publicexpenditure. The reduction in income that will be necessary toachieve a certain given target of reducinG balance of payments deficitdepends on the rate foreign trade multiplier. .Exchange Depreciation and DevaluationReducing excess demand through price measures involves changingrelative prices of imports and exports. Relati;e prices of imports andexports can be changed through exchange depreciation and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSdevaluation. Exchange depreciation refers to fall in the value of homecurrency in terms of foreign currency and devaluation refers to fall inthe value of home currency in terms of gold. However, ill terms ofpurchasing power, parity between devaluation and depreciation turnsout to be the same and its impact on foreign demand is also the same.Therefore, we shall consider them as one in their role of correctingadverse balance of payments. Devaluation and exchange depreciation change the relative pricesof imports and exports, i.e., import prices increase and export pricesdecrease, though not necessarily in the proportion of devaluation. Asa result of change in relative prices of exports and imports, thedemand for imports decreases in the country, which devalues itscurrency and foreign demand for its goods increases provided foreigndemand for imports is price elastic. Thus, if devaluation or exchangedepreciation is· effective, imports will decrease and exports willincrease. Countrys payments for imports would decrease and exportearnings would increase. This ultimately decreases the deficits in thebalance of payments in due course of time. However, whetherexpected results of devaluation or exchange depreciation areachieved or not depends on the following condition5. The most important condition in this regard is the Marshall-Lerner conditidh. The Marshall-Lerner condition states that devaluation will . improve the balance of payments only if the sum of elasticises of home demand for imports and foreign demand for exports is greater than unity. If (he sum of elasticises is less than unity, the balance of payments can be improved through revaluation instead of devaluation. Devaluation can be successful only if the alTectcd countries do nol devalue their currency in retaliation. Devaluation must not change the cost-price structure in favour of imports. Finally, the government ensures that inflation. which may be the result of deyaluation, is kept undcr control, so that the effect of BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS devaluatibn is not counter-balanced by the effect of inflation.Direct Measure: Exchange ControlThe exchange control refers to a set of restrictions imposed on theinternational transactions and payments, by the government or theexchange cotHrol authority. Exchange control may be partial, confinedto only few kinds of transactions or payments, or total covering allkinds of international transactions depending on the requirement ofthe country. The main features of a full-fledged exchange control system are as follows: The government acquires, through the legislative measures, a Complete domination over the foreign exchange transactions. The government monopolises the purchase and sale of foreign exchange. Law el iminates the sale and purchase of foreign exchange by the resid~nt individuals. Even holding foreign exchange without informing the exchange control authority ;s declared illegal. All payments to the foreigners and receipts from them are routed through the exchange control authority or the authorised agents. Foreign exchange payments arc restricted, generally, to the import of essential goods and service such as food items, raw materials, other essential industrial inputs like petroleum products. A system of rationing is adopted in the foreign exchange allocation for essential imports. To ensure the effectiveness of the exchange control system BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS and to prevent the possible evasion, strict, stringent laws like FERA and/COFEPOSA in India arc enactec. The circuitous legal procedure of acquiring import amI export licences is brought in force. In the process, the convertibility of the home-currency is sacri ficed.Why Exchange Control?The cxchange control systcm as a mcasurc of adjusting adversehalance 01 plIYlllcnl diffcrs IIldiclIlly (hllil lhe Indirect elHTtdilnllIISlIrl·S. Wllik till" 1"lkl works through the markct forccs, thefonncr works through a cOlllrol lIIechanism based on adhoc rulesand regulations. In contrast to the self-sustained and automaticfunctioning of the market system, the exchange control requires acumbersome bureaucratic system of checks and controls. Yet, manycountries facing balance of payment deficits opt for exchangecontrol for lack of options. In fact, automatic adjustment in thebalance of payments requires the existence 