STUDY MATERIAL

Unit I [12 Periods]

Meaning, Nature and Scope of Business Economics - Basic Economic Problems - Market
forces in solving economic problems- Objectives of business firms - Profit Maximization -
Social responsibilities - Demand analysis - Law of Demand - Types of Demand

Meaning, Nature and Scope of Business Economics

Managerial Economics generally refers to the integration of economic theory with business
practice. While economics provides the tools which explain var-ious concepts such as
Demand, Supply, Price, Competition etc. Managerial Eco-nomics applies these tools to the
management of business. In this sense, Managerial Economics is also understood to refer to
business economics or applied economics.
Definitions of Managerial Economics

According to Prof. Spencer Sigelman, Managerial Economics deals with inte-gration of

economic theory with business practice for the purpose of facilitat-ing decision making
and forward planning by management.
According to Prof. Hauge, Managerial Economics is concerned with using logic of
economics, mathematics & statistics to provide effective ways of thinking about business
decision problems.
According to Prof. Joel Dean, The purpose of Managerial Economics is to show how

economic analysis can be used in formulating business policies.

Nature and characteristics of Managerial Economics:

1.Microeconomics: It studies the problems and principles of an individual business firm or

an indi-vidual industry. It aids the management in forecasting and evaluating the trends of
the market.
2.Normative economics: It is concerned with varied corrective measures that a management
undertakes under various circumstances. It deals with goal determination, goal development
and achievement of these goals. Future plan-ning, policy-making, decision-making and
optimal utilisation of available resources, come under the banner of managerial economics.
3.Pragmatic: Managerial economics is pragmatic. In pure micro-economic the-ory, analysis
is performed, based on certain exceptions, which are far from reality.
4.Uses theory of firm: Managerial economics employs economic concepts and principles,
which are known as the theory of Firm or 'Economics of the Firm'. Thus, its scope is
narrower than that of pure economic theory.
5.Takes the help of macroeconomics: Managerial economics incorporates cer-tain aspects
of macroeconomic theory. Knowledge of macroeconomic issues such as business cycles,
taxation policies, industrial policy of the government, price and distribution policies, wage
policies and antimonopoly policies and so on, is integral to the successful functioning of a
business enterprise.
6.Aims at helping the management: Managerial economics aims at supporting the
management in taking corrective decisions and charting plans and policies for future.
7.A scientific art: Science is a system of rules and principles engendered for attaining given
ends. Scientific methods have been credited as the optimal path to achieving one's goals.
Managerial economics has been is also called a scientific art because it helps the
management in the best and efficient utilisa-tion of scarce economic resources.
8.Prescriptive rather than descriptive: Managerial economics is a normative and applied

discipline. It suggests the application of economic principles with regard to policy

formulation, decision-mak-ing and future planning. It not only describes the goals of an

organisation but also prescribes the means of achieving these goals.

Scope of Managerial Economics

The scope of Managerial Economics is so wide that it embraces almost all the problems
and areas of the manager and the firm. It deals with demand analy-sis and forecasting,
resource allocation, production function, cost analy-sis,inventory management ,
advertising, price system, capital budgeting etc. However, the scope of managerial
economics may be discussed under follow - ing points:
a) Demand analysis and forecasting :Demand forecasting is the process of finding the
values for demand in future time period. The current values are needed to make optimal
current pricing and promotional policies, while future values are necessary for planning
future production inventories, new product devel-opment etc. Correct estimates of demand
is essential for decision making , strengthening market position and enlarging profits.
b) Cost and Production Analysis: Production deals with the physical aspects of the
business investment. It is the process whereby inputs are transformed into outputs.
Efficiency of production depends on ratio in which various inputs are employed absolute
level of each input and productivity of each input. A pro-duction function is the relation
which gives us the technically efficient way of producing the output given the inputs. The
firm must undertake cost estima-tion and forecasting to judge the optimality of present
output levels and assess the optimal level of production in future.
c) Inventory Management: It refers to stock of raw materials which a firm keeps. If it
is high, capital is unproductively tide up which might, if stock of inventory is reduced, be
used for other productive purpose . On the other hand, if the level of inventory is low,
production will be hampered. Hence, managerial economics with methods such as ABC
analysis a simple simula-tion exercise and some mathematical models with a view to
minimize inven-tory cost.
d) Advertising: Managerial economics helps in determining the total advertis-ing cost

and budget, the measuring of economic effects of advertising and form an integral part of

decision making and forward planning.

e) Market Structure and Pricing Policies: Managerial economics helps to clear sur-plus

and excess demand to bring market equilibrium as there is continuos

changes in market. Success of business firm depends on correctness of price decisions.
Price theory works according to the nature of the market depend-ing on the number of
sellers, demand conditions etc.
f) Resource Allocation: Managerial economics with the help of advanced tools such as
linear programming are used to arrive at the best course of action for the maximum use of
the available resources and its substitutes.
g) Capital Budgeting: Capital is scarce and it costs something . Hence, manage-rial

economics helps in decision making and forward planning on allocation of capital to

various factors of productions , marketing and management.

h) Investment Analysis: It involves planning and control capital expendi-

ture. Whether or not to invest funds in purchase of assets or other resources in an attempt
to make profit and how to choose among completing uses of funds. Managerial economics
help in analysis and decision making on the in-vestment of funds.
i) Risk and Uncertainty Analysis: As business firm have to operate under condi-tions of
risk and uncertainty both decision making and forward planning becomes difficult. Hence
managerial economics helps the business firm in decision making and formulating plans on
the basis of past data, current infor-mation and future prediction.

Objectives of Business Economics

Managerial economics provides such tools necessary for business decisions. Managerial
economics answers the five fundamental problems of decision making. These problems
are:
(a) What should be the product mix?

(b) Which is the least cost production technique and input mix?

(c) What should be the level of output and price of the product?

(d) How to take investment decisions

(e) How much should be the selling cost. In order to solve the problems of decision -
making, data are to be collected and analysed in the light of business objectives. Business
economics supplies such data to the business economist.
As pointed out by Joel Dean "The purpose of managerial economics is to show how
economic analysis can be used in formulating business policies" The basic objective of
managerial economics is to analyse economic problems of busi-ness and suggest solutions
and help the managers in decision-making. The objectives of business economics are
outlined as below:
ØTo integrate economic theory with business practice.

ØTo apply economic concepts: and principles to solve business problems.

ØTo employ the most modern instruments and tools to solve business prob-lems.

ØTo allocate the scarce resources in the optimal manner.

ØTo make overall development of a firm.

ØTo help achieve other objectives of a firm like attaining industry leadership, expansion

of the market share etc.

ØTo minimise risk and uncertainty

ØTo help in demand and sales forecasting.

ØTo help in operation of firm by helping in planning, organizing, controlling etc.

ØTo help in formulating business policies.

ØTo help in profit maximisation.

Uses of Business Economics

Business economics is useful because:

 6

(i) It provides tools and techniques for managerial decisions,

(ii) It gives answers to the basic problems of business management,

(iii) It supplies data for analysis and forecasting,

(iv) It provides tools for demand forecasting and profit planning,

(v) It guides the managerial economist.

Thus, Business economics offers a number of benefits to business managers. It is also

useful to individuals, society and government.

Basic Economic Problems

Any society, regardless of its size, degree of development and political system, tries to
solve their the basic economic problems of deciding how to satisfy the unlimited needs
of its market through limited Resources. Below is the list of basic economic problems
that must be in your mind as an entrepreneur.
1. What to produce
2. How to produce
3. For Whom to Produce
List of Basic Economic Problems
These basic economic problems are fundamental and interdependent: what to produce?
how to produce? And for whom to produce? Every society must decide how to
allocate its resources between the different productive activities and how they are
going to distribute the goods and services of consumption between the individuals that
compose it.
Well, the mechanism by which a society is organized to address these issues is
its economic system. Consequently, the economic system of a society is the set of
relationships and institutionalized procedures with which it tries to solve the basic
economic problem.
What to produce? The answer to the first question indicates in which the productive
resources will be used and how much of the final product will be obtained with these
means of production. This will depend on the needs of the members of society and the
resources available, since the latter are limited and susceptible to alternative uses. This
fact raises other questions: Will more consumer or production goods be
consumed? Will the quantity or quality in the production be the primary factor? Will
the production of material goods or the provision of services increase? Will goods be
produced for the internal market or will production be directed towards the outside?
How to produce? This question refers to the organization of production, that who is
going to be in charge of carrying out the productive activity, how this activity is going
to be undertaken and how the productive factors that are available will be
combined. All of this implies that society will ask questions such as whether intensive
technologies will be used in machinery or labor, whether it will be done through
private companies or public initiative, what sources of energy will be used in
production or if the productive processes by Those that will be chosen will be
polluting or respectful with the environment.
For whom to produce? Every society should design a system of distribution of goods
and services, which leads to reflect on issues such as: Who will be the target of that
production, a few or the vast majority of citizens? What method or system will be used
to distribute the entire production? Will the distribution of income be equal or will
there be very sharp differences between members of society?
It is very easy to understand that: WHAT, HOW, and for WHOM to produce would not
be problems if the usable resources were unlimited. However, in reality, there are
unlimited needs and limited resources available and manufacturing techniques. Based
on these restrictions, the Economy must choose between the goods to be produced and
the technical processes capable of transforming scarce resources into production.
This factor and the answer to these questions are closely linked to the production
management, the economy and of course the Financial Management, because as seen
previously, to produce you need to invest and to invest you need planning and
resources. Therefore, Financial Management comes to support the economy.
Presenting now a classical division of economics, microeconomics and
macroeconomics, it will be verified that, however great the differences between them,
 7

Financial Management is present and with a high degree of importance.

Generally, microeconomics is conceived as the branch of Economic Science focused
on the study of the behavior of consumer units represented by individuals and / or
families (these being characterized by a single budget), the study of companies, their
respective productions and costs, And the study of the production and prices of the
various goods, services and productive factors.
In this way it is distinguished from macroeconomics, because it is interested in the
study of aggregates as the production, consumption and income of the population as a
whole.
The bifurcation of Economic Science in these two branches, that is, macroeconomics
and microeconomics, date of 1930. decade of beginnings
Both segments revolve around the problem of limited and finite character of
productive resources in the face of the vital needs of Civilization, infinite and
limitless, underlying the human being, a problem that underlies and justifies the reason
for the existence of economics as a science. However, micro and macroeconomics go
as initially noted, for different channels and can be identified and / or distinguished
according to certain parameters.
The criteria adopted for the distinction are, however, fragile, since the understanding
of any economic phenomenon inevitably requires the interrelationship of the theories
that are inserted both within the scope of the micro segment and in the macro branch
of Economic Science. Among these criteria, the first one is based on the level of
abstraction-ism involved. Indeed, as author Robert Y. Awh ponders, microeconomics,
in laying down general principles, is far more abstract than macroeconomics, which is
concerned with the examination of questions and measures peculiar to a given place
and instant of time.
Secondly, microeconomics presents a microscopic view of economic phenomena, and
macroeconomics, a telescopic lens, that is, the latter has much larger amplitude,
appreciating the functioning of the economy in its global.
It follows a comparative title: considering a forest, microeconomics would study the
plant species that comprise it, that is, the composition of the product as a whole, while
the macroeconomics would worry about the total product level the forest and its
operation.
A third way of distinguishing microeconomics and macroeconomics encompasses the
analysis of the behavioral forms of aggregate variables and individual
variables. However, the aggregativity here explained must be understood in terms of
the homogeneity or not of the set considered.
Thus, if the aggregate could be extracted, at random, an element as representative of
the behavior pattern of the others, the area of microeconomics performance would
be; otherwise, if there were no possibility of isolating one element of the group in such
a way as to reflect the pattern of behavior, the others would enter the field of
macroeconomics.
For example, the large aggregates studied by macroeconomics such as income,
employment and unemployment, consumption, investment, and savings are all
heterogeneous in nature. Microeconomics is devoted to the appreciation of the
individual units of the economy.
Thus, the study of Consumer Theory considers the behavior of the individual (or
family, as long as the unit of consumption and / or expenditure is unique) and will
subsidize the Demand Analysis; Also, in the Theory of Firm, which unfolds in
Theories of Production, Costs and Income and based on the Analysis of the Offer,
again we have the analysis of the forms of behavior of individual units, in this case,
the companies. But both Consumer Theory and Firm Theory allow instrumental and /
or notions to be inferred, such as those underlying Individual and Aggregate Searches
and Individual and Aggregate Bids. It should be noted, however, that both Aggregate
Demand and Aggregate Supply allow us to obtain a standard element of the set, given
the homogeneous character of which they are endowed.
The last and no less important criterion of distinction between microeconomics and
macroeconomics rests on the price aspect. The last segment, at most, addresses the
absolute levels of prices, while relative prices are concerns, par excellence, of the first
segment.
Effectively, microeconomics is also known as Price Theory, since it seeks to evidence
the formation of prices of goods and services, as well as of productive resources. How
is this accomplished?
In the Consumer Theory, microeconomics extols the intention of individuals, in view
of their respective incomes, to appropriate a combination of quantities of goods in
 8

order to maximize their satisfaction. In other words, the searches (individual and
aggregate) that will result in income for the firms originate there.
In the Firm Theory, one has the figure of the individual-entrepreneur striving to
combine the factors of production, due to its budget constraint, with the intention of
maximizing the level of profit of his organization. Put another way, we obtain from the
analysis of this procedure, the elements necessary to derive individual and market
offers.
The combination of the quantities of factors of production, goods and / or services that
consumers would be willing to buy (which are usually infinite and unlimited), and the
quantities of these elements that entrepreneurs would be able to sell (which always
translate into a supply Finite and limited, in the face of the scarcity of productive
resources), imposes the determination of a common denominator, which will be
nothing more than the price.
The determination of this price, the level of which will depend a great deal on the
economic framework or the market structure involved, is the task that microeconomics
proposes when studying the question, both in terms of factors of production and in the
case of goods and / Or services. It is clear that the theme of economics is vast and can
cover much more topics and in more depth, but since the course is Financial
Management, the main concern is to insert in the course of the course the economy,
with its basic concept and the elementary division between micro And
macroeconomics.
Clarifying now some concepts about market will be approached the generic concept of
market and a greater detail on the market that interests more in this course, the
financial market.
There are classic market definitions, such as Adam Smith’s, but in a more simplistic
way the market is defined as a set of voluntary contact points between sellers and
potential buyers of a good or service that, under contractual conditions of purchase and
Sale, they do business.
Implicit aspects in the market concept
1- The context include any type of exchange: direct exchange (direct negotiations
between sellers anywhere) and indirect exchange (trading through commodity
exchanges, intermediaries, such as brokers or similar institutions). Thus, the definition
of the market is characterized by the idea of economic space, that is, it is not confined
to a specific region that is to say that there is no physical or geographical limitation.
2- Negotiations are voluntary and the price system functions as a common
denominator in trade.
3- There is no need for the explicit presence of the parties involved in the
process. This possibility is possible through the development of international real-time
telecommunication networks and product standardization (commodities). Markets thus
develop in local, regional, national and international terms.
It is worth noting that there are different stages in the transaction process, but the most
common and known is the wholesale and retail.
How Markets Solve the Three Economic Problems
We have just described how prices help balance consumption and production (or
demand and supply) in an individual market. What happens when we put all the
different markets together-beef, cars, land, labor, capital, and everything else? These
markets work’simultaneously to.determine a general equilibrium of prices and
production.
By matching sellers and buyers (supply and demand)in each market, a market
economy simultaneously solves the three problems of what, how, and for whom. Here
is an outline of a market equilibrium: 1. What goods and services will be produced is
determined by the dollar votes of consumers-not every 2 or 4 year at the polls, but in
their daily purchase decisions. The money that they pay into businesses’ cash registers
ultimately provides the payrolls, rents, and dividends that consumers, as employees,
receive as income.
Firms, in turn, are motivated by the desire to maximize profits. Profits are net
revenues, or the difference between total sales and total costs. Firms abandon areas
where they are losing prof.its; by the same token, firms are lured by high profits into
production of goods in high demand.Some of the most profitable activities today are
producing and marketing legal drugs drugs for depression, anxiety, impotence, and
all other manner of human frailty. Lured by the high profits, companies are investing
billions in research to come up with yet more new and improved chemicals.
2. How things are produced is determined by the competition among different
producers. The best way for producers to meet price competition and maximize profits
 9

is to keep costs at a minimum by adopting the most efficient methods of production.

