MANAGERIAL-ECONOMICS SKIIMS-MBA-I-SEMESTER

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Declaration

I am here to declare that the material which I prepared belong to SKIIMS only. I
prepared this material with the help of Books of Legendary authors, Google articles and my
own research. I really thankful to the management of SKIIMS and Principal to supporting me
to create this material and also thankful to Mr. D Rajasekhara who is reviewing and
simplifying this material to easily understandable.

Regards,
P Muni Chandra
[Link] At SKIIMS Srikalahasthi.

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103 – Managerial Economics

UNIT-I
Nature and scope of Managerial economics-Objectives of the firm - profit maximisation - sales
maximisation - satisfying and optimising firms.
UNIT-II
Demand analysis: Theory of demand- demand function- Price, income, promotion, and cross
elasticity of demand - Forecasting- sources of data-survey methods-statistical methods.
UNIT – III
Cost analysis: Production function - returns to scale-cost concepts cost curves - break even
analysis - profit forecasting-make or buy decisions. Cost behaviour in short and long terms.
Learning curve. Supply function
UNIT - IV
Pricing decisions: Objectives- Basic factors in Pricing-pricing under perfect, monopoly,
oligopoly, and monopolistic competition-discriminatory pricing-multiple product pricing-price
control by government - pricing of new products – pricing practices.
UNIT – V
National Income – Estimation and projection of GDP – Sectors in Indian Economy - Business
cycles – Response of firms to business cycles – Economic Policy of Government of India

References:

[Link] Peterson,[Link] Lewis :Managerial Economics (Pearson)

Paul [Link] and Philit [Link]: Managerial Economics (Pearson)
[Link]: Managerial Economics (Himalaya)
Suma Damodaran: Managerial Economics (Oxford)
D.N. Dwivedi: Managerial Economics (Vikas)
[Link]: Managerial Economics (Sultan Chand)
Samuel C. Wabb: Managerial Economics (Cengage)

NOTE TO THE PAPER SETTER:

(i) The questions shall cover all the units of the syllabus.
(ii) With regard to Part A of the question paper, ten questions shall be set
covering all units of the syllabus with equal weightage, out of which any five
questions will be answered by the students.
(iii) For Part - B of the question paper, the CASE shall be not less than 500 words.

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Chapter- I
Managerial economics- Introduction

Introduction:
Economics is the science of making decisions in the presence of scarce
resources. Resources are simply anything used to produce a good or service to
achieve a goal. Economic decisions involve the allocation of scarce resources so as
to best meet the managerial goal. The nature of managerial decision varies
depending on the goals of the manager.

A Manager is a person who directs resources to achieve a stated goal and

he/she has the responsibility for his/her own actions as well as for the actions of
individuals, machines and other inputs under the manager’s control.
Managerial economics is the study of how scarce resources are directed
most efficiently to achieve managerial goals. It is a valuable tool for analyzing
business situations to take better decisions.
[Link] Managerial Economics as “Managerial
Economics is concerned with the application of economic principles and
methodologies to the decision making process within the firm or organization under
the conditions of uncertainty”
According to Milton H Spencer and Louis Siegelman “Managerial Economics
is the integration of economic theory with business practices for the purpose of
facilitating decision making and forward planning by management”
According to Mc Nair and Miriam, ‘Managerial Economics consists of the use
of economic modes of thoughts to analyze business situations’.

Meaning of economics:

Economics is the social science that studies the production, distribution and
consumption of goods and services. Which means we have unlimited wants but
limited resources.

The term “economics” comes from the Greek word “oikos” (house) and
“nomos” (rules), rules of the house management.

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Definition of the economics:

According to Spencer and Siegelman” economics is the integration of
economic theory with business practices for the purpose of facilitating decision
making and forward planning by management.
There are two main branches of economics:

1. Microeconomics
2. Macroeconomics
1. Microeconomics: Microeconomics is a branch of economics that study of small
units of an economy. Such as individuals, firms and industries;
Micro derived from Greek word ‘mikros’ which means small.
2. Macroeconomics: Macroeconomics is a branch of economics that studies of
large units of an economy. Such as aggregate demand and supply, inflation,
employment level.
Macro derived from Greek word ‘makros’ which means large.
Micro, Macro, and Managerial Economics Relationship

Microeconomics studies the actions of individual consumers and

firms; managerial economics is an applied specialty of this
branch. Macroeconomics deals with the performance, structure, and behavior of an
economy as a whole. Managerial economics applies microeconomic theories and
techniques to management decisions. It is more limited in scope as compared to
microeconomics. Macroeconomists study aggregate indicators such as GDP,
unemployment rates to understand the functions of the whole economy.

Microeconomics and managerial economics both encourage the use of

quantitative methods to analyze economic data. Businesses have finite human
and financial resources; managerial economic principles can aid management
decisions in allocating these resources efficiently. Macroeconomics models and
their estimates are used by the government to assist in the development of
economic policy.

Managerial economics:

Management economics is nothing but, it is integration of economic theory with

business practices for making decision is called as “managerial economics”.

Definitions:

1. According to------ MC Nair and Meriam “managerial economics is the use of

economics modes of thought to analyses business situation.”

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2. Managerial economics is the integration of economic theory with business

practices for the purpose of facilitating decision-making and forward planning by
management” ---Spencer and Siegelman.

3. “ A fundamental academic subject which seeks to understand and to analyses the

problems. of business decision-making”---Hauge.

Nature and scope of ME:

1. Art and science:

2. Management oriented
3. Multi-disciplinary
4. Use to micro economics
5. Use to macro economics
6. Prescriptive discipline
7. Conceptual

1. Art and science

Managerial economics is determined as both art and science. The application of

managerial economics in decision making requires creativity and lots of analytical
thinking. It is regarded as science as it uses various economic theories and concepts
for managing business and solving problems.
2. Management oriented

ME is a management-oriented concept and it helps the management in rational

decision making and solving business problems logically by supplying all relevant
information.
3. Multi-disciplinary

ME is multi-disciplinary In nature and it uses principles and theories from various

subjects like economics, finance, stats, marketing, accounting, mathematics and
human resources ect..
4. Use to micro economics

ME analysis and solves problems of a particular firm or organizations only, but not of
the hole economy. It focuses on individual units of the economy and provides
optimum solutions for facing problems.

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5. Use to macro economics

ME properly studies macro or external environment within which business operates

for better management of the business. It analyses different external factors which
are affect to the business organizations like govt. policies, Market conditions etc..
6. Prescriptive discipline

ME defines course of action for business for attaining goals and objectives. It
chooses the best option among all alternatives available for solving the problems.
7. Conceptual

ME is conceptual in nature as is based on economic theories and concepts.

Scope of Managerial Economics:

Managerial economics is works as a tool for businesses that is used to

understand the functioning of a market and also how to sustain themselves in an
ever-changing market.
From analyzing demands and forecasting future demand to capital
management, managerial economics provides help with almost everything. It also
helps companies in Pricing Decisions, Policies, and Practices, cost and production
analysis, and manage their profits.

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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 production. After estimating the current demands, managers move
ahead to predict future demands 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 cost and 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 an important practice. Planning and control of capital expenditures is
a basic executive function. It involves the Equi-marginal principle. The prime
objective is to ensure the sustainable use of capital. This means that funds should be
kept at a bay when the managerial returns are less than in other uses.

*Note: The main topics dealt with during capital management are Cost of Capital,
Rate of Return, and Selection of Projects.

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5. Profit Management

A business firm is an organization designed with an intention to make profits

and profits reflect the 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.

6. Decision making

Managerial economics helps business organizations in taking effective

decisions. It tells how management can gives various quantitative tools and
economic theories for formulating policies and various managerial decisions.

What is Firm?

A firm is a for-profit business, usually formed as a partnership that provides

professional services, such as legal or accounting services. The theory of the firm
posits that firms exist to maximize profits.

Types of firms:

 A sole proprietorship or sole trader is owned by one person, who is liable

for all costs and obligations, and owns all assets. Although not common under
the firm umbrella, there exists some sole proprietorship businesses that
operate as firms.
 A partnership is a business owned by two or more people; there is no limit to
the number of partners that can have a stake in ownership. A partnership's
owners each are liable for all business obligations, and together they own
everything that belongs to the business.
 In a corporation, the businesses' financials are separate from the owners'
financials. Owners of a corporation are not liable for any costs, lawsuits, or
other obligations of the business. A corporation may be owned by individuals
or by a government. Though business entities, corporations can function
similarly to individuals. For example, they may take out loans, enter into
contract agreements, and pay taxes. A firm that is owned by multiple people is
often called a company.
 A financial cooperative is similar to a corporation in that its owners have
limited liability, with the difference that its investors have a say in the
company's operations.1

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Economic objectives of firms

The main objectives of firms are:

1. Profit maximization
2. Sales maximization
3. Increased market share/market dominance
4. Social/environmental concerns
5. Profit satisficing
6. Co-operatives
Sometimes there is an overlap of objectives. For example, seeking to increase
market share, may lead to lower profits in the short-term, but enable profit
maximization in the long run.

1. Profit maximization

Usually, in economics, we assume firms are concerned with maximizing profit.

Higher 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:

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 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
growths of supermarkets have lead 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. Growth maximization

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.

4. Long run profit maximization

In some cases, firms may sacrifice profits in the short term to increase
profits in the long run. For example, by investing heavily in new capacity, firms may
make a loss in the short run but enable higher profits in the future.

5. Social/environmental concerns

A firm may incur extra expense to choose products which don’t harm the
environment or 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. Co-operatives

Co-operatives may have completely different objectives to a typical PLC. 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.

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Diagram showing different objectives of firms:

 Q1 = Profit maximization (MR=MC)

 Q2 = Revenue Maximization (MR=0)
 Q3 = Marginal cost pricing (P=MC) – allocative efficiency
 Q4 = Sales maximization – maximum sales while still making normal
profit (AR=ATC)

Profit maximization

Profit maximization is a process business firms undergo to ensure the best

output and price levels are achieved in order to maximize its returns.

Influential factors such as sale price, production cost and output levels are adjusted
by the firm as a way of realizing its profit goals.
In business, profit maximization is a good thing, but it can be a bad thing for the
client if, for example, lower-quality materials and labour are used or if the business
decides to raise the prices for executing projects, all in pursuit of profit maximization.
Let’s now explore some of its advantages and disadvantages.
Advantages of profit maximization

 Economic survival: Profit is vital for the survival of any business

 Measurement standard: Profits are the right measurement of the viability of

a business model. In the absence of profits, the business loses its key goal
and incurs a direct risk to its survival.

