UNIT I NATURE AND FUNDAMENTAL CONCEPTS AND BASIS TECHNIQUES OF MANAGERIAL ECONOMICS

WHY DO THE MANAGERS NEED TO KNOW ECONOMICS? Economics contributes a great deal towards the performance of managerial duties and responsibilities. Like biology contributes to medical profession and physics to engineering, economics contributes to managerial profession. All other things remaining the same, managers with working knowledge of economics can perform their functions more efficiently than those without it. The basic function of the managers of a business firm is to achieve the objective of the firm to the maximum possible extent with the limited resources placed at their disposal. The emphasis here is on the maximisation of the objective and limitedness of the resources. Had the resources been unlimited, like sunshine and air, the problem of economizing on resources or resource management would have never arisen. But the resources, howsoever defined, are limited Resources at the disposal of a firm, be it finance, men or material, are by all means limited. Therefore, the basic task of the management is to optimize the use of the resource. Economics, though variously defined, is essentially the study of logic, tools and techniques of making optimum use of the available resources to achieve the given ends. Economics thus provides analytical tools and techniques that managers need to achieve the goals of the organisation they manage. Therefore, a working knowledge of economics, not necessarily a formal degree, is essential for the managers. Managers are essentially practicing economists.; How Does Economics Contribute to Managerial Functions? In performing his functions, a manager has to take a number of decisions in conformity with the goals of the firm. Many business decisions are taken under the condition of uncertainty and therefore involve risk. Uncertainty and risk arise mainly due to uncertain behaviour of the market forces, i.e., demand and supply, changing business environment, government policy, external influence on the domestic market, and social and political changes in the country. The complexity of the modern business world adds complexity to the business decision making. However, the degree of uncertainty and risk can be greatly reduced if market conditions could be predicted with a high degree of reliability. The prediction of future course of business environment alone is not sufficient. What is equally important is to take appropriate business decision and to formulate business strategy conforming to the goals of the firm. Taking appropriate business decisions requires a clear understanding of the technical and environmental conditions under which business decisions are taken. Application of economic theories to explain and analyse the technical conditions and the economic environment in which a business undertaking operates contributes a good deal to the rational decision-making. Economic theories have therefore gained a wide application to the analysis of practical problems of business. With the growing complexity of business environment, the usefulness of economic theory as a tool of analyses and its contribution to the process of decision-making has been widely recognised. Baumol has pointed out three main contributions of economic theory to business economics. First, 'one of the most important things which the economic (theories) can contribute to the management science' is building analytical models .which help in recognising the structure of managerial problems, eliminating the minor details which might obstruct decision-making, and in concentrating on the main issue. Secondly, economic theory contributes to the business analysis a set of analytical methods' which may not be directly applied to specific business problems but they do enhance the analytical capabilities of the business analyst. Thirdly, economic theories offer clarity to the various concepts used in business analysis, which enables the managers to avoid conceptual pitfalls. Definition of Managerial Economics Managerial economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial economics is thus constituted of that part of economic knowledge and economic theories which is used as a tool of analyzing business problems for rational business decisions. To quote Mansfield, "Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision" Look at another definition of managerial economics. "Managerial economics....is the integration of economic theory with

business practice for the purpose of facilitating decision-making and forward planning by management". Managerial economics is often called Business-Economics or Economics for Firms. BUSINESS DECISIONS AND ECONOMIC ANALYSIS Business decision-making is essentially a process of selecting the best out of alterative opportunities open to the firm. The process of decision-making comprises four main phases: i. Determining and defining the objective; ii. Collection of information regarding economic, social, political and technological environment and foreseeing the necessity and occasion for decision; iii. "Inventing, developing and analyzing possible course of action", and iv. 'Selecting a particular course of action', from the available alternatives. This process of decision-making is, however, not as simple as it appears to be. Steps (ii) and (iii) are crucial in business decision-making. These steps put managers' analytical ability to test and determine the appropriateness and validity of decisions in the modern business world. The modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient. Personal intelligence, intuition and business acumen of the decision makers need to be supplemented with quantitative analysis of business data on market conditions and business environment. It is in this area of decision-making that economic theories and tools of economic analysis contribute a great deal. For instance, suppose a firm plans to launch a new product. One method of deciding whether or not to launch the product is to obtain the services of business consultants or to seek expert opinion. If the matter has to be decided by the managers of the firm themselves, the two areas which they will need to investigate and analyse thoroughly are: (a) production related issues, and (b) sale prospects. In the field of production, managers will be required to collect and analyse data on: available techniques of production cost of production associated with different production technology supply position of inputs required to produce the planned commodity price structure of inputs cost structure of competitive products availability of foreign exchange if inputs are to be imported In order to assess the sales prospects, the managers will be required to collect and analyse data on: general market trends trends in the industry to which the planned products belongs major (expected) competitors and their market share prices of the competing products pricing strategy of the prospective competitors market structure and degree of competition supply position of complementary goods It is in this kind of market analysis that knowledge of economic theories and tools of economic analysis aid the process of decision-making in a significant way. Economic theories state the functional relationship between two or more economic variables, under certain given conditions. Application of relevant economic theories to the problems of business facilitates decision-making in three ways. Firstly, it helps clear understanding of various economic concepts (i.e., cost, price, demand, etc.) used in business analysis. For example 'cost' concept include 'total', 'average', 'marginal', 'fixed', 'variable', actual costs, and opportunity cost. Economics clarifies what cost concepts are relevant and in what context. Secondly, it helps in ascertaining the relevant variables and specifying the relevant data. For example it helps in deciding what variables need to be considered in estimating the demand for two different sources of energypetrol and electricity. Thirdly, economic theories state general relationship between two or more economic variables and events. The application of relevant economic theory provides consistency to business analysis and helps in arriving at right -conclusions. Thus application of economic theories to the problems of business not only guides, assists and streamlines the process of decision-making but also contributes a good deal to the validity of decision.

THE SCOPE OF MANAGERIAL ECONOMICS Economics is grouped under two broad categories: (i) Microeconomics, and (ii) Macroeconomics. Both micro and macro economics are applied to business analysis and decision-making directly or indirectly. Managerial economics comprises, therefore, both micro and macro economic theories. The parts of micro and macro economics that constitute managerial economics depend on the purpose of analysis. In general, the scope of managerial economics comprehends all those economic concepts, theories and tools of analysis which can be used to analyse the business environment and to find out solution to practical business problems. In other words, managerial economics is economics applied to the analysis of business problems and decision-making. Broadly speaking, it is applied economics. The areas of business issues to which economic theories can be directly applied may be broadly divided into two categories: (a) operational or internal issues; and (b) environmental or external issues. Microeconomics Applied to Operational Issues Operational problems are of internal nature. They include all those problems which arise within the business organisation, and fall within the purview and control of the management. Some of the basic internal issues are : (i) choice of commodity, i.e., what to produce; (ii) choice of size of the firm, i.e., how much to produce; (iii) choice of technology, i.e., choosing the factor-combination; (v) choice of price, i.e., how to price the commodity; (v) how to promote sales; (vi) how to face price competition; (vii) how to decide on new investments; (viii) how to manage profit and capital; (ix) how to manage inventory, i.e., stock of both finished goods and raw materials. These problems may also figure in forward planning. Microeconomics deals with these questions and alike confronted by the managers of the business enterprises. The microeconomic theories which deal with most of these questions are following: 1. Theory of demand. Demand theory explains the consumer's behaviour. It answers the questions: How do the consumers decide whether or not to buy a commodity? How do they decide on the quantity of a commodity to be purchased? When do they stop consuming a commodity? How do the consumers behave when price of the commodity, their income, and taste and fashions, etc., change? At what level of demand, changing price becomes inconsequential in terms of total revenue? The knowledge of demand theory can, therefore, be helpful in choice of commodities for production. 2. Theory of production. Production theory, also called "Theory of Firm," explains the relationship between inputs and output. It also explains under what conditions costs increase or decrease; how total output increases when units of one factor (input) are increased keeping other factors constant, or when all factors are simultaneously increased; to what extent one factor (say, labour) can substitute another, (say, capital); how optimum size of output is achieved. Production theory, thus, helps in determining the size of the firm, size of the total output and the factor proportion, i.e., the amount of capital and labour to be employed. 3. Theory of exchange or price theory. Price theory explains how prices are determined under different market conditions; when price discrimination is desirable, feasible and profitable; to what extent advertisement can be helpful in expanding the sale in a competitive market. Price theory, thus, can be helpful in determining price policy of the firm. Price and production theories together, in fact, help in determining optimum size of the firm. 4. Theory of profit. Profit making is the most common objective of the business undertakings. But, making a satisfactory profit is not always guaranteed because a firm has to carry out its activities under conditions of uncertainty in regard to: (i) demand for the product, (ii) input prices in the factor market, (iii) nature and degree of competition in the product market, and (iv) price behaviour under changing conditions in the product market, etc. Therefore, an element of risk is always there even if most efficient techniques are used for predicting future and even if business activities are meticulously planned. The firms are therefore supposed to safeguard their interest and avert, as far as possible, the possibilities of risk or minimise it. Profit theory guides in the measurement and management of profit, in making allowances for risk premium, in calculating the pure return on capital and pure profit and also in future profit planning. 5. Theory of capital and investment. Capital like all other inputs, is a scarce and an expensive factor. Capital is the foundation of the business. Its efficient allocation and management is one of the most important tasks of the managers. The major issues related to capital are: (i) choice of investment project, (ii) assessing the efficiency of capital, and (iii) most efficient allocation of capital. Knowledge of capital

theory can contribute a great deal in investment-decisions, choice of projects, maintaining capital intact, capital budgeting, etc. Macroeconomics Applied to Business Environment Environmental issues pertain to the general business environment in which a business operates. They are related to the overall economic, social and political atmosphere of the country. The factors which constitute economic environment of a country include the following factors. i. the type of economic system of the country, ii. general trends in production, employment, income, prices, saving and investment, etc., iii. structure of and trends in the working of financial institutions, e.g., banks, financial corporations, insurance companies, etc., iv. magnitude of and trends in foreign trade, v. trends in labour and capital markets, vi. government's economic policies, e.g., industrial policy, monetary policy, fiscal policy, price policy, etc., vii. social factors like value systems of the society, property rights, customs and habits, viii. social organisations like trade unions, consumers' cooperative and producers' union, and ix. social structure and class character of the various social groups. Political environment is constituted of such factors as political systemdemocratic, authoritarian, socialist, or otherwise, State's attitude towards private business, size and working of the public sector, and political stability It is far beyond the powers of the single business firm, howsoever large it may be, to determine and guide the course of economic, social and political factors of the nation, although all the firms together or at least giant business houses may jointly influence the eco-political environment of the country. For business community in general, however, the economic, social and political factors are to be treated as business parameters. The environmental factors have a far-reaching bearing upon the functioning and performance of the firms. Therefore, business decision-makers have to take into account the changing economic, political and social conditions in the country and give due consideration to the environmental factors in the process of decision-making. This is essential because business decisions taken in isolation of environmental factors may not only prove infructuous, but may also lead to heavy losses. For instance, a decision to set up a new alcohol manufacturing unit or to expand the existing ones, ignoring the impending prohibitiona political factorwould be suicidal for the firms a decision to expand the business beyond the paid-up capital permissible under Monopoly and Restrictive Trade Practices Act (MRTP Act) amounts to inviting legal shackle and hammer; a decision to employ a highly sophisticated, labour-saving technology ignoring the prevalence of mass open unemploymentan economic factor may prove to be self-defeating; a decision to expand the business on a large scale, in a society having a low per capita income and hence a low purchasing power stagnated over a long period may lead to wastage of resources. The managers of a firm are therefore supposed to be fully aware of the economic, social and political conditions prevailing in the country while taking decisions on the wider issues of the business. Managerial economics is, however, concerned with only economic environment, particularly with those economic factors which form the business climate. The "study of political and social factors fall out of the purview of managerial economics. It should, however, be borne in mind that economic, social and political behaviour of the people are interdependent and interactive. For example, growth of monopolistic tendency in the industrial sector of India led to the enactment of Monopoly and Restrictive Trade Practices Act (1961) which restricts the proliferation of large business houses. Similarly, various industrial policy resolutions formulated until 1990 in the light of socio-political ideology of the government restricted the scope and area of private business. Besides, governments' continuous effort to transfer resources from the private to the public sector with a view to setting up a 'socialist pattern of society' has restrained the expansion of private business in India. Some of the major areas in which politics influences economic affairs of the country are concentration of economic power, growth of monopoly, state of technology, existence of mass poverty and open unemployment, foreign trade, taxation policy, labour relations, distribution system of essential goods, etc. In this book, we shall be

concerned with only basic macroeconomics, business cycles, economic growth and economic factors, content and logic of some relevant state activities and policies which form the business environment. Macroeconomic Issues The major macro-economic or environmental issues which figure in the business decision-making, particularly in regard to forward planning, may be described under three categories. Firstly, there are issues that are related to the trends in macro variables, e.g., the general trend in the economic activities of the country, investment climate, trends in output and employment, and price trends. These factors not only determine the prospects of private business, but also greatly influence the functioning of individual firms. Therefore, a firm planning to set up a new unit or to expand its existing size would like to ask itself: What is the general trend in the economy? What would be the consumption pattern of the society? Will it be profitable to expand the business? Answer to these questions and alike are sought through the macroeconomic studies. Secondly, an economy is also affected by its trade relations with other countries, more so the sectors or firms dealing in exports and imports. Fluctuations in the international market, exchange rate, and inflows and outflows of capital in an open economy have a serious bearing on its economic environment and, thereby, on the functioning of its business undertakings. The managers of a firm would, therefore, be interested in knowing the trends in international trade, prices, exchange rates, and prospects in the international market. Answers to such problems are obtained through the study of international trade and international monetary mechanism. Lastly, the government policies designed to control and regulate the economic activities of the people affect the functioning of the private business undertakings. Besides, firms' activities as producer and their attempt to maximise their private gains or profits lead to considerable social costs, in terms of environmental pollution, congestion in the cities, creation of slums, etc. Such social costs not only bring firm's interest in conflict with that of the society, but also impose a social responsibility on the firms. The government policies and its various regulatory measures are designed, by and large, to minimise such conflicts. The managers should be therefore fully aware of the aspirations of the people and give such factors a due consideration in their decisions. The economic concepts and tools of analysis help in determining such costs and benefits. Concluding Remarks. Economic theories, both micro and macro, have wide application to the business decision-making! Some of the major theories which are widely applied to business analysis have been mentioned above. But it should always be borne in mind that economic theories, models and tools of analysis do not offer readymade answers to the practical problems of individual firms. They provide only logic and methods to .find answers, not the answers as such. It depends on the managers' own understanding, experience and intelligence and training as to how to use the tools of economic analysis to find a correct answer to the practical problems of business. Briefly speaking, microeconomic theories including theory of demand, theory of production, theory of price determination, theory of profit and capital budgeting, and macroeconomic theories including theory of national income, theory of economic growth and fluctuations, international trade and monetary mechanism, and the study of state policies and their repercussions on the private business activities constitute, by and large, the scope of managerial economics. This should however not mean that only these economic theories form the subject-matter of managerial economics. Nor does the knowledge of these theories fulfill wholly the requirement of economic logic in decision making. An overall study of economics and a wider understanding of economic behaviour of the society, individuals, firms, and state would always be desirable and more helpful. ANALYSIS OF INDIVIDUAL DEMAND The objectives of business firms can be various. Objectives of business firms may be different but their basic business activity is the same. They all produce and sell goods and services that are in demand. Demand is, in fact, the basis of all productive activities. Like 'necessity is the mother of invention', demand is the mother of production. It is, therefore, essential for the business managers to have a clear understanding of the following aspects of the demand for their products: i. What are the sources of demand? ii. What are the determinants of demand? iii. How do the buyers decide the quantity of a product to be purchased?

How do the buyers respond to the change in a product prices, their income and prices of the related goods? v. How can the total or market demand for a product be assessed and forecast? These questions are answered by the Theory of Demand. In this and the following chapters we will discuss the theory of individual and market demand. MEANING OF DEMAND Conceptually, the term 'demand' implies a 'desire' for a commodity backed by ability and willingness to pay for it. Unless a person has an adequate purchasing power or resources and the preparedness to spend his resources, his desire for a commodity would not be considered as his demand. For example, if a man wants to buy a car but he does not have sufficient money to pay for, his want is not his demand for the car. And, if a rich miser man wants to buy a car but is not willing to pay, his desire too is not his demand for a car. But, if a man has sufficient money and is willing to pay, his desire to buy a car is an effective demand. The desires without adequate purchasing power and willingness to pay do not affect the market, nor do they generate production activity. A want with three attributes desire to buy, willingness to pay and ability to pay-becomes effective demand. Only an effective demand figures in economic analysis and business decisions. The term 'demand' for a commodity (i.e., quantity demanded) has always a reference to 'a price', 'a period of time' and 'a place'. Any statement regarding the demand for a commodity without reference to its price, time of purchase and place is meaningless and is of no practical use. For instance, to say 'demand for TV sets is 50,000' carries no meaning for a business decision, nor it has any use in any kind of economic analysis. A meaningful statement regarding the demand for a commodity should therefore contain the information regarding (i) quantity demanded; (ii) price of the commodity; (iii) time unit of demand; and (z) place of demand. To say that 'the annual demand for TV sets in Delhi at Rs. 20,000 a piece is 50,000' is a meaningful statement. THE UTILITY: THE BASIS OF CONSUMER DEMAND Meaning of Utility Utility is the power or property of a commodity to satisfy human needs. People pay for a commodity for its want-satisfying quality. The want-satisfying property of a commodity is 'subjective', not 'objective'. That is, whether a commodity is useful for a person or not depends on whether he or she feels the need for that commodity. For a consumer, post-consumption utility is psychic satisfaction or a feeling of well-being. Utility is often user-specific. A commodity need not be useful for all. For example, meat has no utility for strict vegetarians; cigarette has no utility for non-smokers, liquor has no utility for teetotalers, and so on. Besides, utility of a commodity varies from person to person and from time to time depending on the urgency or intensity of its need. Another important qualification of utility is that the concept of utility is 'ethically neutral' in the sense that it may satisfy a frivolous or socially immoral need, e.g., alcoholism, prostitution, drugs, etc. Total Utility Assuming that utility is measurable and additive, total utility may be defined as the sum of the utilities derived by a consumer from the various units of goods and services he consumes. Suppose a consumer consumes four units of a commodity, X, at a time and derives utility as u1, u2, u3 and u4. His total utility (TUx) will be : TUx = u1 + u2 + u3 + u4 If a consumer consumes n number of commodities, his TUn will be the sum of total utilities derived forms each commodity. For instance, if consumption goods are X, Y and Z and their total respective utilities are Ux, Uy and Uz, then TUn = Ux + Uy + Uz Marginal Utility Marginal utility may be defined in a number of ways. It is defined as the utility derived from the marginal unit consumed. It may also be defined as the addition to the total utility resulting from the consumption

iv.

(or accumulation) of one additional unit. Marginal Utility (MU) thus refers to the change in the Total Utility (ATU) obtained from the consumption of an additional unit of a commodity. It may be expressed as TU MU = Q where, TU total utility, and Q - change in quantity consumed by one unit. Another way of expressing marginal utility (MU), when number of units consumed is n, can be as follows : MU of with unit = TUn TUn-1 The Law of Diminishing Marginal Utility Table. Total and Marginal Utility Schedules No. of units consumed Total utility Marginal utility 1 30 30 2 50 20 3 60 10 4 65 5 5 60 -5 6 45 -15 The law of diminishing marginal utility states: as the quantity consumed of a commodity increases, the utility derived from each successive unit decreases, consumption of all other commodities remaining the same. In simple words, when a person consumes more and more units of a commodity per unit of time, keeping the consumption of all other commodities constant, the utility which he derives from the successive units of consumption goes on diminishing. This law applies to all kinds of consumer goodsdurable and non-durablesooner or later. Let us assume that utility is measurable in quantitative terms and illustrate the law of diminishing marginal utility. The law of diminishing marginal utility is illustrated numerically in Table. The law is illustrated graphically in Fig.
70 60 50

Utility TU & MU

40 30 20 10 0 -10 1 2 3 4 5 6 7

MU

Quality

As shown in Table with the increase in the number of units consumed per unit of time, the TU increases but at a diminishing rate. The diminishing MU is shown in the last column. Fig. illustrates the law of diminishing MU. The rate of increase in TU as the result of increase in the number of units consumed is shown by MU curve in Fig. The downward sloping MU curve shows that marginal utility goes on decreasing as the consumption increases. At 4 units consumed, the TU reaches its maximum level, the point of saturation, and MU becomes zero. Beyond this, MU becomes negative and TU begins to decline. The downward sloping MU curve illustrates the law of diminishing marginal utility. Why Does the MU Decrease?

The utility gained from a unit of a commodity depends on the intensity of the desire for it. When a person consumes successive units of a commodity, his need is satisfied by degrees in the process of consumption, and the intensity of his need goes on decreasing. Therefore, the utility obtained from each successive unit goes on decreasing. Assumptions The law of diminishing marginal utility holds only under certain conditions. These conditions are referred to as the assumptions of the law. They are listed below. First, the unit of the consumer goods must be a standard, one, e.g., a cup of tea, a bottle of cold drink, a pair of shoes or trousers, etc. If the units are excessively small or large, the law may not hold. Second, consumer's taste or preference must remain the same during the period of consumption. Third, there must be continuity in consumption. Where break in continuity is necessary, the time interval between the consumption of two units must be appropriately short. Fourth, mental condition of the consumer must remain normal during the period of consumption. Given these conditions, the law of diminishing marginal utility holds universally. In some cases, e.g., accumulation of money, collection of hobby items like stamps, old coins, rare paintings and books, melodious songs, the marginal utility may initially increase rather than decrease. But it does eventually decrease. As such, the law of marginal utility generally operates universally. THE LAW OF DEMAND The law of demand is one of the fundamental laws of economics. The law of demand states that the demand for a commodity increases when its price decreases and it falls when its price rises, other things remaining constant. This is an empirical law, i.e., this law is based on observed facts and can be verified with new empirical data. As the law reveals, there is an inverse relationship between the price and quantity demanded. The law holds under the condition that "other things remain constant". "Other things" include other determinants of demand, viz., consumers' income, price of the substitutes and complements, taste and preferences of the consumer, etc. These factors remain constant only in the short run. In the long run they tend to change. The law of demand, therefore, holds only in the short run. The law of demand is based on the law of diminishing marginal utility. It can be illustrated through a demand schedule, a demand curve and a demand function. In this section, we explain the law of demand through the demand schedule and demand curve. The law of demand is explained through the demand function. Demand Schedule. The law of demand can be presented through a demand schedule. Demand Schedule is a series of prices placed in descending (or ascending) order and the corresponding quantities which consumers would like to buy per unit of time. A hypothetical demand schedule for a commodity, tea, is given in Table. Table. Demand Schedule for Tea Price per cup of No. of cups of tea Points representing tea (Rs.) demand by a price-quantity consumer per day combination 1 1 i 6 2 i 5 3 k 4 4 I 3 5 m 2 6 n 1 7 0 Table presents seven alternative prices of tea and the corresponding quantities (number of cups of tea) demanded per day. At each price, a unique quantity is demanded. As the table shows, as price of tea per cup decreases, daily demand for tea increases. This relationship between quantity demanded of a product and its price is the basis of the law of demand. The Demand Curve The law of demand can also be presented through a demand curve. A demand curve is a locus of points showing various alternative price-quantity combinations. Demand curve shows the quantities of a commodity which a consumer would buy at different prices per unit of time, under the assumption of the law of demand. By plotting the data given in Table we obtain an individual demand curve for tea, as

shown in Fig. The curve DD' is the demand curve. It reads the law of demand. Each point on the demand curve shows one unique price-quantity combination. The combinations read downward along the demand curve show decreasing price of tea and increasing number of cups of tea demanded. Pricequantity combinations read upwards show increasing price of tea per cup and decreasing number of cups of tea per day consumed by an individual. Thus, the demand curve shows a functional relationship between the alternative prices of a commodity and its corresponding quantities which consumer would like to buy during a specific period of time, say, per day, per week, per month, per season, or per year.

D 7 6 k i j

Price per cup (Rs.)

5 4 3 2 1 1 2 3 4 5 6 7 l m n o D

Cups of tea demanded per day Factors behind the Law of Demand: As Fig shows, demand curve slopes downward to the right. The downward slope of the demand curve depicts the law of demand, i.e., the quantity of a commodity demanded per unit of time increases as its price falls, and vice verse. The factors that make the law of demand operate are following. Substitution Effect When price of a commodity falls, prices of all other related goods (particularly of substitutes) remaining constant, the goods of latter category become relatively costlier. Or, in other words, the commodity whose price has fallen becomes relatively cheaper. Since utility maximising consumers substitute cheaper goods for costlier ones, demand for the cheaper commodity increases. The increase in demand on account of this factor is known a substitution effect. Income Effect As a result of fall in the price of a commodity, the real income of the consumer increases. Consequently, his purchasing power increases since he is required to pay less for the same quantity. The increase in real income encourages the consumer to demand more of goods and services. The increase in demand on account of increase in real income is known as income effect. It should however be noted that the income effect is negative in case of inferior goods. In case the price of an inferior good accounting for a considerable proportion of the total consumption expenditure falls substantially, consumers' real income increases and they become relatively richer. Consequently, they substitute the superior goods for the inferior ones. As a result, the consumption of inferior goods falls. Thus, the income effect on the demand for inferior goods becomes negative. Utility-Maximising Behavior The utility-maximising behavior of the consumer under the condition of diminishing marginal utility is also responsible for increase in demand for a commodity when its price falls. As mentioned above, when a person buys a commodity, he exchanges his money income for the commodity in order to maximise his satisfaction. He continues to buy goods and services so long as marginal utility of his money (MUm) is less than the marginal utility of the commodity (MU). Given the price of a commodity, the consumer adjusts his purchases so that MUm =Pc =MUc When price of the commodity falls, (MUm = Pc) < MUc, and equilibrium is disturbed. In order to regain his equilibrium, the consumer will have to reduce the MUc to the level of MUm. This he can done only by purchasing more of the commodity. Therefore, the consumer purchases the commodity till MUm - Pc = MUc. This is another reason why demand for a commodity increases when its price decreases.

Exceptions to the Law of Demand The law of demand does not apply to the following cases. (a) Expectations regarding further prices. When consumers expect a continuous increase in the price of a durable commodity, they buy more of it despite increase in its price with a view to avoiding the pinch of a much higher price in future. For instance, in pre-budget months, prices generally tend to rise. Yet, people buy more of storable goods in anticipation of further rise in prices due to new levies. Similarly, when consumers anticipate a further fall in the falling prices in future, they postpone their purchases rather than buying more at the initial fall in the price. (b) Status Goods. The law does not apply to the commodities which are used as a 'status symbol', for enhancing social prestige or for displaying wealth and riches, e.g., gold, precious stones, rare paintings, antiques, etc. Rich people buy such goods mainly because their prices are high and buy more of them when their prices move up. (c) Giffen Goods. Another exception to the law of demand is the classic case of Giffen goods. A Giffen good maybe any inferior commodity much cheaper than its superior substitutes, consumed by the poor households as an essential commodity. If price of such goods increases (price of its substitute remaining constant), its demand increases instead of decreasing because, in case of a Giffen good, income effect of a price rise is greater than its substitution effect. The reason is, when price of an inferior good increases, income remaining the same, poor people cut the consumption of the superior substitute so that they may buy more of the inferior good in order to meet their basic need. For instance, let us suppose that the monthly minimum consumption of foodgrains by a poor household is 20 kgs of bajra (an inferior good) and 10 kg of wheat (a superior good). Suppose also that bajra sells at Rs. 5 per kg and wheat at Rs. 10 per kg and that the household spends its total income of Rs. 200 on these items. Now, if price of bajra increases to Rs. 6 per kg, the household will be forced to reduce the consumption of wheat by 5 kgs3 and increase that of bajra by the same quantity in order to meet its minimum monthly consumption requirement, his expenditure on foodgrains remaining the same. The consumer substitutes bajra for wheat because he can in no other way meet his basic needs. Obviously, household's demand for bajra increases from 20 kgs to 25 kgs per month despite increase in its price. SHIFT IN DEMAND CURVE When demand curve changes its position (retaining its shape though not necessarily), the change is known as shift in demand curve. Consider, for instance, the demand curves viz. D1, D2 and D3 in Fig. Let us suppose that demand curve D2 is the original demand curve for commodity X. As shown in the figure, at price OP2, consumer buys OQ2 units of X, other factors remaining constant. But, if any of the other factor (e.g., consumer's income or price of the substitutes) changes, it will change the consumer's ability and willingness to buy commodity X. For example, if consumer's disposable income decreases due to increase in income tax, he may be able to buy only OQ1 units of X instead of OQ2 This is true for the whole range of prices of X; consumers would be able to buy less at all other prices. This will cause a downward shift in demand curve D2 to D1. Similarly, increase in disposable income of the consumer due to, say, reduction in taxes may cause an upward shift in D2 to Dr Such changes in the location of demand curves are known as shift in demand curve. Reasons for Shift in Demand Curve Shifts in a price-demand curve may take place owing to the change in one or more determinants of the demand for a commodity. Consider, for example, the decrease in demand for commodity X by Q1Q2 in above Fig. Given the price OP2, the demand for X might have fallen from OQ2 to OQ1 (i.e., by Q1 O2) for any of the following reasons. i. Fall in consumer's income so that he can buy only OQ1 of X at price OP2; it is income effect; ii. Price of Xs substitute falls so that the consumers find it worthwhile to substitute Q1Q2 of X with its substitute; it is substitution effect; iii. Advertisement made by the producer of the substitute, changes consumer's taste or preference against commodity X so much that they replace Q1Q2 of it with , its substitute, again a substitution effect ; iv. Price of complement of X has increased so much that the consumer can now afford only OQ1 of X; and

Price remaining the same, demand for X might also decrease for such reasons as X going out of fashion, deterioration in its quality, change in consumer's technology and seasonality of the product. It is important for the business decision makers to bear in mind the distinction between changes in demand due to (i) shift in price-demand curve; and (b) movement along the demand curve. For instance, in Fig. the increase in quantity demanded from OQ1 to OQ2 can be explained in two different ways: one, by moving down from point A to C along the demand curve D1 which results from a fall in price from P2 to P1; and two, through upward shift in demand curve from D1 to D2. In the former case, additional demand is obtained at the cost of some revenue. In the latter case, demand increases due to shift in the demand curve on account of some other factors, such as increase in consumer's income, increase in the price of the substitutes, increase in population etc. This kind of increase in demand results in increase in revenue. However, in case demand curve is made to shift through advertisement or other sales promotion devices, the additional demand is not free of cost. Moreover, it is the latter kind of increase in demand which is hoped for and attempted by the business firms. Increase and Decrease Vs Extension and Contractions of Demand Economists sometimes distinguish between: a) increase and decrease in demand, and b) extension and contraction in demand Increase and decrease in demand are associated with non-price-quantity relationships of demand whereas extension and contraction of demand are associated with price-quantity relationship of demand. For example, in Fig. movement from point A to B is increase in demand and movement from B to A is decrease in demand. On the other hand, movement from A to C is extension of demand and movement from C to A is contraction of demand. In other words, movement along the demand curve implies extension or contraction of demand. This kind of distinction between changes in demand caused by different factors is, however, a matter of terminological convenience. It has no theoretical basis. THE MEANING AND NATURE OF INDIFFERENCE CURVE An indifference curve may be defined as the locus of points, each representing a different combination of two substitute goods, which yield the same utility or level of satisfaction to the consumer. Therefore he is indifferent between any two combinations of goods when it comes to making a choice between them. A consumer is very often confronted with such combinations in real life. Such actuation arises because he consumes a large number of goods and services, and often finds that one commodity can be substituted for another. It gives him an opportunity to substitute one commodity for another, if need arises, and to make various combinations of two substitutable goods which give him the same level of satisfaction. If a consumer is faced with such combinations, he would be indifferent between the combinations. When such combinations are plotted graphically, the resulting curve is known as indifference curve. Indifference curve is also called Iso-utility curve or Equal utility curve. For example, let us suppose that a consumer makes five combinationsa, b, c, d, and eof two commodities, X and F, as presented in Table. All these combinations yield him the same level of satisfaction. Table. Indifference Schedule of Commodities x and y Combination Units of + Units of Total Utility Commodity Y Commodity X a = 25 + 5 = U b = 15 + 7 = U c = 10 + 12 = U d = 6 + 20 = U e = 4 + 30 = U Table is an indifference schedulea schedule of various combinations of two good, between which a consumer is indifferent. The last column of the table shows an undefined utility (U) derived from each combination of X and Y. The combinations a, b, c, d, and e given in Table are plotted and joined by a smooth curve (as shown in Fig. 3.6). The resulting curve is known as indifference curve. On this curve,

v.

one can locate many other points showing many different combinations of X and Y which yield the same satisfaction. Therefore, the consumer is indifferent between the combinations which may be located on the indifference curve. Indifference Map We have drawn a single indifference curve in Fig. 3.6 on the basis of an indifference schedule given in Table. The combinations of the two commodities, X and F, given in the indifference schedule or those indicated by the indifference curve are by no means the only combinations of the two commodities. The consumer may make many other combinations with less of one or both of the goodseach combination yielding the same level of satisfaction but less than the level of satisfaction indicated by the indifference curve IC in following Fig. As such, an indifference curve below the one given in Fig. can be drawn, say, through points f, g and h. Similarly, he may make many other combinations with more of one or both the goodseach combination yielding the same satisfaction but greater than the satisfaction indicated by IC. Thus, another indifference curve can be drawn above IC, say, through points j, k and l. This exercise may be repeated as many times as one wants, each time generating a new indifference curve. In fact, the area between X and Y axes is known as indifference plane or commodity space. This plane is full of finite points and each point on the plane indicates a different combination of goods X and Y. Intuitively, it is always possible to locate any two or more points indicating different combinations of goods X and Y yielding the same satisfaction. It is thus possible to draw a number of indifference curves without intersecting or touching the other, as shown in Fig. The set of indifference curves IC1, IC2, IC3, and IC4 drawn in this manner make the indifference map. In fact, an indifference map may contain any number of indifference curves, ranked in the order of consumer's preferences. The Marginal Rate of Substitution (MRS) An indifference curve is formed by substituting one good for another. The MRS is the rate at which one commodity can be substituted for another, the level of satisfaction remaining the same. The MRS between two commodities, Z and Y, may be defined as the quantity of which is required to replace one unit of Y (or quantity of F required to replace one unit of X), in the combination of the two goods so that the total utility remains the same. It implies that the utility of X (or Y) given up is equal to the utility of additional units of Y (or X). The MRS is expressed as Y/ X. The Diminishing MRS The basic postulate of ordinal utility theory is that MRSyx (or MRSxy) decreases. It' means that the quantity of a commodity that a consumer is willing to sacrifice for an additional unit of another goes one decreasing when he goes on substituting one commodity for another. The diminishing MRSxy obtained from combinations of X and Y given in above Table are presented in following Table. Table. The Diminishing MRS between Commodities X and Y Indifferenc Combinations Change in Y Change in X MRSy.x e Points Y+ X (- Y) ( X) ( Y/ X) a 25 + 5 b c d e 15 + 7 10 + 12 6 + 20 4 + 30 -10 -5 -4 -2 2 5 8 10 -5.0 -1.0 -0.5 -0.2

As Table shows, when the consumer moves from point a to b on his indifference curve he gives up 10 units of commodity Y and gets only 2 units of commodity X, so that - Y - 10 MRSy,x = = = -5 - X 2 As he moves down from point b to c, he loses 5 units of Y and gains 5 units of X, giving - Y - 5 MRSy,x = = = -1 - X 5

The MRSy,x goes on decreasing as the consumer moves further down along the indifference curve, from point c through d and e. The diminishing marginal rate of substitution causes the indifference curves to be convex to the origin. Why Does MRS Diminish? The MRS decreases along the IC-curve because, in most cases, no two goods are perfect substitutes for one another. In case they are perfect substitutes, the indifference curve will be a straight line with a negative slope and constant MRS. Since goods are not perfect substitutes, the subjective value attached to the additional quantity (i.e., subjective MU) of a commodity decreases fast in relation to the other commodity whose total quantity is decreasing. Therefore, when the quantity of one commodity (X) increases and that of other (F) decreases, the subjective MU of Y increases and that of X decreases. Therefore, it becomes increasingly difficult for the consumer to sacrifice more units of Y for one unit of X. But, if he is required to sacrifice additional units of Y, he will demand increasing units of X to maintain the level of his satisfaction. As a result, the MRS decreases. Furthermore, when the combination of two goods at a point on indifference curve is such that it includes a large quantity of one commodity (F) and a small quantity of the other commodity (X), then consumer's capacity to sacrifice Y is greater than to sacrifice X. Therefore, he can sacrifice a larger quantity of Y in favour of a smaller quantity of X. For example, at combination a (see the indifference schedule, Table), the total stock of Y is 25 units and that of X is 5 units. That is why the consumer is willing to sacrifice 5 units of F for 1 units of X (SeeTable). This is an observed behavioral rule that the consumer's willingness and capacity to sacrifice a commodity is greater when its stock is greater and it is lower when the stock of a commodity is smaller. These are the reasons why MRS between the two substitute goods decrease all along the indifference curve. PROPERTIES OF INDIFFERENCE CURVE Indifference curves have the following four basic properties: 1. Indifference curves have negative slope; 2. Indifference curves are convex to the origin; 3. Indifference curves do not intersect nor are they tangent to one another; 4. Upper indifference curves indicate a higher level of satisfaction. These properties of indifference curves, in fact, reveal consumer's behavior, his choices and preferences. They are therefore very important in the modern theory of consumer behavior. Let us now look into their implications. (1) Indifference Curves have a Negative Slope In the words of Hicks, "so long as each commodity has a positive marginal utility, the indifference curve must slope downward to the right." The negative slope of an indifference curve implies (a) that the two commodities can be substituted for each other; and (b) that if quantity of one commodity deceases quantity of the other commodity must increase so that the consumer stays at the same level of satisfaction. If the quantity of the other commodity does not increase simultaneously, the bundle of commodities will decrease as a result of decrease in the quantity of one commodity. And, a smaller bundle of goods is bound to yield a lower level of satisfaction. The consumer's satisfaction cannot remain the same if indifference curves have a positive slope (i.e.,Y/X > 0) or if slope is equal to infinity, (i.e.,Y/X = ). These situations are shown in Fig. through inconsistent indifference curves. Let us suppose that the consumer is initially at point e where he is deriving some utility from OQx of X and OQy of Y. If an indifference curve has a positive slope (i.e.,Y/X > 0 ), as shown by the line OB and curve JK, it implies that the consumer is equally satisfied with larger and smaller baskets of X and Y. For the

movement along the line and the curve means increase or decrease of both X and Fin the basket. For example, if consumer moves from point e to b, the combination of the two goods increases by ea (= bc) of X and ec (= ab) of Y. Unless MU of ea and ec are equal to zero, the level of satisfaction is bound to increase. On an indifference curve, the total utility remains the same. Therefore, line OB and curve JK cannot be indifference curve. Similarly, in case of a vertical indifference line, Qx, the movement from e to a means an increase in the quantity of Y by ea, while quantity of X remains the same, OQx. If MU of ea > 0, the total utility will increase. So is the case if an indifferences curve takes the shape of a horizontal line, like Qy C. (2) Indifference Curve is Convex to Origin Indifference curves are not only negatively sloped, but are also convex to origin. The convexity of the indifference curves implies two properties (i) that the two commodities are substitute for each other and (ii) that the marginal rate of substitution (MRS) between the two goods decreases as a consumer moves along an indifference curve. This characteristic of indifference curve is based on the postulate of diminishing marginal rate of substitution. The postulate states an observed fact that if a consumer substitutes one commodity (X) for another (Y), his willingness to sacrifice more units of Y for one additional unit of X decreases, as quantity of Y decreases. There are two reasons for this : (i) no two commodities are perfect substitutes for each other, and (ii) MU of a commodity increases as its quantity decreases and therefore more and more units of the other commodity is needed to keep the total utility constant. (3) Indifference Curves neither Intersect nor Be Tangent to Each Other If two indifference curves intersect or touch each other, it will mean-that two-equal combinations of two goods yield two different levels of satisfaction or that two different combinations-one being larger than the other-yield the same level of satisfaction. Such conditions are impossible if consumer's subjective valuation of a commodity is greater than zero. Besides, if two-indifference curves interest, it would mean negation of consistency or transitivity assumption in consumer's preferences. Let us now see what happens when two indifference curves, IC and IC, intersect each other at point A (Fig). Consider two other points-point B on indifference curve IC and C on indifference curve IC both being on a vertical line. Points A, B and C represent three different combinations of commodities X and Y. Let us call these combinations, respectively, as A, B, and C. Note that combination A is common to both the indifference curves. The intersection of the two 7C5 implies that in terms of utility, A=B A=C B=C But, if B = C, it would mean that, in terms of utility, ON of X + BN of Y = ON of X+CN of Y Since 'ON of X is common to both the sides, the above equation would mean that BN of Y = CN of Y But, as above Fig. shows, BN > CN. Therefore, combination B and C cannot be equal in terms of satisfaction. The intersection therefore violates the transitivity rule which is a logical necessity in indifference curve analysis. The same reasoning is applicable when two indifference curves are tangent with each other. (4) Upper Indifference Curves Represent a Higher Level of Satisfaction than the Lower Ones An indifference curve placed above and to the right of another represents a higher level of satisfaction than the lower one. In the following figure indifference curve IC2 is placed above the curve IC1. It represents therefore a higher level of satisfaction. The reason is that an upper indifference curve contains all along its length a larger

quantity of one or both the goods than the lower indifference curve. And a large quantity of a commodity is suppose to yield a greater satisfaction than the smaller quantity of it provided MU > 0 For example, consider the indifference curves 7C, and 7C2 in Fig. The vertical movement from point a on the lower indifference curve IC, to point b on the upper indifference curve 7C2, means increase in quantity of Y by ab, the quantity of X remaining the same-(OA). Similarly, horizontal movement from point a to d means a greater quantity (ad) of commodity X, quantity of /remaining the same (OY). The diagonal movement, i.e., from a to c, means larger quantities of both X and Y. Unless the utility of additional quantities of X and Y are equal to zero, these additional quantities will yield additional utility. Therefore, the level of satisfaction indicated by the upper indifference curve (IC2) would always be greater than that indicated by the lower indifference curve (IC1). ELASTICITIES OF DEMAND IMPORTANCE OF ELASTICITY CONCEPT We have earlier discussed the nature of relationship between demand and its determinants. From a managerial point of view, however, the knowledge of nature of relationship alone is not sufficient. What is more important is the extent of relationship or the degree of responsiveness of demand to the changes in its determinants, i.e., elasticity of demand. The concept of elasticity of demand plays a crucial role in business-decisions regarding maneuvering of prices with a view to making larger profits. For instance, when cost of production is increasing, the firm would want to pass rising cost on to the consumer by raising the price. Firms may decide to change the price even without change in cost of production. But whether this actionraising the price following the rise in cost or otherwisewill prove beneficial depends on (a) the price elasticity of demand for the products' i.e., how high or low is the proportionate change in its demand in response to a certain percentage change in its price; and (b) price-elasticity of demand for its substitute, because when the price of a product increases, the demand for its substitutes increases automatically even if their prices remains unchanged. Raising price will be beneficial only if (i) demand for a product is less elastic; and (ii) demand for its substitute is much less elastic. Although 'most businessmen intuitively are aware of the elasticity of demand of the goods they make use of precise estimates of elasticity of demand will add precision to the business decisions. In this section, we will discuss various methods of measuring elasticities of demand. The concepts of demand elasticities used in business decisions are: (i) Price-elasticity; (ii) Cross-elasticity; (iii) Incomeelasticity; and (iv) Advertisement elasticity, (v) Elasticity of price expectation. PRICE ELASTICITY OF DEMAND Price elasticity of demand is generally defined as the responsiveness or sensitiveness of demand for a commodity to the changes in its price. More precisely, elasticity of demand is the percentage changes in demand as a result of one per cent in the price of the commodity. A formal definition of price-elasticity of demand (ep) is given as Percentage change in quantity demanded ep = Percentage change in price A general formula for calculating coefficient of price-elasticity, derived from this definition of elasticity, is given as follows. Q P Q P ep = = Q P Q P Q P = Q Q where Q = original quantity demanded, P = original price, Q = change in quantity demanded, and AP = change in price. It is important to note here that, a minus sign () is generally inserted in the formula before the fraction with a view to making elasticity coefficient a non-negative value. The elasticity can be measured between two points on a demand curve (called are elasticity) or on a point (called point elasticity).

Arc Elasticity The measure of elasticity of demand between any two finite points on a demand curve is known as arc elasticity. For example, measure of elasticity between points j and k is the measure of arc elasticity. The movement from point j to k on the demand curve (>x) shows a fall in the price from Rs. 20 to Rs. 10 so that AP = 20 - 10 = 10. The fall in price increases demand from 43 units to 75 units so that AQ = 43 - 75 = -32. The elasticity between points j and k (moving from j to k) can be calculated by substituting these values into the elasticity formula as follows: Q P P Q (with minus Sign) -32 20 == 1.49 10 43 It means, a one per cent decrease in price of commodity X results into a 1.49 per cent increase in demand for it. Problem in using arc elasticity. The arc elasticity should be measured, interpreted and used carefully; otherwise it may lead to wrong decisions. Arc elasticity co-efficients differ between the same two finite points on a demand curve if direction of change in price is reserved. For instance, as estimated in Eq. (4.8), the elasticity between points j and k Moving from j to k- equals 1.49. It may be wrongly interpreted that the elasticity of demand for commodity X between points j and k equals 1.49 irrespective of direction of price change. But it is not true. A reverse movement in the price, i.e, the movement from point k to j implies a different elasticity co-efficient (0.43). Movement from point k to j gives P = 10, AP = 10 - 20 = -10, Q = 75, and AQ = 75 - 43 = 32. By substituting these values into the elasticity formula, we get 32 10 ep= . = 0.43 -10 75 The measure of elasticity co-efficient in Eq. (4.9) for the reverse movement in price is obviously different from one given by Eq. (4.8). Thus, the elasticity depends also on the direction of change in price. Therefore, while measuring price elasticity, the direction of price change should be carefully noted ep = Fig. Linear Demand Curve Some Modifications: Some modifications have been suggested in economic literature to resolve the problems associated with are elasticity. First, the problem arising due to the change in the direction of price change may be avoided by using the lower values of P and Q in the elasticity formula, so that, Q P1 ep= P Q1 where Pt = 10 (the lower one of the two prices) and Qt = 43 (the lower one of the two quantities). Thus, 32 10 ep= . = 0.74 43 10 43 This method is however devoid of logic as the choice of lower values of P and Q is arbitrary it is not in accordance with the rule of calculating percentage change. Second, another method suggested to resolve this problem is to use the average of upper and lower values of P and Q in fraction P/Q. In that case the formula is

Q ep= P Or Q1 Q2 ep= P1 P2 .

(P1 + P2 ) / 2 (Q1 ++ Q2 ) /2

(P1 +P2) /2 (Q1 + Q2 ) /2

Substituting the values from our example, we get, 43-75 ep= 20-10 (43 + 75) 12 = 0.81. This method has its own drawbacks as the elasticity co-efficient calculated through this formula, refers to the elasticity mid-way between P1 P2 and Q1 Q2. Elasticity co-efficient (0.81) is not applicable for the whole range of price-quantity combination at different points between j and k on the demand curve it gives only mean of the elasticities between the two points. Point Elasticity Point elasticity on linear demand curve. Point elasticity is another way to resolve the problem in measuring the elasticity. The concept of point elasticity is also useful in measuring the elasticity where change in price and quantity combinations is infmitesimally small. Point elasticity is the elasticity of demand at a finite point on a linear demand curve, e.g., at point P or B on the demand curve MN this is in contrast to the arc elasticity between points P and B. A movement form point B towards P implies change in price ( P) becoming smaller and smaller, such that point P is almost reached. Here the change in price is infinitesimally small. Measuring elasticity for an infinitesimally small change in price is the same as measuring elasticity at a point. The formula for measuring point elasticity is given below. P Q Point elasticity (ep) = Q P Q has been substituted for In the formula for arc elasticity. P P The derivative Q / P is reciprocal of the slope of the demand curve MN. Point elasticity is thus the product of price-quantity ratio (at a particular point on the demand curve) and reciprocal of the slope of the demand line. The reciprocal of the slope of the straight line QN MN at point P is geometrically given by so that PQ Note that Q = P PQ QN Q eq. 1.1 (20+10)/2

Note that at point P, price P = PQ and Q = OQ. By substituting these values in Eq. 1.1 We get

QN = OQ PQ OQ Given the numerical value for QN and OQ elasticity at point P can be easily obtained. We may compare here are elasticity and point elasticity at point j in fig. At point j, QN 108 - 43 ep= = = 1.51 OQ 43 Note that ep = 1.51 is different from different measures of arc elasticities (i.e., 1.49, 0.43, 0.74, 0.81). As we will see below, geometrically, QN/OQ = PN/PM. Therefore elasticity of demand at point P (see Fig. ), may be expressed as PN ep= PM Proof. The fact that ep = PN/PM can be proved as follows. Note that in Fig. there are three triangles MON, MRP and PQNand LMOM, LMRP and LPQN are right angles. Therefore, the other corresponding angles of the three triangles will always be equal and hence, MON, MRP and PQN are similar. According to geometrical properties of similar triangles, the ratio of any two sides of a triangle are always equal to the ratio of the corresponding sides of the other triangles. By this rule, between PQN and MRP, QN = RP PN PM Since RP = OQ, by substituting OQ for RP in the above equation, we get, QN = OQ PN PM It follows that QN = PN OQ PM It may thus be concluded that price elasticity of demand at point P (See Fig.) is given by PN ep= PM Point elasticity on a non-linear demand curve. The ratio D/ P in respect of a non-linear demand curve is different at each point. Therefore, the method used to measure point elasticity on a linear demand curve cannot be applied straightaway. A simple modification in technique is required. In order to measure point elasticity on a non-linear demand curve, the chosen point is first brought on a linear demand curve. This is done by drawing a tangent through the chosen point. For example, suppose we want to measure elasticity on a non-linear demand curve, DD (See Fig.) at point P. For this purpose, a tangent MN is drawn through point P. Since demand curve DD and the line MN pass through the same point (P), the slope of the demand curve and that of the line at this point is the same. Therefore, the elasticity of demand curve at point P will be equal to that of the line at this point. Elasticity of the line at point P can be measured as P P (ep) = Q P QN QN QN = . = OQ PQ OQ ep= .

PQ

QN

Geometrically, QN = PN OQ PM

It has been proved above

To conclude, the price elasticity of demand at any point on a linear demand curve is equal to the ratio of lower segment to the upper segments of the line i.e. Lower segment ep= Upper segment By this rule, at mid-point of a linear demand curve, ep = I, as shown at point P in following Fig. It follows that at any point to the left of point P, ep >1, and at any point to the right of point P, ep < 1. According to the above formula, at the extreme point N, ep = O, and at extreme point M, ep is undefined because division by zero is undefined. It must be noted here that these results are relevant between points M and N and that the elasticities at the extreme points M and N are, in effect, undefined. INCOME-ELASTICITY OF DEMAND Apart from the price of a product and its substitutes, consumer's income is another basic determinant of demand for a product. As noted earlier, the relationship between quantity demanded and income is of positive nature, unlike the negative pricedemand relationship. The demand for goods and services increases with increase in consumer's income and vice-versa. The responsiveness of demand to the changes in income is known as income-elasticity of demand. Income-elasticity of demand for a product, say X, (i.e., el) may be defined as: Xq/ Xq I Xq eI = = . I/I Xq I (where Xq = quantity of X demanded; I = disposable income; Xq = change in quantity of X demanded; and I - change in income). Obviously, the formula for measuring income-elasticity of demand is the same as for measuring the price-elasticity. The only change in the formula is that the variable 'income' (I) has been substituted for the variable 'price' (P). Here, income refers to the disposable income, i.e., income net of taxes. All other formulae for measuring price-elasticities may be adopted to measure the income-elasticities, keeping in mind the difference between them and the purpose of measuring income-elasticity. Unlike price-elasticity of demand, which is always negative, income-elasticity of demand is always positive because of a positive relationship between income and quantity demanded of a product. But there is an exception to this rule. Income-elasticity of demand for an inferior good is negative, because of inverse substitution effect. The demand for inferior goods decreases with increase in consumer's income and vise-versa. The reason is when income increases, consumers switch over to the consumption of superior commodities, i.e, they substitute superior goods for inferior ones. For instance, when income rises, people prefer to buy more of rice and wheat and less of inferior foodgrains; buy more of meat and less of potato, and travel more by plane and less by train. Nature of commodity and income-elasticity. For all normal goods, income-elasticity is positive though the degree of elasticity varies in accordance with the nature of commodities. Consumer goods of the three categories,, viz., necessities, comforts, and luxuries have different elasticities. The general pattern of income-elasticities of different kinds of goods for increase in income and their effect on sales are given in Table. Table. Income-Elasticities
Consumer goods 1. Essential goods 2. Comforts 3. Luxuries Co-efficient of income-elasticity Less than one (e. < 1) Almost equal to unity Greater than unity (e; > 1) Effect on Sale Less than proportionate change in sale Almost proportionate change in sale More than proportionate increase in sale

The income-elasticity of demand for different categories of goods may however vary from household to household and from time to time, depending on choice and preference of the consumers, levels of consumption and income, and their susceptibility to 'demonstration effect'. The other factor which may cause deviation from the general pattern of income-elasticities is the frequency of increase in income. If frequency of rise in income is high, income-elasticities will conform to the general pattern. Uses of Income-elasticity in Business Decisions. While price and cross elasticities are of greater significance in pricing of a product aimed at maximising the total revenue in the short period, income-elasticity of a product is of a greater significance in production planning and management in the long run, particularly during the period of business cycle. The concept of income-elasticity can be used in estimating future demand provided the rate of increase in income and income-elasticity of demand for the products are known. The knowledge of incomeelasticity can thus be useful in forecasting demand, when change in personal incomes is expected, other things remaining the same. It helps also in avoiding over-production or underproduction. In forecasting demand, however, only the relevant concept of income and data should be used. It is generally believed that the demand for goods and services increases with increase in GNP depending on the marginal propensity to consume. This may be true in ve context of aggregate national demand, but not necessarily for a particular product. It is quite likely that increase in GNP flows to a section of consumers who do not, or are not in a position to, consume the product in which a businessman is interested. For instance, if the major proportion of incremental GNP goes to those who can afford car, growth rate in GNP should not be used to calculate income-elasticity of demand for cycles. Therefore, the income of only a relevant class or income-group should be used. Similarly, where product is of regional nature, or if there is a regional division of market between the producers, the income-elasticity of only the relevant region should be used n forecasting the demand. The concept of income-elasticity may also be used to define the 'normal' and 'inferior' goods. The goods whose income-elasticity is positive for all levels of income are termed as "normal goods'. On the other hand, the goods whose income-elasticities are negative beyond a certain level of income are termed as 'inferior goods.' DEMAND FORECASTING Why demand forecasting? Demand forecasting is predicting future demand for a product. The information regarding future demand is essential for planning and scheduling production, purchase of raw materials, acquisition of finance and advertising. It is much more important where a large-scale production is being planned and production involves a long gestation period. The information regarding future demand is essential also for the existing firms for avoiding under or over-production. Most firms are, in fact, very often confronted with the question as to what would be the future demand for their product. For, they will have to acquire inputs and plan their production accordingly firms are hence required to estimate the future demand for their product. OtherwIse, their functioning will be shrouded with uncertainty and their objective may be defeated. This problem may not be of a serious nature for the small firms which supply a very small fraction of total demand and whose product caters to the short-term, seasonal demand or to demand of a routine nature. Their past experience and business skill may suffice for their purpose in planning and production. But, the firms working on a large scale find it extremely difficult to obtain a fairly accurate information regarding the future market demand.1 In some situations, it is very difficult to obtain information needed to make even short-term demand forecasts, and extremely difficult to make long-term forecasts or to determine how changes in specific demand variables like price, advertisement expenditure, credit terms, prices of competing products, etc., will affect demand. It is nevertheless indispensable for the large firms to have at least a rough estimate of the demand prospects For, demand forecast plays an important role in planning to acquire inputs, both men and material (raw material, and capital goods), organizing production, advertising the product, and in organizing sales channels These functions can hardly be performed satisfactorily in an atmosphere of uncertainty regarding demand prospects for the product. The prior knowledge of market-size becomes therefore an extremely important element of decision-making by the large-scale firms.

