MODULE -1 INTRODUCTION

Managerial Economics: Meaning, Nature, Scope, & Significance, Uses of Managerial

Economics, Role and Responsibilities of Managerial Economist. Theory of the Firm: Firm and
Industry, Objectives of the firm, alternate objectives of firm.

Managerial theories: Baumol’s Model, Marris’s Hypothesis, Williamson’s Model.

Economics is a social science concerned with the production, distribution, and consumption of goods and
services.
Economics studies how individuals, businesses, governments, and nations make choices about how to
allocate resources. Economics focuses on the actions of human beings, based on assumptions that humans
act with rational behavior, seeking the most optimal level of benefit or utility.
Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the
economy as a whole (analyzes the decisions made by countries and governments), and microeconomics,
which focuses on individual people and businesses (allocation of resources, and prices of goods and
services, taxes, regulations and government legislation.).

MANAGERIAL ECONOMICS: MEANING & DEFINITION

• “Managerial economics is concerned with the application of economic concepts and economicanalysis to
the problems of formulating rational managerial decisions.
• Branch of Economics: ‘Managerial Economics is the study of Economic Theories, Principles and
Concepts which is used in Managerial Decision Making.’
• ‘Managerial Economics is the Application of various Theories, Concepts and Principles of Economics in
the Business Decisions.’
• It also includes ‘The Application of Mathematical and Statistical tools in Managementdecisions.’

Definition:
1. “Managerial economics is the study of allocation of resources available to a firm among theactivities of
that unit” - Hynes.
2. “The integration of economic theory and business practice for the purpose of facilitatingdecision making
and forward planning by management. – Spencer and Seligman.
3. “Managerial economics is the application of economic principles and methodologies to the decision-

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 making process within the firm or organization.”-Douglas.
4. “Managerial economics applies economic theory and methods to business and administrative decision-
making.”- Pappas & Hirschey.

MACROECONOMICS:

⚫ The study of economic activity by looking at the economy as a whole.

⚫ Macroeconomics analyzes overall economic issues such as employment, inflation, productivity, interest
rates, the foreign trade deficit, and the federal budget deficit. ...
⚫ An example of macroeconomics is the study of U.S. employment.

MICROECONOMICS:

⚫ Microeconomics is the social science that studies the implications of incentives and decisions, specifically
about how those affect the utilization and distribution of resources.
⚫ Microeconomics shows how and why different goods have different values, how individuals and businesses
conduct and benefit from efficient production and exchange, and how individual’s best coordinate and
cooperate with one another.
⚫ Generally speaking, microeconomics provides a more complete and detailed understanding than
macroeconomics.

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 NATURE OF MANAGERIAL ECONOMICS:

1. Art and Science: Management theory requires a lot of critical and logical thinking and analytical skills to
make decisions or solve problems. Many economists also find it a source of research, saying it includes
applying different economic concepts, techniques and methods to solve business problems.
2. Micro Economics: In managerial economics, managers typically deal with the problems relevant to a
single entity rather than the economy as a whole. It is therefore considered an integral part of
microeconomics.
3. Uses Macro Economics: A corporation works in an external world, i.e. it serves the consumer, which is an
important part of the economy. For this purpose, it is important that managers evaluate the various
macroeconomic factors such as market dynamics, economic changes, government policies, etc., and their
effect on the company.

Multidisciplinary: It uses many tools and principles that belong to different disciplines, such as accounting,
finance, statistics, mathematics, production, operational research, human resources, marketing, etc.

4. Prescriptive/Normative Discipline: By introducing corrective steps it aims at achieving the objective and
solves specific issues or problems.
5. Management Oriented: This serves as an instrument in managers’ hands to deal effectively with business-
related problems and uncertainties. This also allows for setting priorities, formulating policies, and taking
successful decision-making.
6. Pragmatic: The solution to day-to-day business challenges is realistic and rational.
7. It is concerned with the application of theories and principles of economics.

SCOPE OF MANAGERIAL ECONOMICS:

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 Managerial economics is concerned with the application of economic concepts and analysis to the problem
of formulating rational managerial decisions. There are four groups of problem in both decision making and
forward planning.
1. Demand Analysis and Forecasting:
 A firm relies on converting inputs into outputs and generates revenue from them. A clear and accurate
estimation of demand ensures a continuous efficiency of the firm. Several external factors like price,
income, affect the demand that need to be analyzed.
 Upon analyzing these factors affecting the demand for a product, managers can decide on the produ ction.
After estimating the current demands, manager’s move ahead to predict futuredemands for the product. This
is referred to as demand forecasting.

2. Cost and Production Analysis:

 Cost Analysis is yet another function of Managerial economics.
 A company makes a profit in two ways: by increasing the demand or by reducing the cost.
 The determinants of assessing costs, the connection between cost and yield, the gauge of costand benefit
are indispensable to a firm.

3. Pricing Decisions, Policies, and Practices:

⚫ Among the 4Ps of marketing, Price finds an important place. For any firm, Pricing is a very important
aspect of Managerial Economics as a firm's revenue earnings largely depend on its pricing policy. However,
it is a bit challenging as other players are competing in the same price segment.
⚫ When pricing a product is done, the costs of production are also taken into account. Managerial

Economics helps the management to go through all the analyses and then price a product. In an oligopoly
market condition, the knowledge of pricing a product is essential.

4. Capital Management:
⚫ Every asset a business owns is known as its capital. Capital management thus becomes animportant
practice.
⚫ Planning and control of capital expenditures is a basic executive function. It involves the Equi- marginal
principle.

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⚫ The prime objective is to ensure the sustainable use of capital. This means that funds should bekept at a
bay when the managerial returns are less than in other uses.

5. Profit Management:
⚫ A business firm is an organization designed with an intention to make profits and profits reflectthe success
of a company. After all the analyses, it all rolls down to profits.
⚫ To maximize profits a firm needs to manage certain things like pricing, cost aspects, resource allocation,
and long-run decisions. This would mean that the firm should work from the very beginning, evaluate its
investment decisions and frame the best capital budgeting policies. Profit management is considered as a
difficult area of managerial economics.

OTHER:

⚫ Resource allocation: Scarce resources have to be used with utmost efficiency to get optimal results. These
include production programming, problem of transportation, etc.
⚫ Inventory and queuing problem: Inventory problems involve decisions about holding of optimal levels of
stocks of raw materials and finished goods over a period. These decisions are taken by considering demand
and supply conditions. Queuing problems involve decisions about installation of additional machin es or
hiring of extra labour in order to balance the business lost by not undertaking these activities.
⚫ Pricing problems: Fixing prices for the products of the firm is an important part of the decision

Making process. Pricing problems involve decisions regarding various methods of pricing to be adopted.
⚫ Investment problems: Forward planning involves investment problems. These are problems of

Allocating scarce resources over time. For example, investing in new plants, how much to invest, sources of
funds, etc.

Study of managerial economics essentially involves the analysis of certain major subjects like:

 Demand analysis and methods of forecasting

 Cost analysis
 Pricing theory and policies
 Profit analysis with special reference to break-even point

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 Capital budgeting for investment decisions
 The business firm and objectives
 Competition.
 Inflation and economic conditions.

SIGNIFICANCE OF MANAGERIAL ECONOMICS:

 Business Planning: Managerial economics assists business organizations in formulating plans and better
decision making. It helps in analyzing the demand and forecasting future business activities.
 Cost Control: Controlling the cost is another important role played by managerial economics. It properly
analyses and decides production activities and the cost associated with them. Managerial economics ensure
that all resources are efficiently utilized which reduces the overall cost.
 Price Determination: Setting the right price is one of the key decisions to be taken by every business
organization. Managerial economics supplies all relevant data to managers for deciding the right prices for
products.
 Business Prediction: Managerial economics through the application of various economic tools and theories
helps managers in predicting various future uncertainties. Timely detection of uncertainties helps in taking
all possible steps to avoid them.
 Profit Planning and Control: Managerial economics enables in planning and managing the profit of the
business. It makes an accurate estimate of all cost and revenue which helps in earning the desired profit.
 Inventory Management: Proper management of inventory is a must for ensuring the continuity of business
activities. It helps in analyzing the demand and accordingly, production act ivities are performed. Managers
can arrange and ensure that the proper quantity of inventory is always available within the business
organization.
 Manages Capital: Managerial economics helps in taking all decisions relating to the firm’s capital. It
properly analyses investment avenues before investing any amount into it to ensure the profitability of an
investment.
 Assist in Decision Making
 Optimization of Resources

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 USES OF MANAGERIAL ECONOMICS:
1. Production Decisions : Production theory explains the principles in which the business has to take
decisions on how much of each commodity it sells and how much it produces and also how much of raw
material ie., fixed capital and labour it employs and how much it will use.
2. Inventory Decisions: Inventory decisions have a direct impact on production. For example, a decision to
increase safety stock means that the production rate must increase until the desired level of safety stock is
achieved
3. Cost Decisions: Its goal is to advise management on the most appropriate course of action based on the cost
efficiency and capability. Cost accounting provides the detailed cost information that management needs to
control current operations and plan for the future.
4. Marketing Decisions: Marketing decisions are those decisions that are taken by a marketing manager to
achieve the ultimate marketing objectives of the organization.
5. Investment Decisions: Investment decision refers to selecting and acquiring the long-term and short- term
assets in which funds will be invested by the business.
6. Personnel Decisions: Personnel decisions are decisions made in organizations that affect people's work
lives, such as selection, placement, and discharge. • All business organizations must make personnel
decisions about their employees. Some organizations use less formal and scientifically based methods than
others.

MANAGERIAL ECONOMIST:

⚫ A Managerial Economist is also termed as an economic advisor or business economist.

⚫ He is responsible for analyzing various internal and external environmental forces that influence the
functioning of business organizations.
⚫ Managerial economist makes several successful business forecasts and updates the management team
regarding the economic trends from time to time

ROLES AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST:

A managerial economist helps the management by using his analytical skills and highly developed
techniques in solving complex issues of successful decision-making and future advanced planning and
assists the business planning process of a firm.

⚫ Studies Business Environment

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 The managerial economist is responsible for analyzing the environment in which business operates.
Proper study of all external factors that affect the functioning of organization is must for proper
functioning. He studies various factors like growth of national income,

Competition level, price trends, phases of the business cycle and economy and updates the
management regarding it from time to time.
⚫ Analyses Operations Of Business

He analyses the internal operation of business and helps management in making better decisions in
regard to internal workings. Managerial economist through his analytical and forecasting skills provides
advice to managers for formulating policies regarding internal operations of the business.

⚫ Demand Forecasting and Estimation

Proper estimation and forecasting of future trends helps the business in achieving desired
profitability and growth. Managerial economist through proper study of all internal and external forces
makes successful forecasting of future uncertainties or trends.
⚫ Production Planning

Managerial economist is responsible for scheduling all production activities of business. He

evaluates the capital budgets of organizations and accordingly helps in deciding timing and locating of
various actions.

⚫ Economic Intelligence

He provides economic intelligence services by communicating all economic information to

management. Managerial economist keeps management always updated of all prevailing economic trends so
that they can confidently talk in seminars and conferences.
⚫ Performing Investment Analysis

A managerial economist analyzes various investment avenues and chooses the most appropriate one.
He studies and discovers new possible fields of business for earning better returns.

⚫ Focuses On Earning Reasonable Profit

He assists management in earning a reasonable rate of profit on capital employed in the business.
Managerial economist monitors activities of organizations to check whether all operations are running
efficiently as per the plans and policies.

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⚫ Maintaining Better Relations

A managerial economist maintains better relations with all internal and external individuals
connected with the business. It is his duty to develop a peaceful and cooperative environment within the
organization and aims to reduce any opposition taking place.

THEORY OF THE FIRM:

The theory of the firm is the microeconomic concept founded in neoclassical economics that states that a
firm exists and makes decisions to maximize profits. The theory holds that the overall nature of companies
is to maximize profits meaning to create as much of a gap between revenue and costs. The firm's goal is to
determine pricing and demand within the market and allocate resources to maximize net profits.
Theory of the firm is related to comprehending how firms come into being, what are their objectives, how
they behave and improve their performance and how they establish their credentials and standing in society
or an economy and so on.
The theory of the firm aims at answering the following questions:

• Existence – why do firms emerge and exist, why are not all transactions in the economy mediatedover the
market?
• Which of their transactions are performed internally and which are negotiated in the market?

• Organization – why are firms structured in such a specific way? What is the interplay of formaland
informal relationships?
• Heterogeneity of firm actions/performances – what drives different actions and performancesof firms?

FIRM AND INDUSTRY

A Firm is a commercial enterprise, a company that buys and sells goods and services to consumers with the
aim of making a profit. A business entity such as a corporation, limited liability company, public limited
company, sole proprietorship, or partnership that has goods or services for sale is categorized as a firm.
An Industry is an economic activity concerned with the processing of raw materials and manufacture of
goods. It can also be said as a sector that produces goods or related services within an economy.

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 OBJECTIVES OF THE FIRM
1. Profit maximization
2. Sales maximization
3. Utility maximization
4. Increase market share/market dominance
5. Social/environmental concerns
6. Profit satisficing
7. Co-operatives

1. Profit maximization: Considering any business that exists, they are usually concerned with
maximizing [Link] profit means:
 Higher dividends for shareholders.

 More profit can be used to finance research and development. Higher profit makes the firm less

vulnerable to takeover.
 Higher profit enables higher salaries for workers.

2. Sales Maximization: Firms often seek to increase their market share, even if it means less profit. This
could occur for various reasons:
Increased market share increases monopoly power and may enable the firm to put up prices and make more
profit in the long run.
Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries.
Increasing market share may force rivals out of business. E.g. the growth of supermarkets has led to the
demise of many local shops. Some firms may actually engage in predatory pricing which involves making a
loss to force a rival out of business.
3. Utility maximization: It means “that managers get satisfaction from using some of the firm's
potential profits for unnecessary spending on items from which they personally benefit.” To pursue his
goal of utility maximization, the manager directs the firm's resources many ways.
4. Increase Market Share/ Market Dominance: This is similar to sales maximization and may involve
mergers and takeovers. With this objective, the firm may be willing to make lower levels of profit in order
to increase in size and gain more market share. More market share increases its monopoly power and ability
to be a price setter.
5. Social Concern: A firm may incur extra expense to choose products which don’t harm the environment or

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 products not tested on animals. Alternatively, firms may be concerned about local community / charitable
concerns.
 Some firms may adopt social/environmental concerns as part of their branding. This can ultimately help

profitability as the brand becomes more attractive to consumers.

 Some firms may adopt social/environmental concerns on principal alone – even if it does little to improve

sales/brand image.
6. Profit Satisficing: Profit satisficing is a situation where there is a separation of ownership and control. As a
result, the owners are likely to have different objectives to the managers and workers.
7. Co-operatives: Co-operatives may have completely different objectives to a typical business. A co-
operative is run to maximize the welfare of all stakeholders – especially workers. Any profit the co-
operative makes will be shared amongst all members.

ALTERNATE OBJECTIVES OF THE FIRM:

• Economic objectives:
• Maximize growth rate
• Desire for liquidity
• Non-economic objectives:
• Survival
• Retention of Customers
• Innovation
• Recognition
• Optimum Utilization of Resources
• Supplying desired goods at reasonable prices
• Social welfare
• Building up public confidence for the public

MANAGERIAL THEORIES OF THE FIRM:

Managerial theories of the firm place emphasis on various incentive mechanisms in explaining the behavior
of managers and the implications of this conduct for their companies and the wider economy.
According to traditional theories, the firm is controlled by its owners and thus wishes to maximize short
run profits. The more contemporary managerial theories of the firm examine the possibility that the firm is
controlled not by its owners, but by its managers, and therefore does not aim to maximize profits. Although

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 profit plays an important role in these theories as well, it is no longer seen as the sole or dominating goal of
the firm. The other possible aims might be sale revenue maximization or growth.

MANAGERIAL THEORIES OF THE FIRM

• Baumol's Theory of Sales Revenue Maximization
• Marris Growth Maximization Model
• Williamson’s Managerial Discretionary Theory

1. BAUMOL'S THEORY OF SALES REVENUE MAXIMISATION:

Baumol’s Model: Baumol's theory of sales revenue maximization was created by American economist
William Jack Baumol. It's based on the theory that, once a company has reached an acceptable level of
profit for a good or service, the aim should shift away from increasing profit to focus on increasing revenue
from sales.
[Link] suggested Sales Revenue maximization as an alternative goal to profit maximization. Managers
only ensure acceptable level of profit, pursuing a goal which enhances their own utility.
Assumption of the Theory:

1. There is a single period time horizon of the firm.

2. The firm aims at maximizing its total sales revenue in the long run subject to a profitconstraint.
3. The firm’s minimum profit constraint is set competitively in terms of the current market value of its
shares.
4. The firm is oligopolistic whose cost curves are U-shaped and the demand curve isdownward sloping. Its
total cost and revenue curves are also of the conventional type.

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 From the above graph considering Output in X axis and TR/TC/profit in Y axis, where TC is the total cost
curve, TR the total revenue curve, TP the total profit curve and MP the minimum profit or profit constraint
line. The firm maximizes its profits at OQ level of output corresponding to the highest point В on the TP
curve. But the aim of the firm is to maximize its sales rather than profits. The sales maximization output is
OK where the total revenue KL is the maximum at the sales maximization output OK is higher than th e
profit maximization output OQ. But sales maximization is subject to minimum profit constraint highest
point of TR. This sales maximization output OK is higher than the profit maximization output OQ. But sales
maximization is subject to minimum profit constraint. The output OK will not maximize sales as the
minimum profits OM are not being covered by total profits KS hence total revenue gets decrease from L to
E showing the quantity level showing the quantity of output ‘OD’. By the above Baumol justified t hat sales
revenue has to be optimally increased.

ARGUMENTS IN FAVOUR OF MAXIMISATION OF SALES GOAL:

Baumol’s argument to justify sales revenue importance.

1. If the sales of a firm are declining then the banks, creditors and the capital market are notprepared to
provide finance to the firm anymore.
2. Its own distributors and dealers might stop showing interest on the firm’s product infuture.
3. Consumers might not buy its product because of its unpopularity and there is a more chance of
competitors acquiring the consumers.

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4. Firm reduces its managerial and other staff with fall in sales.

5. But if firm’s sales are large, there are economies of scale and the firm expands and earnslarge profits.
6. Salaries of workers and management also depend to a large extent on more sales and the firm gives them
bonus and other facilities.

Conclusion: This theory states that the sales maximization is to increase the total revenue by money
where, Sales can increase up to the point of profit maximization where the marginal cost equals marginal
revenue. If sales are increased beyond this point money sales may increase at the expense of profits. If sales
are increased beyond this point money sales may increase at the expense of profits.

2. MARRIS’S GROWTH MAXIMIZATION MODEL:

Robin Marris in his book The Economic Theory of ‘Managerial’ Capitalism (1964) has developed adynamic
balanced growth maximizing theory of the firm. He concentrates on the proposition that modern big firms
are managed by managers and the shareholders are the owners who decide about the management of the
firms.
The managers aim at the maximization of the growth rate of the firm and the shareholders aim at the
maximization of their dividends and share prices. To establish a link between su ch a growth rateand the
share prices of the firm, Marris develops a balanced growth model in which the manager chooses a
constant growth rate at which the firm’s sales, profits, assets, etc., grow.
“In Corporate firms, there is structural division of ownership and management which allows managers to set
goals which do not necessarily conform to those of the owners.
The shareholders are the owners. Their utility function includes variables such as
 Profits,
 Size of output,
 Size of capital,
 Market share and
 Public image.
The Managers have other ideas. Their utility functions are:
 Salaries,
 Job security,

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  Power and status
The Marris’s model is based on the following assumptions:
 It assumes a given price structure.
 Production costs are given.
 There is no oligopolistic interdependence.
 Factor prices are constant.
 Finns are assumed to grow through diversification.
 All major variables such as profits, sales and costs are assumed to increase at the same rate.
 The objective of the firm is to maximize its balanced growth rate.

The Growth itself depends on two factors: First, the rate of growth of demand for the firm’sproduct -
GD; and second, the rate of growth of capital supply – GS.
All major variables such as profits, sales and costs are assumed to increase at the same rate.

• According to Marris, there are two different utility functions for the manager and the owner of the firm. The
utility function of the manager consists of his emoluments, status, power, job security, etc. On the other
hand, the utility function of the owner includes profits, capital, output, market share, etc.
• The firm may grow in size through the creation of new products which create new demands. Marris calls it
differentiated diversification. The introduction of new products depends upon the rate of diversification,
advertising expenses, R&D expenditures, etc.

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• Marris establishes the relationship between growth and profits on the demand side through diversification
into new products. The links between growth and profits are different at different levels of growth. In this
growth-profits relationship, growth determines profits. When the rate of growth of the firm is low, the
relationship is a positive one.
• As new products are introduced, the firm expands (grows) and profits increase. With the further increase in
the growth rate due to greater diversification into new products, the growth-profits relationship becomes
negative. This is because there is the managerial constraint which sets a limit on the rate of managerial
growth that restricts the growth of the firm.

The firms’ managerial ability to cope with a great number of changes at once is limited. It is not possible to
develop a larger management team for the development and marketing of new products.

• The higher rate of diversification requires higher expenditures on advertising and R &D. As a result, beyond
a certain growth rate, the higher growth rate leads to a lower rate of profit. This is illustrated in Figure 4
where the GD curve first rises, reaches the highest point M andthen starts falling.
• The growth-supply curve will be very steep as shown by GS1 curve. The firm’s equilibrium will be at point
L where the GS1 curve intersects the GD curve. This is again not the optimal equilibrium point of the firm
because here the growth rate is low and profits are below the maximum level.
• Larger retained profits are required by managers to invest larger funds for the growth of the firm. These
raise the retention ratio which, in turn, leads to higher profits and higher growth rates until point M of
maximum profits is reached.
• This is again not the optimum equilibrium point of the firm because the managers feel that this combination
of higher growth rate and higher profits is approved by the shareholders and there is no threat to their job
security. They will, therefore, be encouraged to raise the retention ratio further, invest more funds, expand
and increase the growth rate of the firm.
• As a result, the growth-supply curve will become flatter and take the shape of GS3 curve as in the figure
where it intersects the DS curve at point E. At this point, distributed profits to shareholders fall. But they are
adequate to satisfy the shareholders so that there is no fear of fall in the prices of shares and of the threat of
take-overs. There is also job security for managers.
• Thus point E is the optimal equilibrium point of the firm. If the managers adopt a higher retention ratio than
this, the distributed profits will fall further and the shareholders will not be satisfied which will endanger the
job security of managers. The existing shareholders may decide to replace the managers. If the distribution
of low profits to shareholders bringsa fall in the market prices of shares, it may lead to take-over of the firm.

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• Criticism:
⚫ Marris assumes a given price structure for the firms. He, therefore, does not explain how prices of products
are determined in the market. This is a serious weakness of his model.
⚫ . Another defect of this model is that it ignores the problem of oligopolistic interdependence of firms in non-
collusive market.
⚫ The assumption that all major variables such as profits, sales and costs increase at the same rate is highly
unrealistic.
⚫ It is also doubtful that a firm would continue to grow at a constant rate, as assumed by Marris. The firm
might grow faster now and slowly later on.
⚫ Marris lumps together advertising and R&D expenses in his model. This is a serious shortcoming of the
model because the effectiveness of these two variables is not the same in any given period.

Conclusion:
• Thus the manager of a firm aims at maximizing his utility, and his utility depends upon the rate of growth of
the firm. Though promoting the growth of the firm is the main aim of the manager, yet he is also motivated
by his job security. The manager’s job security depends upon the satisfaction of shareholders who are
concerned to keep the firm’s share prices and dividends as high as possible.
• Thus the manager aims at maximizing the rate of growth of the firm and the shareholders (owners) aim at
maximizing their profits in the form of dividends and share prices. Marris analyses the means by which the
firm tries to achieve its growth-maximization goal.

3. WILLIAMSON’S MANAGERIAL DISCRETIONARY THEORY:

 Oliver E. Williamson found (1964) that profit maximization would not be the objective of the managers of
a company.
 This theory assumes that utility maximization is a manager’s sole objective. However it is only in a
corporate form of business organization that a self-interest seeking manager

Maximize his/her own utility, since there exists a separation of ownership and control.

 The managers can use their ‘discretion’ to frame and execute policies which would maximize their own
utilities rather than maximizing the shareholders’ utilities.
 This is essentially the principal–agent problem. This could however threaten their job security, if a

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 minimum level of profit is not attained by the firm to distribute among the shareholders.
 Utility function or "expense preference"[8] of a manager can be given by:

U=U(S,M,Id)

U denotes the Utility function,

S denotes the “monetary expenditure on the staff” (not only the manager's salary and other forms of
monetary compensation received by him from the business firm)

M stands for "Management Slack“(non-essential management perquisites such as entertainment

expenses, lavishly furnished offices, luxurious cars, large expense accounts, etc. which are above
minimum to retain the managers in the firm) and
ID stands for amount of "Discretionary Investment". (The amount of resources left at a manager's disposal,
to be able to spend at his own discretion. For example, spending on latest equipment, furniture, decoration
material, etc.)

Managerial utility function:

The managerial utility function includes variables such as salary, job security, power, status, dominance,
prestige and professional excellence of managers.
The basic assumptions of the model are:
• Imperfect competition in the markets.
• Divorce of ownership and management.
• A minimum profit constraint exists for the firms to be able to pay dividends to their shareholders.

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• Fig 1. Shows the various levels of utility (U1, U2, U3) derived by the manager by combining different
amounts of discretionary profits and staff expenditure. Higher the indifference curve, higher is the level of
utility derived by the manager. Hence the manager would try to be on the highest level of indifference curve
possible given the constraints. Staff expenditure is plotted on the x-axis and discretionary profits on the y-
axis.
• The discretionary profit in this simplified model is equal to the discretionary investment. The
indifference curves are downward sloping and convex to the origin. This shows diminishing marginal rate
of substitution of staff expenditure for discretionary profits. The curves are asymptotic in nature
which implies that at any point of time and under any given circumstance the manager will choose positive
amounts of both discretionary profits and staff expenditure

⚫ Assuming that the firm is producing an optimum level of output and the market environment is given, the
discretionary profits curve is generated, shown in Fig 2. It gives the relationship between staff expenditure
and discretionary profits.
⚫ It can be seen from the figure that profit will be positive in the region between the points B and
⚫ Initially with increase in profits, the staff expenditure the discretionary profits also increase, but this is only
till the point Πmax that is, till S level of staff expenditure. Beyond this if staff expenditure is increased due

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 to increase in output, and then a fall in the discretionary profits is noticed.
⚫ Staff expenditure of less than B and more than C is not feasible as it wouldn't satisfy the

Minimum profit constraint and would in turn threaten the job security of managers.

• To find the equilibrium in the model, Fig 1. Is superimposed on Fig 2.

• The equilibrium point is the point where the discretionary profit curve is tangent to the highest possible
indifference curve of the manager, which is point E in Fig 3. Staying at the highest profit point would
require the manager to be at a lower indifference curve U2.
• In this case the highest attainable level of utility is U3. At equilibrium, the level of profits would be lower
but staff expenditure S* is higher than the staff expenditure made at the maximum profit point.
• As indifference curve is downward sloping, the equilibrium point would always be on the right of the
maximum profit point. Thus the model shows the higher preference of managers for staff expenditure
as compared to the discretionary investments
Arguments:

⚫ In the Williamson theory or model argues that managers have discretion in pursuing policies which
maximize their own utility rather than attempting the maximization of profits which maximizes the utility of
owner and shareholders.

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 ⚫ Profit acts as a constraint to this managerial behavior in that the financial market and the

Shareholders require a minimum profit to be paid out in the form of dividends, otherwise the job
Security of managers is endangered.