 Social and economic welfare: In a business, profits demonstrate proficient

use and allotment of resources. Resource allocation and payments for land,

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labour, capital and the organization lends itself to social and economic
welfare.

Disadvantages of profit maximization

 Profit’ definition is unclear: Different perceptions of the term exist among

organizations and individuals. For example, profit can be the gross profit, net
profit, before tax profit or the profit rate.

 Time value of money is ignored: The formula is based on the idea that the
higher the profit, the better the proposal, but what about its timing? In finance,
when considering present value, we know that cash now won’t have the same
value in the future.

 Attention not paid to risk: In the pursuit of profit, risks involved are ignored,
which may prove unaffordable at times, simply because higher risk directly
questions the survival of a business.

 Ignores quality: The most challenging part of profit maximization as a goal is

that it neglects the intangible benefits such as quality, image, technological
advancements etc. However, the input of intangible assets in generating value
for a business is not worth neglecting, as they indirectly create assets for the
organization.

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Sales maximization – definition

Sales maximization is a theoretical objective of a firm which involves selling as

many units of a good or service as possible, without making a loss.

This means sacrificing some short-term profit with a view to achieving a long-term
gain. For example, while seasonal ‘sales’ may result in lower profits, space is
created as stocks are cleared, and more profitable lines can be introduced.

Graphically, it means selling at a quantity where AR = ATC, as shown (at point B.)

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Unit 2
Demand analysis

Introduction:

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. Market demand is the
total quantity demanded across all consumers in a market for a given good.
Aggregate demand is the total demand for all goods and services in an economy.
Multiple stocking strategies are often required to handle demand

 Demand refers to consumers' desire to purchase goods and services at given

prices.
 Demand can mean either market demand for a specific good or aggregate
demand for the total of all goods in an economy.
 Demand, along with supply, determines the actual prices of goods and the
volume of goods that changes hands in a market.

What is Demand?

Demand refers to the willingness or effective desire of individuals to buy a

product supported by their purchasing [Link] economics, Demand is
generally classified based on various factors, such as the number of
consumers for a given product, the nature of products, the utility of products,
and the interdependence of different demands.

What is Demand Theory?

Demand theory is a principle that emphasizes the relationship between consumer

demand and the price for goods and services within a market. It can also be
illustrated as the demand curve, which is downwards sloping in a horizontal manner,
as the price of the good decreases as quantity increases. Vice-versa, where the
price of the good increases as the quantity decreases.

Understanding Demand Theory:

Demand is the quantity of a good or service the consumer is willing to

purchase at specific prices during a time period. The demand for a good at a certain

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price generally reflects the consumer’s willingness to pay and expectation for
consuming that product. The goods indeed range in price, from necessities to
luxuries.

For example, regarding necessities, people need food, healthcare, clothing,

entertainment, shelter, and water across all welfares. The price of the goods tends to
be fairly affordable for most individuals. Whereas, designer bags, for example, tend
to be priced at a premium, as such goods are considered wants and are not required
to continue to live a healthy life.

The demand for a good or service is generally driven by two factors – utility and
ability to pay for the good or service.

The two aspects coincide with one another. Demand happens when a good or
service yields some level of utility while being backed by the ability, which ultimately
provides satisfaction to the consumer.

Demand aims to convey how bad people wish to purchase specific goods, along with
how much is bought based on their income levels and utility. Based on the
satisfaction that the good provides, companies adjust their supply level accordingly,
which changes prices.

For example, if a good is extremely popular and with high utility, companies will first
see a scarce supply, shifting the supply curve and raising prices. However, over
time, they will increase production, shifting the supply curve back to its original
position, bringing the price back down.

Factors That Affect Demand:

Various factors affect demand, including:

 Consumer preferences
 Taste
 Choices
 Income
 Related goods

As various factors may affect demand, businesses need to evaluate demand, as it is

one of the most integral decision-making drivers that must be considered to grow the
business and continue to stay competitive within the market.

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Defining the Market System:

Supply and demand determine the price within the market. When supply is
equivalent to demand, price is in a state of equilibrium. However, when demand is
higher than price, prices rise to reflect scarcity in quantity. On the other hand, when
supply is higher than demand, then prices fall due to a surplus in goods.

The Law of Demand:

The law of demand illustrates the inverse relationship between price and
demand for a goods or services within the market. As the commodity increases in
price, the demand decreases. However, if the commodity decreases in price, the
demand increases, assuming all other factors remain constant.

At times, consumers may purchase goods or services beyond factors in

price. It is also known as a change in demand. A change in demand is a shift in the
curve from right to left or left to right, based on the factors mentioned above.

For example, if an individual has more disposable income, they may be willing to
spend more goods within the market, regardless of whether the price lowers; in such
a case, the demand curve would shift to the right.

Types of Demand:

Definition: The Demand for a product refers to the quantity of goods and services
that the consumers are willing to buy at a particular price for a given point of time.

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The demand can be classified on the following basis:

1. Individual Demand and Market Demand:

The individual demand refers to the demand for goods and services
by the single consumer, whereas the market demand is the demand for a
product by all the consumers who buy that product. Thus, the market demand
is the aggregate of the individual demand.

2. Total Market Demand and Market Segment Demand:

The total market demand refers to the aggregate demand for a

product by all the consumers in the market who purchase a specific kind of a
product. Further, this aggregate demand can be sub-divided into the
segments on the basis of geographical areas, price sensitivity, customer size,
age, sex, etc. are called as the market segment demand.

3. Derived Demand and Direct Demand:

When the demand for a product/outcome is associated with the

demand for another product/outcome is called as the derived demand or
induced demand. Such as the demand for cotton yarn is derived from the
demand for cotton cloth. Whereas, when the demand for the
products/outcomes is independent of the demand for another
product/outcome is called as the direct demand or autonomous demand.
Such as, in the above example the demand for a cotton cloth is autonomous.

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4. Industry Demand and Company Demand:

The industry demand refers to the total aggregate demand for the
products of a particular industry, such as demand for cement in the
construction industry. While the company demand is a demand for the product
which is particular to the company and is a part of that industry. Such as
demand for tires manufactured by the Goodyear. Thus, the company demand
can be expressed as the percentage of the industry demand.

5. Short-Run Demand and Long-Run Demand:

The short term demand is more elastic which means that the changes
in price or income are reflected immediately on the quantity demanded.
Whereas, the long run demand is inelastic, which shows that demand for
commodity exists as a result of adjustments following changes in pricing,
promotional strategies, consumption patterns, etc.

6. Price Demand:

The demand is often studied in parlance to price, and is therefore

called as a price demand. The price demand means the amount of commodity
a person is willing to purchase at a given price. While studying the demand,
we often assume that the other factors such as income of the consumer, their
tastes, and preferences, the prices of other related goods remain unchanged.
There is a negative relationship between the price and demand Viz. As the
price increases the demand decreases and as the price decreases the
demand increases.

7. Income Demand:

The income demand refers to the willingness of an individual to buy a

certain quantity at a given income level. Here the price of the product,
customer’s tastes and preferences and the price of the related goods are
expected to remain unchanged. There is a positive relationship between the
income and demand. As the income increases the demand for the commodity
also increases and vice-versa.

8. Cross Demand:

It is one of the important types of demand wherein the demand for a

commodity depends not on its own price, but on the price of other related
products is called as the cross demand. Such as with the increase in the price
of coffee the consumption of tea increases, since tea and coffee
are substitutes to each other. Also, when the price of cars increases the

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demand for petrol decreases, as the car and petrol are complimentary to
each other.
These are some of the important types of demand that the firms must cater to before
deciding on the price and other factors related to their products..

Price Elasticity
The response of the consumers to a change in the price of a commodity is
measured by the price elasticity of the commodity demand. The responsiveness of
changes in quantity demanded due to changes in price is referred to as price
elasticity of demand. The price elasticity of demand is measured by dividing the
percentage change in quantity demanded by the percentage change in price.

Price Elasticity = Proportionate change in the Quantity Demanded/

Proportionate change in price

Percentage change in quantity demanded

= ----------------------------------------------
Percentage change in price

ΔQ / Q 10

= --------- = ------ = 0.5

ΔP / P 20

ΔQ = change in quantity demanded

ΔP = change in price
P = price
Q = quantity demanded

For example:
Quantity demanded is 20 units at a price of Rs.500. When there is a fall in price to
Rs. 400 it results in a rise in demand to 32 units. Therefore the change in quantity
demanded is12 units resulting from the change in price of Rs.100.

The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3

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Types of Price Elasticity of Demand

Definition: The Price Elasticity of Demand is commonly known as the elasticity of

demand, which refers to the degree of responsiveness of demand to the change in
the price of the commodity.

Types of price Elasticity of Demand

The following are the main types of price elasticity of demand:

1. Perfectly Elastic Demand (Ep = ∞):

The demand is said to be perfectly elastic when a slight change in

the price of a commodity causes a major change in its quantity demanded.
Such as, even a small rise in the price of a commodity can result into fall in
demand even to zero. Whereas a little fall in the price can result in the
increase in demand to infinity.
In perfectly elastic demand the demand curve is a straight horizontal
line which shows, the flatter the demand curve the higher is the elasticity of
demand.

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2. Perfectly Inelastic Demand (Ep =0):

When there is no change in the demand for a product due to the

change in the price, then the demand is said to be perfectly inelastic. Here,
the demand curve is a straight vertical line which shows that the demand
remains unchanged irrespective of change in the price., i.e. quantity OQ
remains unchanged at different prices, P1, P2, and P3.

3. Relatively Elastic Demand (1 to ∞):

The demand is relatively elastic when the proportionate change in the

demand for a commodity is greater than the proportionate change in its price.
Here, the demand curve is gradually sloping which shows that a
proportionate change in quantity from OQ 0 to OQ1 is greater than the
proportionate change in the price from OP1 to Op2.

4. Relatively Inelastic Demand (0-1):

When the proportionate change in the demand for a product is less

than the proportionate change in the price, the demand is said to be relatively
inelastic demand. It is also called as the elasticity less than unity, i.e. 1. Here
the demand curve is rapidly sloping, which shows that the change in the
quantity from OQ0 to OQ1 is relatively smaller than the change in the price
from OP1 to Op2.