0 I thc followingconditions. International competitive strength of the deficit countries. A fairly high elasticity of demand for imports. Perfectly competitive international market mechanism. Absence of government intervention with the demand and supply conditions. . The existence of these conditions has always been doubted.Owing to differences in resource endowments technology, and thelevel of industrial growth, countries differ in their economic strengthand their industries lack the competitiveness. The protectionistpolicies adopted by various countries intervene with internationalmarket mechanism. Besides, automatic method of balance ofpayments adjustment requires a strict discipline, economic strength BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICSand political will to bear the destabilising shocks which theautomatic method is expected to bring to a country in the process ofadjustment. Since these conditions rarely exist, the efficacy ofinternational market mechUl1ism to bring automatic balance ofpayments adjustment is orten doubted.For these reasons, exchange control remains the last resort for thecountries under severe str<lin of balancc or payments dclicits. Thee:-:ch:llge contn)1 is qid to possess a superior effectiveness inproviding solutions to the deficit problem. Besides, it insulates aneconomy against thc impact of eeonOlnir. nlleluOItioliS i1 "~I foreigncountries. Another positive advantage or exchange control lies II lScfrcctivcness in dealing with the problem or capital movements. ThegovernlllCnlS I monopoly over the roreign exchange can eflectivelystop or reduce the eapit:li t"i movements by simply refusing to releaseforeign exchange for capital transrcr. Many countries, i.e., Germany,Denmark and Argentina, adopted exchange control during 1930sbecause of this advantage. Although the exchange control is positivelya superior method of dealing with disequilibrium in th~ balance ofpayments, it docs not pro -ide a perman<.:nt solution to the basic cau~es ofdeficit problem. Exchange control may no doubt provide solution to balance of paymentdeficits, but it also creates following problems: When restrictions on exchange control becomes wide spread then large number of currencies are rendered inconvertible. This restricts foreign trade and the gains from foreign 1rade are either lost or reduced to a minimum. Even after the interest of an economy is secured, i.e., external deficit is rCll1ov<.:d and insulation of e<.:onomy against external influence is complete; the exchange-control countries instead of giving up exchange control feel lITe to gear their int<.:rnal policks, monetary and fiscal, towards the promotion of economic growth, a<.:hieving full employment and its maintenance. In doing so, they adopt easy monetary and BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS promotional fiscal policies. Consequently, income and prices tend to rise, and inflationary trend is set in the economy. Price also tends to rise, since in an insulted economy, import-competing industries are not under compulsion to check cost increases and to improve efficiency. As a result, exports become relatively costlier and imports relatively cheaper and hence, exports tend to shrink and imports tend to expand. These are the first outcome of overvaluation of home-currency. The balance of payments is no doubt maintained in equilibrium, but the init.ial advantage gradually disappears. The countries confronted with the problems arising out of exchangecontrol ,IIC forced to find new outlets for their exports and new sources ofimports. The dTorts in this direction give rise to bilateral trade· agreementsbetween the countries having common interest. The basic feature of thebilateral trade ;Igreements is to accept each others inconvertible currency forexports and use the same Jor imports. Under the trade agreements, thecommodities and their quan~iltes or values should I also be specified.Another outcome of exchange contr leading to bilateral trade agreement is theemergence of disorderly cross cxcl ,anl,1.: r[lte~, i.e., the multiplicity ofinconsistent exchange rates. In other words, i .. IlIhl(;rii~)1<; currencies havedifferent exchange ratep betweeI: them. - l(inilleonvertible currency has different exchange relation with thecountries .. ~ p,ty to the bilateral trade agreement therefore, exchange ratesare not consis fent with each other. The multiplicity of inconsistent exchangerates occom;;;s inevitable when countries having trade surplus and deficits fixup official r;llts frnlll timc to time dq1lndin!