⚫ In this theory Williamson considered the two important factors namely, staff expenditures on emoluments
(slack payments), and funds available for discretionary investment give to managers a positive satisfaction
(utility) because these expenditures are a source of security and reflect the power, status, prestige and
professional achievement of managers.
⚫ Being the head of a large staff is a symbol of power, status and prestige, as well as a measure of

Professional success, because a progressive and increasing staff implies successful expansion of the
particular activity for which a manager is responsible within a firm.

Criticism:

⚫ This model does not clarify the basis of the derivation of his feasibility curve. In particular, he fails to
indicate the constraint in the profit-staff relation, as shown by the shape of the feasibility curve.
⚫ It lumps together staff and manager’s emoluments in the utility curve. This mixing up of non-

Pecuniary and pecuniary benefits of the manager make the utility function ambiguous.

⚫ This model does not deal with oligopolistic interdependence and of oligopolistic rivalry.
Arguments:

• In the Williamson theory or model argues that managers have discretion in pursuing policies which
maximize their own utility rather than attempting the maximization of profits which maximizes the utility of
owner and shareholders.
• Profit acts as a constraint to this managerial behavior in that the financial market and the shareholders
require a minimum profit to be paid out in the form of dividends; otherwise the job security of managers is
endangered.
• In this theory Williamson considered the two important factors namely, staff expenditures on emoluments
(slack payments), and funds available for discretionary investment give to managers a positive satisfaction
(utility) because these expenditures are a source of security and reflect the power, status, prestige and

Page 21
 professional achievement of managers.
• Being the head of a large staff is a symbol of power, status and prestige, as well as a measure of

Professional success, because a progressive and increasing staff implies successful expansion of the
particular activity for which a manager is responsible within firm.

From the above graph, taking Discretion Profit in Y-axis and Staff Expenditure in X- axis, where U1, U2,
U3 shows the utility level of the managers with facilities provided by the firm. With the different
combination of factors the level of utility changes. Hence the profit of the firm relies on the ideal
combination of factors such as Discretion Profit and Staff Expenditure.

Criticism:

1. This model does not clarify the basis of the derivation of his feasibility curve. In particular, he fails to
indicate the constraint in the profit-staff relation, as shown by the shape of the feasibility curve.
2. It lumps together staff and manager’s emoluments in the utility curve. This mixing up of non- pecuniary and
pecuniary benefits of the manager makes the utility function ambiguous.
3. This model does not deal with oligopolistic interdependence and of oligopolistic rivalry.

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 QUESTION BANK:

1. Define managerial economics.3m

2. What is Managerial Revenue and Managerial Cost?3m
3. Explain the concepts of Micro and Macroeconomics.7m
4. Discuss the scope of managerial economics.7m/10m
5. Explain the significance and uses of managerial economics.10m
6. Who is Managerial Economist? Elaborate the roles and responsibilities of managerial
economist.10m
7. Discuss the objectives of the firm.7m
8. Explain the Baumol’s sales revenue maximization model, with a suitable graph.10m
9. Elaborate the Marris’s model? Explain with graph 10m
10. Enumerate the Williamson’s Discretionary model with a graph? 1

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 Module – 2 Demand Analysis

Demand meaning:
Demand is an economic principle referring to a consumer's desire to purchase goods and
services and willingness to pay a price for a specific good or service. Holding all other factors
constant, an increase in the price of a good or service will decrease the quantity demanded,
and vice versa.
Demand analysis is the process of understanding the customer demand for a product or
service in a target market. Companies use demand analysis techniques to determine if they
can successfully enter a market and generate expected profits to expand their business
operations.

Definition:
“The demand for anything, at a given price, is amount of it, which will be bought per unit of
time, at that price.”
- Benham
“The demand for any commodity or service is amount that will be bought at any given price
per unit of time.”

-G L Thiekettle
In economics, demands refer to effective demand, which implies three things:
1. Desire to buy a product,
2. Means to purchase,
3. Ask the quality of product, and
4. On willingness to use those means for that purchase.

Nature of demand:
1. Desire and demand.
2. Demand and price.
3. Point of time.
4. Utility.
5. Effective Demand.

6. Flow concept.
7. Final consumer goods.
8. Desired quantity.

Objectives of demand analysis:

1. Demand forecasting.
2. Production planning.

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 Module – 2 Demand Analysis

3. Sales forecasting.
4. Control of business.
5. Inventory control.
6. Growth and long-term investment programs.
7. Economic planning and policy making.

Types of demand:
Demand = Desire + Willingness to pay+ Ability to pay.

Consumer Goods and Producer Goods (direct & derived demand)

Goods and services used for final consumption are called consumer goods. These include,
goods consumed by human-beings, animals, birds etc.
Producer goods refer to the goods used for production of other goods, like plant and
machines, factory buildings, services of employees, raw materials etc.

Perishable and Durable Goods

Refers to the classification of demand on the basis of usage of goods. The goods are divided
into two categories, perishable goods and durable goods.
Perishable or non-durable goods refer to the goods that have a single use.

For example, cement, coal, fuel, and eatables.

On the other hand, durable goods refer to goods that can be used repeatedly.
For example, clothes, shoes, machines, and buildings. Perishable goods satisfy the present
demand of individuals. However, durable goods satisfy both present as well as future demand
of individuals. Therefore, consumers purchase durable items by considering its durability. In
addition the durable goods need replacement because of their continuous use. The demand for
perishable goods depends on current price of goods and customer incomes, tastes and
preferences and changes frequently, while the demand for durable goods changes over a
longer period of time.

Short-term and Long-term Demand:

Refers to the classification of demand on the basis of time period.

Short-term demand refers to the demand for products that are used for a shorter duration of
time or for current period. This demand depends on the current tastes and preferences of
consumers.
For example, demand for umbrellas, raincoats, sweaters, long boots is short term and
seasonal in nature.
A cut in the price of electricity in the short run will induce the existing users of electric
appliances to make greater use of these appliances.
On the other hand, long-term demand refers to the demand for products over a longer period
of time.
Generally, durable goods have long-term demand.
For example a cut in the price of electricity will induce more and more people to use these
electric appliances. This will result in a still greater demand for electricity.
The long-term demand of a product depends on a number of factors, such as change in
technology, type of competition, promotional activities, and availability of substitutes. The

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 Module – 2 Demand Analysis

short-term and long-term concepts of demand are essential for an organization to design a
new product.

Firm and Industry Demand

Refers to the classification of demand on the basis of market.
The demand for the products of a firm at given price over a point of time is known as firm’s
demand.
For example, the demand for Toyota cars is organization demand.
The sum total of demand for products of all organizations in a particular industry is known as
industry demand.
For example, the demand for cars of various brands, such as Toyota, Maruti Suzuki, Tata, and
Hyundai, in India constitutes the industry’ demand.

Autonomous and Derived Demand:

Refers to the classification of demand on the basis of dependency on other products.
The demand for a product that is not associated with the demand of other products is known
as autonomous or direct demand. The autonomous demand arises due to the natural desire of
an individual to consume the product.
For example, the demand for food, shelter, clothes, and vehicles is autonomous as it arises
due to biological, physical, and other personal needs of consumers.
On the other hand, derived demand refers to the demand for a product that arises due to the
demand for other products.
For example, the demand for petrol, diesel, and other lubricants depends on the demand of
vehicles. Apart from this, the demand for raw materials is also derived demand as it is
dependent on the production of other products. Moreover, the demand for substitutes and
complementary goods is also derived demand.

Law of Demand:
According to Marshall, “The amount demanded increases with a fall in price, and diminishes
with a rise in price”. Thus, it expresses an inverse relation between price and demand. The
law refers to the direction in which quantity demanded changes with a change in price.

Assumptions of law of demand:

1. Income Level should remain constant:
2. Tastes of the buyer should remain constant:
3. Prices of other goods should remain constant:
4. No new substitute for the commodity:
5. Price rise in future should not be expected:

Exceptions to the law of demand: In an economic environment, the central determinants of

the economic situation are the supply and demand factors. In the cutthroat business sectors,
the stability of the price of an item continues to vacillate insofar as demand and supply aren’t
equal. The present circumstance is where the demand and supply are in balance or at
equilibrium.
Below is the list as to why there are exceptions to the Law of Demand:
War:

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 Module – 2 Demand Analysis

If shortage is feared in anticipation of war, people may start buying for building stocks or for
hoarding even when the price rises.
Depression:
During a depression, the prices of commodities are very low and the demand for them is also
less. This is because of the lack of purchasing power with consumers.

Giffen goods:
Giffen Goods was conceptualised and presented by Sir Robert Giffen. Godrej goods are
products that are substandard or inferior goods when compared to luxury products. In any
case, the remarkable feature of Giffen goods is that as the cost increases, the quantity
demanded will also increase. Also, this component is the thing that makes it an exemption for
the law of interest.
The Irish Potato Famine is an exemplary illustration of the Giffen goods. Although the potato
famine in Ireland didn’t cut the consumption of potatoes, it increased in its consumption as
potatoes are a staple in the Irish eating routine. During the famine, when the cost of potatoes
had increased exceptionally from its regular price, individuals saved on extravagant food
sources like meat and purchased more potatoes to adhere to their eating regimen. So as the
cost of potatoes expanded, so did the demand, which is a complete inversion of the law of
demand.

Veblen goods:
Thorstein Veblen, an economist, is the one who conceptualised and presented the Veblen
goods in his Theory of “Conspicuous consumption”. As per Veblen, there are some products
that become more significant and valuable as their price or cost increases. Assuming an item
or a product or service is costly, then, at that point, its worth, value, and utility are seen to be
more, and henceforth the demand for that product or service increases.
Also, this happens generally with luxury products and precious metals and stones, for
example, gold, platinum, precious stones, diamonds, and extravagant vehicles like Porsche.
As the cost of these merchandise expands, their demand also increases due to the fact that
these items then, at that point, become a superficial point of interest and symbol of status.

Price change expectations:

There are times when the cost or price of an item, product, or service increases, and the
economic situations are such that products or services might become more costly. In such
cases, purchasers might purchase a greater amount of these items before the cost builds any
further. Therefore, when there is a drop in price or value or expected to drop further, the end
consumers may defer or postpone the buy to profit from the advantages of a lower cost.

Essential or necessary products and services:

One more exception case for the law of demand is the essential or necessity goods and
products. Individuals will keep on purchasing necessities, for example, medications or
essential staples like salt, rice, and sugar, regardless of whether the cost increases. The costs
of these items don’t influence the quantity demanded.

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 Module – 2 Demand Analysis

Change in income:
There will be a change in the behavioural purchase of goods and services according to the
changes in personal income. Assuming that a family’s personal disposable income increases,
they might buy more items independent of the rise in their cost, in this way increasing the
quantity demanded of the item. Essentially, they may defer purchasing an item regardless of
whether its cost lessens, assuming their personal disposable income has decreased.
Henceforth, a change in an end consumer’s income may likewise be an exemption for the law
of demand.

Luxury goods:
The consumption of luxury goods and services doesn’t cease even if the price of a certain
product or service increases. For example, gold, real estate, etc.

Consumers negligence:
At certain times, the consumers are unaware of the price changes that take place in the
market. At these times, the end consumers may end up paying more than the maker price.

Effect of demonstration:
Middle-income consumers tend to imitate or copy the upper-middle-class consumer
behaviours and may tend to purchase the same products or services of the upper-middle class.

Changes in taste, preferences, and fashionable products:

Consumers’ changes in taste and preferences in fashionable products don’t change the
quantity demanded with an increase in price rise as the consumers are willing to spend more
on these products and services.

Trading in stock exchanges:

The law of demand won’t hold good in the speculation market. According to the law of
demand, an increase in price will reduce the demand, but in the case of speculation and
trading, people will buy more stocks even though there is an increase in the price of the
stocks.
Elasticity of demand:
Elasticity of Demand, or Demand Elasticity, is the measure of change in quantity demanded
of a product in response to a change in any of the market variables, like price, income etc. It
measures the shift in demand when other economic factors change.

In other words, the elasticity of demand is the percentage change in quantity demanded
divided by the percentage change in another economic variable like price of the product.

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 Module – 2 Demand Analysis

Importance of elasticity of demand:

1. In the Determination of Output Level:

For making production profitable, it is essential that the quantity of goods and services should
be produced corresponding to the demand for that product. Since the change in demand is due
to the change in price, the knowledge of elasticity of demand is necessary for determining the
output level.

2. In the Determination of Price:

The elasticity of demand for a product is the basis of its price determination. The ratio in
which the demand for a product will fall with the rise in its price and vice versa can be known
with the knowledge of elasticity of demand.

3. In Price Discrimination by Monopolist:

Under monopoly discrimination the problem of pricing the same commodity in two different
markets also depends on the elasticity of demand in each market. In the market with elastic
demand for his commodity, the discriminating monopolist fixes a low price and in the market
with less elastic demand, he charges a high price.

4. In Price Determination of Factors of Production:

The concept of elasticity for demand is of great importance for determining prices of various
factors of production. Factors of production are paid according to their elasticity of demand.
In other words, if the demand of a factor is inelastic, its price will be high and if it is elastic,
its price will be low.

5. In Demand Forecasting:
The elasticity of demand is the basis of demand forecasting. The knowledge of income
elasticity is essential for demand forecasting of producible goods in future. Long- term
production planning and management depend more on the income elasticity because
management can know the effect of changing income levels on the demand for his product.

6. Dumping:
A firm enters foreign markets for dumping his product on the basis of elasticity of demand to
face foreign competition.

7. In the Determination of Prices of Joint Products:

The concept of the elasticity of demand is of much use in the pricing of joint products, like
wool and mutton, wheat and straw, cotton and cotton seeds, etc. In such cases, separate cost
of production of each product is not known.

Therefore, the price of each is fixed on the basis of its elasticity of demand. That is why
products like wool, wheat and cotton having an inelastic demand are priced very high as
compared to their by-products like mutton, straw and cotton seeds which have an elastic
demand.

8. In the Determination of Government Policies:

The knowledge of elasticity of demand is also helpful for the government in determining its
policies. Before imposing statutory price control on a product, the government must consider
the elasticity of demand for that product.

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 Module – 2 Demand Analysis

Types of elasticity of demand/Measurement of elasticity of demand:

1. Price Elasticity of Demand (PED)

Any change in the price of a commodity, whether it’s a decrease or increase, affects the
quantity demanded for a product. For example, when there is a rise in the prices of ceiling
fans, the quantity demanded goes down.

PED = % Change in Quantity Demanded % / Change in Price

The result obtained from this formula determines the intensity of the effect of price change on
the quantity demanded for a commodity.

2. Income Elasticity of Demand (YED)

The income levels of consumers play an important role in the quantity demanded for a
product. This can be understood by looking at the difference in goods sold in the rural
markets versus the goods sold in metro cities.

The Income Elasticity of Demand, also represented by YED, refers to the sensitivity of
quantity demanded for a certain good to a change in real income (the income earned by an
individual after accounting for inflation) of the consumers who buy this good, keeping all
other things constant.

The formula given to calculate the Income Elasticity of Demand is given as:

YED = % Change in Quantity Demanded% / Change in Income

The result obtained from this formula helps to determine whether a good is a necessity good
or a luxury good.

3. Cross Elasticity of Demand (XED)

In a market where there is an oligopoly, multiple players compete. Thus, the quantity
demanded for a product does not only depend on itself but rather, there is an effect even when
prices of other goods change.

Cross Elasticity of Demand, also represented as XED, is an economic concept that measures
the sensitiveness of quantity demanded of one good (X) when there is a change in the price of
another good (Y), and that’s why it is also referred to as Cross-Price Elasticity of Demand.

The formula given to calculate the Cross Elasticity of Demand is given as:

XED = (% Change in Quantity Demanded for one good (X)%) / (Change in Price of
another Good (Y))

The result obtained for a substitute good would always come out to be positive as whenever
there is a rise in the price of a good, the demand for its substitute rises. Whereas, the result
will be negative for a complementary good.

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 Module – 2 Demand Analysis

4. Advertising and Promotional Elasticity of demand:

The responsiveness of the change in demand due to the change in advertising or other
promotional expenses is known as advertising elasticity of demand. It can be expressed as:

Classification of price elasticity of demand:

[Link] Elastic Demand:
When a small change in price of a product causes a major change in its demand, it is said to
be perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in
demand to zero, while a small fall in price causes increase in demand to infinity. In such a
case, the demand is perfectly elastic or Ep= 00.

The degree of elasticity of demand helps in defining the shape and slope of a demand curve.
Therefore, the elasticity of demand can be determined by the slope of the demand curve.
Flatter the slope of the demand curve, higher the elasticity of demand.

In perfectly elastic demand, the demand curve is represented as a horizontal straight line,
which is shown in Figure.
`

From Figure- it can be interpreted that at price OP, demand is infinite; however, a slight rise
in price would result in fall in demand to zero. It can also be interpreted from Figure-2 that at
price P consumers are ready to buy as much quantity of the product as they want. However, a
small rise in price would resist consumers to buy the product.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the demand of a
product with change in its price. The numerical value for perfectly inelastic demand is zero
(Ep=0).
In case of perfectly inelastic demand, demand curve is represented as a straight vertical
line, which is shown in Figure-3:

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 Module – 2 Demand Analysis

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2 and OP2 to
OP3 does not show any change in the demand of a product (OQ). The demand remains
constant for any value of price. Perfectly inelastic demand is a theoretical concept and cannot
be applied in a practical situation. However, in case of essential goods, such as salt, the
demand does not change with change in price. Therefore, the demand for essential goods is
perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the proportionate change produced in
demand is greater than the proportionate change in price of a product. The numerical value of
relatively elastic demand ranges between one to infinity.

Mathematically, relatively elastic demand is known as more than unit elastic demand (e p>1).
For example, if the price of a product increases by 20% and the demand of the product
decreases by 25%, then the demand would be relatively elastic.
The demand curve of relatively elastic demand is gradually sloping, as shown in Figure-
4:

It can be interpreted from Figure-4 that the proportionate change in demand from OQ1 to
OQ2 is relatively larger than the proportionate change in price from OP1 to OP2. Relatively
elastic demand has a practical application as demand for many of products respond in the
same manner with respect to change in their prices.

For example, the price of a particular brand of cold drink increases from Rs. 15 to Rs. 20. In
such a case, consumers may switch to another brand of cold drink. However, some of the
consumers still consume the same brand. Therefore, a small change in price produces a larger
change in demand of the product.

4. Relatively Inelastic Demand:

Relatively inelastic demand is one when the percentage change produced in demand is less
than the percentage change in the price of a product. For example, if the price of a product
increases by 30% and the demand for the product decreases only by 10%, then the demand

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 Module – 2 Demand Analysis

would be called relatively inelastic. The numerical value of relatively elastic demand ranges
between zero to one (Ep<1). Marshall has termed relatively inelastic demand as elasticity
being less than unity.
The demand curve of relatively inelastic demand is rapidly sloping, as shown in Figure-5:

5. Unitary Elastic Demand:

When the proportionate change in demand produces the same change in the price of the
product, the demand is referred as unitary elastic demand. The numerical value for unitary
elastic demand is equal to one (Ep=1).
The demand curve for unitary elastic demand is represented as a rectangular
hyperbola, as shown in Figure-6:

From Figure-6, it can be interpreted that change in price OP1 to OP2 produces the same
change in demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.

Types of cross elasticity of demand:

1. Positive:
When goods are substitute of each other then cross elasticity of demand is positive. In other
words, when an increase in the price of Y leads to an increase in the demand of X. For
instance, with the increase in price of tea, demand of coffee will increase.

In fig. 21 quantity has been measured on OX-axis and price on OY-axis. At price OP of Y-
commodity, demand of X-commodity is OM. Now as price of Y commodity increases to
OP1 demand of X-commodity increases to OM1 Thus, cross elasticity of demand is positive.

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 Module – 2 Demand Analysis

2. Negative:
In case of complementary goods, cross elasticity of demand is negative. A proportionate
increase in price of one commodity leads to a proportionate fall in the demand of another
commodity because both are demanded jointly. In fig. 22 quantity has been measured on OX-
axis while price has been measured on OY-axis. When the price of commodity increases
from OP to OP1 quantity demanded falls from OM to OM1. Thus, cross elasticity of demand
is negative.

3. Zero:
Cross elasticity of demand is zero when two goods are not related to each other. For instance,
increase in price of car does not effect the demand of cloth. Thus, cross elasticity of demand
is zero. It has been shown in fig. 23.

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 Module – 2 Demand Analysis

Therefore, it depends upon substitutability of goods. If substitutability is perfect, cross

elasticity is infinite; if on the other hand, substitutability does not exist, cross elasticity is
zero. In the case of complementary goods like jointly demanded goods cross elasticity is
negative. A rise in the price of one commodity X will mean not only decrease in the quantity
of X but also decrease in the quantity demanded of Y because both are demanded together.

Measurement of Cross Elasticity of Demand:

Cross elasticity of demand can be measured by the following formula:

Types of Income elasticity of demand:

1. Positive income elasticity of demand

It refers to a condition in which demand for a commodity rises with a rise in consumer
income and declines with a decline in consumer income. Commodities with positive income
elasticity of demand are normal goods.

The upward slope implies that the rise in income contributes to a rise in demand and vice
versa. There are three forms of positive income elasticity of demand stated as follows:

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 Module – 2 Demand Analysis

 Unitary – The positive income elasticity of demand will be unitary if the

proportionate change in the amount of a product demanded equals the change in
consumer income in due proportion.(ey=1)
 More than unitary – The positive income elasticity of demand will be more than
unitary if the proportionate change in the amount of a product demanded is higher
than the change in consumer income in due proportion.(ey>1)
 Less than unitary – If the change in the amount of a product demanded in due
proportion is less than the change in consumer income in due proportion, positive
income elasticity of demand will be less than unitary.(ey<1)

2. Negative income elasticity of demand

It refers to a condition in which demand for a commodity decreases with a rise in consumer
income and increases with a fall in consumer income. Inferior goods are such commodities.
For example, the demand for millet will decrease if the income of consumers increases since
they will prefer to purchase wheat instead of millet. Thus, millet is an inferior good to wheat
for customers.

The downward slope implies that the increase in income contributes to a fall in demand, and
a decrease in income causes a rise in demand.

3. Zero income elasticity of demand

It corresponds to the situation when there is no impact of rising household income on

commodity production. Such goods are termed essential goods. For example, a high-income
consumer and a low-income consumer will need salt in the same quantity.

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 Module – 2 Demand Analysis

Uses of elasticity of demand for managerial decision making:

Decision making in managerial economics: The most important function in managerial

economics is decision-making. It involves the complete course of selecting the most suitable
action from two or more alternatives. The primary function is to make the most profitable use
of resources which are limited such as labor, capital, land etc.

Uses: It is important to know the extent to which a percentage increase in unit price will
affect the demand for a product. With elastic demand, total revenue will decrease if the price
is raised.
 With inelastic demand, however, total revenue will increase if the price is raised.
Economists compute several different elasticity measures, including the price
elasticity of demand, the price elasticity of supply, and the income elasticity of
demand.
 Elasticity is typically defined in terms of changes in total revenue since that is of
primary importance to managers, CEOs, and marketers.
 For managers, a key point in the discussions of demand is what happens when they
raise prices for their products and services. It is important to know the extent to which
a percentage increase in unit price will affect the demand for a product. With elastic
demand, total revenue will decrease if the price is raised. With inelastic demand,
however, total revenue will increase if the price is raised.
 The possibility of raising prices and increasing dollar sales (total revenue) at the same
time is very attractive to managers. This occurs only if the demand curve is inelastic.
 Here total revenue will increase if the price is raised, but total costs probably will not
increase and, in fact, could go down.
 Since profit is equal to total revenue minus total costs, profit will increase as price is
increased when demand for a product is inelastic. It is important to note that an entire
demand cure is neither elastic or inelastic; it only has the particular condition for a
change in total revenue between two points on the curve (and not along the whole
curve).
 Demand elasticity is affected by the availability of substitutes, the urgency of need,
and the importance of the item in the customer's budget. Substitutes are products that
offer the buyer a choice.
 For example, many consumers see corn chips as a good or homogeneous substitute
for potato chips, or see sliced ham as a substitute for sliced turkey. The more
substitutes available, the greater will be the elasticity of demand.
 If consumers see products as extremely different or heterogeneous, however, then a
particular need cannot easily be satisfied by substitutes. In contrast to a product with
many substitutes, a product with few or no substitutes—like gasoline—will have an
inelastic demand curve. Similarly, demand for products that are urgently needed or
are very important to a person's budget will tend to be inelastic.

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 It is important for managers to understand the price elasticity of their products and
services in order to set prices appropriately to maximize firm profits and revenues.

Law of supply:

The law of supply is the microeconomic law that states that, all other factors being equal, as
the price of a good or service increases, the quantity of goods or services that suppliers offer
will increase, and vice versa. The law of supply says that as the price of an item goes up,
suppliers will attempt to maximize their profits by increasing the number of items for sale.

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.

The law of supply is a fundamental principle of economic theory which states that, keeping
other factors constant, an increase in price results in an increase in quantity supplied. In other
words, there is a direct relationship between price and quantity: quantities respond in the
same direction as price changes.

Description: Law of supply depicts the producer behaviour 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.

Elasticity of supply:

Es= [(Δq/q) ×100] ÷ [(Δp/p)×100] = (Δq/q) ÷ (Δp/p)

Δq= The change in quantity supplied

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q= The quantity supplied

Δp= The change in price
p= The price
Types of Elasticity of Supply

1. Perfectly Inelastic Supply

A service or commodity has a perfectly inelastic supply if a given quantity of it can be supplied
whatever might be the price. The elasticity of supply for such a service or commodity is zero. A
perfectly inelastic supply curve is a straight line parallel to the Y-axis. This is representative of
the fact that the supply remains the same irrespective of the price.

The supply of exclusive items, like the painting of Mona Lisa, falls into this category. Whatever
might be the price on offer, there is no way we can increase its supply.

2. Relatively Less-Elastic Supply

When the change in supply is relatively less when compared to the change in price, we say that
the commodity has a relatively-less elastic supply. In such a case, the price elasticity of supply
assumes a value less than 1.

3. Relatively Greater-Elastic Supply

When the change in supply is relatively more when compared to the change in price, we say that
the commodity has a relatively greater-elastic supply. In such a case, the price elasticity of
supply assumes a value greater than 1.

4. Unitary Elastic
For a commodity with a unit elasticity of supply, the change in quantity supplied of a
commodity is exactly equal to the change in its price. In other words, the change in both price
and supply of the commodity are proportionately equal to each other. To point out, the elasticity
of supply in such a case is equal to one. Further, a unitary elastic supply curve passes through
the origin.

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 Module – 2 Demand Analysis

5. Perfectly Elastic supply

A commodity with a perfectly elastic supply has an infinite elasticity. In such a case the supply
becomes zero with even a slight fall in the price and becomes infinite with a slight rise in price.
This is indicative of the fact that the suppliers of such a commodity are willing to supply any
quantity of the commodity at a higher price. A perfectly elastic supply curve is a straight line
parallel to the X-axis.

Demand forecasting:

Demand forecasting is a technique that is used for the estimation of what can be the demand
for the upcoming product or services in the future. It is based upon the real-time analysis of
demand which was there in the past for that particular product or service in the market
present today.

Definition: According to Evan J. Douglas, “Demand estimation (forecasting) may be defined

as a process of finding values for demand in future time periods.”

In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a
specified future period based on proposed marketing plan and a set of particular
uncontrollable and competitive forces.”

1. Fulfilling objectives:
Implies that every business unit starts with certain pre-decided objectives. Demand
forecasting helps in fulfilling these objectives. An organization estimates the current demand
for its products and services in the market and move forward to achieve the set goals.

2. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For
instance, an organization has forecasted that the demand for its product, which is priced at Rs.
10, would be 10, 00, 00 units. In such a case, the total expected revenue would be 10*
100000 = Rs. 10, 00, 000. In this way, demand forecasting enables organizations to prepare
their budget.

3. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing
according to the forecasted demand of products helps in avoiding the wastage of the
resources of an organization. This further helps an organization to hire human resource
according to requirement. For example, if an organization expects a rise in the demand for its
products, it may opt for extra labor to fulfill the increased demand.

4. Expanding organizations:
Implies that demand forecasting helps in deciding about the expansion of the business of the
organization. If the expected demand for products is higher, then the organization may plan to
expand further. On the other hand, if the demand for products is expected to fall, the
organization may cut down the investment in the business.

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 Module – 2 Demand Analysis

5. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital.

6. Evaluating Performance:
Helps in making corrections. For example, if the demand for an organization’s products is
less, it may take corrective actions and improve the level of demand by enhancing the quality
of its products or spending more on advertisements.

[Link] Government: Enables the government to coordinate import and export activities
and plan international trade.

Methods of demand forecasting:

(A) Survey methods

Under this method surveys are conducted to collect information about the future purchase
plans of potential consumers. Survey methods help in obtaining information about the
desires, likes and dislikes of consumers through collecting the opinion of experts or by
interviewing the consumers. Survey methods are used for short term forecasting. Important
survey methods are:

a) Consumers' interview method (Consumers survey): Under this method, consumers are
interviewed directly and asked the quantity they would like to buy. After collecting the data,
the total demand for the product is calculated. This is done by adding up all individual
demands. Under the consumer interview method, either all consumers or selected few are
interviewed. When all the consumers are interviewed, the method is known as complete
enumeration method. When only a selected group of consumers are interviewed, it is known
as sample survey method

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 Module – 2 Demand Analysis

b) Collective opinion method: Under this method the salesmen estimate the expected sales
in their respective territories on the basis of previous experience. Then demand is estimated
after combining the individual forecasts (sales estimates) of the salesmen. This method is also
known as sales force opinion method.
c) Experts’ opinion method: This method was originally developed at Rand Corporation in
1950 by Olaf Helmer, Dalkey and Gordon. Under this method, demand is estimated on the
basis of opinions of experts and distributors other than salesmen and ordinary consumers.
This method is also known as Delphi method. Delphi is the ancient Greek temple where
people come and prey for information about their future.
d) Consumer clinics: In this method some selected buyers are given certain amounts of
money and asked to buy the products. Then the prices are changed and the consumers are
asked to make fresh purchases with the given money. In this way the consumers" responses
to price changes are observed. Thus the behaviour of the consumers is studied. On this basis
demand is estimated. This method is an improvement over consumer’s interview method.
e) End use method: This method is based on the fact that a product generally has different
uses. In the end use method, first a list of end users (final consumers, individual industries,
exporters etc.) is prepared. Then the future demand for the product is found either directly
from the end users or indirectly by estimating their future growth. Then the demand of all end
users of the product is added to get the total demand for the product.

(B) Statistical Methods

Statistical methods use the past data as a guide for knowing the level of future demand.
Statistical methods are generally used for long run forecasting. These methods are used for
established products. Statistical methods include: (i) Trend projection method, (ii) Regression
and Correlation, (iii) Extrapolation method, (iv) Simultaneous equation method, and (v)
Barometric method.

1. Trend projection method: Future sales are based on the past sales, because future is the
grand-child of the past and child of the present. Under the trend projection method demand is
estimated on the basis of analysis of past data. This method makes use of time series (data
over a period of time). We try to ascertain the trend in the time series. The trend in the time
series can be estimated by using any one of the following four methods: (a) Least-square
method, (b) Free-hand method, (c) Moving average method and (d) semi-average method.

2. Regression and Correlation: These methods combine economic theory and statistical
technique of estimation. Under these methods the relationship between the sales (dependent
variable) and other variables (independent variables such as price of related goods, income,
advertisement etc.) is ascertained. Such relationship established on the basis of past data may
be used to analyse the future trend. The regression and correlation analysis is also called the
econometric model building.

3. Extrapolation: Under this statistical method, the future demand can be extrapolated by
applying Binomial expansion method. This method is used on the assumption that the rate of
charge in demand in the past has been uniform.

4. Simultaneous equation method.-This involves the development of a complete

econometric model which can explain the behaviour of all the variables which the company
can control. This method is not very popular.

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 Module – 2 Demand Analysis

5. Barometric technique: This is an improvement over the trend projection method.

According to this technique the events of the present can be used to predict the directions of
change m the future. Here certain economic and statistical indicators from the selected time
series are used to predict variables. Personal income, non-agricultural placements, gross
national income, prices of industrial materials, wholesale commodity prices, industrial
production, bank deposits etc. are some of the most commonly used indicators.

Other Methods:
1. Evolutionary approach: This method is based on the assumption that the new product is
the improvement and evolution of the old product. The demand is forecasted on the basis of
the demand of the old product. For example, the demand for black and white TV should be
taken in to consideration while forecasting the demand for colour TV sets because the latter is
an improvement of the former.

2. Substitute approach: Here the new product is treated as a substitute of an existing

product, e.g. polythene bags for cloth bags. Thus the demand for a new product is
analysed as a substitute for some existing goods or service.

3. Growth curve approach: Under this method the growth rate of demand of a new
product is estimated on the basis of the growth rate of demand of an existing product.
Suppose Pears soap is in use and a new cosmetic is to be introduced in the market. In this
case the average sale of Pears soap will give an idea as to how the new cosmetic will be
accepted by the consumers.

4. Opinion poll approach: Under this method the demand for a new product is estimated on
the basis of information collected from the direct interviews (survey) with consumers.

5. Sales Experience approach: Under this method, the new product is offered for sale in a
sample market, i.e. by direct mail or through multiple shop or departmental shop. From this
the total demand is estimated for the whole market.

Methods of Measuring Price Elasticity of Demand

Basically, there are four ways by which we can calculate the price elasticity of demand, and
these are:
 Percentage method
 Total outlay method
 Point method
 Arc method
The Percentage Method:
The price elasticity of demand is measured by its coefficient E p. This coefficient Ep measures
the percentage change in the quantity of a commodity demanded resulting from a given
percentage change in its price: Thus

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 Module – 2 Demand Analysis

Where q refers to quantity demanded, p to price and ∆ to change. If E p> 1, demand is elastic.
If Ep < 1, demand is inelastic, it Ep = 1 demand is unitary elastic.

The Total Outlay Method:

Marshall evolved the total outlay, total revenue or total expenditure method as a measure of
elasticity. By comparing the total expenditure of a purchaser both before and after the change
in price, it can be known whether his demand for a good is elastic, unity or less elastic. Total
outlay is price multiplied by the quantity of a good purchased: Total Outlay = Price x
Quantity Demanded.

The Arc Method:

when elasticity is measured between two points on the same demand curve, it is known as arc
elasticity. In the words of Prof. Baumol, “Arc elasticity is a measure of the average
responsiveness to price change exhibited by a demand curve over some finite stretch of the
curve.”
Any two points on a demand curve make an arc. The area between P and M on the DD curve
in Figure is an arc which measures elasticity over a certain range of price and quantities. On
any two points of a demand curve the elasticity coefficients are likely to be different
depending upon the method of computation.

Point Elasticity Method

This method is used to measure the elasticity at a specific point on a demand curve. The point
elasticity method is also known as geometric method or slope method. In this method, the
point elasticity of demand curve is measured by using the same formula which is being used
in the measure of general price elasticity. The only difference is that under the point method,
we take demand equation to measure point elasticity at specific point of demand curve.

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 Module-3

Cost analysis and production analysis

Production concept:
Introduction: Production Function
The production function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a function of
inputs. Mathematically production function can be written as
Q= f (A, B, C, D)
Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as
land, labour, capital and organization. Here output is the function of inputs. Hence output
becomes the dependent variable and inputs are the independent variables.
The above function does not state by how much the output of “Q” changes as a consequence
of change of variable inputs. In order to express the quantitative relationship between input
and output, Production function has been expressed in a precise mathematical equation i.e.

Fixed and variable input: An input is the production of goods and services that does not
change in the short run. A fixed input should be compared with a variable input, an input that
changes in the short run.
Fixed and variable inputs are most important for the analysis of short-run production by a
firm.
The best example of a fixed input is the factory, building, equipment, or other capital used in
production. The comparable example of a variable input would then be the labour or workers
who work in the factory or operate the equipment. In the short run (such as a day or so) a firm
can vary the quantity of labour, but the quantity of capital is fixed.

Short run: A production period of time in which at all inputs in the production process are
fixed, Meaning the quantity of output itself is fixed. Also termed market period, the short run
exists if the period is so short that no additional production is possible. In other words, the
good have been produced all that remains is to sell them.

Long run: A production time period in which all inputs are variable, including those under
control of the firm and those beyond the control of the firm. During the very long run, not
only are the labor, capital, land, and entrepreneurship inputs variable, but so too are key
production inputs such as government rules, technology, and social customs. In other words
we can say that production in economics is all those activities that have to do with the
creation of commodities, by imparting to raw materials utility, added value, or the ability to
satisfy human wants.

Importance:
1. When inputs are specified in physical units, production function helps to estimate the level
of production.

1
 2. It becomes is equates when different combinations of inputs yield the same level of output.

3. It indicates the manner in which the firm can substitute on input for another without
altering the total output.

4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
Production function with one variable input
In the short run a manager has to decide about how much to produce by employing additional
variable inputs, due to capacity constraint, since fixed inputs cannot be increased readily at a
short notice.
Total Product, Average Product and Marginal Product
The production function shows the maximum output or total product (TP) that can be
produced by employing a combination of factors of production at a given time period. The
average product (AP) depicts the TP per unit of input used. The marginal product (MP) is the
change in the total product resulting from a unit change in a variable input. If we assume
labour (L) as a variable input, then
TP=f(Q)
APL=TP/L
MPL=ΔTP/ΔL
To see what happens to the total product in the short run as labour increases, we can derive a
short run production function. We assume capital fixed at 2 units and labour increases by one
unit. The TP increases to a maximum of 56 units when 7 units of labour is used and then
decreases to 52 units with additional unit of labour. It means that in a year employing 7 full
time labourers can produce a maximum of 56 speciality parts.
Production in the short run with one variable input
1. Total, Average and Marginal Product of a Variable Input
2. Total Product of Labour (TPL) Curve and the Law of Variable Proportions
3. The Average Product of Labour (APL) and the Marginal Product of Labour (MPL) Curves—
Derivation of the APL and MPL Curves from the TPL Curve and Other Details
4. Relation between the Average and Marginal Product of a Variable Input
5. Derivation of the MPL – APL Relation—the Calculus Method
6. Returns to a Factor
7. Equilibrium of the Firm in Production with One Variable Input and Efficiency of the Second
Stage of Production
1. Total, Average and Marginal Product of a Variable Input:
Total Product:

2
The firm uses a number of inputs to produce its output. If the firm varies the quantity of only
one input, keeping the other input quantities unchanged, then the quantity of its output
obtained at any quantity of the variable input is called the total product of the input.

For example, if the said variable input is labour and if it is obtained that the firm produces 42
units of output when it uses 6 units of labour along with the fixed inputs, then we say that the
total product of labour is 42 units when 6 units of labour are used.

The schedule of total product obtained at different quantities of labour used by the firm is
called the total product schedule of labour—it expresses the total product of the firm (i.e., the
total quantity of output) as a function of the quantity of labour used. This function is called
the total product function.

Columns (1) and (2) of Table 8.1 constitute the total product schedule or total product
function of labour. This function may be written as

=q = f (L)

or, TPL = f (L)

Here q or TPL is the total product of the firm or the total product of labour and L is the
quantity of labour used.

3
Average Product:
If we divide the total product of an input by the quantity used of it, we obtain the average
product of the input. For example, if the total product of labour is 40 units per day when the
firm uses 5 units of labour per day, then the average product of labour (AP L) would be 40/5
or 8 units.
The average product schedule obtained at different quantities of labour used is called the
average product schedule of labour—this schedule expresses APL as a function of labour.
Columns (1) and (3) of Table 8.1 constitute the AP schedule of labour or the AP function of
labour. We may express this function as
APL = q/L = f(L)/L = g(L
Marginal Product:
Marginal product of a variable input, say, labour (MP L), is the increment in total product of
labour (TPL) obtained as a result of the use of the marginal (or an additional) unit of labour.
For example, if the TPL be 32 units and 40 units, respectively, when the firm uses 4 and 5
units of labour, then the marginal product of labour (MP L) at L = 5 units would be the
increment in TPL that would be obtained as a result of the use of the 5th unit of labour, and so
here we would have MPL = 40 – 32 = 8 units.

Law of variable proportion:

Law of Variable Proportions: Assumptions, Explanation, Stages, Causes of Applicability and

Applicability of the Law of Variable Proportions!
Law of Variable Proportions occupies an important place in economic theory. This law is
also known as Law of Proportionality.

Keeping other factors fixed, the law explains the production function with one factor
variable. In the short run when output of a commodity is sought to be increased, the law of
variable proportions comes into operation.

Therefore, when the number of one factor is increased or decreased, while other factors are
constant, the proportion between the factors is altered. For instance, there are two factors of
production viz., land and labour.

Land is a fixed factor whereas labour is a variable factor. Now, suppose we have a land
measuring 5 hectares. We grow wheat on it with the help of variable factor i.e., labour.
Accordingly, the proportion between land and labour will be 1: 5. If the number of laborers is
increased to 2, the new proportion between labour and land will be 2: 5. Due to change in the
proportion of factors there will also emerge a change in total output at different rates. This
tendency in the theory of production called the Law of Variable Proportion.

4
Definitions:
“As the proportion of the factor in a combination of factors is increased after a point, first the
marginal and then the average product of that factor will diminish.” Benham

“An increase in some inputs relative to other fixed inputs will in a given state of technology
cause output to increase, but after a point the extra output resulting from the same additions
of extra inputs will become less and less.” Samuelson

Assumptions:
Law of variable proportions is based on following assumptions:

(i) Constant Technology:

The state of technology is assumed to be given and constant. If there is an improvement in
technology the production function will move upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production are to be
combined in a fixed proportion, the law has no validity.

(iii) Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and amount
with every other unit.

(iv) Short-Run:
The law operates in the short-run when it is not possible to vary all factor inputs.

Explanation of the Law:

In order to understand the law of variable proportions we take the example of agriculture.
Suppose land and labour are the only two factors of production.

5
By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown
with the help of the following table:

From the table 1 it is clear that there are three stages of the law of variable proportion. In the
first stage average production increases as there are more and more doses of labour and
capital employed with fixed factors (land). We see that total product, average product, and
marginal product increases but average product and marginal product increases up to 40
units. Later on, both start decreasing because proportion of workers to land was sufficient and
land is not properly used. This is the end of the first stage.

The second stage starts from where the first stage ends or where AP=MP. In this stage,
average product and marginal product start falling. We should note that marginal product
falls at a faster rate than the average product. Here, total product increases at a diminishing
rate. It is also maximum at 70 units of labour where marginal product becomes zero while
average product is never zero or negative.

The third stage begins where second stage ends. This starts from 8th unit. Here, marginal
product is negative and total product falls but average product is still positive. At this stage,
any additional dose leads to positive nuisance because additional dose leads to negative
marginal product.

Graphic Presentation:
In fig. 1, on OX axis, we have measured number of labourers while quantity of product is
shown on OY axis. TP is total product curve. Up to point ‘E’, total product is increasing at
increasing rate. Between points E and G it is increasing at the decreasing rate. Here marginal
product has started falling. At point ‘G’ i.e., when 7 units of labourers are employed, total
product is maximum while, marginal product is zero. Thereafter, it begins to diminish
corresponding to negative marginal product. In the lower part of the figure MP is marginal
product curve.

6
Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of labourers are
employed, it is maximum. After that, marginal product begins to decrease. Before point ‘I’
marginal product becomes zero at point C and it turns negative. AP curve represents average
product. Before point ‘I’, average product is less than marginal product. At point ‘I’ average
product is maximum. Up to point T, average product increases but after that it starts to
diminish.

Three Stages of the Law:

1. First Stage:
First stage starts from point ‘O’ and ends up to point F. At point F average product is
maximum and is equal to marginal product. In this stage, total product increases initially at
increasing rate up to point E. between ‘E’ and ‘F’ it increases at diminishing rate. Similarly
marginal product also increases initially and reaches its maximum at point ‘H’. Later on, it
begins to diminish and becomes equal to average product at point T. In this stage, marginal
product exceeds average product (MP > AP).

2. Second Stage:
It begins from the point F. In this stage, total product increases at diminishing rate and is at its
maximum at point ‘G’ correspondingly marginal product diminishes rapidly and becomes

7
‘zero’ at point ‘C’. Average product is maximum at point ‘I’ and thereafter it begins to
decrease. In this stage, marginal product is less than average product (MP < AP).

3. Third Stage:
This stage begins beyond point ‘G’. Here total product starts diminishing. Average product
also declines. Marginal product turns negative. Law of diminishing returns firmly manifests
itself. In this stage, no firm will produce anything. This happens because marginal product of
the labour becomes negative. The employer will suffer losses by employing more units of
labourers. However, of the three stages, a firm will like to produce up to any given point in
the second stage only.

In Which Stage Rational Decision is Possible:

To make the things simple, let us suppose that, a is variable factor and b is the fixed factor.
And a1, a2 , a3….are units of a and b1 b2b3…… are unit of b.
Stage I is characterized by increasing AP, so that the total product must also be increasing.
This means that the efficiency of the variable factor of production is increasing i.e., output
per unit of a is increasing. The efficiency of b, the fixed factor, is also increasing, since the
total product with b1 is increasing.
The stage II is characterized by decreasing AP and a decreasing MP, but with MP not
negative. Thus, the efficiency of the variable factor is falling, while the efficiency of b, the
fixed factor, is increasing, since the TP with b1 continues to increase.
Finally, stage III is characterized by falling AP and MP, and further by negative MP. Thus,
the efficiency of both the fixed and variable factor is decreasing.

Rational Decision:
Stage II becomes the relevant and important stage of production. Production will not take
place in either of the other two stages. It means production will not take place in stage III and
stage I. Thus, a rational producer will operate in stage II.

8
Suppose b were a free resource; i.e., it commanded no price. An entrepreneur would want to
achieve the greatest efficiency possible from the factor for which he is paying, i.e., from
factor a. Thus, he would want to produce where AP is maximum or at the boundary between
stage I and II.

If on the other hand, a were the free resource, then he would want to employ b to its most
efficient point; this is the boundary between stage II and III.

Obviously, if both resources commanded a price, he would produce somewhere in stage II.
At what place in this stage production takes place would depend upon the relative prices of a
and b.

Condition or Causes of Applicability:

There are many causes which are responsible for the application of the law of variable
proportions.

They are as follows:

1. under Utilization of Fixed Factor:
In initial stage of production, fixed factors of production like land or machine, is under-
utilized. More units of variable factor, like labour, are needed for its proper utilization. As a
result of employment of additional units of variable factors there is proper utilization of fixed
factor. In short, increasing returns to a factor begins to manifest itself in the first stage.

2. Fixed Factors of Production.

The foremost cause of the operation of this law is that some of the factors of production are
fixed during the short period. When the fixed factor is used with variable factor, then its ratio
compared to variable factor falls. Production is the result of the co-operation of all factors.
When an additional unit of a variable factor has to produce with the help of relatively fixed
factor, then the marginal return of variable factor begins to decline.

3. Optimum Production:
After making the optimum use of a fixed factor, then the marginal return of such variable
factor begins to diminish. The simple reason is that after the optimum use, the ratio of fixed
and variable factors become defective. Let us suppose a machine is a fixed factor of
production. It is put to optimum use when 4 labourers are employed on it. If 5 labourers are
put on it, then total production increases very little and the marginal product diminishes.

4. Imperfect Substitutes:

9
Mrs. Joan Robinson has put the argument that imperfect substitution of factors is mainly
responsible for the operation of the law of diminishing returns. One factor cannot be used in
place of the other factor. After optimum use of fixed factors, variable factors are increased
and the amount of fixed factor could be increased by its substitutes.

Such a substitution would increase the production in the same proportion as earlier. But in
real practice factors are imperfect substitutes. However, after the optimum use of a fixed
factor, it cannot be substituted by another factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of production. This law
applies to any field of production where some factors are fixed and others are variable. That
is why it is called the law of universal application.

The main cause of application of this law is the fixity of any one factor. Land, mines,
fisheries, and house building etc. are not the only examples of fixed factors. Machines, raw
materials may also become fixed in the short period. Therefore, this law holds good in all
activities of production etc. agriculture, mining, manufacturing industries.

1. Application to Agriculture:
With a view of raising agricultural production, labour and capital can be increased to any
extent but not the land, being fixed factor. Thus when more and more units of variable factors
like labour and capital are applied to a fixed factor then their marginal product starts to
diminish and this law becomes operative.

2. Application to Industries:
In order to increase production of manufactured goods, factors of production has to be
increased. It can be increased as desired for a long period, being variable factors. Thus, law of
increasing returns operates in industries for a long period. But, this situation arises when
additional units of labour, capital and enterprise are of inferior quality or are available at
higher cost.

As a result, after a point, marginal product increases less proportionately than increase in the
units of labour and capital. In this way, the law is equally valid in industries.

Postponement of the Law:

The postponement of the law of variable proportions is possible under following conditions:
(i) Improvement in Technique of Production:

10
The operation of the law can be postponed in case variable factors techniques of production
are improved.

(ii) Perfect Substitute:

The law of variable proportion can also be postponed in case factors of production are made
perfect substitutes i.e., when one factor can be substituted for the other.

Production functions with two variable inputs:

The Laws of Returns to Scale: Production Function with two Variable Inputs:
The laws of returns to scale can also be explained in terms of the isoquant approach. The laws
of returns to scale refer to the effects of a change in the scale of factors (inputs) upon output
in the long run when the combinations of factors are changed in the same proportion.

If by increasing two factors, say labour and capital, in the same proportion, output increases
in exactly the same proportion, there are constant returns to scale. If in order to secure equal
increases in output, both factors are increased in larger proportionate units, there are
decreasing returns to scale. If in order to get equal increases in output, both factors are
increased in smaller proportionate units, there are increasing returns to scale.

The returns to scale can be shown diagrammatically on an expansion path “by the distance
between successive ‘multiple-level-of-output” isoquants, that is, isoquants that show levels of
output which are multiples of some base level of output, e.g., 100, 200, 300, etc.”

Increasing Returns to Scale:

Figure 8 shows the case of increasing returns to scale where to get equal increases in output,
lesser proportionate increases in both factors, labour and capital, are required.

It follows that in the figure:

100 units of output require 3C + 3L

11
200 units of output require 5C + 5L

300 units of output require 6C + 6L

So that along the expansion path OR, OA > AB > BC. In this case, the production function is

homogeneous of degree greater than one. The increasing returns to scale are attributed to the

existence of indivisibilities in machines, management, labour, finance, etc. Some items of

equipment or some activities have a minimum size and cannot be divided into smaller units.

When a business unit expands, the returns to scale increase because the indivisible factors are

employed to their full capacity.

Increasing returns to scale also result from specialisation and division of labour. When the

scale of the firm expands there is wide scope for specialisation and division of labour. Work

can be divided into small tasks and workers can be concentrated to narrower range of

processes. For this, specialized equipment can be installed.

Thus with specialization efficiency increases and increasing returns to scale follow:

Further, as the firm expands, it enjoys internal economies of production. It may be able to

install better machines, sell its products more easily, borrow money cheaply, procure the

services of more efficient manager and workers, etc. All these economies help in increasing

the returns to scale more than proportionately.

Not only this, a firm also enjoys increasing returns to scale due to external economies. When
the industry itself expands to meet the increased long-run demand for its product, external

economies appear which are shared by all the firms in the industry. When a large number of

firms are concentrated at one place, skilled labour, credit and transport facilities are easily

available.

12
Subsidiary industries crop up to help the main industry. Trade journals, research and training

centres appear which help in increasing the productive efficiency of the firms. Thus these

external economies are also the cause of increasing returns to scale.

Decreasing Returns to Scale:

Figure 9 shows the case of decreasing returns where to get equal increases in output, larger

proportionate increases in both labour and capital are required.

It follows that:
100 units of output require 2C + 2L

200 units of output require 5C + 5L

300 units of output require 9C + 9L

So that along the expansion path OR, OG < GH < HK.

In this case, the production function is homogeneous of degree less than one. Returns to scale

may start diminishing due to the following factors. Indivisible factors may become inefficient

and less productive. Business may become unwieldy and produce problems of supervision

and coordination.

Large management creates difficulties of control and rigidities. To these internal

diseconomies are added external diseconomies of scale. These arise from higher factor prices

13
or from diminishing productivities of the factors. As the industry continues to expand the

demand for skilled labour, land, capital, etc. rises.

There being perfect competition, intensive bidding raises wages, rent and interest. Prices of

raw materials also go up. Transport and marketing difficulties emerge. All these factors tend

to raise costs and the expansion of the firms leads to diminishing returns to scale so that

doubling the scale would not lead to doubling the output.

Constant Returns to Scale:

Figure 10 shows the case of constant returns to scale. Where the distance between the

isoquants 100, 200 and 300 along the expansion path OR is the same, i.e., OD = DE = EF. It

means that if units of both factors, labour and capital, are doubled, the output is doubled. To

treble the output, units of both factors are trebled.

It follows that:
100 units of output require

1 (2C + 2L) = 2C + 2L

200 units of output require

2 (2C + 2L) = 4C + 4L

300 units of output require

14
3 (2C + 2L) = 6C + 6L

The returns to scale are constant when internal economies enjoyed by a firm are neutralised

by internal diseconomies so that output increases in the same proportion. Another reason is

the balancing of external economies and external diseconomies.

Constant returns to scale also result when factors of production are perfectly divisible,

substitutable, and homogeneous and their supplies are perfectly elastic at given prices. That is

why, in the case of constant returns to scale, the production function is homogeneous of

degree one.

Alternative Method:
We have explained above the three laws of returns to scale separately on the assumption that
there are three processes and each process shows the same returns over all ranges of output.
“However, the technological conditions of production may be such that returns to scale may
vary over different ranges of output. Over some range, we may have constant returns to scale,
while over another range we may have increasing or decreasing returns to scale.”

To explain it we draw an expansion path OR from the origin in Fig. 11 This are divided into

segments by the successive isoquants representing equal increments in output, i.e., 100, 200,

300 and so on. As we move along the expansion path, the distance between the successive
isoquants diminishes; it is a case of increasing returns to scale.

15
This stage is shown in the figure from К to M. The distance between KL and Z.M becomes
smaller LM<KL. The firm, therefore, requires smaller increases in the quantities of labour
and capital to produce equal increments of output.

If the segments between two isoquants are of equal length, there are constant returns to scale.
If labour and capital are doubled, the output would also be doubled. Thus, when output
increases from 300 to 400 and to 500 units, the isoquants representing these output levels
mark off equal distances along the scale line, up to point P, i.e., MN = NP.

If these are decreasing returns to scale, the distance between a pair of isoquants would
become longer on the expansion path. ST is longer than PS. It shows that to increase output
larger increases in quantities of labour and capital are required. Thus, on the same expansion
path from К to M, there are increasing returns to scale, from M to P, there are constant
returns to scale and from P to T, and there are diminishing returns to scale.

Indifference curves:

An indifference curve shows a combination of two goods that give a consumer equal
satisfaction and utility thereby making the consumer indifferent. Along the curve, the
consumer has an equal preference for the combinations of goods shown—i.e. is indifferent
about any combination of goods on the curve.

An indifference curve is a curve that represents all the combinations of goods that give the same
satisfaction to the consumer. Since all the combinations give the same amount of satisfaction,
the consumer prefers them equally. Hence the name indifference curve.