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5. Unitary Elastic Demand (Ep =1):

The demand is unitary elastic when the proportionate change in the price of a
product results in the same change in the quantity demanded. Here the shape
of the demand curve is a rectangular hyperbola, which shows that area
under the curve is equal to one

.
Thus, these are some of the types of the price elasticity of demand that helps the
firms to price their product in accordance with the demand patterns of an individual
which changes with the change in the price of the commodity.

DETERMINANTS OF DEMAND:

The demand for a commodity by a buyer is generally not a fixed quantity. It is

affected by many factors. The factors that influence the demand are called
the determinants of demands. The determinants of demand are also known
as demand shifters. The following factors affect an individual's demand for a
commodity:
Definition:

The word ‘demand’ is used to imply the quantity (how much) of a given commodity
or service, the consumers are willing and able to buy, in a market during the

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particular period of time, at any price, or at any income or at any price of related
goods.

Demand is not just the desire for the commodity, rather when the desire is
supported by the means to purchase, the willingness of the consumer to use those
means to buy the commodity and purchasing power of the consumer, then only it is
termed as demand.

Determinants of Demand:

 Price of the Commodity:

Other things being constant, there is an inverse relationship between

the commodity’s price and its demand, i.e. an increase in the price of the
commodity, results in the decrease in its demand, and vice versa. For
instance: The rise in the price of detergent produced by A Ltd. will decrease
its demand, as the price-sensitive consumers may choose detergent
produced by some other company over the detergent produced by A Ltd.

 Price of Related Goods:

Related goods refer to the goods whose change in price may change
the quantity demanded of a commodity. The related goods are classified as:

1. Complementary Goods: The products which are used or taken

together or simultaneously are called complementary goods. For
instance: Shampoo and Conditioner wherein a fall in the price of
Shampoo leads to the rise in the demand of Conditioner.

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2. Competing Goods: When two commodities share similar wants and

can be used interchangeably are called as Competing Goods or
Substitute Goods. For instance: Soap or Shower Gel wherein a fall in
the price of Shower Gel results in the fall in quantity demanded of its
Soap. So, there is a direct relationship between demand for the
commodity and the price of its substitutes.

 Income of the Consumer:

Other things remain constant; the income level of the consumer

also influences the demand for a commodity, as the buying power of the
consumer depends on the income level itself. The nature of consumer goods
decides the nature of the relationship between income and the quantity
demanded. As the income of the consumer increases, the consumer wants
more of a given commodity, but this is not true in all the situations, as in case
of inferior goods, where the rise in the level of income leads to decrease in its
demand, because the consumer switch to better quality product, which they
can afford after the rise in their income.

 Consumer Expectations:

When the price of a particular commodity, is expected to rise in the

near future, the demand for that good, goes up, for that particular time. In the
same way, when the price of a commodity is expected to fall, the demand for
it usually comes down, as the customers will postpone the purchase. For
instance: If the gold prices are expected to rise in the coming time, then its
demand increases for that duration.

 Tastes and Preferences of Consumer:

The tastes and preferences of the consumer also have a significant

effect on the demand for its commodity. We all know that when something is
in fashion, it is high in demand, which may change over a period of time. For
instance: With the introduction of 5G technology handsets in the market, the
demand for 4G smart phones has been reduced.

1. Demonstration Effect: A person’s demand for a particular good or

service is also influenced by his seeing his relative, friend, colleagues,
neighbors consuming it. There are two main reasons behind it, i.e. by
seeing the other person consuming it, the individual also gets the
desire to consume the same, or he/she thinks that if his relative can
afford it, then he/she can also afford it. This is called a Demonstration
Effect.

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2. Snob Effect: The opposite of the demonstration effect is the snob

effect, which says that if a commodity is common among all the people,
some people will stop using it, leading to the decrease in overall
demand.
3. Veblen Effect: Goods which are high in price is a status symbol for
rich people and so are consumed by that class only, to fulfil their need
for prestige. This is called a Veblen Effect.
In addition to the above factors, there are factors like the size of the population, the
composition of the population, national income and its distribution, which also affects
the demand for a commodity.

Demand Function:
The demand functions are two functions:
1. Individual and
2. Market Demand Functions

Demand function shows the relationship between quantity demanded for a particular
commodity and the factors influencing it.

It can be either with respect to one consumer (individual demand function) or to all
the consumers in the market (market demand function).

Individual Demand Function:

Individual demand function refers to the functional relationship between individual

demand and the factors affecting individual demand. It is expressed as:
Dx = f (Px, Pr, Y, T, F) Where,
Dx = Demand for Commodity x;
Px = Price of the given Commodity x;

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Pr = Prices of Related Goods;

Y = Income of the Consumer;
T = Tastes and Preferences;

F = Expectation of Change in Price in future.

Demand function is just a short-hand way of saying that quantity demanded (D x),
which is on the left-hand side, is assumed to depend on the variables that are listed
on the right-hand side.

Market Demand Function:

Market demand function refers to the functional relationship between market demand
and the factors affecting market demand. As mentioned before, market demand is
affected by all factors affecting individual demand. In addition, it is also affected by
size and composition of population, season and weather and distribution of income.

So, market demand function can be expressed as:

Dx = f(Px, Pr, Y, T, F, PD, S, D) Where,

Dx = Market demand of commodity x;
Px = Price of given commodity x;
Pr = Prices of Related Goods;
Y = Income of the consumers;
T = Tastes and Preferences;

F = Expectation of Change in Price in future;

P0 = Size and Composition of population;

S = Season and Weather; D = Distribution of Income.

Elasticity of Demand:

Definition: The Elasticity of Demand measures the percentage change in

quantity demanded for a percentage change in the price. Simply, the relative change
in demand for a commodity as a result of a relative change in its price is called as
the elasticity of demand.

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Types of Elasticity of Demand:

Definition: The Elasticity of Demand measures the percentage change in

quantity demanded for a percentage change in the price. Simply, the relative change
in demand for a commodity as a result of a relative change in its price is called as
the elasticity of demand.

Types of Elasticity of Demand

1. Price Elasticity of Demand:

The price elasticity of demand, commonly known as the elasticity of

demand refers to the responsiveness and sensitiveness of demand for a
product to the changes in its price. In other words, the price elasticity of
demand is equal to

Numerically,

Where,
ΔQ = Q1 –Q0, ΔP = P1 – P0,

Q1= New quantity,

Q2= Original quantity,

P1 = New price,

P0 = Original price

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The following are the main Types of Price Elasticity of Demand:

o Perfectly Elastic Demand

o Perfectly Inelastic Demand
o Relatively Elastic Demand
o Relatively Inelastic Demand
o Unitary Elastic Demand
2. Income Elasticity of Demand:

The income is the other factor that influences the demand for a
product. Hence, the degree of responsiveness of a change in demand for a
product due to the change in the income is known as income elasticity of
demand. The formula to compute the income elasticity of demand is:

For most of the goods, the income elasticity of demand is greater than one
indicating that with the change in income the demand will also change and
that too in the same direction, i.e. more income means more demand and
vice-versa.

3. Cross Elasticity of Demand:

The cross elasticity of demand refers to the change in quantity

demanded for one commodity as a result of the change in the price of another
commodity. This type of elasticity usually arises in the case of the interrelated
goods such as substitutes and complementary goods. The cross elasticity of
demand for goods X and Y can be expressed as:

The two commodities are said to be complementary, if the price of one

commodity falls, then the demand for other increases, on the contrary, if the
price of one commodity rises the demand for another commodity decreases.
For example, petrol and car are complementary goods.
While the two commodities are said to be substitutes for each other if the
price of one commodity falls, the demand for another commodity also
decreases, on the other hand, if the price of one commodity rises the demand
for the other commodity also increases. For example, tea and coffee are
substitute goods.

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4. Advertising Elasticity of Demand:

The responsiveness of the change in demand to the change in

advertising or rather promotional expenses, is known as advertising elasticity
of demand. In other words, the change in the demand as a result of the
change in advertisement and other promotional expenses is called as the
advertising elasticity of demand. It can be expressed as:

Numerically,

Where,
Q1 = Original Demand
Q2= New Demand
A1= Original Advertisement Outlay
A2 = New Advertisement Outlay
These are some of the important types of elasticity of demand that helps in
understanding the criteria of demand for the goods and services and the factors that
influence the demand.

Demand Forecasting

Definition:

Demand Forecasting refers to the process of predicting the future demand

for the firm’s product. In other words, demand forecasting is comprised of a series of
steps that involves the anticipation of demand for a product in future under both
controllable and non-controllable factors.

The business world is characterized by risk and uncertainty, and most of the
business decisions are taken under this scenario. An organization come across
several risks, both internal or external to the business operations such as
technology, attrition, unrest, employee grievances, recession, inflation, modifications
in the government laws, etc.

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Predicting the future demand for a product helps the organization in making
decisions in one of the following areas:

 Planning and scheduling the production and acquiring the inputs accordingly.
 Making the provisions for finances.
 Formulating a pricing strategy.
 Planning advertisement and implementing it.
Demand forecasting holds significance in the businesses where large-scale
production is involved. Since the large-scale production requires a long gestation
period, a good deal of forward planning should be done. Also, the potential future
demand should be estimated to avoid the conditions of overproduction and
underproduction. Most often, the firms face a question of what would be the future
demand for their product as they have to acquire the input (labor and raw material)
accordingly.

The objective of demand forecasting is attained only when the forecasting is done
systematically and scientifically. Thus, the following steps in demand
forecasting are followed to facilitate a systematic estimation of future demand for
product:

1. Specifying the Objective

2. Determining the Time Perspective
3. Choice of method for Demand Forecasting
4. Collection of Data and Data Adjustment

Estimation and Interpretation of Results Thus, demand forecasting is a

systematic process that assumes greater significance in large-scale producing firms.
Demand forecasting may not be a serious issue for the small scale firms which
supply a small portion of total demand or produces the product that caters to the
short demand or seasonal demand. Such firms can plan their production on the
basis of the business skills and their past experiences.

Forecasting refers to the practice of predicting what will happen in the future
by taking into consideration events in the past and present. Basically, it is a decision-
making tool that helps businesses cope with the impact of the future’s uncertainty by
examining historical data and trends. It is a planning tool that enables businesses to
chart their next moves and create budgets that will hopefully cover whatever
uncertainties may occur.