Sometimes change is incremental and consists of.little more than tinkering with
the machinery or adjusting the input mix to gain a cost advantage., which can he very
important in a competitive market. At other times there are drastic shifts in technology,
as with steam engines displacing horses because steam was cheaper per unit of useful
work, or airplanes replacing railroads as the most efficient mode for long
distance travel. Right now we are in the midst of . just such a transition to a radically
different technology, with computers revolutionizing many tasks in the workplace,
from the checkout counter to the drafting table.
3. For whom things are produced-a-who is consuming and how much-depends, in
large part, on the supply and demand in he markets-for factors of production. Factor
markets (i.e., markets for factors of production) determine wage rates, land rents,
interest rates, and profits. Such prices are called factor prices. The same person may
receive wages from ajob, dividends from stocks, interest on a bond, and rent from a
piece of property. By-adding up all the revenues from factors, we can calculate the
person’s market income. .The distribution of income among the population is thus
determined by the quantity of factor services (person-hours, acres, etc.) and the
prices of the factors (wage rates, land rents, etc.)
Be warned, however, that incomes reflect more than the rewards for sweaty labor or
frugal living. High incomes can come from large inheritances, good luck, and skills
highly prized in the marketplace. Those with low incomes are often pictured as lazy,
but the truth is that low incomes are generally the result of poor
education, discrimination, or living where jobs are few and wages are low. When we
see someone on the unemployment line, we should rem-em-· her, “There, but for the
grace of supply and demand,go I.
Monarchs of the Marketplace
Who rules a market economy? Do giant companies like Microsoft and AT&T call the
tune? Or perhaps Congress and the president? Or the advertising moguls from
Madison Avenue? All these entities can affect us, but the core determinants of the
shape of our economy are the dual monarchs of tastes and technology. Innate and
acquired tastes-as expressed in the dollar votes of consumer demands-direct the uses
of society’s resources. They pick the point on the production-possibility frontier (PPF).
But consumers alone cannot dictate what goods will he produced. The available
resources and technology place a fundamental constraint on their choices. The
economy cannot go outside its PPF. You can fly to Hong Kong, but there are no flights
to Mars. An economy’s resources, along with the available science and technology,
limit the candidates for the dollar votes of consumers. Consumer demand has to
dovetail with business supply of goods. So business cost and supply decisions, along
with consumer demand, help determine what is produced.
You·will find it helpful to recall the dual monarchy when you wonder why some
technologies fail in the marketplace. From the Stanley Steamer-a car that ran on
steam-to the Premiere smokeless .cigarette, which was smokeless but also tasteless,
history is full of products that found no markets. How do useless products die off? Is
there a government agency that pronounces upon the value of new products? No such
agency is necessary. Rather, they become extinct because there is no consumer
demand for the products at the going market price. These products earn losses
rather than profits. This reminds us that profits serve as the rewards and penalties for
businesses and guide the market mechanism.
Like a farmer using a carrot and a stick to coax a donkey forward, the market system
devoutness profits and losses to induce firms to produce desired goods efficiently.

OBJECTIVES OF BUSINESS FIRM

1.2 PROFIT MAXIMIZATION

INTRODUCTION
Business Economics is “the Integration of economic theory with business
practices for the purpose of facilitating decision making and forward planning by
management”.
It is the science which deals in the present day business problems. To strength the
revenue and minimize the cost over the activities it is a tool. In solving practical
business problem in the right time and to take right business decision it is playing
main role.
Areas of Business Economics:
1. Theory of Business firm and Entrepreneur.
 10

2. To find and minimize the implicit cost and explicit costs like wages, Commission and
Etc.
3. In order to obtain the economic profit and Super-normal profit.
4. Break-Even Sales and Profit.
5. Measurement of Economic Relationship in demand and returns to Scale
6. Predicting Economic Order Quality, Business Forecasting.

1.1. OBJECTIVES OF BUSINESS FIRM

The main aim of business firm is to reduce the risks and increase the profit
economically. To reduce the risks by unexpected happenings economics theoretical ideas
are useful.

1.2 PROFIT MAXIMIZATION

Profits are the primary measure of the success of any business. It is test of the
economic strength of the firm. Economic theory makes a fundamental assumption that
maximizing profit is the basic objective of every firm. This assumption does not always
true. In practice, the firms may not always try to maximize profits.

This may due to a number of reasons:

1. Achieving Leadership:
Firms often like to become leaders in the respective line of business. They would
rather try to attain industrial leadership at the cost of profits.

2. For Avoiding potential competition:

Firms may restrict the profit in order to discourage other firms from
entering the field and competing with them. In order to avoid potential
competition, the firms may adopt a policy of profit restriction, instead of profit
maximization. This is more so in the case of firms enjoying weak or small
monopoly.

3. For preventing Governments intervention:

The Government attitude towards profit will be different. Maximum profit
May create an impression that the firm is exploiting the consumers and this may
result in the public demand for nationalizing the firm or firms.

4. For maintaining customers goodwill:

In modern business, customer’s goodwill is valued more than anything else. In
order to maintain that, the firms may adopt the policy of restricted profit and low
price for the commodity.

5. For Restraining wage demands:

Higher profit is an indication of ability to pay higher wages by the firms.
Organized trade union advance their arguments on the basis of higher profits
earned by the firm for increasing the wages of laborers, bonus benefit etc.

6. For achieving financial soundness and liquidity:

Some firms may give greater importance to financial soundness and
liquidity, rather than profit maximization.

7. For avoiding risks:

Decision regarding profit maximization may involve risks .Generally,
business managers will avoid taking those risks which may result even in losing their
jobs or losing the image of the firm. The first duty of the business economics is not
profit maximization, but avoiding loss.
SOCIAL RESPONSIBILITIES

The concept of “Social responsibility” in business has assumed importance in

these days. Generally social responsibility has been construed as the social and
 11

economic goals of the business units. The economic responsibility involves efficiency
in production which in turn can be interpreted as utilization of the resources in an
economical way rendering service to the people by efficiently distributing them at the
lowest possible price, and then the firm can achieve its goal of profit maximization.

Social responsibility refers to the “ the intelligent and objective concern for the
welfare of society that restrains individual and corporate behavior from ultimately
destructive activities no matter how immediately profitable and leads to the direction
of positive contribution to human betterment variously as the latter may be defined”

Should business firms assume social responsibilities?

It is quite often argued that assumption of social responsibility by the business
Firms are unwarranted, impossible and it falls beyond the scope of business firms.

The argument for as follows:

 The corporation and business units owe their existence through the statute of
parliament which is representative bodies of the society. So the society
expects the business community to undertake social responsibility.
 The Self interest of the business community will be better served only if it
undertakes the social responsibility.
 If business firms undertake social responsibilities, it may reduce the work of
the state in making business regulations. This will in turn reduce the cost of
the business under regulations will be very expensive.
 The businessmen are citizens of the country and they are expected to use their
corporate power to develop a better society. Hence, the business community
should undertake social responsibility in a bigger and a serious way.

MEANING OF DEMAND:
A desire for a commodity baked by willingness and ability to pay a price.

DEMAND ANALYSIS

Demand means in ordinary language desire and likeness of a product or thing or

services. Alfred Marshall defines; demand means the desire for a commodity backed
by willingness and ability to pay a price.
Assumptions:
a. Consumer Income is assumed to remain the change position.
b. Taste and preference of consumer also assumed to remain the change
c. No Substitute product price affect the consumer wants because such
product price also assumed as constant
d. Other factors (things) also assumed as constant.

DEMAND SCHEDULE:
Demand schedule is a table or statement showing how much of a commodity
is demanded (purchased) in a particular market at a different prices. A demand schedule
thus states the relationship between the price and quantity demanded.
We can understand better the concept of demand schedule of market or
individual consumers by giving examples. The following is an imaginary demand
schedule of a consumer of butter
INDIVIDUAL DEMAND SCHEDULE FOR BUTTER
Price of butter per Kg.in Quantity of butter
rupees demanded in Kgs.per
month
60 1
54 2
48 3
45 4
56 5
30 6
 12

It is clear from the schedule that when the price of butter is at Rs.60, our imaginary
demands just one kg. When the price falls to Rs. 48, he had a demand for 3 Kg s.and
when the price falls further to Rs.30, he could demand 6 Kgs.

Demand diagram and explanation:

As according to the above Demand Schedule Price is recorded in the
Y-axis where Demand for Butter is marked in X- axis.
Wherever the Demand Curve is taken it explains about the combination and relationship
among the price and Demand.
The shape of demand curve is Downward Sloping which begins from
Top and fall to Bottom.

The first price value and firsts time given value of demand is taken and recorded by
proper scaling we taken Intersection point between Rs. 60 and 1 Kg of demand.
Consequently next downward point for 2Kg and Rs.54 price, when in the market price of
butter is fallen to Rs. 30 Demand and ability among New Consumer is growing is Known
Demand. So price and demand contains Inverse Relationship.
The Shape of the curve is also in downward sloping.

DRAWBACKS

1. The law of demand theory practically is irrelevant for Luxurious goods.

2. Consumer taste and preference alters time to time.
3. Modern Advertisement creates the change in the side of consumer.

SUMMARY:
Social responsibility has been construed as the social and economic goals of
the business units. The businessman is citizens of the country and they are expected to
use their corporate power to develop a better society. Demand means the desire for a
commodity backed by willingness and ability to pay a price. Draw backs of demand
theory - the law of demand theory practically is irrelevant for Luxurious goods and
Consumer taste and preference alters time to time.

SUGGESTED QUESTIONS
1. Explain social responsibilities of a businessman.
2. Define Demand.
3. Write a short note on demand schedule.

3.1 LAW OF DEMAND

3.2 ELASTICITY OF DEMAND

LAW OF DEMAND
The Law of Demand indicates the relationship between the price of a
commodity and the quantity demanded in the market. It may be stated as follows
Other things being equal, the quantity demanded extends with a fall in price and
contracts with a rise in price. In simple language it means that a person will purchase
more of a commodity when its price falls and he will purchase less of it when its price
rises.
Marshall defines “The greater the amount to be sold the smaller must
be the price at which it is offered in order that it may find Purchasers, or in other words,
the amount demanded increases with a fall in price and diminishes with a rise in price

ELASTICITY OF DEMAND:

Prof. Alfred Marshall define, “ the Elasticity (or responsiveness) of demand in a

market is great or small according to the amount demanded increases much or little for a
given fall in the price and diminishes much or little for a given rise in price”.
 13

Types of Elasticity of Demand

1. Price Elasticity of Demand

2. Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Advertisement Elasticity of Demand
Elasticity of Demand in all the types expected to be e=1. In which
proportionate change in price or income it is expected to result within the value of 1.

I. Price Elasticity of Demand:

Price elasticity of demand is the ratio of proportionate change in the quantity
demanded of a commodity to a given proportionate change in its price .This means

E= Relative change in quantity demanded

Proportionate change in price

(i) Perfectly Price Elasticity of Demand:

This is a condition in which a very small change in price will result in
infinitely large response in the demand.

E= Delta change in demand

Delta change in price

(ii) Perfectly inelastic demand.

The price of the product only change but the demand would not
change is to be titled as Perfectly Inelasticity of demand. Because the demand for
Prohibited, Dangerous product.

(iii) Unitary price elasticity of demand.

The change in demand will happen equal of change which can happen in the price
negatively. E=1 is the value for Unitary elasticity of demand. A 50% fall in the price or
Add in the price which will create for the result of 50% Addition in the Quantity
demanded is explained as unitary price elasticity of demand.
A fall in the price of Onion from Rs. 10 into Rs.5 which create the change in the
demand from 3Kg. To 6Kg. In consumer demand is called as unitary value in demand.

(iv) Relatively Elasticity of demand:

It means the demand change in less level which can create a more change in
demand. The price of cloth in the market is reduced by 10% which can create for the
change in the Cloth of Raymond mills demand increases due to good product
. Elasticity value is recorded as greater than one.

(V) Relatively inelasticity of demand:

The change in demand should happen while the product priced into minimum
also. For instance product of Handloom made when it is sold in the market for Rs. 10
from the price of Rs.100, the demand for those products doesn’t increase substantially;
but the change in demand can happen less substantial.

MEASUREMENT OF ELASTICITY OFDEMAND:

 14

1. Geometric Method: Elasticity of demand on each point of a demand curve shall be

different and can be measured with the help of the following formula:
Lower segment of the demand curve
Point Elasticity of demand =
Upper segment of the demand curve

At the point of horizontal axis Ed=0, and shall be infinity where it touches vertical
axis. It shall be equal to unit at the central point of the demand curve.

2. Total Outlay Method: Total outlay is defined as the product of the price of a
commodity and the number of units purchased of this commodity. In short,
TQ=pxq where TQ stands for total outlay, p and q for price and quantity
respectively.

i) Less than unit elastic e<1; with a fall in price, total outlay also falls
ii) Unit elastic when total outlay does not vary with change in price of the commodity
e=1
iii) More than unit elastic; Demand is more than unit elastic when with a fall in price,
Total outlay increases. e<1
3. Arc Method: In this method small change in price and quantities is very large
taken into study. The price variation from Rs. 20 to Rs. 30 comparatively taken in
between the demand for goods.
Formula:

Original quantity-new quantity

Elasticity of demand = Original quantity +new quantity

Original price + new price

Original price + new price

Arc elasticity is calculated in between two cutting point in the diagram.

SUMMARY:

The Law of Demand indicates the relationship between the price of a commodity
and the quantity demanded in the market. Elasticity of demand in a market is great or
small according to the amount demanded increases much or little for a given fall in the
price and diminishes much or little for a given rise in price. Types of elastic demands are
Price Elasticity of Demand, Income Elasticity of Demand, and Cross Elasticity of
Demand Advertisement Elasticity of Demand.

SUGGESTED QUESTIONS

PART -A
1. Demand and price contains of -------- relationship (Inverse)
2. In Income demand due to change in ------- studied (Income).
Part -B
3. Define Law of Demand
4. What are the types of Measuring Elasticity of Demand?
5. Define Cob-web.
PART-C
6. Define the types of Price Elasticity of Demand.
7. Define Law of Demand with suitable illustrations.
8. What is meant by demand analysis? Explain the shape of Demand curve and
elasticity.

*****************

Unit II [12 Periods]

 15

Concept and Law of supply - Production function - Factors of production - Laws of

diminishing returns and Law of variable proportions. Cost and Revenue Curves -
Break - even- point analysis.
Definition of 'Law Of Supply'

Definition: Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the price paid
by buyers for a good rises, then suppliers increase the supply of that good in the market.

Description: Law of supply depicts the producer behavior at the time of changes in the
prices of goods and services. When the price of a good rises, the supplier increases the
supply in order to earn a profit because of higher prices.

The above diagram shows the supply curve that is upward sloping (positive relation
between the price and the quantity supplied). When the price of the good was at P3,
suppliers were supplying Q3 quantity. As the price starts rising, the quantity supplied also
starts rising.

LESSON: 1

1.1 PRODUCTION FUNCTION

1.2 FACTORS OF PRODUCTION

1.1 PRODUCTION FUNCTION AND SUPPLY

MEANING:

Production means creation of utilities and not matter. All things we use in this world
come form the nature by the working of man. Production is not complete unless the
product is placed in the hands of the consumer. Hence, all the activities like producing
raw materials, assembling them, transporting, manufacturing, storing, banking, insurance
etc. are all productive activities.

Factors of production:
Production is done with the co - operation of factors of production. The factors of
production are land, labour, capital and organization.

1. Land:
In economics, land as a factor of production has a wider meaning. Besides, the surface of
the earth includes agricultural land, building sites, mines, fisheries, forests, rivers,
underground water, air, sun shines, etc. it also includes animals and cattle. All the natural
resources the country, the waterfalls and valleys come into the category of ‘land’.

2. Labour as a factor of production:

 16

Labour is a primary factor and it is a ‘human factor’. Labour is any work of body or mind
undertaken for a reward, which results in production. As a factor of production labour has
some peculiarities:
1. Labour is undertaken for reward. Any work undertaken for sympathy, affection or
for pleasure is not labour.
2. Labour cannot be separated from laborer
3. Labour is perishable.
4. Labour is both means and ends of economic activity.
5. Laborers differ in their efficiencies. It arises due to racial qualities of labour,
education and training, condition of work, environmental factors.

3. Capital:
It is not an original factor of production. It is produced means of production. All capital is
wealth, but all wealth is not capital. An article of wealth cannot be called capital unless it
is used for further production of wealth. Capital has many-sided functions. It provides
equipment; it provides raw materials for further production. it provides means of
transport and communication. It provides employment.

4. Organization:
The three factors land, labour and capital powerless by themselves. These three factors
have to be gathered, planned, engineered and managed in the production operation. Only
then, production will be possible. Organization, which does this function of coordinating
the factors of production. It may be defined as the factors the factors which starts the
productivity activity by properly coordinating all other factor and successively manages
the business, undertaking all risks out of the activity. The person who undertakes this
work is called as ‘entrepreneur’.

ENTERPRISE:
Enterprise is the fifth factor of production. The term includes organization also, but at the
same time it doesn’t to refer to mere organization. It refers to the enterprising skill and
entrepreneurial activity of the organizer to take up bold ventures risking many things.
Law of diminishing returns:
Introduction:
This law establishes a relationship between input and output and points out that with the
increasing input, output has a tendency to decline under certain circumstances.

LESSON-II

2.1 LAWS OF DIMINISHING RETURNS

2.2 LAW OF VARIABLE PROPORTIONS

Marshall’s definition of law:

Marshall defined the law of diminishing returns as follows: “an increase in the capital and
labour applied in the cultivation of land causes in general a less than proportionate
increase in the amount of the produce raised, unless it happens to coincide with an
improvement in the arts of agriculture.

Let us suppose a farmer having a plot of land measuring 10 acres is interested in

increasing the output from his land by investing more and more capital and labour. Let us
assume that a unit of capital and labour is increased as successive doses result in extra
output. The land is kept as a fixed factor and the input (labour and capital) has been made
a variable factor. There are three types of output:

1. Total output or total returns

2. Average output or average returns and
3. Marginal output or marginal returns.

Labour and capital Output of corn in Average output of Marginal output of

invested (input in units (total output) corn in units corn in units
units)
 17

1. 10 10 10
2. 18 9 8
3. 24 8 6
4. 28 7 4
5. 30 6 2
6. 30 5 0
7. 28 4 -2
8. 24 3 -4

Total return is the total output of corn for the total doses of capital and Labour applied.
Average returns refer to the output per unit of capital and Labour invested. Marginal
returns to the output of corn due to increase in one unit of the input.