Here is an example to understand the indifference curve better. Peter has 1 unit of food and
12 units of clothing. Now, we ask Peter how many units of clothing is he willing to give up
in exchange for an additional unit of food so that his level of satisfaction remains unchanged.

Peter agrees to give up 6 units of clothing for an additional unit of food. Hence, we have two
combinations of food and clothing giving equal satisfaction to Peter as follows:

1. 1 unit of food and 12 units of clothing

2. 2 units of food and 6 units of clothing

By asking him similar questions, we get various combinations as follows:

16
Combination Food Clothing

A 1 12

B 2 6

C 3 4

D 4 3

The diagram shows an Indifference curve (IC). Any combination lying on this curve gives the
same level of consumer satisfaction. Another name for it is Iso-Utility Curve.

17
Indifference Map: An Indifference Map is a set of Indifference Curves. It depicts the complete
picture of a consumer’s preferences. The following diagram shows an indifference map
consisting of three curves:

We know that a consumer is indifferent among the combinations lying on the same indifference
curve. However, it is important to note that he prefers the combinations on the higher
indifference curves to those on the lower ones.

This is because a higher indifference curve implies a higher level of satisfaction. Therefore, all
combinations on IC1 offer the same satisfaction, but all combinations on IC2 give greater
satisfaction than those on IC1.

Properties of an Indifference Curve or IC

Here are the properties of an indifference curve:

An IC slopes downwards to the right

This slope signifies that when the quantity of one commodity in combination is increased, the
amount of the other commodity reduces. This is essential for the level of satisfaction to remain
the same on an indifference curve.

An IC is always convex to the origin

From our discussion above, we understand that as Peter substitutes clothing for food, he is
willing to part with less and less clothing. This is the diminishing marginal rate of substitution.
The rate gives a convex shape to the indifference curve. However, there are two extreme
scenarios:

1. Two commodities are perfect substitutes for each other – In this case, the indifference
curve is a straight line, where MRS is constant.

18
2. Two goods are perfect complementary goods – An example of such goods would be
gasoline and water in a car. In such cases, the IC will be L-shaped and convex to the
origin.

Indifference curves never intersect each other

Two ICs will never intersect each other. Also, they need not be parallel to each other either.
Look at the following diagram:

Fig 3 shows two ICs intersecting each other at point A. Since points A and B lie on IC1, they
give the same satisfaction level to an individual. Similarly, points A and C give the same
satisfaction level, as they lie on IC2. Therefore, we can imply that B and C offer the same level
of satisfaction, which is logically absurd. Hence, no two ICs can touch or intersect each other.

A higher IC indicates a higher level of satisfaction as compared to a lower IC

A higher IC means that a consumer prefers more goods than not.

An IC does not touch the axis

This is not possible because of our assumption that a consumer considers different combinations
of two commodities and wants both of them. If the curve touches either of the axes, then it
means that he is satisfied with only one commodity and does not want the other, which is
contrary to our assumption.

Indifference Curve Analysis

Indifference curves are based on a number of assumptions, such as that each indifference curve
is convex to the origin and that no two indifference curves ever overlap. When obtaining
bundles of commodities on indifference curves that are farther from the origin, consumers are
supposed to be more satisfied.

The majority of the time, indifference curve analysis assumes that all other variables are stable
or constant. The slope of the indifference curve is referred to by the MRS. The MRS measures
how eager a consumer is to trade one product for another. If a customer values a banana, for

19
example, the rate of substitution for watermelon will be slower, and the slope will reflect this
rate of substitution.

Iso-quant curve:

Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm
can produce equal amount of product.” Bilas

“Iso-product curve shows the different input combinations that will produce a given output.”
Samuelson

“An Iso-quant curve may be defined as a curve showing the possible combinations of two
variable factors that can be used to produce the same total product.” Peterson

“An Iso-quant is a curve showing all possible combinations of inputs physically capable of
producing a given level of output.” Ferguson

Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.

2. Divisible Factor:
ADVERTISEMENTS:

Factors of production can be divided into small parts.

3. Constant Technique:
Technique of production is constant or is known before hand.

4. Possibility of Technical Substitution:

The substitution between the two factors is technically possible. That is, production function
is of ‘variable proportion’ type rather than fixed proportion.

5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.

Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule
shows the different combination of these two inputs that yield the same level of output as
shown in table 1.

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The table 1 shows that the five combinations of labour units and units of capital yield the
same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by
combining.

(a) 1 units of labour and 15 units of capital

(b) 2 units of labour and 11 units of capital

(c) 3 units of labour and 8 units of capital

(d) 4 units of labour and 6 units of capital

(e) 5 units of labour and 5 units of capital

Iso-Product Curve:
From the above schedule iso-product curve can be drawn with the help of a diagram. An.
equal product curve represents all those combinations of two inputs which are capable of
producing the same level of output. The Fig. 1 shows the various combinations of labour and
capital which give the same amount of output. A, B, C, D and E.

21
Iso-Product Map or Equal Product Map:
An Iso-product map shows a set of iso-product curves. They are just like contour lines which
show the different levels of output. A higher iso-product curve represents a higher level of
output. In Fig. 2 we have family iso-product curves, each representing a particular level of
output.

The Iso-product map looks like the indifference of consumer behaviour analysis. Each
indifference curve represents particular level of satisfaction which cannot be quantified. A
higher indifference curve represents a higher level of satisfaction but we cannot say by how
much the satisfaction is more or less. Satisfaction or utility cannot be measured.

The Fig. 3 shows that when the amount of labour is increased from OL to OL 1, the amount of
capital has to be decreased from OK to OK1, The iso-product curve (IQ) is falling as shown
in the figure.
1. The possibilities of horizontal, vertical, upward sloping curves can be ruled out with
the help of the following figure 4:

(i) The figure (A) shows that the amounts of both the factors of production are increased-
labour from L to Li and capital from K to K1. When the amounts of both factors increase, the
output must increase. Hence the IQ curve cannot slope upward from left to right.
(ii) The figure (B) shows that the amount of labour is kept constant while the amount of
capital is increased. The amount of capital is increased from K to K1. Then the output must
increase. So IQ curve cannot be a vertical straight line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour
increases, although the quantity of capital remains constant. When the amount of capital is
increased, the level of output must increase. Thus, an IQ curve cannot be a horizontal line.

22
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand this fact,
we have to understand the concept of diminishing marginal rate of technical substitution
(MRTS), because convexity of an isoquant implies that the MRTS diminishes along the
isoquant. The marginal rate of technical substitution between L and K is defined as the
quantity of K which can be given up in exchange for an additional unit of L. It can also be
defined as the slope of an isoquant.

It can be expressed as:

MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.

Equation (1) states that for an increase in the use of labour, fewer units of capital will be
used. In other words, a declining MRTS refers to the falling marginal product of labour in
relation to capital. To put it differently, as more units of labour are used, and as certain units
of capital are given up, the marginal productivity of labour in relation to capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C
to D along an isoquant, the marginal rate of technical substitution (MRTS) of capital for
labour diminishes. Every time labour units are increasing by an equal amount (AL) but the
corresponding decrease in the units of capital (AK) decreases.

3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves cannot cut each
other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2
represent two levels of output. But they intersect each other at point A. Then combination A
= B and combination A= C. Therefore B must be equal to C. This is absurd. B and C lie on
two different iso-product curves. Therefore two curves which represent two levels of output
cannot intersect each other.

23
4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output as shown in the figure 7 given
below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital.
IQ1 represents an output level of 100 units whereas IQ2 represents 200 units of output.

5. Isoquants Need Not be Parallel to Each Other:

It so happens because the rate of substitution in different isoquant schedules need not be
necessarily equal. Usually they are found different and, therefore, isoquants may not be
parallel as shown in Fig. 8. We may note that the isoquants Iq 1 and Iq2 are parallel but the
isoquants Iq3 and Iq4 are not parallel to each other.

6. No Isoquant can touch Either Axis:

If an isoquant touches X-axis, it would mean that the product is being produced with the help
of labour alone without using capital at all. These logical absurdities for OL units of labour
alone are unable to produce anything. Similarly, OC units of capital alone cannot produce
anything without the use of labour. Therefore as seen in figure 9, IQ and IQ1 cannot be
isoquants.

24
7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a consequence of
the fact that if a producer uses more of capital or more of labour or more of both than is
necessary, the total product will eventually decline. The firm will produce only in those
segments of the isoquants which are convex to the origin and lie between the ridge lines. This
is the economic region of production. In Figure 10, oval shaped isoquants are shown.

Curves OA and OB are the ridge lines and in between them only feasible units of capital and
labour can be employed to produce 100, 200, 300 and 400 units of the product. For example,
OT units of labour and ST units of the capital can produce 100 units of the product, but the
same output can be obtained by using the same quantity of labour T and less quantity of
capital VT.

Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100. The
dotted segments of an isoquant are the waste- bearing segments. They form the uneconomic
regions of production. In the up dotted portion, more capital and in the lower dotted portion
more labour than necessary is employed. Hence GH, JK, LM, and NP segments of the
elliptical curves are the isoquants.

Difference between Indifference Curve and Iso-Quant Curve:

The main points of difference between indifference curve and Iso-quant curve are
explained below:
1. Iso-quant curve expresses the quantity of output. Each curve refers to given quantity of
output while an indifference curve to the quantity of satisfaction. It simply tells that the

25
combinations on a given indifference curve yield more satisfaction than the combination on a
lower indifference curve of production.

2. Iso-quant curve represents the combinations of the factors whereas indifference curve
represents the combinations of the goods.

3. Iso-quant curve gives information regarding the economic and uneconomic region of
production. Indifference curve provides no information regarding the economic and
uneconomic region of consumption.

4. Slope of an iso-quant curve is influenced by the technical possibility of substitution

between factors of production. It depends on marginal rate of technical substitution (MRTS)
whereas slope of an indifference curve depends on marginal rate of substitution (MRS)
between two commodities consumed by the consumer.

Iso-Cost Line:
The iso-cost line is similar to the price or budget line of the indifference curve analysis. It is
the line which shows the various combinations of factors that will result in the same level of
total cost. It refers to those different combinations of two factors that a firm can obtain at the
same cost. Just as there are various isoquant curves, so there are various iso-cost lines,
corresponding to different levels of total output.
Definition:
Iso-cost line may be defined as the line which shows different possible combinations of two
factors that the producer can afford to buy given his total expenditure to be incurred on these
factors and price of the factors.

Explanation:
The concept of iso-cost line can be explained with the help of the following table 3 and Fig.
12. Suppose the producer’s budget for the purchase of labour and capital is fixed at Rs. 100.
Further suppose that a unit of labour cost the producer Rs. 10 while a unit of capital Rs. 20.

From the table cited above, the producer can adopt the following options:
(i) Spending all the money on the purchase of labour, he can hire 10 units of labour (100/10 =
10)

(ii) Spending all the money on the capital he may buy 5 units of capital.

(iii) Spending the money on both labour and capital, he can choose between various possible
combinations of labour and capital such as (4, 3) (2, 4) etc.

26
Diagram Representation:

In Fig. 12, labour is given on OX-axis and capital on OY-axis. The points A, B, C and D
convey the different combinations of two factors, capital and labour which can be purchased
by spending Rs. 100. Point A indicates 5 units of capital and no unit of labour, while point D
represents 10 units of labour and no unit of capital. Point B indicates 4 units of capital and 2
units of labour. Likewise, point C represents 4 units of labour and 3 units of capital.

Optimum combination of factors/Least combination factor:

Optimum or Least-Cost Combination of Factors: An equal product map or isoquant map

represents the various factor combinations which can yield various levels of output, every
equal product curve or isoquant showing those factor combinations each of which can
produce a specified level of output.

In simple words, producer’s equilibrium implies to that situation in which producer

maximizes his profit. In short, the producer is producing given amount of output with least
cost combination of factors. It is also known as optimum combination of the factors.

Optimum combination is that combination at which either:

 The output derived from a given level of inputs is maximum or

 The cost of producing given output is minimum.

For producer’s equilibrium or optimum combination, it must fulfil following two conditions
as: At the point of equilibrium the iso-cost line must be tangent to iso-quant curve.

At point of tangency that is iso-quant curve must be convex to the origin or its falling.

27
The iso-cost line gives information regarding factor prices and financial resources of the firm.
With a given outlay and prices of two factors, the firm obtains least cost combination of
factors, when the iso-cost line becomes tangent to an iso-product curve.

A profit maximisation firm faces two choices of optimal combination of factors (inputs).

1. To minimise its cost for a given output; and

2. To maximise its output for a given cost.

Thus the least cost combination of factors refers to a firm producing the largest volume of
output from a given cost and producing a given level of output with the minimum cost when
the factors are combined in an optimum manner. We study these cases separately.

Cost-Minimisation for a Given Output:

In the theory of production, the profit maximisation firm is in equilibrium when, given the
cost-price function, it maximises its profits on the basis of the least cost combination of
factors. For this, it will choose that combination which minimizes its cost of production for a
given output. This will be the optimal combination for it.

Assumptions:
This analysis is based on the following assumptions:
1. There are two factors, labour and capital.

2. All units of labour and capital are homogeneous.

3. The prices of units of labour (w) and that of capital (r) are given and constant.

4. The cost outlay is given.

5. The firm produces a single product.

6. The price of the product is given and constant.

7. The firm aims at profit maximisation.

8. There is perfect competition in the factor market.

Output-Maximisation for a given Cost:

The firm also maximises its profits by maximising its output, given its cost outlay and the
prices of the two factors. This analysis is based on the same assumptions, as given above.

The conditions for the equilibrium of the firm are the same, as discussed above.

28
Economies of scale:

Economies of scale refer to the cost advantage experienced by a firm when it increases its
level of output. The advantage arises due to the inverse relationship between per-unit fixed
cost and the quantity produced. The greater the quantity of output produced, the lower
the per-unit fixed cost.

Economies of scale also result in a fall in average variable costs (average non-fixed costs)
with an increase in output. This is brought about by operational efficiencies and synergies as
a result of an increase in the scale of production.

Effects of Economies of Scale on Production Costs

1. It reduces the per-unit fixed cost. As a result of increased production, the fixed cost gets
spread over more output than before.
2. It reduces per-unit variable costs. This occurs as the expanded scale of production
increases the efficiency of the production process.

The graph above plots the long-run average costs (LRAC) faced by a firm against its level of
output. When the firm expands its output from Q to Q 2, its average cost falls from C to C1.
Thus, the firm can be said to experience economies of scale up to output level Q 2.
In economics, a key result that emerges from the analysis of the production process is that a
profit-maximizing firm always produces that level of output which results in the least average
cost per unit of output.

Sources of Economies of Scale

1. Purchasing: Firms might be able to lower average costs by buying the inputs required for
the production process in bulk or from special wholesalers.

2. Managerial: Firms might be able to lower average costs by improving the management
structure within the firm. The firm might hire better skilled or more experienced managers.

3. Technological: A technological advancement might drastically change the production

process. For instance, fracking completely changed the oil industry a few years ago.
However, only large oil firms that could afford to invest in expensive fracking equipment
could take advantage of the new technology.

Types of economies of scale:

29
Economists consider there to be two distinct economies of scale: one based on internal
factors and one based on external factors.

1. Internal economies of scale: Internal economies of scale involve decisions made

by individual organizations. A factory could choose to ramp up its production
process, which prompts marginal cost savings. It could also engage in bulk buying,
which gives it more raw goods to feed into its assembly line. In both cases, the
economy of scale affects the business itself. Both small businesses and large firms
can experience internal economies of scale.

Examples: Technological economies of scale, Marketing economies of scale,

Financial economies of scale, Managerial economies of scale, Commercial
economies of scale.

2. External economies of scale: External economies of scale affect entire

industries—not just a single business. For example, industry-specific tax cuts can
factor into external economies of scale because they lower the total cost of doing
business throughout an industry.

Examples: Economies of concentration, Economies of Information, Economies of

disintegration.

Diseconomies of scale definition:

In microeconomics, diseconomies of scale are the cost disadvantages that economic

actors accrue due to an increase in organizational size or in output, resulting in production
of goods and services at increased per-unit costs. The concept of diseconomies of scale is the
opposite of economies of scale. In business, diseconomies of scale are the features that lead
to an increase in average costs as a business grows beyond a certain size.

Diseconomies of Scale Graph

Below is the graph of diseconomies of scale: –

In the above chart, the Y-axis represents the cost in $, and X-axis represents production units
in Q. The upward-facing curve represents the long-run average cost – LRAC.

The curve is divided into three states –

30
 Economies of Scale – It is a state where the firm experiences the highest operational
efficiency. The LRAC of the firm keeps falling with the increase in the production of units.

 2) Constant Returns of Scale – The constant return of scale is a state where the firm begins
to start entering the maturity stage. At this stage, the LRAC remains static with the increase
in production.

 3) Diseconomies of Scale – It is a state where a firm experiences a lower operational

efficiency. That is because the LRAC keeps increasing with the increase in the production of
units.

The average cost of production ($) from the left shows a decreasing trend that reflects the
scale’s economies. The average production price in a zone of economies of scale keeps
decreasing to the point where we have constant scale returns (represented in dotted lines).

Causes of diseconomies of scale:

1 – Employee Costs: Employee cost is directly related to the production of units. They
remain relevant costs until firms are in the zone of economies of scale. In times of
diseconomies of scale, the employees in production processes are relatively higher than
required. This situation happens due to the overcrowding of employees in the production,
marketing, and administrative process.

2 – Communication Failure: An increase in the number of employees resulted in an

increasing number of communication channels. However, complex communication channels
result in high costs, wastage of time, and effort.

3 – Administration Costs: As the firm grows, it requires a good administration to manage

facilitations like logistics, inventory control, human resources, security system, etc.
Therefore, the additional cost incurred on administration increases the average cost of units
produced.

4 – Compliance Costs: Large-size firms are bound to comply with the regulatory bodies.
Maintaining the required records and complying with the statutory bodies requires huge costs
and efforts. Therefore, an increased level of compliance is common in large firms. As
monitoring in such firms is high, the excess risk control measures are placed, which brings
some bureaucracy to the system, which is unavoidable.

5-Poor communication: As the business expands communicating between different

departments and along the chain of command becomes more difficult. There are more layers
in the hierarchy that can distort a message and wider spans of control for managers. This may
result in workers having less clear instructions from management about what they are
supposed to do when.

6-Lack of motivation: Workers can often feel more isolated and less appreciated in a larger
business and so their loyalty and motivation may diminish. It is harder for managers to stay in
day-to-day contact with workers and build up a good team environment and sense of
belonging. This can lead to lower employee motivation with damaging consequences for

31
output and quality. The main result of poor employee motivation is falling productivity levels
and an increase in average labour costs per unit.

7- Loss of direction and co-ordination: It is harder to ensure that all workers are working
for the same overall goal as the business grows. It is more difficult for managers to supervise
their subordinates and check that everyone is working together effectively, as the spans of
control have widened. A manager may be forced to delegate more tasks, which while often
motivating for his subordinates, leaves the manager less in control.

Technological progress and production function:

As knowledge of new and more efficient methods of production become available,

technology changes.

Furthermore new inventions may result in the increase of the efficiency of all methods of
production. At the same time some techniques may become inefficient and drop out from the
production function.

These changes in technology constitute technological progress.

Graphically the effect of innovation in processes is shown with an upward shift of the
production function (figure 3.27), or a downward movement of the production isoquant
(figure 3.28). This shift shows that the same output may be produced by less factor inputs, or
more output may be obtained with the same inputs.

Technical progress may also change the shape (as well as produce a shift) of the isoquant.
Hicks has distinguished three types of technical progress, depending on its effect on the rate
of substitution of the factors of production.
Capital-deepening technical progress:
Technical progress is capital-deepening (or capital-using) if, along a line on which the K/L
ratio is constant, the MRSL K increases. This implies that technical progress increases the
marginal product of capital by more than the marginal product of labour. The ratio of
marginal products (which is the MRSL K) decreases in absolute value; but taking into account

32
that the slope of the isoquant is negative, this sort of technical progress increases the MRS L K.
The slope of the shifting isoquant becomes less steep along any given radius. The capital-
deepening technical progress is shown in figure 3.29.

Labour-deepening technical progress:

Technical progress is labour-deepening if, along a radius through the origin (with constant
K/L ratio), the MRSL, K increases. This implies that the technical progress increases the
MPL faster than the MP K. Thus the MRSL, K, being the ratio of the marginal products
increases in absolute value (but decreases if the minus sign is taken into account). The
downwards-shifting isoquant becomes steeper along any given radius through the origin. This
is shown in figure 3.30.

Neutral-technical progress:
Technical progress is neutral if it increases the marginal product of both factors by the same
percentage, so that the MRSL K (along any radius) remains constant. The isoquant shifts
downwards parallel to itself. This is shown in figure 3.31.

33
Cost concept: It refers to the amount of payment made to acquire any goods and
services. In a simpler way, the concept of cost is a financial valuation of resources, materials,
risks, time and utilities consumed to purchase goods and services.

Types of CostConcept of cost in terms of Expenses1. Outlay costs: The actual expenses
incurred by the entrepreneur in employing inputs are called outlay costs. These include costs on
payment of wages, rent, electricity or fuel charges, raw materials, etc. We have to treat them are
general expenses for the business.

2. Opportunity costs: Opportunity costs are incomes from the next best alternative that is
foregone when the entrepreneur makes certain choices.

For example, the entrepreneur could have earned a salary had he worked for others instead of
spending time on his own business. These costs calculate the missed opportunity and calculate
income that we can earn by following some other policy.

Concept of Costs in terms of Traceability

1. Direct costs: Direct costs are related to a specific process or product. They are also called
traceable costs as we can directly trace them to a particular activity, product or process.

They can vary with changes in the activity or product. Examples of direct costs include
manufacturing costs relating to production, customer acquisition costs pertaining to sales, etc.

2. Indirect costs: Indirect costs, or untraceable costs, are those which do not directly relate to a
specific activity or component of the business. For example, an increase in charges of electricity
or taxes payable on income. Although we cannot trace indirect costs, they are important because
they affect overall profitability.

Concept of Costs in terms of the Purpose

1. Incremental costs: These costs are incurred when the business makes a policy decision. For
example, change of product line, acquisition of new customers, and upgrade of machinery to
increase output are incremental costs.

2. Sunk costs: Suck costs are costs which the entrepreneur has already incurred and he cannot
recover them again now. These include money spent on advertising, conducting research, and
acquiring machinery.

Concept of Costs in terms of Payers

1. Private costs: These costs are incurred by the business in furtherance of its own objectives.
Entrepreneurs spend them for their own private and business interests. For example, costs
of manufacturing, production, sale, advertising, etc.

34
2. Social costs: As the name suggests, it is the society that bears social costs for private interests
and expenses of the business. These include social resources for which the firm does not incur
expenses, like atmosphere, water resources and environmental pollution.

Concept of Costs in terms of Variability

1. Fixed costs: Fixed costs are those which do not change with the volume of output. The
business incurs them regardless of their level of production. Examples of these include payment
of rent, taxes, interest on a loan, etc.

2. Variable costs: These costs will vary depending upon the output that the business generates.
Less production will cost fewer expenses, and vice versa, the business will pay more when its
production is greater. Expenses on the purchase of raw material and payment of wages are
examples of variable costs.

Difference between fixed cost and variable cost:

Fixed cost Variable cost

Definition

Fixed cost is referred to as Variable cost is referred to as the type of cost that will show
the cost that does not variations as per the changes in the levels of production.
register a change with an
increase or decrease in the
quantity of goods produced
by a firm.

Nature of cost

It is time-dependent and It is volume-dependent and changes based on the volume

changes after a certain produced.
period of time.

How are they incurred?

Fixed costs are incurred Variable costs are incurred as and when any units are
irrespective of any units produced.
produced.

Does it change with the number of units?

Fixed cost decreases with an Variable cost remains the same irrespective of the number of
increase in the number of units produced.
units produced.

35
Impact on profit

Higher production results in There is no impact on profit with the level of production.
reducing the costs and
increasing the profits.

Examples

Rent, salaries, and property Labour cost, cost of raw materials, and sales commissions
taxes

Incurred when Fixed costs are definite, they are Variable costs are
incurred whether the units are incurred only when the
produced or not. units are produced.

Unit Cost Fixed cost changes in unit, i.e. as Variable cost remains
the units produced increases, fixed same, per unit.
cost per unit decreases and vice
versa, so the fixed cost per unit is
inversely proportional to the
number of output produced.

Behaviour It remains constant for a given It changes with the

period of time. change in the output
level.

Combination of Fixed Production Overhead, Fixed Direct Material, Direct

Administration Overhead and Fixed Labor, Direct Expenses,
Selling and Distribution Overhead. Variable Production
Overhead, Variable
Selling and Distribution
Overhead.

Cost curves:

In economics, a cost curve is a graph of the costs of production as a function of total quantity
produced. In a free market economy, productively efficient firms optimize their production

36
process by minimizing cost consistent with each possible level of production, and the result is
a cost curve.

Meaning of Short-run and Long-run:

In Economics, distinction is often made between the short-run and long-run.

By short-run is meant that period of time within which a firm can vary its output by varying
only the amount of variable factors, such as labour and raw material.

In the short-run period, the fixed factors such as capital equipment, management personnel,
the factory buildings, etc., cannot be altered.

If, therefore, a firm wants to increase production in the short-run, it can do so only by hiring
more workers or buying and using more raw materials. It cannot, in the short-run, enlarge the
size of the existing plant or build a new plant of a bigger capacity. Thus, in the short-run,
only variable factors can be varied, while the fixed factors remain the same.

On the other hand, long-run is a period of time during which the quantities of all factors,
variable as well as fixed, can be adjusted. Thus, in the long-run, output can be increased by
increasing capital equipment or by increasing the size of the existing plant or by installing a
new plant of bigger capacity.

Short-run Fixed and Variable Costs:

We have already drawn a distinction between prime (or variable) costs and supplementary (or
fixed) costs. During the short period, only the prime costs relating to labour and raw materials
can be varied, whereas the fixed costs remain the same. But, during the long period, even the
fixed costs relating to plant and machinery, staff salaries, etc., can be varied. That is, in the
long run, all costs are variable, and no costs are fixed.

Short-run Cost Curves:

We may repeat that, in the short-run, a firm will adjust output to demand by varying the
variable factors. If all the factors of production can be used in varying proportions, it means
that the scale of operations of the firm can be changed. Each time, the scale of operations is
changed, a new short-run cost curve will have to be drawn for the firm such as SAC’, SAC”
and SAC” in the next diagram (Fig. 23.5)

To begin with, let us suppose that the firm has the short-run cost curve SAC “. ,In this case,
the optimum output will be OM’. Now, if it is desired to increase the output to OM” in the
short-run, it can be obtained at the average cost M”L” along the short-run cost curve SAC”,

37
because in the short-run, the scale of operations is fixed. But, in the long run, a new and
bigger plant can be built on which OM ” is the optimum output. That is, the firm has now a
short-run average cost curve SAC “‘, and by increasing the scale of its operations, the firm
can produce the OM” output at a cost of M “L” ‘ instead of M “L”

Thus, it will be seen that, at any scale of operations in the short-run, a firm will have regions
of rising and falling costs. But, in the long-run, the firm can produce on a completely
different cost curves to the left (i.e., SAC’) or right (i.e., SAC”’) of the original cost curve
(i.e., SAC”). For each different scale represented by a different short-run cost curve, there
will be an output where the average cost is the minimum. This is the optimum output.

Long-run Average Cost Curve:

In the diagram (Fig. 23.6), SAC,, SAC,, and SAC, are the short-run cost curves
corresponding to the different scales of operations. In each case, the firm in question will be
producing the desired output at the lowest cost. For example, OM”’ output is produced at
PM”’ in the scale of operations represented by the curve SAC OM will be produced on SAC,
and so on.