In this chapter, we will discuss the important methods of estimating and forecasting demand. The techniques of forecasting are many, but the choice of a suitable method is a matter of experience and expertise. To a large extent, it depends also on the nature of the data available for the purpose. In economic forecasting, classical methods use historical data in a rather rigorous statistical manner for making the future projections. There are also less formal methods where analyst's own judgement plays a greater part in picking, choosing and interpreting the available data than the statistical tools. TECHNIQUES OF FORECASTING DEMAND The various techniques of demand forecasting are listed in the chart on the next page. In this section, we have described demand forecasting methods and their limitations. SURVEY METHODS Survey-methods are generally used where purpose is to make short-run forecast of demand under this method, surveys are conducted to collect information about consumers' intentions and their future purchase plans. This method includes. (i) survey of potential consumers to elicit information on their intentions and plan; (ii) opinion polling of experts, i.e., opinion survey of market experts and sales representative, and through market studies and experiments, The following techniques are used to conduct the survey of consumers and experts. (i) Consumer Survey Methods The Consumer survey method of demand forecasting involves direct interview of the potential consumers. It may be in the form of: complete enumeration, sample survey, or end-use method. These consumer survey methods are used under different conditions and for different purposes. Their advantages and disadvantages are described below Direct Interview Method the most direct and simple way of assessing future demand for a product is to interview The-potential consumers or users and to ask them what quantity of the product they would be willing to buy at different prices over a given period, say, one year. This method is known as direct interview method. This method may cover almost all the potential consumers or only selected groups of consumers from different cities or parts of the area of consumer concentration. When all the consumers are interviewed, the method is known as complete enumeration survey or comprehensive interview method, and when only a few selected representative consumers are interviewed, it is known as sample survey method. In case of industrial inputs, interviews or postal inquiry of only end-users of a product may be required. Let us now describe these methods in detail. Complete Enumeration Method In this method, almost all potential users of the product are contacted and are asked about their future plan of purchasing the product in question The quantities indicated by the consumers are added together to obtain the probable demand for the product. For example, if only n out of m number of households in a city report the quantity (d) they are willing to purchase of a commodity, then total probable demand (Dp) may be calculated as Dp = d1 + d2 + d3 + ... + dn
n

= di
i=1

This method has certain limitations. it can be used successfully only in case of those products whose consumers are concentrated in a certain region or locality) In case of a widely dispersed market, this method may not be physically possible or may prove very costly in terms of both money and time Besides, the demand forecast through this method may not be reliable for many reasons : (f) consumer themselves may not be knowing their actual demand in future and hence may be unable or unwilling to answer the query (ii) even if they answer, their answer to hypothetical questions may be only

hypothetical, not real; (in) consumers' response may be biased according to their own expectations about the market conditions; and (iv) their plans may change with the change in factors not included in the questionnaire. Sample Survey Method Tinder this method, only a few potential consumers and users selected from the relevant market through a sampling method are survey method of survey may be direct interview or mailed questionnaire to the sample-consumer on the basis of the information obtained, the probable demand may be estimated through the following formula : HR Dp= (H.AD) HS were DP = probable demand forecast; H = census number of households from the relevant market; HS = number of households surveyed or sample households; HR= number of households reporting demand for the product; AD = average expected consumption by the reporting households (= total quantity reported to be consumed-by the reporting households number of households). This method is simpler, less costly, and less time-consuming than the comprehensive survey method this method is generally used to estimate short-term demand from business firms, government departments and agencies and also by the households who plan their future purchase Business firms, government departments, and such other organisations budget their expenditure at least for one year in advance. It is therefore possible for them to supply fairly reliable estimate of their future purchases. Even the households making annual or periodic budget of their expenditure can provide reliable information about then-purchases. pimple survey method is widely used to forecast demand this method, however, has ,some limitations similar to those of complete enumerations or exhaustive survey method The forecaster therefore should not attribute reliability to the forecast more than warranted besides, sample survey method can be used to verify the demand forecast made by using quantitative or statistical method Although some authors1 suggest that this method should bemused to supplement the quantitative method for forecasting rather than to replace it, this method can be gainfully used where market area is localized. Sample survey method can be of greater use in forecasting where quantification of variables (e.g., feelings, opinion, expectations, etc.) is not possible and where consumer's behaviour is subject to frequent changes. The End-Use Method The end-use method of demand forecasting has considerable amount of both theoretical and practical values\ Making forecasts by this method requires building up a schedule of probable aggregate demand for inputs in future by consuming industries and various sectors. In this method, technological, structural and other changes, which might influence the demand, are taken care of in the very process of estimation. This aspect of the end-use approach is of particular importance. The end-use method of demand forecasting consists of four distinct stages of estimation. In the first stage, it is necessary to identify and list all the possible users of the product in question this is a difficult process, but it is fundamental to this method of forecasting. Difficulty arises because published data on the end-users are rarely available. Dispatch records of the manufacture even if available, need not necessarily enumerate all the final uses. Records of the sales pattern by individual firms or establishments are difficult to be assembled. In several cases, the distribution of the products covers such a wide network and there are so many wholesale and retail agencies in the chain that it would be virtually impossible to organize and collect the data from all these sources so as to know all final enduses of the product. Where there is lack of data, the managers need to have a thorough knowledge of the product and its uses. Such knowledge comes generally with experience. Manager's own knowledge and experience needs to be supplemented by consultations and discussions with manufacturers or their association, traders, users, etc. Preparation of an exhaustive list of all possible end-uses is in any case a necessary step. Spite every effort made to trace all the end-uses, it is quite likely that some of the current uses of

the product are overlooked. In order to account for such lapses, it may be necessary at the final stage of estimation to provide some margin. A margin or allowance is also necessary to provide for possible new applications of the product in future. The second stage of this method involves fixing suitable technical 'norms' of Consumption of the product under study Norms have to be established for each and every end-use. Norms are usually expression physical terms either per unit of production of the complete product or in, some cases, per unit of investment, per capita, etc. Some times, the norms may have to be on value basis. But the valuebased norms should be avoided as far as possible because it might be rather difficult to specify later the types and sizes of the product in question if value norms are used. The establishment of norms is also a difficult process mainly due to lack of data. For collecting necessary data, questionnaire method is generally employed. The preparation of a suitable questionnaire is of vital importance in the end-use method, as all subsequent analysis has to flow mainly from the information collected through the questionnaires. Where estimating future demand is called for in great detail, such as by types and sizes of the concerned product, framing of the questionnaire requires a good knowledge of all the variations of the product. For a reliable forecast, it is necessary that response is total, if not, then as high as possible. Having established the technical norms of consumption for the different industries and other end-uses of the product, the third step is the application of the norms For this purpose, it is necessary to know the desired or targeted levels of output of the individual industries for the reference year and also the likely development in other economic activities which use the product and the likely output targets. Fourth and final stage in the end-use method is to aggregate the product or use-wise content of the item for which the demand is to be forecast `this aggregate result gives the estimate of demand for the product as a whole for the terminal year in question. By the very nature of the process of estimation described here, it is obvious that the end-use approach results in what may be termed as a "derived" demand. The end-use method has two exclusive advantages. First, it is possible to spell out the future demand for an industrial product in considerable detail by types and size. In other methods, the future demand can be estimated only at aggregate levels. This is because past data are seldom available in such details as to provide the types and sizes of the product demanded by the economy. Hence, projections made by using the past data, either by the trend method, regression techniques or by historical analogies produce only aggregate figures for the product in question. On the other hand, by probing into the present usepattern of consumption of the product, the end-use approach affords every opportunity to determine the types, categories and sizes likely to be demanded in future. Secondly, in forecasting demand by the end-use approach, it is possible to trace and pinpoint at any time in future as to where and why the actual consumption has deviated from the estimated demand. Besides, suitable revisions can also be made from time to time based on such examination. If projections are based on other methods, and if actual consumption falls below or rises above the estimated demand, all that one can say is that the economy has or has not picked up as anticipated. One cannot say exactly which use of the product has not picked up. In case of end-use method, one can. (ii) Opinion Poll Methods Opinion poll methods aim at collecting opinions of those who are supposed to possess knowledge of the market, e.g., sales representatives, sales executives, professional marketing experts and consultants. The opinion poll methods include (a) Expert-opinion method, (b) Delphi method, and (c) Market studies and experiments. (a) Expert-Opinion Method Firms having a good network of sales representatives can ask them to assess the .demand for the product in the areas; Regions, and cities they represent. Sales representatives, being in close touch with the consumers or users of the goods, are supposed to know the future purchase-plans of their customers, their reaction to the market changes and to the introduction .of a new product, and the demand for competing products. They are, therefore in a position to provide at last an approximate, if not accurate estimate of likely demand their region or area the estimates of demand thus nutmeat from

different regions are added up together .target the overall probable demand for a product Firms not having this facility, gather similar information about the demand for their products through the professional market experts or consultants.-who can, through their--experience and expertise, predict the future demand. This method is also known as opinion poll method. Although this method too i simple and inexpensive, it has its own limitations. First, estimates provided by the sales representatives or professional experts are reliable only to the extent of their skill to analyse the market and their experience. Second, demand estimates may involve the subjective judgement of the assessor, which may lead to over or under-estimation. Finally, the assessment of market demand is usually based on inadequate information available to the sales representatives since they have only a narrow view of the market/The factors of wider implication, such as change in GNP, availability of credit, future prospects of the industry, etc., fall outside their purview. (b) Delphi Method Delphi method of demand forecasting is an extension of the simple expert opinion poll method this. Method used to consolidate the divergent expert opinions and to arrive at a compromise estimate of future demand the process is simple. Under Delphi method, the experts are provided information on estimates of forecasts of other expert along with the underlying assumptions, 'the experts may revise estimates in the light of forecasts made by other experts. The consensus of experts about the forecasts constitutes the final forecast. It may be noted that the empirical studies conducted in the USA have shown that unstructured opinions of the experts is most widely used technique of forecast. This may appear a bit unusual in as much as this gives the impression that sophisticated techniques, e.g., simultaneous equations model and statistical methods, are not the techniques which are used most often. However, the unstructured opinions of the experts may conceal the fact that information used by experts in expressing their forecasts may be based on sophisticated techniques. The Delphi technique can be used for crosschecking the information on forecasts. (c) Market Studies and Experiments An alternative method of collecting necessary information regarding demand is to carry out market studies and experiments in consumer's behaviour under actual though. Controlled market conditions this method is known in common parlance as market experiment method under this method, firms first select some areas of the representative markets three or four cities having similar features, viz., population, income levels, cultural and social background, occupational distribution, choices and preferences of consumers. Then, they carry out market experiments by changing prices, advertisement expenditure, and other controllable variables in the demand function under the assumption that other things remain the same. The controlled variables may be changed over time either simultaneously in all the markets or in the selected markets.2 After such changes are introduced in the market, the consequent changes in the demand over a period of time (a week, a fortnight, or month) are recorded. On the basis of data collected, elasticity coefficients are computed. These coefficients are then used along with the variables of demand function to assess the demand for the product. Alternatively, market, experiments can be replaced by consumer clinic or controlled laboratory experiment. Under this method, consumers are given some money to buy in stipulated store goods with varying prices, packages, displays, etc. The experiment reveals the consumers' responsiveness to the changes made in prices, packages and displays, etc. Thus, the laboratory experiments also yield the same information as the field market experiments. But the former has an advantage over the latter because of greater control over extraneous factors and its somewhat lower cost. Limitations. The market experiment methods have certain serious limitations and disadvantages which reduce the reliability of the method considerably. First, experimental methods are very expensive. It cannot be afforded by small firms. Second, being a costly affair, experiments are usually carried out on a scale too small to permit generalization with a high degree of reliability. Third, experimental methods are based on short-term and controlled conditions which may not exist in an uncontrolled market. Hence the results may not be applicable to the uncontrollable long-term conditions of the market.

Fourth, changes in socio-economic conditions taking place during the field experiments, such as local strikes or lay-offs, advertising programme by competitors, political changes, natural calamities, may invalidate the results. Finally, "tinkering with price increases may cause a permanent loss of customers to competitive brands that might have been tried." Despite these limitations, however, market experiment method is often used to provide an alternative estimate of demand, and also "as a check on results obtained from statistical studies." Besides, this method generates elasticity co-efficients which are necessary for statistical analysis of demand relationships. An experiment of this kind was conducted by Simmons Mattress Company (US). It put on sale two types of identical mattressone with Simmons label and the other with an unknown name at the same price and then at different prices for determining the cross-elasticity. It was found that at the equal price, Simmons mattress sold 15 to 1; and at a price higher by 5 dollars it sold 8 to 1, and at a price higher by 25 per cent, it sold almost 1 to l.2 STATISTICAL METHODS In the foregoing sections, we have described survey and experimental methods of estimating demand for a product on the basis of information supplied by the consumers themselves and on-the-spot observation of consumer behavior in this section, we will explain statistical methods which utilize historical (time-series) and cross-section data for estimating long-term demand Statistical methods are considered to be superior techniques of demand estimation for the following reasons. I. The element of subjectivity in this method is minimum, II. Method of estimation is scientific III. Estimation is based on the theoretical relationship between the dependent and independent variables, IV. Estimates are relatively more reliable, and V. Estimation involves smaller cost. Statistical methods of demand projection include the following techniques. (1) Trend Projection Methods, (2) Barometric Methods, and (3) Econometric Method. Trend Projection Methods Trend projection method is a 'classical method of business forecasting. This method is essentially concerned with the study of movements of variables through time. The use of this method requires a long and reliable time-series data. The trend projection method is used under the assumption that the factors responsible the past trends in the variable to be projected (e.g., sales and demand) will continue to play their part in future in the same manner and to the same extent in magnitude and direction. This assumption may be quite justified in many cases. However, since cause-and-effect relationship is not revealed by this method, the projections made on the trend basis are considered by many as a mechanical or a 'naive' approach. Nevertheless, "There is nothing uncomplimentary in the adoption of such an approach. It merely represents one of the several means to obtain an insight of what the future may possibly be and whether or not the projections made using these means are to be considered as most appropriate will depend very much on the reliability of past data and on the judgement that is to be exercised in the ultimate analysis." In projecting demand for a product, the trend method is applied to time-series data on sales. Firms of a long standing may obtain time-series data on sales from their own sales department. New firms can obtain necessary data from the older firms belonging to the same industry. There are three techniques of trend projection on the basis of time-series data. (a) Graphical method, (b) Fitting trend equation or least square method, and (c) Box-Jenkins method. In order to explain these methods, let us suppose that a local bread manufacturing company wants to assess the demand for its product for the years 1995, 1996 and 1997. For this purpose, it uses timeseries data of its total sales over the past 10 years. Suppose its sales data are as given in Table. Time-Series Data on Sale of Bread

Year Sales of Bread ('000 tonnes) 1985 10 1986 12 1987 11 1988 15 1989 18 1990 14 1991 20 1992 18 1993 21 1994 25 Let us first use the graphical method and project demand for only one year, 1986. (a) Graphical Method Under this method, annual data on sales are plotted on a graph paper and a line is drawn through the plotted points. Then a free hand line is so drawn that the total distance between the line and the points is minimum. This is illustrated in by the dotted lines. The dotted line M is drawn through the mid-values of variations and line S is a straight trend line. The solid, fluctuating line shows the actual trend, while the dotted lines show the secular trend. By extending the trend lines (marked M and S), we can forecast an approximate sale of 26,200 tonnes in 1996. Although this .method is very simple and least expensive, the projections made through this method are not very reliable. The reason is that the extension of the trend line involves subjectivity and personal bias of the analyst. For example, an optimist may take a short-run view, i.e., since 1992, and extend the trend line beyond point P towards O, and predict a sale of 30,000 tonnes of bread in 1996. On the other hand, a conservative analyst may consider the fluctuating nature of sales data and expect the total sale in 1996 to remain the same as in 1994 as indicated by broken line PC. One may even predict a fall in the sale after 1994, if one overemphasises the fluctuating sales figures in one's judgement. This is indicated by the line PN. (b) Fitting Trend Equation: Least Square Method Fitting trend equation is a formal technique of projecting the trend in demand. Under this method, a trend line (or curve) is fitted to the time-series sales data with the aid of statistical techniques the form of the trend equation that can be fitted to the time-series Data is determined either by plotting the sales data (as shown in Fig. 5.1) or by trying different forms of trend equations for the best fit. When plotted, the time-series data may show various kinds of trends. We shall however discuss here only the common types of trend equations, viz., (i) linear, (ii) exponential, and (ii) quadratic. Linear trend When the time-series data reveal a rising trend in the sales, then a straight-line trend equation of the following from is fitted: S = a + bT Where S = annual sales, T = time (years), a and b are constants. The parameter b gives the measures of annual increase in sales. The co-efficient a and b are estimated by solving the following two equations based on the principle of least square: S = na + bT . (i) ST = a T + b T2 ....... (ii) The terms included in equations (/) and (ii) are calculated using sales data given in Table 5.1 and presented in Table

Estimation of Trend Equation Year Sales(s) T rST 1985 10 1 1 10 1986 12 2 4 24 1987 11 3 9 33 1988 15 4 16 60 1989 18 5 25 90 1990 14 6 36 84 1991 20 7 49 140 1992 18 8 64 144 1993 21 9 81 189 1994 25 10 100 250 n = 10 25 = 164 27/= 55 27* = 385 25r = 1024 By substituting numerical values in equations (i) and (ii), we get 164 = 10 a + 55 b ... (iii) 1024 = 55 a + 385 b ... (iv) By solving equations (iii) and (iv), we get the trend equation as S = 8.26 + 1.48T Having estimated the trend equation, it is quite easy to project the sales for 1995, 1996 and 1997 i.e., for the 11 th, 12th and the 13th year, respectively. Calculation procedure 5 given below. 1995 S95 = 8.26 + 1.48 (11) 24,540 tonnes 1996 1997 S96 S97 = 8.26 + 1.48 (12) = 8.26 + 1.48 (13) 26,020 tonnes 27,500 tonnes

Abnormal Years. Time-series data on sales may, more often than not, reveal abnormal years. An abnormal year is one in which sales are abnormally low or high. Such years create problem in fitting the trend equation and lead to under or over-statement of the projected sales. Abnormal years should therefore be carefully analysed and data be suitably adjusted. The abnormal years may be dealt with (z) by excluding the year from time-series data, (iii) by adjusting the sales figures of the year to the sales figures of the preceding and succeeding years, or (iii) by using a 'dummy' variable. Exponential trend When sales (or any dependent variable) have increased over the past years at an increasing rate or at a constant percentage rate, then the appropriate trend equation to be used is exponential trend equation of the following forms. (1) Y = aebT ...(5.2a) or its semi-logarithmic form log Y = log a + bT ...(5.2b) This form of trend equation is used when growth rate is constant. (2) Double-log trend of the form Y = aTb ...(5.3a) or its double logarithmic form log Y = log a + b log T ...(5.3/3) This form of trend equation is used when growth rate is increasing. (3) Polynomial trend of the form Y = a + bT+ cT2 ...(5.4) In these equations a, b and c are constants, y is sales, y is time and c = 2.718. Once the parameters of the equations are estimated, it becomes quite easy to forecast demand for the years to come. The trend method is quite popular in business forecasting because of its simplicity. It is simple because only time-series data on sales are required. The analyst is supposed to possess only working knowledge of statistics. Since data requirement of this method is limited, it is also inexpensive. Besides, trend method yields fairly reliable estimates of future course of demand. Limitations The trend method has, however, the following limitations.

The first limitation of this method arises out of its assumption that the past rate of change in the dependent variable will persist in future too. Therefore, the forecast based on this method may be considered to be reliable only for the period during which this assumption holds. Secondly, this method cannot be used for short-term estimates. It cannot be used also where trend is cyclical with sharp turning points of troughs and peaks. Thirdly, this method, unlike regression analysis, does not bring out the measure of relationship between dependent and independent variables. Hence, it does not yield the necessary information (e.g., price and income elasticity) which can be used for future policy formulations. The analyst should bear these limitations in mind while making the use of this method. (c) Box-Jenkins Method Box-Jenkins method1 of forecasting is used only for short term prediction .besides, this method is suitable for forecasting demand with only stationary .time-series sales data Stationary time-series is one which does not reveal a long-term trendily other words, Box-Jenkins technique can be used only in those cases in which time-series analysis depicts only monthly or seasonal variation or variations that recur with some degree of regularity. When sales data of various commodities are plotted, many commodities will show a seasonal or temporal variation in sales. For examples, Sale of woollen clothes will show a hump during months of winter in all the years under reference. The, sale of New Year (Greeting Cards will be particularly very high in the last week of December every year similarly sale of desert coolers is very high during the summers each year) this is called seasonal variation} Box-Jenkins technique is used for predicting demand where time=Series sales data reveal this kind of seasonal variation According to Box-Jenkins approach, any stationary time-series data can be analysed by the following three models: (ii) auto regression model, (iii) moving average model, and (iv) Autoregressive-moving average model. The three models are, in fact, the three stages of Box-Jenkins method. The auto regressive-moving average model is the final form of the Box-Jenkins model. The purpose of three models is to explain movements in the stationary series with minimised error term, i.e., the unexplained components of stationary series. The steps and models of Box-Jenkins approach are described briefly here with the purpose of acquainting the reader with this approach rather than providing the entire methodology. Steps in Box-Jenkins Approach As mentioned above, Box-Jenkins method can be applied to only stationary time-series. Therefore, the first step in Box-Jenkins approach is to eliminate trend from the time-series data. Trend is eliminated by taking first differences of time-series data, i.e., Subtracting observed value of one period from the observed value of the preceding year. After trend is elimated, stationary time-series is created. The second step in the Box-Jenkins approach is to check whether there is seasonality in stationary timeseries. If a certain pattern is found to repeat over time, there is seasonality in stationary time-series. The third step involves use of models to predict the sales in the intended period. Let us now describe briefly the Box-Jenkins models which are used in the same sequence. (i) Autoregressive Model In a general autoregressive model, the behaviour of a variable in a period is linked to the behaviour of the variable in future periods. The general form of the autoregressive model is given below. Y1 = a1 Yt.1 + a2 yt.2 + ... + an yt-n + e1 ...(5.5a) This model states that the value of Y in period t depends on the values of Y in periods t-1, t-2 ... t-n. The term et is the random portion of Y1 that is not explained by the model. If estimated value of one or some of the co-efficient. A1, a2... an are different from zero, it reveals seasonality in data. This completes the second step. The model (5.5 a), however, does not specify the relationship between the value of F (and residuals (e) of previous periods. Box-Jenkins method uses moving average method to specify the relationship between F and ef, values of residuals in previous years. This makes the third step. Let us now look at the moving average model of Box-Jenkins method. (ii) Moving Average Model

The moving average model estimates Y in relation to residuals (e) of the previous years. The general form of moving average model is given below. Y1= m + b1 e1 + b2 et-2 + ... + bp et-p + et ...(5.5b) Where m is mean of the stationary time-series and et-1;et-2.. et-p pare the residuals, the random components of F in t-l, t-2, ... t-p periods, respectively. (iii) Autoregressive-Moving Average Model After moving average model is estimated, it is combined with autoregressive model to form the final form of the Box-Jenkins model, called autoregressive-moving average model, given below. Y1 = a1 Yt-1 + a2 Yt-2 + ... + an +yt-n+ b1 et-1 +b2 et-2+ .bp et-p + et ...(5.6) Clearly, Box-Jenkins method of forecasting demand is a sophisticated and complicated method. Without computer aid, it is rather an impracticable method. Moving Average Method: an alternative Technique As noted above, the moving average model of Box-Jenkins method is a part of a complicated technique of forecasting demand in period on the basis of its past values. There is a simple, rather a naive, yet a useful, method of using moving average to forecast Demand. This simple method assumes that demand in a future year equals the average of demand in the past years. The formula of simple moving average method is expressed as 1 DT = (Xt-1 + Xt-2 + ...+ Xt-n) N Where Dt = demand in period t; Xt-1;t-2;.t-n = demand or sales in previous years; N- number of preceding years. According to this method, the likely demand for a product in period t equals the average of demands (sales) in proceeding several years. For example, suppose that the number of refrigerators sold in the past 7 years in a city is given as follows and we want to forecast demand for refrigerators for the next years, i.e., for 1998.' Year 1991 1992 1993 1994 1995 1996 1997 Sales 11 12 12 13 13 15 15 (000) Given this sales data, demand for 1998 will be computed as follows. 1 D1998 = (15 + 15 + 13 + 13 + 12 + 12 + 11) = 13 7 Thus, the demand for refrigerators for 1998 is forecast at 13,000 units. Now suppose-that the actual sale of refrigerators in the city in 1998 turns out to be 15,000 refrigerators against the forecast figure of 13,000. Given the actual sales figure for 1998, the demand for 1999 can be forecast as 1 D1999 = (15 + 15 + 15 + 13 + 13 + 12 + 12) = 13.57 7 Note that, in moving average method, the sale of 1998 is added and the sale of 1991 the last of the preceding years) is excluded from the formula. This moving average method is simple and can be used to make only short term-forecast. This method has a severe limitation, which has to be borne in mind while using this method. In case of rising trends in sales, this method yields an underestimate of future demand, as can be seen in the above example. And, in ease of declining trend in sales, it may yield an overestimate of future demand. One way of reducing the margin of over and under-estimate is to take the average of fluctuations and add it to the moving average forecasts. This method is, in fact, more suitable where sales fluctuate frequently within a limited range. (2) Barometric Method of Forecasting The barometric method of forecasting follows the method meteorologists use in weather forecasting Meteorologists use barometer to .forecast weather conditions on the basis of movements of mercury in the barometer. Following the to logic of this method many economists use economic indicators as barometer to forecast trends in business activities. This method was first developed and used in the 1920s by the Harvard Economic Service. This technique was, however, abandoned as it had failed to predict the Great Depression of the 1930s. The barometric technique was however revived, refined and

developed further in the late 1930s by the National Bureau of Economic Research (NBER) of the US. It has since then been used often to forecast business cycles in the US. It may be noted at the outset that barometric technique was developed to forecast the general trend in overall economic activities. This method can nevertheless be used to forecast demand prospects for a product, not the actual quantity expected to be demanded. For example, development and allotment of land by the Delhi Development Authority (DDA) to the Group Housing Societies (a lead indicator) indicates higher demand prospects for cement, steel, bricks and other construction materials. The basic approach of barometric technique is to construct index of relevant economic indicators and to forecast future trends on the basis of movements in the index of economic indicators. The indicators used in this method are classified as: (a) Leading indicators, (b) Coincidental indicators, and (c) Lagging indicators. A time-series of various indicators is prepared to read the future economic trend. The leading series consists of indicators which move up or down ahead of some other series. Some examples of the leading series are: (I) index of net business (capital) formation; (ii) new orders for durable goods; (Hi) new building permits; (iv) change in the value of inventories; (v) index of the prices of the materials; (vi) corporate profits after tax. The coincidental series, on the other hand, are the ones that move up or down simultaneously with the level of economic activity. Some examples of the coincidental series are : (i) number of employees in the non-agricultural sector, (ii) rate of unemployment, (Hi) gross national product at constant prices, (iv) sales recorded by the manufacturing, trading and the retail sectors. The1 lagging series consists of those indicators which follow a change after some time-lag. Some of the indices that have been identified as the lagging series by the NBER are: (i) labour cost per unit of the manufacturing output, (ii) outstanding loans, (iii) lending rate for short-term loans. The time, series of various indicators is selected on the basis of the following criteria: (i) Economic significance of the indicator: the greater the significance, the, greater the score of the indicator. (ii) Statistical adequacy of time-series indicators: a higher score is given to an indicator provided with adequate statistics. (iii) Conformity with overall movement in economic activities. (iv) Consistency of series to the mining points in overall economic activity. (v) Immediate availability of the series, and (vi) Smoothness of the series. The problem of choice may arise because some of the indicators appear in moorhen one class of indicators. Furthermore, it is not advisable to rely on just one of the indicators. This leads to the usage of what is referred to as the diffusion index a diffusion index copes with problem of differing signals given by the indicators. A diffusion index gives the percentage of rising indicators. In calculating a diffusion index, for a group of indicators, scores allotted are 1 to rising series, VI to constant series and zero to falling services. The diffusion index is obtained by the ratio of the number of indicators, in a particular class, moving up or down to the total number of indicators in that group. Thus, if three out of six indicators in the lagging series are moving up, the index shall be 50 per cent. It may be noted that the most important is the diffusion index of the leading series. However, there are problems of identifying the leading indicator for the variable under study. Also, lead time is not of an invariable nature. Leading indicators can be used as input for forecasts of aggregate economic variable, 5NP, aggregate consumers expenditure, aggregate capital expenditure, etc. The only advantage of this method is that it overcomes the problem of forecasting the value of dependent variable under the regression method. The major limitations of this method are: (i) it can be used only for a short-term forecasting, and (ii) a leading indicator of zk variable to be forecast is not always easily available. 3) Econometric Methods The econometric methods combine statistical tools with economic theories to estimate economic variables to forecast even if the forecasts made through econometric methods are much more reliable than those made through any other method^ The econometric methods are, therefore, most widely use

to forecast demand for a product for a group of products and for the economy as a whole. Our concern here is primarily to explain econometric methods used for forecasting demand for a product. An econometric model may be a single-equation regression model or it may consist of a system of simultaneous equations. Single-equation regression serves the purpose of demand forecasting in case of most commodities. But, where relationships between economic variables are so complex and interrelated that unless one is determined, the other cannot be determined, a single-equation regression model does not serve the purpose. In that case, a system of simultaneous equations is used to estimate and forecast the target variable. The econometric methods are briefly described here under two basic methods. (1) Regression method, and (2) Simultaneous Equations model. (1) Regression Method Regression analysis is the most popular method of demand estimation. This method combines economic theory and statistical techniques of estimation. Economic theory is employed to specify the determinants of demand and to determine the nature of relationship between the demand for a product and its determinants. Economic theory thus helps in determining the general form of demand function. Statistical techniques are employed to -estimate the values of parameters in the equation estimated. In regression techniques of demand forecasting, the analysts estimate the demand function for a product. In the demand function, quantity to be forecast is a "dependent variable and the variables that affect or determine the demand (the dependent variable) are called as 'independent' or 'explanatory' variables. For example, demand for cold drinks in a city may be said to depend largely on 'per capita income' of the city and its population. Here demand for cold drinks is a 'dependent variable' and 'per capita income' and 'population' are the 'explanatory' variables." While determining the demand functions for various commodities, the analyst may come across many commodities whose demand depends, by and large, on a single independent variable. For example, suppose, in a city, demand for such items as salt and sugar is found to depend largely on the population of the city. If it is so, then demand functions for salt and sugar are single-variable demand functions. On the other hand, the analyst may find that demand for sweets, fruits and vegetables, etc. depends on a number of variables like commodity's own price, price of its substitutes, household income, population, etc. Such demand functions are called multi-variable demand function. For single variable demand functions, simple regression equation is used and for multiple variable functions, multi-variable regression equation is used for estimating demand function. The single variable and multi-variable regressions are explained below. Simple Regression (Single Variable) In simple regression technique, a single independent variable is used to estimate a statistical value of the 'dependent variable', that is, the variable to be forecast. The technique is similar to trend analysis. An important difference between the two is that, in trend fitting, independent variable is 'time' (t) whereas in regression equation, the chosen independent variable is the single most important determinant of demand. Besides the regression method is less mechanical than trend fitting method of projection. For an illustration, consider the hypothetical data on quarterly consumption of sugar given in table. Quarterly Consumption of Sugar Year Population(millions) Sugar Consumed(000) tonnes 1985-86 10 40 1986-87 12 50 1987-88 15 60 1988-89 20 70 1989-90 25 80 1990-91 30 90 1991-92 40 100 Suppose we have to forecast demand for sugar for 1994-95 on the basis of 7-year data given in Table. This can be done by estimating a regression equation of the form Y = a + bX ...(5.7) Where Y is sugar consumed, X is population and a and b are constants.

Like trend fitting method, Eq. (5.7) can be estimated by using the 'least square' method. The procedure is the same as shown in Table 5.2. That is, the parameters a and b can be estimated by solving the following two linear equations: y. = na + bX. ...(i) XY. =IX1 a + bXi 2 ...(ii) The procedure of calculating the terms in equations (/) and (ii) above is presented in Calculation of Terms in Linear Equations. Year Population Sugar X2 XY (X) consumed (Y) 1985-86 10 40 100 400 1986-87 12 50 144 600 1987-88 15 60 225 900 1988-89 20 70 400 1400 1989-90 25 80 625 2000 1990-91 30 90 900 2700 1991-92 40 100 1600 4000 2 n = 7 Xt = 152 Yt = 490 Xt = 3994 Xt Yt = 12,000 By substituting the values from Table 5.4 into equation (i) and (ii), we get 490 = la + 152 b ...(iii) 12,000 = 152a + 3994 b ...(iv) By solving equations (iii) and (iv), we get a = 27.42 and b - 1.96 By substituting values for a and b in Eq. (5.7), we get the estimated regression equation as Y = 27.44 + 1.96 X ...(5.8) Given the regression equation (5.8), the demand for sugar for 1994-95 can be easily project if population for 1994-95 is known. Supposing population for 1994-95 is projected to be 70 million, the demand for sugar in 1994-95 may be estimated as Y = 27.44 + 1.96 (70) = 164,640 tonnes The simple regression technique is based on the assumption that (i) independent variable will continue to grow at its past growth rate, and (it) the relationship between the dependent and independent variables will continue to remain the same in future as in the past. (For further details and on the reliability of estimates consult a standard book on Statistics). (b) Multi-variety Regression The Multi-variate regression equation is used where demand for a commodity is deemed to be the function of many variables or in cases in which number of explanatory variables is greater than one. The procedure of multiple regression analysis may be briefly described here. The first step in multiple regression analysis is to specify the variables that are supposed to explain the variations in the demand for the product under reference. The explanatory variables are generally chosen from the determinants of demand, viz., price of the product, price of its substitute, consumers' income, and their taste and preference. For estimating the demand for durable consumer goods, (e.g., TV sets, refrigerators, house, etc.), the other variables which are considered are availability of credit and rate of interest. For estimating demand for capital goods (e.g., machinery and equipments), the relevant variables are additional corporate investment, rate of depreciation, cost of capital goods, cost of other inputs (e.g., labour and raw materials), market rate of interest, etc. These variables are treated as independent variables. Once independent variable is specified, the second step is to collect time-series data on the independent variables. After necessary data are collected, the next step is to specify the form of equation which can

appropriately describe the nature and extent of relationship between the dependent and independent variables. The final step is to estimate the parameters in the chosen equations with the help of statistical techniques. The multivariate equations cannot be easily estimated manually. They have to be computerized. Specifying the Form of Equation The reliability of the demand forecast depends to a large extent on the form of equation and the degree of consistency of the explanatory variables in the estimated demand function. The greater the degree of consistency, the higher the reliability of the estimated demand and vice versa. Adequate precaution should therefore be taken in specifying the equation to be estimated. Some common forms of multivariate demand functions are given below. Linear function. Where the relationship between demand and its determinants is given by a straight line, the most common form of equation for estimating demand is : Qx = a + bPx + cY+ dPy + jA ...(5.9) where Qx = quantity demanded of commodity X; Px = price of commodity X; Y= consumers' income ; P = price of the substitute; A = advertisement expenditure; a is constant (the intercept), and b, c, d and j are the parameters expressing the relationship between demand and Px, Y, Py and A, respectively. In a linear demand function, quantity demanded is assumed to change at a constant rate with change in independent variables Y, Py and A. The parameters (regression co-efficients) are estimated by using the least square method. After parameters are estimated, the demand can be easily forecast if data on independent variables for the reference period are available. Suppose the estimated equation for sugar takes the following form: Qs = 50 - 0.75Ps + 0.1F+ 1.25Py + 0.05,4 ...(5.10) The numerical values in this equation express the quantitative relationship' between demand for sugar and the variables with which they are associated. More precisely, regression co-efficients give the change in demand for sugar as a result of unit change in the explanatory variables. For instance, it reveals that a change of one rupee in the sugar price results in a 0.75 unit (say, tonne) change in the demand for sugar, and a change of one rupee in income leads to a 0.1 unit (tonne) change in sugar demand, and so on. Power function. It may be noted that in linear equation (5.9) the marginal effect of independent variables on demand is assumed to be constant and independent of change in other variables. For example, it assumes that the marginal effect of change in price is independent of change in income or other independent variables, and so on. But there may be cases in which it is intuitively or theoretically found that the marginal effect of the independent variables on demand is neither constant nor independent of the value of all other variables included in the demand function. In such cases, a multiplicative form of equation which is considered to be 'the most logical form of demand function' is used for estimating demand for a product. The multiplicative form of demand function or power function is given as Qx = a Px b Yc Py d Aj ...(5.11) The algebraic form of multiplicative form of demand function can be transformed into a log-linear form for the sake of convenience is estimation as given below. log Qx - log a + b log Px + c log Y+ d log P + j log A ...(5.12) The log-linear demand function can be estimated by the least square regression technique. The estimated function yields the intercept a and the values of the regression co-efficients. After regression co-efficients are estimated and data on the independent variables for the years to come are obtained, forecasting demand becomes an easy task. Reliability of Estimates. As mentioned earlier, statistical methods are scientific, devoid of subjectivity, and they yield fairly reliable estimates. But the reliability of forecast depends also on a number of other factors. A very important factor in this regard is the choice of right kind of variables and data. Only those independent variables which have causal relationship between the dependent and independent variables should be included in the demand function. The relationship between the dependent and independent variables should be clearly defined. Besides, the reliability of estimates depends also on the

form of demand function used. The forecaster should therefore bear in mind that there is no hard and fast rule and an a priori basis of determining the most appropriate form of demand function of a product. The demand function to be estimated is generally determined by testing different forms of functions. Whether a particular form of functions is good fit or not is judged by the coefficient of determination, i.e., the value of R2. The value of R2 gives the proportion explained of the total variation in the dependent variable. The higher the value of R2, the greater the explanatory power of the independent variables. Another test is the expected sign of co-efficients of independent variables. What is more important therefore is to carefully ascertain the theoretical relationship between the dependent and the independent variables. Some case studies based on multiple regression analysis will be presented at the end of this chapter. (2) Simultaneous Equations Model In explaining this model, it will be helpful to begin with comparison of simultaneous equation method with regression method. We may recall that regression technique of demand forecasting consists of a single equation. In contrast, the simultaneous equations _ -model of forecasting involves estimating several simultaneous equations. These equations are, generally, behavioral equations, mathematical identities and market-clearing equations. Furthermore, regression technique assumes one-way causation, i.e., only the independent variables cause variations in the dependent variables, not vice versa. In simple words, regression technique assumes that a dependent variable affects in no way the Independent variables. For example, in demand function D = a + bP used in regression method, it is assumed that price affects demand, but demand does not affect price. This is an unrealistic assumption. On the contrary, forecasting through econometric models of simultaneous equations enables the forecaster to take into account the simultaneous interaction between dependent and independent variables. The simultaneous equations method is a complete and systematic approach to forecasting. This technique uses sophisticated mathematical and statistical tools which are beyond the scope of this book.1 We will therefore confine here only to the basic feature of this method of forecasting. The first step in this technique is to develop a complete model and specify the behavioral assumptions regarding the variables included in the model. The variables that are included in the models are called as (/) endogenous variables, and (ii) exogenous variables. Endogenous variables. The variables that are determined within the model are called endogenous variables. Endogenous variables are included in the model as dependent variables, i.e., the variables that are to be explained by the model. These are also called 'controlled' variables. It is important to note that the number of equations included in the model equals the number of endogenous variables. Exogenous variables. Exogenous variables are those that are determined outside the model. Exogenous variables are inputs of the model. Whether a variable is treated as endogenous or exogenous depends on the purpose of the model. The examples of exogenous variables are 'money supply', 'tax rates', 'government spending', 'time', and 'weather', etc. The exogenous variables are also known as 'uncontrolled' variables. The second step in this method is to collect the necessary data on both endogenous and exogenous variables. More often than not, data are not available in the required form. Sometimes data are not available at all. In such cases, data have to be adjusted or corrected to suit the model and, in some cases, even data has to be generated from the available primary or secondary sources. After model is developed and necessary data are collected the next step is to estimate the model through some appropriate method. Generally, a two-stage least square method is used to predict the values of exogenous variables. Finally, the model is solved for each endogenous variable in terms of exogenous variables. Then by plugging the values of exogenous variables into the equations, the objective value is calculated and prediction made. This method is theoretically superior to the regression method. The main advantage of this method is that it is capable of capturing the influence of interdependence of the variables. But, its limitations are similar to those of the regression method. The use of this method is sometimes hampered by nonavailability of adequate data.

It is important to note here that the example of econometric model given above is ii extremely simplified model. The econometric models used in actual practice are fraternally very complex. They include scores of simultaneous equations.

UNIT II PRODUCTION & COST ANALYSIS

Introduction Whatever the objective of business firms, achieving optimum efficiency in production or minimising cost for a given production is one of the prime concerns of the managers. In fact, the very survival of the firm in a competitive market depends on their ability to produce at a competitive cost. Therefore, managers of business firms Endeavour to minimise the production cost. In their effort to minimise the cost of production, the fundamental questions which managers are faced with are: A. How are the production and costs related? B. Does substitution between factors affect cost of production? C. How does the technology, i.e., factor combination, matter in reducing the cost of production? D. How can the least-cost combination of inputs be achieved? E. What happens to the rate of return when more plants are added to the firm? F. What are the factors which create economies and diseconomies for the firm? The theory of production provides answer to these questions through abstract models built under hypothetical conditions. The production theory may therefore not provide solution to the real life problems. But it does provide tools and techniques to analyse the production conditions and to find solution to the practical business problems. This chapter is devoted to the discussion of the theory of production, pending the theory of costs till the next chapter. Production theory deals with input-output relationship. Input-output relationships can be expressed in physical terms as well as in money terms. Production theory deals with physical relationships, i.e., technical and technological relations between inputs, and between output and inputs. In the present chapter, we have discussed the production theory in its physical aspects. The other part of the production theory dealing with cost-output relationship in money terms will be taken up in the following chapter. Let us first discuss some basic concepts used in production theory. Meaning of Production In economics, the term 'production' means a process by which a commodity or commodities are transformed into a different usable commodity. In other words, production means transforming inputs (labour, machines, raw materials etc.) into an output. This kind of production is called 'manufacturing'.

The production process however does not necessarily involve physical conversion of raw materials into tangible goods. Some kinds of production may involve an intangible input to produce an intangible output. For example, in the production of legal, medical, social and consultancy services both input and output are intangible; lawyers, doctors, social workers, consultants, hair-dressers, musicians, orchestra players are all engaged in producing intangible goods. In economic sense, production process may take a variety of forms other than manufacturing. For example, transporting a commodity from one place to another where it can be used is production. Sand dealers collects and transfer the sand from the river bank to the construction site. A coal miner does virtually nothing more than transporting coal from coal mines to the market place. Similarly, a fisherman only transports fish to the market place. Their activities too are 'production'. Transporting men and materials from one place to another is itself a productive activity: it produces service. Storing a commodity for future sale or consumption is also 'production'. Wholesaling, retailing, packaging, assembling are all productive activities. These activities are just as good examples of production as manufacturing. Cultivation is the earliest form of production process. Input and Output An input is a good or service that goes into the process of production. In the words of Baumol, "An input is simply anything which the firm buys for use in its production or other process for sale. '"An output is any good or service that comes out of production process. The term 'inputs' needs some more explanations. Production process requires a wide variety of inputs, depending on the nature of product. But, economists have classified input as (i) labour, (i) capital; (iii) land; (iv) raw materials; and (v) times. All these variables are 'flow' variables, since they are measured per unit of time. Fixed and variable inputs Inputs are classified as (i) fixed inputs or fixed factors, and (if) variable inputs or variable factors. Fixed and variable inputs are defined in economic sense and in technical sense. In economic sense, a fixed input is one whose supply is inelastic in the short run. Therefore, all of its users cannot buy more of it in the short-run. Conceptually, all its users cannot employ more of it in the short-run. If one user buys more of it, some other users will get less of it. A variable input is defined as one whose supply in the short-run in elastic, e.g., labour and raw material, etc. All the users of such factors can employ a larger quantity in the short-run. In technical sense, a fixed input remains fixed (constant) up to certain level of output whereas a variable input changes with change in output. Short Run and Long Run The short run refers to a period of time in which the supply of certain inputs (e.g., plant, building and machines, etc.) is fixed or is inelastic. In the short-run, therefore, production of a commodity can be increased by increasing the use of only variable inputs, like labour and raw materials. It is important to note that short-run and long run are economists' jargon. They do not refer to any fixed time period. While in some industries short run may be a matter of few weeks or few months, in some others (e.g., electric and power industry), it may mean three or more years. The long run refers to a period of time in which the supply of all the inputs is elastic, but not enough to permit a change in technology. That is, in the long-run, all the inputs are variable. Therefore, in the long-run production of a commodity can be increased by employing more of both, variable and fixed, inputs. The economists use another term, i.e., very long period which refers to a period in which the technology of production is supposed to change. In the very long run, the production function also changes. The technological advances mean that a larger output can be created with a given quantity of inputs. PRODUCTION FUNCTION In this section onwards, we will be concerned with the laws of production, i.e., the relationship between inputs and output. Production function is a tool of analysis used to explain the input-output

relationship. A production function describes the technological relationship between inputs and output in physical terms. In its general form, it tells that production of a commodity depends on certain specific inputs. In its specific form it presents the quantitative relationships between inputs and output. Beside, the production function represents the technology of a firm, of an industry or of the economy as a whole. A production function may take the form of a schedule or table, a graphed line or curve, an algebraic equation or a mathematical model. But each of these forms of a production function can be converted into the other forms. Before we illustrate the various forms of a production function, let us note how a complex production function is simplified and the number of inputs in the production function, used as independent variables, reduced to a manageable number especially M theoretical analyses or models. A real life production function is generally very complex. It includes a wide range of inputs. The economists have however classified the inputs as (i) land; (ii) labour; (Hi capital; (IV) raw material; (v) time; and (vi) space. All these variables enter the actual production function of a firm. The economies have however reduced the number of variables used hi a production function to only TV | viz., capital and labour, for the sake of convenience and simplicity in the analysis of input-output relations. The reasons for ignoring other inputs are following: Land, as an input, is Constar for the economy as a whole, and hence it does not enter into the aggregate product function. However, land is not a constant variable for an individual firm or industry. In the case of individual firms, land is lumped together with 'capital'1. In case of raw Materials' it has been observed that this input 'bears a constant relation to output at all levels of production'. For example, cloth bears a constant, relation to the number of garments. Similarly, for a given size of a house, the quantity of bricks, cement, steel, etc., remains constant, irrespective of number of houses constructed. This constancy of input-output relations leaves the methods of production unaffected. So is the case, generally, with time and space. Those is why, in most production functions only two inputslabour and capitalare included. We will illustrate the tabular and graphic forms of a production function when we move on to explain the laws of production. Here, let us illustrate the algebraic or mathematical form of a production function. It is this form of production function which is most commonly used in production analysis. To illustrate the algebraic form of production function, let us suppose that a coalmining firm employs only two inputscapital (K) and labour (L)in its coal production activity. As such, the general form of its production, function may be algebraically expressed as, Q = f (K, L) Where Q = the quantity of coal produced per time unit, K = capital, and L = labour. The production function (6.1) implies that quantity of coal produced depends on the quantity of capital, K, and labour, L, employed to produce coal. Increasing coal production will require increasing K and L. Whether the firm can increase both K and L or only L depends on the time period it takes into account for increasing production, i.e., whether the firm considers a short run or a long run. By definition, supply of capital is inelastic in the short run and elastic in the long run. In the short run, therefore, the firm can increase coal production by increasing labour only since the supply of capital in the short run is fixed1. In the long run, however, the 5rm can employ more of both capital and labour. Accordingly, the firm would have two ".types of production functions: (i) Short-run production function; and (ii) Long-run production function. The short-run production function or what may also be termed as 'tingle variable production function', can be expressed as, Q = f ( L) In the long-term production function, both K and L are included and the function sites the form Q = f (K, L) ..(6.3) Assumptions A production function is based on certain assumptions:

(i) perfect divisibility of both inputs and output; (ii) limited substitution of one factor for the other; (iii) Constant technology; and (iv) Inelastic supply of fixed factors in the short run. If there is a change in these assumptions, the production function will have to be modified accordingly. The two most important functions used in economic literature to analyse input-output relationships are Cobb-Douglas and CES. Production functions. Before we discuss these functions, let us first explain the laws of production through a simple production function. THE LAWS OF PRODUCTION As mentioned above, production function states the relationship between output and input. Given the production function, the relationship between additional quantities of inputs and the additional output can be easily obtained. This kind of relationship yields the laws of production. The traditional theory of production studies the marginal input-output relationships under (i) short run, and (ii) long run conditions. In the short run, input-output relations are studied with one variable input, other inputs held constant. The laws of production under these assumptions are called. 'The Laws of Variable Proportions'. In the long run, input-output relations are studied assuming all the input to be variable. The long run input-output relations are studied under 'Laws of Returns to Scale'. SHORT RUN LAWS OF PRODUCTION: THE LAWS OF RETURNS TO VARIABLE PROPORTIONS Production with one Variable Input As mentioned earlier, the laws of returns state the relationship between the variable input and the output in the short-term. By definition, some factors of production are available in unlimited supply even during the short period. Such factors are called variable factors. In the short-run, therefore, the firms can employ an unlimited quantity of the variable factor. In other words, firms can employ in the short run, varying quantities of variable inputs against a given quantity of fixed factors. This kind of change in input combination leads to variation in factor proportions. The laws which bring out the relationship between varying factor proportions and output are therefore known as the law of variable proportions, or what is more popularly known as the Law of Diminishing Returns. The Law of Diminishing Returns This law states that when more and more units of a variable input are applied to a given quantity of fixed inputs, the total output may initially increase at an increasing rate and then at a constant rate but it will eventually increase at diminishing rates. That is, the marginal increase in the total output eventually decreases when additional units of variable factors are applied to a given quantity of fixed factors. To illustrate the law of diminishing returns let us assume (i) that the coal-mining firm (in our earlier example) has a set of mining machinery as its capital (K), fixed in the short run, and (ii) that it can employ more of mine-workers to increase its coal production. Thus, the short run production function for the firm will take the form Let us assume that the labour-output relationship in coal production is given by the following production function. Qc = -L3 + 15L2 +-10L1 ...(6.4) Given the production function (6.4), we may substitute different numerical values for L in the function and work out a series of QC, i.e., the quantity of coal that can be produced with different number of workers. For example, if L=5, then by substitution, QC = - 53 + 15 x 52 + 10 x 5 = - 125 + 375 + 50 = 300 A tabular array of output levels associated with different number of workers from 1 to 12, in our hypothetical coal-production example, is given in Table (Cols. 1 and 2). From the table, we derive the marginal product (MPT) and the average product (APT) schedules, as given in the table (Cols. 3 and 4).

The information contained in Table 6.1 is presented graphically in panels (a) and (b) of Fig. 6.1. Panel (a) of Fig. 6.1 presents the total product curve (TPT) and panel (b) presents marginal product (MP^ and average product (APL) curves. The TP {schedule demonstrates the law of diminishing returns. As the curve TPL shows, the total output continues to increase at an increasing rate till the employment of the 5th worker, as indicated by the increasing slope of the TPL curve, (see also col. 3 of the table). Beyond the 6th worker, TP1 continues to increase (until the 10th worker) but the rate of increase in TPL (i.e., marginal addition to TPT) begins to fall and turns negative 11th worker onwards. This shows the operation of the law of diminishing returns. The Three Stages in Production. Table and Fig. present the three usual stages in the application of the laws of diminishing returns. No. of Total ' Marginal* Average Stage of workers product (N) -TPL (tonnes) Product (MPJ Product (APJ Production 1 24 24 24 2 72 48 36 3 138 66 46 I 4 216 78 54 Increasing and 5 300 84 60 constant returns 6 384 84 64 7 462 78 66 II 8 528 66 66 Diminishing 9 576 48 64 returns 10 600 24 60 11 594 -6 54 III 12 552 -42 46 Negative returns * MP, = TP - TP, or MP. = - 3L2 + 301 + 10, i.e., the first derivative of the production function. In stage I, TPL increases at increasing rate. This is indicated by the rising MPL till the employment of the 5th worker. Given the production function (6.4), the 6th worker produces as much as the 5th worker. The output from the 5th and the 6th workers represents an intermediate stage of constant returns to the variable factor, labour. In stage II, TPL continues to increase but at diminishing rates, i.e., MPL begins to decline. This stage in production shows the law of diminishing returns to the variable factor. Total output reaches its maximum level at the employment of the 10th worker. Beyond this level of output, TPL beings to decline. This marks the beginning of stage III in production. To conclude, the law of diminishing returns can be stated as follows. Given the employment of fixed factor (capital), when more and more workers are employed, the return from the additional worker may initially increase but will eventually decrease. Factors behind the Laws of Returns The reasons which underlie the application of the laws of returns in Stages I and II may be described as follows. As shown in Fig. 6.1, the marginal productivity of workers (MPL) increases in Stage I, whereas it decreases in Stage II. In other words, in Stage I, Law of Increasing Returns is in operation and in Stage II, the Law of Diminishing Returns is in application. One of the important factors causing increasing returns to a variable factor is the indivisibility of fixed factor (capital). It results in under-

utilisation oil capital if labour is less than its optimum number. Let us suppose that optimum capitallabour combination is 1 : 6. If capital is indivisible and less than 6 workers are employed, then capital would remain underutilized. When more and more workers are added, utlisation of machine increases and also the productivity of additional worker. Another reason for increase in labour productivity is that employment of additional workers leads to advantages of division of labour, until optimum capital-labour combination is reached. Once the optimum capital-labour ratio is reached, employment of additional workers will amount to substitution of capital with labour. But, technically, one factor can substitute another only up to a limited extent. In other words, there is a limit to which one input can be substituted for another. That is, the elasticity of substitution between input is not infinite. Hence, to replace the same amount of capital, more and more workers will have to be employed because per worker marginal productivity decreases. Assumptions The application of the law of diminishing returns is based on the following assumptions. (a) The state of technology remains unchanged, (b) Input prices remain unchanged, and (c) The variable factors are homogeneous. Application of the Law of Diminishing Returns The law of diminishing returns is an empirical law, frequently observed in various production activities. This law however may not apply universally to all kinds of productive activities since the law is not as true as the law of gravitation. In some productive activities, it may operate quickly, in some its operation may be delayed; and in some others, it may not appear at all. This law has been found to operate in agricultural production more regularly than in industrial production. The reason is, in agriculture, natural factors play a predominant role whereas man-made factors play the major role in industrial production. Despite the limitations of the law, if increasing units of an input are applied to the fixed factors, the marginal returns to the variable input decrease eventually. The Law of Diminishing Returns and Business Decision The law of diminishing returns as presented graphically has a relevance to the business decisions. The graph can help in identifying the rational and irrational stages of operations. It can also provide answer to such questions as (z) how much to produce; and (ii) what number of workers (or other variable inputs) to apply to a given fixed input so that, given all other factors, output is maximum. Fig. 6.1 exhibits the three stages of production. Stage III shows a very high labour-capital ratio. As a result, employment of additional workers proves not only unproductive but also causes a decline in the TP. Similarly, in stage I, capital is presumably underutilized. So a firm operating in stage I is required to increase labour, and a firm operating in stage III is required to reduce labour, with a view to maximising its total production. From the firm's point of view, setting an output target in stages I and III is irrational. The only meaningful and rational stage from the firm's point of view is stage II in which the firm can find answer to the questions 'how many workers to employ'. Figure 6.1 shows that the firm should employ a minimum of 7 workers and a maximum of 10 workers even if labour is available free of cost. Thus, the firm has a limited choice ranging from 7 to 10 workers. How many workers to employ against the fixed capital and how much to produce can be answered, only when the price of labour, i.e., wage rate, and that of the product are known. MARGINAL REVENUE PRODUCTIVITY AND LABOUR EMPLOYMENT It may be recalled from Fig. that an output maximising coal-mining firm would like to employ 10 workerssince at this level of employments, the output is maximum. The firm can, however, employ 10 workers only if workers are available free of cost. The labour is however not available free of cost the firm is required to pay wages to the workers. Therefore, the question arises 'how many workers will the firm employ10 or less or more than 10'? This question can be answered with the help of Equi-Marginal Principle. The firm will in fact employ workers until marginal revenue productivity of labour equals the marginal wage rate. The marginal revenue productivity is the value of product resulting from the marginal unit of variable input (labour). In specific terms, marginal revenue productivity (MRP) equals marginal physical productivity (MPP) of labour multiplied by the price (P) of the product, i.e.

MRP = MPP x P For example, suppose that the price (P) of coal is given at Rs. 10 per quintal. Now, MRP of a worker can be known by multiplying its MP (as given in Table 6.1) by Rs. 10. For example, MRP of the 3rd worker (see Table) equals 66 x 10 = Rs. 660 and of the 4th worker, 78 x io = 780. Likewise, if whole column (MP) is multiplied by Rs. 10, it gives us a table showing marginal revenue productivity of workers. Let us suppose that wage rate (per time unit) is given at Rs. 660. Given the wage rate, the profit maximising firm will employ only 8 workers because at this employment, MRP = wage rate: MRP of 8th worker 66 x 10 = Rs. 660 (wage rate). If the firm employs the 9th worker, his MRP = 48 x 10 = Rs. 430 < Rs. 660. Clearly, the firm loses Rs. 180 on the 9th worker. And, if the firm employees less than 8 workers it, will not maximise profit. To generalize, if the whole series of MRP is graphed, it will give a MRP curve as shown in Fig. 6.2. Similarly, the MRP curve for any input may be drawn and compared with MC (or MW) curve. Labour being the only variable input, in our example, let us suppose that wage rate in the labour market is given at OW (Fig.). When wage rate is given, average wage (AW) and marginal wage (MW) are equal, i.e., AW = MW, for the whole range of employment in a short period. When A W = MW, the supply of labour and marginal cost (MC = MW) are shown by a straight horizontal line, as shown by the line AW = MW. With the introduction of MRP curve and A W=MW line (Fig.), a profit maximising firm can easily find the maximum number of workers which can be optimally employed against a fixed quantity of capital. Once the maximum number of workers is determined, the optimum quantity of the product is automatically determined. The marginality principle of profit maximisation tells that profit is maximum when MR = MC. This is a necessary condition of profit maximisation. Figure shows that MRP and MW (= MC) are equal at point P, the point of intersection between MRP and A W=MW. The number of workers corresponding to this point is ON. A profit maximising firm should therefore employ only ON workers. Given the number of workers, the total output can be known by multiplying ON with average labour productivity (AP). LONG TERM LAWS OF PRODUCTION LONG-TERM PRODUCTION WITH TWO VARIABLE INPUTS We have discussed, in the preceding section, the technological relationship between inputs and output assuming labour to be a variable factor, capital remaining constant. This is a short-run phenomenon. We will now discuss the relationships between inputs and output under the condition that both the inputs, capital and labour, are variable factors. This is a long-run phenomenon. In the long-run, supply of both the inputs is supposed to be elastic and firms can hire larger quantities of both labour and capital. With large employment of capital and labour, the scale of production increases. The technological relationship between changing scale of inputs and output is explained under the laws of returns of scales. The laws returns to scale can be explained through the production function and isoquant curve techniques. The most common and simple tool of analysis is isoquant curve technique. We have therefore first introduced and elaborated on this tool of analysis. The laws of return of scale have then been explained through isoquant curve technique. The discussion on the laws of returns to scale through production function follows in the next section. Isoquant Curve The terms 'isoquant' has been derived from the Greek word iso meaning 'equal' and Latin word quantus meaning 'quantity'. The 'isoquant curve' is therefore also known as 'Equal Product Curve' or 'Production Indifference Curve'. An isoquant curve is locus of points representing various

combinations of two inputscapital and labour yielding the same output. Note that an 'isoquant curve' is analogous to an 'indifference curve', with two points of distinction : (a) an indifference curve is made of two consumer Goods while an isoquant curve is constructed of two producer goods (labour and capital); and (b) an indifference curve measures 'utility' whereas an isoquant measures output. To illustrate the isoquant curves, let us assume : (a) there are only two factors of production, viz., labour (L) and capital (K), to produce a commodity X; (b) the two factors can substitute each other but at a diminishing rate; and (c) The technology of production is given. Given these conditions, it is always possible to produce a given quantity of commodity X with various combinations of capital and labour. The factor combinations are so formed that the substitution of one factor for the other leaves the output unaffected. This technological fact is presented through an Isoquant Curve (IQ=100) in Fig. The curve IQX all along its length represents a fixed quantity 100 units of the product X. This quantity of output can be produced with a number of labour-capital combinations. For example, points A, B, C, and D on the Isoquant IQt show four different combinations of inputs, K and L, as given in Table: all yielding the same output 100 units. Note that movement from A to D indicates deceasing quantity of K and increasing number of L. This implies substitution of labour for capital such that all the four input-combinations, yield the same Capital-labour Combinations and output Point Input Combination K OK4 OK3 OK2 OK1 + + + + + L OL1 OL2 OL3 OL4 Output

A B C D

= 100 = 100 = 100 = 100

Properties of Isoquant Isoquant have the same properties as indifference curve. They are explained below in terms of inputs and output. (a) Isoquants have a negative slope. An isoquant has a negative slope in the economic region or in the relevant range. The economic region is the region on the isoquant plane in which substitution between inputs is technically possible. It is also known as the profit maximising region. The negative slope of the isoquant implies substitutability between the inputs. It means that if one of the inputs is reduced, the Other input on an isoquant is other input has to be so increased that the total output remains unaffected. For example, movement from A to B on IQX (Fig. 6.3) means that if K^K, units of capital are removed from the production process, L L2 units of labour have to be brought in to maintain the same level of output. (b) Isoquants are convex to origin. Convexity of isoquants implies not only the substitution between the inputs but also that the marginal rate of technical substitution (MRTS) decreases in the economic region. The MRTS is defined as: K MRTS = = slope of the isoquant L In plain words, MRTS is the rate at which a marginal unit of labour can substitute a marginal unit of capital (moving downward on the isoquant) without affecting the total output. This rate is indicated by the slope of the isoquant. The MRTS decreases because no factor is a perfect substitute for another. As such, more and more units of an input are needed to replace each successive unit of other input. For example, suppose various units of K (minus sign ignored) in Fig. 6.3 are equal, i.e., K1 = K2 = K3 but the subsequent units of L substituting K go on increasing, i.e., L1 < L2 <L As a result, MRTS goes on decreasing, i.e.,

K1 K2 AK > > L1 L2 L3 (c) Isoquants cannot intersect or be tangent to each other. The intersection or tangency between two isoquants implies that a given quantity of a commodity can be produced with a smaller as well asji larger input-combination. This is untenable so long as marginal productivity of inputs is greater than zero. In Fig. 6.4 (a), two isoquants intersect each other at point M. Consider two other pointspoint J on isoquant marked 100 and point K on isoquant marked 200. One can easily infer that a quantity that can be produced with the combination of K and L at point M can be produced also with factor combination at points J and K. On the isoquant 100, factor combinations at points M and J are equal in terms of their output. On the isoquant 200, factor combinations at M and K are equal in terms of their output. Since point M is common to both the isoquants, it follows that input combinations at J and K are equal in terms of output. It means OL2 + JL2 = OL2 + KL2 Since OL2 is common to both the sides, it means, L2 = KL2 But it not true, because as Fig. shows JL2 < KL2 The intersection of the isoquants means that JL2 and KL2 are equal, which is wrong. That is why isoquants will not intersect or be tangent to each other. (b) Upper Isoquants Represent Higher Level of Output. Between any two isoquants, the upper one represents a higher level of output than the lower one. The reason is, an upper isoquant implies a larger input combination which, in general, produces a larger output. Therefore, upper isoquants indicate a higher level of output. For instance, IQ2 in Fig.(b) will always mean a higher level of output than IQV For, any point at IQ2 consists of more of either capital or labour or both. For example, consider point a on IQj and compare it with any point at IQ2. The point b on IQ2 indicates more of capital (ab), point d more of labour (ad) and point c more of both. Therefore, IQ2 represents a higher level of output (200 units) than IQX indicating 100 units. THE LAWS OF RETURNS TO SCALE Having introduced the isoquant curves, let us now return to the laws of returns to scale. The laws of returns to scale explain the behaviour of the total output in response to change in the scale of the firm, i.e., in response to a simultaneous and proportional increase in all the inputs. More precisely, the laws of returns to scale state how a simultaneous and proportionate increase in all the inputs affects the total output at various levels of inputs. When a firm expands its scale, i.e., it increases all its inputs proportionately, then there are three technical possibilities: 1. Total output may increase more than proportionately, 2. total output may increase proportionately, and

3. Total output may increase less than proportionately. Accordingly there are three kinds of returns to scale: 1. Increasing returns to scale; 2. Constant returns to scale, and 3. Diminishing returns to scale. So far as the sequence of the laws 'return to scale' is concerned, the law of increasing returns to scale is followed by the law of constant and then by this law of diminishing returns to scale. This is the most typical sequence of the laws of returns to scale. Let us now explain the laws of returns to scale with the help of isoquants for a two-input and single output production system. (f) Increasing Returns to Scale When a certain proportionate change in both the inputs, K and L, leads to a more than proportionate change in output, it exhibits increasing returns to scale. For example if quantities of both the inputs, K and L, are successively doubled and the corresponding output is more than doubled, the returns to scale is said to be increasing. The increasing returns to scale are illustrated in Fig. The movement from point a to b on the line OB means doubling the inputs. It can be seen in Fig. that input-combination increases from 1K + 1L to 2K + 2L. As a result of doubling the inputs, output is more than doubled as it increases from 10 units to 25 units. Similarly, the movement from point b to point c indicates 50% increase in inputs as a result of which the output increases from 25 units to 40 units, i.e., by more than 50%. This kind of relationship between the inputs and output shows increasing returns to scale. The Causes of Increasing Returns to Scale There are at least three plausible reasons for increasing returns to scale. (1) Technical and managerial indivisibilities. Certain inputs, particularly mechanical equipments and managerial skills, used in the process of production are available in a given size. Such inputs cannot be divided into parts to suit the small scale of production. For example, half a turbine cannot be used; a quarter or a part of a locomotive engine cannot be used; one-third or a part of a composite harvester and earth-movers cannot be used. Similarly, half of a production manager cannot be employed, if part-time employment is not acceptable to the manager. Because of indivisibility of machinery and managers, they have to be employed in a minimum quantity even if scale of production is much less than the capacity output. Therefore, when scale of production is expanded by increasing all the inputs, the - productivity of indivisible factors increases exponentially. This results in increasing returns to scale. (2) Higher degree of specialization. Another factor causing increasing returns to scale is higher degree of specialisation of both labour and machinery, which becomes possible with increase in scale of production. The use of specialised labour suitable to job needs and composite machinery increases productivity per unit of inputs. Their cumulative effects contribute to the increasing returns to scale. Besides, employment of specialised managerial personnel, e.g., administrative manager, production managers, sales manager and personnel manager, contributes a great deal in increasing production. (3) Dimensional relations. Increasing returns to scale is also a matter of dimensional relations. For example, when the length and breadth of a room (15' x 10' = 150 sq. ft.) are doubled, then the size of the room is more than doubled: it increases to 30' * 20' = 600 sq. ft. When diameter of a pipe is doubled, the flow of water is more than doubled. In accordance with this dimensional relationship, when the labour and capital are doubled, the output is more than doubled and so on.