In the figure x-axis represents inputs in units of capital and Labour. Y-axis
represents the output of corn in units. TR curve represents total returns, AR represents
average returns and MR represents marginal returns.

Assumption of the law:

1. The law is applicable only if one factor of production is kept constant or fixed. In
the example, land is the fixed factor.
2. The factors of production utilized successively should be identical units.
3. Another important assumption is that the technique of production remains
constant throughout the application of additional doses.

From the diagram there are three curves illustrate two basic facts:
1. Total output at diminishing rate
2. Average and marginal output decrease.

Assumptions:
1. The law is applicable only if one factor of production is kept constant or fixed. In
our example, we have taken a plot measures 10 acres as the fixed factor.
2. The factor of production utilized successively should be identical units.
3. The technique of production remains constant throughout the application of
additional doses.

Causes of diminishing returns:

1. The fertility of the land and the productive capacity of machinery are fixed. If
additional inputs are used, the utilization of land and machinery reach their fullest
capacity.
2. Even fixity of supply of one factor would not be a problem if one of the variable
factors were a perfect substitute.
 18

Law of increasing returns:

Marshall has defined the law,” an increase of Labour and capital leads generally to
improved organization, which increases the efficiency of the work of Labour and
capital. Therefore, in those industries which are not engaged in raising raw produce,
an increase of Labour ad capital generally gives a return increase more than in
proportion, and further this improved organization tends to diminish or even over ride
and increased resistance which nature may offer to raise increased amounts of raw
produce”.

The points to be noted about the law are as follows:

1. The tendency to increasing returns is due to the improved organization
2. The increasing returns need not necessarily operate only in industries. It can
operate in any field of productive activity including agriculture and industries
producing raw materials.
3. If an increase in the quantities of factors of production leads to the improvement
of the organization efficiency, then the law of increasing returns will definitely
operate. When the organization efficiency remains unchanged then, the law will
not operate.

Example:
It states that as more of Labour and capital is invested in an industry, the marginal
returns go on increasing. The following table illustrates the point: in a factory
manufacturing cloth:

Doses of Labour and capital Marginal returns Total production

(Labour and capital) (metres of cloth) (metres of cloth)
First 1,000 1,000
Second 1,500 2,500
Third 2,000 4,500
Fourth 2500 7,000
Fifth 3,000 10,000
From the table it is clear that the marginal returns are getting increasing. It can
be represented in the graph:

The IR curve drawn in the diagram indicates the working of the law of increasing
returns. The increasing returns as pointed earlier, is also known as law of decreasing
returns. More than a proportionate increase in output accompanies every increase in
the doses of labour and capital. As a result, the cost per unit goes on diminishing.

Causes of increasing returns:

1. The first reason is that the indivisibility of factors of production.
2. It arises out of division of labour and specialization
 19

3. It is due to the internal and external economies.

LAW OF VARIABLE PROPORTION:

The level of output of a firm depends on the combination of different factors, viz.,
land, labour, capital and organization. The factors whose quantities are given and kept
fixed are called fixed factors, while those supply can be easily changed are called as
variable factors. The law, which brings the relationship between one variable factor
and output, keeping other factors fixed, is called the law of variable proportions.

Three stages of the law:

Stage I: in this the total product increases at an increasing rate. The TP increases
sharply up to the point F. afterwards beyond F, the TP increases at a diminishing rate,
as the marginal product falls, but is positive. The point F where the TP stops increases
at an increasing rate and starts increasing at a diminishing rate is called as point of
inflexion.

Stage II: in this stage the TP continues to increase but at a diminishing rate. But at a
point of S where it completely stops to increase. This is called as the stage of
diminishing returns.

Stage III: the TP declines and the curve slop downwards. This stage is called the
negative returns stage.

Law of constant returns:

The law of constant returns is said to operate when the total output increases exactly
in proportion to the increase in the factors of production. If two factors C and L are
required for the manufacture of a product P and C + L result in P, then according to
the law 2C + 2L will result in 2P. The productive factors are increased to get an
exactly proportional output.

Production function:

In modern terminology, the various factors like land, Labour, capital, organization
skill, raw materials and other factors made use of in production are called as inputs.
The products realized due to the inputs is called output. Production is a process in
which the physical inputs are transformed into physical output. The functional
relationship between physical inputs and physical outputs of a firm is known as
production function.

The production function can be algebraically expressed in an equation in which the

output is the dependent variable and inputs are the independent variables. The
equipment can be expressed as: q= {a, b, c, and d ….n}
 20

Production functions through ISO – QUANT curve:

In production function, the indifference curve technique is made use of in finding out
producer’s equilibrium. In this field, it assumes the name ‘equal product curve’ or iso
– quant curve. This equal product curve shows different combination of two factors of
production; let us say Labour and capital which are capable of producing the same
output. The particular combination selected by the producer in he equal product
curve, depends upon the relative prices of the two factors of production.

When the producer combines Labour and capital to produce a commodity, he will do
it in such a way that he produces the maximum with minimum cost. In the diagram,
units of Labour and units of capital are shown on X axis and Y-axis respectively. Ic
drawn is the indifference curve relating to the production. This curve relates to an
output of 100 units of the commodity produced. Any factors of production on this
curve will yield the same result i.e. production of 100 units.

The equilibrium point shown in the curve depends on the price of capital and Labour.
If the price of capital in terms of Labour is cheap, then the equilibrium point will be
K1 where the producer will use more units of capital and less units of labor. The price
line BA denotes the price relationship between Labour and capital. This line is called
the factor price line. When Labour in terms of capital becomes cheaper, the producer
moves to a new equilibrium point K2 and more units of Labour and less units of
capital. Consequent on the fall in the price of Labour, the factor price line shifts to
the position B1A1, and it is tangible to the equal product curve at K2.

With the fall in the price of Labour, the producer has substituted more units of Labour
in the place of capital to produce the same quantity of the product, i.e. 100 units. In
this manner the producer can find out his most advantageous point in production in
combining different factors of production.

LESSON-III

ECONOMICS OF SCALE
COST AND REVENUE CURVES.
BREAK EVEN POINT ANALYSIS

3.1 ECONOMICS OF SCALE:

The scale of production:

Large scale of production offers certain advantages, which help in reducing the cost
of production. Economics arising out of large-scale production can be grouped into
two categories:
1. Internal economies
2. External economies

Internal economies are those economies of production, which accrue to the firm
when it expands the output. These economies arise within the firm and help the firm
only.
 21

External economies are the benefits accruing to each member firm of the industry as
a result of the expansion of the industry.

Internal economies of large-scale production:

It can be classified as follows:

1. Labour economies:
Division of Labour and consequent affords definite advantageous to the producer
when he producer on a larger scale. Quality of the product is bound to increase as
the firm can afford to employ ‘specialists’ in every branch of operation.

2. Technical economies:
1. Large-scale producers can introduce up – to date machines and there by
increase the productivity of Labour. it can utilities the full capacity only
when large scale production is carried on.
2. Under technical economies, the producer can have the benefits arising out
of experiments and research.
3. Utilization of by – products in large-scale operation is another advantage
of large-scale production.

3. Marketing economies:
1. The large-scale producer has better bargaining power in buying as well as
in selling. In buying the raw materials, he can slice off the prices by
effective bargaining and but the raw material sat cheapest market.
2. Economics of freight are another advantage to large-scale producers. They
can bargain effectively.

4. Managerial economics:
Large-scale production gives the benefits of managerial specialization by creating
departments entrusting to each particular item of work such as ‘purchase’,
‘stores’, ‘selling’, etc.

5. Financial economics:
Big firms command better financially footing not available to small-scale
producers. They can borrow at any time at a favorable rate from the public by way
of shares.

External economics:
External economics are the benefits accruing to the industry as a whole because
all the firms of the industry share its growth and benefits. Such economics include
specialized transport facilities, other commercial facilities and banking facilities.

Supply and elasticity of supply:

Meaning of supply:

The term ‘supply’ means the amount of goods offered for sale per unit of time.
Supply means the commodity offered for sale at a price. It is defined as “how
much of goods will be offered for sale at a given time.”
Supply schedule:
Supply of different quantities placed on the market at different prices is
mentioned with the help of a schedule called supply schedule. The supply
schedule represents the functional relationship between the quantity supplied and
the prices.
Supply schedule of a commodity X
Price in Rs Quantity
supplied in units
3 40
4 50
5 60
6 75
7 90
 22

LAW OF SUPPLY:

From the above table we can understand that when the price is the highest i.e.
Rs.7 per unit the supply is maximum i.e. 90 units and when the price falls to Rs.
3, the supply get contracted to 40 units. The law of supply states that other things
being constant; the price of a commodity has a direct influence on the quantity
supplied. As the price of a commodity rises, its supply is extended, as the price
falls, its supply is contracted.” Large quantities are supplied at higher prices and
small quantities are supplied at lower prices.

SUPPLY CURVE

Determinants of supply and assumptions of supply schedule:

1. Number of firms or sellers:
Supply depends on the number of firms or sellers producing and selling in
the market. When the sellers are few, the supply will be small. If they are
in large numbers, the supply will also be large.

2. State of technology:
It is assumed that the level of technology of production remains constant.

3. Cost of production:
The cost of production is an important concept that will affect the supply and this
is assumed to remain constant.

4. Prices of related goods:

It is assumed that the supply of a commodity depends on the prices and not the
prices of other commodities relate to it. If the prices of related products fall, the
firm producing many goods may increase the supply of a particular product even
though its price has not gone up.

5. Natural factors:
It is assume that the there is no change in the natural factors, as the supply is
governed by natural factors like rain, drought.
6. Labour trouble:
It is assumed that there is no Labour trouble and consequent strike or lock out
reducing the quantity of supply.

7. Change in government policy:

Any change in the government policy will affect the supply. A fresh tax or
levy of excise duty on a commodity will affect the price of the commodity and
as a result the supply will get affected.

ELASTICITY OF SUPPLY:

It measures the adjustability of supply to prices. This is expressed as the ratio between
proportionate changes in the quantity supplied and proportionate change in the price. The
formula:
 23

Es = proportionate change in quantity supplied

Proportionate change in prices

Example:
Suppose the price of a commodity X increase from Rs. 2,000 per unit to Rs. 2,100 per
unit and consequently the quantity supplied rises from 2,500 units to 3,000 units. The
elasticity of supply will be as:

INELASTIC SUPPLY:

3.2 COST AND REVENUE

INTRODUCTION:

The term cost of production means expenses incurred in the production of a commodity.
This refers to the total amount of money spent on the production of a commodity. The
term cost of production may be used in three different senses:

1. Money cost
2. Real cost
3. Opportunity cost

Money cost of production:

According to the accountants the money cost of production includes those costs whish are
directly paid out or accounted for by the producer. Wages, interest, rent, depreciation
charges on fixed capital, taxes paid and other sundry expenses come under the cost.
These are called as explicit cost of production. Some more items in addition to the above,
they are wages for the work performed by the entrepreneur, interest on the capital, and
rent of land and buildings belonging to the producer, they are called as implicit cost of
production. The term cost of production includes both implicit and explicit.

Economic cost = explicit costs + implicit costs

The firm will be earning economic profits only if it is making revenue in excess of the
total of accounting cost and implicit costs.

Economic profit = total revenue – economic costs.

 24

Real cost of production:

Marshall defines the real cost as follows: “ the exertions of all different kinds of labour
that are directly or indirectly involved in making it together with the abstinence or rather
waiting required for saving the capital used in making it”. The money paid fro securing
the factors is the real cost. The efforts and sacrifices of the factors or its owners is the real
cost.

Opportunity cost:

It depends on the sacrifice of alternative product that has been produced. This means that
the “cost of using something in a particular venture is the benefit foregone by not using it
in its best alternative use”.

Fixed cost and variable cost:

The inputs or factors of production used by a firm can be divided into two classes. Some
inputs can be used over a period of time for producing more than one batch of goods. The
fixed capital of the firm, e.g. equipment, machinery, land, building comes within this
class. The costs incurred in these are called as fixed cost. There are other inputs, which
are exhausted by a single use, e.g. raw materials, fuel, etc. The costs incurred in these are
called variable costs.

The total cost is the sum of its variable cost and fixed cost of a particular level of output.
Thus,
TC = TFC + TVC
The total cost will increase with the increase in the output. The total variable cost will
also increase with increase in output. The total fixed cost will be constant whatever be the
output. The diagram below will illustrates the behavior of the different costs mentioned
and the relationship between them.

TC = TOTAL COST
TVC = TOTAL VARIABLE COST
TFC = TOTAL FIXED COST
Short run and long run:
The short run period is increasing the variable input can have a time in which output can
be increased or decreased by changing only the amount of variable factors such as labour,
fuel, raw materials, etc. in the short run an increase in output. But the output in the short
run cannot be increased beyond the capacity of the equipment and machines. Thus, in the
short run period only the variable cost will change. In the long period new equipment,
machines can be installed and the capacity of production can be increased. The factory
would become bigger in size. So, the distinction between the fixed cost and variable cost
can be made only in short run. In the long run period all the costs become variable.
 25

From the figure we can see that the total fixed cost curve starts from a point on the y-axis.
This means that the fixed cost will be incurred even if the output is zero. The curve
indicating TVC rises as the firm’s output increases since larger outputs require larger
quantities of variable factors.

AVERAGE FIXED AND VARIABLE COST (SHORT RUN):

The concept of costs has more significance only in the context of per unit cost of
production rather than total costs.

1. Average fixed cost (AFC):

It is the total fixed cost divided by the number of units of output produced. It can
be stated as AFC = TFC / Q

Where q represents the number of units of output produced.

2. Average variable cost (AVC):
It refers to the variable cost per unit of output. It is the variable cost divided by the
number of units of produced. Therefore,
AVC = TVC / q

3. Average total cost (ATC):

It is the sum of average fixed cost and the average variable cost.
ATC = AVC + AFC

From the figure it is clear that the behavior of ATC curves depends upon the
behavior of AVC and AFC curves. In the beginning both AVC and AFC curves is
falling steeply, the ATC curve continues to fall. Because during this stage the fall
in AFC is heavier than the raise in more than offsets the falls in AFC. Therefore,
the ATC curves rises after a point. The ATC curve like AVC curve falls first
reaches the minimum value and then rises. Hence it has taken a U shape.

MARGINAL COST:
 26

Marginal cost can be defined as the addition made to the total cost by the
production of one additional unit of output. This means marginal cost is the
addition to the total cost of producing n units instead of n-1 units where n is any
given number.
Suppose the total cost of producing 9 units is Rs. 450 and the total cost of
producing 10 units is Rs. 510 then the marginal cost is Rs. 60. By increasing the
output from 9 units to 10 units the marginal cost incurred is Rs. 60. Symbolically,
we may denote it as:

MCn = TCn – TC (n-1)

The figure, which shows the marginal cost, shows that the marginal cost declines
first and afterwards increases which gives the U shape.

Concepts of revenue:
The amount of money, which the firm receives by the sale of its output in the
market, is known as its revenue.

Total revenue:
It refers to the total amount of money that the firm receives from the sale of its
products. It is the gross revenue realized by the firm in selling the output. The
total revenue can be calculated by multiplying the quantity of output by the price
per unit over a period of time.
TR = q.p
TR = total revenue
q= quantity
p = price per unit of the commodity

Average revenue:
It is the total revenue divided by the number of units sold. So as to give the
average revenue per unit sold. AR = TR / q

Marginal revenue:
It is the change in total revenue resulting from an increase in sale by an additional
unit of the product in a particular time. It is an increase in total revenue by selling
one more unit of the commodity. MRn = TRn –TRn-1

3.3 BREAK – EVEN ANALYSIS:

Meaning:
Break – even analysis of cost, revenues and sales of a firm and finding out the
volume of sales where the firm’s costs and revenues will be equal. The break-even
point is that level of sales where the net income is equal to zero. The break-even
point is the zone of no profit and no loss as the costs equals revenues. Its objective
is to create an understanding and relationship between costs, revenues and output.

DETERMINATION OF BREAK – EVEN POINT:

It can be found in two ways:
 27

(i)BEP in terms of physical units:

This method is convenient for a firm producing a single product. The BEP
is the number of units of the commodity that should be sold to earn
enough revenue just to cover all the expenses of production. The firm does
not earn any profit, nor any loss. It is meeting point of total revenue and
total cost curve of the firm.

Output in units Total revenue Total fixed cost Total variable Total cost
Price Rs.4 per cost
unit
0 0 300 0 300
100 400 300 300 600
200 800 300 600 900
300 1200 300 900 1200
400 1600 300 1200 1500
500 2000 300 1500 1800
600 2400 300 1800 2100

Total revenue and total cost and BEP (selling price Rs.4 per unit):
Some assumptions are made in illustrating the BEP. The price of the
commodity is kept constant at Rs. 4 per unit. The total fixed cost is kept constant at
Rs.300 at all levels of output. The total variable cost is assumed to be increasing by a
given amount throughput.