38
It should be clearly understood that only in the long-run can the scale of operations be
altered; in the short-run, it will be fixed, and the average cost of output above or below the
optimum level will necessarily rise along the short-run cost curve in question, whether it be
SAC,, SAC 2 and SAC3. A long-run average cost will show what the long-run cost of
producing each output will be. It will be seen, in the Fig. 23.6 that the short-run average cost
curve SAC, has a lower minimum point than either the curves SAC, and SAC 3. The optimum
output of the firm is obtained at OM.

The long-run average cost curve LAC is a tangent to all the short-run cost curves SAC,
SAC2 and SAC. The LAC curve will, therefore, be U-shaped like the short-run cost curves,
but its U-shape will be less pronounced than that of the short-run cost curves. It will be
flatter. That is why the long-run cost curve is called an ‘Envelope’, because it envelops all the
short-run cost curves.
The cost curves, whether short-run or long-run, are U-shaped because the cost of production
first starts falling as output is increased owing to the various economies of scale. But after
touching the lowest point at the optimum output level, it starts rising, and goes on rising if
production is continued beyond the optimum level.

Cost/output relationship in the short run and in the long run:

Cost/output relationship in the short run

The cost concepts made use of in the cost behavior are Total cost, Average cost,
and Marginal cost. Total cost is the actual money spent to produce a particular quantity of
output. Total Cost is the summation of Fixed Costs and Variable Costs.

TC=TFC+TVC

Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building,
equipment etc, remains fixed. But the Total Variable Cost i.e., the cost of labor, raw materials
etc., vary with the variation in output. Average cost is the total cost per unit. It can be found
out as follows.

AC=TC/Q

The total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased
and Average Variable Cost (TVC/Q) will remain constant at any level of output.

Marginal Cost is the addition to the total cost due to the production of an additional unit of
product. It can be arrived at by dividing the change in total cost by the change in total output.

The short-run cost-output relationship can be shown graphically as follows.

39
 In the above graph the “AFC’ curve continues to fall as output rises an account of its spread
over more and more units Output. But AVC curve (i.e. variable cost per unit) first falls and
than rises due to the operation of the law of variable proportions. The behavior of “ATC’
curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In the initial stage of
production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a certain
point ‘AVC’ starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC
will still continue to decline otherwise AC begins to rise. Thus the lower end of ‘ATC’ curve
thus turns up and gives it a U-shape. That is why ‘ATC’ curve are U-shaped. The lowest
point in ‘ATC’ curve indicates the least-cost combination of inputs. Where the total average
cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the
maximum output level rather it is the point where per unit cost of production will be at its
lowest.

The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1. If both ‘AFC’ and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
3. ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
4. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
5. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘A

Cost Output Relationship in Long Run

That is why Spencer has said, in the long term production function no factor is fixed, due to
the long time period and no cost of the firm is fixed. In the long period, long-run marginal
cost and long run average cost have an important role in price determination, which is
explained, as follows:
1. Long Run Average Cost
2. Long Run Marginal Cost
Long Run Average Cost
Long Term average cost is calculated by dividing long term total cost by the units of
production. Long run average cost curve explains the minimum long run average cost at
various quantities of production. In other words, the curves framed by touching various short
term average cost curves for production are known as long run average cost curves. It may be
explained by the diagram also.

40
 Diagram 1

In this diagram, long term average cost, LAC has been shown. In LAC curve, short term AC
Curves. SAC1, SAC2 and SAC3 have been shown. It should be remembered here that SAC1
and SAC2 and SAC3 are the best plants of different production levels, like (1) SAC, curve
plant OQ, (2) SAC2, curve plant, show the best quantity of OQ1 and (3) SAC3 curve plant
production quantity of OQ2.

If a curve is drawn by joining these various curves from each other, the LAC curve will be
formed. The characteristics of long term average cost may be explained by this diagram.

Diagram 2

1. Long term average cost (LAC) is the envelope of all short term average cost curves
(SACs). That is why LAC is also known as envelope curve.
2. LAC is always less than SAC. That is why, all SAC curves are located above LAC.
3. LAC indicates minimum cost of production and optimum size of the firm (Law of
constant returns).
4. LAC curve only touches the SAC curves and not cuts them.
5. LAC curve is also U shaped like SAC curves, but LAC curve is more flat as compared to
SAC.
6. LAC curve does not touch all SAC curves at their lowest points.
LAC touches SAC at its lowest point at its own lowest points. Till the LAC curve falls, it
touches the falling parts of SAC curves and when the LAC curve rises upwards, then it
touches the rising part of SAC curves.

Long Run Marginal Cost

Long run marginal cost curve is also ‘U’ shaped. In the long term difference between fixed
costs and variable costs comes to an end. All costs become variable and total variable cost

41
and total cost become equal. Hence, in long run, marginal cost can be expressed or defined in
the terms of variable cost. The total cost in the longer term due to the production ‘of one
additional unit is known as long run marginal cost.
Long run marginal cost and long term average cost have the same relationship which is in
short term marginal cost and short term average cost.

Diagram 3

It is clear from the diagram that when LAC falls, then LMC is less than it. At the lowest point
P of LAC, SMC becomes equal. Thereafter LAC increases and LMC remains higher than
that. In the diagram, SAC and SMC are short term average cost curves and short term
marginal cost curves, respectively. Thus, it is clear that at point P, LAC = LMC = SAC =
SMC.

Why LAC Curves U-shaped

In the short run, SAC curve is U-shaped because the laws of returns operate but in the long
run, LAC is also U-shaped because the Laws of Returns to scale operate namely law of
increasing return to scale, Law of Constant Returns to scale and the Law of Diminishing
Returns to scale.

Break even analysis:

The Break-even point is the level of production where the company’s total revenues and
expenses are equal. At the BEP, the revenue of the company by the sale of manufactured
products is equal to the total costs incurred in manufacturing the product. In accounting
terms, at this point, the company’s total profit is zero. So it is a situation where there is no
profit, no loss to the company.

According to Charles [Link], “the break –even point of activity is where total revenue
and total expenses are equal. It is the point of zero profit and zero loss”.

Assumptions:

(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable
cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

42
(iv) The volume of sales and volume of production are equal.

(v) The fixed costs remain constant over the volume under consideration.

(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

Limitations of Break-Even Analysis:

1. In the break-even analysis, we keep everything constant. The selling price is assumed to be
constant and the cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future with
the help of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small
range of output. It is not an effective tool for long-range use.

4. Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis.

5. When break-even analysis is based on accounting data, as it usually happens, it may suffer
from various limitations of such data as neglect of imputed costs, arbitrary depreciation
estimates and inappropriate allocation of overheads. It can be sound and useful only if the
firm in question maintains a good accounting system.

6. Selling costs are specially difficult to handle break-even analysis. This is because changes
in selling costs are a cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly
corporate income tax.

8. It usually assumes that the price of the output is given . In other words, it assumes a
horizontal demand curve that is realistic under the conditions of perfect competition.

43
9. Matching cost with output imposes another limitation on break-even analysis. Cost in a
particular period need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation of a

breakeven point is considered an approximation rather than a reality.

Determination of the Break-Even Point:

Break-even point may be determined either in terms of physical units or in money terms, i.e.,
sales value in rupees.
1. Break-Even Point in Terms of Physical Units:
This method is convenient for the single-product firm. The break-even volume is the number
of units of the product which must be sold to earn enough revenue just to cover all
expenses—both fixed and variable. The selling price of a unit covers not only its variable cost
but also leaves a margin (contribution margin) to contribute toward the fixed costs (costs
remaining fixed irrespective of the volume).

The breakeven point is reached when sufficient numbers of units have been sold so that the
total contribution margin of the units sold is equal to the fixed costs. The formula for
calculating the break-even point is as follows –
BEP = Fixed cost/Contribution margin per unit
Where the contribution margin is selling price-variable costs per unit.

2. Break-Even Point in Terms of Sales Value:

Multi-product firms are not in a position to measure the break-even point in terms of any
common unit of product. They find it convenient to determine their breakeven point in terms
of total rupee sales. Here, again, the break-even point would be the point where the
contribution margin (Sales value – Variable costs) would equal the fixed costs. The
contribution margin, however, is expressed as a ratio to sales.
For example, if the sales are Rs.200 and the variable cost of these sales is Rs.140, the
contribution margin ratio is (200 –140)/200, i.e., 0.3.
BEP = Fixed cost/Contribution ratio

Uses of BEA in managerial decisions:

1. Safety Margin:
The break-even chart helps the management to know at a glance the profits generated at the
various levels of sales. The safety margin refers to the extent to which the firm can afford a
decline before it starts incurring losses.

Safety Margin = (Sales – BEP)/Sales x 100

44
2. Target Profit:
The break-even analysis can be utilised for the purpose of calculating the volume of sales
necessary to achieve a target profit.

When a firm has some target profit, this analysis will help in finding out the extent of
increase in sales by using the following formula:
Target Sales Volume = Fixed Cost + Target Profit/Contribution Margin Per Unit.

3. Change in Price:
The management is often faced with a problem of whether to reduce prices or not. Before
taking a decision on this question, the management will have to consider a profit. A reduction
in price leads to a reduction in the contribution margin.

This means that the volume of sales will have to be increased even to maintain the previous
level of profit. The higher the reduction in the contribution margin, the higher is the increase
in sales needed to ensure the previous profit.

New Sales Volume = Total Fixed Cost + Total Profit/New Selling Price – Average Variable
Cost

4. Change in Costs:
When costs undergo change, the selling price and the quantity produced and sold also
undergo changes.

Changes in cost can be in two ways:

(i) Change in variable cost, and

(ii) Change in fixed cost.

Variable Cost Change:

An increase in variable costs leads to a reduction in the contribution margin. This reduction in
the contribution margin will shift the break-even point downward. Conversely, with the fall
in the proportion of variable costs, contribution margins increase and break-even point moves
upwards.

Fixed Cost Change:

An increase in fixed cost of a firm may be caused either due to a tax on assets or due to an
increase in remuneration of management, etc. It will increase the contribution margin and

45
thus push the break-even point upwards. Again to maintain the earlier level of profits, a new
level of sales volume or new price has to be found out.

5. Decision on Choice of Technique of Production:

A firm has to decide about the most economical production process both at the planning and
expansion stages. There are many techniques available to produce a product. These
techniques will differ in terms of capacity and costs.

The breakeven analysis is the most simple and helpful in the case of decision on a choice of
technique of production. For example, for low levels of output, some conventional methods
may be most probable as they require minimum fixed cost

6. Make or Buy Decision:

Firms often have the option of making certain components or for purchasing them from
outside the concern. Break-even analysis can enable the firm to decide whether to make or
buy.

BEP = Fixed Cost/Purchase Price – Variable Cost

7. Plant Expansion Decisions:

The break-even analysis may be adopted to reveal the effect of an actual or proposed change
in operation condition. This may be illustrated by showing the impact of a proposed plant on
expansion on costs, volume and profits. Through the break-even analysis, it would be
possible to examine the various implications of this proposal.

BEP at present capacity = Fixed Cost/Margin Contribution %

8. Plant Shut Down Decisions:

In the shut-down decisions, a distinction should be made between out of pocket and sunk
costs. Out of pocket costs include all the variable costs plus the fixed cost which do not vary
with output. Sunk fixed costs are the expenditures previously made but from which benefits
still remain to be obtained e.g., depreciation.

9. Advertising and Promotion Mix Decisions:

The main objective of advertisement is to stimulate or increase sales to all customers—
former, present and future. If there is keen competition, the firm has to undertake vigorous
campaign of advertisement. The management has to examine those marketing activities that
stimulate consumer purchasing and dealer effectiveness.

46
The break-even point concept helps the management to know about the circumstances. It
enables him not only to take appropriate decision but by showing how these additional fixed
cost would influence BEPs. The advertisement cost pushes up the total cost curve by the
amount of advertisement expenditure.

10. Decision Regarding Addition or Deletion of Product Line:

If a product has outlived its utility in the market immediately, the production must be
abandoned by the management and examined what would be its consequent effect on revenue
and cost. Alternatively, the management may like to add a product to its existing product line
because it expects the product as a potential profit spinner. The break-even analysis helps in
such a decision.

47
 Module-4 Market structure and Pricing practice

Market structure: Market structure, in economics, depicts how firms are differentiated and
categorized based on the types of goods they sell and how their operations are affected by
external factors and elements. Market structure makes it easier to understand the
characteristics of diverse markets.

Market structure refers to how different industries are classified and differentiated based on
their degree and nature of competition for services and goods. The four popular types of
market structures include perfect competition, oligopoly market, monopoly market, and
monopolistic competition.
Perfect competition: Perfect competition is a market structure where many firms offer a
homogeneous product. Because there is freedom of entry and exit and perfect information,
firms will make normal profits and prices will be kept low by competitive pressures.
According to Boulding- “A perfect competition market may be defined as a large number of
buyers and sellers all 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.”

Perfect competition: An industry structure in which there are many firms, none large enough
to influence the industry, producing homogeneous products. Firms are price takers. There are
no barriers to entry. Agriculture comes close to being perfectly competitive.

Features/characteristics of perfect competition:

1. Large number of buyers and sellers

2. Homogenous product is produced by every firm

3. Free entry and exit of firms

4. Zero advertising cost

5. Consumers have perfect knowledge about the market and are well aware of any changes in
the market. Consumers indulge in rational decision making.

6. All the factors of production, viz. labour, capital, etc, have perfect mobility in the market
and are not hindered by any market factors or market forces.

7. No government intervention

8. No transportation costs

9. Each firm earns normal profits and no firms can earn super-normal profits.

10. Every firm is a price taker. It takes the price as decided by the forces of demand and
supply. No firm can influence the price of the product.

11. Many Competing Firms

A perfectly competitive market has many buyers and sellers. This means that firms are
known as ‘price takers’. In other words, the firm must sell at the ‘equilibrium’ price – this is
where the firm sells when supply and demand align. If not, they will go out of business, as

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 Module-4 Market structure and Pricing practice

there are many other firms that sell the same good at a lower price. As a result, customers
have little cost of switching to a substitute good.

Determination of price under perfect competition:

A Market situation with many homogeneous product suppliers is called Perfect Competition.
A single Company provides a small portion of total production and is not powerful enough to
affect Market Prices.
Pricing under Perfect Competition will be considered in three different periods-
A. Market Period

B. Short Run
C. Long Run

Market Period
In a Market period, the time span is so short that no one can increase its output. The Market
period of the stock may be an hour, a day or a few days or even a few weeks depending upon
the nature of the product.
For example, in the case of perishable stock such as vegetables, fruits, fish, eggs, baked
goods the period may be limited by a day or two by quantity available or stock in a day that
neither can be increased nor can be withdrawn for the next period, the entire stock must be
sold away on the same day, whatever may be the Price.

Short Run
Short term means that amount of time is not enough to change the fixed input or the number
of companies in the industry, but it is enough to change the output by changing the variable
input.

In the Short term, there are two distinct costs: (i) fixed costs and (ii) variable costs.
Fixed costs in the form of fixed elements, i. H. Plants, machines, buildings, etc. do not
change as the Company's production changes. When a Company increases or decreases
production, changes are only made to the number of variable resources such as labour and
raw materials.
In the Short term, the demand curve facing the Company is also horizontal. The number of
companies in the industry remains the same since no new Company can enter nor can any
Company leave. With Perfect Competition, the Company accepts the Prices of the products
on the Market. The Company sells all products at current Market Prices.
Long Run
A Long term is a time period Long enough to allow you to change both variable and fixed
factors. Therefore, in the Long run, all factors are variable and not fixed. Therefore, in the
Long run, companies can change production by increasing fixed equipment. You can modify
old plants, or replace them with new ones.
In addition, in the Long run, new companies can also enter the industry. Conversely, if
needed, fixed equipment can be used up without replacement, in the Long run, allowing
existing companies to leave the industry as well. So there is no stop to companies entering or
leaving.

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 Module-4 Market structure and Pricing practice

Conditions for Company Equilibrium

To achieve Equilibrium, a Company must meet two conditions:

You need to make sure that the marginal revenue is equal to the marginal cost (MR = MC).
1. If MR> MC, the Company has an incentive to expand production and sell additional
units.
2. If MR<MC, the Company needs to reduce production because additional units
generate more costs than revenue.
Only when MR = MC does the Company achieve maximum profit.

Equilibrium of the Industry in a Perfectly Competitive Market

In Economics, the industry comprises several firms. Each of the firms consists of factories or
mines, as per the requirement. If the total output of the industry equals the total demand, then
the Equilibrium is created. In this situation, the ongoing Price of the good is noted to be its
Equilibrium cost. While determining how Equilibrium Price is determined under Perfect
Competition, we will need to discuss the following theory.

Equilibrium of the Firm in a Perfectly Competitive Market

When there is profit maximization, the firm is said to be in Equilibrium. The input that
provides the highest output to that particular firm is known as the Equilibrium output. In such
a state, there are no factors to increase or reduce the output. The firm is the Price taker in a
competitive Market. They produce homogenous commodities. Therefore, influencing the
pricing factors isn't on the will of the firms. They strictly follow the Price structure, as stated
by the industry. This is how Price and output Determination under Perfect Competition is
done. Now, we will explore more on the topic of how Prices are determined under Perfect
Competition.

Price Determination in a Perfect Competition Market

In a Perfectly Competitive Market or industry, the Equilibrium Price is determined by the
forces of demand and supply. Equilibrium signifies a state of balance where the two opposing
forces operate subsequently. Equilibrium is typically a state of rest from which there is no
possibility to change the system. Market Equilibrium takes place when both the demand and
supply balance each other, i.e., there’s no difference between these opposing forces and are at
rest. The following theory will explain how Equilibrium Price is determined under Perfect
Competition.

Monopoly market: A market structure characterized by a single seller, selling a unique

product in the market. In a monopoly market, the seller faces no competition, as he is the sole
seller of goods with no close substitute.
“Monopoly is a market situation in which there is a single seller. There are no close
substitutes of the commodity it produces, there are barriers to entry”. – Koutsoyiannis

Price discrimination under Monopoly:

According to Robinson, “Price discrimination is charging different prices for the same
product or same price for the differentiated product “.

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Meaning of price discrimination: Price discrimination is the important feature under

monopoly form of market. Under price discrimination, the seller charges different price for
the same commodity from different group of buyers. It can be defined as the practice of the
seller, specifically of the monopolist, by which different price can be charged for the same
commodity from different group of buyers depending on the market condition. For example;
the Calcutta Electric Supply Corporation supplies electricity to different categories of
consumers (domestic, commercial, industrial etc.) at the different rates. Here the concerned
monopolist is termed as the discriminating monopolist.

Different types of price discrimination: Price discrimination can be classified into different
categories depending on its nature. In this context important classifications are:
(a) Personal price discrimination: When the monopolist charges different price for the
same commodity from different persons then it is called personal price discrimination. For
example; doctor charges relatively higher fees from the rich patients than the poor one for the
same surgery. (b) Price discrimination according to use: When monopolist charges
different price for the same commodity from different group of buyers based on the nature of
use of the commodity then it is called price discrimination according to use. For example; the
CESC charges higher price or rate of electricity for industrial use than the domestic use.
(c) Regional or local price discrimination: When the monopolist charges different price for
the same commodity from different consumers residing in different locality or region then it
is called regional or local price discrimination. For example; the multinational giant firm sells
the commodity at a cheaper rate in the international market than the domestic market to
capture the foreign markets. Such price discrimination in international level is called
dumping.
Degrees of price discrimination: Depending on the nature of price discrimination
economist [Link] classified it into three different categories:
(a) Price discrimination of first degree
(b) price discrimination of second degree and
(c) price discrimination of third degree.
Under first degree price discrimination, the monopolist has the perfect idea of nature of the
demand curve of the consumer. Here, the monopolist charges the maximum price that a
consumer is ready and willing to pay for it. It implies that, the monopolist squeezes entire
consumers’ surplus. As the consumers’ surplus is entirely taken away by the monopolist
while selling the product, it is termed as the perfect price discrimination.
In second degree price discrimination, monopolist charges different rates for the product
according to the quantity demanded. In case of electricity, the company is charging different
rates for the different blocks of electricity consumption. Here block implies the quantum of
units of electricity upto a certain range. For example rate of electricity upto 50 units of
consumption differs from the rate within the block 51 to 100 units and so on. Such a
discriminating pricing policy is termed as the block pricing.
Third degree price discrimination is very common phenomenon under price discrimination
policy by the monopolist. Here, the monopolist charges different prices for the commodity
from different categories of buyers due to difference in their response towards change in
demand for change in price i.e., price elasticity.

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Price discrimination is an essential feature under monopoly. To conduct price discrimination

successfully certain conditions are essential to exist even if it is monopoly. Few of such
conditions are as follows:
1. Consumers’ ignorance: Consumers’ ignorance regarding price fluctuation in different
markets helps the monopolist in conducting price discrimination successfully.
2. Nature of the commodity: If the commodity is characterized by service in nature, then it is
not possible to resale it. Hence, price discrimination is conducted successfully.
3. Tariff barrier: If cost of transportation (tariff) of the commodity is very high from one
market to another then none of the buyers of the costly market are induced to buy it from the
cheaper market. Hence, the monopolist easily conducts price discrimination.

4. Government intervention: Legal sanction of the Government empowers the monopolist to

conduct price discrimination successfully. For example, transfer of electricity from the
cheaper domestic use to the costly commercial or industrial use is a criminal offence by law.
5. Price elasticity in two different markets must be different: A monopolist conducts price
discrimination successfully only when price elasticity of demand for the commodity is
different in two separated markets.
Profitable condition for price discrimination: Price discrimination generally means
charging different price for the same product from different group of buyers. But it is
essential to judge the market where price is relatively higher compared to other. Otherwise,
the buyers supposed to enjoy the commodity at a higher price will be offered at the lower
price. Hence, objective of the discriminating monopolist to maximize net profit could not be
materialized. In this context essential profitable condition is: The price is relatively higher in
that market where demand price elasticity for the commodity is relatively lower. More
specifically, we separate the markets into ‘Market A’ and ‘Market B’ with their respective
demand price elasticity as EA and EB respectively. Now to conduct price discrimination
successfully and in a profitable way, price in market ‘A’ (say PA) is greater than price in
market ‘B’ (say PB) when EA is less than EB. Therefore, the profitable condition is; if EA <
EB => PA > PB.

Features of monopoly market:

1. Single Seller of the Product: In a monopoly market, usually, there is a single firm which
produces and/or supplies a particular product/ commodity. It is fair to say that such a firm
constitutes the entire industry. Also, there is no distinction between the firm and the industry.

2. Entry Restrictions: Another feature of a monopoly market is restrictions of entry. These

restrictions can be of any form like economical, legal, institutional, artificial, etc.

3. No Close Substitutes: Usually, a monopolist sells a product which does not have any close
substitutes. Therefore, the cross elasticity of demand for such a product is either zero or very
small. Also, the price elasticity of demand for the monopolist’s product is less than one. Hence,
in the monopoly market, the monopolist faces a downward sloping demand curve.

4. Price Maker: Since there is only one firm selling the product, it becomes the price maker for
the whole industry. The consumers have to accept the price set by the firm as there are no other
sellers or close substitutes.

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 The product has only one seller in the market.

 Monopolies possess information that is unknown to others in the market.
 There are profit maximization and price discrimination associated with monopolistic
markets. Monopolists are guided by the need to maximize profit either by expanding
sales production or by raising the price.
 It has high barriers to entry for any new firm that produces the same product.

 The monopolist is the price maker, i.e., it decides the price, which maximizes its
profit. The price is determined by evaluating the demand for the product.
 The monopolist does not discriminate among customers and charges them all alike for
the same product.

Monopolistic competition:
Monopolistic competition is a market structure which combines elements of monopoly and
competitive markets. Essentially a monopolistic competitive market is one with freedom of
entry and exit, but firms can differentiate their products. Therefore, they have an inelastic
demand curve and so they can set prices. However, because there is freedom of entry,
supernormal profits will encourage more firms to enter the market leading to normal profits
in the long term.

Features of monopolistic competition:

1. Large Number of Sellers: There are large numbers of firms selling closely related, but not
homogeneous products. Each firm acts independently and has a limited share of the market.
So, an individual firm has limited control over the market price. Large number of firms leads
to competition in the market.

2. Product Differentiation: Each firm is in a position to exercise some degree of monopoly

(in spite of large number of sellers) through product differentiation. Product differentiation
refers to differentiating the products on the basis of brand, size, colour, shape, etc. The
product of a firm is close, but not perfect substitute of other firm.

3. Selling costs: Under monopolistic competition, products are differentiated and these
differences are made known to the buyers through selling costs. Selling costs refer to the
expenses incurred on marketing, sales promotion and advertisement of the product. Such
costs are incurred to persuade the buyers to buy a particular brand of the product in
preference to competitor’s brand. Due to this reason, selling costs constitute a substantial part
of the total cost under monopolistic competition.

4. Freedom of Entry and Exit: Under monopolistic competition, firms are free to enter into
or exit from the industry at any time they wish. It ensures that there are neither abnormal
profits nor any abnormal losses to a firm in the long run. However, it must be noted that entry
under monopolistic competition is not as easy and free as under perfect competition.

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5. Lack of Perfect Knowledge: Buyers and sellers do not have perfect knowledge about the
market conditions. Selling costs create artificial superiority in the minds of the consumers and
it becomes very difficult for a consumer to evaluate different products available in the
market. As a result, a particular product (although highly priced) is preferred by the
consumers even if other less priced products are of same quality.

6. Pricing Decision: A firm under monopolistic competition is neither a price- taker nor a
price-maker. However, by producing a unique product or establishing a particular reputation,
each firm has partial control over the price. The extent of power to control price depends
upon how strongly the buyers are attached to his brand.
7. Non-Price Competition: In addition to price competition, non-price competition also
exists under monopolistic competition. Non-Price Competition refers to competing with other
firms by offering free gifts, making favorable credit terms, etc., without changing prices of
their own products.

Price and output determination under monopolistic competition

The firm will be in equilibrium position when marginal revenue is equal to marginal cost. So
long the marginal revenue is greater than marginal cost, the seller will find it profitable to
expand his output, and if the MR is less than MC, it is obvious he will reduce his output
where the MR is equal to MC. In short run, therefore, the firm will be in equilibrium when it
is maximising profits, i.e., when MR = MC.

(a) Short Run Equilibrium: Short run equilibrium is illustrated in the following diagram:

Diagram: Monopolistic Competition Short Run Equilibrium

In the above diagram, the short run average cost is MT and short run average revenue is
MP. Since the AR curve is above the AC curve, therefore, the profit is shown as PT. PT is the
supernormal profit per unit of output. Total supernormal profit will be measured by
multiplying the supernormal profit to the total output, i.e. PT × OM or PTT’P’ as shown in
figure (a). The firm may also incur losses in the short run if it is facing AR curve below the
AC curve. In figure (b) MP is less than MT and TP is the loss per unit of output. Total loss
will be measured by multiplying loss per unit of output to the total output, i.e., TP × OM or
TPP’T’.

(b) Long Run Equilibrium: Under monopolistic competition, the supernormal profit in the
long run is disappeared as new firms are entered into the industry. As the new firms are

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entered into the industry, the demand curve or AR curve will shift to the left, and therefore,
the supernormal profit will be competed away and the firms will be earning normal profits. If
in the short run firms are suffering from losses, then in the long run some firms will leave the
industry so that remaining firms are earning normal profits.