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Forecasting Methods:

Businesses choose between two basic methods when they want to predict what can
possibly happen in the future, namely, qualitative and quantitative methods.

1. Qualitative method:

Otherwise known as the judgmental method, qualitative forecasting offers subjective

results, as it is comprised of personal judgments by experts or forecasters. Forecasts
are often biased because they are based on the expert’s knowledge, intuition, and
experience, and rarely on data, making the process non-mathematical.

One example is when a person forecasts the outcome of a finals game in the NBA,
which, of course, is based more on personal motivation and interest. The weakness
of such a method is that it can be inaccurate.

2. Quantitative method:

The quantitative method of forecasting is a mathematical process, making it

consistent and objective. It steers away from basing the results on opinion and
intuition, instead utilizing large amounts of data and figures that are interpreted.

Features of Forecasting:

Here are some of the features of making a forecast:

1. Involves future events:

Forecasts are created to predict the future, making them important for planning.

2. Based on past and present events:

Forecasts are based on opinions, intuition, guesses, as well as on facts, figures, and
other relevant data. All of the factors that go into creating a forecast reflect to some
extent what happened with the business in the past and what is considered likely to
occur in the future.

3. Uses forecasting techniques:

Most businesses use the quantitative method, particularly in planning and budgeting.

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The Process of Forecasting

Forecasters need to follow a careful process in order to yield accurate results.

Here are some steps in the process:

1. Develop the basis of forecasting:

The first step in the process is developing the basis of the investigation of the
company’s condition and identifying where the business is currently positioned in the
market.

2. Estimate the future operations of the business:

Based on the investigation conducted during the first step, the second part of
forecasting involves estimating the future conditions of the industry where the
business operates and projecting and analyzing how the company will fare.

3. Regulate the forecast:

This involves looking at different forecasts in the past and comparing them with the
actual things that happened with the business. The differences in previous results
and current forecasts are analyzed, and the reasons for the deviations are
considered.

4. Review the process:

Every step is checked, and refinements and modifications are made.

Sources of Data for Forecasting:

1. Primary sources:

Information from primary sources takes time to gather because it is first-hand

information, also considered the most reliable and trustworthy sort of information.
The forecaster himself does the collection, and may do so through things such
as interviews, questionnaires, and focus groups.

2. Secondary sources:

Secondary sources supply information that has been collected and published by
other entities. An example of this type of information might be industry reports. As
this information has already been compiled and analyzed, it makes the process
quicker.

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Demand Forecasting Process :

To have efficient, accurate and reliable demand forecasting a manager must

take the following steps;

1. Specifying the objective of Demand Forecasting:

While forecasting demand one may have different objectives like quantity and
composition of demand, price to be quoted, production planning, inventory planning
or capital budgeting, short or long term demand, firm’s market share etc. Thus, the
objective for which demand is to be estimated must be clearly defined at first stage.

2. Determining the nature of goods:

The next step in demand forecasting is identification of type of goods as

different type of goods such as consumer goods, capital goods, industrial goods,
durable and nondurable goods; perishable or seasonal goods have different type of
demand pattern. This will help in applying write approach to demand estimation
process.

3. Determining the time perspective:

Depending upon the nature of goods and firm’s objective, the demand can be
forecasted for short term as well as for long term. In short term many of the
determinants of demand may remain constant or not to be change significantly but in
long run these determinants may change significantly. Thus, while forecasting
demand one has to define the time span for the forecast. The time period is normally
divided into short run up to 3 to 6 months, medium term up to 2 or 3 years and long
term beyond 3 or 5 years.

4. Determining the level of forecasting;

Demand forecasting may be undertaken at micro or firm level, industry level,

macro level or international level. It may be done for product line forecasting, general
or specific purpose or for established or new products. There are different factors
that influence the demand at different level of forecasting. Thus one must specify the
level of forecasting beforehand.

5. Selection of proper method or technique of forecasting:

Economists have developed different methods or techniques for forecasting.

However, these methods are not suitable for all type of demand forecasting due to
the type or objectives of forecasting, data requirement, availability of data and time
frame. One has to select an appropriate method for demand forecasting to achieve

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stated objectives. It also depends upon the purpose, knowledge and experience of
the forecaster.

6. Data Collection and modification:

Depending upon the objective and method of forecasting next step in

demand forecasting is to collect the required data. There are different method of
collection of primary data like observation, interview, survey or questionnaire, focus
group discussion methods etc. Data can also be collected from various secondary
sources but, this data required modification as it may not be available in the required
mode.

7. Data analysis and estimations:

Once the data has been collected and method of data analysis has been
finalized the next step in demand forecasting is analysis of data and interpretations
of results. The Efficiency of estimation depends upon the efficiency with which it has
been analyzed and interpretive. Sometimes, estimation required support from
background factors which has not been used in estimation process. One mist
frequently revised the estimates depending upon the changed business conditions.

Methods of Demand Forecasting:

Demand forecasting is the art as well as the science of predicting the likely
demand for a product or service in the future. This prediction is based on past behavior
patterns and the continuing trends in the present. Hence, it is not simply guessing the
future demand but is estimating the demand scientifically and objectively. Thus, there
are various methods of demand forecasting which we will discuss here.

Demand forecasting seeks to investigate and measure the forces that determine
sales for existing and new products. Generally companies plan their business –
production or sales in anticipation of future demand. Hence forecasting future
demand becomes important. The art of successful business lies in avoiding or
minimizing the risks involved as far as possible and faces the uncertainties in a
most befitting manner.

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DEMAND FORECASTING TECHNIQUES

Demand forecasting is a highly complicated process as it deals with the

estimation of future demand. It requires the assistance and opinion of experts in
the field of sales management. Demand forecasting, to become more realistic
should consider the two aspects in a balanced manner. Application of
commonsense is needed to follow a pragmatic approach in demand forecasting.
Broadly speaking, there are two methods of demand forecasting:

A) Survey Method ( Direct method)

B) Statistical Method ( Indirect method)

FORECASTING
TECHNIQUES

A) Survey B) Statistical
Method
Method

2. 4. Leading 5. Simultaneous
1. Trend 3. Economic Indicator Equation method
method Regression Indicator method
1. Expert Opinion method
- Delphi
- Dealer
- Sales force 2. Consumer
interaction

method

Complete E n Sample Market

Survey End-Use
numeration experiment
E nt

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A) SURVEY METHOD (DIRECT METHOD):

1. Expert Opinion:

In this method, the experts on the particular product whose demand is

understudies are requested to give their opinion about the likely share in the
future period. These are the persons who have been dealing in this and related
products for the year and are thus able to predict the likely level of sales in future
periods under different conditions, based on their experience. If the no. of such
expert is large and their expectations are different than an average simple or
weighted is found to lead the unique forecast.

 Delphi Method:
A variant of the opinion poll and survey method is Delphi method. It consist
of an attempt to arrive at a collective or general opinion in an uncertain
area, by questioning a group of experts. Each expert is given the
opportunity to react to the information or consideration advanced by others
but interchange is anonymous so as to avoid or reduce the „halo effect‟,
„band wager effect‟ and „ego involvement‟ associated with publicity
expressed opinion.

 Sales Force and Dealers Opinion:

Under this method, Salesmen are required to estimate expected sales in
their respective territories and sections. The advantage of this method is
that salesman being the closest to the customers are likely to have the
most intimate idea of the market. i.e, customer reaction to the products of
the firm and their sales trend.

Advantages:

 This method is simple to understand.

 This method is free from the heavy costs of survey.
 It is also useful when a firm introduces a new product in the
market. Limitations:
 The opinion of the experts many a times may be biased.
 They may not aware of other demand determinants.

2. Consumer Interaction Method:

Under this method of demand forecasting, intentions of the buyers as to what they
intend to buy, how much quantity to buy at different price etc. are known through
personal contacts. Thus, this method shifts the burden of demand forecasting on
to buyers. This work of consumer survey is entrusted to trained, reliable and
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experienced investigators.

a) Complete Enumerative survey:

Under this method all the potential buyers of the product are contacted;
their interviews are conducted to find out the probable demand. Having
ascertained the individual demand for the product by complete
enumerative method, these are added together to find out the probable
demand.
The main advantage of this method is that since all potential buyers are
contacted, there is a greater degree of accuracy. Besides, this method is
useful when new products are introduced by a firm.
But this method is expensive, time consuming and is of little use when the
consumer are spread over a large area.

b) Sample Survey:
In view of the limitations of the complete enumerative method, Sample
survey method has become more popular for forecasting the demand.
Under this method, only a few customers are selected from the potential
buyers of the product; they are interviewed.
The chief merit of this method is that it is less costly and less time
consuming.
But the efficiency and accuracy of this method depends upon the
competence of field investigators and experts. There is a relative shortage
of such personnel in developing countries. Besides, if there is no careful
planning and proper procedure sample survey method may lead to
inaccurate and misleading results

c) Market Experiment method:

A potential problem with survey data is that survey responses may not
translate into actual consumer behavior. That is, consumers do not
necessarily do what they say they are going to do. This weakness can be
partially overcome by the use of market experiments designed to generate
data prior to the full-scale introduction of a product or implementation of a
policy. To set up a market experiment, the firm first selects a test market.
This market may consist of several cities; a region of the country, or a
sample of consumers taken from a mailing list. Once the market has been
selected, the experiment may incorporate a number of features. It
may
Finally, it should be possible to purchase advertising that is
directed only to those who are being tested. Market experiments have an
advantage over surveys in that they reflect actual consumer behavior, but
they still have limitations. One problem is the risk involved. In test markets
where prices are increased, consumers may switch to products of
competitors. Once the experiment has ended and the price reduced to its
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original level, it may be difficult to regain those customers. Another problem

is that the firm cannot control all the factors that affect demand. The results
of some market experiments can be influenced by bad weather, changing
economic conditions, or the tactics of competitors.

d) End – Use method:

Under this method, the sales of a product are projected through a survey of
its end-users. A product is used for final consumption or as an intermediate
product in the production of other goods in the domestic market, or it may
be exported as well as imported. The demands for final consumption and
exports net of imports are estimated through some other forecasting
method, and its demand for intermediate use is estimated through a survey
of its user industries.

Advantages:

 The principal advantage at this method is that provides use wise or sector
wise demand forecast. In the process of obtaining the forecasts of
aggregate demand, the forecaster obtains separately the demand by the
individual consumer industries, by final consumer categories and by export
and import sectors. This information may be useful in manipulating future
demand.
 As compare to other survey methods, this method does not require any
historical data.