From the above table, when the output is zero the firm incurs only the
fixed cost under total cost. When the output is 100 the total cost is Rs.600 (TFC+TVC).
The total revenue at that level of Output is Rs.400. the firm incurs a loss of Rs.200.
similarly when the output is 200 the firm incurs a loss of Rs.100. at that level of output of
300 units, total revenue is equal to total cost (Rs.1200). At that point the firm is working
at a point where there is no loss or profit. This is break even point.
 28

ALTERNATIVE METHOD

This is by means of formula. We adopt average revenue and average cost instead of total
revenue and total cost. The BEP is that level of output at which the price of the product
covers the average cost. The price should be sufficient to cover not only the variable cost
but also some extend of fixed cost. The excess of selling price over average variable cost
goes towards meeting some portion of the fixed cost. This excess is called as contribution
margin. So, the BEP is

BEP = total fixed cost

Contribution per unit.

(ii) BEP in n terms of sales value:

The BEP in terms of physical output is suitable only in the case of single product
firm. If the firm is producing many products, the BEP can be approached only in terms of
money value or total sale vale.

Usefulness of break-even analysis:

1. Safety margin:
It helps the management to find at glance the profit generated at various levels of
output. The safety margin refers to the extent to which the firm can affords a
decline in sales before it starts incurring losses. It tells the minimum increase in
sakes to reach BEP and avoid loss.

Safety margin = (sales – BEP) X 100

Sales

2. Target profit:
It will help the management in finding out the level of output and sales in order to
reach out the target of profit fixed.

Target sales volume = fixed cost + target profit

Contribution margin percent

3. Change in price:
In the competitive world, the firm will be faced with the problems of taking
decisions regarding reduction process fro the commodity. The management has to
consider many points in reducing the prices. The BEP helps in calculating the new
volume of sales if the process is reduced or increased.

LIMITATIONS OF BREAK – EVEN ANALYSIS:

1. It is static in nature.
2. Projection of future with the past is not correct.
3. The profits are functions of not only output but also other factors like
technological change etc.
4. The assumptions that cost – revenue output relationship is linear are true not
only over a small range of output.
 29

SUGGESTED QUESTIONS:

1. What is a production?
2. Explain the types of cost in production.
3. Explain the following laws:
a) Law of diminishing returns.
b) Law of increasing returns
c) Law of constant returns
d) Law of variable propositions
4. What is supply? Explain the law of supply.
5. What is marginal revenue and marginal cost?
6. What is break – even analysis?
7. Explain the production through ISO – quant curve.
8. How to determine of BEP?
9. What is the total cost? How to calculate it?
10. Explain the factors of production.

**************

Unit III [12 Periods]

Market structure and prices - Pricing under perfect Competition - Pricing under
Monopoly – Price discrimination - Pricing under Monopolistic competition -
Oligopoly.
 30

LESSON: 1

1.1 MARKET STRUCTURE AND PRICES

1.2 PRICING UNDER PERFECT COMPETITION.

INTRODUCTION
Market is a place where buyers and sellers gather in order to buy and sell a
particular good or commodity.
In the words of Chapman,” the term market refers not necessarily to a place but always to
a commodity and the buyers and sellers who are in direct competition with one another”.
Features of market:
1. Commodity: the market must have a commodity. Without the commodity, the
existence of the market is impossible. Each commodity should have a separate
market.
2. Competition: another feature of the market is that there must be a competition
among the buyers and sellers. Every seller wishes to sell the commodity at higher
price while the buyer wishes to buy at lower price.
3. Area: by market, we do not mean a particular region where buyers and sellers can
collect the commodity. For example: ‘lux’ has its market all over India. It can
cover the whole world.
4. Existence of buyers and sellers: there should be sellers to sell the products and
buyers to buy the products.

CLASSIFICATION

Generally the determination of price and output depends on the type of the market. The
types are:
1. On the basis of area:
The area of the market can be classified as:
a) International market:
When commodities are sold all over the world, they are said to have international
market.
b) National market:
If the buyers and sellers do not extend the commodity beyond the political
boundaries of nation, the commodity is said to have national market or home
market.
c) Local market:
If the commodity is sold within a small or local area only, it is said to have local
market.

2. On the basis of time:

On the basis of time, a market can be classified into four types as:
a) Market price:
The price that prevails in the market price is called market price. In this market,
time is too short for firms to increase the supply.
b) Short period:
The price that prevails in the short run is called short run price. Here the
production can be increased only by the effective utilization of resources.
c) Long period:
The price, which prevails in the long run, is called long run price, normal price or
regular price. In such a period, existing firms can install new capital equipment
and new firms can enter the market.

d) Spot period:
If goods are exchanged on the spot, it is called spot market. If a transaction to buy
and sell for foreign exchange is made on spot, is called spot market.

3. On the basis of competition:

On the basis of competition a market may be of following types:

a) Perfectly competitive market:

A perfectly competitive market is said to exist, when there is large
number of producers producing the homogeneous product. The price prevails in
 31

the market is known to all buyers and sellers. Since, there are many firms in the
industry producing homogeneous product; no individual firms can influence the
price of the product.

Features of perfect market:

1. Free and perfect market: there are no checks on buyers and sellers. They are
free to buy and sell
2. Large number of firms: a product is produced and sold by large number of
firms. Since, there are large number of firms therefore each firm is supplying
only a small part of the total supply.
3. Large number of buyers: in this market there is large umber of buyers each
demanding a small part of the total market supply of the product.
4. Homogeneous product: all the firms produce and supply the identical
products. They are perfect substitutes to each other.
5. Free entry and exit: there is no restriction on the entry of new firms into
market.
6. Prefect knowledge: no buyer or seller is ignorant about the price prevailing in
the market.
7. No selling costs: as products are homogeneous, so there is no need incurring
expenses on advertisement and salesmanship.
8. Perfect mobility of factors of production: the factors of production are
completely mobile leading to factor price equalization throughout the market.

b) MONOPOLY:
It is a market situation in which there is a single seller of the
commodity having full control over the entire market. There are no close
substitutes available of the commodity. Since, under monopoly there is only seller
of the commodity, there is no difference between firm and industry.

Features:
1. Single seller and large number of buyers: there is sole seller of a commodity
and he has full control over the supply of the product.
2. No difference between a firm and an industry: the firm itself is an industry.
There is no difference between the firm and industry.
3. No close substitutes: the monopoly has the power to influence the price of the
product because he has control over the supply.
4. Barriers on the entry of new firms: there are strong barriers on the entry of
new firms in the industry because if a firm enters the market, monopoly ceases
to exist.
5. Producer is the price maker: the producer has the power to influence the price
of the commodity because of his control over the supply.

c) Imperfect competition:
It is an important market category where the individual firms
exercise their control over the price to a smaller or larger degree. It is also called
as
“Monopolistic competition” – given by Prof. Chamberlin. Under imperfect
competition, there are large number of buyers and sellers. Each seller can follow
its own price – output policy. Each producer produces the differentiated product,
which are close substitutes of each other.

Features:
1. Large number of sellers and buyers: there are large numbers of firms in the
marker. All the firms are small sized. It means that each firm produces or sells
such an insignificant portion of the total output or sale that it cannot influence
the market price by its individual action.
2. Product differentiation: the product of each seller may be similar but not
identical with the product of other sellers sin the industry.
3. No selling costs: since there is product differentiation and products are close
substitutes selling cost is important.
4. Free entry and exit of firms: there is free entry to join to the industry and leave
the industry at any time.
5. Price makers: each firm is a price maker as it can determine the price of its
own brand of the product.
 32

6. Blend of competition and monopoly: in this market, each firm has a monopoly
power over its product as it would not lose all customers if it raises the price
as its product is not perfect substitutes.

d) OLIGOPOLY:
It is a market situation in which there are only sellers of a commodity.
Under this, each seller can influence its price- output policy. It is because the number
of sellers is not very large and each seller controls a big portion of total supply. Price
output of a firm does affect the rivals. The price, which is fixed under oligopoly
without product differentiation, is indeterminate.

Features:
1. Monopoly power: there is an element of monopoly power in oligopoly. Since,
there are only few firms and each firm has a large share of the market.
2. Interdependence of firms: there is interdependence of firm. No firm can ignorant
the actions and reactions of rival firms.
3. Conflicting attitude of firms: the firm comes into clash with one another on the
question of distributing of profits and allocation of market.
4. Few sellers: only few sellers are found.
5. no product differentiation:
6. Large number of consumers: there are large numbers of buyers to demand the
product.

Price output determination under perfect competition:

Definition of perfect competition:

According to boulding, “perfect competition market is a situation where
large number of buyers and sellers are engaged in the purchase and sale of identically
similar commodities, who are in close contact with one another and who buy and sell
freely among themselves”.

Price determination under perfect competition:

Prof. Stonier and Hague have correctly remarked, “The only really
accurate answer to the question whether it is supply or demand which determines price is
that it is both”.

1. Total demand: a fall in price induces the existing to buy more commodities and
rise in price leads to reduction in quantity demanded.
2. Total supply: it means the quantity offered for sale by producers. A rise in price I
price leads to an increase in the quantity offered for sale, and fall in price reduces
the quantity offered for sale.

Equilibrium between demand and supply:

Equilibrium between demand and supply is obtained by the interaction of

these two forces. It is explained through this table.

Price Demand Supply

5 12 1
10 10 2
15 8 4
20 6 6
25 4 8
30 2 10
35 1 12

Diagrammatic presentation:
Form the table at price Rs.20 the quantity demanded and quantity
supplied are equal to each other. Thus, at price Rs.20 will be settles down in the market
where both the buyers and sellers are satisfied. Now suppose the price is Rs.25 prevails in
the market, the buyers would demand only four units while the sellers are ready to supply
8 units. For this the sellers will compete with each other to sell more units of commodity.
 33

This process will continue, till the equilibrium price is reached. On the other hand, if the
price falls below equilibrium level say Rs.15 the buyers will demand 8 units and the
sellers will be ready to supply 4 units.

Form the figure, DD is the demand curve, SS is the supply curve. Demand and supply are
in equilibrium at point E where both curves intersect each other. Here the output is OX1
and the price is OP. now, suppose the price is greater than the equilibrium price i.e., OP2.
At the price quantity demanded is P2D2 while the quantity supplied is P2S2. Thus, D2S2
is the excess supply.

CHANGE IN EQUILIBRIUM:
a) Effect of shift in demand:
Demand changes wherever there is a change in the conditions of demand –
income, tastes, prices of substitutes and complements etc. if demand increase due to a
change in any one of these conditions the demand curve moves upwards to the right. If it
decreases demand curve moves downwards to the left. The effect is that an upward shift
in the demand curve causes the price to rise. A downward shift of the demand causes the
price to fall. Thus, we can conclude that if the supply conditions are given then there is
direct relation between demand and price.

b) Effect of shift in supply:

An increase in supply is represented by a shift of the supply curve towards to the
right and a decrease in supply is represented by a shift to the left or upward. The general
rule: if the supply increases, price falls and if the supply decreases price rises.
 34

TIME ELEMENT IN THE THEORY OF PRICE DISCRIMINATION:

Time element is an importance element in the theory of price. Prof. Marshall has divided
the time on the basis of supply rather than demand.

CLASSIFICATION OF TIME ELEMENT:

a) Market price:
Very short period refers to the type of competitive market in which the
commodities are perishable and supply of such commodities cannot be changed at all.
Example: vegetables, fruits, milk and milk products such as butter etc. The supply of
these commodities is fixed.
b) Short period:
It is much different form very short period except that the commodities in
question are not perishable but durable though of a short duration than capital. the supply
of the commodities is more capital equipment cannot be used and production of a
greater output is possible, only by an intensive use of existing capital. However, a
maximum limit beyond which output cannot be increased.
c) Long run:
Adam Smith as “natural price” calls it and Marshall called it as normal price. In
the short period the influence of demand is greater than supply. While in the long run
influence of supply is greater than demand. The long price of the commodity may be
higher than or lower than or equal to the original market price according as the industry is
subject to increasing, decreasing, or constant costs.
d) Secular price:
Marshall also talked of secular or very very long period. During this period all
underlying economic factors such as the size of population, supplies of raw materials,
general conditions of capital supply etc., have time to alter.

DETERMINATION OF EQUILIBRIUM PRICES:

1. MARKET PERIOD PRICE DETERMINATION:

Dr. Marshall has divided the determination under market price into two
categories:

a) Perishable goods:
It refers to those goods, which perish very quickly. In simple terms, which cannot
be stored for some time are called the perishable goods. If demand increases the supply
cannot be increased so quickly. Form the figure, SS is the supply curve. It shows that the
supply is fixed. DD is the demand curve. Thus, the equilibrium point is at E. now suppose
in the short period demand increases and assumes the form of D2D2. It shows if the
demand increases the price also increases.
 35

b) Durable goods:
Durable goods are those, which can be reproduced, or those can be stored. Like
perishable goods, the supply of durable is not vertical throughout the length. Firm selling
such goods has reserve price. They will not sell the goods less than reserve price. MPS is
the market period supply curve where OQo is the stock of the commodity. To start with
the demand for the commodity is shown by D1D1 where the price is OP1 and the
quantity supplied is OQ1. Q1Q0 stock will be held back. If the demand is DoDo the
whole stock will be sold out at OPo price. But incase the demand is D2D2, the
equilibrium will be at E2 and the price will be OP2 where the entire output is sold.

2. Short period price determination:

The figure depict that DD is the demand curve, SRS is the short run supply curve.
OP is the market price. When the demand increase to D1D1 and the industry is in
equilibrium at point E1, which determines the price OP1. The new price is less than the
new marker price OH. On the other hand is the demand falls the new equilibrium point is
at E2 and the price is OP2. At the price P2 the firm cannot incur the Average cost and
incur losses.

3. Determination of long period normal price:

Normal price is that price which tends to prevail in a market when full time is
given to the forces of demand and supply to adjust them. The total supply will increase
and all producers will get normal profits only. If supply is more than demand than they
will incur loss. Thus the total supply will decrease and again the price all rises to normal
level.
 36

Normal price and laws of returns:

a) Normal price and law of increasing returns:
According to this law, when production is increased in the long run, industry
enjoys several economies of scale. Form the figure SS is the supply curve which slopes
downwards. Suppose DD demand curve intersect SS at point E. when demand increases
by D1D1 the price will fall to OP1. Thus the normal price would fall if demand increases
and rise if demand falls.

v) Normal price and law of diminishing returns:

According to this law, the normal price would rise if demand increases and fall if
demand decreases.

c) Normal price and law of constant returns:

If an article is produced under normal costs, normal price remains the same
irrespective of a rise and fall in demand.
 37

Comparison between the normal price and market price:

S.No Market price Normal price

1 Supply cannot be increased or
decreased in very short period.
So, the demands play a vital role
in market price determination.
2 It is temporary
3 It can be less than or more then
the average cost of production.
4 The producer can enjoy super
profits if the market price is more
than average cost. He may bear
loss if it less than average cost
5 It the price which actual prevails
in the market
6 It is both reproducible and non
reproducible
7 It change continuously
Supply plays a vital role in the
normal price determination.
It is permanent
It remains equal to the cost of
production.
The producer always gets the
normal profits.
It is a imaginary at which goods are
not sold or bought
It can be only in case of
reproducible.
It is always stable

SUMMARY:

Market is a place where buyers and sellers gather in order to buy and sell a particular
good or commodity. Market classified On the basis of area, On the basis of time and On
the basis of competition. Oligopoly is a market situation in which there are only sellers of
a commodity. Under this, each seller can influence its price- output policy. Perfect
competition market is a situation where large number of buyers and sellers are engaged in
the purchase and sale of identically similar commodities, who are in close contact with
one another and who buy and sell freely among themselves.

SUGGESTED QUESTIONS
1. Define Market
2. State the method of pricing under perfect competition?
3. Describe the features of perfect market?
4. Define Oligopoly
5. Distinguish between market price and normal price
6. Explain in detail price determination under perfect competition?

LESSON: 2

2.1 PRICING UNDER MONOPOLY

2.2 PRICE DETERMINATION

INTRODUCTION

MEANING OF MONOPOLY:
According to McConnell, “pure or absolute monopoly exists when a single firm is
the sole producer for a product for which there are no close substitutes”.
Kinds of monopoly:
1. Private and public monopolies:
When the monopolistic control exists in the hands of private sector we can call it
as private monopoly. If the state controls the production and pricing of the commodity, it
is called public or state monopoly.
2. Pure monopoly:
It exists only in public sector. Production of particular commodity will be the
privilege of state or state sponsored undertaking. Ex: Indian telephone industry.
3. Simple monopoly:
In this the single producer produces a commodity having only a remote substitute.
4. Discriminating monopoly:
He can change the price of the goods for different customers. He has not only the
power to fix the price but also to change form customers to customers.
 38

Determination of price and equilibrium under monopoly:

It would be a mistake to suppose that the monopolist will always push up his price
higher and higher. If he does so, the demand will decrease and he cannot compel the
customers to buy more. He can have the control over the supply and leave the price to be
decided by the customers or fix the price and leave the quantity to be decided by the
customers. Form the figure the monopolistic cannot for example fix the output at OM and
expect to be able to well it at price K2M2 per unit. If he decides the price at K2M2 he
automatically fixes the output at OM2.

Short run equilibrium under monopoly:

It refers to that period in which the monopolist has to work with a given existing
plant. Three possibilities are descried:
1. Super normal profits:
If the price determined by the monopolistic is more than AC, he gets super normal
profits. Form the figure, output is measure in X axis and price on Y axis SAC and SMC
are short run average cost and marginal cost curves while AR and MR are the marginal
revenues and average revenue curves. At equilibrium point both the conditions of
equilibrium are satisfied i.e., MC= MR and MC intersects the MR curve form below. At
this level the producer produces OQ1 level of output and sells it at CQ1 which is more
than AC DQ1. Therefore in this case total profits of the monopolist will be equal to
shaded portion area ABCD.