-,- nn their requirelllents ,ll1d1ll,Iintain it through arbitrary rules. Exchange rates beconie multiple alsobecause exchange arbitrage, i.e., the simultaneous purchase and saleof exchange in di fferent markets, becomes impossible. Under the multiple exchange rate system, there may be a dualexchange rate policy. In dual exchange rate policy, there is an officialrate for permissible private transactions and official transactions and amarket rate for all other kinds of transactions. However, the multipleexchange rate system has its own shortcomings .. The system adds BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICScomplexity and uncertainty to international transactions. Besides, itrequires efficient and honest administrative machinery in the absenceof which it often leads to inefficient use of resources. It is, therefore,desirable for the deficit countries to first evaluate the consequence:>,efficacy and pract::ability of exchanre control and then decide on thecourse of action. It has been suggested that exchange control, ifadopted, should be moderate and as temporary measure until thebasic solution to the problems of balance of payments deficit isobtaired. The exchange control problem does not provide permanentsolution to the balance-of-payments deficit and therefore, it shouldbe adopted only with proper understanding.REVIEW QUESTIONS I. What is the relevance of national income statistics in business decisions? 2. What kinds of business decisions are influenced by the change in national income? 3. Describe the various methods of measuring national income. How is a method chosen for measurfng national income? 4. Distinguish between net-product method and factor-income method. Which of these methods is followed in India? 5. What is value-added? Explain the value-added method of estimating national income. 6. Define inflation. Explain its effect on (a) total output, and (b) distribution of income between, different economic classes. 7. What are the causes of price inflation? Is it inevitable in the course of economic developm.ent? 8. What is an inflationary gap? Explain methods used to close this gap. 9. Distinguish clearly between demand-pull, cost-push and sectoral infl~ltion. 10."Inflation is unjust and in~quitable and deflation is BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS inexpedient." Discuss this statement fully.11.What is meant by a trade cycle? Describe carefully the di fTcrcnt phuses of a trade cycle.12: Distinguish trade cycles from other economic fluctuations. What, in your opinion; is the most adequate explanation of a trade cycle?13.Describe the various phases of the trade cycle. What courses can the Government ~dopt to control a boom?14."T,he business cycle is purely a monetary phenomenon." ~iscuss.15.Discuss the view that innovations alone cannot explain the phenomenon of trade cycles without a substantial monetary explanation.16.Define balance of payments. If balances of payments always balance, how is the deficit or surplus in balance of payments known?17.What are the causes of different kinds of disequilibrium in the balance of payments? Suggest measure to correct an adverse balance of payments.18.What is the purpose of exchange control? Examine the efficacy of exchange control as a measure to correct adverse balance of payments.19.What is meant by devaluation? What are the conditions for its effectiveness as a corrective measure of un favourable balance of payments?20.What is the difference hetween balance of trade and balance of payment? BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS QUESTION PAPER Paper 1.3: MANAGIRIAL ECONOMICSTime: 3 Hours Max. Ma SECTION~A (5 x 8 = 40) Answer any Five questionsNote: All questions carry equal marks 1. What is Managerial Ecor.omics? How does it differ from traditional ece 2. Give short note on "Demand Analysis". 3. Explain the relationship between marginal cost, average cost, and tot 4. What are the main features of pure competition? How does an organisatil its policies to a purely competitive situation? 5. Distinguish between the Pure Profit and opportunity Cost. 6. What is meant by Price discrimination? What are its objectives? 7. What is the difference between balance of trade and balance ofpaymCi 8. What is value-added? Explain the value-added method of estimating Income. BABASAB PATIL (BEC DOMS )
    • MANAGERIAL ECONOMICS SECTION -B (4 x 15 = 60) Answer any Four questions 9. Discuss some of the important economic concepts and techniques busines~. management.10.What are the advantages and limitations of large-scale production, II. Distinguish between Production function and Cost filllc{ion, I iow dcvclop tllC production fUllction? Whlltun: its uscs!.12.Explain the first and second order conditions of profit maximization13.Explain the effects of government interve.ntion in price fixation. WI necessary to make this intervention effective?14."The Business Cycle is purely a monetary, phenomenon." Discuss.15.Define Inflation. Explain its effect on (a) Total output (b) Distribution of income between, different economic classes. BABASAB PATIL BABASAB PATIL (BEC DOMS )