Limitations:

 The major weakness of this method is that it requires every industry to

furnish its plan of production correctly and well ahead of time.
 Consumer goods demands can’t easily forecasted through this method.
 The individual industry will have to rely on some other method to estimate
the future demand of its product for final consumption, export & imports,
because the sum of consumption, export net of import demand for any
commodity is convenient for the national planning organization. Thus only
the intermediate demands or the input demand can be predicted by the
end- use method.

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B) STATISTICAL METHOD (INDIRECT METHOD):

1. Trend Projection Method:

Under the trend projection method which is one of the indirect methods of
demand forecasting, past data is used to project the sales in the coming
years. A firm which has been in existence for a long period has its disposal
considerable data on sales pertaining to different time periods. Forecast for
the future involves gathering of the past information on the subject which
calls for the uses of statistical data which is collected at regular intervals of
time. This type of data is known as “time series”. Thus, When data for
different points of time are collected for sales, production, imports, exports
etc. say for a period of five years, such data constitute time series. A firm
with a long standing may collect time – series data on sale from its own
sales department. New firms can obtain similar data from other established
firms in the same industry. The time- series data can be used to project the
demand for a product through a graph or least square method. Such data
can be presented graphically or in a tabular form for further analysis.

 This method is simple and less expensive.

 It gives information only about the increasing, decreasing or constant trend
and not the actual quantity likely to be demanded.
 Extension of trend line involves subjectivity and personal judgment
which may vary from person to person. Therefore the result may not be
reliable.
 This method cannot be used for new product.
 It is based on assumption that has happened in the past will happen in
future which is not always true.
 This method cannot be used for short – term estimates and also where
trend is of cyclical nature having turning points of troughs and peaks.

2. Regression Method:

This method makes use of both economic theory and estimation

techniques to generate forecasts from historical data. From the economic
theory, the forecaster identifies the variables which determine the variable
under forecasts. He then estimates the alternatives forms of the
dependence relationship between the dependant (forecasting) variable and
the casual variable, using the historical data on them. The least – square
method is usually used for estimation purposes. He selects the form of
equation (best relation) both on the basis of economic theory and statistical
inference. If forecaster can somehow obtain the likely values of casual

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variables in the prediction period, he can then feed those values into the
estimated equation to obtain the forecast.

Advantages:

 The principal advantage of this method is that it is prescriptive as well as

descriptive that is besides generating demand forecasting, it explains why
demand has been at the level it is .
 The regression method is neither mechanistic like the trend method nor as
subjective as the experts‟ opinion survey method.
 Any social scientist possessing sufficient knowledge of economic theory
and econometric methods can use this method for forecasting purposes.
 Through the regression method, even cross–section data may be used to
predict sales through the regression method. [ The cross selection data are
data of different populations (individual, consumer, consumer from different
regions a country or from different countries etc) measured at the same
point of time]

Limitations:

 The major limitation of regression method of forecasting is that it require

the use of some other forecasting method to estimate the values of the
casual variables in the prediction period. To the extent that forecasts of the
values of casual variables are wrong, the forecasts based on this method
will be wrong.
 As it is true for all statistical methods, the regression method forecasts on
the basis of the past average relationship and so to the extent the future
relationship deviates from the past average, the forecast will be wrong.

3. Economic Indicator Method:

This method of demand forecasting uses the most reliable indicator for
forecasting the demand for the product concerned, e.g. the most
trustworthy indicator for predicting the demand for walking stick, denture
etc. is the relative rise in percentage of old people in total population, for
agricultural product – right indicator is agricultural income etc. Government
and other private institutions publish statistical information which the
demand analyst can use with profit.
The difficulty however lies in identifying the correct indicator. It may be
necessary in case of some good to take more than one indicator for
gauging future demand. In case of certain goods, appropriate indicator
may not be available. This difficulty is more pronounced in case of new
goods.

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 Leading Indicator Method:

Leading Indicator Method of forecasting is also called Barometric method.
This techniques involve statistical indicators, usually time series which,
when combined in certain ways, provide indications of the direction in
which economy or certain industries in it moving. Normally , three series of
indicators are identified:
 Leading Series: There are leading indicators which run in advance of
changes in demand for a particular product. An example of these might be
an increase in the number of building permits granted which would lead to
an increase in demand for building-related products. Such as wood,
concrete and so on. These indicators tend to reflect future market
conditions and comprise those aspects which moves up and down ahead
of some other series Leading indicators can be used as input for forecasts
of aggregate economic variables like gross national product, aggregate
consumer expenditure, aggregate capital expenditure etc.
 Coincidental Series: These indicators coincide with rise or fall in the level
of economic activity or market trends. Some of the examples of the
coincidental series are as under – rate of unemployment, no. of employees
in the non- agricultural sector, gross national product at constant prices etc.
Coincidental indicators are used in confirming or refuting the validity of the
leading indicator used a few months afterwards.
 Lagging Series: Lagging series are those which record change after some
time lag. Some of its indices are- labor cost per unit of manufacturing
output, loan outstanding, lending rates for short-term loan.

4. Simultaneous Equation Method:

Here is a very sophisticated method of forecasting. It is also known as the

„complete system approach‟ or „econometric model building‟. Moreover,
this method is normally used in macro-level forecasting for the economy as
a whole; in this course, our focus is limited to micro elements only. Of
course, as corporate managers, should know the basic elements in such an
approach. The method is indeed very complicated. However, in the days of
computer, when package programmers are available, this method can be
used easily to derive meaningful forecasts. The principle advantage in this
method is that the forecaster needs to estimate the future values of only
the exogenous variables unlike the regression method where he has to
predict the future values of all, endogenous and exogenous variables
affecting the variable under forecast. The values of exogenous variables
are easier to predict than those of the endogenous variables. However,
such econometric models have limitations, similar to that of regression
method

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Unit-III

Cost analysis

Introduction:

The Cost Analysis refers to the measure of the cost – output relationship,
i.e. the economists are concerned with determining the cost incurred in hiring the
inputs and how well these can be re-arranged to increase the productivity (output) of
the firm

In other words, the cost analysis is concerned with determining money value of
inputs (labor, raw material), called as the overall cost of production which helps in
deciding the optimum level of production.

There are several cost concepts relevant to the business operations and decisions
and for the convenience of understanding these can be grouped under two
overlapping categories:

Types of cost concepts in managerial economics

The kind of cost concept to be used in a particular situation depends upon the
business decisions to be made. They are:-

1. Actual Cost and Opportunity Cost

2. Incremental Costs and Sunk Costs

3. Past Cost and Future Costs

4. Short-Run and Long-Run Costs

[Link] and Variable Costs

6. Direct and Indirect Costs

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7. Sunk Shutdown, and Abandonment Costs.

1. Actual Cost and Opportunity Cost:

Actual costs mean the actual expenditure incurred for acquiring or

producing a good or service. In some other alternative uses, opportunity cost can be
defined as the revenue forgone by not making the best alternative use. The concept
of opportunity cost is more important and useful to management in making a
decision among alternatives.
Imputed costs are the costs which are not actually incurred but would have
been incurred in the absence of employment of self-owned factors. For example, in
the case of an owner-manager, very often the cost of managerial functions is
ignored.
An imputed cost is a real cost even though it is not recorded in account books of a
company and management must not ignore it in making business decisions.

2. Incremental Costs (Differential Costs) and Sunk Costs:

Incremental cost is the additional cost due to a change in the level or

nature of business activity. The change may take several forms, e.g., adding a new
product line, changing the channel of distribution, adding a new machine, replacing a
machine by better machine, expanding to additional markets, etc. Thus, the question
of incremental or differential cost would not arise when a business is to be set up
afresh. It arises only when a change is contemplated in the existing business.
Sunk cost is one which is not affected or altered by a change in the level or nature of
business activity. It will remain the same whatever the level of activity is. The most
important example of sunk cost is the amortization of past expenses, e.g.,
depreciation.
The distinction between sunk cost and increment cost assumes importance in
evaluating alternatives. Incremental costs will be different in the case of different
alternatives. Hence incremental costs are relevant to the management in the
analysis for decision making.
Sunk cost, on the other hand, will remain the same irrespective of the
alternative selected. Thus, it need not be considered by the management in
evaluating the alternatives as it is common to all of them.

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3. Past Cost and Future Costs:

Past costs are actual costs incurred in the past and are generally contained in
the financial accounts. The measurement of past costs is essentially a record-
keeping activity and an essentially passive function insofar as the management is
concerned. These costs can merely be observed and evaluated in retrospect.

4. Short-Run and Long-Run Costs:

Short-run costs are costs that vary with output when fixed plant and capital
equipment remain the same. Long-run costs are those which vary with the output
when all input factors including plant and equipment vary.
Short-run costs become relevant when a firm has to decide whether or not to
produce more in the immediate future. In this case setting up of a new plant is ruled
out and the firm has to

manage with the given plant. Long-run costs become relevant when the firm has to
decide whether to set up a new plant.
Long-run costs can help the businessman in planning the best scale of plant
or the best size of the firm for his purposes. Thus, long-run costs can be helpful both
in the initiation of new enterprises and the expansion of existing ones.

[Link] and Variable Costs:

Total costs can be divided into two components – fixed costs and variable
costs. Fixed costs remain constant in total regardless of changes in volume up to a
certain level of output. They will have to be incurred even when output is nil. There is
an inverse relationship between volume and fixed costs per unit. Thus, total fixed
costs do not change with a change in volume but vary per unit of volume inversely
with volume.
If the total production increases, fixed costs per unit will go down and vice
versa. Total variable costs vary in direct proportion to changes in volume. An
increase in volume means a proportionate increase in the total variable costs and
decrease in volume results in a proportionate decline in the total variable costs.
There is a linear relationship between volume and total variable costs, but variable
costs are constant per unit.
The distinction between fixed and variable costs, however, is not a watertight
one. Cost may be fixed and variable in each different management decision. Again, it
may be noted that the variability of costs is in relation to output and not to the time
factor, though in the long run all costs tend to be variable. What is fixed at one level
of output may become variable at another level of output.