2. Normal profit:
He enjoys the profit when AR=AC.
 39

3. Minimum loss:
In the short run, the monopolist may incur loss. This situation occurs if in the
short run price falls below the variable cost. In other words, if price falls due to
depression and fall in demand, the monopolist will continue to produce as long as price
covers the average variable cost.

Long run equilibrium under monopoly:

It is the period in which changing the factors of production can change output. In
other words all variable factors can be changed and monopolist would choose the plant
size, which is appropriate for the demand. Here the equilibrium can be attainted only
when the long run marginal cost cuts MR form below.

Monopoly equilibrium and laws of costs:

The decision of the equilibrium depends on the elasticity of demand and effect of laws of
costs:
1. Nature of elasticity of demand:
If the demand is inelastic, the monopolistic will fix high price of his product.
Inelastic refers to the situation in which the consumers must have to buy the commodity
what ever may be the price. On the other hand, if demand is elastic, the monopolist will
fix the low price per unit.

2. Effect of law of costs:

a) Increasing costs:
If the monopolist produces the goods under law of diminishing returns, he will get
the maximum profit at point E where the marginal revenue is equal to marginal cost.
 40

b) Diminishing costs:
Here AC and MC are falling. The MC and MR are equal at point E.
accordingly; the monopolist will produce OM units of commodity and sell the same at
PM Price. His net monopoly revenue will be PQRS.

c) Constant costs:
Form the figure; the AC curve will be horizontal line running parallel to OX and
for all level of output. The producer will produce OM and sell it at PM Price and the
profit will be PERS.

Difference between monopoly and perfect competition:

1. Output and price:
Under perfect competition price is equal to marginal cost at the
equilibrium output. Under monopoly, the price is greater than average cost.
2. Equilibrium:
Equilibrium is possible only when MR=MC and MC cuts the MR form below.
But under monopoly, equilibrium can be realized whether MC is rising, constant
or falling.
3. Discrimination:
A monopoly can change different prices form the different groups of buyers. But
in the perfect competition, it is absent.
4. Supply curve of firm:
Under perfect competition, supply curve can be known. It is so because all firms
can sell desired quantity at the prevailing price. Moreover, there is no price
discrimination. Under monopoly supply curve cannot be known.
5. Long run profits:
In perfect competition the firms in the long run can earn only normal profits. In
the short run they may earn super profits. But in monopoly firms in short or long
run it earns super normal profits, as there is no question of new firms entering and
competing.
 41

PRICE DISCRIMINATION:
MEANING:
It means the practice of selling the same commodity of different prices to different
buyers. Under the monopoly, the producer usually restricts the output ands sells it at a
higher price, thereby making a maximum profit. If the monopolist charges different
prices form different customers for the same commodity, it is called price discriminating
or discriminating monopoly.

Types of price discrimination:

1. Personal discrimination:
In this case, the producer will charge the price form different customers on the
basis of their ability to buy. Rich customers will be asked to pay more and poor
customers will be asked to pay less. This is possible in case of the specialized
personal services of doctors and lawyers. If it is a commodity, the discrimination
will not be done openly but in disguised manner.
2. Place discrimination:
Monopoly having different markets in different regions may charge different
prices for the same commodity in the different regions or localities. The locality
in which market is situated will be the criterion in fixing up the price. Supposing a
monopolist has a shop in an aristocratic locality and also in a slum. He will charge
higher in former and lesser in slum areas.
3. Trade discrimination:
This can be called as ‘use discrimination’. By this method, the monopolist will
charge different prices for different types of uses of the same commodity. For ex:
electricity will be sold at cheaper rates for industrial units and bulk consumption,
while it will be charged at a higher rate for domestic consumption.

Degrees of price discrimination:

1. Prof. A.C.Pigou has distinguished between three types of price discrimination
on the basis of the degrees or extent of price. Under the first degree, the
producers will exploits the consumer to the maximum extent by asking him to
pay the maximum he is prepared to pay. This is called perfect discrimination.
2. The second degree, the markets are divided on the basis that in each market
the lowest price, which the poorest member of the group are prepared to pay,
will be charged in the market for all consumers.
3. In the third degree that has been commonly practices by the monopolist. In
this case the markets are divided into many sub markets and in each sub
market the price charged would not be the minimum price but the price
depending on the output and demand of the market.

CONDITIONS OF PRICE DISCRIMINATION:

Price discrimination is possible only in the following cases:
1. The demand must not be transferred from the high priced market to the low priced
market.
2. The monopolist should keep the two markets or different markets separate so that
the commodity will not be moving from one market to the other market.

Pricing under discriminating monopoly:

In order to discriminate the prices, the entire market is divided into sub markets on
the basis of the elasticity of demand. Only if the elasticity of demand is different, price
discrimination is profitable. After dividing the market the producer has to deicide the
supply for each sub market. Here the output for the market depends on the equilibrium.
The monopolist should decide two things on the basis of his cost and revenue curves.
1. How much total output should be produced?
2. How the total output is shared between the sub markets and what prices should be
charged?
 42

The above figure illustrates the revenue curves of the two sub
markets A and B and the aggregate situation in the entire market under control.
For the sake of simplicity, we shall take that a monopolist divides his market into two sub
markets, sub market A and sub market B and finds the SR curve different in these two.
In the sub market A, the extreme left; AR1 is the demand curve or the average revenue
curve. In the sub market B, AR2 is the demand curve. Note that the elasticity of demand
in these two markets is different. In sub market A the elastic is inelastic and in B it is
elastic. The marginal curves in the two markets are MR1 and MR2.
The figure on the extreme right shows the total market where
aggregate conditions of the revenue curve are shown. The total average revenue curves of
the two sub markets have been shown in the total market as AAR. Similarly the aggregate
of two marginal revenue curves of the sub markets has been shown as AMR. According
to the figure AR1+AR2=AAR, MR1+MR2=AMR. MC is the total market shows the
marginal cost for the entire production. The level of production is determined at the point
where MR=MC. In the total market the aggregate MR curve cuts MC at E and the output
is determined at OM for the sub markets.
To find how much of OM goes to two sub markets, a line is
drawn indicating marginal revenue curves of the two sub markets A and B at E2 and
E1.cost of output cuts the marginal revenues curves of the two sub markets A and B, the
marginal cost of production are equal. So the equilibrium lies at E1 where the quantity
should be OM1. Similarly, the equilibrium point in sub market B lies at E2 where the
marginal cost level meets the marginal revenue level at that level of the sub market.
Therefore quantity OM1 will be sold in sub market A and quantity OM2 in sub market B.

OLIGOPOLY

Prof. Stigler defines oligopoly as that “situation in which a firm bases

its market policy in part on the expected behavior of a few close rivals.

CLASSIFICATION OF OLIGOPOLY
1. Pure or perfect and differentiated or imperfect oligopoly:
Oligopoly is said to be perfect or pure based on the product. If rims competing
produce homogenous product it is perfect oligopoly. If there is product differentiation
where the products of the few competing firms are only close substitutes but not perfect
substitutes, it is called imperfect oligopoly.
2. Open and closed oligopoly:
 43

In the open oligopoly new firms can enter into the market and compete with
existing firms. But in closed entry into the industry is not possible.
3. Collusive and competitive oligopoly:
When a few firms of the market come into common understanding or act as
collusion with each other in fixing price and output it is collusive oligopoly. A non –
collusive oligopoly denotes lack of understanding between the firms and they may be
competing making competitive oligopoly.
4. Partial and full oligopoly:
Oligopoly is partial when one large firm, which is considered or looked upon as
the leader of the group, dominates the industry. The dominating firm will be the price
leader. The rest of the smaller firms would follow the leader in fixing prices of their
products. In full oligopoly, the market will be conspicuous by the absence of price
leadership.
5. Syndicated and organized oligopoly:
Syndicated oligopoly refers to that situation where the firms sell their product
through a centralized syndicate. Organized oligopoly refers to the situation where the
firms organize themselves into a central association for fixing prices, output, quotas, etc.

PRICE RIGIDITY
The important feature of oligopoly with price differentiations price rigidity. The
price will be kept unchanged due to fear of retaliation and prices tend to be sticky and
inflexible. Even for years together the price may remain rigid. No firm would indulge in
price-cutting, as it would eventually lead to a price war with no benefit to anyone. The
reasons for price rigidity are:
1. The firm knows the ultimate outcome of price-cutting.
2. Large firms will have to incur unnecessary expenditure in bringing out revised prices.

KINKED DEMAND CURVE

Price rigidity under oligopoly is better explained by kinked demand curve used
by Prof. Paul M.Sweezy. The kinked demand model represents a condition in which the
firm has no incentive either to increase the price or to decrease the price but keep the
price rigid at a particular level. The firm believes that the rival firms will not follow suit
if it raises the price. But if it cuts down the price, the rival firms will not follow suit.
Acing on this belief the firm maintains the present price. If it increases the price, sales
will be decreased automatically and the position will prove advantageous to the rivals
who have not increased the price. If price reduction is resorted, the rivals also would do
likewise and ultimately the sales might not improve appreciably.

Under such a condition the demand curve of the firm, as anticipated by the firm would be
kinked. This means that the curve will have a kink at the present price.

In the figure the demand curve with a kink at point P has been shown. P is the
price at which the firm is selling the product by products ON units. Above the price P the
demand curve as anticipated by the firm is OP. the curve is elastic. Below the price P the
anticipated demand will be PB, which is inelastic. This shows that when the firm
increases the price above P and if all other firms maintain at the old price.
Then the demand for the firm’s product would fall off. So, the demand curve is
highly elastic above P. the total revenue and profits of the firm would be reduced.
The firm decreases the price, the demand curve becomes much less elastic and the
demand curve is shown as PB. At this level, the marginal revenue curve is shown as
MR1. When the demand curve is DP the marginal revenue curve is positive. When the
 44

demand curve is PB the marginal curve becomes negative. So, the price PN as shown in
the figure becomes rigid.
The peculiarly of this figure is that there is a gap or discontinuity in MR curve
below the point of kink. KL shows the gap or extent of discontinuity between MR and
MR1. This gap will depend on the elasticity of demand above and below the kink. The
gap is larger if the elasticity is grater above the kink and inelasticity is also greater below
the kink. Price will not change in oligopoly unless there is a drastic change in demand
and cost conditions.

SUMMARY

Kinds of monopolies are private and public monopolies, pure monopoly, simple
monopoly and discriminating monopoly. Price discrimination means the practice of
selling the same commodity of different prices to different buyers. Under the monopoly,
the producer usually restricts the output ands sells it at a higher price, thereby making a
maximum profit. Types of Price discriminations are Personal discrimination, place
discrimination and trade discrimination. Kinked demand model represents a condition in
which the firm has no incentive either to increase the price or to decrease the price but
keep the price rigid at a particular level.

SUGGESTED QUESTIONS

1. Define Monopoly
2. List out kinds of monopoly
3. Explain equilibrium under monopoly
4. Define Price discrimination
5. Distinguish between monopoly and perfect competition
6. Explain in detail kinked demand curve

LESSON: 3

3.1 PRICING UNDER MONOPOLISTIC COMPETITION

3.2 OLIGOPOLY

INTRODUCTION
MONOPOLISTIC COMPETITION:
According to Joe S.Bain, “monopolistic competition is found in the industry where there
is a large number of small sellers selling differentiated but close substitute products”.

Nature of demand and cost under monopolistic competition:

1. Demand curve:
Like perfect competition and monopoly, price under monopolistic competition is
also determined by the intersection of demand and supply. Generally under monopolistic
competition due to product differentiation a firm faces a downward sloping demand
curve. It is highly elastic but not perfectly elastic with in relevant range of prices at which
he can sell any amount of the product, some of his customers will stop buying his product
and will shift to his rival firm who has not changed his price. On the other hand, at the
fewer prices he will attract new customers.
2. Cost curve:
Under this competition the AC, AVC, MC is also of U-shape.
Equilibrium price and output under monopolistic competition:
Short run equilibrium:
There are three variables under monopolistic competition. There are:
1. Price
2. Product
3. Selling outlay
 45

Individual equilibrium:
For maximum the conditions required are:
1. MC =MR
2. MC must cut MR from below.

It is stated that three equilibrium conditions of a firm in the short period under
monopolistic competition. They are:
1. It may earn abnormal profits
2. It may undergo losses
3. It may earn only normal profits.

1. Super normal profits:

Under monopolistic competition, the firm earns maximum profits when MC =MR
and MC must cut MR from below. The firm is earning super normal profits or abnormal
profits since average revenue is greater than average cost. The main reason is that the
firms are not able to produce closely competitive substitutes. Hence, they are not able to
attract consumers towards their product.

2. Normal profits:
If the price of the product is equal to AC then the firm will be earning the normal profits.
In the figure MC is equal to MR at point E. this is the equilibrium point.

3. Sustaining losses:
 46

It may not able to attract the consumers towards the products. In that situation the
firm is compelled to sell the product at the price which is less than even its short period
average cost. Hence, it may incur loss.

SUMMARY

Monopolistic competition is found in the industry where there are a large number
of small sellers selling differentiated but close substitute products. Selling costs are costs
incurred in order to alter the position or shape of the demand curve for the product.

SUGGESTED QUESTIONS:

1. How do determine the price under the monopolistic competition?

2. How do determine the price under the oligopoly?
3. Explain the classification of oligopoly?
4. Explain the features of perfect competition?
5. Explain the MC and AC in short run.
6. Give the classification of market.

*********************

LESSON: 1

1.1 PRICING UNDER FACTORS OF PRODUCTION

1.2 WAGES
1.3 MARGINAL PRODUCTIVITY THEORY

WAGES -MEANING
Wages are the remuneration paid to labour for its productive resources
paid by the producer. Labour refers to all kinds of workers (unskilled, skilled or blue
collar and white collar workers, as well as independent workers, like teachers, medical
 47

practitioners, etc.).The term wages also has as a broad connotation. It includes pay, salary,
emoluments fee, commission, bonus and etc.

Real Wages and Money Wage:

Real wage refers to the quantities of goods and services which can be brought
with the money-wage received by a worker. Adam-Smith defines a worker is rich or poor,
is well or ill rewarded in proportion to the real not to the nominal value of his wages
interest the incidental charges.

Modern Theory of Wages

It is an extension of theory in logical and rational manner. It states that the price
of labour, wage rate is determined by the interaction of the forces of demand for and at
the supply of labour in a given market situation.
Demand for labour: Demand for labour refers the Job opportunity available for
appointment. Time top tie m and the availability of the workers demand moves f when
demand is more – more wages; when less demand for labour less wage are p[aid to the
labour.
Determinants of Demand for labour:
1. Productivity: The labour who give better production by the help of inputs and
more Outputs more demand for the Knowledge and skill.
2. Technology: The business which adopt labour Intensive Technology can employ
more labour and pay more wage. The Latest technology by capital is there less
demand and fewer wages.
3. Demand for the Product: When more demand for selected d company made
produce they can pay more wage to the labour by earning supernormal profit.
Otherwise the demand for the product from the buyer’s angel creates less sales
and producer pay less pay.
4. The price of Capital; The other factor price while production price are more in
labour wage decrease otherwise when the other factor inputs price are less more
wage to labour may prevails in the business.
Supply of labour:
The number of labour are ready to work from various skill is known as Supply forces.
In a particular the labour decided to work totally called as Supply of Labour.
Determinants of Supply of Labour:
1. The Occupational Mobility: When there is more chances to move from one
business concern to another business in two location normal supply from labour
will create for normal wages.
2. Wage Rate: Where and in which concern there is more wages and Job Security,
Confirmation more number of labour supply
3. Working Condition and Treatment of Labour: The concern which will employ
and treat the labour in Specialization of Job and Knowledge based -risk less work
are offered Supply Increase
TRADE UNION -1926
The association which is started by the group of o workers voluntarily and involuntarily
to fulfill the basic needs and solve problem is Trade Union.
Agriculture and Non-Agriculture wise in all the sectors are existing.
Importance:
1. A trade union may work for the better raise of wage
2. The trade unions may reduce the labour dispute and minimize waste in labour
energy Standard of living and Atmosphere.
3. Major Miss-understanding is possible to minimize.

Nominal Wages and Real Wages

Nominal wages refer to the wages paid in terms of money. This can be called
money wages. The remuneration received by labour in cash is called money wage or
nominal wage. But money does not measure the real earnings of the workers. In order to
ascertain the real earnings of the worker we use the term real wages, which indicators the
exact benefit that would accrue to labour through the remuneration he gets. It thus
denotes the necessaries, comforts and conveniences and other facilities which a labour
could enjoy by working at a job. Since the money received by labour commands the
necessary comforts and conveniences, the purchasing power of money determines to a
large extent:
 48

Factors determining the real wage:

1. Purchasing power of Money.
2. Method of payment.
3. Subsidiary earnings.
4. Nature of Employment.
5. Regularity of Employment.
6. Future prospects.

THEORIES OF WAGES

1. Subsistence theory.
2. The wage fund theory.
3. The residual claimant theory.
4. The marginal productivity theory.

1. The Subsistence Theory of Wages.

This theory was formulated by the French Economist. The theory stated
that the wages of labour always remained at the subsistence level. Just the normal value
of a commodity under free competition is determined by its cost of production, so the
value of commodity ‘labour’ is determined by its cost of production. This theory meant
that the minimum subsistence expense is required for the support of the laborer and that
of his family in order to ensure a continuous supply of labour. According to the theory,
the laborer should be paid just enough to live and perpetuate his clan. This theory is
called the iron law of wages by LaSalle.
According to the theory, if wages exceeded the minimum subsistence
level, population would increase and with it supply of labour, until wages were again at
bare subsistence level. If on the other hand wages fell below the level there would be a
reduction in population and therefore in the supply of labour, until wages were raised to
the subsistence level. Thus the theory is closely associated with the doctrine of
Malthusian over population.