The AR curve in the long run will be more elastic, since a large number of substitutes will be
available in the long run. Therefore, in the long run, equilibrium is established when firms are
earning only normal profits. Now profits are normal only when AR = AC. It is further
illustrated in the following diagram:

Product differentiation in monopolistic market competition:

Product differentiation is a marketing strategy designed to distinguish a company's products
or services from the competition. Successful product differentiation involves identifying and
communicating the unique qualities of a product or company while highlighting the distinct
differences between that product or company and its competitors.
1. Brand Name: Products are known by their Brand names. Over the years certain firms
acquire goodwill in the market. Firm name itself becomes a brand name for its
products.
2. Size: Products are manufactured in different in sizes. Economy, family, extra large
are some of the sizes in which the products are available.
3. Design: Products could be differentiated on the basis of design. Refrigerators,
cupboards, scooters, cars, are some of the products which are considered by the
buyers on the basis of design.
4. Color: color is one of the important factor on which goods differentiated. Textiles,
Readymade garments, Plastic products, Automobiles, are preferred by the customer
on the basis of their color.
5. Taste and Perfume: Products like confectioneries, toothpaste, soaps, and cosmetics
are selected on the basis of taste and perfume.
6. Good salesmanship: Customers may prefer the products of a particular firm against
its rival firms simply because of good salesmanship, positive attitude, approach and
cooperation of the sales people.
7. After sale services: Consumer durable items have a warranty period during which
free service is offered. Services are offered thereafter on payment. Quality and
promotions of after sale service influence the customers while selecting the products.

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Oligopoly Market:
Oligopoly market is that a few companies rule over many in a particular market or industry,
offering similar goods and services. Because of a limited number of players in an
oligopolistic market, competition is limited, allowing every firm to operate successfully. The
situation typically breeds regular partnerships between firms and fosters a spirit of
cooperation.
Oligopoly market characterized by few sellers, selling the homogeneous or differentiated
products. In other words, the oligopoly market structure lies between the pure monopoly and
monopolistic competition, where few sellers dominate the market and have control over the
price of the product.

Features of Oligopoly market:

Few firms: Under oligopoly, there are few large firms. The exact number of firms is not
defined. Each firm produces a significant portion of the total output. There exists severe
competition among different firms and each firm try to manipulate both prices and volume of
production to outsmart each other.
Interdependence: Firms under oligopoly are interdependent. Interdependence means that
actions of one firm affect the actions of other firms. A firm considers the action and reaction
of the rival firms while determining its price and output levels. A change in output or price by
one firm evokes reaction from other firms operating in the market.

Non-Price Competition: Under oligopoly, firms are in a position to influence the prices.
However, they try to avoid price competition for the fear of price war. They follow the policy
of price rigidity. Price rigidity refers to a situation in which price tends to stay fixed
irrespective of changes in demand and supply conditions. Firms use other methods like
advertising, better services to customers, etc. to compete with each other.

Barriers to Entry of Firms: The main reason for few firms under oligopoly is the barriers,
which prevent entry of new firms into the industry. Patents, requirement of large capital,
control over crucial raw materials, etc, are some of the reasons, which prevent new firms
from entering into industry. Only those firms enter into the industry which is able to cross
these barriers. As a result, firms can earn abnormal profits in the long run.

Role of Selling Costs: Due to severe competition ‘and interdependence of the firms, various
sales promotion techniques are used to promote sales of the product. Advertisement is in full
swing under oligopoly, and many a times advertisement can become a matter of life-and-
death. A firm under oligopoly relies more on non-price competition.

Group Behaviour: Under oligopoly, there is complete interdependence among different

firms. So, price and output decisions of a particular firm directly influence the competing
firms. Instead of independent price and output strategy, oligopoly firms prefer group
decisions that will protect the interest of all the firms. Group Behaviour means that firms tend
to behave as if they were a single firm even though individually they retain their
independence.

Nature of the Product:

The firms under oligopoly may produce homogeneous or differentiated product.

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i. If the firms produce a homogeneous product, like cement or steel, the industry is
called a pure or perfect oligopoly.

ii. ii. If the firms produce a differentiated product, like automobiles, the industry is
called differentiated or imperfect oligopoly.

Indeterminate Demand Curve: Under oligopoly, the exact behaviour pattern of a producer
cannot be determined with certainty. So, demand curve faced by an oligopolist is
indeterminate (uncertain). As firms are inter-dependent, a firm cannot ignore the reaction of
the rival firms. Any change in price by one firm may lead to change in prices by the
competing firms. So, demand curve keeps on shifting and it is not definite, rather it is
indeterminate.

Price determination under oligopoly:

Sweezy assumes that if the oligopolistic firm lowers its price, its rivals will react by
matching that price cut m order to avoid losing their customers. Thus the firm lowering the
price will not be able to increase its demand much. This portion of its demand curve is
relatively inelastic.

The Sweezy Model of Kinked Demand Curve (Rigid Prices):

In his article published in 1939, Prof. Sweezy presented the kinked demand curve analysis to
explain price rigidities often observed in oligopolistic markets. Sweezy assumes that if the
oligopolistic firm lowers its price, its rivals will react by matching that price cut m order to
avoid losing their customers. Thus the firm lowering the price will not be able to increase its
demand much. This portion of its demand curve is relatively inelastic.

On the other hand, if the oligopolistic firm increases its price, its rivals will not follow it and
change their prices. Thus the quantity demanded of this firm will fall considerably. This
portion of the demand curve is relatively elastic. In these two situations, the demand curve of
the oligopolistic firm has a kink at the prevailing market price which explains price rigidity.

Assumptions:
(1) There are few firms in the oligopolistic industry.

(2) The product produced by one firm is a close substitute for the other firms.

(3) The product is of the same quality. There is no product differentiation.

(4) There are no advertising expenditures.

(5) There is an established or prevailing market price for the product at which all the sellers
are satisfied.

(6) Each seller’s attitude depends on the attitude of his rivals.

(7) Any attempt on the part of a seller to push up his sales by reducing the price of his
product will be counteracted by the other sellers who will follow his move.

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(8) If he raises the price, others will not follow him. Rather they will stick to the prevailing
price and cater to the customers, leaving the price-raising seller.

(9) The marginal cost curve passes through the dotted portion of the marginal revenue curve
so that changes in marginal cost do not affect output and price.

The Model:
Given these assumptions, the price-output relationship in the oligopolist market is explained
in Figure 1 where KPD is the kinked demand curve and OP 0 the prevailing price in the
oligopoly market for the OR product of one seller. Starting from point P, corresponding to the
current price OP1, any increase in price above it will considerably reduce his sales, for his
rivals are not expected to follow his price increase. This is so because the KP portion of the
kinked demand curve is elastic, and the corresponding portion KA of the MR curve is
positive. Therefore, any price-increase will not only reduce his total sale but also his total
revenue and profit.

On the other hand, if the seller reduces the price of the product below OP Q (or P), his rivals
will also reduce their prices. Though he will increase his sales, his profit would be less than
before. The reason is that the PD portion of the kinked demand curve below P is less elastic
and the corresponding part of marginal revenue curve below R is negative. Thus in both the
price-raising and price-reducing situations, the seller will be a loser. He would stick to the
prevailing market price OP0 which remains rigid.
In order to study the working of the kinked demand curve, let us analyse the effect of changes
in cost and demand conditions on price stability in the oligopolistic market.

Changes in Costs:
In oligopoly under the kinked demand curve analysis changes in costs within a certain range
do not affect the prevailing price. Suppose the cost of production falls so that the new MC
curve is MC1, to the right, as in Figure 2. It cuts the MR curve in the gap AB so that the profit
maximising output is OR which can be sold at OP0 price.
It should be noted that with any cost reduction the new MC curve will always cut the MR
curve in the gap because as costs fall the gap AB continues to widen due to two reasons:

(1) As costs fall, the upper portion KP of the demand curve becomes more elastic because of
the greater certainty that a price rise by one seller will not be followed by rivals and his sales
would be considerably reduced.

(2) With the reduction in costs the lower portion PD of the kinked curve becomes more
inelastic, because of the greater certainty that a price reduction by one seller will be followed
by the other rivals.

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Thus the angle KPD tends to be a right angle at P and the gap AB widens so that any MC
curve below point A will cut the marginal revenue curve inside the gap. The net result is the
same output OR at the same price OP0 and larger profits for the oligopolistic sellers.
In case the cost of production rises the marginal cost curve will shift to the left of the old
curve MC as MC2. So long as the higher MC curve intersects the MR curve within the gap
upto point A, the price situation will be rigid. However, with the rise in costs the price is not
likely to remain stable indefinitely and if the MC curve rises above point A, it will intersect
the MC curve in the portion KA so that a lesser quantity is sold at a higher price. We may
conclude that there may be price stability under oligopoly even when costs change so long as
the MC curve cuts the MR curve in its discontinuous portion. However, chances of the
existence of price rigidity are greater where there is a reduction in costs than there is a rise in
costs.

Changes in Demand:
We now explain price rigidity where there is a change in demand with the help of Figure 3,
D2 is the original demand curve, MR2 is its corresponding marginal revenue curve and MC is
the marginal cost curve. Suppose there is decrease in demand shown by D 1 curve and MR1 is
its marginal revenue curve. When demand decreases, a price-reduction move by one seller
will be followed by other rivals.

This will make LD1, the lower portion of the new demand curve, more inelastic than the
lower portion HD2 of the old demand curve. This will tend to make the angle at L approach a
right angle. As a result, the gap EF in MR1 curve is likely to be wider than the gap AВ of the
MR2 curve.
The marginal cost curve MC will, therefore, intersect the lower marginal revenue curve
MRX inside the gap EF, thus indicating a stable price for the oligopolistic industry. Since the

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level of the kinks H and L of the two demand curves remains the same, the same price OP is
maintained after the decrease in demand. But the output level falls from OQ 2 to OQ1.
This case can be reversed to show increase in demand by taking D2 and MR2 as the original
demand and marginal revenue curves and D 2and MR2 as the higher demand and marginal
revenue curves respectively. The price OP is maintained but the output rises from OQ 1 to
OQ. So long as the MC curve continues to intersect the MR curve in the discontinuous
portion, there will be price rigidity.
The whole analysis of the kinked demand curve points out that price rigidity in oligopolistic
markets is likely to prevail if there is a price reduction move on the part of all sellers.
Changes in costs and demand also lead to price stability under normal conditions so long as
the MC curve intersects the MR curve in its discontinuous portion. But price increase rather
than price rigidity may be found in response to rising cost or increased demand.

Collusive oligopoly: Collusive oligopoly is a market situation wherein the firms cooperate
with each other in determining price or output or both. A non-collusive oligopoly refers to a
market situation where the firms compete with each other rather than cooperating.

Cartels: A cartel is an organization created from a formal agreement between a group of

producers of a good or service to regulate supply in order to regulate or manipulate prices. In
other words, a cartel is a collection of otherwise independent businesses or countries that act
together as if they were a single producer and thus can fix prices for the goods they produce
and the services they render, without competition.

Joint Profit Maximisation Cartel under Perfect Collusion:

The uncertainty is found in an oligopolistic market which provides an incentive to rival firms
to form a perfect cartel. Perfect cartel is an extreme form of perfect collusion. Under it, firms
producing a homogeneous product form a centralized cartel board in the industry.

The individual firms surrender their price-output decisions to this central board. The board
determines for its members the output, quotes the price to be charged and the distribution of
industry profits. The central board acts like a single monopoly whose main aim is to
maximize the joint profits of the oligopolistic industry.

Assumptions: The analysis of joint profit maximisation cartel is based on the following
assumptions:

1. Only two firms A and B are assumed in the oligopolistic industry that forms the cartel.

2. Each firm produces and sells a homogeneous product that is a perfect substitute for each
other.

3. The market demand curve for the product is given and is known to the cartel.

4. The number of buyers is large.

5. The price of the product determines the policy of the cartel.

6. The cost curves of the firm’s are different but are known to the cartel.

7. The cartel aims at joint profit maximisation.

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Advantages:
Perfect collusion by oligopolistic firms in the form of a cartel has many advantages. It avoids
price wars among rivals. The firms forming a cartel gain at the expense of customers who are
charged a high price for the product. The cartel operates like a monopoly organization which
maximizes the joint profit of firms. Generally, joint profits are high than the total profits
earned by them if they were to work independently.

The problems of cartels are stated below:

1. It is difficult to make an accurate estimate of the market demand curve.

2. The estimation of the market MC curve may be inaccurate because of the supply of wrong
data about their MC by individual firms to the cartel.

3. The formation of a cartel is a slow process which takes a long time for the agreement to
arrive at by firms especially if their number is very large.

4. The larger the number of firms in a cartel, the less is its chances of survival for long
because of the distrust. The cartel will, therefore, break down.

5. In theory, the cartel-members agree on joint profit maximisation. But in practice, the
seldom agree on profit distribution.

6. The price of the product fixed by the cartel cannot be changed even if the market
conditions require it to be changed. This is because it takes a long time for the members to
arrive at an agreed price.

7. Prices tackiness gives rise to ‘chislers’ who scarcely cut the price or violate the quota
agreement.

8. Unless all member firms in the cartel are strongly committed to cooperation, outside
disturbances, such as a sharp fall in demand, may lead to the breakdown of the cartel.

9. Some high-cost uneconomic firms may refuse to shut down or leave the cartel despite the
cartel board’s request.

2. Market-Sharing Cartel:
Another type of perfect collusion in an oligopolistic market is found in practice which relates
to market-sharing by the member firms of a cartel.

There are two main methods of market-sharing:

(a) Non-price competition; and

(b) Quota system.

They are discussed as under:

(a) Non-Price Competition Cartel:
The non-price competition agreement among oligopolistic firms is a loose form of cartel.
Under this type of cartel, the low-cost firms press for a low price and the high-cost firms for a
high price. But ultimately, they agree upon a common price below which they will not sell.
Such a price must allow them some profits. The firms can compete with one another on a
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non-price basis by varying the colour, design, shape packing etc. of their product and having
their own different advertising and other selling activities. Thus each firm shares the market
on a non-prices basis while selling the product at the agreed common price.

(b) Market Sharing by Quota Agreement:

The second method of market sharing is the quota agreement among firms. (All firms in an
oligopolistic industry enter into collusion for charging an agreed uniform price. But the main
agreement relates to the sharing of the market equally among member firms so that each firm
gets profits on its sales.

Assumptions:
This analysis is based on the understated assumptions:
1. Only two firms can enter into market-sharing agreement on the basis of the quota system.

2. Each firm produces and sells a homogeneous product.

3. The number of buyers is large.

4. The market demand curve for the product is given and known to the cartel.

5. Each firm has its own demand curve having the same elasticity as that of the market
demand curve.

6. Both firms share the market equally.

7. Cost curves of the two firms are identical.

8. There is no threat of entry by new firms.

9. Each sells the product at the agreed uniform price.

Price leadership model:

Price leadership takes place when there is only one dominant organization in the industry,
which sets the price and others follow it.

Sometimes, an agreement may be developed among organizations to assign a leadership role

to one of them. The dominant organization is treated as price leader because of various
reasons, such as large size of the organization, large economies of scale, and advanced
technology. According to the agreement, there is no formal restriction that other
organizations should follow the price set by the leading organization. However, sometimes
agreement is formal in nature.

Price leadership is assumed to stabilize the price and maintain price discipline.

This also helps in attaining effective price leadership, which works under the following
conditions:
i. When the number of organizations is small

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ii. Entry to the industry is restricted

iii. Products are homogeneous

iv. Demand is inelastic or less elastic

v. Organizations have similar cost curves

Types of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price discipline. There are three
major types of price leadership, which are present in industries over a passage of time.

These three types of price leadership are explained as follows:

i. Dominant Price Leadership:
Refers to a type of leadership in which only one organization dominates the entire industry.
Under dominant price leadership, other organizations in the industry cannot influence prices.
The dominant organization uses its power of monopoly to maximize its profits and other
organizations have to adjust their output with the set price.

The interests of other organizations are ignored by the dominant organization. Therefore,
dominant price leadership is sometimes termed-as partial monopoly. Price leadership by the
leading organization is most commonly seen in the industry.

ii. Barometric Price Leadership:

Refers to a leadership in which one organization declares the change in prices at first and
assumes that other organizations would accept it. The organization does not dominate others
and need not to be the leader in the industry. Such type of organization is known as
barometer.

This barometric organization only initiates a reaction to changing market situation, which
other organizations may follow it if they find the decision in their interest. On the contrary,
the leading organization has to be accurate while forecasting demand and cost conditions, so
that the suggested price is accepted by other organizations.

Barometric price leadership takes place due to the following reasons:

a. Lack of capacity and desire of organizations to estimate appropriate supply and demand
conditions. This influences organizations to follow price changes made by the barometric
organization, which has a proven ability to make correct forecasts.

b. Rivalry among the organizations may make a leader, which can be unacceptable by other
organizations. Thus, most of the organizations prefer barometric price leadership.

iii. Aggressive Price Leadership:

Implies a leadership in which one organization establishes its supremacy by threatening the
organizations to follow its leadership. In other words, a dominant organization establishes
leadership by following aggressive price policies and forces other/organizations to follow the
prices set by it.

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Price-Output Determination under Price Leadership:

Price leadership takes place when there is only one dominant organization in the industry,
which sets the price and others follow it. Different economists have developed different
models for determining price and output in price leadership.

Here, we would discuss a simple model for determining price and output in price
leadership, which is shown in Figure-4:

Suppose there are two organizations, A and B producing identical products where
organization A has a lower cost of the production than organization B. Therefore, consumers
are indifferent between these two organizations due to identical products. This implies that
both the organizations would face same demand curve, which further represents equal market
share.

In Figure-4, DD is the demand curve of both the organizations and MR is their marginal
revenue. MCa and MCb are the marginal cost curves of organization A and B respectively. As
stated earlier, the cost of production of organization A is less than B, thus, MC a is drawn
below MCb.
Let us first start the discussion of price leadership with the case of organization A. The profits
of organization A would be maximized at a point where MR intersects MC a. At this point, the
output of organization A would be OQ with the price level OP. On the other hand, the profits
of organization B would be maximized at a point where MR intersects MCb with output
OQ1 and price OP1.
ADVERTISEMENTS:

In such a case, the price of organization B is more as compared to organization A. However,

both the organizations have to charge the same price as products are homogeneous. In this
case, organization A is the price leader and organization B is the follower.

Thus, organization A will dictate the price to organization B. Both the organizations will
follow the same output, OQ and price OP. However, the profits earned by organization B are
less than A, as it has to produce at price OP which is less than its profit maximizing price,
OP1. In addition, the organization B also has high costs of production that leads to lower
profits at price OP1.

Drawbacks of Price Leadership:

The price leadership suffers from various drawbacks.

These are discussed as follows:

i. Makes it difficult for the price leader to assess the reactions of followers.

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ii. Leads to malpractices, such as charging lower prices by rival organizations in the form of
rebates, money back guarantees, after delivery free services, and easy installment facility.
The prices charged by rival organizations are comparatively less than the prices set by the
price leader.

iii. Leads to non-price competition by rival organizations in the form of aggressive promotion
strategies.

iv. Influences new organizations to enter into the industry because of price rise. These new
organizations may not follow the leader of the industry.

v. Poses problems if there are differences in cost of price leaders and price followers. In case,
if cost of production of price leader is less, then he/she would fix lower prices. This will lead
to a loss for a price follower if his/her cost of production is more than the price leader.

Descriptive pricing approaches:

Full cost or average cost pricing:

The below mentioned article provides an overview on the theory of full-cost or average
cost pricing.
In 1939, Hall and Hitch of the University of Oxford mounted a ‘root-and-branch’ attack on
the notion of profit maximisation on the basis of answers to questionnaires of 38
entrepreneurs, 33 of whom were manufacturers, 3 retailers and 2 builders.

Hall and Hitch sought information from them about the elasticity and the position of their
demand, and their attempts to equate their estimated marginal cost and marginal revenue. The
answers revealed that the majority of them apparently made no efforts, even implicitly, to
estimate elasticities of demand or marginal cost. They did not consider them to be of any
relevance to the pricing process.

On the basis of the empirical study, Hall and Hitch concluded that the majority of
entrepreneurs under oligopoly base their selling prices upon, what they call, ‘full cost’ and
including an allowance of profit, and not in terms of the equality of marginal cost and
marginal revenue at all.

Thus a price based on full average cost is the ‘right price’, the one which ‘ought to be
charged’, based on the idea of ‘fairness to competition’ under oligopoly. But what is full
cost? Full cost is full average cost which includes average direct costs (AVC) plus average
overhead costs (AFC) plus a normal margin for profit: Thus price, P = AVC + AFC + profit
margin (usually 10%).

According to Hall and Hitch, there are certain reasons which induce firms to follow the
full-cost pricing policy:
(i) Tacit or open collusion among producers;

(ii) Failure to know consumers’ preferences;

(iii) Reaction of competitors to a change in price;

(iv) Moral conviction of fairness; and

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(v) Uncertainty of effects of price increases or decreases. All these reasons prevent
oligopolistic producers from setting a price other than the full-cost price.

Thus firms set their price on the basis of the full-cost principle and sell at that price whatever
the market takes. They observed that prices were sticky in the oligopoly market despite
changes in demand and costs. They explained the stickiness of prices in terms of the kinked
demand curve. The kink occurs at the point where the price QP (= OB) fixed on the full-cost
principle actually stands in Figure 3.

Any increase in the price above it, will reduce the firm’s sales, for its competitors will not
follow it in raising their prices. This is because the PD portion of the kinked demand curve is
elastic. On the other hand, if the firm reduces the price below QP, its competitors will also
reduce their prices.

The firm will increase its sales but its profits will be less than before. This is because the
PD1 portion of the curve is less elastic. Thus in both the price-raising and price-reducing
situations, the firm will be a loser. It would, therefore, stick to the price QP so long as the
prices of the direct factors of production (i.e., raw materials, etc.) remain unchanged.
As the AC curve falls over a large range of output, price varies inversely with output. The
smaller the level of output, the higher will be the average cost and the higher the price of the
product. But Hall and Hitch rule out the possibility of oligopoly firms producing small
outputs and charging higher prices.

They give three reasons for this;

(a) Oligopoly firms prefer price rigidity,

(b) They cannot raise the price because of the kink, and

(c) They want to “keep the plant running as full as possible, giving rise to a general feeling in
favour of price concessions”.

Product line pricing:

Product line pricing. Product line pricing is a product pricing strategy, used when a company
has more than one product in a product line. It is a process that traders adopt to separate
products in the same category into various price groups, to create different quality levels in
the customers' minds.

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Product line pricing refers to the practice of reviewing and setting prices for multiple
products that a company offers in coordination with one another. Rather than looking at
each product separately and setting its price, product-line pricing strategies aim to
maximize the sales of different products by creating more complementary, rather than
competitive, products. If you offer more than one product or service, consider the impact
that one product's or service's price will have on the others.

Pricing strategy:

Pricing strategies determine the price companies set for their products. The price can be set to
maximize profitability for each unit sold or from the market overall. It can also be used to
defend an existing market from new entrants, to increase market share within a market or to
enter a new market. Pricing strategies can bring both competitive advantages and
disadvantages to its firm and often dictate the success or failure of a business; thus, it is
crucial to choose the right strategy.

1. Penetration pricing
It’s difficult for a business to enter a new market and immediately capture market share, but
penetration pricing can help. The penetration pricing strategy consists of setting a much lower
price than competitors to earn initial sales. These low prices can draw in new customers and
take away revenue from competitors. While your company will likely take a loss at first, you
can earn new customers and turn them into loyal customers once you start raising your prices
again. Companies like internet and Smartphone providers use this strategy to gain market
share.
Example: A new cafe opens up in town and offers coffee that is 40% cheaper than any other
cafe in the area.

2. Skimming pricing
Businesses that charge maximum prices for new products and gradually reduce the price over
time follow a skimming strategy. Prices drop as products end their life cycle and become less
relevant. Businesses that sell high-tech or novelty products typically use price skimming.
Example: A home entertainment store starts selling the latest, most advanced television well
above market price. Prices then gradually decrease over the year as newer products come to
market.

3. High-low pricing
High-low pricing is similar to skimming, except the price drops at a different rate. With the
high-low pricing method, the price of a product drops significantly all at once rather than at a
gradual pace. Retail businesses that sell seasonal products typically use a high-low strategy.
Example: A boutique clothing store sells women’s sundresses at a high price during the
summer and then puts them on clearance once autumn arrives.

4. Premium pricing
Premium pricing occurs when prices are set higher than the rest of the market to
create perceived value, quality, or luxury. Customers are willing to pay a premium
price when they know the brand name and have a positive brand perception. Companies that
sell luxury, high-tech, or exclusive products—like businesses within the fashion or tech
industry—often use the premium pricing technique.

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Example: A beauty salon builds up credibility within its market and offers its services for
30% higher than its competitors.

5. Psychological pricing
Psychological pricing strategies play on the psychology of consumers. In a way, you are
luring in customers by slightly altering price, product placement, or product packaging.
Some psychological pricing techniques include setting the price to $9.99 rather than $10, or
offering a “buy one, get one free” deal. For example, 90% of retail prices end with either “9”
or “5.” Nearly any type of business can use this strategy, but retail and restaurant businesses
most commonly employ this method.
Example: A restaurant sets a gourmet hamburger’s price at $12.95 to lure customers into
purchasing at a perceived lower price compared to $13.

6. Bundle pricing:
Bundle pricing is selling two or more similar products or services together for one
price. Bundling is an effective way to upsell additional products to customers or add value to
their purchase. Restaurants, beauty salons, and retail stores are among the many businesses
that apply this strategy.
Example: A taco cantina sells tacos, tortilla chips, and salsa individually, but offers a
discounted price if customers buy an entire meal with all of these items.

7. Competitive pricing
The competitive pricing strategy sets the price of your products or services at the current
market rate. Your pricing is determined by all other products in your industry, which helps
you stay competitive if your business is in a saturated industry. You can also decide to price
your products above or below the market rate, as long as it’s still within the range of prices
set by all competitors in your industry.
Example: A landscaping company compares its prices to local competitors and sets its prices
below the market average to attract price-sensitive customers.

8. Cost-plus pricing
Cost-plus pricing involves taking the amount it cost you to make the product and increasing
that amount by a set percentage to determine the final price. You can work backwards to
determine your markup percentage by first figuring out how much you want to profit from
each product sold.
Example: A pizza shop adds up the cost of its ingredients and labor, then sets the pizza price
to receive a 20% profit margin.

9. Dynamic pricing
Dynamic pricing matches the current market demand for a product. This pricing
strategy most often occurs when the product at hand fluctuates on a daily or even hourly
basis. Industries like hotels, airlines, and event venues set different prices daily and apply this
strategy to maximize profits.
Example: A boutique hotel raises its room rates for one weekend because there is a popular
summer festival in town.

Loss leader pricing:

A loss leader strategy involves selling a product or service at a price that is not profitable
but is sold to attract new customers or to sell additional products and services to those

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customers. Loss leading is a common practice when a business first enters a market. A loss
leader introduces new customers to a service or product in the hopes of building a customer
base and securing future recurring revenue.

Peak load pricing: The Peak Load Pricing is the pricing strategy wherein the high price is
charged for the goods and services during times when their demand is at peak. In other
words, the high price charged during the high demand period is called as the peak load
pricing.

This type of price discrimination is based on the efficiency, i.e. a firm discriminates on the
basis of high usage, high-traffic, high demand times and low demand times. The consumer
who purchases the commodity during the high demand period has to pay more as compared
to the one who buys during low demand periods.

The peak load pricing is widely used in the case of non-storable goods such as electricity,
transport, telephone, security services, etc. These are the goods which cannot be stored and
hence their production is required to be increased to meet the increased demand. Thus,
the marginal cost is also high during the peak periods as the capacity to produce these goods
is limited. And, hence, the price is set at its highest level with an aim to shift the demand or at
least the consumption of goods and services to attain a balance between demand and supply.

Transfer Pricing:- Transfer pricing can be defined as the value which is attached to the
goods or services transferred between related parties. In other words, transfer pricing is
the price that is paid for goods or services transferred from one unit of an organization to its
other units situated in different countries.