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6. Direct and Indirect Costs (Traceable and Common Costs):

A direct or traceable cost is one which can be identified easily and

indisputably with a unit of operation (costing unit/cost centre). Common or indirect
costs are those that are not traceable to any plant, department or operation, or to
any individual final product. To take an example, the salary of a divisional manager,
when division is a costing unit, will be a direct cost.
The monthly salary of the general manager, when one of the divisions is a
costing unit, will be an indirect cost. The salary of the manager of the other division is
neither a direct nor an indirect cost. Thus, whether a specific cost is direct or indirect
depends upon the costing unit under consideration. The concepts of direct and
indirect costs are meaningless without identification of the relevant costing unit.

Common Production Costs (Costs of Multiple Products):

In some manufacturing enterprises, two or more different products emerge

from a single, common production process and a single raw material. A familiar
example is the variety of petroleum products derived from the refining of crude oil.
So also in a shoe factory, the same piece of leather may be used for men’s,
women’s, and children’s shoes.
However, for managerial analysis, these costs need not be identified with
individual products unless it is meaningful and useful to identify them.

7. Sunk, Shutdown, and Abandonment Costs:

A past cost resulting from a decision which can no more be revised is called
a sunk cost. In other words, sunk cost is a cost once incurred but cannot be
retrieved. It is usually associated with the commitment of funds to specialized
equipment or other facilities not readily adaptable to present or future use, e.g.,
brewery plant in times of prohibition.

Production Function:

Definition: The Production Function shows the relationship between the quantity
of output and the different quantities of inputs used in the production process. In
other words, it means, the total output produced from the chosen quantity of various
inputs.

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Generally, production is the transformation of raw material into the finished

goods. These raw materials are classified as land, labor, capital or natural resources.
These may be fixed or variable depending upon the nature of the business.

This function establishes the physical relationship between these inputs and
the output. The efficiency of this relationship depends on the different quantities used
in the production process, the quantities of output and the productivity at each point.
It can be shown algebraically:

O = f (I1, I2, I3, I4…….. Zn)

Where, O = quantity of output

I1, I2, I3 = Quantity of different inputs

It can be classified on the basis of the substitutability of the inputs by other

inputs:

1. Fixed Proportion Production Function

2. Variable Proportion Production Function
3. Linear Homogeneous Production Function
4. Cobb. Douglas Production Function

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5. Constant Elasticity of Substitution

Thus, it is a comprehensive function that involves different activities
ranging from the production of output from the given inputs and its distribution by the
marketing division of the organization.

1. Fixed Proportion Production Function

Definition: The Fixed Proportion Production Function, also known as

a Leontief Production Function implies that fixed factors of production such as
land, labor, and raw materials are used to produce a fixed quantity of an output and
these production factors cannot be substituted for the other factors.

In other words, fixed quantity of inputs is used to produce the fixed quantity of
output. All the factors of production are fixed and cannot be substituted for one
another. Suppose there are 50 workers required to produce 500 units of a product,
then the technical Coefficient of production will be 1/10. In the case of a fixed
proportion production function, this one tenth of labor must be employed for the
production of fixed output and no other factors of production can be substituted in
place of labor.

The concept of fixed proportion production function can be further understood with
the help of a figure as shown below:

2. Variable Proportion Production Function

The Variable Proportion Production Function implies that the ratio in which
the factors of production such as labor and capital are used is not fixed, and it is
variable. Also, the different combinations of factors can be used to produce the given
quantity, thus, one factor can be substituted for the other

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In the case of variable proportion production function, the technical Coefficient

of production is variable, i.e. the required quantity of output can be achieved through
the combination of different quantities of factors of production, such as these factors
can be varied by substituting other factor/ factors in its place.

Suppose 40 workers are required to produce 200 units of a product, then

technical Coefficient of production will be 1/5. In the case of a variable proportion
production function, one fifth of labor is not necessarily to be employed, but however,
the different combinations of factors of production can be used to produce a given
level of output. Thus, the labor can be substituted for any other factors.

The concept of variable proportion production function can be further understood

from an is quant curve, as shown in the figure below:

In the figure, the is quant curves show that the different combinations of factors of
technical substitution can be employed to get the required amount of output. Thus,
for the production of a given level of product, the input factors can be substituted for
the other.
[Link] Homogeneous Production Function

Definition: The Linear Homogeneous Production Function implies that with the
proportionate change in all the factors of production, the output also increases in the
same proportion. Such as, if the input factors are doubled the output also gets
doubled. This is also known as constant returns to a scale.

The production function is said to be homogeneous when the elasticity of substitution

is equal to one. The linear homogeneous production function can be used in the
empirical studies because it can be handled wisely. That is why it is widely used in
linear programming and input-output analysis. This production function can be
shown symbolically:

nP = f(nK, nL)

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Where,

n = number of times
nP = number of times the output is increased
nK= number of times the capital is increased
nL = number of times the labor is increased

Thus, with the increase in labor and capital by “n” times the output also
increases in the same proportion. The concept of linear homogeneous production
function can be further comprehended through the illustration given below:

In the case of a linear homogeneous production function, the expansion is

always a straight line through the origin, as shown in the figure. This means that the
proportions between the factors used will always be the same irrespective of the
output levels, provided the factor prices remains constant.
[Link]-Douglas Production Function:

Definition: The Cobb-Douglas Production Function, given by Charles W. Cobb

and Paul H. Douglas is a linear homogeneous production function, which implies,
that the factors of production can be substituted for one another up to a certain
extent only.

With the proportionate increase in the input factors, the output also increases in
the same proportion. Thus, there are constant returns to a scale. In Cobb-Douglas
production function, only two input factors, labor, and capital are taken into the
consideration, and the elasticity of substitution is equal to one. It is also assumed
that, if any, of the inputs, is zero, the output is also zero.

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Likewise, in the linear homogeneous production function, the expansion path

generated by the cobb-Douglas function is also a straight line passing through the
origin. The CD function can be expressed as follows:

Q = ALαKβ

Where, Q = output
A = positive constant
K = capital employed
L = Labor employed
α and β = positive fractions shows the elasticity coefficients of outputs
for inputs labor and capital, respectively.
Β = 1-α

This algebraic form of Cobb-Douglas function can be changed in a log linear

form, with the help of regression analysis:

Log Q = log A + α log L + β log K

The homogeneity of the Cobb-Douglas production function can be checked by

adding the values of α and β. If the sum of these parameters is equal to one, then it
shows that the production function is linearly homogeneous, and there are constant
returns to a scale. If the sum of these parameters is less or more than one, then
there is a decreasing and increasing returns to a scale respectively.

5. Constant Elasticity of Substitution Production Function:

Definition: The Constant Elasticity of Substitution Production Function or

CES implies, that any change in the input factors, results in the constant change in
the output. In CES, the elasticity of substitution is constant and may not necessarily
be equal to one or unity

Where, Q = output, K = Capital and L = Labor

A = efficiency parameter that shows the organizational aspects of production and the
state of technology.

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The Constant elasticity of substitution production function shows, that any

change in the technology or organizational aspects, the production function changes
with a shift in the efficiency parameter.

α= distribution parameter or capital intensity factor coefficient concerned with relative

factors in the total output.

Φ = substitution parameter, that determines the elasticity of substitution

The homogeneity of the production function can be determined by the value

of the substitution parameter (Φ), if it is equal to one, then it is said to be linearly
homogeneous i.e. the proportionate change in the input factors results in the
increase in the output in the same proportion.

In constant elasticity of substitution production function, all the input factors

are taken into the consideration such as raw material, technology, labor, capital, etc.
The marginal product of one factor increases with the increase in the value of the
other factors of production. Also, the marginal product of labor and capital will be
positive in case of constant returns to scale.

Returns to Scale:
The long run refers to a time period where the production function is defined
on the basis of variable factors only. No fixed factors exist in the long run and all factors
become variable. Thus, the scale of production can be changed as inputs are changed
proportionately. Thus, returns to scale are defined as the change in output as factor
inputs change in the same proportion. It is a long run concept.

Types of Returns to Scale

There are three defined types of returns to scales, which include:

1. Increasing Returns to Scale

When the output increases more than proportionately when all the inputs increase
proportionately, it is known as increasing returns to scale. This represents a kind of
decreasing the cost to the firm. External economies of scale might be one of the
reasons behind such increase in output in increasing returns to scale. Thus, when
inputs double, output more than doubles in this case.

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2. Decreasing Returns to Scale

When the output increases less than proportionately as all the inputs increase
proportionately, we call it decreasing returns to scale or diminishing returns to scale.
In this case, internal or external economies are normally overpowered by internal or
external diseconomies. Thus, if we double the inputs, the output will increase but by
less than double.

3. Constant Returns to Scale

When the output increases exactly in proportion to an increase in all the inputs or
factors of production, it is called constant returns to scale. For example, if twice the
inputs are used in production, the output also doubles. Thus, constant returns to
scale are reached when internal and external economies and diseconomies
balance each other out.

A regular example of constant returns to scale is the commonly used Cobb-Douglas

Production Function (CDPF). The figure given below captures how the production
function looks like in case of increasing/decreasing and constant returns to scale.

Break Even Analysis

Introduction to Break Even Analysis:

The sales volume which equates total revenue with related costs and results in
neither profit nor loss is called break-even point (BEP). Break-even point can be
determined by the following methods:

Definition:

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Break-even indicates a situation where; there is no profit or loss for a business.

“Break-even analysis is undertaken to calculate the level of output and or sales
revenue at which a business makes neither a profit nor loss”.
In its broad sense it may be used to determine the probable profit or loss at any
given output level. Contribution per unit becomes net profit per unit one break-even
point is reached.

the main types of break even analysis is follow;

[Link] methods:

 Contribution Margin Approach

 Equation technique

[Link] presentation:

 Break-even chart
 Profit volume chart

Algebraic Methods

Contribution Margin Approach

Equation Technique

It is based on an income equation i.e.

Sales – Total costs = Net profit.

Breaking up total costs into fixed and variable,

Sales – Fixed costs – Variable cost = Net profit

Sales = Fixed costs + Variable cost + Net profit

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i.e.,.