2. The Wage Fund Theory

This theory, combining capital and wages was first propounded by Adam smith and
J.S, Mill gave the final shape. The theory states that part of the capital is used to support
the working population and this capital or fund set apart decides the rates of wages. The
wage fund theory was explained in full in principles of political economy by J.S.Mill. He
wrote ‘wages depend upon the demand and supply of labour, as it is often expressed, on
the proportion to population and capital. By population, is here meant the number only
of the laboring class or rather of those who work for hire and by capital, circulating,
capital and not even the whole of that, but the part which is expended on the direct
purchase of the laborer’.
According to this theory, at any given time, a certain wage fund is available i.e., a
determinate amount of capital destined for the payment of labour.
The wages of labour are determined strictly on the basis of the formula;

Wage fund
= the wage rate.
Number of laborers

The wage fund thus constitutes the demand for labour and the working
population, the supply of labour. The fund is distributed among the workers solely under
the rule of competition.

3. The Residual Claimant Theory

This theory was advanced by the popular economist F.A.Walker in his

book political Economy. According to this the labour gets the residual portion after
paying the remuneration of all other factors. Walker says: the laboring class receives all
the help to produce, subject to deductions on the three several counts.
First, rent is deducted and rent must come out before the question of wages is considered.
Secondly, remuneration must be deducted for the use of capital and the third and last
deduction is profits, the remuneration of the entrepreneur. These three shares being out
 49

of the product of industry, the whole remaining body of wealth is the property of the
labour class”.

4. The marginal productivity theory of wages.

The general theory of distribution has been extended to wages and this
has come to be known as marginal productivity theory of wages. The theory, as has been
studied, assumes certain condition to enunciate the concept of marginal productivity.

1. There is perfect competition in the market for the factors of production.

2. There is homogeneity in the units of labour.
3. It assumes static conditions and long period. On these assumptions, the theory
states that at any given time wages shall be equal to the marginal productivity of
labour.

MODERN THEORY OF WAGES

We have seen that all classical and old theories of wages are either
defective or inadequate to explain wage determination. Though marginal productivity
theory is fairly satisfactory, it does not take into consideration the supply side of labour
which is equally important as that of demand.

DEMAND FOR LABOUR

Demand for labour is not a direct demand but derived demand. The
elasticity of demand for labour also depends upon the elasticity of demand for goods
which it produces. The demand for labour depends on the price of other
complementary and competitive factors. For example labour and machines are
substitutes and they would be competing with each other for being engaged in a
particular line of production.

MRP

O Units of labour

The demand curve for labour of one employer is shown in the figure. Note
that the marginal revenue productivity is declining as more units of labour are engaged.
The MRP curve of the firm constitutes the demand curve. If we add up the demand
curves of all employers, we will get the market demand for labour. Thus, the demand for
labour slopes downwards and its location and slope or elasticity will depend upon the
factors.
Supply of Labour
Supply of labour refers to the number of workers who would offer themselves for
employment at different wage rates. To a given under conditions of perfect competition,
the supply of labour is perfectly elastic. This is because, at the given wage rate the firm
can employ at many workers as it likes. The demand of the firm will constitute a very
insignificant part of the total demand of labour.
Determination of Wages
The demand for and supply of labour and the interaction of these two and the
equilibrium point decides the wage. The below figure illustrates supply and demand
curves for the market and how the wage rate is determined.
In the market, the supply and demand curve comes to equilibrium at point E where
the wage is EL and the quantity of labour supplied and demanded is OL units. Once the
age is determined for the entire industry, each firm accepts the wage as given. This is
shown on the right side. No firm will pay more than OP wage and no laborer will be
prepared to work for less. This supple curve of labour for the individual firm will
horizontal. This represents the average wage and marginal wage of labour to the firm.
 50

Market Firm

Y D S Y

E AW = MW

O O
X
Units of labour (thousand) units of labour

Relation between Wage and Productivity

Every firm with the given wage rate OP will employ labour at the point where the
marginal cost of labour to him is equal to the marginal revenue product of labour. The
marginal cost of labour should be equal to the marginal revenue product. This will be
both in short and long period. The below figure illustrates how the firm engages labour
on the basis of cost of labour and marginal revenue product.

Suggested Questions
Part- A
1. Remuneration paid to labour is called as ----------
2. Real wages is less wage (true or false)
3. Nominal wage is more than of real wage (true or false)
Part - B
1. Explain Modern Theory of Wages.
2. Explain the types of wages
3. Could Trade Union support a labour to obtain more wages?
Part – C
1. Explain Marginal productivity theory of wages.
2. Differentiate Marginal productivity theory and Modern theory of wages.

LESSON: 2
2.1 INTEREST
2.2 KEYNES’S LIQUIDITY PREFERENCE THEORY

INTEREST
Interest is the reward for capital for its productive services. Prof. Wicksell
has defined it as “payment made by the borrower of capital, by virtue of its productivity,
as a reward for his abstinence’.

Gross Interest and Net Interest

The amount which a lender charges a borrower by way of interest is really gross
interest. It is composed of several other payments including pure or net interest. The
gross interest means the total amount which a creditor gets from the debtor and the net
interest means that part of the payment which is for the use of capital only.

THE CLASSICAL THEORY OF INTEREST

The classical theory of interest is also known as Real theory of interest. The
classical economists visualized interest as marginal productivity or physical capital. But
some physical capital has to be purchased with monetary funds; rate of interest becomes
the rate of return over money invested in physical capital. To invest money in physical
capital, money has to be saved by someone and interest has been termed as the price for
the abstinence or waiting or time preference involved in the act of saving and lending
capital.
According to classical economist, the lender charges interest because, he has to
undergo sacrifice in lending and the interest he charges from the borrower is a
compensation for this sacrifice. . This is called the abstinence theory of interest.
 51

All classical writers have explained the rate of interest in terms of abstinence or
waiting or time preference and they have conceived the phenomenon of saving and
lending differently. But all have agreed on the point that the rate of interest is a payment
for saving.

DEMAND FOR CAPITAL

The demand for capital saved comes from the producers who desire to invest in
capital goods. Capital goods are demanded because they can be used to produce further
goods which can be sold to earn income. These capital goods have revenue productivity.
For any type of capital asset, e.g., a machine, it is possible to draw a marginal revenue
productivity curve showing the addition made to total revenue by an additional unit of a
machine at various levels of the stock of that machine. Like other factors of production,
capital has marginal revenue productivity. A firm, under perfectly competitive conditions
will hire a factor up to the point at which the price of that factor equals the marginal
revenue productivity of the factor.

MRP

O M M1
INVESTMENT
It is the investment demand curve. The MRP is falling as more investment takes
place. When the rate of interest is OR, the entrepreneurs make investment OM. This is
because the expected return from investment is equal to the interest on capital invested.
If the rate of interest falls to OR1 more capital is invested and investment increases to
OM1.

SUPPLY OF CAPITAL
The supply of saved amount in a community depends on several factors like the
income of the people, standard of living, political and economic conditions, family
affections, etc. If all other things remain constant, the factor which will influence the
supply of savings at a particular time is the rate of interest. If the rate of interest is high,
higher shall be the volume of savings and lower the rate of interest, lower will be supply
of savings.

Y D S

E
R

O M
Savings and investment
It is the investment demand curve. SS is the supply of savings curve. They intersect at
point ‘E’ the equilibrium position. At OR interest rate OM amount of savings are
supplied and demanded. If there is any change in the supply of savings, the curves will
shift accordingly and the equilibrium rate of interest will also change.

LOAN ABLE FUNDS THEORY

Loan able funds theory is really an extension of classical theory of demand and
supply to include monetary aspect. According to the theory, rate of interest is the price
 52

paid to the use of loan able funds and is determined by the equilibrium between demand
for and supply of loan able funds. This theory was developed by wick sell, Ohlin, viner
and others. The exponents of the theory saw the interplay of monetary forces along with
non-monetary forces like thrift, waiting, time preference, productivity of capital in
determining the rate of interest
In this theory, the expression’ loan able funds’ is wider in scope and includes not only
savings out of current income, but also bank credit dishoarding and disinvestments. In
the criticism of the classical theory, we have studied that these items were neglected.
According to this theory, the supply of loan able funds can be traced to the above stated
causes, viz., savings bank credit, dishoarding and disinvestments.

SUPPLY OF LOAN ABLE FUNDS

1. Savings.
2. Dishoarding.
3. Bank credit.
4. Disinvestment.

DEMAND FOR LOAN ABLE FUNDS.

1. Investment Demand.
2. Consumption Demand.
3. Demand for Hoarding.

KEYNES LIQUIDITY PREFERENCE THEORY OF INTEREST

Keynes defined interest as the ‘reward paid for parting with liquidity’ for specific
period. Of all assets such as money, securities, land, building, etc., the first one, viz.,
money is the most liquid and people prefer liquid form of asset. If a person has to give
up cash he has to part with liquidity to his asset an interest in the reward to induce people
to part with the liquidity of money. A preference for liquidity is a preference for money.
According to Keynes greater the desire for liquidity, higher shall be the rate of interest
demanded for parting with liquidity. “The rate of interest is the premium which in a form
other than hoarded money”. Thus according to Keynes interest arises because of liquidity
preference and it’s purely a monetary phenomenon.
According to Keynes, there are many causes for preferring liquid money and the
motives behind liquidity preference have been classified into these categories, viz., the
transaction motive, the precautionary motive, and the speculative.
1. The transaction motive.
2. The precautionary motive.
3. The speculative motive.

Thus, according to Keynes, the demand for money under the speculative motive is a
function of the current rate of interest. This has been indicated in the below figure.

r1

O
M M1
Speculative demand for money

The X axis represents the speculative demand for money. This is called ‘inactive
balances’ by Keynes. Y axis represents the rate of interest. The Liquidity preference
schedule. The curve is a downward sloping one indicating that the higher the rate of
interest the lower is the demand or speculative motive and vice versa. On the supply
side, the rate of interest is determined by the supply of money available in the economy.
 53

CRITICISM OF KEYNESIAN THEORY OF INTEREST

1. The theory ignores real facts.
2. It lacks realism.
3. Keynesian theory is also indeterminate.
4. No liquidity without savings.
5. Liquidity has not been clearly explained.
6. Keynes theory is clearly wrong.
7. The theory ignores long period.

MODERN THEORY OF INTEREST

(New- Keynesian Theory)
The modern theory of interest is nothing but the fusion of the classical Keynesian
theories by taking into consideration the real facts of the former and the monetary facts of
the latter. The new theory has successfully combined the four variables-savings,
investment, liquidity preference and money supply. The synthesis of the two theories was
attempted by J.R. Hicks and Hansen.
According to the modern theory, there are four determinants (along with income) on
the rate of interest. These are the savings function, the investment function the liquidity
preference function and supply of money function. The classical theory is right in telling
the rate of interest equalized saving and investment. The Keynesian theory is also right
in the rate of interest brings about an equilibrium between the earned for cash (Liquidity
preference) and the supply of cash. Now these favouarables are integrated along with
income to get a satisfactory explanation of the rate of interest.
In order to arrive at this, modern theory has evolved two curves, the IS curve and
the LM curve. The IS curve shows the equilibrium in the monetary sector.

Y LM

IS

X
O M
Income
Income and rate of interest are therefore determined together at the point of
intersection at Q. The equilibrium rate of interest is thus determined as ON and the level
of income OM. At this point, income and the rate of interest stand in relation to each
other such that (i) investment and savings are in equilibrium and (ii) the demand for
money is in equilibrium with the supply of money.

SUGGESTED QUESTIONS
Part- A
1. Interest is the payment paid by the borrower to the -------------
2. Interest is more when more demand for money (true / false)
3. Net interest is calculated after the profit. (true/false)
Part - B
1. Explain classical theory of interest.
2. Explain the types of interest.
Part – C
1. .Explain Keynesian Liquidity Theory of Interest.
2. Differentiate classical and Keynesian theory of interest.

LESSON: 3

3.1 THEORIES OF PROFIT

3.2 DYNAMIC THEORY OF PROFIT
3.3 RISK THEORY
3.4 UNCERTAINTY THEORY

PROFIT
 54

The profit is an income for the entrepreneur for his work, we cannot decisively say for
what kind of work he is getting the income called profits. Profits have been defined as
wages of management or it is the reward for entrepreneur. It is also a reward of
ownership of capital. Profit is the percentage of return on investment of capital; it is the
reward for taking risk in business.
GROSS PROFIT AND NET PROFIT
Gross profit is the surplus of total expenditure of the firm and in ordinary language
we mean only gross profit whenever we refer to profits. However, if we analyze the term
“gross profit” we all find that it includes several items which are not profits in the strict
sense, Gross profits is a term in which the following items are included in addition to the
net profit due to the entrepreneur.
1. Remuneration for factors of production contributed by entrepreneur himself.
2. Depreciation and maintenance charges.
3. Extra-personal profit.
4. Net profit.
Net profit is the exclusive reward for the entrepreneur for the following functions
performed by the entrepreneur.
1. Reward for coordination.
2. Reward for risk taking.
3. Reward for innovation.

IMPORTANCE OF PROFIT MAXIMIZATION:

Profit is the Acid test of the economic strength of the firm. Short term goal is Asset
maximization whereas Long term goal from profit is Wealth Maximization.
The important reasons are,
1. Achieving Market Leadership; Business firm often like to become as market
leader in the respective field of business. Every concern will adopt different
market strategy to expand the span of sales –by expansion can able to earn profit
in maximum.
2. For Avoiding Potential Competition: In order to discourage other firm in the
same field product Quality and sell at competitive price which will also lead for
maximizing the profit.
3. For Preventing Government Intervention: Every business person avoids
unnecessary interaction in their normal business life. By proper payment in time it
minimizes trouble only by earning profit in season.
4. For Maintaining Customers Goodwill: Business firm always maintain better
contact with customers will earn Goodwill. By rendering real services in the
market the customer support for better performance.
5. For Restraining Wage Demands: Selected business unit will pay better wages to
the worker during profit earning period. The volume of Profit Company which
earn is less can pay less increment, bonus and etc.
6. For Achieving Financial Soundness and Liquidity: Business unit by earning
proper profit can possible to multiple its asset –worth .Opening Capital value
during closing period can able to strength up profit play main role.
7. For Avoiding Risks: During un-season period from business, the Un-distributed
profit in General Reserve Fund is relevant for adjustment to continue in the future.
Profit also helpful for further expansion in limits and serve for the public.

. THEORIES OF PROFIT

WALKER’S RENT THEORY OF PROFIT

This theory was first indicated by senior Mill. It was walker who gave full shape to
the theory. According to him, “profits are of the same genus as rent”. This theory seeks
to explain the concept of profit in the same manner as the concept of rent was explained
by Ricardo. Rent, it was considered as rent of superiority. According to this theory,
marginal entrepreneurs do not get profit, but only get wages of management. Profit does
not enter into price. Since the market price is determined by the cost of production of the
marginal entrepreneur, profit does not enter into price.

HAWLEY’S RISK THEORY OF PROFIT

This theory was advocated by an American Economist prof... Hawley. According to
him profits arise because the entrepreneur undertakes the risks of the business and he has
to be rewarded for than. He is entitled to receive profits. If the entrepreneur is not
rewarded, he will not be prepared to undertake this risk. According to the theory, higher
 55

the risk, greater is the possibility of profit. Entrepreneur is the most important factor in
modern production. Without him, other factors cannot be combined. In employing the
factors of production in looking through the process of production and in selling the
commodity in the market, the entrepreneur undertakes risks, and profits are reward for
such risks borne by the entrepreneur.

KNIGHT UNCERTINTY-BEARNING THEORY

Knight’s uncertainty bearing theory starts on the foundation of Hawley’s risk-bearing
theory. Knight agrees with Hawley that profit is a reward for risk-taking. However, the
term risk is clarified and there are two types of risks.
1. Foreseeable risk, and
2. Unforeseeable risk.
The latter risk is called uncertainty bearing. If risk can be insured against, it is not risk at
all. For instance fire, flood, theft, etc., are risks in business which can be insured and the
loss arising out of these will made good by the insurance company. The premium paid or
insurance is included in the cost of production. Insurable risk, thus, does not give rise to
profit. So, according to prof. Knight Profit is due to non-insurable risk or unforeseen
risk. Some of the non-insurable risks are:

1. Competitive risk.
2. Technical risk.
3. Risk of government’s intervention, and
4. Risk arising out of business cycle.

CLARK,S DYNAMIC THEROY OF PROFIT

J.B.CLARK has enunciated a popular theory of profit called “Dynamic theory”.
Profit arises as a dynamic surplus. According to the theory, under static conditions and in
a stationary state where no change in demand and supply are occurring, profits do not
arise. This is because, under static condition, payments made to the factors of production
on the basis of marginal productivity exhaust the total output. In this condition, in
equilibrium, price of each commodity exactly equals its money cost of production,
including normal profits and there is no surplus of any kind. Profits result only when
selling prices of goods exceed their cost of production. Therefore in a static state, there
are no possibilities of getting profit and it arises only in a dynamic condition. It is a
dynamic surplus.
Now, the question arises what constitutes dynamic change in the economy to give rise to
profits. Clark mentions about five changes which may occur in a dynamic economy to
give rise to profits:
1. changes in the quantity and quality of human wants;
2. Changes in methods or techniques of production:
3. Changes in the amount of capital.
4. Changes in the form of business organization and
5. Changes in population.