(ii) Constant Returns to Scale When the change in output is proportional to the change in inputs, it exhibits constant returns to scale. In other words, if quantities of both the inputs, K and L, are doubled and output is also doubled, the returns to scale is said to be constant. Constant returns to scale are illustrated in Fig. 6.6. The line OA and OB are 'product lines' indicating two hypothetical techniques of production. The isoquants marked Q - 10, Q = 20 and Q = 30 indicate the three different levels of output. In the figure, the movement from point a to b indicates doubling both the inputs. When inputs are doubled, output is also doubled, i.e., output increases from 10 to 20. Similarly, the movement from a to c indicates trebling inputs K increase to 3K and L to 3L and trebling the output from 10 to 30. Alternatively, movement from point b to c indicates a 50 percent increases in each of labour and capital. This increase in inputs results in an increase of output from 20 units to 30 units, i.e., -a 50 percent increase in output. In simple words, a 50 percent increase in inputs leads a 50 percent increase in output. This* relationship between the proportionate change in inputs and the proportional change in outputs may be summed up as follows. This relationship between input and output exhibits the constant returns to scale. The constant returns to scale are attributed to the limits of the economies of scale'. With the expansion in the scale of production, economies arise from such factors as indivisibility of fixed factors, greater possibility of specialisation of capital and labour, use of labour-saving techniques of production, etc. But there is a limit to the economies of scale. When economies of scale reach their limits and diseconomies are yet to begin, return to scale become constant. The constant returns to scale take place also where factors of production are perfectly divisible and where technology is such that capital-labour ratio is fixed. When the factors of production are perfectly divisible, the production function is homogeneous of degree 1 like Cobb-Douglas production function. (iii) Decreasing Returns to Scale The firms are faced with decreasing returns to scale when a certain proportionate change in inputs, K and L, leads to a less than proportional change in output. For example, when inputs are doubled and output is less than doubled, often decreasing returns to scale is in operation. The decreasing returns to scale is illustrated in Fig. 6.7. As the figure shows, when the inputs K and b are doubled, i.e., where capital-labour combination is increased from IK + IL to 2K + 2L, the output increases from 10 to 18 units, which is less that the proportionate increase. The movement from point b to c indicates a 50 per cent increase in the inputs. But, the output increases by only 33.3 per cent. This exhibits the decreasing returns to scale. Causes of Diminishing Returns to Scale The decreasing returns to scale are attributed to the diseconomies of scale. The most important factor causing diminishing returns to scale is 'the diminishing returns to management', i.e., managerial diseconomies. As the size of the firm expands, managerial efficiency decreases. Another factor responsible for diminishing returns to scale is the limitedness or exhaustibility of the natural resources. For example, doubling of coalmining plant may not double the coal output because of limitedness of coal deposits or difficult accessibility to coal deposits. Similarly, doubling the fishing fleet may not

double the fish output because availability of fish may decrease in the ocean when fishing is carried out on an increasing scale.

LAW OF RETURNS TO SCALE THROUGH PRODUCTION FUNCTION The laws of returns to scale may be explained more precisely through the production function. Let us assume a production model involving two variable inputs (K and L) and one commodity X. The production function may then be expressed as KQx = f (KK, KL) ...(6.5) Where Qx denotes the quantity of commodity X. Let us also assume that production function is homogeneous. A production function is said to be homogeneous when all the inputs are increased in the same proportion and the proportion can be factored out. And, if all the inputs are increased in a certain proportion (say, k) and output increases in the same proportion (k), then production function is said to be homogeneous of degree 1. This kind of production function is also known as 'Linear Homogeneous Production Function'. A production function of this type may be expressed as kQx = f(kK, KL) ...(6.6) Or = k (K, L) A homogeneous production function of degree 1 implies constant returns to scale. ECONOMIES OF SCALE The factors which cause the operation of the laws of returns to scale are grouped under economiesand diseconomies of scale. Increasing returns to scale are the result of economies of scale and decreasing returns to scale result from the diseconomies of scale. Where economies and diseconomies arise simultaneously, returns to scale may increase or decrease depending on whether economies or diseconomies are greater. Returns to scale increase when economies of scale are greater than the diseconomies of scale, and returns to scale decrease when diseconomies overweigh the economies of scale. When economies and diseconomies are in balance, returns to scale become constant. In this section, we briefly discuss the various kinds of economies of scale. The economies of scale are classified as (4) Internal economies, and (5) External economies. (1) Internal Economies Internal economies are those which arise from the expansion of the plant-size of the firm. Internal economies may be classified under the following categories: (a) Economies in Production, (b) Economies in Marketing, (c) Managerial Economies, and (d) Economies in Transport and Storage. A. Economies in Production. The economies in production arise from (i) technological advantages, and (ii) advantage of division of labour and specilisation. (I) Technological advantages. Large-scale production provides opportunity to avail the advantages of technological advances. The modern technology is so highly advanced and composite that the accomplishment of the whole process of production of a commodity can be conceived of in one composite unit of production plants. For example, production of cloth in a textile mill may comprise such plants as (i) Spinning; (ii) Weaving; (iii) Printing and Pressing; and (iv) Packing, etc. A composite dairy scheme may consist of plants like (i) Chilling; (ii) Milk processing; and (iii) Bottling. As such, when the scale of production is small, the firm may not find it economical to have a composite plant. But, a large scale firm enjoys the economies of scale in terms of a larger output from a given investment or lowers unit cost. Besides, technological economies arise also because of certain physical properties of technology, known also as 'dimensional relations' as discussed earlier in section. Consider some more technological advantages of this kind. When physical size of a ship is doubled, its capacity is more than doubled, A printing machine printing 100 sheets per time unit does not cost four times the price of a machine printing 25 sheets per time unit. (ii) Advantage of division of labour and specialisation. When a firm expands scale of production more labour of various skills is employed. With the labour according to their qualification and skill and to place them in the process of Production where they are best suited. This is known as division of labour.

Division of 'slicer) ends to specisjisztion which Increases efficiency. Besides, specialised workers develop more efficient tools and techniques and gain speed of work. These aspects of" of labour improve productivity of labour per unit of cost and tune. But there is limit to which division of labour is possiblethe limit is given by the level of beyond this limit the advantage of division of labour may not exist. Further of the firm may therefore lead to decreasing returns to scale. B. Economies in marketing. The economies in marketing arise from the large-scale purchase of raw materials and other material inputs and large-scale selling of firm's own produce. The large-size firms normally make bulk purchases of their inputs. The large-scale purchases entitle the firm for certain discounts and concessions which are not available on the small purchases. As such, the growing firms economies on the cost of their material inputs. The economies in marketing firm's own produce are associated with (a) advertisement economies, (b) economies in large-scale distribution through wholesalers, etc., (c) low cost on sales personnel. With the expansion of a firm, its total production increases. But the expenditure on advertising the product does not increase proportionately. Similarly, selling the product through the wholesale dealers reduces the cost on distribution of product. The firm also gains on large-scale distribution through better utilisation of 'sales force, distribution of samples, etc' This kind of economy however does not fall in the category of production economies. C. Managerial economies. Managerial economies arise from (a) specialisation in management, and (b) mechanization of managerial functions. For a large-size firm, it becomes possible for the management to divide itself into specialised departments under specialised personnel, such as production manager, personnel manager, labour officers, etc. This increases efficiency of management at all levels because of decentralisation of decision-making. Large-scale firms apply advanced techniques of communication, telephones and telex machines, computers, and their own means of transport. These all lead to quick decision-making, help in saving the valuable time of the management, and thereby improve managerial efficiency. > D. Economies in transport and storage. Economies in transportation and storage costs arise from fuller utilisation of transport and storage facilities. Transportation costs are incurred both on production and sales sides. Similarly, storage costs are incurred on both raw material and finished products. The largesize firms may acquire their own means of transport (e.g., lorries, etc.), and then can thereby reduce the unit cost of transportation compared to the market rate, at least to the extent of profit margin of the transport companies; Besides, own transport facility prevents delays in transporting goods,1 Some large-scale firms have their own railway track from the nearest railway point to the firm, and thereby they reduce the cost of transporting goods in and out. For example, Bombay Port Trust has its own railway tracks and oil companies have their own fleet of tankers. Similarly, large-scale firms can create their own god owns in the various centers of product distribution and can save on cost of storage. Theory of cost and break-even analysis In the previous chapter, we have discussed the input-output relations in terms of physical quantities of inputs an output. However, business decisions are taken generally on the basis of money values of the inputs and outputs. The cost of production expressed in monetary terms is an important factor in almost all business decisions, especially those pertaining to (a) locating the weak points in production management; (b) minimising the cost; (c) finding out the optimum level of output; and (d) estimating or projecting the cost of business operations. Besides, the term 'cost' has different meanings under different settings and is subject to varying interpretations. It is therefore essential that only relevant concept of costs is used in the business decisions. This chapter is divided into three sections. Section 7.1 discusses various cost concepts used in business decisions and section 7.2 analyses cost-output relations. Break-even analysis is carried out in section 7.3. Cost concepts The cost concepts which are relevant to business operations and decisions can be grouped, on the basis of their purpose, under two overlapping categories: (i) concepts used for accounting purposes, and (ii) concepts used in economic analysis of the business activities. We will discuss here some important concepts of the two categories. Some accounting cost concepts

(1) Opportunity cost and actual cost Opportunity cost is the loss of earnings due to opportunities foregone due to scarcity of resources. If resources were unlimited, there would be no need to forego any income-yielding opportunity and, therefore, there would be no opportunity cost. Resources are scarce but have alternative uses with different returns. Income maximising resource owners put their scarce resources to their most productive use and forego the income expected from the second best use of the resources. Thus, the opportunity cost may be defined as the expected returns from the second best use of the resources foregone due to the scarcity of resources. The opportunity cost it is also called alternative cost. For example, suppose that a person has a sum of Rs. 100,000 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 money Of his income from printing machine is the expected income from the lathe, i.e., Rs, 15,000. The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost of using resources in printing business, the best alternative is the expected return from the lathe, 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 {i.e., Rs. 20,000 - Rs. 15,000 = Rs. 5,000). The implication of this concept for business man is that investing in printing machine is preferable so long as its economic rent is greater than zero. Also, if firms know the economic rent of the various alternative uses of their resources, it will be helpful in the choice of the best investment avenue. In contrast to opportunity cost actual costs are those which are actually incurred by the firm in payment for labour, material, plant, building, machinery, equipments, travelling and transport, advertisement, etc. The total money expenses, recorded in the books of accounts are, for all practical purposes, the actual costs. Actual cost comes under the accounting concept. (2) Business costs and full costs Business costs include all the expenses which are incurred to carry out a business. The concept of business costs is similar to the actual or real costs. Business costs "include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment". These cost concepts are used for calculating business profits and losses and for filing returns for income-tax and also for other legal purposes. The concept of full costs includes business costs, opportunity cost and normal profit. The opportunity cost includes the expected earnings from the second best use of the resources, or the market rate of interest on the total money capital, and also the value of entrepreneur's own services high are not charged for in the current business. Normal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its present occupation. (3) Explicit and implicit or imputed costs Explicit costs are those which fall under actual or business costs entered in the books of accounts. The payments for wages and salaries, materials, license fee, insurance premium, depreciation charges are the examples of explicit costs. These costs involve cash payment and are recorded in normal accounting practices. In contrast with these costs, there are not certain other costs which do not take the form of cash outlays, nor do they appear m the accounting system. Such costs are known as implicit or imputed costs. Implicit costs may be defined as the earning expected from the second best alternative use of resources. For example, suppose an entrepreneur does not utilize his services in his own business and works as a manager in some other firm on a salary basis. If he starts his own business, he foregoes his salary as manager. This loss of salary is the opportunity costs of income from his own business. This is an implicit cost of his own business; implicit, because the entrepreneur suffers the loss, but does not charge it as the explicit cost of his own business. Thus, implicit wages, rent, and implicit interest are the highest wages, rents and interest which owner's labour, building, and capital can respectively earn from their second best use. Implicit costs are not taken into account while calculating the loss or gains of the business, but they form an important consideration in whether or not a factor would remain its present occupation. The explicit and implicit costs together make the economic cost.

(4) Out-of-pocket and book costs The items of expenditure which involve cash payments or cash transfersboth recurring and nonrecurringare known as out-of-pocket costs. All the explicit costs (e.g., wages, rent, interest, transport expenditure, etc.) Fall in this category. On the contrary, there are certain actual business costs which do not involve cash payments, but a provision is made therefore in the books of account and is taken into account while finalizing the profit and loss accounts. Such expenses are known as book costs. In a way, these are payments by a firm to itself. Depreciation allowances and unpaid interest on the owner's own fund are the examples of book costs. 7.1.2. Some analytical cost concepts (5) Fixed and variable costs Fixed costs are those which are fixed in volume for a certain given output. Fixed cost does not vary with variation in the output between zero and certain level of output. The costs that do not vary for a certain level of output are known as fixed cost. The fixed costs include (i) cost of managerial and administrative staff, (ii) depreciation of machinery, building and other fixed assets, and (in) maintenance of land, etc^/the concept of fixed cost is associated with short-run. Variable costs are those which vary with the variation in the total output they are a function of output. Variable costs include cost of raw materials, running cost on fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with the level of output, and the costs of all other inputs that vary with output. (6) Total, average and marginal costs Total cost represents the value of the total resource requirement for the production of goods and services. It refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level of output. It includes both fixed and variable costs. The total cost for a given output is given by the cost function. Average cost (ac) is of statistical nature, it is not actual cost. It is obtained by dividing the total cost (tc) by the total output (q), i.e. TC Ac = = average cost q Q Marginal cost is the addition to the total cost on account of producing an additional unit of the product. Or, marginal cost is the cost of marginal unit produced. Given the cost function, it may be defined as These cost concepts are discussed in further detail in the following section. Total, average and marginal cost concepts are used in economic analysis of firm's production activities. (7) short-run and long-run costs Short-run and long-run cost concepts are related to variable and fixed costs, respectively, and often figure in economic analysis interchangeably. Short-run costs are the cost which varies with the variation in output, the size of the firm remaining the same. In other words, short-run costs are the same as variable costs. Long-run costs, on the other hand, are the costs which are incurred on the fixed assets like plant, building, machinery, etc. Such costs have long-run implication in the sense that these are not used up in the single batch of production. Long-run costs are, by implication, the same as fixed costs. In the long-run, however, even the fixed costs become variable costs as the size of the firm or scale of production increases. Broadly speaking, 'the shortrun costs are those associated with variables in the utilisation of fixed plant or other facilities whereas long-run costs are associated with the changes in the size and kind of plant." (8) Incremental costs and sunk costs Conceptually, incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation. While marginal cost refers to the cost of the marginal unit of output, incremental cost refers to the total additional cost associated with the marginal batch of output. The concept of incremental cost is based on the fact that in the real world, it is not practicable for lack of perfect divisibility of inputs to employ factors for each unit of output separately. Besides, in the long run, firms expand their production; hire more men, materials, machinery and equipments. The expenditures of this nature are incremental costs, and not the marginal cost (as defined earlier). Incremental costs arise also owing to the change in product lines, addition or introduction of a new product, replacement of worn out plant 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 or recovered when there is change in market conditions or change in business decisions. (9) Historical and replacement costs Historical cost refers to the cost of an asset acquired in the past whereas replacement cost refers to the outlay which has to be made-for-emplacing an old asset. These concepts own their significance to unstable nature of price behaviour. Stable prices over time, other things given, keep historical and replacement costs on par with each other. Instability in asset prices makes the two costs differ from each other. Historical cost of assets is used for accounting purposes, in the assessment of net , worth of the firm. The replacement cost figures in the business decision regarding the renovation of the firm. (10) Private and social costs We have so far discussed the cost concepts that are related to the working of the firm and that are used in the cost-benefit analysis of the business decision. There are, however, certain other costs which arise due to functioning of the firm but do not normally figure in the business decisions nor are such costs explicitly borne by the firms. The costs of this category are borne by the society. Thus, the total cost generated by a firm's working may be divided into two categories: (i) those paid out or provided for by the firms, and (ii) those not paid or borne by the firms it includes use of resource freely available plus the disutility created in the process of production. The costs of the former category are known as private costs and of the latter category are known as external or social costs. To mention a few examples of social cost, Mathura oil refinery discharging its wastage in the Yamuna River causes water pollution. Mills and factories located in city cause air pollution by emitting smoke. Similarly, plying cars, buses, trucks, etc., cause both air and noise pollution. Such pollutions cause tremendous health hazards which involve health cost to the society as a whole. Such costs are termed external costs from the firm's point of view and social cost from society's point of view. The relevance of the social costs lies in understanding the overall impact of firm's working on the society as a whole and in working out the social cost of private gains. A further distinction between private cost and social cost is therefore in order. Private costs are those which are actually incurred or provided for by an individual or a firm on the purchase of goods and services from the market. For a firm, all the actual costs both explicit and implicit are private costs. Private costs are internalized cost that is incorporated in the firm's total cost of production. Social costs, on the other hand, refer to the total cost to the society on account of production of a commodity. Social cost includes both private cost and the external cost. Social cost includes (a) the cost of resources for which the firm is not compelled to pay a price, i.e., atmosphere, rivers, lakes, and also for the use of public utility services1 like roadways, drainage system, etc., and (b) the cost in the form of 'disutility' created through air, water and noise pollutions, etc. The costs of category (b) generally assumed to equal the total private and public expenditures incurred top safeguard the individual and public interest against the various kinds of health hazards created by the production system. The private and public expenditure, however, serve only as an indicator of 'public disutility',they do not give the exact measure of the public disutility or the social costs. Cost-output relations We have discussed in the preceding section the various cost concepts which figure in the business decisions. In this section, we discuss the behaviour of costs in relation to the change in output. This is, in fact, the theory of production cost. Cost-output relations play an important role in business decisions pertaining to cost-minimization or profit-maximisation and optimization of output. Cost-output relations are specified through a cost function expressed as TC = f(q) ` ....(7.1)

Where Tc = total cost, and q = quantity produced. Cost functions depend on (i) production function, and (ii) market-supply function of inputs. Production function specifies the technical relationship between the input-combination and the output. Production function of a firm combined with the supply function of inputs or prices of inputs determines the cost function of the firm. Precisely, cost function is a function derived from the production function and the market supply function. Depending on whether short or long run is considered for the production, there are two kinds of cost functions: (a) short-run cost-function, and (b) long-run cost function. Cost-output relations or cost behaviour in relation to the changing level of output will be discussed here under both kinds of costfunctions. Short-run cost-output relations The basic analytical cost concepts used in the analysis of cost behaviour are total, average and marginal costs. The total cost (TC) is defined as the actual cost that must be incurred to produce a given quantity of output. The short-run TC is composed of two major elements: total fixed cost (TFC) and total variable cost (TVC). That is, in the short-run, TC = TFC + TVC ...(7.2) As mentioned earlier, TFC (i.e., the cost of plant, building, equipment, etc.) Remains fixed in the short-run, whereas TVC varies with the variation in the output. For a given quantity of output (q), the average total cost, (ac), average fixed cost (afc) and average variable cost (avc) can be defamed as follows. TC TFC + TVC Ac = = Q Q TFC AFC = Q TVC AVC = Q A = AFC + TVC Marginal cost (MC) is defined as the change in the total cost divided by the change in the total output, i.e. TC TC MC = or Q Q Since TC = TFC + TVC and, in the short-run, TFC = 0, therefore, TC = TVC Furthermore, under marginality concept, where Q = 1, MC = TVC. Cost function and cost-output relations The concepts AC, AFC and AVC give only a static relationship between cost 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, AVC and AFC behave when output changes. This can be understood better with a cost function of empirical nature. Suppose the cost function (7.1) is specified as TC = a + bQ-cQ2 + dQ3 ...(7.5) (Where a = TFC and b, c, and d are variable-cost parameters) Suppose also that the cost function is empirically estimated as TC = 10 + 6Q - 0.9Q2 + 0.05Q3 ...(7.6) 2 3 And TVC = 6Q - 0.9Q + 0.05Q ...(7.7) The TC and TVC, based on Esq. (7.6) and (7.7), respectively, have been calculated for Q= 1 to 16 and presented in following table. The TFC, TVC and TC have been graphically presented in following fig. As the

figure shows, TFC remains fixed for the whole range of output, and hence, takes the form of a horizontal line-TFC. The TVC curve shows that the total variable cost first increases at a decreasing rate and then at an increasing rate with the increase in the total output. The rate of increase can be obtained from the slope of TVC curve. The pattern of change in the TVC stems directly from the law of increasing and diminishing returns to the variable inputs. As output increases, larger quantities of variable inputs are required to produce the same quantity of output due to diminishing returns. This causes a subsequent increase in the variable cost for producing the same output Table. Cost-output relations Q FC TVC TC AFC AVC AC MC (i) (2) (3) (4) (5) (6) (7) (8) 0 L 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 0.0 5.15 8.80 11.25 12.80 13.75 14.40 15:05 16.00 17.55 20.00 23.65 28.80 35.75 44.80 56.25 70.40 10.00 15.15 18.80 21.25 22.80 23.75 24.40 25.05 26.00 27.55 30.00 33.65 38.80 45.75 54.80 66.25 80.40 10.00 5.00 3.33 2.50 2.00 1.67 1.43 1.25 1.11 1.00 0.90 0.83 0.77 0.71 0.67 0.62 5.15 4.40 3.75 3.20 2.75 2.40 2.15 2.00 1.95 2.00 2.15 2.40 2.75 3.20 3.75 4.40 15.15 9.40 7.08 5.70 4.75 4.07 3.58 3.25 3.06 3.00 3.05 3.23 3.52 3.91 4.42 5.02 5.15 3.65 2.45 1.55 0.95 0.65 0.65 0.95 1.55 2.45 3.65 5.15 6.95 9.05 11.45 14.15

From Esq. (7.6) and (7.7), we may derive the behavioral equations 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 of output make the total fixed cost in the short-run. The fixed cost is represented by the constant term 'a' in eq. (7.6). We know that TFC AFC = q ...(7.8) Substituting 10 for TFC in eq. (7.8), we get 10 AFC = Q ...(7.9) Eq. (7.9) expresses the behaviour of AFC in relation to change in q. The behaviour of AFC for q form 1 to 16 is given in table 7.1 (col. 5) and presented graphically by the AFC-curve in fig. 7.2. The AFC curve is a rectangular hyperbola. Average variable cost (AVC) TVC As defined above, AVC = Q Given the TVC function (eq. 7.7), we may express a VC as follows 6Q- 0.9 Q2 +0.05Q2

AVC= Q = 6 - 0.9Q + o o. 5Q2 ...(7.10) Having derived the AVC function (eq. 7.10), we may easily obtain the behaviour of AVC in response to change in q. The behaviour of AVC for q - 1 to 16 is given in table (col. 6), and graphically presented in fig. by the VC curve. Critical value of AVC From eq. (7.10), we may compute the critical value of q in respect of AVC. The critical value of q (in respect of AVC) is that value of q at which AVC is minimum. The AVC will be minimum when its (decreasing) rate of change equals zero. This can be accomplished by differentiating eq. (7.10) and setting it equal to zero. Thus, critical value of q can be obtained as AVC Q= =-0.9 + 0.100 = 0 ...(7.11) Q Q =9. Thus, the critical value of q = 9. This can be verified from table. Average cost (ac) TC The average cost in defined as ac = Q Substituting eq. (7.6) for TC in above equation, we get 10+6-0.9Q2 +0.05Q=O AC= Q The eq. (7.12 a) gives the behaviour of ac in response to change in q. The behaviour of ac for q = 1 to 16 is given in table. And graphically presented in fig. by the ac-carve. Note that 4c-curve is u-shaped. From eq. (7.12 a), we may easily obtain the critical value of q in respect of a c. Here, the critical value of q in respect of a c is one at which a c is minimum. This can be obtained by differentiating eq. (7.12 a) and setting it equal to zero. Thus, critical value of q in respect of ac is given by AC 10 = - 0.9 + 0.1 Q = 0 2 Q Q This equation takes the form of a quadratic equation as -10-0.9Q2 + o.1 Q3 = 0 Or Q3 9Q2 100 = 0 By solving" equation (7.12b) we get Q = 10 Marginal cost (mc) The concept of marginal cost (MC) is particularly useful in economic analysis. Mc is technically the first derivative of TC function. That is, TC MC = Q Given the TC-function as in eq. (7.6), the mc-function can be obtained as

TC = 6 1.8Q + 0.15Q2 Q (7.13) Eq. (7.13) represents the behaviour of mc. The behaviour of mc for q = 1 to 16 computed as MC = TCN TC, is given in table (col. 8) and graphically presented In fig. The critical value of q in respect of mc is 6 or 7. It can be seen from table . Cost curves and the laws of diminishing returns We now return to the laws of variable proportions and explain it through the cost curves. Fig clearly bring out the short-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 a variable input are applied to the inputs held constant, the returns from the marginal units of the variable input may initially increase but will eventually decrease. The same law can also be interpreted in terms of decreasing and increasing costs. The law can then be stated as, if more and more units of variable inputs are applied to the given amount of a fixed input, the marginal cost initially decreases, but eventually increases. Both interpretations of the law yield the same information one in terms of marginal productivity of the variable input, and the other, in terms of the marginal cost. The former is expressed through production function and the latter through a cost function. Fig. presents the short-run laws of returns in terms of cost of production. As the figure shows, in the initial stage of production, both AFC and AVC are declining because of internal economies. Since ac = AFC + AVC, ac is also declining. This shows the operation of the law of increasing returns. But beyond a certain level of output (i.e., 9 units in our example), while AFC continues to fall, a VC starts increasing because of a faster increase in the TVC. Consequently, the rate of fall in ac decreases. The ac reaches its minimum when output increase to 10 units. Beyond this level of output, ac starts increasing which shows that the law of diminishing returns comes in operation. The mc curve represents the pattern of change in both the TVC and TC curves due to change in output. A downward trend in the AFC shows increasing marginal productivity of the variable input due mainly to internal economy resulting from increase in production. Similarly, an upward trend in the mc shows increase in TVC, on the one hand, and decreasing marginal productivity of the variable input, on the other. Some important cost relationships Some important relationships between costs used in analyzing the short-run cost-behaviour may now be summed up as follows: (a) So long as AFC and AVC fall, ac also falls because AC = AFC + AVC. (b) When AFC falls but a VC increases, change in a c depends on the rate of change in AFC and AVC (ii) Similarly, when mc increases, ac also increases but at a lower rate for the reason given in (i). There is however a range of output over which this relationship does not exist. Compare the behaviour of mc and ac over the range of output from 6 units to 10 units (see fig.). Over this range of output, mc begins to increase while ac continues to decrease. The reason for this can be seen in table: when mc starts increasing, it increases at a relatively lower rate which is sufficient only to reduce the rate of decrease in acnot sufficient to push the ac up. That is why ac continues to fall over some range of output even if mc falls. (iii) MC intersects 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, it is neither increasing nor decreasing it is constant. Whence is constant, AC=MC. OPTIMUM OUTPUT IN SHORT-RUN An optimum level of output is one which can be produced at a minimum average cost, given the technology. We have illustrated, in the previous chapter, the least-cost combination of inputs through the isoquants and are costs. The least-cost combination of inputs indicates also the optimum level of output at a given investment and factor prices. The ac and mc cost curves can also be used to find the optimum level of output given the size of the plant in the short-run. The minimum level of a c is determined by the point of intersection between ac and mc curves. At this level of output AC = MC. Production below or beyond this level will be in optimal. For, if production is less than 10 units (fig.) it will leave some scope for reducing ac by producing more, because mc <ac. Similarly, if production is greater than 10 units, ac can be

reduced by reducing output. Thus, the cost curves can be useful in finding the optimum level of output. It may be noted here that optimum level of output is not necessarily the maximum-profit output. Profits cannot be known unless firm's revenue curves are known. Long-run cost-output relations By definition, in the long-run, all the inputs become variable. The variability 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 the scale of their production by hiring a larger quantity of all the inputs. The long-run-cost-output relations, therefore, imply the relationship between the changing scale of the firm and the total output, whereas in the short-run this relationship is essentially one between the total output and the variable cost (labour). To understand the long-run-cost-output relations and to derive long-run cost curves it will be helpful to imagine that a long-run is composed of a series of short-run production decisions. As a corollary of this, long-run cost curves is composed of a series of short-run cost curves. We may now derive the long-run cost curves and study their relationship with output. Long-run total cost curve (LTC) In order to draw the long-run total cost curve, let us begin with a short-run situation. Suppose that a firm having only one-plant has its short-run total cost curve as given by STC, in panel (a) of fig. Let us also suppose that the firm decides to add two more Plants to its size over time, one after the other. As a result, two more short-run total cost curves are added to STCP in the manner shown by stc2 and stc3 in fig. (a). The STC can now be drawn through the minimum points of STCV stc2 and stc3 as shown by the STC curve corresponding to each STC. Long-run average cost curve The long-run average cost curve (LMC) is derived by combining the short-run average cost curves (sac). Note that there is one sac associated with each STC. Given the STCR STC, stc3 curves in panel (a) of fig. there are three corresponding sac curves as given by SACR sac2 and sac3 curves in panel (b) of fig. Thus, the firm has a series of sac curves, each having a bottom point showing the minimum sac. For instance, c1qi is the minimum ac when the firm has only one plant. The ac decreases to c2q, when the second plant is added and then rises to c3q3 after the inclusion of the third plant. The LAC can be drawn through the bottom of SACR sac2 and sac3 as shown in fig. (b). The LAC curve is also known as 'envelope curve' or 'planning curve' as it serves as a guide to the entrepreneur in his planning to expand production. The sac curves can be derived from the data given in the STC schedule, from STC-function or straightaway from the l7"c-curve. Similarly, LAC and can be derived from 7u-schedule, LTC function or form 7u-curve. The relationship between LTC and output and between LAC and output can now be easily derived. It is obvious from the LTC that the long-run cost-output relationship is similar to the short-run cost-output relation. With the subsequent increases in the output, LTC first increases at a decreasing rate, and then at an increasing rate. As a result, LAC initially decreases until the optimum utilisation of the second plant and then it begins to increase. From these relations are drawn the 'laws of returns to scale'. When the scale of the firm expands, unit cost of production initially decreases, but ultimately increases as shown in fig. (b). The decrease in unit cost is attributed to the internal and external economies and the eventual increase in cost, to the internal and external diseconomies, as elaborated in chapter. Long-run marginal cost curve The long-run marginal cost curve (LMC) is derived from the short-run marginal cost curves (SMCS). The derivation of LMC is illustrated in fig. in which sacs and LAC are the same as in fig. 7.3 (b). To derive the

LMC, consider the points of tangency between sacs and the LAC, i.e., points a, b and c. In the long-run production planning, these points determine the output levels at the different levels of production. For example, if we draw perpendiculars from points a, b and c to the x-axis, the corresponding output levels will be OQ , oq2 and OQY the perpendicular AQ intersects the SMC at point m. It means that at output BO LMC is MQR if output increases to OQ LMC rises to bq2. Similarly, cq3 measures the LMC at output oq3. A curve drawn through points m, b and n, as shown by the LMC, represents the behaviour of the marginal cost in the long-run. This curve is known as the long-run marginal cost curve, LMC. It shows the trends in the marginal cost in response to the changes in the scale of production. Some important inferences may be drawn from fig. The LMC must be equal to SMC for the output at which the corresponding sac is tangent to the LAC. At the point of tangency, LAC = SAC. For all other levels of output (considering each sac separately), SAC > LAC. Similarly, for all the levels of output corresponding to LAC = SAC, the LMC = SMC. For all other levels of output, the LMC is either greater or less the SMC. Another important point to notice is that LMC 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 sac coincides with the minimum LAC. This point is b where SAC, = SMC, = LAC = LMC Optimum plant size and long-run cost curves The short-run cost curves are helpful in showing how a firm can decide on the optimum utilisation of the plant the fixed factor or how it can determine the least-cost output level. Long-run cost curves, on the other hand, can be used to show how a firm can decide on the optimum size of the firm. An optimum size of a firm is one which ensures the most efficient utilisation of resources. Given the state of technology over time, there is technically a unique size of the firm and level of output associated with the least cost concept. This unique size of the firm can be obtained with the help of LAC and LMC. In fig., the optimum size consists of two plants which produce oq2 units of a product at minimum long-run average SAC, LMC Cost (LAC) of BQ,. The downtrend in the LAC indicates that until output reaches the level of OQ the firm is of non-optimal size. Similarly, expansion of the firm beyond production capacity OQ causes a rise in SMC as well as LAC. It follows that given the technology, a firm trying to minimise its average cost over time must choose a plant which gives minimum LAC where SAC = SMC - LAC = LMC. This size of plant assures most efficient utilisation of the resource. Any change in output level, increase THE ANALYSIS OF ECONOMIES OF SCALE Economies of scale can be of two kinds: internal economies and external economies. Internal economies of scale are those which arise from the firm increasing its plant size. On the other hand, external economies arise outside the firmfrom improvement (or, deterioration) in the environment in which the firm operates. The economies entertain to the firm may be realised from actions of other firms in the same or in another industry. While the internal economies of scale relate only-to the long-run and determine the shape of the long-run cost curve (compare Figs), the external economies affect the position of the long-run cost curves. INTERNAL ECONOMIES Internal economies are given in a summary form in Fig. where these are categorized into real and pecuniary economies. Real economies arise when the quantity of inputs used for a given level of output decreases. While pecuniary economics are those savings in expenses which accrue to the firm in the nature of relatively lower prices paid for inputs and lower costs of distribution. These savings arise due to bulk buying and selling by the growing firm. (A) Real Economies of Scale

Real economies are of 4 kinds: (1) Production economies, (2) marketing economies, (3) Managerial economies, and (4) Transport and storage economies. 1. Production economies. Production economies arise from (a) labour, (b) fixed capital, and (c) inventory requirements of the firm. These are : Labour economies. Labour economies arise because of the following factors: (i) Division of Labour Economies. Larger output allows division of labour which reduces cost by increasing specialization, by saving time (otherwise lost in passing from one operation to another), and providing good conditions for inventions of a great number of machines, (ii) Cumulative volume economies. The technical personnel engaged in production tend to acquire significant experience from large-scale production. This 'cumulative volume' experience helps in higher productivity and, therefore, reduced costs. -Technical economies. These are associated with fixed capital, which includes machinery and equipment. Such economies arise because of the following: (i) Specialised equipment. The production methods become more mechanized as the output scale increases. This would imply more specialised capital equipment and lower
ECONOMIES OF SCALE

Internal Economies Real Economies

External Economies Pecuniary Economies

4. Transport and Storage Economies

1. Production Economies2. Marketing Economies3. Managerial Economies

Specialisation Labour Division of labour Economics Cumulative volume economies Technical Specialisation Indivisibilities Economies of large machines General purpose machinery Inventory Economies of massed resources Advertising economies Exclusive dealers with after sales service obligation Economies of variations in models and designs Team work experience Decentralization Introduction of modern managerial and organisation al techniques

Bulk buying of materials at competitive price Lower cost of capital Advertising at large scale at lower rate Less per unit rate of transportation Lower wages and salaries due to monophony power and prestige associated with large firm

variable costs, (ii) Indivisibility. The machinery and equipment generally have the property of indivisibility, which means that equipment is available only in minimum sizes or in definite ranges of size. When output is increased from zero to the maximum capacity level of the machine, the same machine and equipment are used. As a result the cost of machine is shared between more and more units of output. In short, as the output is increased, the machinery and equipment comes to be utilised more intensively and consequently the cost of production per unit declines. (Hi) Integration of processes. The large size firms enjoy economies of large machines. Integration of processes occurs where one large automatic transfer or numerically controlled machine can carry out a series of consecutive processes, saving labour cost and time required to set up the work on each of a series of successive specialised

machines, (iv) Economies of increased dimensions, for many types of equipment both initial and running costs increase less rapidly than capacity (e.g., tanks, blast furnaces and other static and mobile containers). These result in economies of increased dimensions. Any container whose external dimensions are doubled has its volume increased eight times, but the area of its surface walls would have increased only four times. This reduces material costs and, where appropriate, heat loss and surface, air and water resistance per unit, (v) Economies in set-up costs. The larger the scale of output, the more multipurpose machinery is left to one set-up and, therefore, set-up costs of general purpose machines reduce. (yi) Economies of overhead costs. Obviously, the larger the scale of output, the lower the unit costs of initial fixed expenses which are need for a new business or a new product. Inventory economies. Role of inventories is to meet the random changes in the input and output sides of the operations of the firm. It has been found that the input as well as output inventories increase at a rate lower than that of increase in output. These economies arise due to the phenomenon of massed resources. 2.Marketing Economies. These economies arise because: (i) The advertising expenditure is generally found to have increased less than proportionately with scale. Consequently, larger the output, smaller the advertising cost per unit. Similar situation prevails in case of other types of selling activities, (ii) the development and adoption of new models and designs involve considerable expenses in R&D. The larger the output, more thinly this R&D expenditure spreads over output. 3.Managerial Economies. Managerial economies arise because: (i) Larger the firm, greater are the opportunities for the division of managerial tasks. The division of managerial tasks helps managers to specialise in their own areas of responsibility, thus leading to greater efficiency, (ii) Teamwork experience. By working in a team, the managers of large firms tend to acquire a more comprehensive outlook as well as a quicker and better decision-making ability. (iii) In a large firm, with decentralization in decision-making, the delays in the flow of information are reduced, thereby increasing the efficiency of management, (iv) Modern managerial and organisational techniques. Large firms provide opportunities for the introduction of modern managerial techniques and organisational restructuring. These help the management to increase efficiency. 4. Transport and Storage Economies. Storage costs obviously fall with the increase in the size of output, as it provides the economies of increased dimensions (discussed already). The transportation costs, on the other hand, involve an L-shaped average cost curvetransport unit costs falling up to the point of the full capacity and remaining constant thereafter. (B) Pecuniary Economies of Scale These economies include the discounts that a firm can obtain due to its large size. These discounts may be in the nature of: (1) Lower raw material price due to bulk buying. (2) Lower cost of capital, as banks usually place greater faith in the large firms and, therefore, charge lower rate of interest. (3) Offers of lower rates for advertising to large firms because of their large-scale advertising. (4) Lower transportation rates due to bulk transportation. (5) In case the large firm is able to attain a size to gain monopsonistic power or is able to create an image of prestige to be associated with the firm it may be in a position to save on labour costs by paying lower wages and salaries. EXTERNAL ECONOMIES Like internal economies, external economies also help in cutting down production costs. With the expansion of an industry, certain specialised firms also come up for working up the by-products and waste materials. Similarly, with the expansion of the industry, certain specialised units may come up for supplying raw material, tools, etc., to the firms in the industry. Moreover, they can combine together to undertake research, etc., whose benefit will accrue to all the firms in the industry. Thus, a firm benefits from expansion of the industry as a whole. These benefits are external to the firm, in the sense that

these arise not because of any effort on the part of the firm but accrue to it due to expansion of industry as a whole. In this sense these economies are external to the firm. All these external economies help in reducing production costs. DISECONOMIES OF SCALE When a firm continues to expand its size, a stage comes when diminishing returns to scale set in. As a firm expands beyond a level, it encounters growing diseconomies. These diseconomies more than cancel out the economies of large-scale production and cause average costs of production to start rising. Let us discuss in detail reasons for such a phenomenon. Technical factors are unlikely to produce diseconomies of scale. If inefficiencies arise as a result of overlarge plant size then they can be avoided by replicating units of plant of a smaller size. In fact, technical factors are more likely to 'limit the sources of scale economies than to act as a source of diseconomies. When diseconomies of scale arise they are more likely to be associated with the human and behavioral problems of managing a large enterprise. Let us understand this with the help of a highly simplified organization chart or a managerial hierarchy given in figure below. Both Vijay and Ashok (who may, for example, be the divisional managers) are responsible to Ram. If Vijay wants to communicate with Ashok he must follow the formal chain of command and pass his message through Ram, whose function is coordination? This will be a time-consuming process involving red-tapism but, given a large organization with a large number of managers, such indirect coordination may be the only practical method of communicating while avoiding disorganization and chaos. Ram

Vijay Ashok Now, if the firm grows further, then another layer of management must be inserted between Ram, Vijay and Ashok. This increases the chain of command and Vijay, in order to communicate with Ram, must pass his message through an intermediary. This increases the costs of communication and also introduces the problems of possible message distortion and misinterpretation with corresponding implications for organisational efficiency. These arguments can be well-explained with the help of Williamson's concept of 'control loss'. The decisions taken by a top executive must be based on information passed across a series of hierarchical levels. In turn, the instructions based on this information must be transmitted down through these successive stages. This transmission results in a serial reproduction loss or distortion, of both the information and instructions. This may occur even when the individuals forming the hierarchy have identical objectives. Increases in the scale of the hierarchy result in reduction of the quality of the information reaching the top coordinator and of the instructions passed down by him to lower-level personnel. Moreover, since the capacity of the top administrator for assimilating information and issuing instruction is limited he can, after a point, only cope with an expansion of the hierarchy by sacrificing some of the details provided before the expansion. Thus, the quantity of information received and transmitted per unit of output will be less after expansion than before it. This is known as 'control loss'. As a result it can be argued that operating units will not adhere as closely to the top administrator's objectives of cost minimisation as they did before the expansion. Secondly, there is the problem of morale and motivation of both management and labour force. It is often argued that due to lack of personal touch the spirit in a large firm is less than that in a small firm. The labour force is more closely identified with small firm and these results in improved productivity and greater overall loyalty to the organisation. Moreover, since management of a large firm may feel more secure they may become sluggish and develop lack of enterprise. This sluggishness is absent in managers of small firms who see the generally present threat of being put out of business. In short, we may say that decreasing returns to scale will become operative when management becomes a problem. This problem is more serious in agriculture than in industry: as their operations expand the law of decreasing returns becomes operative earlier in agriculture than in industry.

UNIT III OBJECTIVES & EQUILIBRIUM OF THE FIRM

MARKET STRUCTURE MARKET STRUCTURE AND DEGREE OF COMPETITION In economic sense, market is a system in which buyers and seller bargain for price of product, settle the price and transact their businessbuy and sell a product. Personal contact between the buyers and sellers is not necessary. In some cases, e.g., forward sale and purchase, even transfer of the ownership of goods is not necessary. Market does not necessarily mean a peace. Markets may be local, regional, national or international. What makes a market is a set of buyers, a set of sellers and a commodity. While buyers are willing to buy and sellers are willing to sell and there is a price for the commodity. We are concerned in these chapters with how price is determined in the market. The determination of price of a commodity depends on the number of sellers and the number of buyers. Barring a few cases; e.g., occasional phases in share and property markets, the number of buyers is larger than the number of sellers. The number of sellers of a product in a market determines the nature and degree of competition in the market. The nature and degree of competition make the structure of the market. Depending on the number of sellers and the degree of competition, the market structure is broadly classified as under. (i) Perfect or Pure CompetitionA large number of sellers selling a homogenous product. (ii) MonopolyA single seller of a product without a close substitute. (iii) Monopolistic CompetitionA fairly large number of sellers selling differentiated products, (iv) OligopolyA small number of big sellers selling the same product (e.g., petroleum) or differentiated products, e.g., cars.) (v) Bilateral MonopolyA small number of buyers competing against a small number of sellers. There are other rare kinds of markets, eg. oligopoly, monophony, monopoly. We will however discuss price determination under the first four kinds of market structure. PRICING UNDER PERFECT COMPETITION CHARACTERISTICS OF PERFECT COMPETITION The term perfect competition refers to a set of conditions prevailing in the market. A perfectly competitive market is one which has the following characteristics. (1) Large number of sellers and buyers. Under perfect competition, the number of sellers and buyers is very large. The number of sellers and buyers is so large that the share of each seller in total supply and the share of each buyer in total demand is so small that no single seller can affect the market price by changing his supply, nor can a single buyer by changing his demand. (2) Homogeneity of products. Products supplied by all firms are approximately homogeneous. Homogeneity of products does not mean that products supplied by various firms are so identical in appearance and use that buyers do not distinguish between them nor do they prefer the product of one firm to that of another. Product of each firm is regarded as a perfect substitute for the product of other firms. Hence, no firm can gain any competitive advantage over other firms. Nor do the firms distinguish between the buyers. For example, wheat and vegetables produced by all the farmers, other things given, is treated as homogenous. (3) Perfect mobility of factors of production. For a market to be perfectly competitive there should be perfect mobility of resources. It means that the factors of production must be in a position to move freely into or out of an industry and from one km to another. (4) Free entry and free exit of firms. There is no restriction, legal or otherwise, en the firm's entry into or exit from the industry. (5) Perfect knowledge. There is perfect dissemination of the information about ~e market conditions. Both buyers and sellers are fully aware of the nature of the product, 35 availability or salability and of the price prevailing in the market. (6) Absence of collusion or artificial restraint. There is not any sellers' union or other end of collusion between the sellers like cartels or guilds, nor is there any kind of collusion: between the buyers, like consumers' association or consumer forum. Each seller or buyer acts independently. The firms enjoy the freedom of independent decisions.

The perfect competition, as characterized above, is considered as an unrealistic phenomenon in the real business world. However, the actual markets that approximate to the conditions of perfectly competitive model include the share markets, securities and bond markets, and agricultural product markets, e.g., local vegetable markets. Although perfectly competitive markets are uncommon phenomena, perfect competition model has been the most popular model used in economic theories due to its analytical value. Some economists make distinction between perfect competition and pure competition. The difference between the two is only the matter of degree. Perfect competition less perfect mobility of factors and perfect knowledge is regarded as pure competition. In this book, however, we shall use the two terms interchangeably.' PRICE DETERMINATION UNDER PERFECT COMPETITION By definition, perfect competition is a market setting in which, there is a large number of sellers of a homogeneous product. Each seller supplies a very small fraction of the total supply. No single seller is powerful enough to influence the market price. Nor can a single buyer influence the market price. Market price in a perfectly competitive market is determined by the market forcesmarket demand and market supply. Market demand refers to the demand for the industry as a whole: it is the sum of the quantity demanded by each individual firm at different prices. Similarly, market supply is the sum of quantity supplied by the individual firms in the industry. The market price is therefore determined for the industry, and is given for each individual firm and for each buyer. Thus, a seller in a perfectly competitive market is a 'price-taker', not a 'price-maker'. In a perfectly competitive market, therefore, the main problem for a profit maximising firm is not to determine the price of its product but to adjust its output to the market price so that profit is maximum. The mode of price determinationprice level and its variationsdepends on the time taken by supply position to adjust itself to the changing demand conditions. Price determination is analyzed under three different time periods I. market period or very short run, II. short run, and III. Long run. The short run and long run have already been defined (see Chapter 6, section 6.1). As regards the market period or very short run, it refers to a time period in which quantity supplied is absolutely fixed or, in other words, supply response to price is nil. Price determination in the three types of markets is described below. (i) Pricing in Market Period In a market period, the total output of a product is fixed. Each firm has a stock of commodity to be sold. The stock of goods with all the firms makes the total supply. Since the stock is fixed, the supply curve is perfectly inelastic, as shown by the line SQ in Fig.. In this situation, price is determined solely by the demand conditions. Supply remains an inactive agent. For instance, suppose that the number of marriage houses (or tents) in a city in a marriage season is given at OQ (Fig.) and the supply curve takes the shape of a straight line, SQ. Suppose also that the demand curve for marriage houses (or tents) during a season is given by D1 Demand curve and supply line intersect each other at point M, determining the rent at MQ. If during a marriage season demand for marriage houses (or tents) increases suddenly because a relatively larger number of parents decide to celebrate the marriage of their daughters and sons, then the demand curve >, shift upward to Dr The equilibrium pointthe point of intersection between demand and supply curvesshifts from point M to P, and the rent rises to PQ. This price becomes a parametric price for all the buyers. The other

example of very short-run markets may be daily fish market, stock markets, daily milk market, coffin markets during a period of natural calamities, certain essential medicines during epidemics, etc. (ii) Pricing in the Short-run The short run is, by definition, a period in which firms can neither change their size nor quit, nor can new firms enter the industry. While in market period (or very short run) supply is absolutely fixed, in the short run, it is possible to increase (or decrease) the supply by increasingly (or decreasing) the variable inputs. In the short run, therefore, supply curve is elastic, unlike a straight vertical line in the market period. The determination of market price in the short run is illustrated in Fig.(a) and adjustment of output by the firms to the market price and firm's equilibrium are shown in Fig.(b). Fig.(a) shows the price determination for the industry by the demand curve DD and supply curve SS, at price OP1 or PQ. This price is fixed for all the firms in the industry. Given the price PQ (= OP1), an individual firm can produce and sell any quantity at this price. But any quantity will not yield maximum profit. Given their cost curves, the firms are required to adjust their output to the price PQ so that they maximise their profit. The process of firm's output determination and its equilibrium are shown in Fig.(b). As profit is maximum at the level of output where MR=MC. Since price is fixed at PQ, firm's AR=PQ. The firm's MR is shown by AR=MR line. Firm's upward sloping MC curve intersects AR=MR at point E, i.e., firm's equilibrium point. A coordinate EM drawn from point E to the horizontal axis determines the profit-maximising output at OM. At this output firms' MR = MC. This satisfies the necessary condition of maximum profit*. The total maximum profit has been shown by the area P, TNE. The total profit may be calculated as Profit = (AR -AC) Q In Fig. (b), AR = EM; AC - NM; and Q - OM. Substituting the values from the Fig. 9.2 (b) we get Profit = (EM- NM) OM = P TNE. Since EM - NM - EN, Profit = EN. OM = PXTNE. This is the maximum supernormal profit, given the price and cost curves. This is a case of supernormal profit in the short run.

Firms may make losses in the short run. For instance, if market price decrease to PQ' due to downward shift in the demand curve to D'D' [Fig. 9.2 (a)]. A new process of adjustments will start and firms will reach a new equilibrium at point E'. Here again firm's AR' = MR' = MC. But its AR < AC. Therefore, the firm incurs loss. But, since in the short run, it may not be desirable to close down the production, the firm tries to inanities the loss, by adjusting its output downward to OM' where it covers its MC, i.e. E'M'. The firm survives in the short run so long as it covers its MC. It is important to note here that in the short run, a firm in the perfectly competitive market may be in a position to earn economic profit. It may as well be forced to make, losses, depending on the price and cost conditions. Once market price for the product is determined, it is given for all the firms. No firm is large enough to influence the price. If a firm fixes the price of its product lower than the market price, it may lose a part of its total profit, or may even incur losses. If it raises the price of its product above the market price, it may not be in a position to sell its produce in a competitive market. The only option for a firm is to produce as much as it can sell at the given price. If price changes due to change in demand, the firms will be required to adjust their output to the new market price. (iii) Pricing in the Long-run

In contrast to the short run, the firms can adjust their size or quit the market and new firms can enter the industry in the long run. If market price is such that AR > AC, then the firms make economic or supernormal profit. As a result, new firms get attracted towards the industry causing a rightward shift in the supply curve. Similarly, if AR < AC then firms make losses. Therefore, marginal firms quit the industry causing a leftward shift in the supply curve. The rightward shift in supply curve pulls down the price and its leftward shift pushes it up. This process continues until price is so determined that AR -AC and firms earn only normal profit. The price determination in the long run and output (or size) adjustment by an individual firm are presented in Fig. (a) and (b).

Let us suppose that the long run demand curve is DD'; the short-run supply is SSX and price is determined at OP1 At this price the firms adjust their output to point M, the equilibrium point where OP1 = AR' = MR' = LMC. Firms make an economic profit of MS per unit. The supernormal profit lures other firms into the industry. Consequently, the industry's supply curve shifts rightward to SS2 causing a fall in price to OP2 At this price, firms are in a position to cover only LMC (= NQ2) at output OQ2 and are making losses because AR < LAC. Firms incurring losses cannot survive in the long run. Such firms therefore quit the industry. As a result, the total production in the industry decreases causing a leftward shift in the supply curve, say to the position of SS. Price is determined at OPQ. The existing firms adjust their output to the new market price, at OQ. At the output OQ, firms are in a position to make only normal profit, since at this output, OPQ = AR = MR = LMC = LAC (= EQ). No firm is in a position to make economic profit, nor does any firm make losses. Therefore, there is no tendency of new firms entering the industry or the existing ones going out. At this price and output, individual firms and the industry are both in long-run equilibrium. PRICING UNDER PURE MONOPOLY The term pure monopoly signifies an absolute power to produce and sell a product which has no close substitute. In other words, a monopoly market is one in which there is only one seller of a product having no close substitute. The cross elasticity of demand for a monopolized product is cither zero or negative. A monopolized industry is a single-firm industry. Firm and industry are identical in a monopoly setting. In a monopolized industry, equilibrium of the monopoly firm signifies the equilibrium of the industry. Moreover, the precise definition of monopoly has been a matter of opinion and purpose. For instance, in the opinion of Joel Deal1, a noted authority on managerial economics, a monopoly market is one in which 'a product of lasting distinctiveness is sold. The monopolized product has distinct physical properties recognised by its buyers and the distinctiveness lasts over many years. Such a definition is of practical importance if one recognizes the fact that most of the commodities have their substitutes varying in degree and it is entirely for the consumers/users to distinguish between them and to accept or reject a commodity as the substitute. Another concept of pure monopoly has been advanced by E.H. Chamberlin1 who envisages the control of all goods and services by the monopolist. But such a monopoly has hardly ever existed, hence his definition is questionable. In the opinion of some authors, any firms facing a sloping demand curve is a monopolist. This definition however includes all kinds of firms except those under prefect competition. For our purpose here, we use the general definition of pure monopoly, i.e., a firm that produces and sells a commodity that has no close substitute.