SP(S) = FC + VC(S) + P

Where;

SP = Selling price per unit

S = Number of units required to be sold to break-even

FC = Total fixed costs

VC = Variable cost per unit

P = Net profit (Zero)

SP(S) = FC + VC(S) + Zero

SP(S) = FC + VC(S) + 0

SP(S) – VC(S) = FC

or

S(SP – VC) = FC

S = FC / (SP−VC )

To calculate the level of sales required to earn a particular level of profit, the formula
is:

Required Sales (in) = (Fixed cost +Desired profit_ / P/V Ratio

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[Link] Presentation

Break-even chart

According to the Chartered Institute of Management Accountants, London the break-

even chart means “a chart which shows profit or neither loss at various levels of
activity, the level at which neither profit nor loss is shown being termed as the break-
even point”.

It is a graphic relationship between costs, volume and profits. It shows not only the
BEP but also the effects of costs and revenue at varying levels of sales. The break-
even chart can therefore, be more appropriately called the cost-volume-profit graph.

Break Even Analysis with Diagram:

Break even chart may be prepared in different forms and styles; but they all in
addition to break-even point indicate revenues, costs, profits or losses on different
output levels. Usually a break-even cahart is prepared in the following form diagram:

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Preparation Method, Procedure and Explanation of the Break-Even Chart:

(1) It is customary to use the horizontal axis for units of output and vertical axis for
monetary values like sales, revenue and total costs.

(2) Sales revenue line makes an angle of 45o and start from (0,0).
(3) As fixed costs remain the same at all output levels so fixed cost line is drawn
across the chart as a straight line parallel to the horizontal axis.

(4) The variable cost lines commences on the vertical axis from the same point
where fixed cost line intersects the vertical axis. This is to show total cost on the
chart.

(5) On the chart, break even point represents the point at which total cost and total
revenue lines cross each other.
(6) The break-even point so determined tells the reader that the break-even point in
terms of units of output on the horizontal axis and in terms of sales revenue and total
costs on the vertical axis.

(7) Shaded area below the break-even point indicates losses, whereas shaded area
above the break-even point indicates profits.

(8) Profit and loss on break even chart may be determined by looking at the vertical
distance between the sales revenue and total cost line.

(9) The difference between the prevailing sales and the break even sales
represents margin of safety, both in terms of sales revenue and output level.

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(10) If breakeven point appears well over the right side of the chart then it would
imply too high total fixed costs or low contribution. This will result in lower margin of
safety.

(11) If the breakeven point over to the left side of the chart coupled with a large angle
of incidence then it would imply either lower total fixed costs or high contribution.

Assumptions and Limitations of Break Even Analysis:

the following are the assumptions and limitations of the break even analysis.

Assumptions:

 Costs are bifurcated into variable and fixed components.

 Fixed costs will remain constant and will not change with change in level of
output.
 Variable cost per unit will remain constant during the relevant volume range of
graph.
 Selling price will remain constant even though there maybe competition or
change in volume of production.
 The number of units produced and sold will be the same so that there is no
operating or closing stock.
 There will be no change in operating efficiency.

Limitations:
(1) The existence of semi variable costs is ignored, whereas most of the costs are
not either perfectly fixed or perfectly variable.

(2) Fixed costs may change if output increases or decreases substantially.

(3) Possible changes in per unit variable costs due to various reasons like bulk
buying discounts, overtime, etc., are ignored.

(4) Sales price may have to be reduced to win the extra sales or may be increased to
cover increased costs.

(5) As discussed above selling prices and variable costs per unit vary at different
output levels.

(6) Various external factors like inflation rate, economic state may also affect sales
volume.

(7) This restricts its usefulness as it is difficult to experience in practice.

(8) The technology, production methods may change in practice.

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(9) As a result it ignores the possibility of any increase in inventory levels (when
production volume exceeds sales volume) or ‘de-stocking’, (when sales volume
exceeds production levels).

Importance/Significance:
Despite of its limitations, break even analysis is a useful technique for
managers in the following cases:

(1) To make a feasibility before starting a new business.

(2) To determine the selling price or the desired sales mix for earning target
profits.
(3) To measure profits or losses for the businesses for different output levels.

(4) To calculate lowest possible activity level without putting the business in
jeopardy.

(5) To evaluate alternatives available and special orders as a part of decision

making process

Managerial Uses of Break-Even Analysis:

 Product planning: it helps the firm in planning its new product

development. Decisions regarding removal or addition of new products in
their product line.
 Activity planning: the firm decides the expansion of production capacity.
 Profit planning: this helps the firm to plan about their profit well in advance
and at the same time it helps to identify the quantity to be sold to achieve
the targeted profit.
 Target capacity: the targeted sales quantity helps to decide the purchase,
inventory and management.
 Price and cost decision: Decision regarding how much the price of the
commodity should be reduced or increased to cover their cost of production.
 Safety margin: it helps to understand the extent to which the firm can
withstand their fall in sales.
 Price decision: the selling price can be fixed based on its expected
revenue or profit.
 Promotional decision: the firm can decide the kind of promotion required
and how much amount could be spent.
 Distribution decision: Break even analysis helps to improve the
distribution system and for business expansion.

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 Dividend decision: firm can decide the dividend to be fixed for their
shareholders.
 Make or buy decision: break even analysis helps to decide on whether to
make or buy the product. It means outsourcing or in house production.
We can conclude that the break – even analysis is a useful tool for decision
making at various levels of a business firm in the short and long run. Therefore it is
an essential tool to be used by the Managers.

A break-even chart can be presented in different forms.

First Method of Break even chart:

On the X-axis of the graph is plotted the volume of productions or the quantities of
sales and on the Y-axis (vertical line) costs and sales revenues are represented. The
fixed costs line is drawn parallel to X-axis. The variable costs for different levels of
activity are plotted over the fixed cost line, which shows that the cost is increasing
with the increase in the volume of output. The variable cost line is joined to fixed cost
line at zero volume of production. This line is regarded as the total cost line. Sales
values at various levels of output are plotted from the origin and joined is called the
sales line. The sales line will cut the total cost line at a point where the total costs
equal to total revenues and this point of intersection of two lines is known as break-
even point or the point of no profit no loss. The lines produced from the inter-section
to Y-axis and X-axis may give sales value and the number of units produced at
break-even point respectively. Loss and profit are as have been shown in the chart
which shows that if production is less than the break-even point, the business shall
be running at a loss and if the production is more than the breakeven level, there will
be profit. The angle which the sales line makes with total cost line while intersecting
it at BEP is called angle of incidence. A large angle of incidence denotes a good
profit position of a company.

Illustration 2

From the following data, calculate the break-even point by means of a break-even
chart:

Selling price per unit Variable cost per unit Total fixed cost

Solution:

Selling price per unit = 15

Variable cost per unit = 10

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Total fixed cost = 1,50,000

For plotting the data, we need at least two points – one for plotting the total cost line
and other for plotting the total sales line. Therefore, it will be necessary to presume
different levels of output and sales as below:

Second Method of Break even chart

This is variation of the first method in which variable cost line is drawn first and
thereafter drawing the fixed cost line above the variable cost line. The later line will
be the total cost line. The sales line is drawn as usual. The added advantage of this
method is that contributions at various levels of output are automatically depicted in
the chart.

Contribution break-even chart: The chart helps in ascertaining the amount of

contribution at different levels of activity besides the break-even point. In this
method, the fixed cost line is drawn parallel to the X-axis. The contribution line is
then drawn from the origin which goes up with the increase in output. The sales line
is plotted as usual, but the question of intersection of sales line with cost line does
not arise. The contribution line crosses the fixed cost line and the point of
intersection is treated as break-even point. At this point, contribution is equal to fixed
expenses and there is no profit or loss. If the contribution is more than the fixed
expenses, profit will arise and if the contribution is less than the fixed expenses, loss
will arise.

Profit-volume Graph: Profit volume graph is the graphical representation of the

relationship between profit and volume. Separate lines for costs and revenues are
eliminated from the P/V graph as only profit points are plotted. It is based on the
same information as is required for the traditional break-even chart and is
characterized by the same limitations. The steps in the construction of profit volume
graph are as follows:

 Profit and fixed costs are represented on the vertical axis.

 Sales are shown on the horizontal axis.
 The sale line divides the graph into two parts both horizontally and vertically.
The area above the horizontal line is the ‘profit area’ and that below it is the
‘loss area’ at which fixed costs are represented on the vertical axis below the
sale line and profits on the same axis above the sale line.
 Profits and fixed costs are plotted for corresponding sales volume and the
points are joined by a line which is the profit line.

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Illustration 5

Sales are 1, 50,000, producing a profit of 4,000 in period I. Sales are 1,90,000,
producing a profit of 12,000 in period II. Determine the BEP.

Solution:

The Question may be presented in the given format:

Behavior of Cost in the Short Run:

Short-run costs are important to understanding costs in economics. The distinction
between short-run and long-run based on fixed and variable factors of
production makes the concept of understanding short run costs simpler. Let us
understand the concepts by way of examples, diagrams for graphical representation.

Make-or-Buy Decision

What is a Make-or-Buy Decision?

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A make-or-buy decision refers to an act of using cost-benefit to make a strategic

choice between manufacturing a product in-house or purchasing from an external
supplier. It arises when a producing company faces a diminishing capacity,
experiences problems with the current suppliers, or sees changing demand.

The make-or-buy decision compares the costs and benefits that accrue by
producing a good or service internally against the costs and benefits that result from
subcontracting. For an accurate comparison of costs and benefits, managers need to
evaluate the benefits of purchasing expertise against the benefits of developing and
nurturing the same expertise within the company.

Summary:

 A make-or-buy decision refers to an act of choosing to develop a product in-

house or outsource its production from external vendors.
 Companies use the total transaction costs accrued in developing products to
reach a make-or-buy decision.
 Make-or-buy decisions reward firms with a competitive advantage and reduce
the cost of production and capital investment.

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Understanding Make-or-Buy Decisions

Managers must incorporate in-house production costs when considering in-

house production. It includes all the transaction costs involved in creating the product
or service. It can also include extra labor needed for production, monitoring costs,
storage requirements costs, and waste product disposal costs resulting from the
production process.

Similarly, businesses must focus on both the production and transaction costs when
considering outsourcing from outside suppliers. For example, the product’s price,
sales tax charges, and shipping costs must be factored in. Companies must also
include inventory holding costs, which comprise warehousing and handling costs, as
well as risk and ordering costs.

The make-or-buy decision is sometimes treated as a financial or accounting

decision. While it is important to conduct an accounting assessment and settle for
the low-cost approach, it is more crucial to understand the basis of the decision.

Thus, companies must consider the strategic dimension of make-or-buy choices

because they determine the profitability of the company and play an important role in
its financial health. They can impact corporate strategy, core competence, cost
structure, customer service, and flexibility.