SCHUMPETER’S INNOVATION THEORY

The theory propounded by Schumpeter is more or less similar to Clark’s theory. The
importance of dynamic changes for getting profit is also stressed in this theory. But,
instead of finance changes mentioned by Clark, Schumpeter explains the change caused
by innovation in the productive process. According to this theory, profit is the reward for
innovations. The term innovation has been used in a broader sense than that of Clark’s
attributes to dynamism. Innovations refer to all those changes in the production process
with an objective and avowed aim of reducing the cost of the commodity so as to create a
gap between the existing price of the commodity and its new cost. Schumpeter’s
innovative may take any shape. It may be the result of introduction of a new technique or
a new plant, a change in the internal structure or organizational set up of the firm. It may
be a change in the quality of raw material a new form of energy, better in the quality in
the quality of the raw material, a new form of energy, better method of salesmanship.

MARGINAL PRODUCTIVITY THEORY OF PROFIT

The marginal productivity of a factor of production and how it is remunerated on the
basis of marginal product converted into marginal revenue product. This general theory
of distribution is also applied to the factor entrepreneur. According to Prof.chapman,
profits are equal to the marginal worth of the entrepreneur and are determined by the
 56

marginal productivity of the entrepreneur, when the marginal productivity is high, profits
will also be high.

SUGGESTED QUESTIONS
Part- A
1. The reward for management is Profit (True/False)
2. Gross profit minus depreciation give Net profit (True/False)
Part- B
1. .Define short run profit and long run profit.
2. Explain the importance of profit Maximization.
3. Define Dynamic Theory of Profit.
Part- C
1. Explain Innovation Theory of Profit.
2. Explain Risk Theory of Profit.

************

Unit V [12 Periods]

Government and Business - Performance of public enterprises in India - Price policy
in public utilities - MRTP Act - National Income - Business cycle - inflation and
deflation - balance of payments - Monetary and Fiscal Policies.
LESSON: 1

1.1 GOVERNMENT AND BUSINESS

1.2 PERFORMANCE OF PUBLIC ENTERPRISES IN INDIA
1.3 PRICE POLICY IN PUBLIC UTILITIES
1.4 GOVERNMENT MEASURES TO CONTROL MONOPOLY IN INDIA
 57

1.5 MRTP ACT

MEANING OF GOVERNMENT ENTERPRISES:

The business unit which is owned, managed and controlled either by state or by Central
Government or both the Government by the contribution of shares is known as
Government Enterprises. While rendering the services to the public it is named as Public
Enterprises.
Types of Government Enterprises are;
a. Departmentation.
b. Public Corporation.
C.Government Company

LAISSEZ FAIR SYSTEM:

It is a French phrase meaning,” allow doing”. Workers are most productive and a
nation economy function most efficiently when people can pursue their private economic
interest is relative freedom.
“It is the theory of economic policy which states that government should not interfere
with decisions made in an open competitive marker”. It includes getting prices and wages
and making other choices that affect the sale of goods and services.
Aims of Government in business:
1. To establish mutuality among the producer and buyers.
2. To create Socialistic pattern of society.
3. To Strength the standard of people and establish better economy.
4. To remove the inequalities among the states.
5. To establish employment opportunities to more people.
6. To establish balance among various regions.
7. To control exploitation system in poor group of people.
8. To coordinate the production and distribution system in all group of people.
9. To strength economy from all different sectors.

OBJECTIVES OF ECONOMIC PLANNING:

India prepares every plan containing the time gap of yearly of five year wise planning.

1. Higher National Output: The Government in order to develop more population

earnings and per capita income it prepare plans to enrich the economy.
2. Rapid industrialization: Government in order to use all the resources it adopted

CAPITALISM:
This system explains about private parties allowed and involve in business
activity. Mostly at U.S.A., and well rich country this system is in practice. The Capitalist
companies should invest in Profitable Business.

SOCIALISM:
This system explains about the Government Regulated and Concentrated business. In the
Communistic principles depended country this system is in practice.

Difference between Socialism and Capitalism

1. Investment on profitable business is Capitalism where as more labour and service
oriented business system, the goods are produced for the common benefit of all.
2. The private enterprise only pays the proper tax to Government. In socialism less tax is
fixed Service and Welfare oriented business is conducted.
3. Less Salary and less Job Security in capitalism whereas Labour is given more
important and more Salary and Welfare compensation is given.
4. Less Employment to Illiterate and more to literate and in socialism always it give
more Employment opportunities to all kind of labour.
5. Earned profit it goes to Individual welfare whereas profit when it is earned by
Government enterprise for Service and well being of people .by tax.

MIXED ECONOMY:
 58

India is the country which contains Capitalistic form of Private Business and State
and Central Government Business. To develop the skill and Improvement of Backward
countries and poor Countries.
Central Government of India and Planning Commission prepare Central Plan for
Equality in all State and people all over India for that Mixed Economy system is
practiced.
In India Rs. 640 Million Dollar is the National Income in 2006March.Where as
the Developed country annual Income shows above than RS.2500 million dollars.
Features: 1. Agricultural oriented business 2. Illiterate also more 3. Lack of Knowledge 4.
Lack of Transport 5. Lack of Finance 6. Lack of Science and Technique. 7. Lack of
Political Instability is the reasons .8. Lack of Transport facility 9. Social and Economic
problems are existing.
Present Central and State Government by Computer Advancement rendering better
service and “India is shining”. Prime Minister Man Mohan Singh introduced New Second
Green Revolution for improving of Agriculture and other field of business.
GLOBALIZATION AND INDIA It is growing in all fields product production and
Sales among World countries.

NATIONAL INCOME:

Prof. J.R. Hicks defines,’ National Income consists of collection of goods and
services produced to common basis measured in terms of money”

MEASUREMENT OF NATIONAL INCOME:

National Income is calculated in a Nation from the collection of each individual

resides within the boundary of that Nation
Yearly.
 The Net value of all product and services.
 Net value during a year
 Counted without duplication
 After having allowed for depreciation
 Both in public and private sectors details totaled into account
 In consumption of capital goods from all sectors
 Net gains from International transactions comprising of gains not merely from
export, 8import trade but also from capital utilized or invested Abroad.
 GNP = Gross National Product (Aggregate production based earnings.)
 NNP = GNP- Depreciation from all business unit
NI = The Factor cost for land, labour, capital and organization is National Income at
factor cost. (NI= NNP-Indirect taxes + subsidies)
 PI = Personal Income National Income is deducted by Corporate profit, social
security contribution are made.
 DPI = Disposable Personal Income (Personal Income - Personal Direct Tax.)

SOCIAL ACCOUNTING
Social Account is the total or aggregate value. The total of various groups of
people in business provides a reliable basis for designing Government policies during
plan Budget. This account is the collective account of Central Government in one
financial year.

BUDGET

Income and Expenditure of Government about the Sources and Uses of Fund for
the financial period which is prepared and released in the Parliament within the month
February to March of every Year.

METHODS OF CALCULATING NATIONAL INCOME

Central Government of India is adopting three methods of calculating National
Income given is
1. National Income by Production method.
2. National Income by Expenditure method.
3. National Income by Income method.

1. Production Method of National Income:

 59

The details from various product or service renders information area wise are added
together by the Central Statistical Organizations in every District from all the State and
Union Territory, Panchayat wise, Corporation - wise all the information is added. In every
of that year except Holiday leave days
 Number of Steel Producers and SS and MS Tonnes
 Total Tonnage of production of Cement from various firms,
 No. of Cars from every company, No. of Motor cycles from all companies; No. of
Ship Constructed, No .of Post cover, No. of Computers made, No. of Cell phones
Assembled all over India, No. of Soap cakes produced from various companies,
No. of Trucks made, No. of LCV produced, No. of Satellite, No. of Heavy Duty
Boiler produced and cost less product produced added together totally give
National Income of that country for that year.

2. Expenditure Method of Calculating National Income:

 Government Expense by State and Central Government for well being of people
added together gives National Income. IN PLAN and Non Plan activities Government is
spending Expenses.
 A. Plan oriented Expenses for instant Allotment for Defense
 Allotment for Education; Allotment for Health and Safety measure of people;
Allotment for Science and Technology;
 Allotment for Sethu Sea Project -
 To pay wages and Salaries to Government Doctor, Teachers, Advocates , Salary to
M.P; and M L A ”s, Salary to President, Prime Minister,
 Allocation for Nature and Disaster Management.
 Road Repairing, New Construction of Tank ; Government Employees Staff Quarters,
Expenses for Library Maintenance; Expense for University and Museum maintenance
and Ground and Administrative activities in collecting Tax Officers Salaries and
Overhead expenses
 Expenses for Midday and Null- Meal Scheme ; Expenses for Ward member sitting
fees
 Subsidy by Government in Oil Imports
 Subsidy in Supply of Food grain materials Income.
 Farmer’s Short term Credit Rebate and Interest Rebate Loss and Damage of Bus or
Train and Accident suffered people Compensation .included in National Income.

3. Income Method of Calculating National Income

 Income from all the sources to every Individual by Job, Business Earnings, Rent ,
Earnings from Winning prize based National Income is calculated
Overall earning from one year within 12 months added together. Export Earning minus
Import Earnings taken into National Income.
The Farmers Earning
The Industrialist Earnings from all the kind of business
Based upon the Total Population it is calculated.

SURPLUS AND DEFICIT BUDGET:

Surplus Budget is called when Income earned by Government is found more that of
Expenditure. Still now in India this type of Budget was not prepared and achieved in
various v five year plans.
Expenditure of Government activities will be more and Revenue found as less in
Government Activities directed in plan from State and Central Government.

FINANCE COMMISSION
Central Government appoints Finance commission in order to share Federal
Finance among State and Central Government by better service. Governance Selected
Experts are appointed to really study the problems and Better Recommended Suggestions
to minimize the problems.

Functions
1. The distribution of Net proceeds of taxes to be shared between Union and State.
2 The principle which should govern the payment of Union Grants in Aids to the
Reserves from State.
To conditional agreement between State and Central Government is in signed form.
 60

First - Finance Commission

In the year 1951 Under the Chairman of K.C. Neyogi. This Commission
recommended to share 80;20 among Centre and State govt. in Tax. Collection\
Second Finance Commission
In 1956 under the Chairmanship of K. Santhanam Finance commission was
framed. This commission recommended in order to strength the small, medium and
large scale industries every State Government operation Income tax and sharing of
other tax was allotted as 55 to 60%
Third Finance Commission
Government of India under the chairmanship of A.K. Chandra it appointed a
commission. This committee collected information from various State Governments.
For removal of Regional Disparity 70 to 90% was shared among State Government. To
Maharastra Government this commission given more allocation and to the states
portion of allocation was less. Grants-in-aid to all State was allowed to Rs.110 Crores.
Population and Standard of earning wise tax collection was implemented separately to
Union Territories.
Fourth Finance Commission
In 1965 under P.V. Rajamannar it appointed Enquiry Commission. This
commission recommended the Central Government to increase the Grants in Lieu of
passenger Railway allotment into Rs. 122 crores to all State Government. More
allocation to State Government from Excise Duty was recommended.
Fifth Finance Commission
Dr. M. Thiyagi appointed as the Chief for this commission. 75% to State
Government from Income Tax was allowed. In order to make equal balance among all
State Government importance was given. Haryana and Punjab additionally sanctioned.
At Andhra, Kerala and Mysore are given importance in Fund allocation. Upto 20%
share from Excise duty it recommended.
Sixth Finance Commission
Bhramananda Reddy was appointed as the Chairman. To grant additional support
to the backward State this committee Recommended by the Central Government.

OBJECTIVES OF ECONOMIC PLANNING

In India, Planning Commission of India prepares every plan containing the time
of five year wise planning.
1. Higher National Output: The Government in order to develop more population
earnings and per capita income it prepare plans to enrich the economy.
2. Rapid Industrialization: Government in order to use all the resources it adopted.

MONOPOLIES ENQUIRY COMMISSION REPORT

This commission “Excluded the public sector and agriculture and studied only
about private sector industries. Observation of this commission is as follows.
Product wise and Country wise concentration

Product wise concentration

Production and distribution or service in the hands of one or few
family members by their own capital is product wise concentration.
Study for 100 commodities of daily consumption was made 65 commodities
producer are in three business houses that is 75 % of source economy went in to their
hand = High degree of concentration like infant milk food, corn, wheat, chocolate,
Kerosene oil, petroleum, Pressure stove, thermos flasks, fluorescent lamps, dry
batteries, sewing machine, ribbons, clocks, soaps, leather food wear, cars etc
Medium level of concentration in which 60% to 70% economy in another three
big business houses = biscuits, electric fans, ratio receivers, wheels, cement etc.
Low level concentration was in two business concern = suiting, worsted knitting
yarn, writing paper.
Nil level concentration:
The share of three businesses was nil that less than 50% of investment was from that
type of business houses. The business like coffee,tea,
Vanaspathi,dhothi,sarees,coal,blankets,sanitary wares,plywood etc.
 61

Country wise concentration

When a large number of concerns engaged in the production or
distribution of different commodities are controlled by individuals or group of persons
or families in inter industry concentration or circular is known as country wise
concentration
In order to find out the group concentration or country wise concentration, the
commission prepared a list of industrial houses which were believed to control a
number of companies engaged in the production of various commodities.
“For the purpose of study, a ‘business house’ has been taken to comprise of all such
concerns which are subject to the ultimate and decisive decision making power of the
controlling interest in the group.
The commission also took advantage of certain studies made by Dr.R.K.Hazari
and other scholars. In addition to these, the commission took advantage of brochures,
pamphlets issued by industrial and business houses,advertisements,articles in financial
and business houses or groups where 50 percent or more equity capital was found to be
owned by an industrialist or his relations. The commission studied and examined
altogether 2,259 companies.
According to the studies made by Dr.R.K.Hazari, the four biggest groups
viz., Tata,Birla, Martin burn and Dalmia-sahu jain,had 18 percent of the share capital
in non-government public companies in 1951. This proportion rose to 22 percent

CONCENTRATION OF ECONOMIC POWER

It means the private sector investors in order to earn more profit and exploit the
resource from consumer
By fixing more price in profitable business and Exploit the wealth mostly from
the field of business.

EVIL EFFECTS OF ECONOMIC CONCENTRATION.

1. Emergence of monopoly system create heavy burden to consumer

2. Block the entry to new business people
3. Perfect Quality goods are sold in Adult form
4. Denial of managerial opportunity to talented people in the vast section of
population
5. Imbalance in the National Wealth and Income-Inequalities
6. It creates corruption in the side of Government officer and Politician.

REMEDIAL MEASURES
Monopoly Inquiry Commission recommended to check the growth of
concentration of Economic power in few private hands:

LEGISLATIVE MEASURES

1. To set up a permanent body in Monopolies and Restrictive Trade Practices

Commission by exercise Vigilance and prevents the evils of monopoly and unhealthy
practices. Three members with a Supreme Court Judge Chairman to conduct inquiry on
complaint and Appointment of Director for those concern by Government.
2. To prepare guiding principle of striking at the concentration of economic power only
when it becomes a menace to the best production or distribution.
3. A clear watch on Big business while misusing the power beyond the law
4. Based upon the general public interest monopolist trader are discouraged and curbed.
5. Monopolistic and restrictive practices must be curbed except when they conduce to the
common good.

NON LEGISLATIVE MEASURES

The Government by proper use of Licensing and other powers can curb the evils
of Monopolistic tendencies.
1. Liberalize Industrial License System to new Small Business Enterprise and create
competition with big business.
2. Issue of License to all producers who are actual users of imported articles directly in
their business.
3. Commencement of public enterprise to discourage and warn the monopoly power
practice by private business houses Malpractices.
 62

4. Investigation case by case in matters of monopolistic and restrictive trade practice.

PUBLIC UTILITIES

The term “public utilities” refers to services like water supply, gas supply,
electricity, telephone services, communication and all forms of transport.
Public utilities refer to those groups of industries which are run with a public
interest.

FEATURES OF PUBLIC UTILITIES

 Monopolistic character
 Large scale operation
 Inelasticity of demand
 Large fixed investment
 Decreasing cost
 Price Discrimination
 Welfare principle

MRTP ACT

The Monopolistic and Restrictive Trade Practices Act, 1969, was enacted
 To ensure that the operation of the economic system does not result in the
concentration of economic power in hands of few,
 To provide for the control of monopolies, and
 To prohibit monopolistic and restrictive trade practices.
The MRTP Act extends to the whole of India except Jammu and Kashmir.
Unless the Central Government otherwise directs, this act shall not apply to:
a. Any undertaking owned or controlled by the Government Company,
b. Any undertaking owned or controlled by the Government,
c. Any undertaking owned or controlled by a corporation (not being a company
established by or under any Central, Provincial or State Act,
d. Any trade union or other association of workmen or employees formed for their
own reasonable protection as such workmen or employees,
e. Any undertaking engaged in an industry, the management of which has been
taken over by any person or body of persons under powers by the Central
Government,
f. Any undertaking owned by a co-operative society formed and registered under
any Central, Provincial or state Act,
Any financial institution.