CAUSES AND KINDS OF MONOPOLIES The emergence and survival of monopoly is attributed to the factors which prevent the entry of other firms into the industry. The barriers to entry are therefore the sources of monopoly power. The major sources of barriers to entry are: I. legal restrictions or barriers to entry of new firms; II. Sole control over the supply of scarce and key raw materials; and III. Efficiency and economies of scale. (i) Legal Restrictions Some monopolies are created by law in the public interest. Most of the state monopolies in the public utility sector in India, e.g., postal, telegraph and telephone services, radio and TV services, generation and distribution of electricity, Indian Railways, Indian Airlines and State Roadways, etc., are public monopolies. Entry to these industries is prevented by law. The state may create monopolies in the private sector also through licence or patent, provided monopolies can reduce cost of production to the minimum by enlarging the size and investing in technological innovations. Such monopolies are known as franchise monopolies. (ii) Control over Key Raw Materials Some firms acquire monopoly power because of their traditional control over certain scarce and key raw materials which are essential for the production of certain other goods, e.g., bauxite, graphite, diamond, etc. For instance, Aluminum Company of America had monopolised the aluminum industry before War II because it had acquired control over almost all sources of bauxite supply3. Such monopolies are often called 'raw-material monopolies'. The monopolies of this kind emerge also because of monopoly over certain specific knowledge of technique of production. (iii) Efficiency A primary and technical reason for monopolies is the economy of scale. If a firm's long-run minimum cost of production or its most efficient scale of production almost coincides with the size of the market, then the large-size firm finds it profitable in the long-run to eliminate competition through price cutting in the short-run. Once its monopoly is established, it becomes almost impossible for the new firms to enter the industry and survive. Monopolies created on account of this factor are known as natural monopolies. A natural monopoly may emerge out of the technical conditions of efficiency or may be created by law on efficiency grounds. PRICING AND OUTPUT DECISION: SHORT RUN As under perfect competition, pricing and output decisions under monopoly are based on revenue and cost conditions. Although cost conditions, i.e., AC and MC curves, in a competitive and monopoly market are generally identical, revenue conditions differ. Revenue conditions, i.e., AR and MR curves, are different under monopoly because, unlike a competitive firm, a monopoly firm faces a downward sloping demand curve. For, a monopolist can reduce the price and sell more and can raise the price and still retain some customers. Precisely, since monopoly firm and monopolized industry are one and the same, the demand curve of industry, a typically sloping downward curve, becomes the demand curve for the firm. When a demand curve is sloping downward, Marginal Revenue (MR), curve lies below the AR curve and the slope of the MR is twice that of AR The revenue and cost conditions faced by a monopoly firm are presented in Fig. Firm's average and marginal revenue curves are shown by the AR and MR curves, respectively, and its short-run average and marginal cost curves are shown by SAC and SMC curves, respectively. The price and output decision rule for profit maximising monopoly is the same as for a firm in the competitive industry. A profit maximising monopoly firm chooses a price-output combination at which MR = SMC. Given the firm's cost and revenue curves in Fig. its MR and SMC intersect each other at point N. An ordinate drawn from point N

to X-axis, determines the profit maximising output for the firm at OQ. At this output, firms' MR = SMC. Given the demand curve AR = D, the output o Q Output per time unit Fig.. Price Determination under Monopoly: Short-run OQ can be sold per time unit at only one price, i.e., PQ (- OP1). Thus the determination of output simultaneously determines the price for the monopoly firm. Once price is fixed, the unit and total profits are also simultaneously determined. Hence, the monopoly firm is in the state of equilibrium. At output OQ and price PQ, the monopoly firm maximizes its unit and total) profit. Its per unit monopoly or economic profit (i.e., AR SAC) equals (PQMQ) - PM. Its total profit, it = OQ PM. Since OQ = P2M = P2M = PM = PXPMP2 as shown by the shaded area. Since in the short run, cost and revenue conditions are not expected to change, the equilibrium of the monopoly firm will remain stable. MONOPOLY PRICING AND OUTPUT DECISIONS IN THE LONG RUN The decision rules regarding optimal output and pricing in the long run are the same in the short run. In the long run. However, a monopolist gets an opportunity to expand e size of its firm with a view to enhance its long-run profits. The expansion of the plant Size may however be subject to such conditions as (a) size of the market, (b) expected economic profit, and (c) risk of inviting legal restrictions. Let us assume, for the time being, at none of these conditions limits the expansion of monopoly firm and discuss the price Hid output determination in the long run. The general case of monopoly equilibrium in the long-run has been depicted in Fig. The AR and MR curves show the market demand and marginal revenue conditions faced by the monopoly firm. The LAC and LMC show the long run cost conditions. In can be seen in Fig. that monopoly's LMC and MR intersect at point P where output is OQ1 this is therefore profit maximizing output. Given the AR curve, the price at which the total output OQ2 can be sold is P2Q1 Thus, in the long run, the output will be 002 and price, P^S^ This output-price combination maximizes the monopolist's long run profit. The total monopoly profit has been shown by the area LP2 SM. Compared to short run equilibrium, the monopolist produces a larger output and charges a lower price and makes a larger monopoly profit in the long run. In the short run, firm's equilibrium is at output OQ2 which is less than long-run output OQ But the short run equilibrium price PXQX is greater than the longrun equilibrium price P2Qr The total short-run monopoly profit is shown by the area JPXTK which is much smaller than the long-run profit area, LP2SM. This, however, is not necessary; it all depends on the cost and revenue conditions in the short and long runs. It may be noted at the end that if there are barriers to entry, the monopoly firm may not reach the optimal scale of production (OQ2) in the long run, nor it may make full utilisation of its existing capacity. The firm's decision regarding plant expansion and full utilisation of its capacity depends solely on the market conditions. If long-run market conditions, i.e., revenue and cost conditions and the absence of competition, permit, the firm may reach its optimal level of output. PRICE DISCRIMINATION UNDER MONOPOLY Price discrimination means selling the same or slightly differentiated product to different sections of consumers at different prices not commensurate with cost of differentiation. Consumers are discriminated on the basis of their income or purchasing power, geographical location, age, sex, color, martial status, quantity purchased, time of purchase, etc. When consumers are discriminated on the basis of these factors in regard to prices charged from them, it is called price discrimination. There is another kind of price discrimination. The same price is charged from the consumers of different areas while cost of production in two different plants located differently is not the same. Some common examples of price discrimination, not necessarily by a monopolist, are given below:

doctors, lawyers, consultants, etc., charge their customers at different rates mostly on the basis of latter's ability to pay; ii. merchandise sellers sell goods to relatives, friends, old customers, etc., at lower price than to others and off-season discounts for the same set of customers; iii. railways and airways charge lower fares from the children and students, etc.; iv. differential rates for cinema shows, musical concerts, etc.; v. different prices in domestic and foreign markets, and vi. Lower rates for the first few telephone calls, lower rates for the evening and night trunk-calls; higher electricity rates for commercial use and lower for domestic consumption, etc. Necessary Conditions for Price Discrimination Firstly, different markets must be separable for a seller to be able to practice discriminatory pricing. The market for different classes of consumers must be so separated that buyers of one market are not in a position to resell the commodity in the other. Markets are separated by (i) geographical distance involving high cost of transportation, i.e., domestic versus foreign markets; (ii) exclusive use of the commodity, e.g., doctor's services; (iii) lack of distribution channels, e.g., transfer of electricity from domestic use (lower rate) to industrial use (higher rate). Secondly, the elasticity of demand must be different in different markets. The Purpose of price discrimination is to maximise the profit by exploiting the markets with different price elasticities. It is the difference in the elasticity which provides opportunity for price discrimination. If price elasticities of demand in different markets are the same, price-discrimination would reduce the profit by reducing demand in the high price markets. Thirdly, there must be imperfect competition in the market. The seller must possess some monopoly over the supply of the product to be able to distinguish between different classes of consumers, and charge different prices. Degrees of Price Discrimination The degree of price discrimination refers to the extent to which a seller can divide the market or the consumers and can take advantage of it in extracting the consumer's surplus. The economic literature presents three degree of price discrimination. First degree. The first degree of price discrimination is the limit of discriminating pricing. When a seller is in a position to know the price each customer is willing to pay, (i.e., he knows his buyer's demand curve for his product), he sets the price accordingly and tries to extract the whole consumer surplus2. What the seller does is that he sets the price at its highest levelthe level at which all those who are willing to buy the commodity buy at least one unit each. After extracting the consumer surplus of this section of consumers for the first unit of commodity, he gradually lowers down the prices, so that the consumer surplus of the users of the second unit is extracted. This procedure is continued until the whole consumer's surplus available at a price where MC = MR is extracted. Consider the case of medical services of exclusive use. A doctor who knows or can guess the paying capacity of his patients can charge the highest possible fee from presumably the richest patient and the lowest fee from the poorest patient. Second degree. Where market size is very large, perfect discrimination is neither feasible nor desirable. In that case, a monopolist uses second degree discrimination or block pricing method. A monopolist adopting the second degree price discrimination intends to siphon off only the major part of the consumer's surplus, rather than the entire of it. The monopolist divides the potential buyers in blocks, e.g., rich, middle class and poor, and sells the commodity in blocksfirst at the highest price to the rich, then at a lower price to the middle class, and so on. The second degree price discrimination is feasible where (i) the number of consumers is large and price rationing can be done, as in case of utility services like telephones, gallons of water, etc; and (ii) demand curve for all the consumers is identical; (Hi) a single rate is applicable for a large number of buyers. As shown in Fig. a monopolist practicing second degree price discrimination, charges the highest price OP1 for OQ1, units and a lower price OP2 for the next QXQZ units, and the lowest price OP for the next Q2Q3 units. Thus, by adopting a block pricing system, the monopolist maximizes his revenue at TR = (OQ1 . AQ1) + (Q1 Q2 . BQ2) + (Q2 Q3 . CQ3

i.

all

Third degree. When a profit maximising monopolist sets different prices in different markets having demand curves with different elasticities, he is practicing the third degree price discrimination. It happens quite often that a monopolist has to sell his goods in two or more markets, completely separated from each other, each having a demand curve with different elasticities. A uniform price cannot be set for the markets without losing profits. The monopolist is therefore required to find different price-quantity combinations that can maximise his profit in each market. For this, he equates his MC and MR in each market, and fixes price in each market accordingly.

For example, suppose that a monopolist has to sell his goods in two markets, A and B. The demand curve (Da) and marginal revenue curve (MRa) given in Fig.(a), represent the AR and MR curves in market A. And, Db and MRb in Fig.(b) represent the AR and MR curves in market B. The horizontal summation of D a and D4 produces the total demand curve for the two markets, a shown by AR=D in Fig. (c) and the horizontal summation of MR and MRb gives the aggregated MR [(Fig.(c)]. The firm's marginal cost is shown by MC which interests MR at point T. Given the MR and MC curves, the optimum level of output for the firm is determined at OQ. For, at this level of output MR = MC. The whole of OQ cannot be profitably sold in any one of the markets at a profit maximising price. Therefore, the monopolist must now allocate output OQ between the two markets in such proportions that the necessary condition of profit maximisation is satisfied in both the markets, i.e., MC (= TQ) must be equal to MR in both the markets. This can be accomplished by drawing a line from point T parallel to X-axis, through MRb and MRa. The points of intersection, S and R on curves MR and MRn respectively, determine the optimum share for market A and market B. As shown in the Fig. 9.7, the monopolist maximizes his profit in market A by selling OQ b units at price AQ^ and in market B, by selling OQb units at price BQb The third degree price discrimination may be suitably practiced between any two or more markets separated from each other by geographical distance, transport barriers or cost of transportation, legal restrictions on the inter-regional or inter-state transportation of commodities by individuals. MEASURING THE POWER OF MONOPOLY Pure private monopolies are rare. Most private monopolies have to face some competition. This market setting is called monopolistic competition. Price and output determination in this market setting will be discussed in the next section. Under monopolistic competition the degree of monopoly power matters a great deal in pricing and output decisions. We will therefore, discuss first the various measure of monopoly power before we turn to discuss the pricing and output decisions under monopolistic competition. Measuring monopoly power has been a difficult proposition. The efforts to devise a measure of monopoly power have not yielded a universal or non-controversial measure. As Hunter has observed, "The idea of devising a measure of monopoly power, with reference both to its general incidence and to particular situation, has been and probably always will remain, an attractive prospect for economists

who wish to probe in this field"1. If not for any other reason, for 'sheer intellectual curiosity' economic theorists feel compelled to work on this problem, for they could not with good conscience go on talking about 'great' or 'little' monopoly power or about various degrees of monopoly without trying to ascertain the meaning of these words2. Therefore, devising at least a 'conceivable' measure of monopoly, even if 'practical' measurement is impossible, continues to interest the economists, for at least two reasons. First, apart from intellectual curiosity, people would like to know about the economy in which they live, about the industrial structure, and about the industries from which they get their supplies. Second, growth of monopolies has forced governments of many countries to formulate policies and to devise legislative measures to control and regulate monopolies. It the government is to succeed in its policy of restraining monopoly, it must have at least some practicable measure of monopoly power and monopolistic trade practices. Measures of Monopoly Power In spite of problems in measuring the power of monopoly economists have devised a number of measures of monopoly power, though none of these measures is free from flaws. Yet, the various measures do provide an insight into the monopoly power and its impact on the market structure. Besides, they also help in formulating an appropriate public policy to control and regulate the existing monopolies and to prevent their growth. We discuss here briefly the various measures of monopoly power. (1) Number-of-Firms Criterion One of the simplest measures of degree of monopoly power is to count the number of firms in an industry. The smaller the number of firms, the greater the degree of monopoly power of each firm in the industry, and conversely, the larger the number of firms, greater the possibility of absence of monopoly power. As a corollary of this, if there is a single firm in an industry, the firm has absolute monopoly power. On the contrary in an industry characterized by perfect competition, the number of firms is so large that each firm supplies an insignificant proportion of the market and no firm has any control on the price, and. hence, no monopoly power whatsoever. This criterion however has a serious drawback. The number of firms alone does not reveal much about the relative position of the firms within the industry because (/) 'firms are not of equal size,' and (ii) their number does not indicate the degree of controls each firm exercises in the industry. Therefore, the numerical criterion of measuring monopoly power is of little practical use. (2) Concentration Ratio The concentration ratio is one of the widely used criteria of measuring monopoly power. The concentration ratio is obtained by calculating the percentage share of the largest group of the firms in the total output of the industry. 'The number of firms chosen for calculating the ratio usually depends on some fortuitous elementnormally the census of production arrangements of the country concerned1. In Britain the share of the largest three firms of a census industry and in the U.S.A., the share of the largest four is the basis of calculating concentration ratio.2 Apart from the share of the largest firms in the industry output, "size of the firm and the concentration of control in the industry may be measured ...in terms of production capacity, value of assets, number of employees or some other characteristics. Concentration ratio as a measure of monopoly power has its own shortcomings. First, the measures of concentration involve statistical and conceptual problems. For example, production capacity may not be used straightaway as it may include 'unused, obsolete or excess capacity' and the value of assets involves valuation problem as accounting method of valuation and market valuation of assets may differ. Employment figure may not be relevant in case of capitalintensive industries and its use may be misleading. The two other convenient measures are 'gross output value' or 'net output' (value added). But the former involves the risk of double counting and the latter, the omission of inter-establishment transfers.4 Secondly, the measures of concentration ratio do not take into account the size of the market. Size of the market may be national or local. A large number of firms supplying the national market may be much less competitive than the small number of firms supplying the local market. For, it is quite likely that the national market is divided among thousand sellers, each seller being a monopolist in his own area.

Thirdly, the most serious defect of concentration ratio as an index of monopoly power is that it does not reflect the competition from other industries. The degree of competition is measured by the elasticity of substitution which may be different under different classification of industries. Therefore, an industry with concentration ratio under one classification of industries may have a very low elasticity of substitution and hence a high degree of monopoly. But, if classification of industries is altered the same industry with a high concentration ratio may have a very low elasticity of substitution, and hence, may show a low degree of monopoly. (3) Excess Profit Criterion J.S. Bain and, following him, many other economists have used excess profit as a measure of monopoly power. If profit rate of a firm continues to remain sufficiently higher than all opportunity costs required to remain in the industry, it implies that neither competition among sellers nor entry of new firms prevents the firm from making a pure or monopoly profit. While calculating excess profit, the opportunity cost of owner's capital and a margin for the risk must be deducted from the actual profit made by the firm. Assuming no risk, the degree of monopoly may be obtained as the ratio of the divergence between the opportunity costs (O) and the actual profit (R), to the latter. Thus degree of monopoly power (MP) may be expressed as R-O MP= P If (P-O) I R = 0, there exists no monopoly, and if it is greater then zero, there is monopoly. The higher the value of (R-O) IR, the greater the degree of monopoly. Another measure of degree of monopoly based on excess profit has been devised by A.P. Lerner.' According to him, the degree of monopoly power (MP) may be measured by the following formula. P - MC MP = P Where P = price, MC - marginal cost. Since for a profit maximising firm, MR=MC, Learner's measure of monopoly power (MP) may be expressed also as, P - MR MP= P We have discussed earlier (see chapter 4, section 4.6.2) that PI(PMR) = e and that (PMR)IP - lie, i.e., the reciprocal of elasticity. Thus, Learner's measure of monopoly power may be expressed also as MP = lie. It may thus be inferred that lower the elasticity, the greater the degree of monopoly, and vice versa. Thus, monopoly power may exist even if firm's AR - AC and it earns only normal profit. Lerner's formula of measuring the degree of monopoly power is considered to be theoretically most sound. Nevertheless, it has been criticized on the following grounds. First, any formula devised to measure the degree of monopoly power should bring out the difference between the monopoly output and competitive output or the 'ideal' output under optimum allocation of resources. The divergence between P and MC used in Lerner's formula does not indicate the divergence between the monopoly and 'ideal' output. Lerner has possibly used the divergence between P and MC as the substitute for the divergence between monopoly and 'ideal' output. "This substitution of a price-cost discrepancy for a difference between actual and 'ideal' output is probably the greatest weakness of a formula which is supposed to measure deviation from the optimum allocation of resources Secondly, price-cost discrepancy may arise for reasons other than monopoly and price and cost may be equal or close to each other in spite of monopoly power. Thirdly, since data on MC are hardly available, this formula is of little practical use. (4) Triffins Cross-Elasticity Criterion Triffins criterion seems to have been derived from the definition of monopoly itself. According to his criterion, cross-elasticity is taken as the measure of degree of monopoly. The lower the cross-elasticity of

the product of a firm, the greater the degree of its monopoly power. But, this criterion indicates only the relative power of each firm. It does not furnish a single index of monopoly power. PRICING UNDER MONOPOLISTIC COMPETITION Perfect competition and pure private monopolies are rare phenomena in the real world. Monopolistic competition approximates most closely to the real business world. The model of monopolistic competition developed by Edward H. Chamberlin1 presents a more realistic picture of the market structure. His model is discussed below. Monopolistic competition is defined as market setting in which a large number of sellers sell differentiated product. Monopolistic competition has the following features: i. large number of sellers; ii. free entry and free exit; iii. perfect factor mobility; and iv. complete dissemination of market information, and v. Differentiated products. Note that three features of monopolistic competition are the same as of perfect competition. There is, however, a big difference between the two: in perfect competition, products are homogeneous, whereas in monopolistic competition, products are differentiated by brand name, trade mark, design, colour and shape, packaging, credit terms, credit terms, promptness in-service etc. Products are so differentiated that buyers are in a position to distinguish between the products supplied by different firms. Despite product differentiation, each product remains a perfect substitute for the rival products. Although there are many firms, each one possesses a quasi-monopoly over its product. There is another differenance between the perfect competition and monopolists competition. While decision-making under perfect competition is independent of other firms, in monopolistic competition, firms' decisions and business behaviour are not absolutely independent of each other. Electrical appliances, textile goods, soaps and detergents, toothpastes, shaving blades, shampoos, TV, VCR, automobiles, refrigerators, etc. are some examples of products produced under monopolistic competition. SHORT-RUN PRICING AND OUTPUT DECISIONS Monopolistic competition is characteristically closer to perfect competition. But in regard to pricing and output determination it is closer to monopoly. Like a monopolist, a firm under monopolistic competition faces a downward sloping demand curve. This demand curve is the product of (i) a strong preference of a section of consumers for the product, and (if) the quasi-monopoly of the seller over the supply. The strong preference or brand loyalty of the consumers gives the seller an opportunity to raise the price and yet retains some customers. And, since each product is a substitute for the other, the firms can attract the consumers of other products by lowering down their prices. The short-term analysis of pricing and output determination under monopolistic competition is similar to price and output determination under monopoly. The short-run revenue and cost curves faced by the monopolistic firm are given in Fig. As shown in the figure, firm's MR intersects its MC at point N. This point fulfills the necessary condition of profitmaximisation at output OQ. Given the demand curve, this output can be sold at price PQ. So the price is determined at PQ. At this output and price, the firms earns a maximum monopoly or economic profit PM per unit of output and a total monopoly profit shown by the rectangle P1PMPr The economic profit, PM (per unit) will exist in the short-run because of no possibility of new firms entering the industry. But the rate of profit would not be the same for all the firms under monopolistic competition because of different in the elasticity of demand. Some firms may earn only a normal profit if their costs are higher than those of others. For the same reason, some firms may make even losses in the short run to the extent of their average fixed cost.

LONG-RUN PRICE AND OUTPUT DETERMINATION The mechanism of determination of price and output in the long run under monopolistic competition is basically the same as in perfect competition. The existence of economic profit in the short run (as shown in Fig. 9.8) attracts new firms to the industry. The entry of new firms intensifies the competition, on the one hand, and reduces the share of individual firms in the total supply, on the other. This shifts their demand curve to the left. Such shifts continue so long as economic profit exists or long-run average cost curve (LAC) is not tangent to AR curve as shown in Fig. 9.9. At the stage where AR = LAC, the individual firms and also the industry attain the equilibrium level. Here, existing firms stop their expansion and new firms ease to enter the industry. The ultimate situation is presented in Fig. 9.9. As the figure shows, in the long run, firms equalize their MR and LMC at output OQ. Price is determined at PQ. The firms are in equilibrium with their optimum output at OQ and at price PQ. Note that at output OQ and price PQ, all the firms earn only a normal profit because their long-run price PQ and long-run average cost (LAC) are equal. Since PQ = LAC, no firm earns economic profit. There is therefore no incentive for the firms to expand or reduce the size of the plant. Nor do the new firms have incentive to enter the industry. When all the firms of the industry reach their equilibrium, the industry attains equilibrium too. At this stage, there will be no tendency of new firms entering or old firms quitting the industry. It may be noted here that, even in the long-run, there will be price differential depending on the nature of demand curve for the product of individual firm. PRICING UNDER OLIGOPOLY The oligopoly1 is a reduced form of monopolistic competition. It is competition among a few big sellers, each selling either differentiated or homogeneous products. The terms 'a few sellers' implies a number so small or a few that market share of each firm is so large that it an influence the market price. It also implies that each seller commands a sizeable proportion of the total market supply2. The products traded by the oligopolists may be differentiated or homogeneous. Accordingly, the oligopoly market may be a heterogeneous oligopoly or a homogeneous (or pure) oligopoly. For example, in India's automobile industry, Maruti, Fiat and Ambassador car are the outstanding examples of differentiated oligopoly. Similarly, cooking gas of Indane and Burshane are the examples of homogenous oligopoly. Differentiated oligopolies include industries like automobiles, cigarettes, refrigerators, and TV, etc. Pure oligopolies include such industries as cooking gas, cement, baby food, vegetable oils, cable wire, dry batteries, etc. Other examples of oligopolistic industries are aluminum, paints, tractors, tyres and tubes, steel, etc. Interdependence and Indeterminateness of price The characteristic fewness of their number brings oligopolists in keen competition with each other. The competition between them takes the form of action, reaction and counteraction in the absence of collusion between competing firms. In this kind of a market, firms' business decisions become interdependent, since a major policy change by one firm is bound to affect the interest of the other firms. Consequently, strategic decisions regarding pricing, marketing, advertising, etc., are based on explicit assumption regarding actions and reactions of the rival firms. An illuminating example of strategic maneuvering by the oligopoly firm is cited by Robert A. Meyer1. To quote the example, in a year, one of the US car manufacturing companies announced in September2 an increase of $180 in the list price of its new car model. Following it, a second company announced a few days later an increase of only $ 80 and a third announced an increase of $ 91. The first company made a counter move: it suddenly reduced the increase in list price to $ 71 from $ 180 announced earlier. This is a pertinent example of interdependence of firms' business decisions. These kinds of actions and reactions have made a systematic analysis of oligopoly extremely difficult. Under oligopolistic conditions a very wide variety of behaviour pattern may emerge; they may come in collusion with each other or 'may try to fight each other to the death'; the agreement may last or may

break down soon3. Therefore, indeterminateness of price and output becomes the basic feature of oligopolistic market. In accordance with the variety of behaviour, economists have developed a variety of analytical models based on different behavioral assumptions. Among notable models are Cournot's Duopoly model (1838), Bertrand's leadership model (1880), Edge worths model (1897), Stackelburg's model (1933), Sweenys kinked demand curve model (1939), Neumann and Morgenstern Game Theory model (1944), and Baumol's Sales Maximisation model. None of these models however provide a universally acceptable analysis of oligopoly, though these models do provide insight into the behavioral partum of oligopolists. We have discussed here some representative models of price and output determination under oligopoly. The representative models have been chosen on the basis of mode of price competition under different forms of oligopolistic competition. The competition between oligopolists generally takes three forms: (i) Free competition in which oligopolists wage price-war against each other and fight tooth and nail which ultimately takes the form of non-price competition, as shown by kinked demand curve analysis. (ii) When oligopoly is a competition among unequals, the larger firms play the role of a pricemaker and smaller ones become the price-takers. This is known as price-leadership model; (iii) Collusion between firms under Cartel system or price agreements, i.e., Collusive Models. Let us begin with the price-competition among oligopolists. The theory of price and output determination is based on demand (revenue) and cost curves. But in a market setting characterized by a few monopolistic sellers, the demand curve loses its significance because it is indeterminate. The demand curves for an oligopolistic keeps shifting back and fort from one position to another due to interdependence of firms' decision. Many models have been developed (mentioned above) to analyse oligopolistic behaviour. None of these models however succeeds in determining a stable equilibrium in oligopoly market. The oligopoly models, however, provide an insight into the nature of problem of price and output determination in an oligopolistic market setting. We will first discuss Control's model of oligopoly. COURNOT'S MODEL OF OLIGOPOLY Augustin Cournot a French economist, was the first to develop a formal oligopoly model in 1838 in the form of a duopoly model. To illustrate his model, Curnot assumed: (a) two firms, each owning an artesian mineral water well; (b) both operate their wells at zero marginal cost2; (c) both face a demand curve with constant negative slope; (d) Each seller acts on the assumption that his competitor will not react to his decision to change his output and price. This is Cournot's behavioural assumption. On the basis of this model, Cournet has concluded that each seller ultimately supplies one-third of the market and charges the same price. And, one-third of the market remains unsupplied. Cournot's duopoly model is presented in Fig. 9.10. To begin with, let us suppose that there are only two sellers A and B, and that, initially, A is the only seller of mineral water in the market. Following the profit maximising rule, he sells quantity OQ where his MC = 0 = MR, at price OP2. His total profit is OP2PQ. Now let B enter the market. The market open to him is QM which is half of the total market3. That is, he can sell his product in the remaining half of the market. He assumes that A will not change his price and output because he is making the maximum profit i.e., A will continue to sell OQ at prices OP 1 Thus, the market available to B is QM and the relevant demand curve is PM. When he draws his MR curve, PM, it bisects QM at point N where QN = NM. In order to maximise his revenue, B sells QN at price OP 1. His total revenue is maximum at QRN'N. Note that B supplies only QN = 1/4 = (l/2/)/2 of the market.

With the entry of B, price falls to OP1 Therefore, A's expected profit falls to OP1 RQ. Faced with this situation, A attempts to adjust his price and output to the changed conditions. He assumes that B will not change his output Wand price OP1 as he is making maximum profit. Accordingly, A assumes that B will continue to supply 1/4 of market and he has 3/4 (= 1-1/4) of the market available to him. To maximise his profit, A supplies 1/2 of (3/4), i.e., 3/8 of the market. It is noteworthy that A's market share has fallen from 1/2 to 3/8. Now it is B's turn to react. Following Cournot's assumption, B assumes that A will continue to supply only 3/8 of the market and market open to him equals 1-3/8 = 5/8. To maximise his profit under the new conditions, B supplies 1/2x5/8 = 5/16 of the market. It is now for A to reappraise the situation and adjust his price and output accordingly. This process of action and reaction continues in successive periods. In the process, A continues to loose his market share and B continues to gain. Eventually, a situation is reached when their market shares equal at 1/3 each. Any further attempt to adjust output produces the same result. The firms, therefore, reach their equilibrium position where each one supplies one-third of the market. Cournot's equilibrium solution is stable. For, given the action and reaction, it is not possible for any of the two sellers to increase their market share. It can be shown as follows. A's share = 1/2 (1 - 1/3) = 1/3. Similarly, B's share = 1/2 (1 - 1/3) = 1/3. Cournot's model of duopoly can be extended to the general oligopoly. For example, if there are three sellers, the industry, and firms will be in equilibrium when each firm supplies 1/3 of the market. The three sellers together supply 3/4 of the total market, 1/4 of the market remaining unsupplied. The formula for determining the share of each seller in an oligopolistic market is: Q (n + 1), where Q = market size, and n = number of sellers. KINKED DEMAND CURVE ANALYSIS OF PRICE STABILITY: SWEEZY'S MODEL Paul M. Sweezy's kinked demand curve analysis provides another famous model of oligopoly price and output. This model does not explain price and output determination under oligopoly. It shows only stability of price and output under oligopoly. Paul M. Sweezy has tried to show through his kinked demand curve analysis that price and output, once determined under oligopolistic conditions, tend to stabilise rather than fluctuating. Sweezy's kinkeddemand curve model is described below. The kinked demand curve model developed by Paul M. Sweezy has features common to most of oligopoly pricing models. This is the best known model explaining relatively more satisfactorily the behaviour of the oligopolistic firms. The kinked demand curve analysis does not deal with price and output determination. Rather, it seeks to establish that once a price-quantity combination is determined, an oligopoly firm will not find it profitable to change its price in response to a moderate change in cost of production. The logic behind this proposition is as follows. An oligopoly firm believes that if it reduces the price of its product, rival firms would follow and neutralize the expected gain from price reduction. But, if it raises its price, rival firms would either maintain their prices or May even cut their prices down. In either case, the price-raising firm stands to lose, at least a part of its share in the market. This behavioral assumption is made by all the firms in respect of others. The oligopoly firms would therefore find it more desirable to maintain their price and output at the existing level. To look more closely at the kinked demand curve analysis, let us look into the possible actions and reactions of the rival firms to the price changes made by one of the firms. There are three possible ways in which rival firms may react: (i) the rival firms follow the price changes, both cut and hike; (ii) the rival firms do not follow the price changes; (iii) Rival firms do not react to price-hikes but they do follow the price-cuts. To begin with, let us suppose that market demand curve for a product is given by dd' curve and that the initial price is fixed at PQ in Fig. Now let one of the firms changes its price. If rival firms react in manner (i), i.e., they react with hike for hike and cut for cut, the price-changing firm will move along the demand curve dd'. And, if rival firms do not follow the price changes, then the price changing firm will move along the demand curve DD'.

Note that the firm initiating the price change faces two different demand curves conforming to two different kinds of reactions (i) and (ii). The demand curve dd' based on reaction (z) is less elastic than the demand curve DD' based on reaction (ii). Demand curve dd' is less elastic because changes in demand in response to changes in price are restrained by the counter moves by the rival firms. Given the two demand curves, dd' and DD', let us now introduce reaction (Hi), a more realistic one, i.e., the rival firms follow the price-cut but do not follow the price-hike. This asymmetrical behaviour of the rival firms makes only a part of the two demand curves relevant and produces a kined demand curve. This can be established by allowing an oligopoly firm to alternatively increase and decrease its price. If a firm increases its price and rivals do not follow, it loses as part of its market to its rivals. The demand for its product decreases considerably indicating a greater elasticity. The firm is therefore forced down from demand curve dP to DP. Thus, the relevant segment of demand curve for it is DP. Now suppose alternatively that the firm decreases its price. Then the rival firms, given their asymmetrical behaviour, cut down their prices. Otherwise, they would lose their customers. This counter price-move by the rivals prevents the oligopoly firm from taking full advantage of pricecut along the demand curve DD'. Therefore, its demand curve below point P rotates down. Thus, the relevant segment of demand curve for the oligopolistic (below point P) is Pd'. The two relevant segments of the demand curve put together give the relevant demand curve for the firm as DPd' which has a kink at point P. Let us now draw the MR curve. Recall that MR - AR AR/e. The MR curve drawn on the basis of this relationship, takes a shape as shown by a discontinuous curve DJKL in Fig. 9.12. The DJ and KL segments of the MR curve correspond to the DP and Pd' segments of the kinked demand curve, DPd'. Suppose that the original marginal cost curve resembles the curve MCX which intersecting MR at point K. Since at output OQ, MR = MC, the firm makes maximum profit. Now, even if MC-curve shifts upwards to MC2 or any level between points / and K, firm's profit would not be affected. Therefore, the firm has no motivation for increasing or decreasing its price. It is always beneficial to stick to the current situation. Thus, both price and output are stabilised. This is what kinked demand curve analysis establishes. Criticism. A major criticism against this model is that it only explains the stability of output and price; it does not tell how the initial price is fixed at a certain level, e.g., at PQ. Besides, the price stability does not stand the test of empirical verificationthere is surprising lack of price rigidity. Furthermore, Stigler1 found in case of 7 oligopolistic industries that there was 'little evidence' of reluctance to the price-hike made by other firms. Stigler's finding was further supported by the findings of Simon. Monopoly prices have been found to be more stable than oligopoly prices.

UNIT IV PRICING IN PRACTICE

COST-PLUS PRICING OR MARK-UP PRICING Cost-plus or mark-up pricing is also known as 'Average cost pricing' or 'Full cost pricing'. The cost-plus pricing is the most common method of pricing a product by the manufacturing firms. The general practice under this method is to add a 'fair" percentage of profit margin to the average variable cost (A VQ. The price is set as P = AVC + AVC (m) ... (10.1) where m is the mark-up percentage. A VC (m) = gross profit margin {GPM).

The mark-up percentage (m) is fixed so as to cover average fixed cost (AFC) and a net profit margin (NPM). Thus AVC (m) = AFC + NPM ... (10.2) The procedure of arriving at A VC and price fixation may be summarized as follows. The first step in price fixation is to estimate the average variable cost. For this, the firm has to ascertain the volume of its output for a given period of time, usually one accounting or fiscal year. To ascertain the output, the firm uses figures of its 'planned' or 'budgeted' output or takes into account its normal level of production. If the firm is in a position to compute its optimum level of output or the capacity output, the same is used as standard output in computing the average cost. The next step is to compute the total variable cost {JVC) of the 'standard output'. The JVC includes direct costs, i.e., cost of labour and raw materials, and other variable costs. These costs added together give the total variable cost. The 'Average Variable Cost' (A VQ is then obtained by dividing the total variable cost (JVQ by the 'standard output' (Q), i.e. JVC AVC= QT After A VC is obtained, a 'mark-up' of some percentage of A VC is added to it for profit and the price is fixed. While determining the mark-up, firms always take into account "what the market will bear' and the competition in the market.1 Mark-up Pricing and Marginalist Rule The mark-up pricing method appears to be a 'rule of thumb' which does not seem to conform to the marginalist rule of pricing. Fritz Makeup has, however, shown that markup pricing is not incompatible with the marginalist rule of pricing. When we look into the logic of mark-up pricing, it appears quite similar to the marginalist rule of pricing. We have earlier noted that profit is maximum at the level of output where MC = MR. we have also noted that the mark-up pricing method is given by P = AVC + AVC (m) Or P = AVC (1 + m) ...(10.3) Let us now show that the mark-up pricing ultimately converges to the marginalist rule of pricing and both methods lead to the profit maximisation objective. Let us recall that profit is maximum where MC = MR ... (10.4a) 1 and MR = P [1- ] e e-1 or MR = P [ ] ...(10.46) e By substituting Eq. (10.46) in Eq. (10.4a), we may restate the necessary condition of profit maximisation as e-1 MC = P [ ] ... (10.5) e

If MC is constant, then MC = AVC. By substituting AVC for MC, Eq. (10.5) may be rewritten as, e-1 AVC = P [ ] ... (10.6) e Solving Eq. (10.6) for P, we get e-1 p = AVC [ ] e or e P = AVC P [ ] e-1 ... (10.7)

e-1 Now consider Eq. (10.5). If MC > 0, then MR, or what is the same as, P [ ] e e-1 must be greater than 0. For P [ ] to be greater than 0, e must be greater than 1. e Note that if e = 1, MR = 0, and if e < 1, MR < 0. If MR < 0 and MC > 0, or in other words, when MR MC, then the rule of profit maximisation breaks down. Thus, profit can be maximised only if e > 1, and MC > 0. Now, if e > 1, then the term el{e1) will always be greater than 1 by an amount, say m. Then e = (1 + m) ... (10.8) e-1 By substituting the term (1+m) in Eq. (10.8) for e/ (e-l) in Eq. (10.7), we get, P = AVC (1 + m) ... (10.9) where m denotes the mark-up rate. Note that Eq. (10.9) is exactly the same as Eq. (10.3). This means that the markup rule of pricing converges into the marginalist rule of pricing. In other words, it is proved that the mark-up pricing method leads to the marginalist rule of pricing. However, m in Eq. (10.3) and in (10.8) needs not the same. Limitations of Mark-up pricing Rule The cost-plus pricing has certain limitation, which should be borne in mind while using this method for price fixation. First, cost-plus pricing assumes that firm's resources are optimally allocated and the standard cost of production is comparable with the average of the industry. In reality, however, it may not be so and cost estimates based on these assumptions may be an overestimate or an under-estimate. Under these conditions pricing may not be commensurate with the objective of the firm. Secondly, in cost-plus pricing, generally, historical cost rather than current cost data are used. This may lead to under-pricing under increasing cost conditions and to overpricing under decreasing cost conditions, which may go against the firm's objective. Thirdly, if variable cost fluctuates frequently and significantly, cost-plus pricing may not be an appropriate method of pricing. Finally, it is also alleged that cost-plus pricing ignores the demand side of the market and is solely based on supply conditions. This is however not true because firm determine the mark-up on the basis of 'what the market can bear', and it does take into account the elasticity aspect of the demand for the product, as shown above. TRANSFER PRICING

Very large firms very often divide their operation into product divisions or subsidiaries. Growing firms add new divisions or departments to me existing ones. TYie firms then transfer some of their activities to other divisions. The goods and services produced by the new division are used by the parent organisation. In other words, the parent division buys the product of its subsidiaries. Such firms face the problem of determining an appropriate price for the product transferred from one division or subsidiary to the other. Specifically, the problem is of determining the price of a product produced by one division and used by the other division of the same firm. This problem becomes much more difficult when each division has a separate profit function to maximise. Pricing of intra-firm 'transfer product' is referred to as 'transfer pricing'. One of the most systematic treatment of the transfer pricing technique has been provided by Hirshleifer. We will discuss here briefly his technique of transfer pricing. To begin with, let us suppose that a refrigeration company established a decade ago used to produce and sell refrigerators fitted with compressors bought from a compressor manufacturing company. Now the refrigeration company decides to set up its subsidiary to manufacture compressors. Let us also assume: I. both parent and subsidiary companies have their own profit functions to maximise; II. refrigeration company sells its product in a competitive market and its demand is given by a straight horizontal line; and III. the refrigeration company uses all the compressors produced by its subsidiary; In addition, we assume that there is no external market for the compressors. We will later drop this assumption and alternatively assume that there is external market for the compressors and discuss the technique of transfer pricing under both the alternative conditions. Let us first discuss transfer pricing with no external market. Transfer Pricing without External Market Given the foregoing assumptions, the refrigeration company has to set an appropriate price for the compressors so that the profit of its subsidiary too is maximum. To deal with the 'transfer pricing' problem, let us first look into the pricing and output determination of the final product, i.e., refrigerator. Since Refrigeration Company sells its refrigerators presumably in a competitive market, the demand for its product is given by a straight horizontal line as shown by the line ARr = MRr in Fig. The marginal cost of intermediate good, i.e., compressor, is shown by MC, curve and that of the refrigerator body by MCb. The MCc and MCb added vertically give the combined marginal cost curve, the MCf. For example, at output OQ, TQ + MQ = PQ. The MC; intersects line ARr = MRr at point P. An ordinate drawn from point P down to horizontal axis determines the most profitable outputs of refrigerator body and compressors each at OQ. Thus, the output of both refrigerator body and compressors is simultaneously determined. Since at OQ level of output, firm's MC( = MRr, the refrigerator company maximises its profits from the final product, the refrigerator. Now the question arises as to what should be the price of the compressors so that the compressor manufacturing division too maximises its profit. The answer to this question can be obtained by applying the marginal principle which requires equalising MC and MR in respect of compressors. The marginal cost curve for the compressors is given by MCc in Fig. The firm therefore has to obtain the marginal revenue of the compressors. The marginal revenue of the compressors (MR.) can be obtained by substracting non-compressor marginal cost of the final good from the MR? Thus, MRc = MRr - {MC-MC) ...(10.10) For example, at output OQ, MRr = PQ, MCt = PQ, and MC = MQ. By substituting these values in Eq. (10.10), we get MRc = PQ-(PQ-MQ)

= MQ Or, since in Fig. PQ - MQ = PM, and PM = TQ, therefore, MRc = PQ-TQ = PT and PT = MQ We may recall that ARr = MRr i.e., MRr, is constant, and that MC( is a rising function. Thus, MRr MCc will be a decreasing function. (Notice the vertical distance between ARr = MRr line and MC, curve, is decreasing as shown in Fig. When MRc, (which equals MR, - MC) is obtained for different levels of output and graphed, it will yield a curve like MRc curve shown in Fig. The MC, curve [which is the same as MC, curve in Fig.intersects the MRc at point P. At point P, MRc = MCc and output is OQ. Thus, the price of compressors is determined at PQ in Fig. This price enables the compressor division to maximise its own profit. Transfer Pricing with External Competitive Market We have discussed above the transfer pricing under the assumption that there is no external market for the compressors. It implied that the refrigeration company was the sole purchaser of the compressors and that compressor division had no external market for its product. Let us now discuss the transfer pricing technique assuming that there is external market for the compressors. The existence of the external market implies that the compressor division has the opportunity to sell its surplus production to other buyers and the refrigeration company can buy compressors from other sellers if compressor division fails to meet its t. .al demand. Assume also that the external market is perfectly competitive. Determination of transfer price under these conditions is a little more complicated task. The method of transfer pricing with external market is illustrated in Fig. Since the compressor market is perfectly competitive, the demand for compressor is given by a straight horizontal line as shown by PJD in which case AR = MR. The marginal cost curve of the compressor is shown by MCc. The MRc curve shows the marginal net revenue from the compressor. (See Fig. 10.4). Note that in the absence of the external market, the transfer price of compressor would have been fixed at OP{ - P Qr At this price, the parent company would have bought compressors only from its subsidiary. But, since compressors are being produced and sold under competitive conditions, the effective marginal cost of the compressor for the refrigeration company is the market price of the compressor, i.e., OP2, instead of OP{ where MRc = MCc. Besides, the price OP2 is also the potential MR for the compressor division. Therefore, in order to maximise the profit, compressor price will be set at point P where MRc > MCc. Thus, the transfer price of compressor will be fixed at Pg, and the refrigeration company would buy OQl compressors for the compressor division.

The total output of compressors is determined at a level where MC, intersects the demand line, D (AR MR), i.e., at point R. At point R, the total output of compressors is OQy Of this, OQx is bought by the refrigeration company and the remaining output, g,g3 will be sold in the external market, both at price OP2. At this level of output and price, the compressor division maximises its profit. Shift in MR and Transfer Price Let us now consider how transfer price is determined when MRc shifts upward to the right. The MRc may shift upward because of increase in demand causing an upward shift in AR = MR. Let the MR in Fig. 10.5

shift to MR'. The MR' intersects the MC at point B. In the absence of the external market, the refrigeration company would have set transfer price of compressors at OP}a price higher than the free market price OP2. But, since an external market does exist in which a price, OP2 is given, transfer price cannot exceed the market price or else the refrigeration company would not be in a position to maximise its profit. Nor can the transfer price be less than the market price, otherwise the compressor division would not be able to maximise its profit. Thus, if there is an external market in which market price of an intermediary product, produced by a subsidiary company is given, then the problem of determining transfer price of a transfer product does not arise. Here, the main problem is to determine the quantity to be produced by the subsidiary and the quantity to be purchased in the external market. Fig. 10.5 shows that after the shift in MR. curve to MR 'c, the demand for compressor by the refrigeration company increase to OQ4 where AR - MR = MR \ But the refrigeration company cannot produce OQ4 units of compressors, given its MC. and the market price. It will therefore produce only OQi number of compressors, which equalises MC with the MR at point .R. Given the market price, OQl is the most profitable output of compressors. Therefore, the difference between the total demand and the total internal supply from the subsidiary, i.e., OQ4 - OQl = 2324! wiH be bought in the external market, at price OP2 = TQ4. Thus, the refrigeration company will buy OQz compressors from its compressor division and buy Q%Q4 in the external market. Transfer Pricing Under Imperfect External Market When refrigerator market is imperfect, the compressor division faces a demand curve with a negative slope in the external market, instead of a straight horizontal demand line. The downward sloping demand curve makes transfer pricing a much more complicated task. To illustrate the transfer pricing technique under imperfect market conditions in the external market, let us suppose (z) that the average and marginal revenue curves for the compressors are given by ARx and MRx, respectively, in Fig. 10.6, and (ii) that the 'marginal net revenue' from the internal use of compressors and the marginal cost of producing compressors are represented by MRc and MC., respectively. With a view to maximising the overall profits, the refrigeration company will determine the output of compressors where MC. = MRc + MRx, i.e., where marginal cost of compressors equals the composite marginal revenue. The composite marginal revenue is obtained through horizontal summation of the MRc and MRx curves as shown by MR, in Fig. As shown in Fig., MC, intersects MRt at point P which determines the output of compressors at OQr The compressor division can maximise its profit by dividing its output between the refrigeration company and the external market so as to equalise its MC and MR in both the marketsinternal and external. If a line (PPX) is drawn from point P parallel to horizontal axis to the vertical axis, through MRx and MRc, the points of intersection (T and M) determine the share of the refrigeration company and the external market in the total output OQr The line PP intersects MRx at point M and MRc at point T. At point M, the MC. = MRx and at point T, MCc = MRc. Thus, the refrigeration company, the parent body, will buy OQx and sell OQ2 in the open market. Note that OQx + OQ2 - OQy The profit maximising price in the external market is OP2. (= BQ2) and the profit maximising transfer price is set at OPx. With these prices and output, both refrigeration and compressor companies maximise their respective profits. Price Discrimination or Differential Pricing In an open price discrimination situation the market is sub-divided on some systematic basis, such that it is almost impossible for the group of buyers to whom a high price is quoted to take advantage by shifting and joining the group to which a lower price is quoted. There are many bases on which the open price discrimination is practiced. These are discussed below. Time Price Differentials. It is a general practice to use the expression "the demand for a product or service", but it is important to note that demand also has a time dimension. The demand may shift in

fairly short-time intervals. For example, demand for telephone facilities is more in the day time rather than at night. On the other hand, demand for entertainment is more at night than in the day when people attend to their job. A seller, who wishes to capitalise on the fact that buyers' demand elasticities vary over time, will quote different prices for the same product or service provided at different points of time. The variations in buyers' demand elasticities may occur within a short span of 24 hours, or it may change over days or months. We discuss these two cases below. Clock-time price differentials. When demand elasticities of buyers undergo a change within 24-hou period, the seller can discriminate between the buyers demanding services at different points of time within the 24-hour time period. These price differentials are called clock-time differentials and its object is to charge higher price for the product or service during the period of relatively inelastic demand and lower price during the period of relatively elastic demand. The oft quoted example of clock-time differentials is the differences between day and night rates of long-distance telephone calls. Three conditions are necessary to make the clock-time price differentials profitable: (i) Buyers must have strong preferences for buying the good at a particular time. (ii) The seller is able to provide the good or service during the slack period at a price that it sufficient to cover at least the incremental cost of this product or service. (iii) It should not be possible for the buyers to store the product or the service. If it is possible to do so, the buyer will buy the product when rates are low, even if he does not need it then. Calendar-time price differentials. When price differentials are not based on demand elasticity differences but simply on time differences like days, weeks, months, etc., we call them calendar-time differentials. These differences are often found in recreational activities. For example, swimming pool charges and charges for hotel accommodation on a hill resort differ on the basis of seasons; prices of fans, clothing, etc., also differ on the basis of off-season and on-season demands. Like clock-time price differentials, the object of calendar-time price variations also is to exploit the variations in demand elasticity over time. In the eyes of law setting discriminatory prices which are unrelated to cost are not permissible, while maintaining the same price despite cost variations are permissible. Use-Price Differentials. Different buyers have different uses of a product or a service. For example, railways can be used for long-haul or short-haul freight traffic. Railways can also be used for transporting different types of commodities. Electricity can, similarly, be used for industrial or residential purposes. Charges for these different uses are often different. In case of use-price variations, the seller divides the market into different segments according to demand elasticity based on buyers' use of the product or service, and then he charges different prices from these different segments. In order to make the use-price variations effective, the following conditions are necessary: (i) Demand elasticity must differ according to product use; (ii) It is possible to divide the market into different segments. This is generally achieved by the seller through the provision of different designs, quality, sales channels, etc. Quality Price Differentials. If the product caters to that group of consumers who are concerned about its quality, then the quality becomes a significant determinant of demand elasticity. The seller has, therefore, to create differences in quality to sell his product. It must be emphasised here that the differences in quality basically depend upon the buyers' understanding of the quality. Sellers use many devices to create quality differences. The buyer may be made to believe that significant differences in quality exist by changing the appearance of the product, by restricting a particular type of the product to a region or to a sale channel, etc. It is also found that consumers judge quality by the price of the product. Quantity Differentials. When the seller discriminates on the basis of the quantity of purchase, it is known as quantity differentials. In business practice there are three types of quantity differentials which are of significance. These are : Cumulative discounts. These discounts are the price concessions provided by the seller on the basis of the total quantity bought by a particular buyer during a period of time (say, a calendar year or a financial year). Such discounts are aimed at encouraging bulk buying, encouraging buyer loyalty, Helping in the stability of seasonal variations in demand and thus reducing inventory cost, and helping in forward planning of output.

Quantity discounts. These are price concessions based on the size of the lot purchased at one time and delivered at one location. These discounts are thus related to size of a single purchase. The size of the lot purchased is measured in terms of either physical units or monetary units. Where goods are homogeneous in nature (like refrigerators, scooters, steel rods, etc.), it is easy to measure the size of purchase in terms of their number, weight, etc. But if the goods are heterogeneous in nature (like furniture, scientific instruments, etc.), these cannot be meaningfully added together in physical units and size of their lot is, therefore, measured in terms of their total money value. The quantity discounts would , therefore, relate to the physical size or the money value of the lot, depending upon the product. Seller may introduce a slab system for quantity discounts, where each slab represents a lot size for purchase. A higher discount is given to the purchaser of the bigger lot size. The main purpose of quantity discount by the seller is to encourage bigger orders which reduce his cost of selling, packing, delivery, accounting, administration, etc. Functional (or Distributors') discounts. Functional or distributors' discounts are according to the trade status, i.e., wholesaler, retailer, jobber, etc. These discounts are granted to a distributor according to the distributor's positions in the trade channel and are, therefore, based on trade classification of the buyers. When the price varies on the basis of the classification of the distributors, it is referred to as distributors' or functional discount. The aim of such discounts is to motivate the distributor to perform his particular marketing functions effectively. The form of distributors' discount may be any one of the following: (I) Charging different prices from distributors of different trade status, that is, prices quoted to the wholesalers, retailers, etc., differ. (iii) Charging the same price from all the distributors but providing different discounts to different levels of trade status with the help of a discount structure. (iv) Providing a uniform discount to all distributors irrespective of their trade status, but providing a supplementary discount over and above the uniform discount to the different levels of trade status. In business, the second form of distributors' discount is more popular as it is easy to implement. It is amenable to easy adjustment as in case of seasonal and cyclical fluctuations in demand the seller need only to adjust his discount rates. With the help of this form of discount, the seller is able to have control over the profit margins of different levels of distribution, while at the same time able to maintain secrecy about the real price of the product. This form of discount thus has more flexibility, but for its effective management the seller has to maintain resale prices. In order to achieve an appropriate structure of functional or distributors' discounts, the following conditions Are necessary: 1. It should be possible to unambiguously classify the distributors on the basis of their strict nature of functions and operations. A distributor may perform more than one function. For example, a TV distributor may be performing servicing and delivery functions, besides displaying and procuring orders for TV receiver sets. For determining the status of such a distributor, it is not possible to classify him under one category. His different functions would fall under different categories and discounts would be offered to him accordingly. 2. Discount structure should be such that it enables the distributors to cover their operating costs and normal profits. In case the discount structure is unable to do so the distributors would not be motivated to sell. While if it provides excessive profit margins to the distributors it would be encouraging the entry of new distributors. But the problem generally faced by the seller is as to whose operating cost he should take into consideration for determining the discount structure because different distributors have different operating costs. There are two considerations which may be helpful to the seller in such a case: The upper limit to the discount rate is set by the cost of selling the product through alternative channels (even including the alternative of performing the distributors' function by the seller himself); The gap between discount rates for different trade status is determined either with a view to rationalizing profit margin at different levels of distribution or to encourage the efficient dealers and discourage the inefficient ones.

3. While deciding about the discount rate and the discount structure, the seller cannot ignore the tradition in the industry and the position of competitors in this regard. If he ignores them he would be inviting a price-war. Geographic Price Differentials. Just like the case where a seller quotes different prices to different buyers on the basis of time of purchase or the quantity of purchase, price discrimination can also be practised by a seller on the basis of differences in buyers' location (known as geographic price differential). Broadly, a seller may quote one of the two types of prices: (i) prices at the point of origin of the goods, or (ii) prices at the point of their destination. The former is known as "F.O.B. price" (i.e., free on board price), while the latter as "delivered price" which includes cost of shipping the goods to the buyer's location or to the nearest point of transportation. Though it is often believed that the delivered prices are discriminatory, it is in fact not always so. The final economic criterion of discrimination "is not the form in which the price is quoted, but the comparison of realised receipts of the seller" from the two forms of prices. There are many alternatives in which geographic price differentials may appear. These are discussed below. F.O.B. Pricing. When a seller charges a uniform price from all the buyers falling into a particular trade status and buying similar quantities of a particular quality of a good, we call it F.O.B. pricing. There are two possibilities of price quotation in this case: (II) Seller quotes the mill price and it is buyer's responsibility to choose his own mode of transportation for which he pays himself; and (III) Seller quotes a price which includes the mill price and the actual transportation cost of delivering the good at the buyer's location. In both the cases the seller's return remains the same, except that in the latter he handles some additional work of packing, delivering the goods to the nearest transportation point and maintaining records of delivery. Moreover, in the latter case he retains the title of the goods in transit and has therefore to handle cases of mishandling, loss or damage to the product during transit. In order to practice F.O.B. pricing, the following conditions must hold : 1. It is only when transportation cost is relatively small compared to the value of goods, that the seller will like to sell outside the local market. 2. Fixed cost or overheads must not be very high to force the sellers to go out searching for customers in distant markets. 3. The firm must have plants which are dispersed and in close proximity to the demand points, so that the situations of excess demand or excess supplies do not occur. 4. The firm should not be under pressure from rivals. For this, it is essential that products must be differentiated. Uniform delivered (or Postage-stamp) Pricing. A seller follows postage-stamp pricing if he charges the same delivered price at all the locations of the buyers. There are two ways in which postage-stamp prices may be quoted: (i) A uniform price is quoted for every destination after including an average expenditure for freight; or (ii) A uniform F.O.B. price is quoted and the buyers are authorised to deduct their freight cost from the Bill. In both the cases, discrimination is involved as the buyer who is located nearer to the seller pays less than that that is located far away. In commodities which have a national market and whose cost of transportation is relatively very small compared to the value of the product, postage-stamp pricing is common and effective. Goods like cloth, cosmetics, soft drinks, electrical and electronic equipments are examples where such pricing is followed. Zone pricing. Many a time, a seller, instead of charging a uniform price throughout the country, divides the economy into zones and charges the same delivered price within each zone but different prices in different zones. This is known as zone pricing. Within a zone there is a uniform price but between zones price differs to the extent it is sufficient to cover his average freight cost as a whole. So long as the seller's price zones are the same as his freight-rate zones there is no discrimination, as the difference in cost only reflects difference in cost of freight. In such a situation zone pricing is the same as F.O.B. pricing.

Basing point pricing. A designated production centre is known as a 'basing point'. When a delivered price is quoted on the basis of a 'basing point', we call it basing-point pricing. A basing-point price includes mill price plus transportation charges. The latter is not always the actual freight cost but the transportation charge from some designated production centre. A seller may use a single-basing or a multiple-basing point system. Under a multiple basing point system, two or more producing centres are designated as basing points. These points are then taken as reference points by the sellers. Each seller sets the mill price at the basing point nearest to the buyer and adds to it the freight cost from this basing point to the location of the buyer (irrespective of the actual freight cost). He thus determines and quotes the delivery price. Often the prices at different basing points are different. When freight cost charged from the buyer is higher than the actual freight cost, we. call it a case of 'Phantom Freight', while if the freight charged is less than the actual freight, it is called a case of 'Freight Absorption'. Freight equalisation pricing. When a seller charges the buyer the freight cost which would have been incurred by the latter had he bought from the nearest seller, it is called freight equalisation pricing. In this case the seller sets delivered prices identical to those of the rivals and in the process absorbs freight cost. His net return from sale is, therefore, dependent on the portion of freight cost he absorbs on each sale. Freight equalisation policy has been found to be followed in cases where: there is excess capacity; there is highly competitive product market; industry requires high fixed costs; and Transportation cost as a proportion of total cost is low. Personal Price Differentials. It is not uncommon to find that sellers give price discounts to certain customers for personal reasons. These reasons may be the loyalty of the buyer to the seller, high regularity and frequency in purchase or simply personal relations. Such type of concessions is also often offered to the employees and shareholders of the company. There are different forms in which personal discounts can be provided. Three common forms are: 1. Charging a price lower than that charged from the rest of the customers; 2. Charging the market price but on credit, which does not carry any interest charges; or 3. Charging the market price but no service charges. National Areas Price Differentials. It is often found that the price charged by a seller in the domestic market differs from that charged in the foreign market. This difference exists mainly because the nature of competition in the foreign and domestic markets differs and the government regulations provide certain benefits when operating in one kind of market rather than another. When domestic buyers have to pay more than foreign buyers for a particular quantity of specific quality of a good, and the domestic buyers are not in a position to import from the cheaper international market due to trade restrictions, we say that national area price differentials exist. Cash Discounts. Many a time price differentials have nothing to do with the quantity, quality, location or time, but rather with the promptness of payment. When price concessions are offered on the basis of promptness of payment, they are called cash discounts. Firms offer case discounts in order to have a comfortable liquidity position and to minimize bad credit risks. A buyer who wishes to buy on credit indicates his weak financial position and is therefore required to pay more to cover up the risk of default. While deciding about the size of cash discount the seller must weigh the cost of cash discounts against its benefits. The rate of cash discounts must be lower than the benefits which the firm gets by offering these discounts.