Transfer pricing is an accounting practice that represents the price that one division in a
company charges another division for goods and services provided.

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Environment:
Environment can be defined as a sum total of all the living and non-living elements
and their effects that influence human life. While all living or biotic elements are
animals, plants, forests, fisheries, and birds, non-living or abiotic elements include
water, land, sunlight, rocks, and air.

Business environment:
The word ‘business environment’ indicates the aggregate total of all people,
organisations and other forces that are outside the power of industry but that may
affect its production.

Business environment refers to those aspects of the surroundings business enterprise,

which affect or influence its operations and determine its effectiveness. According to
Keith Davis, “Business environment is the aggregate of all conditions, events and
influence that surrounds and affect it”.
Definition of Business Environment is sum or collection of all internal and external
factors such as employees, customers needs and expectations, supply and demand,
management, clients, suppliers, owners, activities by government, innovation in
technology, social trends, market trends, economic changes, etc. These factors affect the
function of the company and how a company works directly or indirectly. Sum of these
factors influences the companies or business organisations environment and situation.

Indian business environment: is characterized by the co-existence of both public

and private sector in respect of its participation in various economic activities in the
country. Accordingly, the various economic policies of the country can promote the
development of both the sectors in different spheres of activities.

Nature of Indian business environment:

Complex
Business environment is complex in nature. It consists of several factors, conditions
and events which directly influence the functioning of business. These factors
influence the productivity and profitability of business. It is quite difficult to
understand how a particular factor affects the operations of business. Different factors
affect differently the performance of business.

Dynamic
Business environment is a dynamic concept and keeps on changing continuously.
Various factors which constitute business environment are always changing from time
to time. These changes are in terms of changes in customer preferences, technological
improvements, new competitor’s entry etc. These ever changing factors bring changes
in character and shape of business environment making it dynamic.

Interdependence
Factors of business environment are dependent on each other. Business environment
include economic, social, legal, technological and political factors. Changes in any
one of the factors will bring changes in several other factors. Like countries having
better economy are able to enhance their technology by incurring sufficient
expenditure on research and development.

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Uncertain
Factors which constitute business environment are uncertain. It is quite difficult to
predict several future conditions because no one knows what is going to happen in
nature. These factors changes too frequently like changes in fashion, technology,
demand and economic conditions.

Relativity
Business environment is relative in nature which means that it changes from one place
to another and from one country to another. Economic conditions In Canada are
different from those in India. Similarly, demand for women’s shalwar kameez is high
in India than in U.S.A.

System Approach
Business environment is a systematic approach which facilitates business in its
functioning. Business is a system which manufactures the products and services. It
satisfies the wants of customers by taking several inputs like raw materials, capital,
labour etc. from environment and delivering the required goods and services.

Social Responsibility Approach

Social responsibility is another important characteristic of business environment.
According to this, business exists for serving various members of society. These
include shareholders, employees, customers, government etc. and every business
should consider their interest while operating.

Related to Economic Activities: The main objective of the business is to earn profits.
Hence, the business environment is related to the economic activities of the person
(entrepreneur) like trade, commerce, industries, and direct services etc.

Dynamic Concept: The business environment is the dynamic concept. The

components of the environment are also subject to change according to the country
timings, circumstances, etc.

Effects Various Factors: The business and its environment are interdependent and
also have natural effects. The entrepreneur or the owner of the business cannot
overlook this environment and its factors.

The Market of Business: The environment of the business is the market of the
business also because every entrepreneur provides his products and services to this
environment where he earns income profits from environment alone.

Effect of Economic Systems: Economic systems also affect the business

environment. The business environment of any particular country is in consonance
with capitalist, communist, socialist, and mixed systems, etc. For example, the public
sector and private sectors, both developed in India, as the adoption of the mixed
economy.

Internal and External Environment of the Institutions: Every enterprising,

institution has two types of environment internal and external. The institution has
control over its internal environment, but it has no control over the external

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environment. Hence, the business organization has to mould itself, according to the
external environment.

Formulation of Working Plans: While planning a business institution policy that

effectively achieves its objectives and goals. During the formulation of these working
plans, environment-related information is kept into consideration.

Scope of Indian business environment:

Helps In Planning and Policy Formulation

Proper understanding of business environment helps in formulating better policies and
strategies. It conveys all current information regarding market conditions to business.
All opportunities and threats are scanned through the study of the business
environment. Businessmen are properly aware of environment and thereby take all
decisions according to it. Their entire plan can be changed effectively.

Identifies Business Opportunities and Threats

Business environment helps business in identification of various opportunities and
threats. When business is able to detect market opportunities timely, they can easily
take advantages of such opportunity at earliest. They can earn maximum returns by
availing such opportunity before the competitors. By proper interaction between
business and its environment all threats can be easily detected. It will enable business
in taking corrective measures timely and efficiently through environmental awareness.

Provides Useful Resources

Business depends on the environment in which they operate for several resources.
Business environment supplies several inputs like raw materials, capital and labour
which are used by the business for its operations. These inputs are converted into
goods and services for satisfying the needs of the market. Without proper supply of
inputs, business cannot continue its operations. It is fully dependent upon
environment for taking inputs and delivering the required goods or services.

Improves Performance
Business environment has an effective role in accelerating the overall performance of
business organisations. Through continuous environmental awareness, managers
update their knowledge and skills. Environmental study serves as the medium of
educating management. Monitoring of environment provides qualitative information
which helps in developing strategic thinking. It enables managers to adopt suitable
management practices to control and improve the performance of business.

Helps In Coping with Rapid Changes

Factors which constitute business environment are dynamic in nature. They keep on
changing continuously from time to time. These changes include changes in
customer’s preferences, fashion, technology, economic conditions etc.

Proper understanding of the business environment helps business in detecting all these
frequently occurring changes easily. It enables them in dealing with these changes
efficiently by taking appropriate actions at right time. Managers through continuous
monitoring of environment are sensitive to such changes and respond effectively.

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Enhances Business Image

Businesses through proper understanding of its environment are able to improve its
public image. They are more responsive and sensitive to the environmental needs
through proper knowledge of business environment. Study of environment provides
them information for making realistic plans and implementing them effectively.
Businesses are able to provide better service and serve the interest of entire society.
People are happy with the business and develop confidence towards it. This enables in
developing a better image in market.

Assist In Facing Competition

Business environment communicates all details about competitors in market to
business. Awareness regarding the actions and strategies of competitors is crucial for
every business for meeting competition effectively. It helps business in formulating
plans and policies in accordance with the competitor’s actions. Businesses are able to
face challenges and competition in market through systematic planning in an efficient
way.

Structure of Business Environment:

 Internal Environment
 External Environment

Internal environment refers to those factors within an organisation e.g Policies and
programmes, organisational structure, employees, financial and physical resources.
These factors can be changed or altered and hence are known as controllable factors.

External environment refers to those factors outside the business these factors by
and large are beyond the control of a business and hence uncontrollable .e.g
economic, political and socio-cultural factors.

1. Internal Environment

i. Values system: The values of the founder/ owner of the business , percolates down
to the entire organisation and has a profound effect on the organisation. The success
of an organisation depends upon the sharing of value system by all members. External
business associates like suppliers and distributors consider the value system practised
by an organisation with strong culture of ethical standards and values.

ii. Vision and objectives: The vision and objectives of a business guides its
operations and strategic decisions. Example ‘Amul the taste of India’ Gujarat Co-
operative Milk Marketing Federation GCMMF

iii. Management structure and nature: The structure of management/board and

their style of functioning, the level of professionalism of management, the
composition of the board are the various factors which affects the decision making.
Since the board is the highest decision making authority, it’s composition, degree of
professionalism and style of operations plays a very critical role in the growth and
development in an organisation.

iv. Internal power relations: This refers to the internal power relations that exist in
an organisation. The relations among board members , between board members and

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the CEO and the level of support enjoyed by the board from its’ stakeholders namely
employees and shareholders are significant factors which affects decision making and
its implementation in an organisation.

v. Human resources: The success of an enterprise is solely dependent on its

manpower. Therefore the quality, skill competency, right attitude and commitment of
its human resources is essential for the success of an organisation.

vi. Company image: The image of an organisation plays an important role in

introducing new products, selecting agents and dealers for distribution, forging
alliances with suppliers, expanding and entering new markets both domestic and
international, raising finance etc.

vii. Other factors: The firm’s ability to innovate reflected by its research and
development, the strength of its financial position and the capital structure, the
efficiency in managing the marketing and distribution network ,and the physical
resources like plant, building technology are the other major factors on which affects
the success of a business.

2. External environment

All factors outside the business which have a bearing on the working of a business
can be termed as the external environment. This is subdivided into micro or task
environment and macro or general environment.

Micro Environment

This refers to those factors which are in the immediate environment of a business
affecting its performance. These include the following:

i) Financiers: The financiers of a business which includes the debenture holders and
financial institutions play a significant part in the running of a business. Their
financial capability, policies strategies, attitude towards risk and ability to give non–
financial assistance are all important to a business.

ii) Suppliers: In any organisation the suppliers of raw materials and other inputs play
a very vital role. Timely procurement of materials from suppliers enables continuity
in production and reduces the cost of maintaining stock/inventory. Organisations
generally obtain supplies from a panel of suppliers instead of relying on a single
source. Organisations have realised the importance of nurturing and maintaining good
relationship with the suppliers.

iii) Marketing Channel members: The marketing inter-mediaries serve as a

connecting link between the business and its customers .The middlemen like dealers,
wholesalers and retailers ensure transfer of product to customers .physical distribution
is facilitated by transporters, and warehouses help in storing goods. Market research
agencies help the firm to understand the needs of the customers while advertising
agencies help in promoting the products and services. Insurance firm is another
marketing intermediary which provides coverage for risk in business.

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iv)Public: This refers to any group like media group, citizen action group and local
public which has an impact on the business. The public group has the ability to make
or mar a business. Many companies had to face closure due to actions by local public.

v) Customers: The aim of any business is to satisfy the needs of its customers. The
customer is the king and the fulcrum around which the business revolves. Hence it is
essential for any business to understand the needs of its varied customers
like individuals, retailers, wholesalers, industries and government sector. Customer
relationship management aims at creating and sustaining cordial relations with
customers.

vi)Competitors: All organisations face competition at all levels local, national and
global. Competitors may be for the same product or for similar products. It is
important for a business to understand its competitors and modify their business
strategies in the face of competition.

Macro Environment:

This is the general or overall environment in which the business operates. The success
of a business is dependent on its ability to adapt to the macro environment, since these
are uncontrollable factors. They offer enormous opportunities to business and also
poses serious threats to business. The general or remote environment factors are as
follows;

I. Economic environment: The business is an integral part of the economic system

prevalent in a nation. The multiple variables in the macro environment system which
has a bearing on a business include

1) The nature of economy based on the stage of development: The countries across
the globe can be categorised on the basis of growth and per capita income as
developed nations, developing nations and under developed nations. The USA, Japan,
Germany, Canada and Australia developed economies generally have high degree of
technological advancement, very strong and robust industrial base, and high standard
of living. Many of these developed nations have successfully integrated the computer
based technologies with their existing business. Developing nations like India, China,
Brazil Mexico are middle income economies are characterised by low to moderate
industrial growth, the inequality in the distribution of income, high population, a low
standard of living and slow absorption of technology. Under developed nations are
low income economies with a very low degree of technology adoption and a very
poor standard of living.

2) The nature of economic system: The economic systems can be classified as

Capitalistic, Socialistic and Mixed economy. Capitalistic economy is a free enterprise
market where individual ownership of wealth is predominant. Socialistic economy is a
state controlled with a lot of restrictions on private sector. Mixed economy is a
combination of both state owned and private sector ownership.

3) The economic policies of a nation: Monetary policy, fiscal policy, Export-import

policy, Industrial policy Trade policy, Foreign exchange policy etc are part of the
economic environment.

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4) Economic indices: The Economic indices like GDP, GNP national income, per-
capita income, balance of payments, rate of savings and investments etc. form an
important part of economic environment.

5) Development of financial market: The organisation and development of money

market, capital market securities market and, the banking system has a greater impact.

6) Economic structure: The Economic structure includes capital formation,

investment pattern, composition of trade balance, occupational distribution of
workforce, and the structure of national output.

II. Socio-Cultural environment - Business is a part of the society .Social

environment refers to the sum total of factors of the society in which the business is
located. Social and cultural environment of society affects the business. It is dynamic
and includes the behaviour of individuals, the role and importance of family, customs,
traditions, beliefs and values, religion and languages, the ethical values. The literacy
level, and the social attitudes of the people of the society. The socio-cultural
environment also includes the following;

1) The social institutions and groups

2) Family structure prevalent in the society

3) Role of marriage as an institution

4) Caste system in the society

5) Customs, beliefs and values

6) Demographic factors which includes the size, composition, literacy level,

distribution and mobility of the population

7) The lifestyle of people and their tastes, likes and preferences.

III. Political and Legal environment – The framework for running a business is
given by the political and legal environment. The success of a business lies in its
ability to adapt and sustain to political and legal changes. The legislative, executive
and judiciary are the three political institutions which directs and influences a
business. The major elements of the legal and political environment are

1) Political stability is reflected by the following parameters like the election system,
the law and order situation, the role and structure of Military and Police force, the
declaration of President’s rule, civil war etc

2) Political organisation refers to the ideology and philosophy of the political parties,
the government, the role and degree of authority of bureaucracy, the level of political
consciousness among citizens and the funding of political parties by business houses
and the clout wielded by them.

3) The image of the leader and the country in the inter-national arena.

4) Legal framework of business and their degree of flexibility.

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5) The constitution of the nation.

6) The Foreign policy of the country with special reference to tariffs and free trade.

IV. Geo-physical environment – The natural, geographical and ecological factors

have a bearing on the business. These are as follows;

1) The availability of natural resources like minerals oil .etc, since setting up of
industries requires availability of raw materials

2) The weather and climatic conditions and availability of water and other natural
resources are essential for the agricultural sector.

3) Topographical factors like the terrain impacts type of business since the demand
and consumption pattern may vary in these regions. E.g in the the hilly region mode
of transport will have to be modified to tackle the terrain.

4) Ecological factors are now gaining momentum, since the governments across the
globe are framing stringent policies for ecological conservation and prevention of
pollution. The ban on use of plastic bags imposed by the Ooty Corporation is an
example.

5) Location of certain industries is influenced by the geographical conditions For e.g

In Tamilnadu the concentration of cotton textile industry in Coimbatore is due to
conducive weather conditions. .

6) Availability of natural harbours and port facilities for transporting goods.

V. Technological environment

The development in the IT and telecommunications has created a global market.

Technology is widely used in conducting market research for understanding the
special needs of the customer. Digital and social media are used as a platform for
advertising and promoting the products/services. Data-mining and data analytics are
used to know the customer better. Technology is used in managing inventory, storing
goods in warehouses, in distributing goods and in receiving payment. This dynamic
environment also includes the following ;

1) The level of technology available within the country

2) Rate of change in technology

3) Technology adopted by competitors

4) Technological obsolescence

VI. Global environment

With the rapid growth of technology the physical boundaries are fast disappearing and
the new global market is emerging. The international environmental factor which
affects a business are as follows;

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1) Differences in language and culture

2) Differences in currencies

3) Differences in norms and practices

4) Differences in tastes and preferences of people

5) The tax structure relating to import and export.

6) Differences in the degree of adoption of technology.

Private Sector or Private Enterprises in India

The private sector is the part of the economy that is run by individuals and
companies for profit and is not state controlled. Therefore, it encompasses all for-
profit businesses that are not owned or operated by the government. Companies and
corporations that are government run are part of what is known as the public sector,
while charities and other non-profit organizations are part of the voluntary sector.

Private Sector or Private Enterprises refer to all types of individual or corporate

enterprises, domestic and foreign, in any field of productive activity. Private sector
enterprises are characterized by ownership and management in private hands,
personal initiative and profit motive.

Types of Private Sector Businesses

The private sector is a very diverse sector and makes up a big part of many
economies. It is based on many different individuals, partnerships, and groups. The
entities that form the private sector include:

 Sole proprietorships
 Partnerships
 Small and mid-sized businesses
 Large corporations and multinationals
 Professional and trade associations
 Trade unions

Even though the state may control the private sector, the government does legally
regulate it. Any business or corporate entity operating in that country must operate
under the laws.

Growth of Private Sector in India:

At the dawn of independence, almost the entire productive activities and trade were
owned and managed by the private sector. At that time, the role of public sector was
insignificant, and its activity was very much confined to irrigation, power, railways,
ports, ordinance, posts and telegraphs etc. But the activity of the public sector was
gradually expanded in different new fields by both the Centre and the States.

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Even after the huge expansion of the public sector, the private sector still continued to
play a dominant role in all spheres and thereby accounting nearly 80 per cent of the
gross domestic product and about 90 per cent of the total employment. In a narrow
sense, private corporate sector provides a picture about the private sector. Thus, it is
quite important to study the growth of private corporate sector in comparison to that
of public sector.

Among the private sector corporate units, the largest industrial activity in terms of
paid up capitals is in processing and manufacture of metals and metal-products and
then the same is followed by chemicals, textiles, leather and leather products,
foodstuffs and processing, commerce, agriculture and allied industries, construction
utilities etc.

The Reserve Bank of India Bulletin, January-February 1995-96 reveals that there has
been marked improvement in the financial performance of the private corporate sector
during the first half of 1995-96 registering a 30.3 per cent growth over the
corresponding period of the previous year.

Problems Faced by Private Sector in India

1. Regulatory Procedure and Related Delays:

Too many regulatory measures imposed by the Government on the private sector has
resulted in lengthy procedure and delays in getting final clearance of a new industrial
project. On the Government level, decision making system is so poor that it normally
takes 7 to 8 years for large investment project to complete its gestation period.
Delegation of decision making in the Government bureaucracy is so poor that even
the simple decisions are rolled back to the top level leading avoidable procedural
delays, huge cost escalation, increasing interest burden and higher burden on
consumers.

2. Unnecessary Control:
From the beginning, the private sector of the country is subjected to unnecessary
Government control. Price controls imposed by the Government on certain goods has
resulted in disincentive to increase production. Rather competition among the rival
producers can enlarge the production base and thereby can reduce the prices
automatically.
But in India, under the conditions of shortage, price controls,.dual pricing etc. has
resulted in black marketing and hoarding of such commodities. Moreover, the system
of licensing of capacity as a capacity restraint has also resulted in undesirable effects
on the investors instead of preventing monopolistic tendencies. It is only since 1980,
unnecessary controls on the utilisation of excess capacity and on the creation of new
capacities have been either abolished or liberalized.

3. Inadequate Diversification:
The private sector has been suffering from inadequate diversification as the
Government did not allow them to participate in those basic, heavy and infrastructural
sectors which were earlier reserved for the public sector. It is only in post-1991 period,
some of these areas are now opened for the private sector participation.

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4. Reservation for the Small Sector:

From the initial stage of development, the Government is providing necessary support
to the small industrial sector in the form of reservation of certain products exclusively
for the small sector so as to save it from unfair competition of large units and also by
providing excise exemption or lower excise duties on the goods produced by the small
sector. But for the proper development of the small sector, modernization of their
production techniques, proper product-mix, updating of designs must be given
adequate priority.

5. Lack of Finance and Credit:

Although the large scale industrial corporate units of the private sector are mobilizing
their fund from banks, development financial institutions and from the market through
sale of their equities or debentures but the small scale units are facing acute problem
in raising fund for their expansion.

6. Low Ratio of Profit:

Another important problem of the private sector enterprises is the declining trend in
its net profit ratio. Accordingly, the net profit to turnover ratio of these total Indian
private sector enterprises has been declining from 6.1 per cent in 1994-95 to 3.2 per
cent in 1996-97 and then to 2.3 per cent in [Link], the net profit to net
worth (NP/NW) reflecting on return on investment, of the total private sector
enterprises also declined considerably from 15.2 per cent in 1994-95 to 6.5 per cent in
1996-97 and then to 4.7 per cent in 1997-98 as compared to that of 5.4 per cent of the
Central Public Sector Enterprises (CPSEs).

Prospects of Private Sector in India:

Normally, the government assigned a secondary role to the private sector for a long
time but the Sixth Five-Year Plan (1980-85) gave greater importance to the private
sector and nearly 47 percent of the total investment was to be in the private sector.

The private sector too has shown sufficient buoyancy and has registered a fast rate of
growth by raising increasing funds in the capital market and setting up a series of joint
ventures in other countries.

However, as the Sixth Five-Year Plan itself expressed clearly, “in a large number of
areas, our capabilities are almost 20 years behind those in the advanced nations and as
of behind those established recently in developing countries.”

To overcome these, the government has been taking a series of measures to give a
boost to the private sector, as for example, allowing automatic expansion of capacity
to a large number of industries.

Special facilities for the setting up of export-oriented units, exemption from

Monopolies and Restrictive Trade Practices (MRTP) restrictions on industries
producing for export, easy industrial licences for new units located in “Zero industry”
districts, quick and sympathetic processing of licence applications, liberalisation of
import and pricing policies, etc.

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These measures were in operation during the Sixth Plan period and the government
has further liberalised and strengthened these measures during the Seventh Plan
period.

The Industrial Policy of 1991 has further liberalised the economy in favour of the
private sector, as follows:

(i) Industrial licensing has been abolished for all projects except for a short list of
industries related to security and strategic concerns, social reasons, hazardous
chemicals and overriding environmental concerns.

(ii) Exception from licensing will apply to all substantial expansion of existing units.

(iii) Approvals will be given for direct foreign investment upto 51 percent foreign
equity in high priority industries.

(iv) Automatic permission will be given for foreign technology in high priority
industries.

(v) No permission will be required from the MRTP commission for expansion, new
undertakings, mergers, amalgamations and take over’s and appointment of directors.

In short, a greater role for the private sector is envisaged in the new industrial policy
by removing the barriers and controls and following a more liberalized approach.

Small and medium-sized enterprises (SMEs) or small and medium-sized

businesses (SMBs)

SMEs are businesses whose personnel and revenue numbers fall below certain limits.

Small and medium enterprises are privately owned businesses whose capital,
workforce, and assets fall below a certain level according to the national guidelines.

Local restaurants, grocery stores, garages, etc. that serve a hyperlocal target audience
usually fall under the blanket of a small-to-medium-size enterprise as they generate
less revenue and operate with less than a certain level of workforce and assets.

In India, SMEs are identified on the basis of the investment.

In the case of small enterprises:

 The manufacturing sector’s investment in plant & machinery should be more

than 25 lakh rupees and less than 5 crore rupees.
 The service sector’s investment in the equipment should be more than 10 lakh
rupees and less than 2 crore rupees.

In the case of medium enterprises:

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 The manufacturing sector’s investment in plant & machinery should be more

than 5 crore rupees and less than 10 crore rupees.
 The service sector’s investment in the equipment should be more than 2 crore
rupees and less than 5 crore rupees.

Importance of Small and Medium-sized Enterprises

1. Favors flexibility and innovation

Many technological processes and innovations are attributed to small and mid-size
enterprises (SMEs). Since large enterprises tend to focus on improving the old
products to produce more quantities and obtain general benefits of dimensional
economy, such companies are not as flexible as SMEs.

In order to be successful, SMEs focus on creating new products or services; hence,

they are capable of adapting faster to the changing requirements of the market. SMEs
play a vital role in shaping a country’s economy. They can be considered an attractive
and huge innovative system. Due to the socially and economically beneficial effects
of the SMEs, the sector is considered an area of strategic interest in an economy.

2. Creates a more competitive and healthier economy

Small and medium-sized enterprises stimulate competition for the design of products,
prices, and efficiency. Without SMEs, large enterprises would hold a monopoly in
almost all the activity areas.

3. Assists big enterprises

Small and medium-sized enterprises help large companies in some areas of operation
that they are better able to supply. Hence, SMEs are dissolved immediately; the big
enterprises will be forced to be involved in more activities, which may not be efficient
for these enterprises. Activities such as supplying raw materials and distributing the
finished goods created by big enterprises are developed more efficiently by SMEs.

The significance of small and medium-sized enterprises is also recognized by the

governments. Hence, they offer regular incentives to SMEs, such as easier access to
loans and better tax treatment.

Challenges that SMEs

In today’s world, things are becoming tough for any business to scale up
exponentially like it used to be in the last few decades. The problems and challenges
are greater in number for small and medium-sized enterprises. Some of these
challenges are rather new and that is exactly why SMEs are suffering more as they
still no have a concrete solution to overcome those challenges.

Cash Flow – Cash flow is the money that a company possesses after all the capital
expenditures are done. Lack of cash flow is hurting all SMEs and it is one of the root
causes of several problems they are facing at present. SMEs use their cash flow to pay

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off their debt, pay dividends to their shareholders, buy back stock and most
importantly, expand their business all of which are hindered by its absence.

Cost Of Borrowing – Due to lack of liquidity, SMEs have to take loans from time to
time to execute their big projects and pay different expenses. Due with the rapid
expansion of the economy in most of the countries around the world, the interest rates
of borrowing are also increasing significantly. SMEs have to pay more interest and
other financial fees than it used to be in the past. It is affecting overall business and
profitability. The rise of interest rate can also be attributed to the rise in inflation.

Scalability – Expansion of business is mandatory for any company to progress

consistently and increase their revenue. Lack of expansion can make the business
stagnant and with the rise in interest rate and other expenses, the company is sure to
undergo a financial crisis. The lack of scalability is a direct result of lack of cash flow.
Furthermore, new entrepreneurs are easily satisfied by the growth of their company
without understanding the risk of not expanding in due time.

Lack of scalability has killed many SMEs due to lack of project supply and the
unwillingness of clients to award big projects and moving on to bigger enterprises.
The absence of establishment in cities and countries where the projects inflow could
be really higher is one of the biggest challenges that SMEs are facing that need to be
solved for survival.

Accessing Finance – Access of finance helps an enterprise to avail various financial

services like insurance, risk management services, availing credit whenever needed,
paying the dues quickly and likewise. It is a proven fact that easy access to finance
helps SMEs to grow rapidly, protect themselves from future unforeseen risks and
most importantly, the debt does not stay stagnant for long and there is no dependency
on personal wealth to invest back in the company. Most of the SMEs are having
limited access to finance and they are in a state of under-banked.

Competition – In today’s scenario, competition is at its peak and in future, it is only

going to get high. There are so many small and medium-sized enterprises coming up
every year. With digital marketing, they are taking a good grip on the market and
replacing the old ones comfortably. Even though their sustainability is questionable
yet, constant competition is harming the existing established SMEs to growth at the
normal pace.
Unless SMEs can overcome these challenges in the near future, their long-term future
will be questionable.

One of the biggest challenges that SMEs face is heavy dependency on human labor.
Capture Fast allows small businesses to achieve efficiency by digitizing paper
documents.

Hiring And Retaining Talent

An organization is only as good as its people but recruiting and retaining talent is one
of the biggest problems faced by small businesses. Given the limited resources,
matching market salaries and perks is a big hurdle. However, once businesses realize
that salaries are not the only factor contributing to employee attrition, solutions can be

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found. Making sure your employees feel valued by taking care of their needs and
showing them a path for growth can help retain their loyalty.

Expensive Real Estate

Renting an office space is probably the biggest operational cost for Small and
Medium businesses. That’s exclusive of office operational costs like electricity, Wi-Fi,
security, housekeeping, etc.

High Competition
Making a business stand out in today’s competitive market is one of the biggest
challenges facing small businesses. Products and services can be easily replicated and
maintaining the USP is difficult.
Hence, businesses need to look beyond the product. Simple things like improving
customer service, making the product exclusive and offering convenience in the form
of home deliveries can help a business stand out.