MONOPOLISTIC TRADE PRACTICES

A monopolistic trade practice is one, which has or is likely to have the effect of:
i. maintaining the prices of goods or charges for the services at an unreasonable
level by limiting, reducing or otherwise controlling the production, supply or
distribution of goods or services;
ii. unreasonably preventing or lessening competition in the production, supply or
distribution of any goods or services whether or not by adopting unfair method or
fair or deceptive practices;
iii. limiting technical development or capital investment to the common detriment;
iv. deteriorating the quality of any goods produced, supplied or distribute; and
v. increasing unreasonably -
a. the cost of production of any good; or
 63

b. charges for the provision, or maintenance,of any services; or

c. the prices for sale or resale of goods; or
d. the profits derived from the production, supply or distribution of any
goods or services.
A monopolistic trade practice is deemed to be prejudicial to the public interest, unless it is
expressly authorized under any law or the Central Government permits to carry on any
such practice.
INQUIRY INTO MONOPOLISTIC TRADE PRACTICES
The Commission may inquire into
Any monopolistic trade practice,
 Upon a reference made to it by the Central Government or
 Upon an application made to it by the Director General or
 Upon it own knowledge or information
RELIEF AVAILABLE
a. Where the inquiry by the Commission reveals that the trade practice inquired into
operates or is likely to operate against public interest, the Central Government
may pass such orders as it thinks fit to remedy or present any mischief resulting
from such trade practice.
b. On an inquiry report of the Commission, the Central Government may-
i. Prohibit the owner(s) of the concerned undertaking(s) from continuing to
indulge in a monopolistic trade practice; or
ii. Prohibit the owner of any class of undertakings or undertakings generally,
from continuing to indulge in any monopolistic trade practice in relation to
the goods or services.
c. The Central Government may also make an order:
i. Regulating the production, storage, supply, distribution, or control of any
goods or services by an undertaking and fixing the terms of their sale
(including prices) or supply;
ii. Prohibit any act or practice or commercial policy which prevents or
lessens competition in the production, storage, supply or distribution of
any goods or services;
iii. Fixing standards for the goods used or produced by an undertaking;
iv. Declaring unlawful the making or carrying out of the specified agreement;
v. Requiring any party to the specified agreement to determine the agreement
within the specified time, either wholly or to specified extent;
vi. Regulating the profits which may be derived from the production, storage,
supply, distribution or control of any goods or services; or
vii. Regulating the quality of any goods or services so that their standard does
not deteriorate.

Removal of M.R.T.P

This act was removed to grant Healthy Business and Overcome the World
Competitors from 1995.

New Small Business Entrepreneurship was developed in Rural and Urban level to
Strength all kind of business.

SUMMARY
 64

Adam Smith- The founder of Economics and define economics is a study of wealth of
Nations.
Average Revenue- Total revenue divided by total number of units sold- i.e., revenue per
unit. Average revenue is generally equal to price.
Business Cycles- Fluctuations in total national output, income and employment usually
lasting g for a period of 2 to 10 years.
Consumption- Consumption should apply only to those goods totally used, enjoyed or
“eaten - up” within that period.
Capital goods- Capital is the third factor inputs used in production function’ It refers the
capital applied for durable produced goods that are in turn used in production. The major
components of capital are equipment, structures and inventory. When signifying capital
goods, reference is also made to real capital. In accounting and finance, capital means the
total amount of money subscribed by the shareholder-owners of a corporation , in return
for which they receive shares of the company’s stock.
Classical economics- The predominant school of economic though prior to the
appearance of Keynes work; founded by Adam Smith in 1776, David Ricardo, Thomas
Malthus, and John Stuart Mill.
Consumer price Index – A price index that measures the cost of a fixed basket of
consumer goods in which the weight assigned to each commodity is the share of
expenditures on that commodity by urban consumers in 1992-1994.
Diminishing marginal utility- The law which says that, as more and more of any one
commodity is consumed, its marginal utility declines.
Discounting- The process of converting future in come into an equivalent present value.
This process takes a future dollar amount and reduces it by a discount factor that reflects
the appropriate interest rate.
The rate at which future incomes are discounted is called the discount rate.
Discrimination- Differences in earnings that arise because of personal characteristics that
are unrelated to job performance, race, especially those related to gender, religion.
Distribution-The manner in which total output and Income is distributed among
individuals or factors.
Division of Labour- A Method of organizing production whereby each worker specializes
in part of the productive process. Specialization of labour yields higher total output
because labour can become more skilled at a particular task and because labour can
become more skilled at a particular task and because specialized machinery can be
introduced to perform more carefully defined subtasks.

SUGGESTED QUESTIONS

Part – A
1. Tariff Board was appointed on the recommendations of -------- (Second) Fiscal
Commission.
2. Availability of raw materials was ---------- (not insisted) by the Second Fiscal
Commission for granting protection to industries.
True or False
3. Debtors –the borrowers gain more and the lender – creditors lose at the time of
inflation - True
4. Rise in prices indicates economic development – True
Part – B
1. List out the Importance of MRTP Act
2. Explain Socialism and Capitalism
3. Define Business Cycle.
Part – C
1. Explain the methods of Calculating National Income.
2. Write note on various Finance Commission and Central Government
3. Explain the methods of controlling Business Cycle.

**********
Introduction:
National income is an uncertain term which is used interchangeably with national
dividend, national output and national expenditure. On this basis, national income has
been defined in a number of ways. In common parlance, national income means the total
value of goods and services produced annually in a country.
Definitions of National Income:
 65

The definitions of national income can be grouped into two classes: One, the traditional
definitions advanced by Marshall, Pigou and Fisher; and two, modern definitions.
The Marshallian Definition:
According to Marshall: “The labour and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or revenue
of the country or national dividend.” In this definition, the word ‘net’ refers to deductions
from the gross national income in respect of depreciation and wearing out of machines.
And to this, must be added income from abroad.
Concepts of National Income:
There are a number of concepts pertaining to national income and methods of
measurement relating to them.
(A) Gross Domestic Product (GDP):
GDP is the total value of goods and services produced within the country during a year.
This is calculated at market prices and is known as GDP at market prices. Dernberg
defines GDP at market price as “the market value of the output of final goods and
services produced in the domestic territory of a country during an accounting year.”
There are three different ways to measure GDP:
Product Method, Income Method and Expenditure Method.
These three methods of calculating GDP yield the same result because National Product =
National Income = National Expenditure.
1. The Product Method:
In this method, the value of all goods and services produced in different industries during
the year is added up. This is also known as the value added method to GDP or GDP at
factor cost by industry of origin. The following items are included in India in this:
agriculture and allied services; mining; manufacturing, construction, electricity, gas and
water supply; transport, communication and trade; banking and insurance, real estates
and ownership of dwellings and business services; and public administration and defense
and other services (or government services). In other words, it is the sum of gross value
added.
2. The Income Method:
The people of a country who produce GDP during a year receive incomes from their
work. Thus GDP by income method is the sum of all factor incomes: Wages and Salaries
(compensation of employees) + Rent + Interest + Profit.
3. Expenditure Method:
This method focuses on goods and services produced within the country during one year.
GDP by expenditure method includes:
(1) Consumer expenditure on services and durable and non-durable goods (C),
(2) Investment in fixed capital such as residential and non-residential building,
machinery, and inventories (I),
(3) Government expenditure on final goods and services (G),
(4) Export of goods and services produced by the people of country (X),
(5) Less imports (M). That part of consumption, investment and government expenditure
which is spent on imports is subtracted from GDP. Similarly, any imported component,
such as raw materials, which is used in the manufacture of export goods, is also excluded.
Thus GDP by expenditure method at market prices = C+ I + G + (X – M), where (X-M)
is net export which can be positive or negative.

Business cycle
The business cycle is the natural rise and fall of economic growth that occurs over time.
The cycle is a useful tool for analyzing the economy. It can also help you make better
financial decisions.
Stages
Each business cycle has four phases. They are expansion, peak, contraction, and
trough. They don’t occur at regular intervals. But they do have recognizable indicators.
Expansion is between the trough and the peak.
That's when the economy is growing. Gross domestic product, which measures economic
output, is increasing. The GDP growth rate is in the healthy 2 to 3 percent range.
Unemployment reaches its natural rate of 4.5 to 5 percent. Inflation is near its 2 percent
target. The stock market is in a bull market. A well-managed economy can remain in the
expansion phase for years. That's called a Goldilocks economy.
The expansion phase nears its end when the economy overheats. That's when the GDP
growth rate is greater than 3 percent. Inflation is greater than 2 percent and may reach the
 66

double digits. Investors are in a state of "irrational exuberance." That's when they
create asset bubbles.
The peak is the second phase. It is the month when the expansion transitions into the
contraction phase.
The third phase is contraction. It starts at the peak and ends at the trough. Economic
growth weakens. GDP growth falls below 2 percent.
When it turns negative, that is what economists call a recession. Mass layoffs make
headline news. The unemployment rate begins to rise. It doesn’t happen until toward
the end of the contraction phase because it's a lagging indicator. Businesses wait to
hire new workers until they are sure the recession is over.
Stocks enter a bear market as investors sell.
The trough is the fourth phase. That's the month when the economy transitions from the
contraction phase to the expansion phase. It's when the economy hits bottom. The
business cycle's four phases can be so severe that they’re also called the boom and bust
cycle.
Who Measures the Business Cycle
The National Bureau of Economic Research determines business cycle stages using
quarterly GDP growth rates. It also uses monthly economic indicators, such
as employment, real personal income, industrial production, and retail sales. It takes time
to analyze this data, so the NBER doesn't tell you the phase until after it's begun. But you
can look at the indicators yourself to determine what phase of the business cycle we are
currently in.
Who Manages the Business Cycle
The government manages the business cycle. Legislators uses fiscal policy to influence
the economy. They use expansionary fiscal policy when they want to end a recession.
They should use contractionary fiscal policy to keep the economy from overheating. But
that rarely happens because they get voted out of office when they raise taxes or cut
popular programs.
The nation's central bank uses monetary policy.
It lowers interest rates to end a contraction or trough. That's called expansionary
monetary policy. The central bank raises rates to manage an expansion so it doesn't peak.
That's contractionary monetary policy.
The goal of economic policy is to keep the economy growing at a sustainable rate. It
should be strong enough to create jobs for everyone who wants one but slow enough to
avoid inflation.
Three factors cause each phase of the business cycle. Those are the forces
of supply and demand, the availability of capital, and consumer confidence. The most
critical is confidence in the future. The economy grows when there is faith in the future
and in policymakers. It does the opposite when confidence drops. The history of
U.S. business cycles since 1929 can give an overview of how this measure of confidence
has affected the U.S. economy through the decades.

Inflation and deflation

Inflation is when prices rise, and deflation is when prices fall. You can have both inflation
and deflation at the same time in various asset classes. When taken to their extremes, both
are bad for economic growth, but for different reasons. That's why the Federal Reserve,
the nation's central bank, tries to control them. Here's how to recognize the signs of
rampant inflation and deflation, and how to protect your finances.
How to Tell the Difference Between Inflation and Deflation
There are fives types of inflation. The worst is hyperinflation. That's when prices
rise more than 50 percent a month. Fortunately, it's rare. That's because it's only caused
by massive military spending. On the other end of the scale is asset inflation, which
occurs somewhere nearly all the time. For example, each spring oil and gas
prices spike because commodities traders bid up oil prices. They anticipate rising demand
at the pump thanks to the summer vacation driving season.
The third type, creeping inflation, is when prices rise 3 percent a year or less. It's
somewhat common. It occurs when the economy is doing well. The last time it happened
was in 2007.
The fourth type is walking, or pernicious, inflation. Prices increase 3-10 percent a year,
enough for people to stock up now to avoid higher prices later. Suppliers and wages can't
keep up, which leads to shortages or prices so high that most people can't afford the
basics.
 67

The fifth type, galloping inflation, is when prices rise 10 percent or more a year. It can
destabilize the economy, drive out foreign investors, and topple government leaders. It's a
result of exchange rate fluctuations.
Deflation is when prices fall, but it can be difficult to spot. That's because all prices don't
fall uniformly.
During overall deflation, you can have inflation in some areas of the economy. In 2014,
there was deflation in oil and gas prices. Meanwhile, prices of housing continued to rise,
although slowly. That's why the Federal Reserve measures the core inflation rate. It takes
out the volatile price changes of oil and food.

Balance of payments
The balance of payments (BOP), also known as balance of international payments,
summarizes all transactions that a country's individuals, companies and government
bodies complete with individuals, companies and government bodies outside the country.
These transactions consist of imports and exports of goods, services and capital, as well
as transfer payments such as foreign aid and remittances.
A country's balance of payments and its net international investment position together
constitute its international accounts.
The balance of payments divides transactions in two accounts: the current account and
the capital account (sometimes the capital account is called the financial account, with a
separate, usually very small, capital account listed separately). The current account
includes transactions in goods, services, investment income and current transfers. The
capital account, broadly defined, includes transactions in financial instruments and
central bank reserves. Narrowly defined, it includes only transactions in financial
instruments. The current account is included in calculcations of national output, while the
capital account is not. (See also, What Is the Balance of Payments?)
The sum of all transactions recorded in the balance of payments must be zero, as long as
the capital account is defined broadly. The reason is that every credit appearing in the
current account has a corresponding debit in the capital account, and vice-versa. If a
country exports an item (a current account credit), it effectively imports foreign capital
when that item is paid for (a capital account debit).
If a country cannot fund its imports through exports of capital, it must do so by running
down its reserves. This situation is often refered to as a balance of payments deficit, using
the narrow definition of the capital account that excludes central bank reserves. In reality,
however, the broadly defined balance of payments must add up to zero by definition. In
practice, statistical discrepancies arise due to the difficulty of accurately counting every
transaction between an economy and the rest of the world.

Monetary and Fiscal Policies

 Monetary policy involves changing the interest rate and influencing the money
supply.
 Fiscal policy involves the government changing tax rates and levels of
government spending to influence aggregate demand in the economy.
They are both used to pursue policies of higher economic growth or controlling inflation.
Monetary policy
Monetary policy is usually carried out by the Central Bank/Monetary authorities and
involves:
 Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in the
US)
 Influencing the supply of money. E.g. Policy of quantitative easing to increase the
supply of money.
How monetary policy works
 68

 The Central Bank may have an inflation target of 2%. If they feel inflation is
going to go above the inflation target, due to economic growth being too quick,
then they will increase interest rates.
 Higher interest rates increase borrowing costs and reduce consumer spending and
investment, leading to lower aggregate demand and lower inflation.
 If the economy went into recession, the Central Bank would cut interest rates.
 See: Cutting interest rates
Fiscal policy
Fiscal policy is carried out by the government and involves changing:
 Level of government spending
 Levels of taxation
1. To increase demand and economic growth, the government will cut tax and
increase spending (leading to a higher budget deficit)
2. To reduce demand and reduce inflation, the government can increase tax rates and
cut spending (leading to a smaller budget deficit)
Example of expansionary fiscal policy
In a recession, the government may decide to increase borrowing and spend more on
infrastructure spending. The idea is that this increase in government spending creates an
injection of money into the economy and helps to create jobs. There may also be
a multiplier effect, where the initial injection into the economy causes a further round of
higher spending. This increase in aggregate demand can help the economy to get out of
recession.

This shows that in 2009/10 the UK ran a budget deficit of 10% of GDP. This was caused
by the recession and also the government’s attempt to provide a fiscal stimulus (VAT tax
cut) to try and get the economy out of recession.
 69

See more at: Expansionary fiscal policy

If the government felt inflation was a problem, they could pursue deflationary fiscal
policy (higher tax and lower spending) to reduce the rate of economic growth.
Which is more effective monetary or fiscal policy?
In recent decades, monetary policy has become more popular because:
 Monetary policy is set by the Central Bank, and therefore reduces political
influence (e.g. politicians may cut interest rates in desire to have a booming
economy before a general election)
 Fiscal policy can have more supply side effects on the wider economy. E.g. to
reduce inflation – higher tax and lower spending would not be popular, and the
government may be reluctant to pursue this. Also, lower spending could lead to
reduced public services, and the higher income tax could create disincentives to
work.
 Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to
cause crowding out – higher government spending reduces private sector
expenditure, and higher government borrowing pushes up interest rates.
(However, this analysis is disputed)
 Expansionary fiscal policy (e.g. more government spending) may lead to special
interest groups pushing for spending which isn’t really helpful and then proves
difficult to reduce when the recession is over.
 Monetary policy is quicker to implement. Interest rates can be set every month. A
decision to increase government spending may take time to decide where to spend
the money.
However, the recent recession shows that monetary policy too can have many limitations.
 Targeting inflation is too narrow. During the period 2000-2007, inflation was low
but central banks ignored an unsustainable boom in the housing market and bank
lending.
 Liquidity trap. In a recession, cutting interest rates may prove insufficient to boost
demand because banks don’t want to lend and consumers are too nervous to
spend. Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t
solve recession in the UK.
 Even quantitative easing – creating money may be ineffective if banks just want
to keep the extra money on their balance sheets.
 Government spending directly creates demand in the economy and can provide a
kick-start to get the economy out of recession. Thus in a deep recession, relying
on monetary policy alone, may be insufficient to restore equilibrium in the
economy.
 In a liquidity trap, expansionary fiscal policy will not cause crowding out because
the government is making use of surplus saving to inject demand into the
economy.
 In a deep recession, expansionary fiscal policy may be important for confidence –
if monetary policy has proved to be a failure.