INCREMENTAL PRICING A key question all utilities are now facing is that of pricing incremental O&M costs for use in determining prices for off-system sales. Previous methodologies, which addressed energy versus capacity pricing, do not meet todays needs of defining variable costs. Issue Background

One of the key components in determining incremental costs of power production is variable O&M. The issues surrounding variable O&M have become very important in the utility industry as competition increases and more and more utilities try to improve their earnings or margins through increased offsystem sales. Historically, fixed and variable O&M calculations were established primarily to determine demand and energy charges for long-term sales. Under these circumstances, the concern was proper cost accounting and allocations between the two types of rate charges. Today, as margins for off-system sales become smaller and competition becomes greater, it is important for a utility to know, as closely as possible, its incremental costs of producing electricity so that it can be assured that sales are being made which cover production costs. At many utilities, a "fixed percent" method , i.e. 70% fixed/30% variable has been used for a number of years. This method was developed in the early 1980s and was based on estimates of the appropriate variable and fixed costs needed to operate a power plant. Other methods that have been accepted include the Federal Energy Regulatory Commission (FERC) procedure, which classifies expenses as prorated to demand or energy related; the National Association of Regulated Utility Commissions (NARUC) method, which uses a similar classification of demand in energy related expenses; and the EPRI method of classification. The evaluation of production O&M expenses is generally the responsibility of the Rates Department for most utilities, in conjunction with Power Production, Engineering, and System Operation Department to provide input and utilize the O&M expense information for off-system sales. The impact of decisions regarding variable cost on fuel procurement are somewhat indirect, but extremely important. The pricing structure that is utilized by system operations for off-system sales will dictate the level of system sales and the result in fuel consumption. Some utilities use spot coal in its pricing for off-system sales. By using the spot price of coal for the production of off-system sales, the short-term procurement policies must be capable of changing very quickly, as sales opportunities rise or diminish. Vantage Implementation Approach Our consultants will work directly with power supply, rates, cost accounting, engineering and system operations management to determine both the corporate philosophy and specific costs needed for the evaluation. The typical steps would be to: Determine if management has developed specific objectives regarding off-system sales and develop if necessary. Review the current methodology for determining fixed/variable mix. Establish a proposed sales strategy for each unit in the system. Establish a work team for each station/unit to identify specific activities. Review and allocate all cost elements into variable/fixed categories. Develop algorithms for converting current cost accounting information to incremental pricing activity. Prepare pricing policy for dispatch and sales personnel. The benefits of a system that provides accurate and current information regarding incremental costs provide an array of benefits: At any time, power sales personnel will know, with some assurance, the actual incremental cost of power production. This will help in maximizing profits and avoiding sales at below cost. An increase in sales is also likely as a result of better definition of mission and clearer cost estimates. For example, a 500 MW coal fired unit with a capacity factor of 60% might see an increase in capacity factor of 1% to 3%. With a 5 mill margin between incremental cost and sales level, the annual net revenue would be approximately $219,000 for each 1% increase in capacity factor

UNIT V MARKET FAILURE

MARKET FAILURE It contents the following aspects 1. ASYMMETRIC INFORMATION A situation where one side of a transaction has more information than the other side is called a situation of asymmetric information. In some transactions, such as the sale of a used car, the seller (who has used the car) has more information than the buyer. In certain other transactions, such as those between an insurance company and a customer, the buyer has more information about himself than the seller (especially regarding health). In such situations, where one side knows something that the other side does not and one side is also aware that it does not know something known to the other side, the markets perform differently, leading to inefficiencies and undesirable outcomes. In services, manufacturing industries, and retailing, buyers try to gather information that they do not have by a thorough search-from past buyers, information available in the media, and by actually examining the product. This is possible for a category of goods called 'search goods', such as clothes, furniture, services offered by packers and movers, barbers, etc. However, in case of 'experience goods', the buyer cannot observe certain characteristics at the point of purchase because these can only be experienced after the purchase. For example, the quality of a used car, the quality of a used air conditioner, the quality of paint, etc., can only be known after experiencing the product, which can happen only after the purchase. The chances of asymmetric information are, therefore, higher in the case of experience goods than in the case of search goods. The asymmetry in information can arise from two types of information first, about the characteristic, wherein one side knows some characteristic which the other side would like to know, but does not know; and second, about an action that one side can take and the other side cannot directly observe. The former is referred to as a situation of hidden characteristic and the latter is referred to as a situation of hidden action. In a transaction of used cars, the seller of the car has information on such characteristics of the car that the buyer does not have. For example, the seller would know that the car has skidded four times in the past. The buyer would desire to have this piece of information, but he/she does not have the information. This is a situation of hidden characteristic. Similarly, a customer, to whom an insurance company is trying to sell a health insurance policy, does not know that the buyer, although a well-known athlete, has suffered cardiac arrest twice in the past. Here, the buyer has some information on his/ her

own characteristic, which the seller would wish to have but does not have. This is again a situation of hidden characteristic. A situation where an employee is hired to put in hard work, but the employer is not able to observe the actions of the employee, is one of hidden action. Similarly, the seller of home insurance would like to know whether anyone in the household smokes indoors but is unable to observe anyone in the action of smoking. Asymmetric information could, therefore, arise either due to hidden characteristics or due to hidden actions. 2. SIGNALLING When faced with a situation of hidden characteristic, sellers and buyers bend backwards to find ways of getting information about hidden characteristics. An indicator of a hidden characteristic is called a 'signal', and we will now see how the 'signalling' mechanism is used by sellers to get information about hidden characteristics. Let us begin by taking the case of a monopolist seller, who wishes to know the willingness to pay of each of the customers of his/her product or service, with the obvious intention of practising price discrimination. Let us take up the airlines industry, which uses signalling extensively to identify different kinds of customers on the basis of their willingness to pay. Jet Airways has launched a flight from Calicut in Kerala to Colombo in Sri Lanka. The marginal cost of carrying an extra passenger is Rs 1,500. This route targets two categories of fliersthe tourist traveller and the business traveller. The business traveller is willing to pay Rs 5,000 with a guaranteed return the next day. If he/she does not get a confirmed return the next day and has to wait for up to a week, he/she is willing to pay only Rs 2,500. The tourist traveller, on the other hand, is willing to pay Rs 2,100 and wants to return only after two weeks. The dilemma facingjet Airways is that if it has to charge a uniform price, charging Rs 5,000 would mean only the business traveller would travel and the airways would earn Rs 5,000 - Rs 1,500 = Rs 3,500, and charging a low price would mean selling to both the business traveller, and the tourist traveller and earning 2(21001500) = Rs l,200,which is much less than what is earned by selling only to the business traveller. However, ideally, if Jet Airways could charge Rs 5,000 to the business traveller and Rs 2,000 to the tourist traveller, it would earn (Rs 5000 - Rs 1500) + (Rs 2100 - Rs 1500) = Rs 4,100, which is the highest earning. This is price discrimination, and amongst the necessary conditions that should exist for practising price discrimination, one is that the seller should be able to identify customers with different demand elasticities. How can Jet Airways identify the two kinds of customers? They will not reveal their willingness to pay if price is the only difference between the two tickets, because everyone will only want to pay the lowest price. Jet Airways, therefore, needs to find a signal that will effectively sort the customers, and it cannot be price alone. In this situation, it has to be a combination of price and the length of the stay before return. If, for instance, the airways charges a price of Rs 2,100 with a guaranteed return after a week and offers another package wherein the price is Rs 4,440 and guaranteed return the next day, the business traveller, could choose Rs 2,100 and stay for week, because this is still below what he/she was willing to pay (Rs 2,500) if he/she had to extend his/her stay. In this case, the traveller would enjoy a consumer's surplus of Rs 400. On the other hand, if he/she chooses Rs 4,440 with immediate return, he/she would enjoy a consumer's surplus of Rs 650 because he/she was willing to pay Rs 5,000 for a guaranteed immediate return. The business traveller will choose the Rs 4,440 package. The tourist traveller will obviously choose the Rs 2,100 package. The earnings to the airways (if the customers select the packages the way it has been described above), is (Rs 4440 - Rs 1500) + (Rs 2100 - Rs 1500) - Rs 3,540. The monopolist Jet Airways advertises these two packages hoping that the customers will select the package most suitable for them in the manner described above. These fare packages are called selfselection devices. The choice made by the customer (which is the more informed party) reveals the hidden characteristics to the seller (which is the uninformed party). This way, the seller uses the selfselection device to sort or screen the customers into different types, based on their willingness to pay. To ensure that the business traveller chooses the Rs 4,440 package, Jet Airways has to offer him/her an incentive (a surplus) to choose the Rs 4,440 package. If it was the Rs 5,000 package, the business traveller would choose the Rs 2,100 package because he/she would get a surplus of Rs 400 there and, therefore, for all practical purposes, would be a tourist traveller. In such a case, the monopolist would

lose the earnings, and the very purpose of price discrimination would be defeated. Thus, the reduction in revenue of Rs 560 from the business traveller is the price that the seller has to pay for not having information on the hidden characteristic. While price discrimination increases the profits of the seller, it also increases the total surplus of the society. In the situation described above, had the monopolist chosen not to, or was not permitted to, discriminate, he would have charged a uniform high price of Rs 5,000 and the tourist traveller would have been excluded. Thus, price discrimination is justified and any device used to facilitate price discrimination is also justified. After understanding the need for signalling, self-selection device, and screening, it becomes easy to understand the various packagesoff season, weekend, executive packagesoffered by airline companies all over the world. Signalling is also used in competitive markets. The labour market is considered to be a highly competitive market and pioneering work has been done by Michael Spence, the Nobel Prize winner, along with George Akerlof and Stiglitz. How can individuals credibly transmit or signal their information to the uninformed individuals in a labour market? Spence's pioneering essay demonstrates how education can be a signal of productivity in the competitive labour market. If, in a competitive labour market, information is symmetric, the labour is paid according to the marginal revenue product. The low-productivity category of workers will be paid lower (say, Rs 50 per day) as against the high-productivity workers, who will be paid higher (say, Rs 100 per day). However, if information is asymmetric, the worker (who is the informed party) knows his productivity, but the employer is uninformed. At the time of hiring, the employer only knows that there is an equal chance of the worker being a low-productivity worker or a high-productivity worker. Therefore, the employer works out the worker's expected marginal revenue product as 0.5 x 50 + 0.5 x 100 = Rs 75 per day and fixes the wages at this level which is, on the average, the same as in the symmetric situation (and so the employer is not symmetric situation. However, from the point of view of the two categories of workers, there is a difference. The low-productivity worker is better off and the high-productivity worker is worse off in a situation of asymmetric information. The high-productivity worker has to inform the uninformed employer in a credible and inimitable manner that he/she is entitled to a better wage. Education is one such signal. 'Education' or 'going to college' does not come free. It has monetary costs (such as fee) and non-monetary costs (writing tests, term papers, etc., are costs). These costs are higher for the low-productivity workers (because they are less able) than for the high-productivity workers, who are more able because the lowproductivity workers struggle through college. However, even if higher education is costly, people choose it because there are certain benefits. A college educated worker gets a higher wage than a non graduate. This is shown in Fig. The thick line gives us the combinations of income levels and education levels. The high-productivity workers choose to go to college and, therefore, earn double the wage of the low-productivity workers who choose not to go to college because it is more costly. Thus, education signals productivity and low-productivity workers cannot mimic the signal provided, thereby enabling the employer to 'screen' effectively. 3. ADVERSE SELECTION One of the outcomes of asymmetric information is a phenomenon called adverse selection, which is a certainty if attempts are not made by the uninformed parties to gather more information and if informed parties do not 'signal' and credibly transmit information to the uninformed party. Adverse selection is a phenomenon under which the informed side of a deal gets exactly the wrong people trading with it. A buyer of used cars gets only sellers with poor quality cars trying hard to sell their ware, or a health insurer gets only the 'sick' people buying the policies. Pioneering work in this field has been done by George Akerlof, who explains this in the context of the used cars market, the 'Market for Lemons' (lemon is a colloquialism for a defective old car). In a used car market, the buyer has less

information than the seller, and the buyer is sure of only one thingthat sellers of 'lemons' are most anxious to sell their cars. Knowing this, the consumers would place a lower value on the cars. In a market for used cars with low price, a person with a good car will have no incentive to sell. The buyer, who is aware of this, places an even lower value on the cars, thereby lowering prices further, and also lowering the average quality of cars sold. Thus, the poor quality 'lemons' will be the only ones sold, and if a good car has to be sold, the seller will have to incur huge costs in convincing the buyer that it is a good car, which the owner of a good car may not benefit from. Thus, the uninformed side, that is, the buyers, get exactly the sellers whom they do not want to deal withthe sellers of 'lemons'. This is the phenomenon of adverse selection. This phenomenon occurs in insurance markets also wherein the seller is less informed than the buyer. The life insurance company would like to have information about the life-expectancy of the buyer. But this piece of information is a hidden characteristic with the buyers. Without this information, the seller has to offer the insurance policy at the same price to both the healthy people and the sick people. The group which has much greater incentive to buy the policy will be the sick people and they are the ones who are likely to get the benefits because they are in poor health. But this is precisely the group that the life insurance company does not want to deal with. We therefore have the problem of adverse selection again. Let us now see the outcome of adverse selection in the following two cases: In the case of the used car market, where all the characteristics remain the same, let us now introduce the possibility of submission for inspection wherein the sellers can submit their cars to an appointed agency for inspection and the agency can certify that the car is good. The cost to pass the inspection for a good car is Rs 20,000 while for a lemon it is Rs 1,10,000. While the pooled price of Rs 1,50,000 is acceptable to everyone, the seller of a good car would like to signal the quality of the good car with the inspection certificate, which he/she can get at a cost of Rs 20,000. Therefore, if the seller chooses to go through the inspection, he/she can sell the car for Rs 2,00,000 (the value placed by the buyer on a good car). He/she would earn a profit of Rs 2,00,000 -Rs 1,50,000 - Rs 20,000 = Rs 30,000. Had the seller stuck to the pooled price of Rs 1,50,000, his/her profit would be zero. However, would lemon sellers choose to get their cars certified? If they did, they would get Rs 2,00,000 -Rs 50,000 - Rs 1,10,000 = Rs 40,000. If they chose not to get the car inspected they would get, Rs 1,00,000 - Rs 50,000 = Rs 50,000. Thus, the owners of lemons would not choose to get their cars inspected. The result is that inspection (and the cost attached) has effectively screened the cars and lemons and there is what is called a separating equilibrium with two prices for two different categories of cars. However, if the cost of signalling is very high, say Rs 60,000 even for a good car, the owners of good cars will choose not to get the vehicles inspected and the outcome would be the pooled equilibrium. Market Responses to Adverse Selection We have seen above that adverse selection leaves some players in a market unhappy. So, we can expect that attempts will be made to correct the asymmetry to the extent possible. It is in fact being done. We will see how the mechanisms of signalling and screening correct the outcomes of adverse selections arrived at in Case 1 and Case 2 of the previous sub-section. Let us look at the insurance market case with some modifications. The proportion of healthy to sick people is 50:50. The risk of illness for a healthy person is 1/1000 and that for a sick person is 1/500. The cost to insure is Rs 10,000 for a healthy person and Rs 20,000 for a sick person. (If the price charged is equal to the cost to insure, the company is said to be charging actuarially fair rates). A healthy person is willing to pay Rs 14,000 and a sick person is willing to pay Rs 25,000. The insurance company introduces the possibility of a health check up. This check up costs Rs 4,000 for a healthy person and Rs 15,000 for a sick person. The insurance company offers two kinds of policiesone policy for Rs 24,000 without the health check up and another for Rs 10,000 with the health check up. Without this screen the average cost to insure the whole population would be: (0.5 x 10,000) + (0.5 x 20,000) = Rs 15,000. The healthy person would opt for the policy of Rs 10,000 plus 'clearance' of health check up at Rs 4,000. It would cost Rs 14,000, which is what he/she was willing to pay. The sick person would go for the Rs 24,000 policy because if he/she went for 'health clearance', the costs would be: Rs 10,000 + Rs 15,000 = Rs 25,000. This is a case of separating equilibrium.

The different parties to a transaction are convinced that signalling and screening devices can be used effectively to avoid the outcome of adverse selection in the context of asymmetric information. In the insurance market, insurance companies have come up with a good number of screening devices. One of the most commonly used screening mechanism is the medical examination, which screens an individual and categorizes him/her as healthy or sick. While such an examination prevents adverse selection, which is desirable from the company's point of view, socially, the test does not add value. If anything, it imposes a cost on the individuals and deprives a section of the society of the benefits of insurance (because insurance policies are priced very steeply for sick individuals). Group health insurance is another instrument to overcome the problem of adverse selection. In many organizations, the employer provides insurance to all employees and the employees automatically get enrolled in these group health insurance schemes. These schemes are priced lower because the employer bears some of the administrative costs. The employer also has greater buyer power than individuals and so is able to get a better deal from the insurance companies. With everyone having to enroll, there is no adverse selection. This is beneficial to the employees because it is priced lower and the insurance company cannot keep off the sick people. Another market that has responded to the problem of adverse selection is the labour market. One way out is to use education as a signal of ability. However, where education is not available or cannot be used as a signal, how is the problem of adverse selection dealt with? A firm will have to offer wages that will attract both the low-productivity/ability and the high-productivity/ ability workers. If the wages are low enough to attract only the poor-performance workers, it is confronted with the problem of adverse selection. Hence, in a market with hidden characteristic, paying a higher price avoids the outcome of adverse selection. By offering a higher wage, the firms actually stand to benefit because they are able to attract high-productivity workers. This phenomenon of raising wages to improve the productivity of the workforce is known as efficiency wages. This is practised to avoid the problem of adverse selection. This is also dealt with in the sub-section on principal-agent problem. Government Responses to Asymmetric Information arising from Hidden Characteristics Government intervention adds to the market response to mitigate the problem of adverse selection arising from asymmetric information on hidden characteristics. The government promotes compulsory public pension programmes, such as provident fund and family pension schemes, wherein every individual has to compulsorily join the programmesimilar to the group insurance programmes of individual companiesthereby avoiding the problem of adverse selection. The government also makes information dissemination mandatory for those who are more informed. The government ensures that the information that is disseminated (through advertising, for instance) is not false. It makes it mandatory to reveal information on certain quality indicators, such as fuel efficiency. In situations where market response will not be forthcoming, such as in situations where revealing information is adverse for all the firms (the cigarette industry, for instance, does not wish to reveal that cigarette smoking causes cancer), the government can play a very important role in making information dissemination mandatory. 4. HIDDEN ACTIONS Hidden characteristics are, many a time, inherent to a situation or a person, and there is some 'helplessness' about it. However, a hidden action is something that is fully under the control of the individual and the other party has no information as to whether the individual is actually going to perform the hidden action or not. For example a worker is hired and expected to work hard, but the employer has no idea and does not have the time to observe whether the worker is actually working hard. It is entirely under the control of the worker and he/she can choose to work hard or not to work hard. An individual who has taken fire insurance can choose to smoke in the kitchen, but the insurance company will have no information as to whether he/she has chosen to smoke or not. Essentially, a situation of hidden action is characterized by: One side of the economic transaction or relationship is not able to observe the action taken by the other. The action, which may or may not be taken, affects the other side.

There is no agreement on whether the action is to be taken and whether it is best to take the action or not to take the action. While one side may want the action to be taken, the other side may not want the action. The insurance company may not want the customer to smoke in the kitchen, while the customer may want to. In such situations of asymmetric information arising out of hidden actions, the problem that arises is that the informed side may take the wrong action, an action which ought not to have been taken. Hence, such situations are called moral hazards. Just as we have the problem of adverse selection in situations of hidden characteristics, we have the problem of moral hazards in situations of hidden actions. Moral Hazards in the Insurance Market This problem was first identified in the insurance market, wherein once insured, the individuals made no attempt to prevent accidents. Sometimes individuals actually made accidents happen. There are incidents of owners setting warehouses on fire to claim insurance. No attempt is made to prevent accidents because there is no incentive to do so. We will take up the situation of driving. A driver with no insurance will take all possible measures to prevent any accident because the cost incurred due to an accident is so high that it is worth preventing. Figure shows the total cost of damages associated with each level of preventive measures taken. It is downward sloping for the obvious reason that higher levels of preventive measures are associated with lower levels of cost of damages. Figure shows the marginal benefits of increasing levels of preventives measures. As the level of preventive measures taken increases, the contribution by further units of preventive measures decreases. Let us also further assume that the marginal cost of taking up preventive measures is constant at Rs X. Now we are in a position to decide the optimal level of preventive measures that will be taken by an individual in the absence of any insurance. This is shown in Fig. The optimal level of preventive measures will be that at which marginal benefit is equal to marginal cost and this happens at e.

Fig: Total cost of damage Fig: Marginal Benefits of Preventive measures Now suppose that the driver takes up comprehensive auto insurance. How does this alter the picture? The marginal cost of preventive measures does not change with insurance. However, the marginal benefit of preventive measures changes dramatically. The driver will now not see the prevention of an accident as a great benefit because the cost incurred in case of an accident is now borne by the insurance company. There still is some benefit that can be derived by taking preventive measures; the reputation of not having an accident is one such benefit. This reduction in marginal benefit is captured in Fig. wherein the marginal benefit curve shifts inwards. With this shift, the optimal level of preventive measures reduces from the level V in the absence of insurance to level V in the presence of insurance. Thus, with insurance, the cost of the accident to be borne by the individual reduces and therefore, the incentive to prevent accidents reduces, leading to much lower levels of preventive measures. As was observed initially, sometimes the effect of moral hazards, reaches an extreme point where a life is worth more when dead than when alive, where a vehicle is worth more when stolen than when not, or where a house is worth more when it is burnt than when it is in existence. Under such situations, the marginal benefit of preventive measures is actually negative! Under such circumstances, the individual makes the accidents happen, so that he/she gains more. This truly is a moral hazard!

Fig: Optimum level of preventive measures Fig: Optimum level of preventive measures with & without Insurance Efficiency Effects of Moral Hazards With a reduction in the cost to be borne by individuals in case of accidents, one would conclude in a hurry that society is benefitted. However, it actually leads to a shift in the incidence of the burden. The cost of the accident is now borne by the insurance company. The burden of an accident to the society as a whole does not reduce with insurance. Besides this, when policy holders choose low levels of preventive measures, the insurance company is forced to hike the premiums to cover the increase in expected claims. However, would the premiums go down if policy holders chose higher levels of care? The answer is no because the insurance company has no information on the hidden actions of the policy holders and so does not trust them. Given this, the policy holders will stick to low levels of preventive measures. Thus, a situation of a moral hazard is instrumental in bringing about inefficiency in pricing unduly high premiums to be borne by all policy holders. Ways of Mitigating Moral Hazards One measure that can be taken is to build in a feature that will ensure that the policy holders bear some part of the cost and so are forced to take a reasonable level of preventive measures. This is practised by insurance companies through what is called co-insurance. Under this scheme, the insurance company does not pay full value of the claim (or the cost of the accident). If the co-insurance rate is 20 per cent it means that the insurance company will pay 80 per cent of the claim and the individual will pay 20 per cent. The higher the co-insurance rate, the larger the proportion of the cost or claim to be borne by the policy holder and therefore, the greater the incentive to prevent it. The policy holder is, thus, forced to take a higher level of preventive measures to ensure that his/ her burden is reduced. Yet another instrument used by insurance companies is called a 'deductable'. This is a scheme wherein the policy holder, in case of a claim, pays the initial damages up to a certain predetermined limit, above which the insurance company pays. For example, if the estimate of damages is to the tune of Rs 1,50,000 and the deductable is Rs 40,000, the policy holder pays the initial Rs 40,000 and the insurance company bears the rest of the cost of damages. If the damage is to the extent of Rs 40,000, the policy holder pays the entire amount. This scheme also ensures that the policy holder takes reasonable level of preventive measures so that the cash outflow does not actually have to be borne by the policy holder. While these measures do not prevent the problems associated with moral hazards, they certainly reduce the intensity. The Principal-Agent Problem A principal-agent relationship exists whenever the principal (such as the owner) employs an agent (such as a manager) to carry out what the principal wishes. What is the problem in this kind of relationship? The problem arises from two sourcesfirst, the principal and the agent may have different and even conflicting objectives. For instance, profit maximization may be the objective of the firm, but the manager would be interested in enhancing and enriching his/her own compensation, which would work against profit maximization by resulting in higher costs and reduction in profits. Second, the principal cannot monitor the agent in a cost-effective mannera situation of hidden action. These two characteristics lead to a situation of moral hazard.

Agency relationships are widespread; doctors serving as agents in hospital, managers serving as agents in firms, managers serving as agents in real estate firms, etc., are some examples. What devices can be employed to ensure that managers work to further the principals' (or the owners') interest? The principal-agent problem is widely prevalent in private and public enterprises, since most of these are controlled by the management. The managers' objective is to increase cash, thereby enabling them to enrich their compensation. However, there are certain market forces that keep the managers under control. One such force is the voice of the shareholders, which can publicize the fact that profits are not being maximized. Another force is that of corporate control, which sends the signal that poorly-managed companies will face takeover bids, which is a very credible threat, and will make the managers perform. While public enterprises may not have many of these market forces helping them, the government machinery does a part of the difficult monitoring joboffices of accounts and budgets monitor the public sector enterprises. However, despite this, the principal-agent problem still persists. Incentives in Principal-Agent Situations The principals' concern is that they cannot observe the managers when they are not performing, that is, when they shirk work. A manager shirks work because he/she prefers leisure to work. The principal is concerned about this because there is an inverse relationship between profits and shirking, as shown in Fig. What compounds the concern is that this shirking by the manager is unobservable. If it could be observed, the owner could base the salary on the extent of work the manager shirks, but where this is unobservable, what is the solution? A flat salary to the manager is one of the prevailing forms of compensation. A flat salary gives no incentive for not shirking. A manager can shirk work for the entire period that he/she was supposed to work and yet get his/her salary. This form of compensation will ward off the principal-agent problem only when shirking is observable. The principal can then fire the manager. However, where shirking is unobservable, this form of compensation fails to address the principal-agent problem. This leads us to performance-based compensation schemes, wherein the owner may tie up the managers' salary to the profitability of the firm. One such scheme is one where the manager is a residual claimant. This happens when his salary is arrived at by a formula, such as salary = profits minus a fixed amount. For example, if the profit during a year is Rs 2,00,000, and the fixed amount to be deducted is Rs 50,000, the manager would get a salary of Rs 1,50,000. The manager's salary varies directly with the firm's profits and so he/she has an incentive to work towards profit maximization, which is in the interest of the owners. In the 1980s, the phenomenon of management buyouts was prevalent, wherein the management (the agents) could buy up all the shares of the company, by paying a fixed fee to the previous owners for their shares from the company's profits. The residual would go to the managers. Banks facilitated these management buyouts through loans. However, flat salary still remains popular because most salary earners do not see shirking as equivalent to leisure. In fact, it is not considered an economic good! Besides, even under a flat salary, 'shirking' becomes observable and sooner or later, the one who shirks work is punished. The residual-claimant model, despite being successful in addressing the moral hazard issue, is not implemented universally because in this model the business risk is to be borne entirely by the agent, while the owner has greater capability to bear the risk, and should at least share the risk. Hence, this compensation model is not widely applied. Another compensation model that explicitly links payment with output produced, thereby serving as an incentive to work, is the piece-rate scheme. This is applicable more at the worker level, where the worker is paid according to the number of pieces produced. Here again, if the machine fails, the worker loses due to sheer bad luck. In competitive labour markets, wages are presumably equal to the marginal revenue product, and all those willing to offer their services at the going wage rate are supposed to be employed. However, in reality, there is persistent employment even in fairly competitive markets. This situation can only be explained in a principal-agent relationship where the employer is not able to observe the hidden actions of the worker and suspects shirking. If a worker is paid only the market-clearing wage, the incentive to

shirk is high because even if the shirking is observed and the worker is fired, the market will absorb him at the going wage rate. If the employer does not want the workers to shirk, he/she should pay the worker a higher wage rate. If the workers still shirk and are fired, they will get an alternate job at the market-clearing wage, which would be lower than the wage that they are presently hired at. The larger the difference in the wages earned and the market clearing wage, the greater the incentive to work and not shirk. This higher wage rate, at which the workers will not shirk is called efficiency wage. Even if all the firms offer efficiency wage, a worker will not be re-absorbed at the efficiency wage by another firm in the event of his/her being fired by his/her employer, because employment in the industry is lower at this higher wage than what it is at the market-clearing wage. Therefore, there is no incentive to shirk at the efficiency wage rate. The task of designing a compensation scheme to prevent the problem in situations of moral hazards is more challenging in the context of an integrated firm with multiple divisions. It is a situation of asymmetric information as each division knows everything about itself and the parent firm relies on each of these divisions for information. The parent firm has to design a compensation scheme that encourages efficiency and productivity and is also equitable. Each division should work under a different set of conditions. To arrive at a compensation scheme that takes into consideration the constraints of each division is a challenge indeed. Martin L. Weitzman's (1976) incentive model provides a method by which some of these constraints could be met. One simple formula is to take the output produced not in absolute terms but in relative terms, that is, relative to the capacity, or relative to the feasible target set by them. For example, if the manager meets his target, he/she gets a performance bonus of Rs 20,000. However, if the target is not met, there is a deduction made according to the following formula: Bonus = 2000 - 0.6(QT - QA) Here 0.6 is the factor by which the bonus is reduced, QT is the target output, and QA is the actual output. It should strike the readers that the manager would do everything to shrink the difference between QT and QA. The easiest thing to do would be to give a pessimistic estimate of the target output. Thus, the formula needs to be modified to make the manager reveal a realistic estimate of the target. A weight could be given to the target declared also. Therefore, if QA exceeds QT, then Bonus = 0.4 QT + 0.2(QA -QT) If QA falls short of QT, then Bonus = 0.4 QT - 0.5(QT - QA) Here QT is given a weightage of 0.4 indicating the importance given to realistic target setting and hence, the manager has the incentive to be truthful and realistic in setting targets; 0.2 is the weightage given for exceeding targets; and 0.6 is the penalty attached for falling short of targets. One hears the term 'targets' most often from salesmen. This formula can be successfully used to design compensation packages for salesmen. That this is well accepted by sales personnel is brought forward by Jacob Gonik (1978) in his work. Moral Hazards in Product Markets The problem of moral hazards has so far been discussed in the context of insurance and labour markets. It is a problem in product markets too with a category of goods called experience goods. In the case of a movie, for instance, about which the movie maker has full information, a consumer gets to know about it only after 'experiencing' the movie. In many markets, there is asymmetric information on product quality, and firms actually cheat the consumers, and the consequence is the same as that in the 'lemons market', wherein the bad quality goods drive out the good quality goods. The producers of good quality goods and the consumers are interested in mitigating this problem, and have responded in many different ways. Brand Name Reputations as Hostages One of the most important market responses to the problems of moral hazards is the development of brand name reputations. It is in the interest of the producer of good-quality products to let the market know the goods' quality. IBM, Totyota, McDonald's, GE, and many others have sunk in substantial investments over extended periods of time to establish a reputation and make customers indulge in repeated purchases, with good quality being reinforced each time the good is experienced. Once this is done, the firm cannot change the quality of the product, and buyers are convinced that the manager will

not do anything that will destroy the brand name reputation. Brand name, therefore, gives an assurance to the buyer that the seller will maintain the quality of the goods. Brand name, once successful, can be extended to the whole range of products sold by the firm; Britannia, originally in confectionary business, has used the brand to sell its range of dairy products; LG has extended its brand name from consumer durable to computers; Nestle has extended its original hot chocolate brand to candy bars and cookies. In such extensions, the firm's reputation is the assurance it offers the consumers in order to ensure that it is providing a good quality product. The above mechanism will successfully substitute a full-information situation only when the seller has the incentive to do so. A seller is forced not to deviate from quality because of the threatened loss of reputation in the future. This would be an effective threat only if he/she is assured of earning supernormal profits in the future due to the reputation. If the seller gets the price just equal to or marginally above the good-quality cost, he/she has no incentive to maintain good quality. He/she would rather cheat by delivering low-quality products to increase his/her present profits. The seller certainly requires a price much above the cost in the future which, even when discounted to the present, results in a positive stream of profits. However, the prevalence of a price much above the costs means inefficiency from society's point of view. Thus, while the problem of asymmetric information is overcome, it has been done at the cost of efficiency in resource allocation. Guarantees and Warrantees Another popular response of sellers of good-quality products is to offer guarantees and warrantees. The firm producing a good-quality product can sell its product for a higher price only if it is able to convince the consumer that its brand of the product is more dependable. A firm by offering guarantee/ warrantee is signalling its willingness to take on the risk/burden of poor quality. Taking on such a burden is a very costly proposition for a commodity of poor quality, whereas for the producer of a good-quality product, this burden or risk is low. Thus, a firm that offers extended guarantee/warrantee schemes is conveying to the market that its product quality is good. While market responses are forthcoming to overcome the problem of asymmetric information, they do not result in solutions that would have been arrived at if full information prevailed, and hence, we can still say that markets fail in situations of asymmetric information. In fact, market responses to asymmetric information result in an increase in prices. For example, individuals who have purchased medical insurance will avail of the facilities offered under the scheme regardless of whether they are required or not. The result is that the providers of these facilities face an increase in demand and thereby raise the price that the non-insured segments have to pay. The insured segment is not bothered because the insurance company bears this price. Thus, while the risks of adverse selection and moral hazards are reduced with market responses, it does not make the markets more efficient in terms of price. EXTERNALITIES The effect of an economic activity that is not incorporated into or reflected in the market price is called an externality. This effect could be negative (imposing a cost on the other individual or firm) or it could be positive (imposing a benefit on the other individual or firm). Spewing effluent gases into the air is a negative externality for a factory. The cost is the resultant air pollution and its effect on individuals and the climate. This cost is not in any way reflected in the price of the product produced by the factory. This cost is external to the market as it is not captured by the market mechanism, and hence, it is called a negative externality. An individual, who is fond of greenery, hires a professional landscaper to do up the area surrounding his/her office. Besides benefiting the individual, such an effort also benefits the people living around the area. However, the individual, while evaluating the benefits of this landscaping, did not take into consideration the benefits conferred on the community such a benefit is external to the transaction, and hence, is called a positive externality. Let us consider the negative externality of polluting the air further. Had there been a market for clean air, there would have been a reduction in its supply, leading to an increase in the price of clean air, and the factory using this clean air would have had to pay the price. Thus, the consumption of clean air will be internalized, and there would be no inefficiency. The problem with an externality is, therefore, one of

missing markets. Since there are no markets for clean air, the market cannot help us arrive at efficient solutions. If clean air was owned by someone, it would have been sold to the user. Thus, externalities arise because of missing markets. Externalities have the following characteristics: 1. Externalities can be caused by the acts of individuals or by acts of institutions. For example, music clubs in students' hostels are often accused of playing loud music, disturbing the peace that ought to prevail at night. 2. When externalities are generated, who ought to own the 'property'? In the example of the music clubs, who should own the 'night'? Or, in the factory example, who should own clean air? The night can be owned both by the music club and by others. If the music club owns the night, it will accuse others who maintain silence in the night, of 'spoiling' the night, and if others own it, they will accuse the music club of 'spoiling' the silence of the night. Smoking in public places is still an issue of dispute, because of this characteristic of externality. 3. Externalities can be positive and negative. (This has already been discussed at length.) 4. Externalities, especially the negative externalities, cannot be done away with. For example, if we aim for one hundred per cent clean air, there can be no factories and no production! A balance has to be struck between the benefits and costs of the activity before imposing restrictions. GOVERNMENT RESPONSES TO EXTERNALITIES Taxes As seen in the case of negative externality generated by the chemicals manufacturer, the output produced is more than the efficient level of output because the costs are underestimated. Therefore, one method of raising the costs to the level of the social marginal cost is to impose a tax. This natural solution was suggested by an economist, A.C. Pigou, and hence, is referred to as Pigouvian tax. This tax is levied on each unit of output equal to the amount of marginal externality {MEN) that is generated at the efficient level of output. The result is shown in Fig. The supply curve shifts up by the amount of the tax and the new equilibrium output is the efficient level of output. In the example of the chemicals manufacturer, should the revenue from such tax be earmarked for the fishing industry? While the intuitive answer would be yes, it is not so. This is because the damage caused to the fishing activity has been taken care of by the reduction in output of chemicals. If the tax revenue is also given as benefit to the fishing activity, there would be more than efficient levels of fishing activity. While imposing a tax seems feasible, implementing it poses a real challenge. One of the challenges is to ascertain the entity that is causing pollution. While, in this example, it is clear that the chemicals manufacturer is responsible for the externality, there could be many others that are also responsible, like firms, individuals, or nature itself. Also, the damage done by each pollutant has also to be assessed. Some cause more damage than others to a specific activity. Assessing the extent of damage done and its quantification is also a difficult task given that these have no markets and, therefore, their value cannot be easily estimated. Despite these difficulties, wherever the problems of implementation are not of great magnitude, such taxes are imposed; for example, special toll on heavy vehicles is levied, which is different from the toll levied on light vehicles. Regulation This is a common response in most countries wherein each polluter is told to reduce pollution by a certain amount, regardless of the damage caused. The typical instance would be of setting emission standards for cars. Ideally the limit should vary with the damage causeda car in a desolate area causes lesser damage even with the same amount of emission. This would mean assessing the quantum of damage and

valuing itthe problem faced while imposing taxand hence, it is not attempted by countries. It is extremely difficult to make such an assessment for each car user. Therefore, emission limits are set and if individuals violate these standards, legal action is taken. Effluent Fee In the context of externalities, we had mentioned 'missing markets', that is, if markets existed for products, such as clean air and clean water, then the problem of inefficiency would be eliminated. Governments take measures to actually create markets where markets are missing. How is this done? The government sells the right to pollute by charging an effluent fee. This is demonstrated in Fig. The government fixes the level of pollution (the vertical supply curve S Y*) and firms bid for the right to pollute. This is the demand for pollution rights. The equilibrium price is P* and those who are willing to buy the right will do so and those not willing to pay the price will have to reduce their levels of output. Transferable Emission Permits Under this system, licenses that give the owner a right to pollute upto a specific limit over a particular period of time are sold. Before selling the licenses, the government sets a maximum level for pollutants that may be safely emitted in an area. This maximum level is then quantified, and sold through the auction mechanism. Further, these licenses can be freely traded in an organized market, permitting their prices to fluctuate with the market demand. Here again, a market is created where it was missing. This method of internalizing externality requires that it is possible to set the maximum level. Further, it requires that pollution/emission is measurable in quantitative terms. Both these may not be possible in many cases. A further criticism is that it favours large firms, because with their financial resources they can buy the rights, while small firms may not be able to buy these rights. In the US, there is a bustling market for sulfur dioxide and hydrocarbon credits. There is an organized exchange, called the Chicago Board of Trade, where sulfur dioxide credits are periodically auctioned. In the context of big firms having the financial resources to buy pollution rights, Times Mirror Company bought the right to emit 150 tons of hydrocarbons into the air annually for US$ 50,000 from the owners of a dry-cleaning firm and a wood-coating plant. Emission Permits (Standards) and Emission FeesWhich is Better? Let us take two firms causing the same amount of damage to the society, but the cost of reducing the pollution is different for the two. Let us call this cost pollution abatement cost. Each firm is required to reduce its emission by any number of units such that the overall emission of pollution reduces by Xunits. We will further assume Xto be 15 units. Figur shows the two firms with differing abatement costs. The two firms together have to reduce the emission by 15 units. They have to move towards the left on the X-axis. Now left to themselves, the two firms can reduce eight and seven units, respectively, at the same marginal cost of four (the horizontal line in the figure). As against this, if the government had imposed a standard reduction of seven and a half units for both the firms, the cost of abatement would have been different for the two firmshigher for the firm with higher marginal abatement cost at 5 and lower for the one with lower marginal abatement cost at 3. This is a situation where the overall reduction in pollution is attained at costs greater than minimum. Thus, a fee of Rs 4 would attain the objective of reducing the emission by 15 units more efficiently than a standard reduction. Recycling Recycling has emerged as an important option in the context of waste disposal. The manner in which waste is dispensed is the result of the fact that there are no private costs of waste disposal to both consumers and producers. With no incentive to recycle the waste, the excessive waste disposal results in an externality and therefore, requires attention. Governments are now trying to correct this by providing incentives for recycling. Let us take the case of disposal of glass containers. As of now, households pay a flat monthly or annual fee regardless of what kind of waste they are disposing. This being the case, the private marginal cost of disporing glass containers will remain constant up to moderate levels of disposal. The social cost of this disposal is, however, excluded because it is an externality and the social cost is the damage done to the environment and the injuries caused by broken glass. How would the above situation change if glass is recycled? This is shown in Fig.

The private marginal cost of waste disposal is more or less constant, and increases only when the level of disposal is highindicated by MC. The marginal social cost increases at an increasing rate with an increase in waste disposal; this is shown by the curve SMC. Recycling, too, has a cost. The municipal authority will probably have to appoint staff for the separation of waste. This will increase with increasing quantities of disposal. This is shown by the marginal cost of recycling curve. Hence, the cost of recycling increases as quantity to be recycled increases and with this increase, the quantity of waste disposal decreases. Thus, MCR increases as we move from right to left on the Xaxis. At the right end of the X axis, all waste is disposed with no recycling. Thus, MCR is zero. It increases as more and more of this waste is recycled. What is the right amount to be recycled? The point where MCR is equal to the marginal social cost of disposal is the optimal level of recycling that should be undertaken. How can this kind of internalization be done? Theoretically, we can think of fees, standards, etc., but implementation poses problems that the schemes run into vis-a-vis other pollutants as well. One method that has met with reasonable success is the system of refundable deposits. Under this system a deposit is paid to the shop owner on the purchase of some item contained in a glass container. On return of the glass container, this deposit is refunded. This is widely practiced in Goa on purchase of alcoholic beverages. The customer pays a deposit of Rs 3 on each beer bottle purchased and the deposit is refunded on return of the beer bottles. The beer bottles are thus recycled.

UNIT VI NATIONAL INCOME ACCOUNTING

BASIC CONCEPTS NATIONAL income is the final outcome of all economic activities of a nation. Economic activities generate two kinds of flows in a modern economy: (i) product-flows; and (ii) money-flows. Product-flows are flows of goods and services from their producers to their final consumers/users. Moneythe medium of exchangeflows in exchange for goods and services. In the process, money incomes are generated in the form of wages, rent, interest and profits, known as factor earnings. On the basis of these two kinds of flows, national income concepts may be broadly divided into (i) concepts related to product flows; and (ii) concepts related to money flows. In this section, we will briefly describe the various concepts used in national income analysis. Definition of National Income Conceptually, national income is the money value of the end result of all economic activities of the nation. Economic activities generate a large number of goods and services, and make net addition to the national stock of capital. These together constitute the national income of a 'closed economy'-an economy which has no economic transactions with the rest of the world. In an 'open economy', national income includes also the net results of its transactions with the rest of the world, (i.e., exports less imports). Economic activities should be distinguished from the non-economic activities from national income point of view. Broadly speaking, economic activities include all human activities which create goods and services that can be valued at market price. Economic activities include production by farmers (whether for household consumption or for market), production by firms in industrial sector, production of goods and services by the government enterprises, and services produced by business intermediaries (wholesaler and retailer), banks and other financial organisations, universities, colleges, and hospitals, etc. On the other hand, non-economic activities are those which produce goods and services that do not have economic value. Non-economic activities include spiritual, psychological, social and political services. The non-economic category of activities also includes hobbies, service to self, services of housewives, services of members of family to other members, and exchange of mutual services between neighbors. We have defined national income from the angle of product flows. The same can be defined in terms of money-flows. While economic activities generate flow of goods and services, on the one hand, they

generate money-flows, on the other, in the form of factor paymentswages, interest, rent profits, and earnings of self-employed. Thus, national income may also be obtained by adding the factor earnings and adjusting the sum for indirect taxes and subsidies. The national income thus obtained is known as national income at factor cost. It is related to money income flows. The concept of national income is linked to the society as a whole. It differs fundamentally from the concept of private income. Conceptually, national income refers to the money value of the entire final goods and services resulting from all economic activities of the country. This is not true of the private income. Also from the calculation point of view, there are certain receipts of money or of services and goods that are not ordinarily included in private incomes but are included in the national incomes, and vice versa. National income includes, for example, employer's contribution to the social security and welfare funds for the benefit of employees, profits of public enterprises, and services of owner occupied houses. But it excludes the interest on war-loans, social security benefits and pensions. These items are however included in the private incomes. The national income is therefore not merely an aggregation of the private incomes. One can however obtain an estimate of national income by summing up the private incomes after making necessary adjustments for the items excluded from the national income. NATIONAL INCOME CONCEPTS Gross National Product (GNP) These are several measures of national income used in national income analysis. The GNP is the most important and widely used measure of national income. It is the most comprehensive measure of the nation's productive activities. The GNP is defined as the value of all final goods and services produced during a specific period, usually one year, plus the difference between foreign receipts and payment. The GNP so defined is identical to the concept of gross national income (GNI). Thus, GNP = GNI. The difference between the two is only of procedural nature. While GNP is estimated on the basis of product-flows, the GNI is estimated on the basis of money income flows, (i.e., wages, profits, rent, interest, etc.). Net National Product (NNP) NNP is defined as GNP less depreciation, i.e., NNP = GNP - Depreciation Depreciation is that part of total productive assets which is used to replace the capital worn out in the process of creating GNP. Briefly speaking, in the process of producing goods and services (including capital goods), a part of total stock of capital is used up. 'Depreciation' is the term used to denote the worn out or used up capital. An estimated value of depreciation is deducted from the GNP to arrive at NNP. The NNP, as defined above, gives the measure of net output available for consumption by the society (including consumers, producers and the government). NNP is the real measure of the national income. NNP = NNI (net national income). In other words, NNP is the same as the national income at factor cost. It should be noted that NNP is measured at market prices including direct taxes. Indirect taxes are however not a point of actual cost of production. Therefore, to obtain real national income, indirect taxes are deducted from the NNP. Thus, NNP - indirect taxes = National Income. National Income: Some Accounting Relationships (a) Relations at market price GNP = GNI (Gross National Income) Gross Domestic Product (GDP) = GNP less Net Income from Abroad NNP = GNP less Depreciation NDP (Net Domestic Product) = NNP less net income from abroad (b) Relations at factor cost GNP at factor cost = GNP at market price less net indirect taxes NNP at factor cost = NNP at market price less net indirect taxes NDP at factor cost = NNP at market price less net income from abroad NDP at factor cost = NDP at market price less net indirect taxes NDP at factor cost = GDP at market price less Depreciation METHODS OF MEASURING NATIONAL INCOME1 For measuring national income, the economic organism through which people participate in economic activities, earn their livelihood, produce goods and services and share the national products can be viewed from three different angels.

1. The national economy is considered as an aggregate of producing units combining different sectors such as agriculture, mining, manufacturing, trade and commerce, etc. 2. The whole national economy is viewed as a combination of individuals and households owning different kinds of factors of production which they use themselves or selhtheir factor-services to make their livelihood. 3. National economy may also be viewed as a collection of consuming, saving, and investing units (individuals, households, and government). Following these notions of a national economy, national income may be measured by three different corresponding methods: (1) Net product methodwhen the entire national economy is considered as an aggregate of producing units; (2) Factor-income methodwhen national economy is considered as combination of factorowners and users; (3) Expenditure methodwhen national economy is viewed as a collection of spending units. The procedures which are followed in measuring the national income in a 'closed economy' an economy which has no economic transactions with the rest of the world are briefly described here. The measurement of national income in an open economy and adjustment with regard to income from abroad will be discussed subsequently. (1) NET OUTPUT OR VALUE ADDED METHOD The net output method is also called value added method. In its standard form, this method consists of three stages: "(i) estimating the gross value of domestic output in the various branches of production; (ii) determining the cost of material and services used, and also the depreciation of physical assets; and (iii) deducting these costs and depreciation from gross value to obtain the net value of domestic output..." The net value of domestic product thus obtained is often called the value added or income product which is equal to the sum of wages, salaries, supplementary labour incomes, interest, profits, and net rent paid or accrued. Let us now describe the stages (i) and (ii) in some detail. Measuring gross value For measuring the gross value of domestic product, output is classified under various categories on the basis of the nature of activities from which they originate. The-output classification varies from country to country depending on (i) the nature of domestic activities; (ii) their significance in aggregate economic activities, and (iii) availability of requisite data. For example, in the US, about seventy-one divisions and sub-divisions are used to classify the national output; in Canada and the Netherlands, classification ranges from a dozen to a score; and in Russia, only half-a-dozen divisions are used. According to the CSO publication, fifteen sub-categories are currently used in India. After the output is classified under the various categories, the value of gross output is computed in two alternative ways: (i) by multiplying the output of each category of sector by their respective market price and adding them together, or (ii) by collective data about the gross sales and changes in inventories from the account of the manufacturing enterprises and computing the value of GDP on the basis thereof. If there are gaps in data, some estimates are made therefore and gaps filled. Estimating cost of production The next step in estimating the net national product is to estimate the cost of production including depreciation. Estimating cost of production is, however, a relatively more complicated and difficult task because of non-availability of adequate and requisite data. Much more difficult is the task of estimating depreciation since it involves both conceptual and statistical problems. For this reason, many countries adopt factor-income method for estimating their national income. However, countries adopting net-product method find some ways and 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 estimating depreciation is to follow the usual business practice of depreciation accounting. Traditionally, depreciation is calculated 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 current output of final goods.

Following a suitable method, deductible costs including depreciation are estimated for each sector. The cost estimates are then deducted from the sectoral gross output to obtain the net sectoral products. The net sectoral products are then added together. The total thus obtained is taken to be the measure of net national products or national income by product method. (2) FACTOR-INCOME METHOD This method is also known as income method and factor-share method. Under this -method, the national income is calculated by adding up all the "incomes accruing to the basic factors of produetion-used in producing the national product." Factors of production are conventionally classified as land, labour, capital and organisation. Accordingly, National income = Rent + Wages + Interest + Profit However, it is conceptually very difficult in a modern economy to make a distinction between earnings from land and capital, on the one hand, and between the earnings from ordinary labour and organisational efforts (including entrepreneurship), on the other. For the purpose of estimating national income, therefore, factors of production are broadly grouped as labour and capital. Accordingly, national income is supposed to originate from two primary factors, viz., labour and capital. In some activities however labour and capital are jointly supplied and it is difficult to separate the labour and capital contents from the total earnings of the supplier. Such incomes are termed as mixed incomes. Thus, the total factor-incomes are grouped under three categories, (i) labour incomes; (ii) capital incomes; and (iii) mixed incomes. Labour Income Labour incomes included in the national income have three components: (a) wages and salaries paid to the residents of the country including bonus and commission, and social security payments; (b) supplementary labour incomes including employer's contribution to social security and employee's welfare funds, and direct pension payments to retired employees1; (c) supplementary labour incomes in kind, e.g., free health and education, food and clothing, and accommodation, etc. Compensations in kind in the form of domestic servants and such other free-of-cost services provided to the employees are included in labour income. War bonuses, pensions, service grants are not included in labour Income as they are regarded as 'transfer payments'. Certain other categories of income, e.g., incomes from incidental jobs, gratuities, tips, etc., are ignored for lack of data. Capital Incomes According to Studenski, capital incomes include such incomes as: (a) dividends excluding inter-corporate dividends; (b) undistributed before-tax profits of corporations; (c) interest on bonds, mortgages, and saving deposits (excluding interests on war bonds, and on consumer-credit); (d) interest earned by insurance companies and credited to the insurance policy reserves; (e) net interest paid out by commercial banks; (f) net rents from land, buildings, etc., including imputed net rents on owner-occupied dwellings, (g) royalties, and (h) Profits of government enterprises. The data for the first two items are obtained mostly from the firms' accounts submitted for taxation purposes. But definition of profit for national accounting purposes differs from that employed by taxation authorities. Some adjustments in the income-tax data become therefore necessary. The data adjustments generally pertain to (i) excessive allowance of depreciation made by tax authorities; (ii) elimination of capital gains and losses since these do not reflect the changes in current income; and (iii) elimination of under or overvaluation of inventories on book-value. Mixed income Mixed incomes include earnings from (a) farming enterprises, (b) sole proprietorship (not included under profit or capital income); and (c) other professions, e.g., legal and medical practices, consultancy services, trading and transporting, etc. This category includes also the incomes of those who earn their living through various sources as wages, rent on own property, interest on own capital, etc.

All the three kinds of incomes, viz., labour incomes, capital incomes and mixed incomes added together give the measure of national" income by factor-income method. (3) EXPENDITURE METHOD The expenditure method, also known as final product method, measures national income at the final expenditure stages. In estimating the total national expenditure, any of the two following methods are followed: first, all the money expenditure at market price are computed and added up together, and second, the value of all the products finally disposed of are computed and added up, to arrive at the total national expenditure. The items of expenditure which are taken into account under the first method are (a) private consumption expenditure; (b) direct tax payments; id) payments to the nonprofit-making institutions and charitable organisations like schools, hospitals, orphanage etc.; and (d) private savings. Under the second method, the following items are considered; (a) private consumer goods and services; (b) private investment goods; (c) public goods and services; and {d) net investment aboard. The second method is far more extensively used because the requisite data required by this method can be collected with greater ease and accuracy. Treatment of Net Income for Abroad We have so far discussed the methods of measuring national income of a 'closed economy'. But most modern economies are open in the sense that they exchange goods and services and have other economic transactions with the rest of the world. In the process, some nations make net income through foreign trade while some lose their income to the foreigners. The net earnings or loss in foreign trade affects the national income. In measuring the national income, therefore, the net results of external transactions are adjusted to the total net incomes from abroad are added to, and net losses to the foreigners are deducted from the total national income arrived at through any of the three methods. Briefly speaking, all the exports of merchandise and of services like shipping, insurance, banking, tourism, and gifts are added to the national income. And, all the imports of the corresponding items are deducted from the value of national output to arrive at the approximate measure of national income. To this is added the net foreign investment. These adjustments for international transactions are based on the international balance of payments of the nations. HOW IS THE LEVEL OF INCOME DETERMINED The amount of goods and services that firms produce constitute the Aggregate Supply. Its value equals factor payments. And, household expenditure represents the Aggregate Demand (AD). According to the Keynesian theory of income determination, the equilibrium level of national income is determined where aggregate demand (AD) equals the aggregate supply (AS). Let us now look into the process of income determination. Production and consumption are a continuous process. The two may not always be equal because consumers' plan and producers' plan may not always match. Consider what happens in the model economy if AD < AS. This kinds of situation arises when households do not spend their entire incomethey set aside a part of their incomes for future consumption. Under this condition, firms find their unsold stock piling up. If they reduce price to get rid of the unsold stock, they incur losses. From this, they conclude, they are producing more than what buyers are willing to buy. So they cut their production. They hire lower quantities of FOP. Factor payments go down. Consequently, household incomes go down. This process continues until household expenditure plans and firms' production plans reach the point of agreement. For example, suppose, at a point of time, firms hire FOP worth Rs. 100 million. Then, Factor Payments = Rs. 100 million Household incomes = Rs. 100 million Value of Output (AS) = Rs. 100 million Suppose also that households decide to spend only Rs. 90 million, i.e., AD = Rs. 90 million. It means AS exceeds AD by Rs. 10 million. That is, unsold stock equals Rs. 10 million. In the following year, therefore, firms will produce goods and services worth only Rs. 90 million and hire FOP worth only Rs. 90 million. This will reduce household incomes to the same level. If households decide again to hoard Rs. 10 million out of the total income of Rs. 90 million, AD will be reduced to Rs. 80 million. The firms will now hire FOP worth Rs. 80 million only. Household incomes will then equal Rs. 80 million. Now, if households decide to spend Rs. 80 million, the firms will produce goods worth Rs. 80 million. The income level will be finally determined at Rs. 80 million.

On the contrary, if AD > AS, (due to, say, consumption of past savings), firms find that they are producing less than what households are willing to buy. Therefore, in order to increase their earnings, firms hire larger quantities of FOP and make larger factor payments. As a result, household incomes increase. If households continue to spend more than their current income, total production continues to grow. Since there is a limit to which consumption can be increased, AS and D will be ultimately in balance and national income will be determined at this level. Once the level of national income is determined, it remains stable at this level until equality of income and expenditure is disturbed. This is called equilibrium level of national income. At the equilibrium level of income, the same amounts of FOP are used; the same amounts of incomes are generated and same amounts of goods and services are produced and consumed year after year. KEYNESIAN THEORY OF NATIONAL INCOME DETERMINATION Two-Sector Model In the preceding section, we have provided an idea of the working of an economy and how national income is determined. In this section, we present a formal exposition of the Keynesian theory of income determination. As we have already mentioned, according to Keynesian theory, the equilibrium level of national income is determined where Aggregate Demand (AD) equals Aggregate Supply (AS). Let us now look into the meaning and behaviour of aggregate supply and aggregate demand in relation to income and expenditure. Aggregate Supply The aggregate supply (AS) refers to the total value of goods and services produced and supplied in an economy per unit of time. Aggregate supply includes both consumer goods and producer goods. The goods and services produced per time unit multiplied by their respective (constant) prices give the total value of the national output. This is the aggregate supply in terms of money value. Aggregate Supply Schedule. If all that is produced is sold, then aggregate supply grows at a constant rate of increase in output. This is shown by a 45 line in Fig. This line is also called aggregate supply schedule. In the Keynesian theory of income, aggregate income equals consumption (Q plus savings (S). Therefore, AS-schedule is generally named as C + S schedule. The aggregate supply has oneto-one relationship with aggregate income. Aggregate Demand The aggregate demand is an ex-post concept. It implies effective demand which means actual expenditure. The aggregate effective demand means the aggregate expenditure made by a society per unit of time, usually, one year. Aggregate demand (AD) consists of two components: (I) aggregate demand for consumer goods (C), (II) aggregate demand for capital goods (I). Thus, AD = C + I Aggregate Demand Schedule. The aggregate demand schedule, i.e., AD schedule, is also called C + I schedule. In the Keynesian framework, investment (1) is assumed to remain constant in the short-run analysis at all levels of income. But, consumption (C) is treated to be a function of income (Y). Pending detailed discussion on the consumption function till the next section, let us assume that the consumption function is given as C = a + bY where a is a constant denoting C when 7=0 and b is the proportion of income consumed, and b = C/AY. The AD function can now be expressed as C + I = a + bY + I The C + I schedule can be constructed on the basis of the following assumptions. (i) a = Rs. 50 billion (ii) b = AC/AY = 0.5; and (iii) I = Rs. 50 billion The AD schedule can now be written as C + I = 50 + 0.5 Y+ 50

An aggregate demand schedule based on the above assumptions is given in Table 13.1. The C + I schedule is plotted in Fig. Table Aggregate Demand Schedule (Rs. in Billion) Income (Y) C = (a + bY) = AS 1 2 0 50 100 150 200 250 300 350 400

I 3

C + I schedule 4

50 + 0 = 50 50 100 50 + 25 = 75 50 125 50 + 50 = 100 50 150 50 + 75 = 125 50 175 50 + 100 = 150 50 200 50 + 125 = 175 50 225 50 + 150 = 200 50 250 50 + 175 = 225 50 275 50 + 200 = 250 50 300 Income Determination. Having explained the concept and derivation of aggregate supply and aggregate demand, we now turn to the question of income determination. In the above table, column 4 represents the aggregate demand and column 1 represents the aggregate supply. It can be seen in the table that AS and AD equal only at one level of income and expenditure, i.e., at Rs. 200 billion. The equilibrium level of the national income is thus determined at Rs. 200 billion. If for some reason, AD exceeds AS or AS exceeds AD, the adjustment process as explained above will bring them back in balance. MULTIPLIER We know that aggregate demand determines the equilibrium level of national income. Aggregate demand is composed of consumption expenditure and investment expenditure. When either consumption expenditure or investment expenditure or both increase, aggregate demand increases, and consequently national income increases. Keynes assumed that consumption function remains stable during short period. So, national income is increased by increasing level of investment in the economy. An increase in investment contributes to an increase in national income by an amount greater than itself. The ratio of the increase in national income (Y) to an increase in investment (T) is called the multiplier, K = (Y/ T). The numerical value of the multiplier (K) shows: how many times is the increase in national income to that of the investment? Let us illustrate the working of multiplier by taking a numerical example. Multiplier Process. Assume that the economy is initially producing at equilibrium level of national income. Suppose suddenly firms decide to increase their expenditure on the purchase of new equipment and construction of factory buildings by an amount equal to Rs. 100 crore (I = Rs. 100 crore). This will increase their demand by Rs. 100 crore. The firms engaged in the production of new equipment and construction activity will employ more factor services to meet this increased demand. Thus, national income will increase by Rs. 100 crore (=I) and suppliers of additional factor services will receive additional income of Rs. 100 crore. This is called the initial effect or the first round effect of increase in national income. The suppliers of factor services, who now receive additional income, will spend a part of their increased income on the purchase of more consumer goods and services depending upon their marginal propensity to consume (MPC). Suppose MPC = 0.8, then additional income of Rs. 100 crore will create an additional demand for consumer goods and services equal to Rs. 80 crore, i.e., 0.8 x Rs. 100 crore (b.I). This will result in further increase in the production of consumer goods and services, and consequently employment of additional factor services. Thus, national income in the second round will increase by Rs. 80 crore (= b. T) and suppliers of factor services to these firms will receive additional income of Rs. 80 crore. Using the same logic we can say that national income in the third round will increase by Rs. 64 crore (= b2.T). This process of increase in national income, demand for consumer goods and services, employment of factor services and output leading to further increase in national

income will continue until the secondary effects of the initial increase in investment are over. The total increase in national income resulting from the additional investment of Rs. 100 crore will, therefore, be Rs. 100 crore + Rs. 80 crore + Rs. 64 crore +......= Rs. 500 crore. This can also be illustrated algebraically. If l is the increase in investment, and 'b'is the constant value of MPC (0<b<l), then increase in national income Y will be Y= I + b. I + b2. I + &.I + b4. I + b5.I +... Y= l (1 + b + b2 + b3 + b4 + b5 +...) 1 7= I x 1 b 1 or, Y= l x 1-MPC Thus, an increase in investment by I brings "about an increase in national income by 1/1- MPC times the initial increase in investment. The numerical value of multiplier, K, can, therefore, be written as 1 K= 1-MPC Since, MPS = 1 - MPC, we can also write the value of multiplier as 1 K= MPS The value of multiplier is, thus, the reciprocal of (1 - MPC) or of MPS. The greater the value of the MPC, greater will be the value of the multiplier. For example, if MPC is taken as 0.8 or MPS = 0.2, the value of 'K' is 1/0.2 = 5. Now if MPC is taken to be equal to 0.9, or MPS = 0.1, the value of 'K' then is 1/0.1 = 10. In practice, there are many factors which do not allow the actual multiplier to be as much as the ideal one. One of the reasons is the leakages. Savings are leakages from the income and expenditure system. Higher the leakages, higher the marginal propensity to save; smaller the marginal propensity to consume and consequently smaller would be the multiplier effect. Similarly, since we pay for imports the excess of imports over exports is also a leakage, which also adversely affects the value of multiplier. The other reason for the difference between the ideal and actual multipliers is the adequate availability of goods. Income propagation through consumption expenditure (as suggested by multiplier) is possible only if enough consumption goods are available. In case of shortage of goods, MPC and, therefore, multiplier would be lower.