Founder Dependence
Founders usually find themselves playing multiple roles in SMBs. They see the
business as their pet project and often find it difficult to let go of roles and
responsibilities. This may seem like maintaining control but it could be the factor
limiting the company’s growth.
As the team and resources grow, founders must learn to delegate responsibilities so
that the business can function even when they’re away.

Ineffective Marketing and Advertising

To reach out to new customers SMBs need to market and advertise their products.
This becomes a battle of resources. It is nearly impossible to compete with brands that
can get celebrity endorsers and put-up giant billboards.
The way out for small and medium businesses is to generate word-of-mouth
recommendations and use digital media smartly. If you’re based out of a coworking
space, you could work with other brands for cross-promotion exercises.

Disorganized Book-Keeping
Most forms of administration like bookkeeping and payroll management are time-
consuming and complicated. However, they are also necessary. It isn’t a surprise to
note that this is often listed among the challenges faced by small and medium
businesses. Not only can poor quality administration work hamper cash flow, but it
could also put your business at risk of being fined for non-compliance with state
regulations.
The most reliable solution to this issue is to outsource it to professionals (at least in
the initial phase of the business). This often works out more budget-friendly as
compared to hiring a full-time employee.

Limited Clients
A business that generates more than 50% of its income from a single source can easily
find itself in trouble. The client may pay well today but once his/ her need goes away,
the business will find it hard to survive.
Diversifying a client base is harder than it sounds as businesses must prove
themselves at every point. However, with consistent efforts via email campaigns,
newsletters, cross-promotions, etc. businesses can expand their audience.

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Corporate Brand Building

As a company grows the need for strong branding increases. With branding comes
customer loyalty, higher SEO ranking, PR attention and more. However, this is a
process that takes time.
Business owners need to understand the value of branding and make consistent efforts
towards strengthening it. To start with, it means having a unique logo, a set color
palette and curate fonts for all communication and a defined tone for communication.

Fiscal Policy Meaning

Fiscal Policy refers to the use of government spending and tax policies to affect
macroeconomic conditions, particularly employment, inflation, and macroeconomic
variables such as aggregate demand for goods and services. These actions are
primarily intended to stabilize the economy. To accomplish these macroeconomic
objectives, fiscal and monetary policy actions are usually combined.
Everything relating to the government’s income and expenditures is covered under
Fiscal Policy. The most significant aspects of the economy are addressed through
fiscal policy measures, which range from budgeting to taxation. The three
components of fiscal policy in India are as follows. Public Debt, Government
Expenditures, and Government Revenues. The Ministry of Finance establishes the
fiscal policy with support from NITI Ayog.

Fiscal Policy in India

The Indian Ministry of Finance develops the country’s fiscal policy. In 2003, this
policy was put into effect. Fiscal policy is becoming more significant today, and
economic stability is the basic foundation on which the country’s progress is based.
Fast and quick economic growth is the primary goal of India’s fiscal strategy.
Monetary policy, together with fiscal policy, is crucial to controlling the nation’s
economy.

Fiscal Policy Objectives

1. Price Stability:-
This policy primarily controls the absolute regulation of prices for all goods or things.
It regulates prices while the nation is through an economic crisis and keeps them
steady during an inflationary time; as a result, it regulates prices throughout the nation.
By regulating the supply of essential goods and services, the government supports
price stability. As a result, it invests money in rationing and stores with reasonable
prices and a sufficient supply of food grains. Additionally, it provides subsidies for
utilities like transportation, water, and cooking gas, keeping their prices low enough
for regular people to afford.

2. Complete Employment
Employment should be the top priority in every nation that needs to better its
economic situation. India has the highest number of young people, which increases
the likelihood of development. The younger generation is more capable than the older
generation in several areas. Therefore, if our nation could offer full or almost full
employment, it would elevate our economic statistics to the next level. The Fiscal

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policy guides all choices pertaining to employment. The government creates more job
opportunities in a number of different ways.
One, it produces jobs when it builds public sector businesses. Two, it provides the
private sector with incentives and other benefits, such as tax breaks, lower tax rates,
and so on, to increase output and employment. Additionally, it promotes people to
launch small, cottage, and rural businesses in order to provide employment. Giving
them tax benefits, incentives, subsidies, and low-interest loans are a few ways to do
this.

3. Economic Growth
Specific fiscal policy initiatives can boost the nation’s growth rate and aid in meeting
its needs. The establishment of heavy industries like steel, chemicals, fertilisers, and
industrial machinery is one way the government promotes economic growth. It also
builds infrastructures that support economic development, including roads, bridges,
railways, schools, hospitals, water and electricity supplies, telecommunications, and
so forth.

Fiscal Policy Types

1. Expansionary Fiscal Policy

These entail the choices made by the governments to increase their financial
contributions to the national economy. Thus, it produces a large number of goods and
services. Additionally, it expands employment prospects, increasing both individual
and governmental profits as a result of all the growth.

2. Contractionary Fiscal Policy

The second kind of fiscal policy is this one. When there is an economic boom, this is
employed. The rapid economic expansion can occasionally be risky, though. The
government is attempting to halt the current economic boom in this instance. Both
inflation and economic growth are controlled by this, which also aids in doing so.

3. Neutral Fiscal Policy

When the country’s economy is in balance, this fiscal policy is employed. With
economic highs and lows, it suggests things are moving well. It covers expenditures
made by the governments that are paid for through taxes levied against citizens,
businesses, or sectors of the economy. and won’t have any impact on the nation’s
economic situation.

Fiscal Policy Instruments

1. Control Over Consumption

This is the method by which the nation’s savings are increased. Consequently, it can
be used to acquire things later on and improve the nation’s current economic situation.

2. By increasing the rate of investment

This may be the best course of action to improve both the current and future state of
the economy. When people invest, money is not wasted on unnecessary items; instead,
it is put to good use, rising in value every day. Consequently, the nation’s economic
situation will improve greatly in the future.

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3. Infrastructure Development
The infrastructure of a country has a significant role in deciding whether it is
considered to be developed or underdeveloped. Thus, if we want to improve the
economy, infrastructure development is more crucial.

4. Maximum taxes on Overseas products and Luxury Products

There are approximately 100% taxes involved in some goods that are directly
imported into India from other nations. Because of this, the nation gains the most
from its revenue. Additionally, it will encourage the purchase of homegrown goods,
which will advance the nation’s industries.
Aside from overcharging for some items based on their quality and other elements,
there are other crucial considerations to consider. The biggest reason why the price of
a product has grown is the enormous tax that the government has imposed on luxury
goods. Because this significant tax is applied to luxury goods, the income earned by
these products will be at its highest, directly affecting the economic health of the
nation.

Fiscal Policy Components

1. Government Receipts
These government receipts take into account the government’s income, which has
been achieved through the collection of taxes, interest, and the revenue produced by
investments, cess, and other forms of revenue the nation has generated. This
represents the total funding received by the government from all sources.
There are two types for government receipts. Income Receipts Any government
payment that neither increases liabilities nor decreases assets is referred to as a
revenue receipt. Revenues from taxes and other sources can also be separated out
from this. The interests and dividends earned on government investments, as well as
cess and some other receipts, constitute non-tax revenues. Direct tax and indirect tax
make up the two categories of tax revenues.

Capital Receipts
All government payments that increase liabilities or decrease assets are considered
capital receipts. These funds are used by the governments to run smoothly. Another
kind of capital receipt is the existence of an incoming cash flow. It is known as a debt
receipt if the government borrows money since the money must be repaid to the
government from whom it was borrowed.
Non-debt receipts are those payments that do not require repayment. Non-debt
receipts make up around 75% of all budgets. Loans taken by the general public, some
foreign governments, and the Reserve Bank of India make up the majority of capital
receipts.

Revenue Receipts
Non-debt receipts are those payments that do not require repayment. Non-debt
receipts make up around 75% of all budgets. Loans taken by the general people, some
foreign governments, and the Reserve Bank of India make up the majority of capital
receipts (RBI).

2. Government Expenditure

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Revenue expenditures
They are one-time costs that are incurred now or usually within a year. Revenue
expenditures are essentially the same as operating expenses since they cover the
charges necessary to cover the government’s continuing operational costs (OPEX).
regular costs for upkeep and repairs on state-owned property. Unlike most capital
expenditures, which are one-time costs, they are ongoing expenses. An illustration
would be paying for electricity, rent, employee salaries, and government-owned
property taxes.
Capital Expenditure
Investments made by the government in capital to run or grow its operations and bring
in more money. Purchasing long-term assets, such as equipment, and purchasing fixed
assets, which are tangible assets. Therefore, compared to revenue expenditures,
capital expenditures are frequently for bigger sums. An illustration would be the
acquisition of manufacturing equipment, commercial purchases, other government
expenditures like furniture, infrastructure investment, etc.

3. Public Accounts of India (Public Debt)

When the government is only acting as a banker in a transaction, the Public Account
of India records the flows for those transactions. According to Article 266(2) of the
Constitution, this fund was established. It takes into consideration flows for
transactions in which the government only serves as a banker. Examples include
minor savings, provident funds, etc. This money doesn’t belong to the government;
instead, they must be returned to their original owners at some point. Consequently,
the Parliament is not required to authorize spending from the public account.

Monetary Policy

Monetary policy is a set of tools used by a nation's central bank to control the overall
money supply and promote economic growth and employ strategies such as revising
interest rates and changing bank reserve requirements.
Monetary policy refers to the steps taken by a country’s central bank to control the
money supply for economic stability. For example, policymakers manipulate money
circulation for increasing employment, GDP, price stability by using tools such as
interest rates, reserves, bonds, etc.

RBI Monetary Policy Objectives

High employment rates, a stable price level, and an improvement in economic

conditions are all the main objectives of the RBI Monetary Policy. The goals of
monetary policy are listed here.

1. Inflation

Monetary policies can target inflation levels. A low level of inflation is considered to
be healthy for the economy. If inflation is high, a contractionary policy can address
this issue.

2. Currency exchange rates

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Using its fiscal authority, a central bank can regulate the exchange rates between
domestic and foreign currencies. For example, the central bank may increase the
money supply by issuing more currency. In such a case, the domestic currency
becomes cheaper relative to its foreign counterparts.

3. The Neutrality of Money

The policy states that the government must aim to prevent money from being aligned
with the economy of the nation. Economic turbulence can result from any shift in
currency. They contend that altering any policy element will negatively impact the
nation’s overall economic situation.

They further contend that rigorous adherence to the neutral monetary policy will
minimise cyclical variations and prevent trade cycles, inflation, and deflation in the
nation’s economy. The authorities in this place maintain a stable currency. The
primary goal of this Monetary Policy objective is to maintain absolute stability in the
money supply.

4. Exchange Stability

The conventional goal of monetary policy authority is exchange stability. One of the
key goals of the Gold Standard for various nations was this. These movements served
to automatically adjust any imbalances or changes to the amount of money.
Unpredictability in the conversation rates will result in gold withdrawals or inflows,
upsetting the undesirable payment balance.

As a result, stable currency rates are crucial for international trade. Therefore, the
main goal of monetary policy is to stabilize and manage the external changes that are
occurring in a nation. Avoiding factors that could lead to exchange rate instability is
crucial.

It may have a sharp volatility, which can increase market speculation.

More volatility can result in significant losses, undermine domestic confidence, and
create difficulties for international investors. This will have a negative influence on
capital outflow, which is essential for capital formation and growth.

More exchange rate fluctuations may also result in higher prices and higher levels of
prices.

5. Price Stability

Prices that remain steady boost public trust and eliminate cyclical volatility. Thus, it
promotes economic equality and helps people appreciate the importance of business
activity. As a result, the community experiences an overall wave of welfare and
wealth that is beneficial to everyone.

Additionally, price stability promotes the improvement of the nation’s economic

situation. Additionally, the growth in good output benefits both the nation and its
citizens. Additionally, it raises imports while lowering exports. Following the

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introduction of the monetary policy, certain slight price increases also aid the
successful operation of the nation’s economy.

6. Full Employment

People who were working were fired as a result of the unexpected rise in
unemployment during the Great Depression, which led to widespread unemployment
throughout society. It is acknowledged to be both economically wasteful and socially
hazardous. As a result, it was also stated as the primary goal of monetary policy.
Currently, it is also referred to as full employment, which could have a direct impact
on the stability of the exchange rate and pricing. If both of these things operate
together, everything will run more smoothly.

According to the economist, having a balance between saving and investment at the
full employment level is the essential factor in achieving full employment. According
to classical economists, full employment is a typical aspect of the economy, but in the
current environment, it cannot be fully utilized; as a result, full employment is
necessary for better improvement of the nation’s economic status.

7. Economic Growth

In recent years, economic development has gained significant attention from

politicians and economists all across the world. Utilizing human, natural, and other
resources is also necessary if we want to raise the per capita income of the nation. The
majority of the time, a nation’s economy is determined by its per capita income.
Another important goal of monetary policy is to enhance per capita income, which is
necessary if we wish to boost the nation’s economy.

8. Stability in the Balance of Payments

Another goal of monetary policy is the balance of payments. It was first made
available after the war. This monetary policy objective’s primary goal stems from the
problem with global trade’s lack of international liquidity. It was believed that the
increase in the payment balance deficit decreased. Many less developed nations
reduce their imports, which negatively impacts the economy and development of the
nation. Consequently, this goal brings about a balance in the payments.... Read more
at: [Link]

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely utilized
policy tools include:

1. Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount
rate (base rate) is an interest rate charged by a central bank to banks for short-term
loans. For example, if a central bank increases the discount rate, the cost of borrowing
for the banks increases. Subsequently, the banks will increase the interest rate they

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charge their customers. Thus, the cost of borrowing in the economy will increase, and
the money supply will decrease.

2. Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a
commercial bank. By changing the required amount, the central bank can influence
the money supply in the economy. If monetary authorities increase the required
reserve amount, commercial banks find less money available to lend to their clients,
and thus, money supply decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new
businesses. Since it constitutes a lost opportunity for the commercial banks, central
banks pay them interest on the reserves. The interest is known as IOR or IORR
(interest on reserves or interest on required reserves).

3. Open market operations

The central bank can either purchase or sell securities issued by the government to
affect the money supply. For example, central banks can purchase government bonds.
As a result, banks will obtain more money to increase the lending and money supply
in the economy.

Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or contractionary.

Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by
decreasing interest rates, purchasing government securities by central banks, and
lowering the reserve requirements for banks. An expansionary policy lowers
unemployment and stimulates business activities and consumer spending. The overall
goal of the expansionary monetary policy is to fuel economic growth. However, it can
also possibly lead to higher inflation.

Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease the money supply in the
economy. It can be achieved by raising interest rates, selling government bonds, and
increasing the reserve requirements for banks. The contractionary policy is utilized
when the government wants to control inflation levels.

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 Module – 6 Indian Industrial Policy

The Government of India announced its new industrial policy 1991 on July 24, 1991, with
the goal of correcting the distortions and weaknesses in the country's industrial structure
that had developed over four decades, raising industrial efficiency to international levels,
and accelerating industrial growth. The economic reforms that were started in the early
1990s were centred on the New Industrial Policy of 1991. The new industrial policy served as
the foundation for all subsequent reform initiatives such as Liberalization, Privatization, and
Globalization. This article pertains to the New Industrial Policy 1991 which is important for
aspirants preparing for the UPSC examination.

New Industrial Policy 1991

In the economic reforms of India, this policy proved to be very effective and brought
significant changes in the economic regulation in the country. As the name suggests the
policy focused on developing and sustaining industries, however, these industries were
divided among various sectors.

 Under this policy, the government shifted its focus from PSUs (Public Sector
Undertakings), and thus its role has been redefined. Many significant changes have
been made in the public sector industries under NIP 1991 and the disinvestment
program was one among them. Also, the private sector has been awarded more
opportunities, even providing some from the reserved public sector units.

 Additionally, the government focused on creating more foreign direct investment

(FDI). The biggest advantage of NIP, in 1991 was that it ended industrial licensing,
which turn into a great relief for investors. However still in some hazardous
industries, industrial licensing is required for example tobacco and chemical
industries. In comparison with the last industrial policies, the NIP 1991 came with
many significant changes and thus proved to be more effective.

 The new industrial policy didn’t only focus on the economic reforms but also on
LPG(Liberalization, Privatization, and Globalization). Through this policy,
privatization started on a large scale and in almost every industrial sector. In NIP,
1991 GOI’s main focus was to increase investment and thus in this government liberal
policy on foreign trade and foreign investment.

 With the end of industrial licensing in 1991 after the launch of NIP, there were only
sectors left for which industrial licensing was required. This resulted in rapid
industrial growth and a rapid increase in the GDP of India. The era of Red Tapism
just ended after the end of industrial licensing. The NIP, 1991 focused mainly on
liberalization, privatization, and globalization, and that bought significant changes in
industrial regulation.

Need for New Industrial Policy in 1991

India was forced to implement a New Industrial Policy in 1991, including privatization,
liberalization, and globalization for the following reasons:

 Mounting Fiscal Deficit: As our planned economy developed, expected spending

constantly exceeded expected revenue, leading to a growing fiscal deficit. Compared
to 5% in 1981–1982, it climbed to 8.5% of GDP in 1991.

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 Government has to undertake interest-bearing public borrowings to cover this

shortfall.
 Adverse Balance of Payment: A deficit in the balance of payments occurs when
foreign payments exceed foreign receipts. It increased from Rs. 2214 crores in India
in 1980–81 to Rs. 17367 crores in 1990–91.
 Thus, the government was forced to borrow money from outside to cover this deficit.
 Gulf Crisis: The Gulf Crisis refers to the 1990–1991 Iran–Iraq war. The result was a
dramatic increase in petrol prices in the global market. Despite a dramatic decline in
exports to Gulf countries, import costs increased significantly.
 The status of the balance of payments became much more severe. The government
was obligated to announce the new industrial plan at this time.
 Fall in Foreign Reserves: Foreign exchange reserves briefly dipped to a level of
2400 crores in 1990–1991; at that time, there was just enough money to cover three
weeks' worth of imports.
 Due to the severity of the situation, Chandra Shekhar's government was forced to
mortgage its gold reserves to pay off the interest and international debts.
 India was compelled to implement a fresh set of policies to build up its foreign
exchange reserves.
 Rise in Prices: When the inflation rate increased from 6.7% to 16.7%, the situation
deteriorated significantly. Poor performance of public sector enterprises: From 1951
to 1991, the Government of India greatly enlarged the public sector, yet the results
were insignificant. So, moving it to the private sector from the public sector was
necessary.

Objectives of New Industrial Policy 1991

 The primary objectives of the New Industrial Policy of 1991 were to promote
efficiency and provide facilities for market forces.
 The bigger roles were played by
o L – Liberalization (Reduction in Government Control.)
o P – Privatization (Increasing the Private Sector's Role & Scope.)
o G – Globalisation (Economic Integration between India and the rest of the
world)

 Relieving the country from regulations like licenses and controls.

 Providing support to the small scale sector.
 Increasing the competitive culture among the industries to benefit the public at
large.
 Providing more incentives to the backward areas and their local people.
 To ensure a fast pace of industrial development to cope with the developed countries.
 In order to liberalize the economy from varied government restrictions.
 To liberate the private sector, to work independently.
 To ensure the increment in exports and liberalize imports.
 To increase employment opportunities
 To liberalize the economy

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Features of New Industrial Policy 1991

The End of Red Tapism via Industrial Delicensing Policy:

The red Tapism just ended in India as the GOI launched the industrial delicensing policy in
1991. Now anyone can easily start his/her industry without any license if that industry
doesn’t come under the 15 sectors for which a license is required. With the ease of licensing
the growth of industries begins at a rapid pace. At present, there are only 13 sectors left for
which industrial licensing is required.

Reform in Foreign Investment Policy:

One of the most important features of NIP, in 1991 was the foreign investment policy. Under
which GOI has provided ease in foreign trade and investment. This resulted in increased
competition among industries and attracted more FDI in India.

Dereservation Policy:
Before the launch of NIP, 1991 the public sector held reservations in some of the key
industries and capital goods. However after the launch of NIP, in 1991 the reservation policy
was abolished that providing equal opportunity to the private sector to invest in these key
industries. However, still, three sectors are reserved for the PSUs and they are mining, atomic
energy, and railways.

Abolition of MRTP Act:

In 1991 the MRTP (Monopoly and Restricted Trade) act was abolished under the NIP. Thus
from 2010, the competition commission jumped into the monitoring and supervision of
competitive practices.

Reforms related to PSUs:

The NIP, 1991 aimed to enhance the productivity and efficiency of the PSUs. Government
identifies new strategies and priority areas for PSUs. Also, the Public Sectors Undertaking
that was in the loss were sold to private sectors.

Impact of New Industrial Policy 1991

 Removal of Restrictions Regarding License, Permit, And Quota Raj: It removed

the restrictions experienced during the license, permit, and quota raj. It intended to
liberalize the economy by removing bureaucratic restrictions on industrial growth.
 Public Sector’s Role And Disinvestment: The role of the public sector was
decreased and two sectors were reserved for the public. The process of disinvestment
was started in PSUs.
 Entry of Multi-National Companies: By removing restrictions it enabled the entry
of multinational companies, privatization, removal of asset limits on MRTP
companies, liberal licensing policy, etc.
 Increment in Domestic And Foreign Investment: Domestic, as well as foreign
investment, increased in almost every sector of the economy.
 Increment in Exports And Related Activities: Increased efforts were undertaken to
increase exports such as Export Oriented Units (EOU), Export Processing Zones
(EPZ), Agri-Export Zones (AEZ), etc emerged.
 Establishment of A Separate Ministry: To better resolve the issues of MSMEs in
2006 a new act and separate ministry were established.

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Advantages of New Industrial Policy, 1991

The new industrial policy of 1991 provided to be quite advantageous for the Indian economy
and some of its major advantages are listed below.

1. Liberalization of industrial regulations helped the industry grow at a rapid pace as

there were fewer restrictions on the industrial sector.

2. The rapid industrial growth due to NIP, in 1991 increased the GDP.

3. Industrial production capacity increased significantly and the industries became more
precise and efficient than ever before.

4. With the liberalization of foreign trade and investment, retail investors got a chance to
compete in the global market.

5. The revenue of the government increased by a significant percentage.

Drawbacks of New Industrial Policy, 1991

As such there are not many drawbacks of the new industrial policy (NIP), 1991 but still, some
of them are discussed below.

 The new industrial policy mainly focuses on the large-scale industries with good
capital, thus exploiting the small-scale industries.

 Liberalization of foreign trade allowed many multinational companies to do business

in India which exploited the local business of India.

 The privatization of PSUs was a major feature of NIP 1991, however, it’s one of the
main options for underprivileged people to earn a job, and get good quality services at
lower prices. Thus it can exploit the poor and underprivileged section of society.

 With the end of licensing process, many industries got developed leading to an
increased level of pollution.

 The NIP, 1991 focused on cherishing industries but it didn’t have any provision for
employment generation and fixed labour wages.

Conclusion
Various steps undertaken by the New Industrial Policy 1991 led to the abolition of industrial
licensing, dismantling of price controls, dilution of reservations for small-scale industries
and the virtual abolition of the monopolies law, relaxation of restrictions on foreign
investment, etc. All such steps helped in the removal of restrictions and benefited in
economic growth and development of the country.

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Production Linked Incentive (PLI) Scheme

Production Linked Incentive or PLI scheme is a scheme that aims to give companies
incentives on incremental sales from products manufactured in domestic units. The scheme
invites foreign companies to set up units in India, however, it also aims to encourage local
companies to set up or expand existing manufacturing units and also to generate more
employment and cut down the country’s reliance on imports from other countries.

It was launched in April 2020, for the Large Scale Electronics Manufacturing sector, but later
towards the end of 2020 was introduced for 10 other sectors. This scheme was introduced in
line with India’s Atma Nirbhar Bharat campaign.

o The PLI scheme was conceived to scale up domestic manufacturing capability,

accompanied by higher import substitution and employment generation.
o Launched in March 2020, the scheme initially targeted three industries:
Mobile and allied Component Manufacturing
Electrical Component Manufacturing and
Medical Devices.
o Later, it was extended to 14 sectors.
o In the PLI scheme, Domestic and Foreign companies receive financial rewards for
manufacturing in India, based on a percentage of their revenue over up to five years.

Targeted Sectors:

o The 14 sectors are mobile manufacturing, manufacturing of medical devices,

automobiles and auto components, pharmaceuticals, drugs, specialty steel, telecom &
networking products, electronic products, white goods (ACs and LEDs), food
products, textile products, solar PV modules, advanced chemistry cell (ACC) battery,
and drones and drone components.

Production Linked Incentive (PLI) Scheme for Promoting Telecom and Networking
Products Manufacturing in India
The Production Linked Incentive (PLI) Scheme provides a financial incentive to boost
domestic manufacturing and attract investments in the target segments of Telecom and
Networking Products. This is in line with the larger objective of Make in India. Shri Chauhan
said that PLI Scheme in telecom sector has been launched to realize the Prime Minister’s
vision of Atmanirbhar Bharat. It will help in reducing India’s dependence on other countries
for import of telecom and networking products. He called upon the industry leaders to focus
on making high quality productstand expressed the commitment to provide incentives and
support to promote world class manufacturing in the country.
The enthusiastic response to the scheme by domestic and global manufacturers indicates
strong confidence in the “Atmanirbhar Bharat” - Make in India and achievement of
scheme objective of creating global champions out of India who have the potential to grow in
size and scale using cutting edge technology and thereby penetrate the global value chains.
Telecom products play an important role in the larger vision of “Digital India”.
New initiatives proposed by Indian government for economic growth in private sector are

Atmanirbhar Bharat Abhiyan

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 Module – 6 Indian Industrial Policy

The Atmanirbhar Bharat Abhiyan (meaning self-reliant India scheme) was announced in four
tranches by the Union Finance Minister Nirmala Sitharaman in May 2020.

The economic stimulus relief package announced by the government is touted to be worth
Rs.20 Lakh crores. This includes the already announced Rs 1.70 lakh crore relief package, as
the PMGKY, for the poor to overcome difficulties caused by the coronavirus pandemic and
the lockdown imposed to check its spread.

5 Important Facts about Atmanirbhar Bharat Scheme

1. The Prime Minister announced that an Atmanirbhar Bharat or a self-reliant India should
stand on the following five pillars:
1. Economy
2. Infrastructure
3. 21st-century technology-driven arrangements and system
4. Demand
5. Vibrant Demography
2. The 20 lakh crore worth package is almost 10% of the GDP of the country.
3. The package emphasizes on land, labour, liquidity, and laws.
4. The package includes measures across many sectors such as MSME, cottage industries,
middle class, migrants, industry, etc.
5. Several reforms are announced to make India a self-reliant economy and mitigate
negative effects in the future. Some of the reforms are:
1. Simple and clear laws
2. Rational taxation system
3. Supply chain reforms in agriculture
4. Capable human resources
5. Robust financial system

Make in India

Make in India aims to promote investment, encourage innovation, enhance skill development,
protect intellectual property and create best-in-class manufacturing infrastructure in the
country. The PLI scheme, as its name reflects, is meant to provide companies incentives on
incremental sales from products manufactured in domestic units. “The Make in India
campaign by the Government has given manufacturing an impetus and the investments made
in infrastructure, healthcare, electronics, amongst others, are already bearing fruit. This will
help India being seen as one of the global manufacturing hubs producing world-class
products,”

Make in India – Schemes

Several schemes were launched to support the Make in India programme. These schemes are
discussed below:

Skill India

This mission aims to skill 10 million in India annually in various sectors. Make in India to
turn into a reality, there is a need to upskill the large human resource available. This is

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important because the percentage of formally skilled workforce in India is only 2% of the
population.

Startup India

The main idea behind this programme is to build an ecosystem that fosters the growth of
startups, driving sustainable economic growth, and creating large-scale employment.

Digital India

This aims to transform India into a knowledge-based and digitally empowered economy. To
know more about Digital India, click on the linked page.

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