UNIT VII MACROECONOMIC POLICY

FISCAL POLICY: DEFINITION AND OBJECTIVES Fiscal policy is defined as government's programmes of taxation, expenditure and other financial operations to achieve certain national goals. Its objectives, like other economic policies of the government, are derived from 'the aspirations and goals' of the society it serves. Since economic. Political and social conditions of the nations vary, the aspirations of the people and therefore the objectives of their fiscal policy may be different (However, the most common objectives of fiscal policy of different countries are : (i) economic growth; (ii) promotion of employment; (iii) stabilisation of economy; and (iv) economic justice or equity The emphasis or the order of priority of these objectives may vary from country to country and from time to time For instance, while stability and equality get higher emphasis in the developed nations, growth, employment and equality get higher priority in the less developed countries Whatever the objectives and the order of their priorities, the two basic instruments that are used to achieve the social goals are taxation and public expenditure In this chapter, we will discuss first the role of fiscal policy, especially taxation, in capital formation and economic growth. This will give an idea of thoughts and considerations that go into the formulation of taxation policy of a less developed country like India. The objectives and the nature of taxation policy may change with the change in economic conditions. We will, however, concentrate on the taxation policy of the less developed countries. We will discuss next the impact of taxation policy on private business. The stabilisation role of fiscal policy and the effects of public expenditure on building infrastructure on the private business have already been discussed in Chapter. FISCAL POLICY AND ECONOMIC GROWTH Capital Formation: A Key Factor in Economic Development Capital formation i.e., increasing the stock of productive assets, plays a key and strategic role in economic development the higher the rate of capital formation, the higher the rate of economic growth. A high rate of capital formation requires that a high proportion of national income is saved and invested in the production of capital goods. Most developed nations have a comparatively higher rate of savings and investment than the less developed countries. For instance, at present about 25 per cent of the national income (at current prices) goes to net investment in India whereas it is much to more than 25 per cent in many developed countries. The low level of saving and investment in the underdeveloped countries is attributed to extremely low level of per capita income and high marginal propensity to consume. The low rate of investments results in a very low rate of increase in national income, i.e., 3-4 per cent per annum. The rate of increase in population being about 2 per cent, per capita income increases by 1-2 per cent. This 1-2 per cent increase in per capita income can hardly generate a higher level of voluntary savings for investment. The underdeveloped countries are thus caught in the vicious circle of poverty. The underdeveloped countries, therefore, tend to stagnate at a low level of GNP or at have been termed as 'underdevelopment equilibrium." Taxation for Capital Formation The 'vicious circle of poverty', can be broken only by accelerating the pace of capital formation or increasing productivity and production capacity. There are five major sources of financing capital formation available to the underdeveloped countries, i.e., (a) taxation; (b) domestic public borrowings; (c) deficit financing (excluding public borrowing); (d) inflation; and (e) foreign aid.

Non-tax Sources have severe Limitations. Financing domestic capital formation through foreign aid or external financial assistance depends on a number of considerations, such as availability of foreign aid, 'conditionally' foreign aid, political relations, danger of economic dependence, etc. Borrowing from the public is limited by low per capita incomes and savings, lack of desire and capacity to sacrifice current consumption, large proportion of non-monetized economy in the underdeveloped countries and low rate of return on government bonds and securities. Deficit financing, a one time popular source of financing public investment, is now the least favoured method as it is fraught with the danger of inflation. India's experience in respect of deficit financing has not been encouraging. Inflation, as Kaldor has rightly remarked, is "a clumsy and ineffective instrument for mobilising resources, since a larger part of the 'enforced' reduction in the consumption of the mass of the population brought about by the rise in the prices in relation to income is wasted in the increased luxury consumption of the profit earning classes." Taxation is a More Reliable Source. For the underdeveloped countries trying to break out of the vicious circle of poverty, there is no comparable alternative to taxation as an instrument for mobilising their domestic saving, and invest it in accumulation of productive assets. kaldor observes "...taxation (or other compulsory levies) provide the most appropriate Instrument for increasing sayings for capital formation out of domestic Sources Possibly for this reason, taxation has been assigned a positive role in the process of capital formation in the underdeveloped countries. The Fiscal Division of the LW went to the extent of suggesting that public investment for economic development should be stepped up even by transferring the resources from the private to the public sector through taxation: "Taxation . . . remains as the only effective financial instrument for reducing private consumption and investment and [for] transferring resource to the government for economic development."2 It is however not desirable to tax the private investment in the initial stages of development unless it is flowing into production of non-essential commodities. For, taxation of private investment would be a mere transfer of resources from the private to the public sector without any addition to the existing stock of capital. "A mixed economy cannot progress without constantly increasing private investment."3 In fact, there is a necessity for raising the level of overall savings. The taxation policy therefore lays more emphasis on taxation of private consumption. Taxation of Potential Savings It may be argued that there is little scope for taxing consumption in the underdeveloped countries for the very reason that levels of income and consumption in these countries are already very low and it may not be desirable to cut the consumption level further down. No doubt, there is little scope for raising additional savings by tightening the belt of the poor people. This however should not mean that the level of savings in the underdeveloped countries cannot be raised. In fact, there is a good deal of saving potential in the underdeveloped countries, which can be justifiably taxed for the purpose of capital formation and economic growth. Economists visualise existence of saving potential in the underdeveloped countries on the following grounds. First, income is unequally distributed among the people. For example, in 1970-71, top 30 per cent of the rural households shared about 58 per cent of the total rural income whereas the corresponding percentage for the bottom 30 per cent was only 11 per cent. Although comparable data for the urban households are not readily available, it may be inferred from the estimates made by RBI, Lydall, Iyenger and Mukerji, for mid-fifties, that similar income disparity exists in the urban area too. Income disparity is the rule rather than exception. The people in the high income brackets generally indulge in conspicuous and wasteful consumption. Therefore, a part of the income of the rich may be taxed away without seriously affecting their consumption level. Secondly, a considerable proportion of national income comprises the incomes earned through accumulated wealth and property, mainly in a feudal society. Property income and income inequalities are closely associated.5 A considerable proportion of income of this class flows towards unproductive uses. This part of their income may be treated as 'surplus' and should be taxed for growth purposes. After the abolition of zamindari system and implementation of land reforms (though not successfully implemented) there is not much scope for additional taxation on this account.

Thirdly, Nurkse visualised the existence of saving potential on account of widespread disguised unemployment in underdeveloped countries. This concept has however not found much favour in practice. Moreover, the need for taxing a part of income of the rich people for the purpose of economic growth (or capital formation) is recognised in general by the economists. What is more important in this regard is to mop up a part of 'surplus' generated through growth efforts. Besides, since the prospects for direct taxation are limited, indirect taxes are generally used to restrain the consumption and to mobilise resources for capital formation. It may amount to restraining or even reducing the consumption level for some time, but considering the long-term growth objective, i.e. raising the standard of living of people, sacrificing a part of current consumption in the short-run would not be inadvisable. Investment in Capital Formation When the basic objective of taxation policy is economic growth, the major portion of savings or economic surplus generated and collected through taxation has got to be invested in building up infrastructure in the economy, i.e., in creating economic and social overhead capital. For, the economic and cultural development of a country, irrespective of its political ideology, depends largely on the 'efficient and steadily expanding provision of a host of non-revenue yielding serviceseducation, health, communication system, etc." and all such other facilities that create external economies for both private and public sectors. Therefore, in the development pogrammes of a country, creation of economic and social overhead capital has to be assigned a high priority in the public investment schemes in the initial stages of economic development. Apart from creating overhead capital, the government is required to invest in the promotion and development of basic and strategic industries which require heavy investment. Public investment in the industries of strategic and social importance is necessary at least for three reasons; (i) growth of such industries is essential for the economic growth of a country; (ii) private investments are generally insufficient to meet the huge investment requirement of such industries; and (iii) if private capital does meet the requirement, it may lead to monopoly powers and economic concentration which are not socially desirable. Some Other Considerations The role of fiscal policy is not limited to taxation of 'economic surplus' (or saving potential) for direct investment in capital formation activities including key and basic industries. Taxation can be and is also used as an instrument of encouraging and facilitating capital formation in the private sector. For this purpose, taxation policy has to be so designed that it discourages consumption and encourages saving and investment. The specific rules- for formulating such a taxation policy are as follows: (i) Orientation of tax-policy towards the taxation of mostly economic surplus or potential saving and not of actual savings. (ii) Taxation should curtail or restrain the potential consumption and divert the resources from consumption to investment. This can be achieved by creating disincentive for consuming incremental income, and incentive for saving and investment. (iii) Taxation of profits of non-essential industries at a higher rate, and that of essential industries at a lower rate. This redirects the private investment in socially more desirable sectors. (iv) Tax policy should not adversely affect the desire and capacity to work more and earn more. It should be borne in mind that economic growth is not generally the only objective of fiscal policy. Fiscal policy is used for achieving many other goals, viz., economic stabilisation and prevention of economic disparities, etc. The growth, stabilization and equity objectives of fiscal policy, very often conflict with each other. Therefore, while formulating fiscal policy, the policy makers are required to pay a good deal of attention to the possible conflict between growth and other objectives and to strike a balance between them, if these objectives are to be fulfilled simultaneously. With this brief discussion on fiscal policy and economic growth, we now turn to discuss the impact of taxation on private business in a general framework. TAXATION AND THE PRIVATE SECTOR

We have discussed in the preceding section how government can use taxation for capital formation in the public sector. Capital formation in the public sector alone is however not adequate to accelerate the pace of economic growth. For, in our economy, private sector output accounts for about 70 per cent of NNP, and unless rate of capital formation in the private sector increases, the overall growth rate cannot be made reasonably high. It is therefore essential that fiscal policy in an underdeveloped economy is so designed that it encourages savings and investment also in the private sector. In this section, we will discuss the impact of taxation on the growth of private enterprise. Taxation and Private Business Wide spread taxation is the most common feature of all modern societies. In India, we have a wide range of direct and indirect taxes. Direct taxes include personal and corporate income taxes on current earnings, wealth tax, gift tax on transfer of property, and land tax on cultivable land. Indirect taxes include excise duty, sales tax, custom duties and a number of other taxes imposed by the States. Not only there is multiplicity of taxation, but also double taxation of incomes and commodities. Apart from this, the total tax revenue of the country accounts for about 22 per cent of the national income. Such a wide spread and heavy taxation cannot be supposed to be neutral to private business activities. It is rather alleged by the business community, even after the tax reforms of 1991 and 1992 that the existing Indian tax-structure is seriously undermining the incentive to save and invest for both individuals and corporations. The taxation reforms made in India since 1991 are expected to have for reaching impact on the private business. Let us first examine the impact of taxation of private business efforts in general. The impact of taxation on the growth of private business in general, and on private investment in particular, may be examined through the effects of taxation on (i) people's work-efforts; (ii) saving of the households in general and of private firms in particular; and (iii) incentive and ability to invest. Unfortunately, there is little evidence available in case of India to support or to refute the proposition regarding the adverse effects of taxation on saving and investment. The empirical evidences available for other countries are not strictly conclusive, and even if they are, the same may not be applicable to the Indian economy. We will therefore confine to the discussion of only theoretical propositions regarding the effects of various taxes on private investment and quote the researches made in other countries in this regard. Effects of Taxation on Work Efforts The effect of taxation on private enterprise depends, among other things, on how taxation effects people's desire to work. The additional work effort depends, in fact, on peoples' choice between leisure and work.2 Leisure gives a kind of satisfaction (or pleasure) while work yields income which yields another kind of satisfaction. Taxation reduces income (the wage rate) and therefore, it alters peoples' choice between leisure and work. When a tax is imposed or tax rate is increased, wage income decreases. As. a result, the reward for an additional unit of labour and the price of an additional unit of leisure, i.e., opportunity cost of leisure are both lowered. Under this condition, 'the worker will tend to substitute leisure for work.' Thus, taxation reduces the supply of labour. But, at the same time, increase in tax rate reduces the total income from given hours of labour. It makes the worker poorer while poor workers normally wish to enjoy fewer units if leisure. The workers would therefore like to work more to raise their income. Thus, taxation has both negative and positive effects on labour supply. The net effect of taxation on work effort (or labour supply) depends on the relative strength of the two effects. A number of surveys and econometric studies carried out in the United States and England on this aspect of taxation have not yielded any definite measure of net effect of taxation on work effort. According to Musgrave and Musgrave, "There is no a priori basis on which to judge the direction in which the net effect will go, although it is reasonable to assume... that effort will decline." They have however contradicted themselves (in the next paragraph) by saying, "...it should not be readily assumed that an income tax must reduce effort." A sander has found that "the typical (business) executive [does not] put forth his best efforts, taxes or no, to fulfill the requirements of his job and to progress on the promotional ladder of his company." George F. Break interviewed 306 lawyers and accountants in England an ideal group to study as they belonged to the category of tax-payers who can easily adjust their working hours with changes in their incomes. According to his findings, 40 men reported definite adverse effect on incentive' for additional work, 32 men reported to have worked harder due to taxation

as some of them wanted to accumulate wealth and some wanted to maintain their standard of living. The remaining 234 men reported minor or no effect on their work effort. It may be inferred from these empirical evidences that taxation of income has, if at all, only marginal effect on work effort. Although under the conditions mentioned above any generalisation would be risky, much of tax effect on work efforts depends on (i) the level of income; (ii) tax-ratesproportional, progressive or regressive; (iii) the productivity of marginal efforts; and (iv) non-monetary benefits, such as free accommodation, education of children, health care, travel benefits, etc. In general, if a person has low income and is willing to raise standard of living to the level of his society, he will have to increase work efforts to earn an additional income to make up the loss in income due to tax. But a very rich person may not like to work more. If tax-rates are progressive, the additional work effort will be less and less paying. If earning per time unit becomes regressive, taxation may have a negative effect on work efforts. The effect will be reverse in case of proportional and regressive tax rates. If hard work, experience and marginal productivity are positively correlated, the tax will have only marginal negative effect, as it happens in the case of lawyers, doctors, managers, consultants, accountants, etc. Also, of non-monetary benefits (not to be included in taxable income) increase with additional work effort, tax would not have a negative effect on the supply of labour. Finally, whether taxation affects work-effort depends to a great extent on a person's desire, effort and ability to shift and to evade tax. It may thus be concluded that general taxation of income does not materially affect the supply of labour. Regarding the effect of indirect taxes (e.g., excise duty and sales tax), economists generally compare with the effect of income tax, both of the equal amounts. Since there is no definite measure of incometax effect on work effort, nothing definite can be said about the effect of indirect taxes too. The general opinion regarding the effect of indirect taxes on work effort is that indirect taxes may affect the labour supply since they raise the price and thereby reduce the real wage rate. But, if money incomes are rising and workers are under money illusion, feel happy with larger money income irrespective of its purchasing power, indirect taxes may not affect the work efforts.1 It is believed that the negative effect of indirect taxes on work effort will be less than that of income tax because worker can avoid indirect taxes by consuming less of taxed commodities, which is not possible under income-tax. It also depends on the nature of commodity taxed; a tax on an essential commodity should have lower negative effect than that on luxury goods. Effects of Taxation of Savings The effect of taxation on private enterprise depends also on the effects of taxation on private savings. The two most important sources of fund for private enterprises are: (i) household savingsexternal source, (ii) banks and financial institutions, and (iii) internal savings of the firms. Household savings are the source of equity and debt capital. The growth of private sector depends, given other factors, on the supply of fund from both external and internal savings. Let us now examine the expected effects of taxation on the household and corporate savings. Household savings will be examined in respect of personal income-tax and corporate savings in respect of corporate income tax and the tax-treatment of depreciation and retained earnings. Effect of Taxation on Personal Savings Direct Taxation. Saving is the function of disposable income: the higher the income, the higher the average propensity of save, i.e., the percentage of total disposable income saved. This income-saving relationship is derived from the law of marginal propensity to consume. The law states that when income increases, the marginal propensity to consume decreases and marginal propensity to save increases. It implies that the households in higher income-brackets save more and supply the major proportion of savings to the capital market. Households in the lower income brackets also save, but major proportion of their savings flows into house construction, bank deposits, insurance policies, and not directly into the capital market. Thus, major part of equity and debt capital is supplied by the households in higher income classes. Therefore, the supply of external capital to the private firms will depend on how taxation affects the savings by the upper-income households. Taxation reduces the disposable income and the capacity to save. Since marginal propensity to save is higher in the higher income classes, a highly progressive income tax reduces the overall rate of saving. "Taxation effect on saving may result not only because the tax-payer's income is reduced, but also because an income tax reduces the net rate of return on savings."1 For this reason, households may prefer to consume rather

than to save and invest their income for future larger consumption. If the rate at which the households substitute future consumption for present consumption decreases, the rate of saving also decreases, given the rate of interest, the other determinant of saving. Through a study of 750 active investors, mostly belonging to high income-brackets, Butters et. al. have found that income taxation had substantially reduced the capacity of the investors to accumulate new investible funds and it had changed the investment pattern. The reason was that security minded investors rechanneled their investment towards tax-exempt government bonds and insurance policies, and the 'application minded' investors put their investment into more risky ventures, e.g., speculative common stocks. In case of India, a study of the 'attitudes and reaction of individual investors and of the trends in the stock market indicates that the willingness of the public to invest in equity shares has not been perceptively affected. The incentive to invest, particularly in the higher income groups, was found to be sustained "to some extent by the concessional treatment of capital gains," though their capacity to invest out of current saving was materially curtailed. The study also indicates that 'the combined impact of income and wealth taxes tends to severely curtail the capacity to save of active entrepreneurinvestors in the larger ranges of income and health.' Indirect taxation. According to Musgrave and Musgrave the effect of indirect taxes Oil saving is comparatively less retarding at least for two reasons. First, the incidence of indirect taxes, unlike the direct taxes, tends to be regressively distributed. The repressiveness of indirect taxes is based on decreasing marginal propensity to consume as income rises. Second, 'consumption tax (or commodity tax) does not reduce the rate of return on savings and therefore avoids the substitution effect of the income tax, which is adverse to saving." Possibly for these reasons, it is generally suggested that the developing countries should adopt commodity taxation for mobilising resources for rapid economic growth. In case of India, however, this argument is not tenable because as the studies made by the Ministry of Finance (MOF) for 1958-59 and 1963-64, and the National Institute of Public Finance and Policy (NIPFP) for 1973-74 have revealed, incidence of indirect taxes in India is fairly progressive. The findings of these studies are summed up in Table. Table. Incidence of Indirect Taxes: Tax as Percentage of Consumer Expenditure Ministry of Finance National Institute of Public Finance of Policy Monthly household 1053-54 1963-64 Monthly per capia 1973-74 expenditure group expenditure group (Rs.) (Rs.) 0-50 2.4 6.5 0-15 2.96 51-100 2.7 7.0 15-28 3.63 101-150 3.1 8.0 28-43 4.89 151-300 3.3 10.1 43-55 6.85 301 and above 5.5 16.6 55-75 7.92 75-100 11.40 100 and above 21.96 The progressiveness of indirect taxes may be relatively less than that of income taxes. It is however difficult to shows those indirect taxes are less deterrent to saving than the income tax since both kinds of taxes are simultaneously payable by the richer section of the society. CORPORATE INCOME TAXATION, BUSINESS SAVINGS AND INVESTMENT Corporate income taxation is the most important factor that affects directly the growth of private sector business. This tax affects firm's own savings and investment by (i) decreasing the incentive to save and invest; (ii) reducing the internal investible funds, and (iii) increasing the risk in the investment. Apparently, the corporate income tax is expected to be deterrent to firm's capacity to save and invest. But the overall effect of this tax on corporate savings and investment depends on a number of other taxfactors2 as mentioned below. (i) Statutory tax disallowances in computing the assessible income, e.g., expenditure of noncapital nature, advertisement expenditure, entertainment expenditure, etc.

Statutory tax concessions, e.g., development rebate, depreciation allowance, allowance on contributions towards employee's welfare, tax holidays, etc. (ii) Corporate income tax rates (proportionate or progressive) and variation in tax-rate on other considerations. (iii) Tax treatment of losses: carry-forward facilities and offsetting of loss against the profit of subsidiaries or closely held companies, etc. (iv) The system of depreciation allowancestraight line method or exponential rates. (v) Tax free reserves, e.g., contingency reserves for bad debts, anticipated losses, unforeseen expenditure on account of damage, etc. (vi) Tax-treatment of corporate retentions. (vii) Personal income tax rates. Company profits are generally subject to double taxationfirst under corporate income tax and then under personal income tax. It may therefore affect people desire to invest their savings in equity. (viii) Taxation of personal capital gains mainly in case of corporate common stocks. (ix) Tax treatment of inter-corporate dividendswhether subject to double taxation, and (x) Taxation of corporate capital gains. To these may be added another important factor affecting the private investment, i.e., the ability of firms to shift the tax-burden. Let us now briefly discuss the important aspects of corporate income taxation in India in relation to private investment. Company Tax and Incentive to Invest Corporate income tax reduces the expected rate of return on investment in proportion to tax paid. In India, the corporate income was being taxed before 1991 -92 at the rates varying between 45 per cent to 65 per cent, depending on (i) whether public investment was 'substantially' involved in the company, and (ii) whether profit exceeds certain limits. Most large scale companies were subject to taxation at the rate of 55 per cent. Such a high rate of company income taxation reduced the after-tax profits to about 45 per cent, i.e., post-tax profit is reduced to less than half of the pre-tax profits. Such a heavy reduction in firm's earning cannot remain without reducing the incentive and also the ability and desire to invest. The disincentive to invest is created by the wedge which corporate income tax drives between beforetax and after-tax rates of return on investment.' For example, a private firm expecting a 20 per cent return on its additional investment will be left with a 9 per cent-return after paying tax at the rate of 55 per cent. Under such a heavy taxation, only the well established firms can afford carrying on their business. The new potential investors may find it least attractive to invest their resources in productive activities. They would rather prefer to invest abroad where tax rates are lower and returns on investment higher or spend their potential savings on the items luxury consumption. Some investors may find it more profitable to lend their money in the 'black' sector of the economy. Company Tax and Ability to Invest Most industrial corporations rely mainly on their internal resources for their expansion for such reasons as high cost of borrowed capital, intervention in management by new equity holders. The major sources of internal finance are depreciation reserves and retained profits. The magnitude of these sources of internal funds depends on depreciation allowances permissible under corporate income taxation and tax-treatment of retained earnings. Depreciation allowance provided in corporate income taxation affects considerably the tax-liability of the firm and post-tax profitability of the corporate investment. It also materially affects the availability of funds for replacement of worn-out capital stock. If depreciation allowed by the tax authorities is very low, "the government is taxing more than the actual income; or to put it in another way, the government takes its share of profit earlier than they are really earned."1 The firms are therefore left with fewer funds to replace the depreciated capital. On the other hand, the accelerated depreciation method allows postponement of some tax-liability to a future date and, therefore, the company benefits by the value of compound interest on the deferred tax-liability. "Postponement of tax-liability influences investment in two ways: first, it increases the ability of firms to expand by increasing the liquid assets at their disposal, and second, it reduces the riskiness of capital investment." In India, not much evidence is available to show the effect of tax-treatment of depreciation and retained earnings (taxable) on the corporate saving and investment. Regarding the retained earning, the remarks

(i)

by the NCAER3 are worth mention. It remarks that "the fluctuations in retained profits (during fifties) were caused mainly by fluctuations in gross profit because tax provisions as a proportion of profit did not vary widely." It also mentions, "It is difficult to say definitely what would have been the effect of greater variation in tax rates. Most probably its impact on retained profits would have been no less than that of fluctuations in gross profits." It may be finally mentioned that Indian government had provided a number of incentives to the private entrepreneurs. Given the incentives for investment, it may be said that corporate income taxation in India would have not affected the corporate saving and investment much because the effective tax burden on individuals as well as on corporations is considerably reduced. Some important incentives provided before 1990 for savings and investment are enumerated below. a. Tax holidays for new undertakings including industries, shops and hotel established after 31 March 1976, for a period of 5 years, on the income upto 7.5 per cent of the capital employed. b. Special-tax holidays for new industrial undertakings set up in backward areas after 31 March 1973, to the extent of 20 per cent of the total profit. c. Liberal depreciation allowance on building, furniture, plant and machinery. Rates for plant and machinery vary from 5 percent to 100 per cent on basis 7 categories thereof, depending on the useful life. d. Investment allowance in the form of depreciation at the rate of 25 per cent of cost of new physical capital installed after 31 March 1976. Investment allowance is comparable to development rebate. e. Allowance of all revenue expenditure incurred on scientific research related) of business, during three years immediately preceding the commencement of business. f. Development allowance for tea industry in new areas at 50 percent of the actual cost of planting done after 31 March 1965 and at 30 per cent of actual cost of replantation between 1 April 1965 and 31 March 1970. g. Concessional treatment of interoperate dividends60 to 100 per cent of intercorporate dividend received by a domestic company were exempted from tax. h. Other incentives and concessions included: I. Five year wealth tax holidays for initial equity; II. Wealth tax exemption for share holdings; III. Export market development allowance; IV. Exemption of dividend and interest up to certain limit; V. Tax concession for book publishing; VI. Carry forward and set-off of accumulated losses; VII. Amortization of prospecting and development expenditure for certain minerals. With such a wide range of incentives, Indian company income taxation might be supposed to have been least deterrent to saving and investment. However, the available data show that saving and investment by the corporate sector have not increased in a great measure. Many of the incentives have now been withdrawn during the fiscal reforms since 1990. The effects of tax reforms of 1990 remain to be investigated. Effect of Indirect Taxes on Inputs and Output. While direct taxation of corporate affects directly the incentive, willingness and ability to invest, indirect taxes imposed on the inputs used by the firms and on their product affect indirectly the firm's investment choices by changing the prices and, thereby, the supply and demand conditions. If all the inputs and products are uniformly taxed, the firm's choices are uniformly affected. If taxation is not uniform, the effect on different firms would be different, and this is more important particularly in respect of investment and production decisions. If certain industrial inputs are taxed more heavily than others, the cost of productions in industries using heavily taxed inputs will increase, leading to increase in their prices. In case goods produced by such industries are price-elastic, demand therefore will decrease. The fall in demand for the product affects their production adversely. Exactly a similar reduction in demand is experienced by the industries whose final products are taxed. Reduction or shift in demand depends also on the income-elasticity of taxed commodities. Shift in demand for products causes a shift in the investment preferences. Thus, even the indirect taxes affect the private business.

Conclusion. Taxation is an important instrument of mobilising saving potential for capital formation in the public sector. In a mixed economy like India, however, capital formation in public sector alone would not be sufficient to accelerate the growth of the economy as a whole. The taxation policy should therefore be so designed that it restrains consumption, increases savings, and encourages investment to productive activities. It is however difficult to maintain such a critical balance in the fiscal policy. Although tax effect on work effort is not certain, it is generally accepted that taxation does affect the williness and capacity to save and invest. The negative effect however depends on the rate and nature, of taxation. Progressive tax rates are more deterrent to saving and investment than the proportional tax rates. And, direct taxation has greater adverse effect than the indirect taxation. An attempt should however be made to minimise the adverse effect of taxation with a view to promoting economic activities which is the basic requirement of developing economies like India.

UNIT VIII BUSINESS CYCLES

BUSINESS CYCLES The effect of upswings and downswings in economic activity is felt quite intensely because of the ever increasing business activity and the strong inter-relations between different sectors of an economy and between various economies. The ill effects of the wide swings in business activity were almost ravaging during the Great Depression of 1930s. It was also noticed that after depression there was no 'natural recovery' of the economic activity. Artificial measures to be adopted for this purpose needed a scientific understanding of the swings in the activity. Business cycle or trade cycle refers to the fluctuations in economic activity occurring regularly in the capitalist societies. In a business cycle there are wave-like fluctuations in four inter-linked economic variables: aggregate employment, income, and output and price level. When the values of these economic variables over time are plotted on a graph, we get a wave-like figure, which is given the name of a 'cycle'. According to Keynes, "A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages, alternating with periods of bad trade characterised by falling prices and high unemployment percentages." Mitchell gives even a more explicit idea of what a business cycle is when he says, "Business cycles are a type of fluctuations found in the aggregate economic activity of nations that organise their work mainly in business enterprises. A cycle consists of expansions occurring at about the same time in many economic activities followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of change is recurrent but not periodic..." In short one can observe that: (i) Business cycles are the wave-like fluctuations in economic activity as reflected in the basic economic variables like employment, income, and output and price level. (ii) These fluctuations are cyclical in nature. One must distinguish between secular trend, random fluctuations, seasonal changes and cyclical fluctuations. The secular trend represents long run changes in business activities which occurs slowly and are spread over a number of years. Such longrun changes are the result of factors like improvement in production techniques, change in population, etc. Random fluctuations are a result of events like labour strike, power cut, war, drought, flood, etc., which occur suddenly and are unpredictable. Effect of these events on the economy is limited to the period of occurrence of the event, as there is no regularity in their occurrence. Thus, neither the secular trend nor the random variations in economic activity can form the part of business cycle. The seasonal changes, which are short-run oscillations with regularity, can be confused with the cyclical fluctuations. But the basic difference between the two is that seasonal variations repeat themselves each year (e.g., demand for heavy woollen clothes, light woollen clothes and cotton clothes, and so on, depending on the season each year), while the cyclical fluctuations have a longer life span. The seasonal fluctuations, therefore, have easier predictability and adjustability in business than the cyclical fluctuations. (3) The sequence of changes in business cycle (i.e., recovery, prosperity, depression and recession) recur frequently and in a fairly similar pattern. (4) The rhythm or the periodicity between the cycles need not be similar.

(5) Business cycles are a type of fluctuations found in the aggregate economic activity and not in any single firm or industry. In fact, it connotes the cyclical changes in overall economic environment affecting all the business entities. Characteristics of Business Cycles. Knight discovered five distinguishing features of business cycles. These are: I. Generally a 'minor' cycle has duration of 3 to 4 years. And, 2 or 3 of these cycles go to make up a 'major' cycle. Thus, the duration between two major cycles is 6 to 12 years. II. It has been empirically found that during a period of prosperity the business activity is usually 10% to 25% above the long-term trend, while during depression it is 5% to 25% below the trend. III. Generally, prosperity takes twice as much time to develop as the depression. IV. The phases and their sequence is same in all cycles. V. It has been found that if the boom is high the succeeding depression will also be severe. But this relationship may not hold good in the reverse; that is, a severe depression need not be followed by a high boom. VI. The above-mentioned characteristics are based on actual observations. From a different point of view, we find some additional characteristics of cycles, like : VII. In every business cycle there are cyclical changes in the general price level. But the beginning of prosperity, as also of depression, is characterised by changes in the prices of stocks and shares, which appear before any changes appear in the wholesale price or in total production. VIII. After the changes in prices of stocks and shares, changes take place in the wholesale prices and in the volume of production. They appear before changes in the interest rate and wage rate manifest themselves. IX. Amongst the commodities, the prices of raw materials fall or rise earlier than those of final goods. X. In general, the retail prices, to a certain extent, lag behind the wholesale prices in both the prosperity and the depression. Phases of Business Cycle. A business cycle is typically divided into four phases: (1) the recovery owevival of economic activity, (2) the prosperity or expansion of the activity, (3) the recession or downturn in the economic activity, and (4) the depression or contraction in the economic activity. These phases of business cycle recur with some sort of regularity and are uniform in case of different cycles. However, the periodicity of different phases of trade cycles and their time interval differ between cycles. For example, a cycle may have a periodicity of about 4.5 years in case of certain advanced countries, while it may be about 7.5 years in case of less developed economies. The time interval of each phase also accordingly differs. Though the periodicity and time interval between cycles may differ, the underlying features of different trade cycles (as reflected in the regular appearance of the four phases) are the same. We can, thus, make a general study of business cycles. We describe below the four phases of a business cycle. (1) Recovery (2) Boom (3) Recession (4) Depression RECOVERY. This is the phase of revival of demand for goods and services. The economic activity as a whole increases slowly, although the general prices start rising. The upward movement of business activity is slow, production picks up, construction activity is revived and there is a gradual rise in employment. This is a period when the industrialists and the businessmen repay the loans taken by them from the banks earlier and the frozen stocks held by the banks are released. Stocks of goods remain below the normal with the shopkeepers. Once the recovery starts, it results in a snowballing process for investment. The result is that demand orders pour in and the producers get stimulus and encouragement to produce more. The sellers stop their conservative buying and plan building larger stock of goods to take advantage of an anticipated rise in prices. This is a period in general favouring expansion in business activity. The capital equipment is replaced. Banks are liberal in the matter of advances. The prices recover and tend to reach the normal. The speed with which the expansion of business activity takes place in response to a given initial increase in investment, would depend upon the multiplier effect.

The revival of demand for goods and services may mainly be due to two reasons: Change in business psychology in favour of optimism; and Fresh public investments in development projects (which are mainly motivated by non-profit considerations) which create additional demand for goods and services. PROSPERITY. During this phase there is a rapid cumulative movement of prices, employment, income and production. The prices and general business activity is above the normal. Total output starts growing at a rapid pace due to higher investment and employment. Prices of finished products rise faster than the increase in wage-rate, raw material prices and interest rate. Consequently, producers stand to gain. Prices of all the commodities do not rise to the same extent. The sequence of general price rise generally begins with increase in security prices, which then passes on to raw material prices, wholesale prices, wages of unskilled labour, retail prices and finally the interest rates. During this phase there is great incentive for new investment, even though interest rates, wage rates and raw material prices are higher. Since sales show a tendency to increase, the dealers increase their stocks to satisfy new customers, keeping existing customers satisfied and to further attract new customers. The dealers start acting more on the basis of anticipated than the actual demand. There is a general optimism in business. Retailers buy more than their present demand and wholesalers buy more than what is demanded by retailers at present. Consequently, the producers tend to produce more than the amount they can sell at present. Therefore, producers start procuring additional capital goods to expand production according to their anticipated future demand. The capital goods industry also, thus, experiences a sharp upturn in its business activity. The peak of prosperity may lead to over-optimism in business psychology resulting in over-full employment of resources and raw material, and therefore, leading to inflationary rise in prices. If it happens it signifies the end of prosperity phase and the advent of recession in the very near future. This phase of boom has inherent seeds of recession in the form of structural constraints of the economy. These constraints are : Limited availability of labour, raw material, etc. Their excess demand would result in a spiralling rise in their costs compared to the commodity prices. This brings a decline in profit margins. Excess pressure of demand on capital gives rise to rate of interest, making investments dearer. Consumption fails to rise due to increasing commodity prices and stability in marginal propensity to consume beyond a point of income increase. This results in piling up of inventories, due to sales lagging behind production. The effect of these forces becomes cumulative, thus, forcing the businessman to be cautious, which after some time turns into pessimism. Thus, the downturn of the cycle starts. RECESSION. When the business cycle takes a downward turn from the state of prosperity, the state of recession is said to have set in. During the phase of prosperity, production increases with every increase in commodity prices. As more and more of unemployed labour, capital and raw material are employed, interest rate, wages and other costs rise with increasing rapidity. Simultaneously, the banks suddenly discover that they have expanded their deposits a little too far. The ratio of cash reserves to total deposits falls. The banks become reluctant to advance loans in the interest of their safety and statutory requirements. In order to meet their obligations, the sellers would, therefore, have to unload their stocks in the market. Due to unloading of stocks by many firms, the prices start declining. Profit margins decline further because costs start overtaking prices. Business psychology becomes depressed and the boom bursts. There is a struggle for solvency among the businessmen. Some firms close down while others reduce production, leading to reduction in investment, employment, income and demand. This process is cumulative. This phase of business cycle is characterised by fall in prices, commercial panic, restriction and calling back loans by banks, a sharp increase in interest rate and fall in investment. Soon the production falls, unemployment increases and inventory stocks get accumulated. There is a collapse of confidence. If not controlled in the beginning by timely monetary and fiscal measures by government which can sustain investment at a high level, recession may give way to even a more grave situation, called depression. DEPRESSION. If unchecked, depression is a natural consequence of the recessionary crisis. Gradually, the process of falling prices, demand and employment gather momentum. Decrease in price follows the same sequence as does the price increase in case of the state of boom.

In this phase, general demand for goods and services falls faster than the production of goods, though this is more in case of capital goods than consumer goods. Producers find selling prices falling faster than their costs. Producers suffer losses because by the time the goods ready for sale the prices are found to have fallen further, with the result that producers are not able to recover their full cost. Businessmen get panicky, and start releasing their stocks, which hastens the decline in prices. The phenomenon of overproduction appears and workers in large numbers are thrown out of work. There are accumulated reserves with banks. Demand for credit is at its lowest, resulting in idle funds with the banks. In general, the bottom of depression is reached when liquidation of accumulated stocks is completed. Depression is, thus, characterised by low prices, idle funds with banks, mass unemployment and slack trade. It must, however, be remembered that the depression also has its end. Gradually, the accumulated stocks are disposed of and cleared; here the fall of price will be checked. Similarly, bad debts are closed. Capitalization which had become excessive is reduced and the volume of investments has fallen. All these, coupled with fresh orders from the dealers, reduce the cost and increase the possibilities of sales and profits. Prices stop falling and tend to stabilize. And, then as production is expanded the prices begin to revive. Side by side through the paying back or cancellation of loans and curtailment of demand for fresh loans, the ratio of cash reserves to bank deposits rises. The banks feel that they are now in a position to resume lending again. So, the depression breaks and recovery sets in. The important features to be noted in this connection are that the different phases follow each other in a regular sequence; cycles continue one after another. Secondly, the cycle shows fluctuations in total output and not of any single commodity or a group of commodities. Lastly, within the movement of total output, production of capital goods and durable consumer goods reveal greater fluctuations than the production of other goods. The main features of the four phases of business cycle are represented in the form of a table (Table 26.4). General Factors Causing Swings in Business Activity. We know that the alternate periods of boom and depression are the characteristic features of the capitalist countries and that the intensity of each successive boom and depression goes on increasing with the advancement of the capitalist system of production. While price stability is maintained by planning in a totalitarian system, certain policy measures are needed for price stability in a capitalist system. In the capitalist system, the 'free enterprise' economy is motivated by 'profits'. Production is undertaken with profit as an objective. Production ceases to have any immediate relation with the needs of the society. Thus, in the short run production may exceed or fall short of the effective demand, i.e., situations of over-production or underproduction may arise, which are the two basic features of a business cycle. The main causes of business cycle are : 1. Banking operations play a vital role. By expanding-and contracting credit creation, changing discount rates, and the ratio between deposits and cash reserves, the banks can change the volume of money supply in the economy, and thus, contribute to the cyclical phenomenon. 2. Changes in the proportion between capital goods and consumer goods production in the economy can also lead to shortages or surpluses in commodity supply in the short run. This results in business cycles. 3. If the purchasing power does not correspond to the expansion or contraction of production, the market suffers from maladjustments and, therefore, cyclical fluctuations. 4. The profit mania of producer is also a contributory cause of the business cycles. This makes the producer too optimistic. He is under a constant illusion regarding the exact nature and volume of demand. The result is that if the retail trade is a little brisk, the producer magnifies the tendency by expanding production considerably and himself causing a mild boom in the raw material and the labour markets. If the retail trade slackens, the over-cautious producer immediately tends to reduce his output and cancels some of the orders placed by him for raw materials, plant, etc. This behaviour tends to intensify the processes of rise or fall in prices. 5. The human psychology also contributes to the occurrence of business cycles. Human psychology has a tendency to undergo frequent changes almost in a cyclical mannerfrom exuberance to depression. Optimism and pessimism 'give birth to one another in an endless chain'. If the boom develops, psychology takes a turn at the peak and tilts in the opposite direction. The turn in the

reverse direction occurs at the bottom of the Depression. It is not possible to give any generalised explanation of these psychological changes. 6. The cyclical changes in weather also contribute to the emergence of trade cycles. These changes affect agricultural production and the prices of those basic goods which the working class in a society consumes. This, in turn, affects the wage rate, cost of raw material, etc., thereby contributing to the fluctuations in the economic activity. The list of causes given above is in no way exhaustive. Moreover, the relative contribution of the various causes differs in different cycles and at different moments in the same cycle. We may classify the causes of recession and inflation as follows: Specific Causes of Recession. (2) Aggregate supply exceeding aggregate demand. When during the phase of rising prices firms become enthusiastic with regard to investment and they miscalculate the future levels of demand, it results in overinvestment. Consequently, supply exceeds demand, prices fall, stocks accumulate and profits fall. (3) Fluctuations in weather. In an agricultural economy, a fall in agricultural production due to bad weather will have its impact on rest of the economy. Due to rise in prices of agricultural goods, purchasing power of masses decline and demand for agro-based raw material falls. This has an overall recessionary effect on the economy. (4) Money supply. A change in money in an economy does have an impact on business activity. When the banks provide liberal credit facilities, credit expands and business activity also expands. But when the central bank finds that the credit by the commercial banks has exceeded its reasonable limit, it starts imposing curbs on credit facilities. Money becomes costly and it, therefore, adversely affects the business activity, resulting in recessionary situation. (5) Reduction in public expenditure. In an economy like India's, public sector shares a substantial portion of the total investment in the economy and has strong linkages with the rest of the economy. In such a situation, if rate of investment in public sector declines or rate of output of the public sector falls, it slows down the growth of the related sectors. If this continues to happen for some time, it can lead 'to the emergence of recessionary tendencies. Specific Causes of Inflation. (1) Demand-pull inflation. When aggregate demand for goods and services exceeds their aggregate supply, it pulls the product prices upwards. And, when the firms respond to the excess demand by producing additional quantity of goods and services required, this creates demand for additional resources. Moreover, since producers compete with each other for these additional resources the cost of inputs to the firms also goes up, which in turn induces the firms to further raise product prices. (2) Cost-push inflation. In a situation where industry is having big and strong trade unions, they may use their collective power to force the firms to pay additional wages which may be in excess of additions to productivity. Rising wages and costs in these firms will have infectious effect on rest of the industry, which would trigger off the tendency of rising prices: Moreover, increased money income now with the workers would push up demand for goods, causing a price rise. Soon the workers find that their increased purchasing power is not sufficient to maintain their level of living, hence a fresh demand for higher wages would arise. In this manner a rising wage-price spiral would emerge. (3) Profit-push inflation. In an economy, there are firms with varying degrees of market power. If firms with strong market power try to have increased profits only by a price increase (and not by cost decline), profit-push inflation results. Ill-effects of Business Cycles. During recovery and expansion phases, individual firms gain because demand, prices and profits increase. And, during recession firms lose due to the opposite effects. But, the very fact that cyclical fluctuations need full understanding of the process of change and the business acumen to make appropriate adjustments quite frequently, often forces a firm into difficult situations. Even when business is passing through the phase of expansion, the firms start experiencing sharp rises in prices of raw materials, rental rates, wage costs, discount rates, etc. At the advanced stage of expansionary phase, the firms find markets highly competitive. The following phase (i.e., recession) lands the firms in even greater difficulty. Demand falls and old orders are cancelled, prices fall and inventory level goes up significantly during this phase. Banks call back their credits. Many a time, firms have to sell their goods even at a loss so as to meet their obligations. The element of overhead cost to the firm is

also a major contributor to loss, because the variable factors like labour, raw material, fuel, etc., can be relatively easily adjusted to changes in demand. A lot of capacity remains excess during the phase of depression. Though firms can make necessary adjustments to overcome the ill-effects of a business cycle, this is not always easy and without cost (particularly due to the time-lag between occurrence of cyclical phenomenon and time of adjustment). Since business cycles cannot be eradicate fall that is possible is to reduce the ill-effects of cyclical fluctuations. The suggested remedies would naturally be of two types: (i) the preventive measures, which tend to eliminate the causes that breed economic crises; and (ii) the curative or relief measures that improve upon the ill-effects of the cyclical fluctuations. General Measures to Control Business Cycles. The Preventive Measures. Different business cycles call for separate remedies to remove the basic cause of maladjustment. The following preventive measures of general nature may be recommended : 1. The complete equilibrium between demand and supply in business is possible if appropriate information is available at the right time. This will be a good check on over-optimism and overpessimism which play a vital role in creating cyclical fluctuations. 2. Taking due care that (a) inventories do not increase or decrease excessively; (b) financial commitments do not exceed financial resources; and (c) plant and equipment increase at a steady rate. 3. The overhead cost per unit of output should not be allowed to go up. 4. Due to lack of demand during depression, the firms are generally less careful in accepting orders, which can be ruinous for the firm. Soundness in judgment in placing the order must, therefore, be ascertained before accepting the offer. Curative Measures. These are important to smoothen cyclical fluctuations. These measures are : 1. Proper monitoring of costs and their reduction can help in overcoming, to some extent, the problem of recession. 2. Changes in quality and nature of product are also likely to give fillip to sagging demand. 3. Firms can also change their sale methods and strategies so as to adjust to new situations. 4. In order to compensate for the loss of market suffered during the period of depression, the firm can take a positive approach. It can utilize the time period of depression to plan for the introduction of new products as soon as the phase of recovery starts. 5. In order to tide over the difficult time of depression the firm can utilise a part of its retained profits. Government Policies for Controlling Inflation and Recession. Two types of policies are pursued by the State to combat the inflationary and deflationary tendencies in the economy. These are called stabilisation policies, which mainly include: (i) Monetary policy, and (ii) Fiscal policy. 1. Monetary policy. It refers to the credit control measures adopted by the central bank of an economy (in India, the Reserve Bank of India). These are of two kinds: Quantitative or general controls, and Qualitative or selective controls. Quantitative or general controls include bank rate variations, open market operations and varying reserve ratios. They aim at regulating the overall level of credit in the economy through the commercial banks. Bank rate is the minimum lending rate at which the central bank discounts bills and securities held by commercial banks. By raising the bank rate, central bank makes borrowing costlier; consequently commercial banks borrow less from the Central bank. On the other hand, commercial banks raise their lending rate. This reduces the money supply in the economy. Reduction in money supply reduces demand for goods and services in the economy, resulting in the check on price rise. Open market operations refer to the sale and purchase of securities by the central bank. When the central bank aims to control inflation it sells securities in the open market, thereby reducing reserves of commercial banks. When the central bank aims to control inflation it sells securities in the open market, thereby reducing reserves of commercial banks. This reduces credit in the market. The reduction in money supply helps in checking price rise. Changes in reserve ratio can help combat inflation. The portion of deposits which a commercial bank has statutorily to keep with the central bank as deposit is called the reserve funds. In order to reduce credit by the commercial banks, many a time the central bank increases the percentage of such deposits. Increase in reserve ratio reduces the bank advances, thereby reducing demand for goods and services, and checks price rise. Selective credit controls are used to encourage or discourage

specific types of credit for particular purposes. In order to check the speculative activity in the economy, the central bank changes the margin requirements to be charged by the commercial banks on those activities. In recessionary conditions, the State should use monetary policies in the opposite direction to control recessionary forces. The central bank should lower the bank rate, thus, making borrowing by commercial banks cheaper. Commercial banks in turn would lower their lending rate, resulting in greater demand for credit. This would encourage investment, output, employment, income and demand. Consequently, prices would start rising. Similarly, while operating in the open market, the central bank should buy securities thereby raising money supply in the economy, whose impact would also be an increase in investment, output, employment, income and prices. The central bank can also use the instrument of reserve ratio to combat recessionary conditions. Lowering reserve ratio would lower reserves of commercial banks which would encourage greater lending, thus reviving economic activity. Lastly, when recession is in some specific sectors of economy the central bank can use some selective credit control measures, particularly lowering margin requirements, which would help in encouraging greater business activity. 2. Fiscal policy. Fiscal policy refers to the deliberate changing of taxes and government spending for the purpose of keeping the actual GNP close to the potential full employment GNP. If the potential GNP is exceeded it causes inflation, while if the actual GNP falls short of the potential it causes recessionary conditions. When inflation is due TO excess purchasing power in relation to the amount of goods and services available in the economy, the basic remedy for controlling inflationary conditions is to drain away excess purchasing power. In such a case, fiscal policy should aim at taking rupees out of the incomeexpenditure stream. As a result of this policy the aggregate demand will reduce, leading to control of price rise. There are two approaches for accomplishing this: (1) to restrain or reduce government spending and create a surplus budget (where tax revenue exceeds government expenditure). The cutback on government expenditures would reduce aggregate demand originating in the public sector; and its spillover effect in rest of the economy would also dampen aggregate demand. (2) To increase taxes on business and consumers without increasing government expenditure. Obviously, its impact would also be to create surplus budget and dampen the aggregate demand. Depending on which of the approaches are used, there wilt be differential impact on public and private sectors. However, both these approaches can also be used simultaneously. To combat recessionary conditions, just the opposite kind of fiscal policy measures need to be adopted. The government should aim to generate fiscal deficit by either increasing government expenditure (keeping tax revenues constant) or decreasing taxes (keeping government expenditure constant) or both. We know that in recession the economy suffers from unemployment as well as low level of output and aggregate demand. To give boost to aggregate demand, there is a need to pump purchasing power in the economy. By increasing aggregate demand, the unused capacity and unemployed labour can be employed. Again, the impact of the increase in government expenditure will be felt through resurgence of demand in the public sector and that of the cutback on taxes through the private sector. CYCLICAL PRICING A large number of pricing decisions of a firm relate to the firm's responses to changes in general economic environment. Fluctuation in overall business activity results in frequent shift in the demand and cost conditions facing the firm. It is, therefore, desirable that the firm has a set policy on cyclical price behaviour so that it can meet changed market conditions. It has been observed that prices of some raw materials and most manufactured goods have remained rigid over time. But this rigidity is just apparent. In reality, at the time of downswing there are concealed price concessions, variations in discount rates, and provisions of certain extras that tend to impart flexibility to the price which the consumer actually pays. Since demand for durable goods (producers' and consumers' goods) is postponable and relatively price inelastic, their prices generally remain inflexible. Further since most of the modern corporate sector is oligopolistic in nature, price rigidity prevails in such markets. In many cases, charging "just price" from consumers restrains price changes. Though one may find price rigidity in broad areas of the economy, this may not be true for an industry or a firm as each of them have specific problems of cyclical pricing. A cyclical price change can take a variety of forms, the main ones being:

(1) Change in list prices, (2) Change in discount rates, and (3) Change in product-line differentials. All these changes are done with an eye on net price of the product. So, the basic decision which the firm has to take in the case of cyclical price change is : whether and how much to change the net price of the product in order to combat the effect of cyclical fluctuations. The cyclical price change policies can be based on the following considerations: (1) Price Changes in Line with the Prices of Substitutes. It is a wise policy to use substitute products as a guide for cyclical pricing. If the spread of price between the firm's product and its substitute is maintained, it would ensure stability of firm's share in the market. A firm which wants to improve its market share can also do so by manipulating prices. Such kind of cyclical price policy is quite popular with price followers in an oligopoly market. (2) Price Changes in Line with the Purchasing Power. At the outset it looks appealing that the firm should keep its price in line with the changes in purchasing power (particularly when purchasing power is falling). However, this policy is weak both in theory and practice. Purchasing power is an average index which conceals extremes of price spreads among firms. It is, therefore, more logical that the cyclical pricing of each product conforms to the prices of substitutes. (3) Price Changes in Line with Cost Changes. A popular practice of cyclical price policy is to relate price to changes in company costs, where several variants of cost can be used as determining factors, like full cost, incremental cost, etc. In those commodities where raw material dominates the production inputs, changes in material cost result in changes in selling price of the product. However, there are three ways to operate cost-plus pricing when the material cost is rising substantially: 1. Price to be based on original cost of materials; 2. Product price to be based on replacement costs of materials; and 3. To realise that your rivals will price on original cost and will, therefore, compel you to do the same. This is based on the logic that the firm must consider how rivals think about these costs rather than how they ought to think. On the whole, we find that the demand function faced by the firm and the strategic goals (e.g., maintenance of goodwill, product quality, etc.) are the most important considerations in firm's cyclical pricing policy.

UNIT IX EXTERNAL SECTOR DYNAMICS

JUSTIFICATION FOR INTERNATIONAL TRADE Generally speaking, the underlying reason of both the domestic and international trade is the same : differences in the availability of resources. Within an economy, the resource endowments of the citizens differ. As a result each individual specialises in the production of those goods which he can produce most efficiently with his resources. He then exchanges his output with the outputs of other producers. In a similar manner, countries differ in terms of their resource endowments (e.g., quality and quantity of land and labour, climatic conditions, capital and technology). Since no country has abundance of all the resources, each country tends to specialise in the production of those goods which can be produced most efficiently with the help of its given resources. It then exchanges the surplus production of these produced goods with the surplus production of the other countries (which also specialise on the basis of their own resource endowments). For example, Japan specialises in the production of electronic goods, automobiles and photography equipment as these goods require efficient and highly skilled labour which Japan has in abundance. On the other hand, Brazil which has lot of unskilled labour and weather conditions conducive to the production of coffee, specialises in the production of coffee. The basic difference in domestic and international trade is that the latter suffers from some natural and artificial barriers, which do not exist in case of domestic trade. Countries are separated by political boundaries and respective economic systems. Each country has its own currency and banking system. Capital and labour do not move freely between countries. Even the movement of goods between countries is subject to certain government restrictions. Besides, countries differ in terms of their languages, social and cultural set-up, etc. In spite of all these factors against international trade, it has been steadily growing in importance.

Classical Theory of International Trade : The Principle of Comparative Advantage According to this principle, each country specialises in the production of those goods and services in which it has greater comparative advantage and exports them. While it imports those goods in which it has greater comparative disadvantage. For example, if India can produce textiles at a cost lower than other goods, it will specialise in the production of textiles and will export textiles. On the other hand, if the resource-cost of producing aviation equipment is higher than other goods in India, it will import this equipment. The basic reason for doing so is that the resources saved by not producing aviation equipment in the country can be used in its relatively efficient textile industry. With the help of comparative advantage principle, we can show that trade between two countries will be profitable for both, provided that its advantage in case of one good is greater than that in the other good. The following table helps in explaining this principle: Table Country Commodity X Commodity Y Cost ratio (per unit of labour) (pre unit of labour) A 6 3 1:2 B 2 1.5 3:4 According to the table, country A can produce both goods X and Y more efficiently than country B. But country A has comparative advantage in producing X, because while it can produce 3 times more X with one unit of labour than can be produced by country B, it can produce only 2 times more than can be produced by country B. On the other hand, country B has comparative advantage in producing Y, because while it can produce goodXequal to V3 of what country ,4 can produce with a unit of labour, while it can produce /equal to 'A of what country^ can produce with a unit of labour. Since, Vi is greater than V3, it implies country B has least disadvantage in producing Y. Country A will, therefore, specialise in the production o Wand country B in the-production of /and will trade with each other. As the export of good X from country A enters country B, the supply of goods X in country B increases and its price falls. Similarly, as export of good /from country B enters country A, the supply of good 7 in country A increases and its price falls. If there are no restrictions on trade, goods X and Y will continue to be traded between the two countries till prices of both the goods are equalised in the two countries. In the absence of trade, each country will have to produce both the goods X and Y on their own. If they specialise and trade, both the countries benefit in the process. For example, if country A has two units of labour and it produces both X and Y itself, then it will have 6X and 3 Y. But, if country A specialises in the production of X, then with 2 units of labour it can produce 12X. After keeping 6Xfor its use, it can export remaining 6Xto country B and get in return 4.5Y (because in country B, it can get 1.5 /for every 2X). Country A thus gains. Similarly, if country B, having 2 units of labour, does not trade it can have only 2Xand 1.5 Y. But, if it specialises in the production of Y, it can produce 3 Y. After keeping 1.5 Y for its own use, country B can export the remaining 1.5 7 to country, 4 from whom it can get in return 3X (because in country A, 1 unit of Y can be exchanged for 2 units of X). Country B, therefore, also gains from trade. Thus, both the trading partners are better off after trade than before trade. The principle of comparative advantage is an important doctrine of international trade. The basic logic of the theory that a country specialises in the production of a commodity for which it has lower comparative cost and imports those commodities for which others have lower comparative cost, is generally valid. The theory is also able to explain the gains from trade accruing to the trading countries. However, there are certain limitations of comparative cost advantage theory which need to be kept in mind: (i) The principle of comparative advantage does not explain why comparative costs of producing goods differ between countries. Its explanation in terms of differences in the efficiency of labour is inadequate. In fact, labour efficiency itself depends upon prevailing technology in the economy. Moreover, cost of production also differs due to differences in factor endowments. (ii) Though theory of comparative cost advantage makes us believe that each country should specialise only in the production of those goods for which it has comparative advantage, yet in reality we find that countries often produce a certain commodity and also import a part of it. They do not have complete specialisation due to certain strategic reasons (like defence),

development considerations (like development of basic technology) or high transportation cost involved in export and import of goods. Modern Theory of International Trade The modern theory of international trade, also known as Heckscher-Ohlin theorem, is an improvement over the classical theory in that it explains even the underlying forces which cause differences in factor endowments between countries and differing proportions in which factors can be combined to produce various goods which result in differences in comparative costs. We know that the countries of the world are not equally endowed with productive resources. Some countries have relatively more of labour, some others have more of land and some have more of capital. The productive resource which is relatively abundant in a country will obviously be relatively cheaper compared to the other resources which are relatively scarce. Thus, differences in factor endowments cause differences in factor prices and, therefore, account for differences in comparative costs. According to the modern theory of international trade, a country specialises in the production of a good (and exports it) which uses more of the relatively abundant factor, and imports those goods which use more of relatively scarce factors. For example, a country having abundant labour but scarce capital will tend to specialise in the production of labour-intensive goods, and will tend to import capital-intensive goods in exchange for its labour-intensive goods. The modern theory can, however, be criticized on the following counts: 1. The basic contention of the modern theory that relative factor prices reflect relative supplies of factors may not be true in many cases. It may be that the demand for the relatively abundant factor is stronger that its supply, which would result in high price for the relatively abundant factor. Under such circumstances, the country would import the goods using relatively abundant factors and export goods using relatively scarce factors. Such a case was found by Leontief for U.S. economy. The U.S.A., in its trade with India, was found to have imported mostly capital-intensive goods and exported labour-intensive goods, which is just the opposite of what its factorendowment would suggest. This fact is popularly known as Leontief Paradox. 2. The direct correspondence between cost ratios and price ratio, of goods, as assumed by Heckscher and Ohlin, may not always hold good. There are certain other factors too which influence price ratios. For example, even if two countries have identical factor endowments and, therefore, same cost ratios they may have different price ratios of goods due to differences in tastes and preferences for goods in the two countries. GAINS FROM TRADE International trade is beneficial for all the trading partners. The principle of comparative advantage shows that if countries specialise on the basis of their comparative costs, all the trading countries will be better off compared to a situation where they do not trade at all. Gains from trade can broadly be classified as: (a) Static gains, and (b) Dynamic gains. Static gains from trade are the increase in well-being of the countries entering into trade with each other, while dynamic gains are the contribution of international trade to the economic growth of nations. 1. Static gains. The static gains can be explained with the help of the principle of comparative advantage. We have seen earlier (Table 30.1) that both countries, A and B, can have more of goods X and Y if they specialise and trade with each other rather than remaining self-sufficient. According to the production conditions given in Table 30.1, we found that if countries A and B do not trade, they can get (6X, 3Y) and (2X, \.5Y) respectively. But if they specialise in the production of Z and /respectively, then country A can get (6X, 4.5Y) and country B can have (2X, 1.57). Obviously, both the countries benefit by specialisation and trade. The principle of comparative advantage, thusr leads to an important conclusion: free trade among nations encourages international specialisation among nations. This results in: (a) relatively more efficient allocation of resources of the trading partners; (b) increased production of goods and services in the countries enjoying comparative advantage; (c) product prices tend to get equalised among trading partners; and

(d) resource prices among trading countries tend to get equalised as relative demand for resources tends to adjust according to chages in relative demand of goods and services. 2. Dynamic gains. International trade has a very significant role to play in economic growth of the nations. Robertson goes to the extent of calling international trade as an 'engine' of growth. Some of these dynamic gains can be listed as follows : Since international trade results in increasing output and income of the nations, it obviously leads to economic growth. Thus, through trade, the world economy can achieve a more efficient allocation of resources and a higher level of well-being of its people. The underdeveloped countries can take advantage of the superior technology of advanced countries. It is possible only when the former import capital goods from the latter. When underdeveloped countries establish trade relations with advanced countries, the former are not only able to procure advanced technology but the latest technical know-how and managerial skills, which are extremely important for growth. Thus, if each nation specialises according to its resource endowments and enters into trade with other nations, the world economy and economy of each of these trading partners can realise greater output and income and can maintain a higher level of economic growth. To the extent that countries are not able to trade freely, they are forced to shift their resources from more efficient (i.e., lower-cost) production to less efficient (i.e., higher-cost) production in order to meet their domestic demands. FREE TRADE Vs. PROTECTION The Case of Free Trade. We know that trade is beneficial for all the partners in international trade. It enables a country to have the goods which it can produce relatively costly and to sell the goods which it can produce relatively cheaply. Apart from this general advantage, there are also some specific advantages of international trade. These are : 1. Free trade results in equalization of factor prices between trading countries. 2. Due to free trade, a country can specialise in the production of those goods in which it has comparative advantage. Specialisation and equalization of factor prices result in raising the real income and standard of living of the people. 3. Specialisation due to international trade enables a country to go in for large-scale production and introduction of improved and modern technology. However, free trade has not generally received favour with the governments because of its limitations. These are : 1. Cheap imported goods may destroy local industries manufacturing those goods. 2. Specialisation resulting from trade may lead to lopsided growth of the economy. 3. Dependence on other countries may prove fatal in situations like war. Consequently, governments often introduce limitations on trade. Forms of Trade Restrictions. Following are the main kinds of restriction on international trade : 1. Tariffs or customs duties. This is the most common form of trade restrictions. A country may follow single column tariff system, conventional tariff system or preferential tariff system. In case of single column tariff system, a uniform treatment is given to import of a commodity, irrespective of the country of origin. In the conventional tariff system a uniform treatment is given to imports from all countries, except to those with whom the country has entered into a specific treaty. When imports from certain countries are given preferential treatment due to political, racial or regional ties, such tariffs are called preferential tariffs. When the tariff duty is imposed in terms of physical units of a good (e.g., tonnes, number, etc.), it is called a specific duty, while if it is imposed on value of the good it is known as an ad valorem duty. When a duty is imposed on an imported good to raise its price in the domestic market so as to protect the domestic producers from incurring losses because of the duties on raw material entering into the cost of production of this good, such a duty on the good is known as compensatory tariff. When an exporting country supports its exported good by a subsidy, then a countervailing duty (in addition to the original customs duty) is imposed on the import of such goods so as to ensure the protection originally intended. 2. Quantitative restrictions. These restrictions limit the physical quantity of goods to be imported during a given period. For this purpose, generally the system of licensing and quota are used. Quota

limits the total quantity of goods to be imported, while import licensing limits the imports of an individual importer. The quantitative restrictions have become very common in the last forty years. 3. Foreign exchange restrictions. This involves control and restriction of sale and purchase of foreign exchange. Though this system was originally used to mitigate the situation of foreign exchange shortage, over time it has been increasingly used to control and restrict imports. The general practice under exchange control and regulation is to release foreign exchange on the basis of set priorities of imports of different goods. The Case of Protection. The custom duties or taxes on imports with a view to restrict trade has the following advantages: 1. Protection of infant industries. Industries which have not reached maturity are called infant industries. Since established industries of exporting country command a certain degree of superiority over newly established industries of importing country, the latter needs protection to survive. Thus, protective tariffs promote economic development and self-sufficiency by protecting the infant industries. However, once infant industries get established, protective tariffs must be done away with. 2. Promotion of employment. By restricting imports, protective tariffs help in the growth of domestic industries, thereby expanding employment and increasing income. The effect of protective tariffs is felt not only in industries thus protected, but also in the related industries which supply raw material and finished goods to the protected industries. Tariffs are imposed in advanced countries particularly to protect the interests of labour. 3. Diversification of industries. The basic disadvantage of specialisation is that the country ends up with a narrow range of exports and dependence upon other countries for a wide variety of imports. It has been felt that this situation is quite undependable and unstable for a country, particularly in strategic situations like war. Moreover, it hinders the development of a balanced and self-sufficient economy. Protective tariffs, by promoting diversification of industries, help the country in this matter. 4. Balance of payments equilibrium. By curtailing imports and promoting exports the country can correct its balance of payments disequilibrium. Effects of Protection. When a tariff duty is imposed, generally the price of the good is raised by the amount of tariff duty. This results in increased production but reduced consumption, while revenue of the government goes up. The price effects of tariff duties may be classified into eight categories : (1) Protective effect. This is also known as import substitution effect as foreign production is substituted by domestic production due to reduction in imports. The extent of protective effect depends upon the elasticity of supplymore elastic the supply, larger would be the protective effect. However, protection for a long time tends to make protected industries ineffective and non-competitive. (2) Consumption effect. At least in the short run the consumers tend to lose on account of protection. The price of imported goods is raised which has an adverse impact on consumption. But it is possible that the tariff helps in promoting the domestic industry, and in the long run prices may reduce and domestic supply may increase thus benefiting the consumers. (3) Revenue effect. The revenue effect is the income earned by the government by imposing customs duty, which would be equal to the tariff duty multiplied by the units of goods imported. (4) Redistribution effect. The imposition of customs duty, and the consequent increase in price of the goods, involves a transfer of income from the consumers to the producers. The higher price of the protected good benefits the domestic producers at the cost of domestic consumers. The transfer of income, thus, occurring is known as the redistribution effect. (5) Terms of trade effect. It is argued that the tariffs enable a country to import goods cheaply as the exporting country pays wholly or partly the tariff duty. However, in practice, it is found that the terms of trade benefit gets dissipated by the retaliatory actions of the other country which also imposes tariff duties. (6) Competitive effect. By protecting domestic industries against global competition, tariffs help in creating sluggish and inefficient monopolies in the domestic market. These industries would influence the government to continue with its protective policies, even if withdrawal of protection would be in the interest of the country.

(7) The income effect. By diverting demand from foreign goods to domestic goods, tariffs help in promoting domestic industries. So long as the domestic economy has idle and underutilised resources and capacity, the country would experience increase in real income as a result of tariff protection. (8) Balance of payments effect. By making imports more costly tariffs help in reducing imports, thereby achieving a better balance of payments position. Tariffs and underdeveloped countries. The most popular reason cited for imposing tariffs in underdeveloped countries is the development of infant industries. Given a very slender industrial sector, industries in these countries cannot stand and grow in the face of stiff competition from the modern and gigantic industries of advanced nations. In order to develop and diversify its industrial sector and to expand employment the underdeveloped countries have, therefore, to rely on protective tariffs. Most of the underdeveloped countries are following an active economic policy, in the sense that there is control and regulation of the economy by the State. In such a case, foreign trade control and regulation also becomes one of the instruments of growth and economic development. Protection is, therefore, used as one of the devices to influence the direction and rate of planned economic development. Lastly, due to world-wide political tensions and strife, currency areas, etc., the underdeveloped countries find it wise to be self-dependent as much as possible, at least in the case of strategic and vital inputs and raw materials. A policy of dependence may prove to be dangerous, while economic self-sufficiency may be a rational course of action. Tariff structure in these countries is, therefore, found to be determined with an aim to be self-sufficient (defence-wise and economically) and to generate employment. RATE OF EXCHANGE AND EXCHANGE CONTROL Every country has its own currency. Trade between countries, therefore, involves different currencies. The rate at which one currency buys or exchanges for another currency is known as the rate of exchange. In other words, it is the price of one currency in terms of the other currency. If, for example, one rupee exchanges for ten cents, it means that one rupee buys in India what ten cents buy in U.S.A. Exchange rate determination Just like any other price, exchange rate is also determined by the forces of demand and supply. In the foreign exchange market there prevails an equilibrium rate of exchange. In order to reflect the day-today fluctuations in demand and supply in the foreign exchange market, a market rate of exchange occurs which revolves round the equilibrium or normal rate of exchange. Equilibrium exchange rate is determined differently under the gold standard and paper currency systems. Let us discuss them separately. Gold standardThe mint par theory. When two countries are on gold standard and value of their currencies is expressed in terms of gold content of their currencies, such a rate of exchange is known as the mint par exchange. For example, if India and U.S.A. were on gold standard and their currencies would have exchanged at the Re. 1 = 10 cents, then it implies that the gold content of one rupee is equal to the gold content of 10 cents, assuming no bank commission. The bank commission is limited to the charges of transport and insurance in shipping gold from one country to another. The actual rate of exchange is, therefore, equal to mint par of exchange bank commission. Paper currency systemsPurchasing power parity theory. When two countries have their own paper currencies, their exchange rate can be determined with reference to their purchasing power in their respective countries. We know that purchasing power of a currency depends upon the price level within the country whose currency it is. If price level falls in the country, it implies that purchasing power of its currency has gone up and consequently its exchange rate would also go up. Opposite will be the case when internal prices increase. For example, if a tonne of wheat is sold in India for Rs. 1,800 and in U.S.A. at $ 180, then the rate of exchange would be Rs. 1,800 = $ 180 orRs. 10 = $ 1. Now if the price of wheat falls to Rs. 1,620, then the rate of exchange would be Rs. 1,620 = $ 180, orRs.9 = $ 1, i.e., exchange rate has gone up for India, in the sense that now it needs to give less rupees per dollar. Since countries exchange more than one commodity, the purchasing power of each

country is taken in terms of the price index numbers in that country rather than price of its particular commodity. Kinds of rates of exchange Broadly, there are three kinds of exchange rates: (i) Spot rate and forward rate. An exchange rate quoted for the spot transaction is called the spot rate of exchange, while the one quoted for buying and selling currency in future is known as forward rate of exchange. (ii) Fixed, flexible and floating exchange rates. When exchange rate is fixed in terms of gold or another currency, it is called fixed exchange rate. When this rate is fixed for a short period but is changed from time to time, it is known as flexible exchange rate. If exchange rate of the currency of a country is allowed to change and find its own level, it is known as floating exchange rate. (iii) Multiple rates. It is possible that a country adopts more than one exchange rate for its currency, e.g., one exchange rate for exports while another for imports. In such a case the country is following multiple exchange rate system. A special case of multiple exchange rate is the two-tier exchange rate system where the government maintains two exchange rates, one for the capital transactions and the other for commercial transactions. The former is generally lower than the latter. Fixed, flexible and floating exchange rates All the three kinds of exchange rates have their advantages and shortcomings which are discussed below: Case for fixed exchange rate. The main advantages of this system are : (1) Fixed exchange rate provides confidence about its continuity in future and thereby helps in the quick flow of goods. (2) Long-term investments are promoted by this exchange rate, as it gives confidence to investors and lenders abroad. (3) This rate being stable, it removes the possibility of speculation. However, it has been found that no country can maintain its exchange rate at a particular level for a long time (say, a decade). Since the internal and external conditions change over time resulting in balance of payments disequilibrium, the country therefore needs to adjust its exchange rate, else the payments disequilibrium may turn severe. Thus, countries usually use flexible exchange rates. Case for flexible exchange rate. (1) So long as the traders and investors have confidence that the fixed exchange rate represents truly the purchasing power of the currency, the fixed exchange rate results in free flow of goods. But if this confidence is lost, the fixed exchange rate becomes counter-productive. Rather the flexible exchange rate would be more appropriate under such conditions, as it gives at least a time direction of change in the purchasing power of the currency. (2) By the very logic given above, one can say that investors' and lenders' confidence can be won not by the fixity of the exchange rate but by making the exchange rate reflect truly the actual purchasing power of any money, which flexible exchange rates often do. Case for floating exchange rate. When it is not possible to maintain either fixed or flexible exchange rates as the conditions in the international market are continuously in flux, the country may prefer a floating exchange rate. But it must be noted that, under conditions of stability floating exchange rate provides greater stability, while under unstable conditions it provides greater instability. In certain cases, currencies are pegged to each other and allowed to float jointly against other currencies, like, in the case of currencies of six European countriesNetherlands, Norway, Sweden, Denmark, Germany and Belgium. Recent scene in foreign exchange of the world Till 1971, the international monetary system was governed by a system of managed flexible exchange rates. The exchange rate was fixed in terms of declared par values of currencies, subject to appreciation/ depreciation within limits. Over time such a system came under severe stress due to the following reasons:

(1) The country which suffered from balance of payments disequilibrium was expected to correct the balance itself. The consequent devaluation had an adverse impact on the prices and incomes of the country. (2) Though gold was the basis of exchange, U.S. dollar was so strong that it was treated as parity rate. The value of U.S. dollar was linked to gold at a fixed value of $ 35 per ounce. Later on, currencies like German mark, French franc and Japanese yen also joined the list of 'hard' currencies and were, therefore, preferred by the 'soft' currency countries for keeping exchange reserves. (3) As world trade grew, the supply of 'hard' currency fell far short of their demand and problem of international liquidity became more severe. All countries were adversely affected by this problem, particularly the developing countries. Added to these problems, the price of gold increased phenomenally after 1971, resulting in severing of link between dollar and gold. Thus, the common denominator of IMF, the dollar lost its place in the international monetary scene. The price of dollar in the international exchange market started falling, while the prices of mark, franc and yen started increasing. It was, therefore, not possible to maintain the IMF parity system. Consequently, the existing system broke down and gave place to floating exchange rate system. Since March 1973, the member-countries of International Monetary Fund (IMF) have adopted a variety of exchange rate systems depending upon their needs. At present, the following kinds of exchange rate systems are being followed : (1) Free floating exchange regime; (2) pegging to a single currency: (3) Pegging to a composite of currencies known as 'basket of currencies', including Special Drawing Rights (SDRs) of IMF; (4) Managed floating of currency, where intervention is permitted as per the guidelines and surveillance of IMF. (5) Joint floating (like in EEC), where there is almost a fixed rate between the member-countries of the group, while value of all currencies float jointly in the exchange market. Exchange control Exchange controls relate to the government control on exchange rate and conversion of domestic currency into foreign currency. These controls arc adopted if (a) market mechanism is found ineffective or unsuitable; (b) there is adverse balance of payments problems; (c) domestic industries need protection against cheap foreign goods; (d) the country wants to ration its scarce foreign exchange resources for priority goods; (e) the government wants to stabilize, appreciate or depreciate its exchange rate; (f) The government wants to use exchange earnings as a planning instrument for the economy. Basically, there are two methods of exchange control: (1) Direct methods, which include intervention, restriction and clearing agreements; and (2) Indirect methods, which are mainly in the nature of quantitative restrictions. Direct methods. One of the direct methods of exchange control is government intervention. Such an intervention is possible only if there is a central authority which has full powers to control and regulate the foreign exchange in the country. Such powers are vested in the central bank of a country. In order to control and regulate foreign exchange, the government engages into "pegging" operations which involve buying and selling of foreign currency in exchange for local currency. In order to maintain the price of its currency within limits the government varies the supply of foreign currency in the international exchange market. For example, if price of dollar is to be maintained at Rs. 10 = $ 1 while it actually is Rs. 9 = $ 1, then the Government of India will supply additional rupees and buy additional dollars in exchange, thus, raising the price of a dollar to Rs. 10; and, opposite will be the case if Rs. 11=$ 1. The former is known as 'pegging down', while the latter as 'pegging up'. But, for the government intervention to be effective there has to be continuous buying and selling of foreign currencies by the government. Government may place restrictions on the supply of its currency coming into the foreign exchange market. The usual device to do so is to route all foreign exchange transactions through a central agency,

usually the central bank. The system of multiple exchange rates is only a variety of government restrictions. With an aim to keep the balance of payments in order, the governments of two countries may enter into exchange clearing agreements, whereby the amount payable to respective foreign creditors is kept in their respective central banks, which in turn use the money in offsetting the counterclaims. Indirect methods. The most common indirect method of regulating exchange rate is the use of customs duties and quantitative restrictions like quotas. These have an impact in terms of reducing demand for foreign goods, and thereby making exchange rate favourable for the country. Another indirect method used for the purpose is varying the interest rate in the country. For example, if interest rate increases in India, it would attract short term capital from abroad. Consequently demand for rupees will increase, resulting in raising the exchange price of the rupee. Opposite would be the effect if interest rate is lowered. FINANCING INTERNATIONAL TRADE One of basic features which distinguish International trade fro.n domestic trade is that in case of the former two different national currencies are involved. Thus, when an Indian firm exports goods to U.S.A., it would be paid in dollars. But the Indian firm needs payment in terms of rupees. The problem then is to exchange dollars for rupees. Assuming rate of exchange as $ 1 = Rs. 10, then goods worth Rs. 10,00,000 would be worth $ 1,00,000. So, when the US importer pays a cheque worth $ 1,00,000 to the Indian firm, it sells the cheque on the US bank to some large Indian bank which deals in foreign exchange. The Indian firm will get Rs. 10,00,000 demand deposit in the Indian bank in exchange for this cheque. The Indian bank will in turn deposit this cheque with the concerned bank on which it was drawn by the U.S. firm. The Indian bank, which has bought the cheque from the Indian firm and has sold it to the concerned bank, provides this service for a fee: it charges fee for buying and selling the foreign exchange. Two features need to be noted in case of this exchange of goods and services : (1) When the Indian firm exports to U.S.A. it creates demand for rupees in U.S.A. and supply of dollars in India which can be used for importing goods from U.S.A. In other words, a nation's exports finance its imports. Exports provide foreign currencies to pay for its imports. (2) Further, the financing of Indian exports to U.S.A. reduces the supply of money or demand deposits in U.S.A. and increases the supply of money in India by the amount of export sale. FOREIGN CAPITAL FLOWS & BALANCE OF PAYMENT International balance of payments do not include only export and import of goods and services. They also consist of: (i) Buying and constructing plants abroad; (ii) Buying and selling foreign securities; (iii) Loans and grants by the government; (iv) Private gifts and grants; and (v) Sale and grant of military aid. The international balance of payments is a summary information of all the transactions that take place between the nation's residents and residents of all the foreign countries. It records the nation's purchases from and sales to all other nations and it accounts for any differences between sales and purchases by showing how these have been financed. Depending on whether it has purchased more or less than what it has sold to the other nations, a country will have balance of payments surplus or deficit. The balance of payments surplus implies that the nation's exports were more than sufficient to finance the sum of its imports, public and private grants, public and private capital outflows. The balance of payments deficit indicates the insufficiency of exports to finance imports and other capital outflows. It must be noted that balance of trade and balance of payments are not the same. Balance of payments is more comprehensive than balance of trade. Balance of trade is the difference between the import and export of goods by a nation, which is only a part of balance of payments. "Balance" in balance of trade implies gap between exports and imports.

Kinds of Disequilibrium in the Balance of Payments. Disequilibrium in balance of payments can arise due to a large number of factors. However, there are three main kinds of disequilibrium in balance of payments, as discussed below: 1. Cyclical disequilibrium arises due to the occurrence of business cycles. Growth over the long period has, generally, been characterised by short-term booms and depressions. The timing and intensity of these booms and depressions of different countries do not coincide. This may lead to the creation of demand-supply gap and, therefore, a balance of payments disequilibrium. 2. Secular disequilibrium results from the movement of the economy from one stage of development to another stage. In the early stages of development, imports far exceed exports, resulting in adverse balance of payments. On the other hand, in developed economies exports far exceed imports and savings are larger than investment, resulting in surplus in balance of payments. 3. Structural disequilibrium may arise due to changes in the pattern of trade. Measures to correct the Imbalances in Balance of Payments. The balance of payments disequilibrium can be corrected by : (a) Monetary measures, which include depreciation/devaluation of the domestic currency, deflation and exchange control; and (b) Non-monetary measures, consisting of import control, export promotion, tariff, quota, bilateral agreements and State trading. Let us discuss the measures sequentially. (i) Devaluation. The term devaluation means the official action to fix the foreign exchange value of the country's currency at a lower level than before (e.g., reducing the exchange rate $ 1 = Rs. 10 to $ 1 = Rs. 17 is a devaluation of rupee). Devaluation reduces the price of exportables and increases the price of import goods. This helps, to some extent, in increasing exports and reducing imports, thus reducing imbalance in trade. (ii) Deflation. This involves monetary contraction in an economy resulting in reduction in domestic prices of goods and services. Reduction in domestic prices results in reducing imports and increasing exports. But such a policy suffers from the drawback that it also reduces the money supply so badly needed for developmental projects in underdeveloped countries. (c) Exchange depreciation. It refers to a situation when there is decline in the value of domestic currency in terms of foreign currency. Exchange depreciation is automatic and can easily correct the deficit in the balance of payments, as this encourages exports and discourages imports. However, the success of this method depends upon elasticity of demand for imports and exports and the co-operation of trading countries; (d) Exchange control. The policies of devaluation and exchange depreciation have the adverse impact on terms of trade. Consequently, a developing country needing substantial foreign exchange to finance its development projects will have to pay more. An alternative method is suggested to overcome such a problem, viz., rationing the scarce foreign exchange among competing uses. This is done through a system of exchange control. The principal aim of exchange control is to stabilise the external value of domestic currency vis-a-vis foreign currencies and to protect terms of trade of the country. Impact of Balance of Payments on Price Level. Balance of payments in its turn influences the domestic price level. A country having deficit balance of payments implies that this country's exports are less than its imports. This would mean greater injection of goods in the economy than their leakage out of the economy. Consequently, the domestic availability of the goods would increase, leading to a price decline. But this is a short-run result. In the long run, no country can continue to have deficit balance of paymentsthe payments should equal the receipts in the long run. Therefore, any price decline due to deficit balance of payments would only be a short-run phenomenon as larger exports would push up prices over time. But if the deficit balance of payments is due to adverse terms of trading or structural imbalances in the economy, the level of participation in international trade would remain at a very low level and hence the impact of balance of payments on prices would be marginal.

UNIT X ECONOMIC ENVIRONMENT OF BUSINESS

ROLE OF GOVERNMENT IN INDIA A CASE OF MIXED ECONOMY The process of regulated development in India took the shape of democratic planning of the economy. The cornerstone of this process is the 'mixed economy' framework. Essentials of a mixed economy are the following: (i) Individual freedom. In a mixed economy, like any capitalist economy, consumers enjoy the freedom of consumption, producers the freedom of production and workers the freedom of choice of occupation. However, the State imposes restrictions on the production and consumption of commodities and services considered harmful for social welfare and growth. (ii) Co-existence of public and private sectors. In a mixed economy, the areas of economic activities are demarcated for the public and private sectors by the State: basic industries requiring heavy investment, strategic industries (like defense production) and the activities relating to social welfare and those essential for economic growth belong to public sector. Rest of the industrial activities is open to private sector. (iii) Planning. Like socialist economies, economic plans (at the national and State levels) are formulated in a mixed economy too. But detailed plans are prepared only for the public sector. For the private sector only the broad targets of production are indicated and creation of new capacities facilitated accordingly. A system of taxes and subsidies is used to encourage private sector to achieve the indicated targets. (iv) Social welfare. In a mixed economy, the State follows policies which increase social welfare. It spends on provision of social services like education, health, housing for weaker sections, etc. It also imposes progressive rates of direct taxes on incomes and wealth of the people so as to reduce inequalities in the distribution of income and wealth in the society. The State also enacts various labour laws to fix minimum wages, to regulate hours of work and other aspects of working conditions. The State also follows policies to develop backward regions and to increase employment opportunities in the country. State regulation of industry has been of an active nature since the inception of the planning process in India. It consisted of two basic dimensions: (i) The creation and growth of public sector in transport, finance and banking, in certain types of internal and external trade and in the production of key and strategic products, like oil, for the economy. (ii) Coordination of current economic needs with long-term development targets. For this, economic planning was resorted to for channelizing investment and regulating changes in the production structure. The share of public sector has grown immensely during the planning period. From a meager 18 per cent share of the public sector in the total investment in the First Five-Year Plan, these shares increased to about 45.24 per cent by the end of the Eighth Five-Year Plan. Of the total employment in the organised sector in 2001 the public sector accounted for 68.87 per cent. The growth of employment slowed down in nineties, and the public and private sectors made an equal contribution to employment during 1990-95. It has helped in reducing the rate of concentration of economic power and has also contributed to the reduction of regional disparities. The public sector's contribution to the gross domestic capital formation has increased from 33 per cent during the First Plan (1951-56) to 63.6 per cent in the Third Plan, but declined to 34.7 per cent by the Ninth Plan (1997-2002). Moreover, the public sector has made significant contribution in the field of industrial diversification, technology development, export promotion and import substitution. It has also made notable contribution towards reducing regional imbalances and increasing employment opportunities. Thus, public sector has come to occupy a prominent place in the Indian economy. Besides encouraging public sector, government of India also used powers vested in it by the Constitution to influence the private business activity. It prevented the entry of private business into certain industrial sectors with the help of its industrial policy. It has also restricted production, consumption and sale of certain socially harmful goods by enacting legislations like the Prohibition Act, COFEPOSA, etc. With the help of MRTP Act, the State tried to limit the growth of economic concentration. In the broad national interest, certain industries like banking were nationalized. The Indian Government has also been regulating private business by following various kinds of policy instruments, like fiscal policy, monetary policy, commercial policy, credit policy, etc.

- All these activities and policies of the Government of India and its managing a mixed economy have significantly influenced the economic environment within which the private business operates. This raises three basic issues regarding the government's role: (i) What is the manner of formulation and the extent of influence of these economic policies on private business activity? (ii) What should be the manner in which the various economic policies are to be formulated and implemented so that they strengthen each other and not contradict or duplicate each other? (iii) What should be the limit of State intervention, directly as well as indirectly? It is not easy to prescribe any rules for judging the role of government. Any set of policies is a reflection of the value judgement of policy makers. For example, the control of restrictive trade practices indicates the value system of stability. J.M. Clark, in his book Social Control of Business, lists the following tests for a good system of controls: (i) Control must be exercised in the interest of the people; (if) Its objectives should be clearly designed; (Hi) It should be powerful enough so as to avoid evasions and violations; (iv) Control should be efficient, while at the same time not adversely affecting the efficiency of the units it is regulating; (v) It should have an efficient system of incentives and penalties; (vi) Control mechanism should be simple enough to be easily understood and followed by those being regulated; (vii) Systems of control must be built in the light of experiences of the given socio-economic political set-up in which it is to be operative; (viii) Control must be adaptable to changed circumstances; (ix) It must be farseeing; and (x) It must be aimed to improve the lot of members of the society. The tests suggested by Clark are for an ideal system. Moreover, some underlying conflict can be visualised among these tests. It is, therefore, not easy to find a control system which meets all these tests. Like any other mixed economy, the role of government in Indian economy can be studied under the following heads: (i) Government as regulator of business; (i) Government as promoter of business; (ii) Government as an entrepreneur; and (iii) Government as a planner. It must, however, be well understood that this four-fold classification of government's role is purely for the ease of understanding the State's economic activities. Any one type of role of government is not independent of its other rolesthese are integrally connected with one another. GOVERNMENT AS REGULATOR OF BUSINESS Though there are a large number of physical controls over the working of private business, we can broadly identify the following as the most far-reaching direct controls : 1. Industrial Policy, 2. Industrial licensing policy, 3. Monopolies and Restrictive Trade Practices, 4. Price Regulation and Distribution Control, 5. Regulation of foreign exchange, 6. Regulation of foreign investment and collaboration, and 7. Controls over import and export. Besides these, indirect controls are exercised with the help of budgetary, fiscal and monetary instruments. Nature of these controls and their operational efficiency in the context of Indian economy is the subject-matter of this section. Industrial Policy in India Industrial Policy is a set of guidelines for the effective integration and coordination of the activities of all the different sectors of the economy with the aim to achieve a desired pattern of development. Industrial Policy Resolution, 1956. With the acceptance of 'socialistic pattern of society' as the basic aim of the social and economic policies and the experience gained in the First Five-Year Plan, a detailed Industrial Policy Resolution was adopted in April 1956. The salient features of this Resolution were the following:

1.The industrial sector was divided into three categories: Schedules .4, B and C. Schedule A consisted of those industries which were an exclusive responsibility of the State. This schedule included 17 industries: arms and ammunition, iron and steel, heavy castings, heavy electrical machinery, atomic energy, heavy machinery, coal, oil, iron ore, copper, zinc, lead, aircraft and air transport, shipping, railways, telephone, telegraph, radio equipment and power. Schedule B consisted of those industries in which the State would set up new undertakings and which were to be progressively owned by the State. The role of private sector was expected to be supplementary only. It consisted of 12 industries: machine tools, ferro-alloys and tool steel, antibiotics and essential drugs, fertilizers, chemicals, chemical pulp, synthetic rubber, carbonization of coal, road and sea transport. 2.Schedule C contained all the rest of the industries. These were to be within the realm of operation of private sector. These industries, however, were subject to State control with the help of Industries (Development and Regulation) Act and other relevant legislations from time to time. 3.To make the private sector grow and function efficiently, the State was to ensure the development of infrastructural facilities like transport, power, education, and to take appropriate fiscal and monetary measures. Provision for financial aid to industries (particularly co-operative sector) and nondiscriminatory treatment to private sector were to continue. 4.Small-scale and cottage industries were to be encouraged, both by restricting volume of production in the large-scale sector and by direct subsidies to small-scale and cottage industries. 5.Industrial development needs to be so patterned that regional disparities are removed. 6.In order to keep industries at efficient Level of working, maintenance of industrial peace and improvement in the working conditions of the labour class need to be improved. The resolution stresses the need for participative management by both the management and workers and it expects that public sector would set an example in this regard. 7.Attitude of the State towards foreign capital remains similar to one in the 1948 industrial resolution. Industrial Policy during Eighties. The decade of eighties witnessed several steps to liberalise the industrial policy. For industries like machine tools, electronics, electrical equipment, chemicals, instruments for automobiles, etc., a scheme of "broad-banding" was introduced. High technology industries, capital goods industries under OGL and industries having export potential were delicensed. The FERA and MRTP companies were also exempted but only if they enter industries which have high export potential or industries of national importance or those located in centrally backward areas or in "no-industry" districts. Modernisation, renovation and replacement which result in an increase of capacity up to 49 per cent over the licensed capacity have been exempted from licensing provisions, provided the items were not reserved for small-scale sector. The New Industrial Policy, 1991. The government announced its New Industrial Policy on July 24, 1991. In line with the liberalisation measures taken during eighties, this new policy further de-regulated the industrial sector. Its objectives included: I. building on the gains already achieved during eighties; II. maintaining a sustained growth in productivity; III. opening avenues for gainful employment; IV. correcting weaknesses or distortions in the policy followed so far; and V. attaining international competitiveness. The salient features of New Industrial Policy, 1991 are the following: (a) Role of public sector diluted. The number of industries reserved for the public sector has been reduced to 8. Now only those industries are reserved for the public sector which are related to security and strategic areas, viz., (i) arms and ammunition and allied items of defence equipment, defence aircraft and warships, (ii) atomic energy, (iii) coal and lignite, (iv) mineral oils, (v) rail transport, (vi) mining of copper, lead, zinc, tin, molybdenum and wolfram, (vii) mining of iron ore, manganese ore, chrome ore, gypsum, sulphur, gold and diamond, and (viii) minerals specified in the schedule to the Atomic Energy (Control of Production and Use) Order, 1993. The new policy provides for greater autonomy of management of public sector enterprises through the system of MOU (memorandum of understanding). The government also announced its intention to dilute its shareholding in public sector enterprises by offering it to mutual funds, financial institutions,

workers and general public. This was done in case of 30 selected public sector enterprises in 1991-92. Sick units are proposed to be referred to the Board for Industrial and Financial Reconstruction. (b) Need for industrial licensing done away with. The new industrial policy abolished industrial licensing for all industrial units except those industries which are related to security and strategic concerns, social reasons, concerns related to safety and overriding environmental issues, products of elitist consumption and articles of hazardous nature. Since April 14, 1993 only 15 industries needed to have industrial licence, viz., cigarettes, sugar, coal, drugs and pharmaceuticals, petroleum, alcohol, paper and newsprint, plywood and other wood products, hazardous chemicals, asbestos, electronics aerospace and defence equipment, entertainment electronics, animal fats and oils, tanned and dressed furskin and industrial explosives. Further existing industries are free to expand production according to their market needs. (c) MRTP Act amended. Earlier all industrial firms/houses having assets of Rs. 100 crores or rrjore came under the purview of MRTP Act. These firms could enter only selected industries and that too only after getting approval from industrial licensing authority and MRTP Commission. Under the new policy, these firms are treated at prior with the other firms and do not require any prior approval from the Commission and the government for investment in the delicensed industries. The MRTP Act has been suitably amended, whose emphasis has now shifted to consumer protection against monopolistic, restrictive and unfair trade practices. (d) More open policy for foreign investment and technology. Foreign investments and foreign technology agreements have been traditionally regulated in India. The New Industrial Policy in its Annexure III lists those industries in whose case no permission is required for direct foreign investment up to 51 per cent foreign equity (provided these firms are to finance their import of capital goods through their foreign equity). These industries listed in the Annexure III belong to high technology and high investment priority industries. The new industrial policy has announced major liberalisation in terms of foreign equity holding in services sector, which until now was available only to hotel industry. No permission is now necessary for getting indigenously developed technology tested abroad as well as for hiring foreign technicians. (e) Dropping the mandatory convertibility clause. The banks and financial institutions have been following a mandatory practice of including a clause which provided them an option of converting part of their loans into equity. This convertibility clause has always been perceived as a threat of taking over by the lending institution. This clause has been done away with in the new policy. (f) Industrial location policy changed. Under the new industrial policy, an entrepreneur need not take any prior approval for locating his industrial unit, so long as he locates the unit at any place other than the 23 cities having population exceeding 1 million. The exceptions are the industries subject to compulsory licensing. The economic reforms of 1990s were expected to result in (i) high growth in industrial production, (ii) shift in investment towards labour-intensive processes/products (given India's comparative advantage), which would result in increased profitability, earnings growth and export-oriented production, leading to greater employment opportunities. However, much progress could not be made in this direction because of certain policy limitations, like: (a) the rigidities in labour legislation and small scale industry reservations, which contributed to lack of competitiveness of Indian industry, (b) share of interest in the cost structure of Indian industry has been found to be one of the highest in the world; (c) lack of stable and predictable tax policies. These limitations have been identified and lately certain efforts are being made to overcome them. Industrial Licensing Policy: Industrial (Development and Regulation) Act, 1951 The industrial licensing policy has been used as the instrument for implementing the Industrial Policy Resolutions. The licensing policy derived its legal sanction from the Industrial (Development and Regulation) Act of 1951 and came into force on May 8, 1952. The Licensing System. The industrial licensing system was aimed to serve five objectives: a achieve optimum allocation of scarce inputs, both indigenous and foreign. It was believed that by regulating industries through licensing the State would be able to prevent overconcentration of resources in particular industries and regions and with small number of individuals. Moreover, the licensing system was expected to result in the growth of industrial sector in accordance

with the plan priorities and targets. A schedule of industries has been provided and all the industries included in the schedule needed to have a licence. Though industries outside the schedule were exempted from it, such industries were very- few in number. The important provisions of the Act were: (1) A licence is necessary for: (a) establishing a new industrial set-up (Sec. 11); (b) substantial expansion of existing plant (Sec. 13); (c) introducing the production of a new article in the existing plant (Sec. 11 A); (d) shifting the location of an existing unit (Sec. 13); and (e) carrying on the business of an industrial unit to which the licensing provisions of the Act did not originally apply but became applicable thereafter (Sees. 13 and 29B). (2) While granting licence for new units, the Government had the powers to lay down conditions with respect to location, size, technology, etc. (3) Under the Act, the State has the power to investigate the working of industries which are (i) using resources of national importance; (ii) managed in a way that harms interests of consumers or shareholders; and (iii) showing rise in prices or deterioration in the volume of production or quality of the product. (4) Industries which violate the provisions of the industrial policy or are unable to carry out instructions of the State could be taken over by the State. (5) The Act empowers the State to set up development councils. (6) the State has the power to lay down conditions regarding prices, technology, level of production and channels of distribution. Evolution of the Licensing System. A licensing committee was set up for reviewing and approving the applications of industrial licences. The committee had inter-ministerial composition along with the representations from Council of Scientific and Industrial Research, the Development Commissioner and the Small Scale Industries. Later on, the Capital Goods Committee was also formulated to look into the capital goods requirements of the applicants. In 1960, for the first time the policy of licensing was liberalised. All industrial undertakings having fixed assets not exceeding Rs. 10 lakhs and employing less that 100 workers were exempted from the licensing provisions. Licensing was further liberalised in 1966 when forty industries were completely delicensed, subject to the conditions that their expansion does not need additional foreign exchange, diversification is not more than 25 per cent of the total output and does not adversely affect the smallscale industry, and that no major installation of equipment is planned. The year 1991 witnessed the maximum liberalisation in licensing. Licensing policy has been revised many times over the years, partly as a result of on-the-spot decisions of the government and partly on the basis of reports of the expert committees appointed by the government. The Hazari Committee (1967) and the Dutt Committee (also known as ILIC) (1969) recommendations have been responsible for certain major changes in the licensing policy. The Hazari Committee revealed that the system of licensing in India has not at all served its purpose. There was lack of guidelines, so the licensing policy could not follow and supplement the plan targets. There were no well-ordered priorities and ad hoc criteria (e.g., availability of foreign exchange through foreign collaboration) were used for granting licences. Further, due to 'first-come, first served' basis for granting licences, some leading houses pre-empted licensing capacity in most of the industries. Once capacities were foreclosed by the big industrial houses, they were not keen on early installation and full utilisation of capacities. The aim of the whole exercise undertaken by the big business houses was to prevent entry of other entrepreneurs in the business. The licensing has failed to disperse industries and bring about a regional balance. Also there was a complete absence of follow-up action once the licence has been granted. The authorities concerned did not have any knowledge whether the approved projects were implemented in a phased schedule as required or not. The Hazari Committee, therefore, suggested that the scope of licensing system must be modified and that the criteria for fixing priority areas and broad policies on prices, foreign exchange and credit needs be laid down unambiguously by the Planning Commission for the use of the licensing authorities.

Dutt Committee Report. The Industrial Licensing Inquiry Committee (popularly known as Dutt Committee), appointed in response to the recommendations of the Hazari Committee, submitted its report in 1969. Its findings were: (a) Share of large business houses in proposed investment and import of capital goods has increased. Twenty large houses accounted for 40.7 per cent of the total proposed investment on machinery and 40.4 per cent in the total approved imports of capital goods. (b) Statutory provisions for issuing a Gazette notification inviting applications was never observed. Consequently, only large business houses, which could maintain their liaison offices in Delhi, were the ones who took maximum advantage of the system. (c) Certain large houses, notable among them being Birla, submitted multiple applications for the same product through various firms controlled by the house. The granted licensed capacity was rarely fulfilled before further licences were obtained for the same product. By resorting to this practice and by installing higher than authorised capacity, these houses could pre-empt the capacity. (d) Curbing monopoly has been completely ignored by the licensing authorities. By granting multiple licences for a product to the same house, granting licensed capacities significantly higher than necessary on techno-economic grounds and thereby concentrating capacity in the hands of a few large business houses, allowing the same business house to develop into different kinds of industries irrespective of judging their competence, and preferential treatment to those having offer of foreign collaborations (which the influential large houses could easily obtain), etc., all led to the concentration of licensed capacity with the large industrial houses, which were not always found to be efficient. (e) The licensing policy has also violated the provisions of Industrial Policy Resolution of 1956. In Schedule A, in the machine tools category, against 9 licences given to public sector the private sector was granted 226 licences. Similarly, in drug and pharmaceuticals, 12 licences were granted to public sector as against 114 to private sector. Similar was the case with Schedule B industries. (f) The Dutt Committee also found that the four industrially advanced States, viz., Maharashtra, Gujarat, West Bengal and Tamil Nadu got 62 per cent of the total licences, thus defeating the objective of regional balance. (g) The licensing authorities were found to be very liberal with regard to foreign collaborations and unmindful of the national economic policies and priorities. Collaboration in large cases was permitted even for non-essential consumer goods like cameras, ball point pens, loud speakers, etc., which only satisfies the demand of higher income groups and does not necessarily lead to economic growth. By permitting liberal foreign collaborations, and sometimes in multiple numbers, along with the licence for non-essential consumer goods have helped in creating demand pressure on already scarce foreign exchange resources. (h) Share of large industrial houses in the total financial assistance provided by the public institutions (the IFCI, IDBI, and ICICI) was quite predominant. Licensing Policy, 1970. In line with the recommendations of the Dutt Committee, the Government of India announced its modified industrial licensing policy in February, 1970. The policy was based on the four-sector division of the industrial sector: (i) Reserved sector consists of industries listed in Schedule A of the Industrial Policy Resolution (1956). (ii) Core and heavy investment sector consisting of industries which are basic, critical and strategic in terms of economic development, including all industries involving fresh investment of more than Rs. 5 crore. These were to be developed in the 'joint sector' and entry of large business houses was restricted in these industries. (iii) Middle sector consistsing of industries involving fresh investment of Rs. 1 crore to Rs. 5 crore. New undertakings in this sector will need licence. Existing units will be exempt from this requirement if :(a) these units do not belong to either the 20 large houses or foreign companies; (b) these units are not 'dominant undertakings' as per the definition of MRTP Act; and (c) these units do not require foreign exchange of more than Rs. 10 lakh or 10 per cent of the investment, whichever is less. (iv) Delicensed sector. All the remaining industries fall in this category. The exemption limit form licensing provisions, including licensing of new enterprises and substantial expansion of existing units, was raised from Rs. 25 lakh to Rs. 1 crore. The exemption of substantial expansion was

applicable only to suit the units having assets of less than Rs. 5 crore and not belonging to large industrial houses. The policy of reservation of certain industrial fields for small-scale sector was continued. The development of agro-industries was to be encouraged in the co-operative sector. The role of public sector was sought to be expanded inasmuch as that this sector should also take up certain suitable projects with short gestation periods. Changes in Industrial Licensing Policy (1973). In order to bring industrial licensing policy and procedures in line with the modifications in industrial policy, the Government of India in 1973 announced major changes in its licensing procedures and removed certain inconsistencies. The definition of 'large industrial houses' for licensing purposes was brought in line with that used in MRTP Act. Accordingly, large houses were regarded as those having assets, in its main and interconnected companies together, of not less that Rs. 20 crore (earlier it was taken as not less than Rs. 35 crore). The small-scale sector received better treatment in 117 items that were reserved for this category. The Government decided to streamline the system of licensing which was aimed at communicating the decisions to the applicants in respect of pre-investment approvals within a stipulated time period. An inter-ministerial team, known as Project Approval Board (PAB), was constituted for the purpose. PAB worked through Licensing Committee, Capital Goods Committee, Foreign Investment Board and Licensing-cum-MRTP Committee. The PAB was supposed to undertake the following tasks: 1. To review the pending cases, arrange for their early disposal and provide the necessary information at its disposal to the committees; 2. To review the progress of the licensed cap'acity up to the stage of commissioning; 3. To act as a forum to clarify policy issues; and 4. To consider directly the composite applications for licences. The PAB was to be assisted by a Secretariat for Industrial Approvals (SIA), whose responsibilities include receipt and processing of applications, issuing the final orders and reviewing the implementation of approvals. Industrial Licensing Policy (1975). In October 1975, the Government further liberalised industrial licensing. It delicensed 21 industries. It allowed unlimited expansion to monopoly houses and foreign companies in 30 other industries with the provision that the consequent excess production will be either exported or sold indigenously as per Government's orders. For those companies which were not covered by the MRTP Act, no licence was required up to the investment of Rs. 1 crore for new undertakings and Rs. 5 crore for expansion. The terms of regularization of unauthorised capacities of monopoly houses and foreign companies were also liberalised. The purpose of this liberalisation has been to give a fillip to production, even at the cost of concentration of economic power. New Industrial Policy and the Licensing Policy (1991). The New Industrial Policy announced on July 24, 1991 seeks to further de-regulate the economy. Liberalising industrial licensing was one of the. most important initiative of this policy. Under this policy all industrial licensing was abolished, irrespective of the level of investment. Exceptions were, however, made for certain industries which relate to products of hazardous nature, to commodities consumed by elite class of the society, and where safety, strategic concerns, environmental considerations and social reasons predominate. Annexure II of the Policy Statement lists such industries, which are only 18 in number. These are petroleum, coal, sugar, drugs and pharmaceuticals, paper and newsprint, asbestos, alcohol, cigarettes, motor cars, hazardous chemicals, plywood and other wood products, entertainment electronics, animal fats and oils, white goods, raw hides and skins and leather, tanned or dressed furskins, industrial explosives, electronics, aerospace and defence equipment. The government further delicensed white goods, motor cars, raw hides and skin and leather on April 14, 1993, thus only 15 industries required license. As a result of the Industrial Policy, 1991 and its further deregulation in 1993, now only 6 industries fall under the purview of licensing framework. Another important feature of the New Industrial Policy, 1991 is that the existing industries are free to expand as per their own assessment of the market demand, without obtaining any prior approval or capacity clearance.

The Monopolies and Restrictive Trade Practices Act The Monopolies and Restrictive Trade Practices (MRTP) Act was enacted in 1969 anrLbrought into force in 1970. The Indian MRTP Act is more or less based on the similar Act in the U.K. One of the directive principles of the Indian Constitution enjoins the State to ensure that "the ownership and control of the material resources of the community are so distributed as best to subserve the common good". Another direction given to the State is to ensure that "the operation of the economic system does not result in the concentration of wealth and means of production to the common detriment." This was the germ which ultimately burgeoned into the Monopolies and Restrictive Trade Practices Act nearly 20 years later. The preamble of MRTP Act says that it is "an act to provide that the operation of the economic system does not result in the concentration of economic power to the common detriment, and is for the control of monopolies, prohibition of monopolistic and restrictive trade practices and for matters connected therewith or incidental thereto." Concentration of Economic Power. The concentration of economic power can refer to either (i) the market power; (ii) the power over disposal of scarce resources of the community; or (iii) the power to influence political decisions. According to MRTP Act, the economic power which is said to be diverted against common detriment is the economic power of the first two categories. For the market power the main considerations would be: (a) power over existing competitors in the market; (b) power over potential competitors in the market; and (c) power over consumers who comprise the market. The power over disposal of scarce resources of the community would, to acertain extent, indirectly flow from the power of the first category because as a result of market power the businessman would be able to draw upon the resources of the community which would have alternative uses. The expression "concentration of economic power" has not been defined in the MRTP Act, but the legislative intent can easily be understood from the various expressions used in the statutes. In substance, concentration refers to (1) The control over material resources of the community; and (2) The possession of certain market power with dominance. The general criteria to be taken into account for this purpose are laid down in Section 28 of the Act, though it is so worded as to leave open to the authorities to consider all matters which appear in the particular circumstances to be relevant. Consistent with the general economic position of the country, the following criteria have been laid down in Section 28 of the Act: 1. To achieve production, supply and distribution, by most efficient and economical means, of goods of such types and qualities, in such volume and at such prices as will best meet the requirements of the defence of India, and home and overseas markets; 2. To have the trade organised in such a way that its efficiency is progressively increased; 3. To ensure the best use and distribution of men, materials and industrial capacity in India; 4. To effect technical and technological improvements in trade and expansion of existing markets and the opening up of new markets; 5. To encourage new enterprises as a countervailing force to the concentration of economic power to the common detriment; 6. To regulate the control of the material resources of the community to subserve the common good; and 7. To reduce disparities in development between different regions and more especially in relation to areas which have remained markedly backward. Methods of Measuring Concentration of Economic Power. The MRTP Commission established under the MRTP Act is supposed to make its own judgment regarding the existence or otherwise of much economic concentration. Though a number of methods for measuring concentration of economic power exist in literature (refer the chapter on Monopoly in the book), these are treated merely as an academic exercise, leaving the implementation of MRTP Act to the purely subjective judgement of the Commission. Scope of MRTP Act. Undertakings which came under the purview of the MRTP Act were: (a) Undertakings whose own assets together with those of their inter-connected undertakings are not less than Rs. 20 crore in value; and

(b) Dominant undertakings whose assets alongwith their inter-connected undertakings are not less than Rs. 1 crore and which enjoy more than the one-third of the market share. The main regulatory provisions of the Act can be summarised under the following categories: (1) regulating expansions, mergers and amalgamations; (2) regulating the establishment of new undertakings; and (3) Control over and prohibition of monopolistic and restrictive trade practices. Critical Appraisal of MRTP Act (A) Theoretical Contradictions. Anti-trust policies are often found to contain certain theoretical contradictions, like: 1. If competition is allowed to play its role the efficient industrial units will grow larger and larger and, thus make the existence difficult for medium and small-scale units, and the entry of new units well-nigh impossible. Technology, economies of large scale and necessity to ensure adequate return on massive investments make these tendencies inevitable. Firms tend to adjust their sizes and their numbers so as to maximise their efficiency or to minimize their costs per unit of output. John Kenneth Galbraith, who has been critical of the anti-trust policies of the U.S. Government, had an occasion to observe that the important effect of the antitrust policy in U.S.A is to deny market power to those who do not have the power or have difficulty in exercising it, while according immunity to those who already have such powers. He added that "the enforcement of the present anti-trust policy attacks the symbols of market power and leaves the substance untouched." The situation in the developing countries, like India, is no different. 2. The definition of concentration of economic power has been rather elusive in the Indian context. It has been viewed differently by different people. The Monopolies Inquiry Commission took the assets of business houses as the criterion of concentration of economic power and the market share alongwith the assets as the criterion for dominant undertakings. Vakil in his work 'Industrial Development of India, Policy and Problems', has defined concentration of economic power as the capacity to influence economic decisions, affecting the lives of large number of people. In reality, in the case of most major firms, the area of managerial decisionmaking is itself so small nowadays as to raise doubts as to what economic power they can really exercise. In all large industries, the level of production permitted, the pattern of such production, the prices at which sales can be made, wage levels, bonus payable and many other matters are all dictated or determined by Government or Government-appointed bodies. Thus, whatever concentration of economic power really exists in India can only come from the possession of ill-gotten fortunes and secret funds. (B) MRTP Act in practice. While no comprehensive study has been undertaken to evaluate the impact of this legislation, there has been wide ranging comments and criticisms about the objectives sought to be secured and the actual results perceived in its implementation. 1. It is often alleged that the MRTP Act has proved anti-size and not anti-monopoly. This criticism is, however, based on misconception that the MRTP Act is designed to prevent growth. The emphasis of MRTP Act is on regulation of growth and not the prevention of growth of the industrial houses. In fact, Sachar Committee has recommended special dispensation with regard to the proposals for expansion and diversification which are considered beneficial from the point of view of defence of the country, security of the State and meeting exclusively export requirements. 2. Under MRTP Act, investment in certain core sectors (which often need very heavy finances) have not been allowed to the large private houses, even when the public sector was facing the problem of insufficiency of resources to invest. This has created a situation of scarcity of vital goods resulting in a parallel 'black-market' economy. This led the government to later on soften the rigours of the MRTP Act for such areas of production by the big houses. 3. It has been felt that the MRTP Act has also come in the way of adoption of modern technology, thus, denying increased productivity and quality improvement. The Sachar Committee sought to correct this anomaly. It has recommended exemption from the application of certain provisions of the MRTP Act to proposals which involve modernisation of plant and machinery and installation of balancing equipment. Likewise, the Committee has recommended exemption for the manufacture of new articles by utilizing waste products or by-products, which again is a step in the right direction in view of the overall need of conserving resources and energy.

4. It is also generally concluded on the basis of the data that even after all the regulations and restrictions imposed on large houses, there does not seem to be any reduction in their growth rate and further concentration. If the top 20 business houses which are registered under the MRTP Act are considered, the value of their assets has risen from Rs. 2,400 crore in 1996 to Rs. 4,500 crore in 1975, with a percentage increase (with 1969 as the base) of 25.9, 38.9, 61.3 and 83.7 in 1972,1973, 1974 and 1975 respectively. However, the percentage share of the top 20 houses in the total private corporate assets during the period 1969-1975 did not undergo any significant change and remained around 44%. While the top 20 houses registered a growth of about 100% between 1963 and 1971; they registered a growth of about 45% between 1971 and 1976. A part of this growth would have been autonomous, but a significant part of the growth is the contribution made by expansion, new undertakings and acquisitions which have been with the concurrence of the government. There was also a significant concentration within the top 20 houses. The top 10 industrial houses applied for as much as about 95% of the total investment applied for by the top 20 houses, while the share of the top 10 houses in the total assets of the top 20 houses was about 72.5%. For substantial expansion, the top 10 houses received 96% of the investment approved for all the 20 houses. This also leads to the conclusion that approvals under the MRTP Act have increased the concentration of the top 10 houses. The above facts prove that the implementation of the MRTP Act has been incapable to hinder the growth of large business. In fact, the Act itself provides for an MRTP unit to grow gradually at the annual rate of 25%. 5. There has been a criticism that the prior approval of the Central Government for expansion and establishment of these undertakings and mergers causes a lot of delay in implementing such schemes, thus, having a cascading effect on decelerating the growth rate of MRTP units. Even though under the MRTP Act, a time-limit is prescribed for completion of the inquiry, the very nature of the process is timeconsuming. In short, it seems true that economic problems such as those relating to monopoly, business concentration and economic power receive not a very high priority. The issues get discussed only at a very general level. The industrialists keep a constant pressure on the government through press and other formal and informal channels. Since they have large resources at their command, the top business houses are able to build up and exploit political contacts. While the legislation aims to prevent the concentration of economic power there has been, over the years, a significant concentration and increase in the size of assets of the big houses. However, it is difficult to make any value-judgment on the basis of the data available for the short span of about two decades since the MRTP Act has come into force. Suffice it to say that the objectives in the legislation would need to be spelt out more clearly and the implementation should be done by a well-trained and dedicated group of experts. Sachar Committee's Recommendations (1978) and MRTP Act. The Sachar Committee was constituted to suggest the possible anomalies in the Companies and MRTP Acts and the methods to remove them. Based on the report of the committee the MRTP Act was amended in October, 1980. According to this amendment export production of a dominant undertaking is excluded from the criteria of market dominance Later in May 1982, the Government presented MRTP amendment bill which proposed: (1) Exemption of large industrial houses from the requirement of MRTP clearance of 'substantial expansion', if they(a) engage in core industries; (b) enter areas of high national priority; or (c) produce exclusively for export. (2) The existing criterion of 'market dominance' of one-third of total production in the market is proposed to be replaced by the criterion whereby market dominance exists when manfacturer's licensed capacity is one-fourth of the total installed capacity in the industry. (3) While deciding about 'substantial expansion' in dominant undertakings, the test would be licensed capacity. Substantial expansion of dominant undertakings would not require MRTP clearance if it is for replacement and modernisation of equipment. Latest Changes. A number of relaxations were announced during late eighties and early nineties. The government began by removing sick industrial companies from the purview of the MRTP Act for the purpose of modernisation, expansion, amalgamation or merger. On June 30, 1988, the government announced a policy under which dominant undertakings were freed from industrial licensing policy restrictions applicable under MRTP Act. The 'dominant' were required to

abide by licensing policy restrictions for the products in which they were classified as dominant. In respect of other products, they were to be treated at par with non-MRTP companies for industrial licensing policy. As per the New Industrial Policy announced on July 24, 1991, the asset limit for MRTP companies has been scrapped altogether. Therefore, the MRTP and dominant undertakings do not now require prior approval from the government for establishment of new undertakings, capacity expansion or diversification. This relaxation has been extended to enable the firms to become large enough to withstand global competition. The amended M RTP Act aimed to lay greater emphasis on the prevention and control of monopolistic, restrictive and unfair trade practices. A Competition Bill, 2001 to amend MRTP Act, 1969 and to propose a modern competition law has been enacted in 2002. The emphasis has thus shifted from restricting monopolistic practices to encouraging competitive conditions and practices. Price Regulation and Distribution Control. In India, during the first three decades of planned period, there was official controls on price, supply and distribution of some of the commodities, which were considered essential goods. The motivating factors behind these controls were: (i) To ensure adequate amounts of necessary material and semi-finished goods for the priority sectors at reasonable price; (ii) To protect the interest of general producers by keeping prices at reasonable levels; (iii) To control inflationary tendencies in the economy; (iv) To have more suitable and fair distribution of goods and services between consumers and across regions; (v) To curb monopolistic and anti-social activities; and (vi) To protect individuals against ill-effects of natural vagaries. In order to control and regulate prices and distribution of goods, the Government of India derived its powers from the Industries (Development and Regulation) Act, 1951, the Essential Commodities Act, 1955, the Central Excise and Salt Act, 1944 and the Supply and Prices of Goods Act, 1950. The essential commodities under the Act were : cattle fodder, coal and coke, cotton and wool textiles, drugs, foodstuffs including oil, iron and steel, paper and paper products, petroleum and petroleum products, raw cotton and raw jute. Later on, by amending the Act, the government added the following to the list of commodities subject to control under the Act: non-ferrous metals, fertilisers, cinema carbons, sugar, soap, matches, natural rubber, cement, motor cars, scooter and commercial vehicles. The system of dual prices. The Government of India adopted the policy of dual pricing, whereby a part of the saleable amount of the good is sold at subsidized prices to the consumers (particularly the needy and weaker sections of the society) and rest is allowed to be sold at open market prices where prices are higher than the controlled prices. The dual pricing policy was extended to steel, sugar, wheat, rice, paper, cement, kerosene, etc. An ideal dual price policy is aimed at (a) protecting the interest of weaker sections, and (b) not discouraging producers from expanding their production and investment in that item. But the success of the dual price policy depends upon the availability of adequate stocks of the goods with the public distribution system and the impact of this policy on production. In practice, in India it is found that generally producers do not expand the output of the goods falling under the scheme of dual prices; rather, they try to earn high profits by charging abnormally high prices on the part of goods sold in the open market. Bureau of Industrial Costs and Prices. Administrative Reforms Commission suggested that a body should be set up which can advise the government on the true basis of fair prices based on cost and input prices. Further, that such an advice should be on a continuing basis. Accepting the recommendations of the Commission, the Government of India constituted the Bureau of Industrial Cost and Prices under the aegis of the Department of Industrial Development. Terms of reference of the Bureau included suggestions regarding improvement in industrial efficiency, cost analysis and cost reduction in industries as well as analysing pricing problems in relation to cost and suggesting fair prices under prevailing cost conditions, capacity utilisation, technology, etc. In order to advise the government, the Bureau undertakes studies of various aspects related to cost, like the present cost conditions and possibilities of cost reduction, technological improvements and costs, various aspects of import substitution, proposals on production costs, etc.

The Bureau, which is headed by a chairman and two full-time members, has complete powers to ask for any information and data from any industry falling under the Industries Act, 1951. In order to maintain its efficiency while keeping its own staff and administrative costs at the minimum, the Bureau keeps in touch with other agencies doing similar or related work and hires consultants for help on contractual basis. Since 1976 when Tariff Commission was wound up, the Bureau has taken up the functions of the Commission also. Public distribution system. In order to maintain stable price conditions, an efficient management of essential goods is highly important. Similarly, providing adequate quantities of raw material at reasonable prices to industry is quite essential for continuing production. The public distribution system in India plays a major role in ensuring the fulfilment of both these needs. The important aspects of public distribution system are the following: (i) Rationing. The government has set up a network of fair price shops to distribute foodgrains, edible oil, kerosene, etc. The number of fair price shops in the country were about 4 lakhs (in 1992) covering a population of over 45 crores. The necessary foodgrains and other items supplied through the public distribution system are made available to the fair price shops through procurements of the same within the country and through imports. For this purpose. the government has developed a support organisation comprising agencies like NAFED and NCCF. (ii) Zonal system. If certain States are having surplus production while other States are facing deficit, any inter-State movement is likely to bring about steep changes in prices. The public distribution system, with the help of support prices, was used to stabilise prices of agricultural products and for this purpose inter-State/ inter-zonal movement of foodgrains was restricted. But since 1977 this restriction has been lifted. (iii) Procurement and buffer stock. Procurement prices are an instrument of procuring foodgrains and building their buffer stocks. These prices are fixed by the government and revised from time to time to secure the interests of the producers. The major problem in maintaining buffer stocks is the high storage costs and storage losses. Drawback of Price Controls. Price controls in India have, many a time, adversely affected the industry. To mention only the main drawbacks, these are the following: 1. The price controls have thwarted the growth of many industries (like coal) and has resulted in the scarcity of may essential commodities. 2. By adversely affecting the modernisation of industries, the dual pricing and other policies of price control have turned many industries into inefficient units. In certain cases, even replacement of old machinery could not be undertaken. Sugar industry where the share of levy in the total production is quite high, and cement industry where excise duty was about 40 per cent of retention price, can be cited as examples for the purpose. 3. In some cases, price control measures have even made industries uncompetitive in the world market. For example, high export duty on jute adversely affected its export market. With a view to control prices another export-oriented industry, tea, had been brought under the Essential Commodities Act. This was likely to erode the competitive strength of this industry too. Though there is nothing wrong in government's regulation of these industries through this method, the control must be accompanied by a continuing understanding and analysis of the conditions faced by the firms and the expectations from these industries be revised accordingly. Since the later half of 90s, the government has started reducing its role in price regulation of commodities and raw materials. The public distribution system has been almost wound up. The policy intent is that in the absence of interference the market is likely to function efficiently. IMPORT AND EXPORT POLICIES The Import Policy. Imports in India at the time of Independence were mainly colonial in nature in the sense that these consisted mainly of manufactured goods. With the advent of the policy of planned development of Indian economy, the government built its import policy within the following framework: (i) Imports in general must be discouraged to reduce pressure on scarce foreign exchange; and (v) Priority should be given to those imports which help in the development of the economy and help in export promotion.

The massive programme of industrialization, as envisaged in the Second Five-Year Plan, led to an unprecedented rise in imports to meet the establishment, expansion, modernisation and replacement of industrial capacity. This led the government to follow a tight import policy in 1957-58. In 1965-66, government further tightened its import policy by introducing major cut on import quotas and placing import restrictions on 60 items of import. In 1966-67, immediately after devaluation of the rupee, the government announced a liberal import policy. The imports for 59 basic industries were made more liberal so as to keep these industries at full capacity utilisation level. Government also helped agricultural sector through its policy of liberal credit when it arranged imports of a sizable quantity of fertilizers and pesticides. The import policy was further liberalised in 1975 and in 1977-78. In 1981, the government announced its new import policy with an aim to discourage and restrict the import of non-essential items and encourage domestic production. However, 1985 was the beginning of real liberalisation process for imports with the introduction of first of the three long-term export-import policies (1985-88, 1988-90 and 1990-92). The liberalisation process of eighties was guided by the recommendations of the three committeesthe Alexander Committee (1978), Tandon Committee (1982) and the Abid Hussian Committee (1985). The thrust of the import policy during eighties was towards liberalisation of imports (mainly that of capital goods and raw materials). Consequently, OGL list of imports expanded, and 1,343 importable items were kept free of licensing formalities in 1990-92; manufacturer-exporters were allowed to import capital goods at concessional rates and import of secondhand capital goods were allowed. Actual users of imported raw materials also benefited as a large number of raw materials, components and consumables were placed under OGL. The REP (Registered Exports Policy) licences were allowed on all exports (except those identified by the policy) and were made fully transferable. In 1990-92 policy, a new category of trading houses was createdthe Star Trading Houses (defined as those with Rs. 75 crore or more of export earnings, which were granted special additional licences. Further, for improving competitive strength of exports through technological upgradation, a Technical Development Fund has been created. Export policy. Due to easy position of foreign exchange reserves in terms of sterling balances and the government's greater pre-occupation with the policy of import substitution, the export side remained neglected up to the end of Second Five-Year Plan. In 1962, the government appointed the Mudaliar Committee which suggested: allowing import of such components and raw materials, which could not be indegineously produced; providing the facilities of import entitlement and some income tax-relief to exporters; and helping the export industry in acquiring greater competitive strength in the world market. On the basis of these recommendations, the Government of India took certain steps like establishment of the Board of Trade and the Export Promotion Advisory Council. In 1966, rupee was devalued with an aim to reduce imports and expand exports. In the post-devaluation period Indian exports, in fact, showed a significant tendency to rise" which continued till 1972-73. But from 1973-74 exports started falling short of imports due to world-wide inflation which pushed up the import bill. So, the Government appointed a committee headed by Prakash Tandon to look into the problems and suggest measures for expansion of exports. The Committee suggested that the Government should set a target growth rate of exports at 10 per cent, for which bold steps like encouraging multinationals to participate in export-promotion efforts, lifting all restrictions on MRTP companies so far as the export production goes, allowing imports of latest technology and even banned and restricting items for exports production, etc. be taken. Despite the liberalisation in import and industrial policies, the desired improvement in the efficiency of industry did not take place. The government, therefore, appointed in July 1984, a high-powered committee under the Chairmanship of Abid Hussain to go into the details of the framework of the import-export policy and suggest measures for rationalisation and improvement in the policy, wherever necessary. The committee submitted its report in December, 1984, based on which the government announced on April, 1985, changes in the import and export policy. Its emphasis was on defining a longterm policy which could strengthen the base for export production through technological upgradation and modernisation of production, facilitating the availability of essential imported inputs and streamlining procedures to decentralise decision-making and reducing licensing. The salient features of the proposed export policy were:

(i) Aiming to minimise export controls. Controls to be imposed only on those items whose supply is critical for the society. For example, a few goods of mass consumption like vegetables, sugar, etc. were in the list of banned items; (ii) Export duties to be fixed and adjusted keeping in view the conditions in the international market and designed to provide competitive edge to Indian goods, (iii) Keeping in view international market conditions the Government to fix, from time to time, the minimum prices of some goods like meat, woollen knitwear, etc. Export-Import Policies in Nineties In the last couple of years trade policy has been substantially liberalized, the important changes that have taken place are the following: (1) Floating Exchange Rate, LERMS and Rupee Convertibility. Since September 1975, floating exchange rate system has been adopted in India. In 1991, the government linked the exchange rate of rupee against the basket of five currencies. In the budget of 1992-93, the Financing Minister announced the Liberalized Exchange Rate Mechanism System (LERMS). Under this system, 40 per cent of foreign exchange earnings were to be surrendered at the official exchange rate while the remaining earnings were to be converted at market rate. The former portion was to be used to import the essential items only. In 1993-94 budget the dual exchange rate system has been dispensed with. Now, all exporter and exchange earners can convert 100 per cent of their earnings at market rate. (2) In view of the devaluation and liberalization, the Cash Compensatory Support was abolished in 1991. (3) Now only two types of import licenseAdvance and Special Importexist against several kinds of licenses prevailing earlier. (4) Earlier large numbers of imports and exports used to be canalised through public sector units. As per 1992-97 policy, all times except the eight items (fertilisers, petroleum, edible oils, etc.) stand decanalised. (5) Free Import of all items (including capital goods) is allowed under 1992-97 export-import policy. However, there is a negative list which included consumer goods and 70 other items. Import of just 3 items has been banned while export of 7 items has been banned. Further, export of 62 items (raw silk, pulses, milk, etc.) is allowed subject to licensing. (6) The import replenishment system was enlarged, restructured and called Eximscrip. Exmiscrips were freely tradable. All export products were to have uniform Eximscrip rate of 30 per cent of f.o.b. Metalbased handicrafts, cinematographic films, jewellery, etc., enjoyed higher benefit or replenishments. The system of Eximscrips was abolished in 1992 and replaced by LERMS. (7) The 1992-97 policy confers higher benefits upon 100 export-oriented units (EOUs) and units in export processing zones (EPZs). (8) The Export Houses, Trading Houses and Star Trading Houses have been allowed (/) to import a wide range of items, (ii) 51 per cent foreign equity participation, and (Hi) the benefit of self-certification under advance licensing system, which allows duty free imports for exports. In March 1993, the government announced modifications to 1992-97 policy, the main ones being : (a) High priority is being accorded to the growth of exports in agriculture and allied sectors. Certain inputs required for agriculture have been removed from Negative List and their import allowed freely now. (b) 144 items have been removed from the Negative List of exports. Now, Negative List of exports consists of only three categoriescanalised items, items subject to licensing and prohibited items. (c) Under the newly introduced "Export Promotion Capital Goods Scheme for the Services Sector", persons who render professional services have been allowed to import capital goods at a concessional duty rate of 15 per cent. From 1993-94, there has been a steady growth in Indian exports-around 8 per cent in latter half of the nineties. Though growth rate has been fluctuating over the years, it has generally been below that of the overall rate of developing countries. During 2002 and 2003, the growth rate of Indian exports was 13.8 per cent and 13.5 per cent respectively.

In recent times, the pattern of demands is-found to have been changing globally. India would, therefore, need to identify its exports items. Though textiles have registered an impressive growth of 22.5 per cent between April to October 1996, agriculture and allied products have maintained their dominating role by posting a growth rate of 55.2 per centthe highest rate. However, during 1997-2002, the efforts was to shift the focus to more value-added goods, like electronic items, gems and jewellery, leather, etc. The export sector needs to consolidate markets for its products in the identified trading countries. Trading with neighbours is always more economical. Singlemost important region that accounts for more than 40 per cent of India's total trade is Asia and Oceania markets. India should consolidate its export position in the fast changing East European market which has witnessed a very low penetration till now. The infrastructure to support the export effort must be made more effective. Post-shipment interest rate be rationalised. Customs clearance, etc. be made quicker. Inland container depots and container freight stations need to be set up. The scope of the existing seven EPZs should be broadened. Promotion of EOUs called for which would mean a number of bold measures during 1997-2002 in the Indian Exim Policy. Under the new WTO trade regime, the Exim policy of India would need major reorientation as discussed in Appendix I of chapter on Economic Decisions in Multinational Setting. Control over Private Foreign Investment As in other developing economies, process of industrialisation in India also faces among others two major constraints: (i) technology gap, and (ii) balance of payments gap. In order to bridge these gaps, Indian planners have followed two types of mutually reinforcing policies. The policy of import substitution was adopted to reduce dependence on imports. But this policy alongwith the technology gap required the participation of foreign companies with experience, technology and capital. So the policy of encouraging inflow of foreign private companies was adopted. There are two aspects, therefore, of foreign investment: transfer of technology and inflow of capital. Technology transfer is possible either with the help of direct participation of foreign companies or through contractual arrangements for which a stipulated amount of royalty fee is to be paid. The inflow of private capital is possible only through direct investment by foreign companies. To encourage direct foreign investment (FDI) the government has made suitable changes in its policy during 1990s. This led to greater inflow of FDI, though far less that expected. During 1991-2004, of the total FDI inflows the electical equipment (including computer & electronics), transportation, telecommunication, energy and service sectors received 14.5, 11.99, 11.17, 10.21 and 8.47 per cent respectively. Further, over the years the nature of FDI applications has undergone a change: numbers of financial approvals have gone up and technical approvals reduced in high priority industries, it was decided by the government in late 1990s that such investments upto 51 % foreign equity be automatically approved, while ensuring no bottlenecks in the process. These high priority industries are generally known as the appendix industries. In a similar manner, automatic approval is also provided for technology agreements in high priority industries and in cases not requiring expenditure of free foreign exchange. Foreign Exchange Regulation Act, 1973. Since 1973, the inflow of foreign capital in India is governed under FERA, besides all the other laws governing Indian companies. The most essential element in the Act is Section 29, which provides for permission, general or specific, by the foreign companies from the Reserve Bank of India in case of the following: (1) To carry on existing or new activitiestrading, commercial or industrial in nature. (2) If it wants to acquire wholly or partly any undertaking or its part. (3) If it wants to purchase any Indian company. (4) If it wants to open branches, offices or other places of business. Under the Act, all subsidiaries of foreign companies and Indian companies with non-resident investments exceeding 40 per cent are required to get the approval of the Reserve Bank of India for undertaking business activities in India which can be directed to reduce equity participation to below 40 percent. However, if a company is exporting more than 40 per cent of its production, it is allowed to hold foreign equity to the extent of 51 per cent; in case of those companies which export their whole output, 100 per cent foreign equity is permitted. In case a foreign firm in India is in high priority or high technology areas or exports more than 75 per cent of its production, it is allowed to retain 74 per cent foreign equity.

The Act specifies that any foreign company may by forced to leave the country in the national interest, if the company is found to violate the FERA guidelines. The latter kind of action was taken earlier in case of IBM and Coca-Cola. Several foreign companies refused to work within the equity guidelines of FERA and therefore left the country. Some of these were : Baker Parkins Internationa] Ltd., Torrance and Sons Ltd., Columbia Gramophone Co. of India (Pvt.) Ltd., Bunge and Co. Ltd., Consolidated Pneumatic Tool Co. Ltd., Johnson and Co. (India), etc. In 1991, the government amended the Act so as to allow 51 % equity participation by all foreign companies. FERA Amendment, 1993. Continuing with its policy to make FERA more relevant to economic needs, the government has promulgated the ordinance amending the provisions of FERA, 1973. The ordinance came into effect on January 8, 1993. The ordinance deletes nine sections, amends nineteen sections and adds two sections to FERA, 1973. The important implications of the Amendment are : 1. No approval under FERA from RBI is necessary for Indian companies for joint ventures or whollyowned subsidiaries abroad. However, cash remittances or export of Indian goods towards equity participation of the Indian company will be subject to RBI approval. 2. It is sought to regulate export of goods on lease, hire or any other arrangement otherwise than sale of goods on outright basis or consignment basis. 3. Now export and import of gold, silver and jewellery will not be regulated by the RBI. It would, rather, be governed by the provisions of Exim Policy. The commercial export of gold, silver and jewelllery will, nevertheless, continue to be under foreign exchange regulating arrangement. 4. Foreigners are no longer required to pay their hotel bills in foreign currency. 5. Foreign nationals seeking employment in India need not seek RBI approval. 6. Airline and shipping companies need not obtain a licence from RBI for booking of foreign passages. The requirement of P form has also been done away with. 7. By lifting certain restrictions on FERA companies, those companies have been brought at par with Indian companies. However, RBI permission is required if FERA companies want to carry on agricultural or plantation activity. 8. The RBI has been empowered to levy penalty on authorised dealers for contravention of RBI directions or for failure to file prescribed returns. However, given the objective of massive investments required to push the economy into high growth rate regime, foreign direct investment is being encouraged. To achieve this lots of incentives are being offered and existing restrictions relaxed. Lately, every effort is being made to attract FDI in infrastructure sector. Now it is proposed to allow FDI in construction sector, air transport and even print media. If India keeps a close watch on the deployment and working of FDI while it creates conditions for greater foreign capital inflow, it can repeat the China story of double-digit growth. Monetary Policy Since the planned development process started in India, the money and credit policy followed by the Reserve Bank of India is based mainly on two considerations : (a) to accelerate growth rate, and (b) to control and reduce inflationary trends in the economy. Obviously, in a state of fast-growing business and industrial activity there is bound to be expansion of currency and credit, but the supply of credit in excess of its need would prove inflationary. The RBI tries to strike a balance between them, and in order to draw policy perspectives, it juxtaposes information on indicators like inflation rate, interest rate, BOP position, fiscal deficit, credit flows, etc. This multiple indicator approach lends flexibility for necessary adjustment. Policies for Expansion of Credit. The following policy instruments have generally been used by the RBI to expand credit facilities: (1) Open market operations. This operation refers to buying and selling secunties by the central bank of the country. Since 1956, the RBI has been extending preferential treatment to government securities. It sold far more securities than it purchased from the public, thus abandoning the policy of expansion of currency and credit through this method. (2) Bill market scheme. This has been an important instrument of expansion of credit. Under this scheme the commercial banks get additional finance from RBI against bills, both local and export bills.

(3) Special schemes. Under these schemes certain sectors, which need encouragement according to economic policy of the government like small units and co-operatives, are provided special credit facilities in terms of liberal finance (even during period of otherwise tight credit policy of the RBI) and lower bank rate. (4) Setting up of the special finance institutions. In order to extend credit facilities to business, industry and agriculture, the RBI has set up several term financing institutions like IFCI, IDBI, SFCs, ARDC and IRC1. The Chakravarty Committee: A Review of the Working of the Monetary System. A committee was set up to review the working of Indian monetary system under the chairmanship of Prof. S. Chakravarty. It submitted its report in 1985. Its main recommendations were the following: (1) Price stability should be the primary aim of monetary policy, though the pursuance of this objective should not be at the cost of other socio-economic goals. The Committee felt that an appropriate framework for the regulation of the RBI credit to the government should be evolved to avoid colossal increase in money supply. (2) The Committee recommended greater freedom to banks for determining their lending rates. Further, concessional rates as a redistributive device should be used very selectively. (3) The Committee recommended restructuring of money market in India. It suggested that in the restructured monetary system, the four marketsthe treasury bills, the call money, the commercial bills and the intercorporate fundsshould play an important role in the allocation of short-term resources. (4) The Committee felt that the official concept of budgetary deficit was not helpful in understanding the monetary impact of fiscal measures. It, therefore, suggested that the definition of budgetary deficit be changed from its present definition of change in treasury bills. (5) The Committee favoured discontinuance of cash as a predominant form of bank credit; rather, loans and bill finance forms of credit need to be encouraged. Further, it was suggested that credit delivery system in priority sectors would be better from the point of view of efficient lending. All the major recommendations of the Chakravarty Committee were accepted and implemented : (i) The government has implemented on an experimental basis the committee's recommendation of developing aggregate monetary targets so as to have orderly monetary growth, (ii) The government has also accepted the recommendations regarding long-term government securities and has consequently increased yield and reduced maturities on these securities. (iii) The Committee's recommendation that increase in the entire Reserve Bank credit to the government be reflected in the budget has been accepted by the government in principle. Fiscal Policy or Budgetary Policy Fiscal policy or budgetary policy in India is designed to achieve the following objectives: (i) to achieve rapid economic development; (ii) to reduce concentration of income and wealth so as to create socialistic pattern of society; (iii) to achieve plan targets of growth and employment; (iv) to reduce regional imbalances by providing incentive for backward area location of industries; and (v) to modify industrial structure according to plan framework by encouraging/discouraging investments in certain industries. In order to achieve these objectives, the government has followed the policy of formulating its annual budgets and tax provisions in such a manner that the desired objectives are fulfilled without creating any noticeable disruption in the existing economic structure. The fiscal policy of the government consists of the following three instruments : 1. Policy of taxation, 2. Policy of public expenditure, and 3. Policy of public debt management. (1) Policy of taxation. For an underdeveloped country endeavouring to break out of its vicious circle of poverty, no instrument is as effective as taxation. The domestic savings, thus, mobilised can be invested

to create productive assets. Mobilising the saving potential through taxation and investing it in the public sector for capital formation and economic growth alone is not adequate to accelerate the pace of economic growth. It is essential that the fiscal policy be so designed as to encourage savings and investment in the private sector also, besides helping capital formation in public sector. In India during 2003-04 direct tax-GDP ratio has increased from 1.9% in 1990-91 to 3.8%, while indirect tax-GDP ratio decreased from 7.9% to 5.3%. Taxes can broadly be classified into personal taxes and corporate taxes. Personal taxes are in the nature of both direct and indirect taxes. The effect of direct taxes is reduction in savings of households, while that of indirect taxes depends on who bears a greater incidence of taxthe consumer, the producer or the trader. In India, revenue from direct taxes as a proportion of Gross Tax Revenue increased from 30.2% in 1995-96 to 38.4% in 2002-03, while that of indirect taxes reduced from 69.1 % to 61.3% during this period. Effect of taxation on corporate savings depends upon the : (i) tax rate, (ii) statutory tax concessions on items like advertisement allowance, entertainment expenditure, etc., (Hi) nature of tax rates, (iv) taxation of capital gains, etc. National Council of Applied Economic research (NCAER) in its study, Taxation and Private Investment, came to the conclusion that to some extent the 'concessional treatment of capital gains' sustained the interest to invest, particularly so in the case of higher income groups. The study, however, found indications that "the combined impact of income and wealth taxes tends to severely curtail the capacity to save of active entrepreneur-investors in the larger ranges of income and wealth." Taxation of corporate incomes is also an important factor influencing the growth of private sector. Such taxation affects the internal sources of capital of a company by (i) reducing incentives to save and invest, (ii) reducing the firm's ability to save and invest, and (ii) increasing riskiness of investment. In India, where corporate tax rates are very heavy (varying between 45 per cent and 65 per cent), the new and potential investors may hesitate to invest. The available funds are, therefore, either wasted in conspicuous consumption or flow towards the 'black money' sector. It is a well-known fact that the internal finance of a company depends on the depreciation allowance and retained earnings of a firm. If low depreciation is allowed it makes less finances available to the firm. While postponement of tax liability increases the ability of firms to expand and reduces riskiness of capital investment. The tax authorities need to consider all these factors while formulating a taxation policy. In India, some of the tax incentives available to industry are the following: (i) Tax holiday to new industrial units for five years on incomes upto 7.5 per cent of capital employed (ii) Investment allowance; (iii) Special tax incentives for backward areas; (iv) R&D expenditure allowance; (v) Export market development allowance; (vi) Depreciation allowance; (vii) Set-off and carry forward of losses, etc. (2) Policy of public expenditure. Ratio of public expenditure to national income has gone up from 9.4 per cent in 1950-51 to 43.1 per cent in 1992-93the share of non-development expenditure increasing even faster. It implies that the share of development expenditure in the total expenditure has declined to some extent. The increase in total expenditure has resulted from the State's preoccupation with economic development and provision of social and economic services with a view to create socialistic pattern of society. The item-wise classification of public expenditure reveals that the allocation of public resources was done with a view to control inflationary tendencies in the economy. (3) Policy ofpublic debt management. A major part of the development expenditure of the Government has been met by public debt. The public debt of the Central Government is Rs. 3,25,200 crore in 1994-95 as against Rs. 2,050 crore in 1950-51. The share of external debt in GDP reduced from 4.3% in 1995-96 to 2.9% in 1999-2000, while the share of internal debt in GDP rose from 47.0% to 47.9% during this period. Long-term Fiscal Policy. In 1985, the Government of India announced Long-term Fiscal Policy (LTFP) so as to provide stability to the fiscal system and to intensify renewed mobilisation effort. It aims to contain non-plan revenue expenditure, providing stability and flexibility to tax structure, increasing saving and reducing borrowings, and reducing budget deficits to contain inflation. The high points of this policy are : (a) Introduction of stability in tax laws and tax rates. No change in personal income-tax rates and no reduction in corporate tax rate in the next five years.

(b) Updating of the base year for valuation under capital gains taxation to April 1, 1974. (c) Introduction of modified value added tax (MODVAT) on an experimental basis as a duty drawback scheme. (d) Merger of several excise duties into basic duties. (e) Creation of revenue capital fund with Rs. 10 crore of seed capital to promote technocrat entrepreneurs. (f) Greater reliance on tariff rather than quantitative restrictions for regulating imports. The New Fiscal Approach. In spite of the progressive measures taken in LTFP, fiscal imbalance could not be controlled. The burden of non-development expenditure continued growing. Both the gross fiscal deficit and the primary deficit as a per cent of GDP has almost doubled during 1975-91. During 19982003 share of interest payments in the revenue expenditure has remained around 35.5%. These point to the crying need for immediate initiation of fiscal correction. The 1995-96 budget continued to rely on strategy of moving towards a simplified system of taxation, moderate tax rates and a wider tax base in case of direct taxes (like income, wealth and capita! gains taxes, etc.). It introduced major structural reforms in indirect taxation (like custom, excise duties, etc.). As part of tax reforms to improve resource allocation and efficiency and to make Indian manufacturing globally competitive a phased reduction the peak rates of custom duty was done. Consequently, the ratio of customs duty to GDP declined from 3.6 per cent in 1990-91 to 1.8 per cent in 2002-03. However, introduction of service tax in 1994 and its gradual extension to 58 services and increase in rate to 8 per cent were aimed at compensating the revenue loss of customs and excise duties. Globalisation. When an economy gets integrated with the world economy we call it a process of globalisation. In India this is being achieved by (i) allowing and encouraging direct foreign investments; (ii) scrapping provisions of FERA which could restrict the entry of MNCs in India; (iii) allowing Indian companies to set up joint ventures with foreign companies in India and in third countries; (iv) carrying out major programme of import liberalisation, and (v) replacing the export incentive schemes by exchange rate adjustments to promote exports. The Indian economy was in a severe balance of payments position in 1990 and 1991. Foreign exchange reserves were not sufficient even for import requirement of two weeks and default on debt services was imminent. The dismal economic condition pushed India into adopting the structural adjustment programme of the IMF and the World Bank. This structural adjustment programme has three components: (i) Reducing fiscal deficit and rate of growth of money supply (Stabilisation); (ii) placing greater reliance on market mechanisation and relaxing control on production, investment, etc. (Domestic Liberalisation); and (Hi) relaxing restrictions on flow of goods, services, technology and capital across countries (External Sector Liberalisation) It is the external sector liberalisation which results in globalisation. Measures to Achieve Globalisation. The Government of India has so far initiated the following measures: Introduction of full convertibility of the rupee was strongly advocated by IMF in 1991. The 1992-93 Budget of the Government of India introduced a debt exchange rate system, thereby allowing partial convertibility of the rupee. The 1994-95 Budget has moved closer to the introduction of full convertibility the budget allows full convertibility on current account. In line with its import liberalisation policy under new export-import policy (1992-97), the Government of India has allowed free import of all items (including capital goods), except a negative list. In Budgets of 1993-94 and 1994-95 substantial relief was given in the import duties. It was believed that import liberalisation would lead to competitive business environment. This would improve efficiency and product quality which, in turn, will help boost exports. Under the New Economic Policy, inflow of foreign capital is not only welcome but is encouraged. In areas like hotels, tourism industries, etc. (where earlier foreign equity was not allowed) have been opened to foreign capital. FERA companies have been given facilities of (i) borrowing money by accepting deposits; (ii) carrying out any commercial, industrial or trading activity; (iii) repatriating their profits; (iv) 100 per

cent equity participation for setting up power plants. From February 2000, the NRls and overseas corporate bodies have the facility of automatic route for investment (except for a small negative list) where profits and capital are repatriable. Globalisation and its Impact. Though it is too early to predict the long-run impact of opening up of the economy, its immediate effects are encouraging. There were certain fears like the blow to domestic industry and trade, flood of imports, etc., which have not happened. Our exports are growing at an encouraging rate due to lifting restrictions on exchange rate and movement of goods and services. Our imports remained almost steady, despite our worst fears. And the globalisation attracted foreign direct and portfolio investment of about $3 billion in 1993-94, which further went up many times in 2000 but was adversely affected by global slowdown during 2001. Though a lot has been said in favour of globalisation, it cannot be ignored that its impact is not only less beneficial than it is pointed out but it is also somewhat misplaced. Those who point to building up of foreign exchange reserves due to globalisation fail to mention that its major component is the borrowings from IMF and foreign currency bank deposits from NRIs, which have to be serviced and eventually paid back. We may head for a major debt repayment problem as the World Bank estimate of debt servicing for India in 1995 is $11.5 billion. GOVERNMENT AS PROMOTER OF BUSINESS Sick Industries and Government Intervention Sickness of industries in India is not only a serious problem but also an ever-growing menace that needs to be tackled at the earliest. Industrial sickness results in loss of employment, wastage of capital assets, loss of production and reduction in revenue to the exchequer of the State. There cannot be a general identification of sicknessit differs from industry to industry and from unit to unit. The RBI defines a sick industrial unit as "that which has incurred cash loss for one year and, in the judgement of bank, is likely to continue incurring cash losses for the current year as well as in the following year and the unit has an imbalance in its financial structure, such as current ratio is less than 1: 1 and there is a worsening trend in debt-equity ratio, i.e., total outside liabilities to the net worth." According to the Sick Industrial Companies (Special Provision) Act, 1985, a sick industrial company means an industrial company (being a company registered for not less than seven years) which has at the end of any financial year accumulated losses equal to or exceeding its exclusive net worth and has also suffered cash losses in such financial year and the financial year immediately preceding such financial year. Causes of Industrial Sickness. As stated above, the reasons for industrial sickness are industry-specific or unit-specific. We need, therefore, to study each unit/industry independently when we try to ascertain the reasons for its sickness. However, the general reasons can be divided into two broad categories: internal causes and external causes. Internal Causes. It refers to the factors that are related to the function of a given industry/unit and are within the control of the management of that industry/unit. These factors include : (a) choice of wrong location for the unit (b) wrong or under-estimation of capital cost for the project (c) delays in the implementation of the project and escalation in cost (d) lack of efficient management (e) sub-optimal plant size or under-utilization of the plant if) poor organisation of the unit (f) inadequacy of working capital (g) Failure in introducing proper financial control and cost reduction methods. External Causes. It refers to those environmental and structural factors which are outside the control of a given industry/unit as such. These factors are : (a) adverse government policy, like undue tax burden (b) statutory price control at a level so low as to result in persistent losses (c) adverse economic conditions like recession (d) shortage of inputs (e) cut-throat competition in the market (f) adverse industrial relations

(g) fast technological changes in the industry to which the unit has not/is not able to adjust (h) frequent and heavy power cuts (i) delay of financial institutions in providing financial assistance (j) management succession problems. Extent of Industrial Sickness. No precise information is available regarding the prevalence of sickness in various industries, as there is no comprehensive, standard and universally accepted definition of a sick unit. In the portfolio of scheduled commercial banks, the total number of sick units stood at 2.24 lakh in 1991, from 60,173 in 1982 and from 24,500 in 1980. The amount of institutional bank credit involved stood at Rs. 10,768 crore in March 1991 compared to Rs. 2,585 crore in 1982 and Rs. 1,809 crore in 1980. The data further reveals that most of these sick units are located in West Bengal. Government Policy towards Industrial Sickness. To effectively and systematically handle the problem of industrial sickness, Government of India in October 1981 announced certain policy measures as guidelines for Central and State ministries and financial institutions. The highlights of these guidelines were : (i) Role of respective administrative ministry. The administrative ministries have been assigned the specific responsibility to deal with this problemboth at the preventive and curative stages. They, are to monitor sickness, identify sick units and take coordinated action for their revival and rehabilitation. In case the Ministry finds that a particular major industrial sector suffers from widespread sickness, it should establish Standing Committees for handling the problem. (ii) Strengthening mechanism of monitoring sickness. Banks and financial institutions should strengthen the system of monitoring sickness so that a timely corrective action is taken to prevent incipient sickness. They need to periodically obtain information from the assisted units and from the Director nominated by them on the Boards of such units. These should be analysed by IDBI and results of the analysis conveyed to the concerned financial institutions and the Government. (iii) Undertaking diagnostic studies and drawing up of revival plans. The financial institutions and banks should study the reasons for the sickness and then initiate necessary corrective action. In case of growing sickness, the financial institutions should also consider taking up management responsibility if they fee! confident to bring the unit back to health. (iv) Consultation between the financial institutions and Government regarding alternatives to be employed. Where the banks and financial institutions are unable to prevent sickness or ensure revival of a sick unit, they should deal with their outstanding dues to the unit in accordance with the normal banking procedures. However, before doing so, they should report the matter to the Central Government who would decide whether the unit should be nationalised or whether any other alternative including workers' participation in the management, can revive the undertaking. Where it is decided to nationalise the undertaking, its management may be taken over under the provisions of the Industries (Development & Regulation) Act, 1951, for a period of six months to enable the government to take necessary steps for nationalisation. Steps taken to combat sickness. The problem of industrial sickness in general and sickness of textile industry in particular grew so gigantic that the government had to take over some of these units and subsequently announce a policy to overcome this problem. Recently, government has enacted the sick Industrial Companies (Special Provisions) Act, 1985, to combat sickness in industrial companies. A Board for Industrial and Financial Reconstruction (BIFR) has been established in January 1987 under the said Act. The Board is intended to coordinate the activities of all existing agencies dealing with industrial sickness and would take remedial steps to check the widespread sickness in industries. Some of the measures announced to rehabilitate the sick units include: (a) rescheduling of outstanding excise duties; (b) waiving penalty and damage related to cash credit; (c) reduction of interest up to 2% on term loans; (d) "self loan scheme" of IDBI for financial help to modernize sick industries; and (e) some special funds have been initiated to combat sickness, like the Small Industries Development Fund (SIDF), the Jute Modernization Fund (JMF) and the Textile Modernization Fund (TMF).

By the end of 1985, only 8,569 units out of a total of 1,19,606 sick units were found "viable". Out of these viable units, banks have been able to take up the responsibility of reviving only 2,751 units till 1987. It may be noted that there has been a perceptible shift in the government policy towards sick units. Government has now almost decided to let the non-viable units die their natural death as efforts to revive them would mean waste of public funds. Though closing down of non-viable units does imply unemployment, their continuation on continuously borrowed funds would imply reduction in employment opportunities somewhere else in the economy. Moreover, it is the society that pays for the inefficiency and mismanagement. The government policy of reviving only the viable sick units, therefore, seems economically appropriate. Promotional Role of Monetary and Fiscal Policies Monetary and fiscal policies of a government are also aimed at giving direction to the economy as per the economic priorities. Once a government has decided about the kind of industries (capital or consumer goods), the scale of these industries (large or small- scale), type of industrial ownership (public or private), domestic or foreign, and the allocation pattern of income between consumption and saving, etc. it develops a scheme of monetary-fiscal-budgetary policies that would help fulfill these objectives. A good mix of these three policies with efficient administrative machinery can create climate for the intended use of resources, pattern of growth in savings and investment and distribution of income. The central bank can mould its monetary policy (money supply and bank rate) to stimulate general industrial growth and revival. Each central budget has a bias in favour of some industries where certain tax concessions and expenditure allocations are done for the revival and growth. Reduction in direct taxes also has a stimulating effect on industry as it results in enhancing demand for the product. Providing funds to financial institutions like IDBI for helping in modernization of industries and charging a lower rate of interest on loans given to SSIs and technocrat-entrepreneurs are incentives in developing modern, efficient and competitive industrial sector. By using tariffs effectively domestic industry can be encouraged, while a judicious corporate tax policy can help growth in employment and output as well as in exports. The fiscal and budgetary policies can be used to alter the capital-structure of firms and their profitability and liquidity position. All these measures can generate a generally favourable climate for industrial sector and/or can provide support to selected sectors of the industry. GOVERNMENT AS ECONOMIC PLANNER The basic challenge before a developing country is to catch up with advanced countries, which is not possible unless these countries are in a position to accelerate the pace of economic growth. This is generally achieved through a process of planned development which amongst other things includes: (i) pre-determining the priorities of development; (ii) development of suitable links between various sectors and functional areas so that economy can grow in an integrated way, (Hi) evolving an organizational mechanism for implementation of plans, and (iv) a built-in system of review and evaluation of the progress plan. Planning in IndiaObjectives and Strategy The objectives of planning in India may be grouped into the following broad categories: (1) Growth of national income and the level of per capita income. (2) To achieve a planned rate of investment within a given period so as to increase output capacity. (3) To reduce inequalities in the distribution of income and wealth. (4) To reduce the concentration of economic power over the productive resources of the economy. (5) To create additional job opportunities. (6) To adopt measures to alleviate the three 'bottlenecks' regarded by the planners as being of critical importance, viz., agricultural production, the manufacturing capacity for producers' goods and the balance of payments. The importance of industrial sector is seen both as a supplier of essential nonagricultural goods and in the long run as an alternative source of jobs to the unemployed and the underemployed agricultural population. Two salient features of the development strategy adopted with the beginning of the Second Plan 1. High priority has been given to industrialization because of the following reasons: (a) productive rates are higher in industry than in agriculture; (b) industrialization can be the most effective instrument

combat the problem of unemployment; (c) industrialization can help correct the lopsided economic structure which is predominantly agrarian in character; (d) due to its complementarily with other sectors of the industrial growth can help promote growth in other sectors too. 2. Within the industrial sector, the emphasis was laid on the growth of 'heavy' and 'basic' industry. These included the industries like steel, power, machine-building, etc. The plan's emphasis on the growth of heavy capital goods industries, of course, did give rise to problem like : (a) the shortage of consumer goods and the consequent price rise; (b) imposition of heavy responsible of managerial and organization resources of the State for which it had neither the experience nor a suitcase administrative set-up; (c) lack of adequate number of skilled, well-trained and disciplined labour and managerial skill; (d) heavy pressure on foreign exchange resources of the economy because of significant imports of machinery and technology, and subsequently the maintenance imports; (e) the additional responsibilities for the State because heavy industries have their peculiarities like heavy capital require long-gestation period and having direct bearing on consumer welfare. Industrial Policy and Plans. Five-Year Plans have been the medium of implementation of the industni. Policy in India. Since Indian economy is a mixed one, an effort is made to coordinate the performance of the private and public sectors. The Plans fix the targets for both the public and private sectors. But the initiative:: fulfil the targets of the private sector lies with the private industry. In fact, Plans indicate the avenues, beer existing and potential, for the private sector to grow and also provide incentives to lure the private sector is respond. Indian Plans are, therefore, only indicative and its scope in the field of industry extends mainly government industrial undertakings. The private and public sectors are, however, integrated into the Plan 2 the prospective buyers and sellers to each other. The participation of the private sector in the planning process is limited to its representation on the Central Advisory Council for Industries and the Development Councils-Over the years, influence of the Planning Commission in the policy formulation has decreased. With the increase in the power of National Development Council (a body of State Chief Ministers to approve the Plan) and the duplication of authority with bodies like Directorate General of Technical Development (DGTD) ha-, t reduced the Planning Commission to a purely advisory body with no authority or responsibility for its execute. Further, the Plans mainly influence the organised industrial sector, as the small-scale and cottage industries are so small and scattered that they do not easily respond to planning. Thus, the area under foucs of the Plans in India is quite restricted. DRAFT NINTH (1997-2002) AND TENTH FIVE YEAR PLANS (2002-07) Focus of the Ninth Plan can be described as "Growth with Social Justice and Equity". This required only higher rates of growth of output and employment, but also an all-round human development with stress on social sectors and emphasis on redistribution aspects. Given this perspective, the Ninth Plan aimed at: 1. Agricultural and rural development for generating employment and eradicating poverty; 2. Growth rate with stable prices; 3. Provision of basic minimum services of safe drinking water, primary health care facilities, universal primary education, shelter and, ensuring food and nutritional security to all; 4. Environmental sustainability and empowerment of neglected sections are including women and peoples" participation through voluntary and non-governmental organisation, besides efforts to bring self-reliance. The last objective required ushering in an era of people-oriented planning, wherein along with the government the people at large becomes effective instruments of planning process. Harmonizing the roles of government and the people would ensure that the benefit of growth reaches the poorest of the poor. The draft document of Ninth Plan stressed the need for greater capital market reforms and disinvestment, selective privatisation of infrastructure, etc. It envisaged the growth rate of 7 per cent in GDP, though recognising that 7.5 per cent growth is needed to reduce unemployment. The Tenth Plan has almost the similar objectives as the Ninth Plan, but decides to pursue them with greater intensity. The Tenth Plan aims to:

(i) (ii) (iii) (iv) (v) (vi) (vii)

reduce poverty ratio by 5 per cent; provide gainful employment to the addition to labour force; primary education to all; provide potable water to all villages; reduction in gender gap in literacy and wage rates: reduction in population increase; Increase in forest and tree cover area. etc.

Sectoral allocation of the financial outlay of the public sector reflects the priorities of the Tenth Plan (Table). The highest allocation of resources has gone to energy sector (26.5%), followed by social services (22.8%), and then the agriculture sector (20.1 %) that also includes rural development, special areas programme and irrigation. As against this, industry and minerals get only 3.9 per cent of the total public sector outlay. The emphasis on investment in favour of agriculture vis-a-vis industry is due to greater employment potential of the former. The main sources of financing the Plan can be divided into the following three major categories : (1) Domestic resources, (2) Net capital inflow from abroad, and (3) Deficit Financing. The manner in which Tenth Plan is envisaged to be financed is as follows: Table Public Sector Outlay by Major Heads of DevelopmentTenth Plan (2002-07) (Rs. crore at 2001-02 prices) Heads Plan Outlay Percentage of Total 1. Agriculture and allied 58,933 3.9 activities 2. Rural development 1,21,928 8.0 3. Special area programmes 20,879 1.4 4. Irrigation and flood control 1,03,315 6.8 5. Energy 4,03,927 26.5 6. Industry and minerals 58,939 3.9 7. Transport 2,25,977 14.8 8. Communications 98,968 6.5 9. Science, technology and 30,424 2.0 environment 10. General economic services 38,630 2.5 11. Social services 3,47,391 22.8 12. General services 16,328 1.1 Total 15,25,639 100.0 The total size of the Tenth Plan is Rs. 15,92,300 crore for public sector, in which the share of the Centre and States in the plan resources are respectively Rs. 12,21,556 crore and Rs. 3,70,744 crore. Table 28.3 presents the overall financing pattern: Table Overall Financing Pattern of the Public Sector Outlay : Tenth Plan (Rs. crore at 2001-02 prices) Resources Centre (including U.T.s States and Total Without legislature) U.T.s with legislature 1. Balance from Current Revenue ( -) 6,385 26,578 20,193 2. Resources of Public Sector Undertakings 5,15,556 82,684 5,98,240 3. Borrowings (including net MCR and other liabilities) 6.85,185 2,61,482 9,46,667 4. Net Inflow from abroad 27,200 0 27,200 5. Aggregate Resources (1 to 4) 12.21.556 3,70.744 15,92,300 6. Assistance for Plans of States and U.T.s with legislature (-) 3,00,265 3,00,265 0

7. Resources for Public Sector Plan (5 + 6)

9,21,291

6,71,009

15,92,300

GOVERNMENT AS ENTREPRENEUR Public Sector in India Public sector in India was designed to control the "commanding heights" of the economy. Investment in public sector has been undertaken mainly as an instrument of the policy of socialistic pattern of society. There has been a dramatic expansion of the public sector during the planning period. There were merely 5 Central Government undertakings (excluding banks, other financial institutions and departmental undertakings like Railways) with an investment of Rs. 29 crore at the commencement of Plans in 1951. Their number grew to 233 and total investment to Rs. 2, 74,114 crore by 2002. The growing emphasis on public sector is because of the following: Many a time, a public enterprise becomes necessary because of the sheer magnitude and size of an enterprise. For example, no private enterprise in India can and would like to provide the capita required for the construction of a dam; only public enterprises has to take up such ventures. In certain public utility services, such as power and transport, which require heavy initial investment and which have a long gestation period, only government can wait for the results. Only public enterprises can have the consideration of a balanced regional development. The social benefits of providing employment in backward areas are much greater than a similar outlay elsewhere. Removal of regional disparities has been the objective of economic policy in the country. But this could not be left to private enterprise alone because relatively poor returns that are expected there do not attract the private sector to backward areas. Naturally, the public sector had to undertake this responsibility. There are a number of projects now started in Bihar, Onssa, etc. to help the removal of regional disparities. If nature of product/technology necessitates monopoly in supply, it is always good to have monopoly of the State rather than a private firm. This prevents concentration of economic power with private individuals. Public enterprises can play a promotional role. They can act as pacesetters for private individuals. For example, it was only after the successfully beginning of some plants in the public sector that the private sector came forward for production of fertilizers. Public ownership of key economic points, like banks, can exert a healthy influence on the entire economy in respect of prices, geographical distribution, etc. The expansion of the public sector has also become necessary for making adequate provision for the infrastructure which is vital for overall industrial growth in the country. It provides better opportunities for expansion of the private sector too. Moreover, the private sector is normally not interested in the development of infrastructure because of the heavy investment, low rate of return and the long gestation period. In the setting up of basic and key industries, like steel and heavy machinery, etc., the public sector has played a most beneficial role since most industries of this type were beyond the capacity of the private sector. The expansion of the public sector has also been found necessary for increasing exports. A number of public sector organisations have come up, such as STC, MMTC, and their subsidiaries which help the objective of export promotion. Not only this, the public enterprises such as Hindustan Steel and Hindustan Machine Tools, etc., could easily orient their production to export requirements. For import-substitution too, public sector undertakings have an important role to play. Thus, we find public sector enterprises working for economic self-reliance in a better way than could be expected from private enterprises. Response of the private sector to new investment being low it was necessary to supplement it by public sector investment. The experience of developing countries has been that the private sector alone cannot fulfil the needs of rapid economic growth. Hence, there is an important supplementory role for the public sector. Thus, the tremendous growth of public sector in India and persistent emphasis on its importance has been with following objectives in view:

 To initiate and accelerate industrialization of the country; To minimise imbalances in personal, sectoral and regional incomes in the country; To tackle the problem of unemployment; To forestall and check the growth of monopolistic tendencies in the private sector; To create infrastructure for smooth and fast growth; and To ensure against economic distortions, often resulting from the operation of free market. Forms of organisation. The public sector undertakings can be classified into four kinds, depending on the type of organisation of these undertakings. These are: (1) Departmental undertakings. This category consists of those public sector units which are organised on the pattern of the departments of the government, e.g., the production units of Indian Railways like Chittaranjan Locomotive Works, Integral Coach Factory, and the production units under the Department of Defence Production. (2) Public utilities. These are again departmentally controlled, although some autonomy in their working has been given in certain cases. This category includes undertakings like the railways, ports, posts and telegraphs, power and irrigation works. (3) Public corporations. This includes those industrial undertakings which are organised as statutory corporations, like Air India International and Indian Airlines Corporation. (4) Government companies. The industrial and commercial undertakings mainly, if not wholly, financed by the government. For example, Hindustan Machine Tools, Modern Bakeries, Neyveli Lignite Corporation, Bharat Heavy Electrical Limited, etc., Evolution of the Public Sector. The growth of public sector belongs mainly to the post-independence period as there was hardly any public sector in India in the pre-independence period, except railways and post and telegraph departments. While the investment in public sector grew phenomenally, an interesting pattern of investment emerged overtime. In March 1998, 65.5 per cent of its investment was in industries relating to producing and selling goods. Even here, bulk of investment (55 per cent) is in basic industries like steel, coal, power, petroleum, etc. The public enterprises rendering services account for nearly 32 per cent of investment the most prominent being financial services (15.1 per cent). Further, the top 10 public sector enterprises account for 48 per cent of the total investment in the public sector undertaking in 1998. Contributions of Public Sector. (1) Public sector in India has made significant contribution towards resource mobilisation and investment. During the first six Plans, the share of public sector in the total investmentin the economy has fluctuated between 53 per cent and 60 per cent. It is only in the Seventh and Eighth Five-Year Plans that this share has gone below 50 per cent. The role of nationalised banks (both commercial and development banks) in mobilising resources has been significant. However, share of public sector in gross domestic savings, which increased from 16.3 per cent in the First Plan to 18 per cent in the Sixth Plan, declined sharply to reach 5.7 per cent in 1997-98. Compared to departmental undertakings non-departmental enterprises have made a greater contribution to the gross internal resources. However, the massive drain on resources caused by the administrative departments had a depressing effect on the savings of the public sector. But situation is somewhat better on the investment front. The share of public sector in gross domestic product increased from 32.7 per cent during the First Plan to 51.4 per cent during the Sixth Plan, but later declined to reach 24.2 per cent in 1997-98. (2) Public sector can help in reducing inequalities of income by (i) producing mass consumption goods, (ii) by adopting discriminatory pricing policy favouring poor consumers and small producers, (iii) by initiating welfare programmes, and (iv) by stopping concentration of economic power in the hands of monopolists. (3) Government has also used public sector as an instrument trjreduce regional disparities. For example, all the four major steel pantsBokarao, Bhilai, Durgapur and Rourkelaare in backward areas. (4) Though private sector remains a dominant sector in Indian economy, the industries of strategic importance are managed by the public sector, For example, defence equipment, production of crude oil, civil aviation, steel, etc., are wholly or mainly under State ownership. (5) One of the basic rationale of public sector is to create infrastructure. Public sector has, by and large, succeeded in this. For the emergence and fast growth of industries, certain infrastructural facilities

like power, transport, communication, etc., are absolutely necessary. But since these industries involve heavy investments and long-gestation periods. Private sector does not find them attractive. Consequently, public sector has taken the responsibility to develop infrastructural facilities for the industry. (6) Certain strategic and key industries were developed by the public sector. Even some capital goods and consumer goods industries were developed in the public sector. This had led to a diversified growth of industry, thus, creating a strong industrial base for the economy. (7) Some public enterprises have made a major contribution in promoting country's exports. For example, STC and MMTC have a wonderful record of export performance. Similarly, Hindustan Steels, HMT, etc., have also successfully moved in this direction. Public sector enterprises have contributed significantly to the foreign exchange earnings with the help of (i) exporting its output, (ii) adding and marketing services, and (Hi) other services rendered by public enterprises. The export earnings of the public sector have gone up from Rs. 170 crore in 1969-70 to Rs. 7,096 crore in 199091, which further rose to Rs. 10,345 crore during 1992-93. (8) The contribution of public sector in import substitution and thereby effecting savings in foreign exchange is also significant. Oil and Natural Gas Commission, Indian Oil Corporation Ltd., IDPL, Bharat Electronics, etc., have reduced country's dependence on imports. (9) Public sector's contribution to the creation of employment opportunities is worth noting. It has contributed significantly to employment situation in the country. Further, it has acted as a model employer by providing them better wages and working conditions compared to the private sector. The total employment in public sector enterprises was 194.2 lakh during 1998, out of which is 50 per cent was in administration, community and social and personal services, 15.7 per cent in finance sector and 8.5 in manufacturing. (10)The ancillary and small-scale industry has also benefited from the public sector. By March 1997, 550 ancillary units were set up under the umbrella of public sector to whom the latter gave the guarantee of purchasing a part or whole of their output. Performance of Public Sector. In terms of net value added, the public sector enterprises constitute a sizeable share among all the majority industry groups. From five enterprises with investment of Rs. 29 crore in 1950-51, the public sector expanded in size and stature to 243 enterprises excluding 8 companies with Central Government investment but without direct responsibfhtyTor management, 6 insurance companies and 2 financial institutions) with investment of Rs. 1,77,599 crores in 1995-96. According to public enterprise survey, 1996-97, some of the major highlights of the year at a glance are: Investment in central public enterprises increased from Rs. 1,77,599 crore in 1995-96 to Rs. 1,93,121 crore in 1996-97, an increase of 8.74%; (2) Increase in gross-sales of Rs. 26,452 crorefrom Rs. 2,26,919 crores in 1995-96 to Rs. 2,53,371 crores in 1996-97. (3) Gross margrp_rofit before interest, depreciation and tax) has increased from Rs. 40,161 crore in 1995-96 to Rs. 44,501 crore in 1996-97. The growth in gross margin works out to 10.8%. Gross profit (profit before interest and tax) has increased from Rs. 27,587 crore in 1995-96 to Rs. 30,574 crore in 1996-97, thereby registering a growth of 10.8% over previous year. (4) Increase in net profit of Rs. 684 crorefrom Rs. 9,574 crore in 1995-96 to Rs. 10,258 crore in 1996-97, an increase of 7.14%. (5) Gross internal resources generated by Central public enterprises in 1996-97 of Rs. 25,533 crore is higher compared to the previous year, registering a growth of 5.5%. (6) Marginal improvement in export earnings of central public enterprises from Rs. 16,269 crore in 1995-96 to Rs. 16,359 crore in 1996-97. (7) Contribution to the exchequer in the form of corporate tax, excise duty, customs and other duties and dividend, etc. has increased from Rs. 30,878 crore during 1995-96 to Rs. 37,447 crore in 1996-97. (9) Number of houses constructed (including those under construction) has increased from 9.11 lakhs in 1995-96 to 9.15 lakhs in 1996-97. (10) Number of regular employees decreased from 20.52 lakhs in 1995-96 to 19.78 lakhs in 1996-97. (11) Overall performance as measured by MOUs: out of 110 MOU-signing PSUs evaluated, 46 were rated as "Excellent" and 27 as "Very Good". In 1970-71, net profit (i.e. net of interest; depreciation and corporate tax) of Central PSU was (-) Rs. 3 crore for a total capital employed of Rs. 3,600 crore. It was only after 1981-82 that these PSUs started yielding positive net profitthe bulk of it contributed by the petroleum sector enterprises. For most of the years between 1982 and 1998, the net profit ranged between 2 per cent to 6.2 per cent of the total

capital employed. Further during 1997-98, 134 profit making enterprises earned a total net profit of about Rs. 20,270 crore, while the 100 loss making PSUs incurred a total loss of Rs. 6,540 crore. However, it does not seem appropriate to take profitability as an index of performance of PSUs because these enterprises are guided by a variety of considerations while arriving at policies relating to its operations, personnel, pricing, etc. Given that the public sector has been investing in low profit, highinvestment and long-gestation-period projects, in social utility services and in strategic sectors, its profitability, as generally understood, are bound to be low. Moreover, a large part of its investment can be classified as 'under construction', for which no return is forthcoming. Further, the public sector has also been spending far higher on its labour in terms of salaries and wages as well as labour welfare. Thus, judging performance of a public enterprise is far more complex than that of the private enterprise. For this we possibly need a criterion like social rate of return. In the absence of an established criterion to find a social rate of return (as an alternative to profitability criterion), we can take the help of the following aspects: (1) Due to the objective of no-profit-no-loss in certain enterprises, the aim of public interest, the lack of managerial cadre to handle public enterprises and the absence of accountability led to unsatisfactory financial performance of the public sector. The government has lately taken serious view of these problems and has tried to overcome them by introducing the element of accountability, developing a special cadre of management suited to the needs of public sector and by removing ambiguities in the stated objectives in the working of these enterprises. Bureau of Public Enterprises is the main body advising the government in the matter of these reforms. (2) The gross block and the value of output of public sector have been growing, but the rate of growth of profits has been very slow. One of the reasons explaining slow rate of growth of profits in face of increasing gross block and output may be that the expanding capital base is not accompanied by proper capacity utilisation. It has been stated in the Annual Report of Bureau of Public Enterprises (1975-76) that more than one-third of the public sector units work below 60 per cent capacity utilisation; majority of these units were working below 80 per cent capacity utilisation. Fuller utilisation of capacity remains a constant challenge for the managements of PSUs. In order to ensure that these enterprises are professionally managed and underutilization of capacity is minimised, the Government has lately started entering into Memorandum of Understanding (MOU)s) with these PSUs. Disinvestment and Privatization. By privatization we mean "shift in business activity from the realm of public to the private sector, involving the introduction of private management expertise and/or private capital into the activities of a public sector unit." Various policy measures have been enunciated for restructuring of the Public Sector Undertakings (PSUs). A major step in this regard was setting up of the Disinvestment Commission in August 1996 for working out the conditions as well as modalities pertaining to disinvestment of Government holdings in PSUs. The Government identified nine well performing PSUs called the 'Navratnas' for providing them with higher managerial and commercial autonomy. These were IOC, ONGC, HPCL, BPCL, IPCL, BHEL, SAIL, NTPC and VSNL. A new Department of Disinvestment was created in 1999 for expediting disinvestment process. During 2003-04, ten PSUs (viz. ONGC, GAIL, DCIL, CMC, IPCL, IBP, ICIL, HZL, Maruti Udyog and Jessop & Co.) were fully/partially disinvested amounting to Rs. 15547.42 crore. However the UPA government, installed in 2004, declared that profit making PSUs will not be privatised. Those who support privatization do so for the considerations of improving efficiency of the business units. However, this argument may not necessarily be true. Observation of IMF study group (regarding the UK) is not very sure whether the increasing profits in industries handed over to private managements are mainly an outcome of privatization or of the improvement in general business environment. Further, any move to privatise must look beyond increasing "profits"such a change has implications affecting equity and justice. This raises a related question. On what terms should the transfer of ownership be done to the private sector? In case only the assets of the sick public sector unit is going to be handed over, with the government absorbing all the accumulated losses of the unit, it is as good as liquidation of the unit and selling the plant and equipment to a private party. Further, the very purpose of signing a memorandum of understanding (MOU) between the Government and various public sector companies gets defeated if instead of holding management accountable for losses and then taking curative actions, the government decides to hand over the plant to private sector. This is particularly serious now as enough management

expertise exists today in India's public sector plants. Lastly, it will be unfair to blame public sector for low profitability as it is forced to take social responsibilities. For example, a private sector unit employs labour according to its needs and absorption capacity, while a public sector unit is saddled with the responsibility of absorbing labour even up to the level where it becomes economically unjustified.