Make-or-Buy Decision Triggers

A company’s decision on whether to make or buy is based on its core

competence. The production cost and quality problems are the major triggers of a
make-or-buy decision. Other factors are managerial decisions and a company’s
long-term business strategy that dictate the current operations pattern.

Historical policy decisions may also compel a company to consider in-sourcing

or outsourcing. Businesses can use such patterns to procure some parts of services
from outside suppliers regardless of the company’s capability. Within the framework,
the trend towards in-sourcing can be attributed to better quality control, existing idle
production capacity, or unsatisfactory performance of outside suppliers.

In contrast, factors that may trigger a company to outsource a part rather than
produce internally include the need for multiple sourcing, lack of internal expertise,
cost reduction, the introduction of a new product or modification of an existing
product or service, and reduced risk exposure. A company with a previous reputation
for successfully providing outsourcing services may be considered to sustain a long-
term relationship.

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Make-or-Buy Decision Criteria

Setting up a standard make-or-buy process that applies to all companies is a

complicated process. It is partly due to companies’ distinct behavior patterns and the
fact that businesses operate in different business environments that are unique to
each business. However, cost accounting remains the primary dimension of the
make-or-buy decision.

Companies evaluate outsourcing to determine if the current overhead costs

can be minimized to access new resources. While cost remains the hallmark of any
business decision, other factors such as strategic, technological, core competency,
risks, and relationships, also constitute outsourcing decisions, not to mention factors
involved in developing and introducing a new product.

For example, managers can consider research and development (R&D),

design, engineering, manufacturing, and assembly as sources of production costs
when conducting an actual cost analysis. The competitors’ financial capabilities and
technological abilities should also be evaluated during a sourcing decision.
Companies can evade the pitfalls typical with make-or-buy decisions when the cost
is the only variable used when considering the technological aspects.

Benefits of a Make-or-Buy Decision:

A make-or-buy decision framework relates to autonomy, and a company selects from

the many advanced options to account for various factors associated with
outsourcing.

1. Lower costs and higher capital investments

One of the most notable advantages that a company enjoys when embracing a
make-or-buy decision approach is that it can lower costs and increase capital
investments, regardless of whether it decides to make materials in-house or
subcontract from an external vendor.

2. Source of competitive advantage

A rigorous make-or-buy analysis can also act as a source of competitive

advantage. For example, a company can increase the value it delivers to customers
and shareholders from its core service and skills. It can also stay flexible by adopting
a make-or-buy decision approach.

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Such a company is better placed to weather the storm of a market downturn.

To realize the benefits, companies must consider the internal and external
environment in which they operate. In particular, the culture in which such decisions
are reached, and the agenda of the parties involved can influence the decisions and
their implementation, as well as the sustainability of the policy.

The Concept of Short Run

It is key to understand the concept of the short run in order to understand short run
costs. In economics, we distinguish between short run and long run through the
application of fixed or variable inputs.

Fixed inputs (plant, machinery, etc.) are those factors of production that cannot be
changed or altered in a short span of time because the time period is ‘too small’. This
makes the short run. Here, the inputs are of two types: fixed and variable.

In the long-run, all the inputs become variable (eg. raw materials). By this, we mean
that all inputs can be changed with a change in the volume of output. Thus, the concept
of fixed inputs applies only to the short-run. It is to short-run costs that we now turn.

Short Run Cost Function

The cost function is a functional relationship between cost and output. It explains that
the cost of production varies with the level of output, given other things remain the
same (ceteris paribus). This can be mathematically written as:

C = f(X)

where C is the cost of production and X represents the level of output.

Total Fixed Cost

Fixed cost refers to the cost of fixed inputs. It does not change with the level of output
(thus, fixed). Fixed inputs include building, machinery etc. Hence the cost of such
inputs such as rent or cost of machinery constitutes fixed costs. Also referred to
as overhead costs, supplementary costs or indirect costs, these costs remain the same
irrespective of the level of output.

Hence, if we plot the Total Fixed Cost (TFC) curve against the level of output on the
horizontal axis, we get a straight line parallel to the horizontal axis. This indicates that

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these costs remain the same and that they have to be incurred even if the level of
output is zero.

Total Variable Cost

The cost incurred on variable factors of production is called Total Variable Cost (TVC).
These costs vary with the level of output or production. Thus, when production level is
zero, TVC is also zero. Thus, the TVC curve begins from the origin.

The shape of the TVC is peculiar. It is said to have an inverted-S shape. This is
because, in the initial stages of production, there is scope for efficient utilization of fixed
factor by using more of the variable factor (eg. Workers employing machinery).

Hence, as the variable input employed increases, the productive efficiency of variable
inputs ensures that the TVC increases but at a diminishing rate. This makes the first
part of the TVC curve that is concave.

As the production continues to increase, more and more variable factor is employed for
a given amount of fixed input. The productive efficiency of each variable factor falls and
it adds more to the cost of production. So the TVC increases but now at an increasing
rate. This is where the TVC curve is convex in shape. And so the TVC curve gets an
inverted-S shape.

Total Cost
Total cost (TC) refers to the sum of fixed and variable costs incurred in the short-run.
Thus, the short-run cost can be expressed as

TC = TFC + TVC

Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of the
TC curve by summing over TFC and TVC curves.

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The following can be noted about the TC curve:

 The TC curve is inverted-S shaped. This is because of the TVC curve.

Since the TFC curve is horizontal, the difference between the TC and TVC
curve is the same at each level of output and equals TFC. This is
explained as follows: TC – TVC = TFC

 The TFC curve is parallel to the horizontal axis while the TVC curve is
inverted-S shaped.

 Thus, the TC curve is the same shape as TVC but begins from the point of
TFC rather than the origin.

 The law that explains the shape of TVC and subsequently TC is called
the law of variable proportions.

Solved Example for You

Question: Comment on the shape of the TC, TVC and TFC curves based on the
following table:

Variable
Output Fixed Cost Total Cost
Cost

0 40 0 40

1 40 20 60

2 40 30 70

3 40 32 72

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4 40 34 74

5 40 36 76

6 40 38 78

7 40 40 80

8 40 46 86

Answer:

1. We see that the Fixed Cost remains the same even as production
increases from 0 to 8 units. Thus the value of FC = 40

2. It can be noted that the Variable Cost increases as the output increases.
The VC increases at a diminishing rate till 7 units of output, after which it
starts increasing at an increasing rate.

3. The final column shows the Total Cost which is the sum of FC and VC and
increases as the output increases.
Long Run Cost Curves
The long run is different from the short run in the variability of factor inputs. Accordingly,
long-run cost curves are different from short-run cost curves. This lesson introduces
you to Long run Total, Marginal and Average costs. You will learn the concepts,
derivation of cost curves and graphical representation by way of diagrams and solved
examples.

The Concept of the Long Run

The long run refers to that time period for a firm where it can vary all the factors of
production. Thus, the long run consists of variable inputs only, and the concept of fixed
inputs does not arise. The firm can increase the size of the plant in the long run. Thus,

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you can well imagine no difference between long-run variable cost and long-run total
cost, since fixed costs do not exist in the long run.

Long Run Total Costs

Long run total cost refers to the minimum cost of production. It is the least cost of
producing a given level of output. Thus, it can be less than or equal to the short
run average costs at different levels of output but never greater.

In graphically deriving the LTC curve, the minimum points of the STC curves at
different levels of output are joined. The locus of all these points gives us the LTC
curve.

Long Run Average Cost Curve

Long run average cost (LAC) can be defined as the average of the LTC curve or the
cost per unit of output in the long run. It can be calculated by the division of LTC by the
quantity of output. Graphically, LAC can be derived from the Short run Average Cost
(SAC) curves.

While the SAC curves correspond to a particular plant since the plant is fixed in the
short-run, the LAC curve depicts the scope for expansion of plant by minimizing cost.

Derivation of the LAC Curve

Note in the figure, that each SAC curve corresponds to a particular plant size. This size
is fixed but what can vary is the variable input in the short-run. In the long run, the firm
will select that plant size which can minimize costs for a given level of output.

You can see that till the OM1 level of output it is logical for the firm to operate at the plat
size represented by SAC2. If the firm operates at the cost represented by SAC2 when
producing an output level OM2, the cost would be more.

So in the long run, the firm will produce till OM1 on SAC2. However, till an output level
represented by OM3, the firm can produce at SAC2, after which it is profitable to
produce at SAC3 if the firm wishes to minimize costs.

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Thus, the choice, in the long run, is to produce at that plant size that can minimize
costs. Graphically, this gives us a LAC curve that joins the minimum points of all
possible SAC curves, as shown in the figure. Thus, the LAC curve is also called
an envelope curve or planning curve. The curve first falls, reaches a minimum and then
rises, giving it a U-shape.

We can use returns to scale to explain the shape of the LAC curve. Returns to scale
depict the change in output with respect to a change in inputs. During Increasing
Returns to Scale (IRS), the output doubles by using less than double inputs. As a
result, LTC increases less than the rise in output and LAC will fall.

 In Constant Returns to Scale (CRS), the output doubles by doubling the

inputs and the LTC increases proportionately with the rise in output. Thus,
LAC remains constant.

 In Decreasing Returns to Scale (DRS), the output doubles by using more

than double the inputs so the LTC increases more than proportionately to
the rise in output. Thus, LAC also rises. This gives LAC its U-shape.

Long Run Marginal Cost

Long run marginal cost is defined at the additional cost of producing an extra unit of the
output in the long-run i.e. when all inputs are variable. The LMC curve is derived by the
points of tangency between LAC and SAC.

Note an important relation between LMC and SAC here. When LMC lies below LAC,
LAC is falling, while when LMC is above LAC, LAC is rising. At the point where LMC =
LAC, LAC is constant and minimum.

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Solved Example for You

Question: Why is the LAC also called the envelope curve?

Answer: The LAC curve suggests the long run optimization problem of the firm. The
firm can choose a plant size to operate at in the long-run where all inputs are variable.
Thus, the firm shall choose that plant at which it can minimize costs.

So, the LAC is derived by joining the minimum most points of all possible SAC curves
of the firm at different output levels. Since the LAC thus obtained almost ‘envelopes’
the SAC curves faced by the firm, it is called the envelope curve.

What Is a Learning Curve?

A learning curve is a concept that graphically depicts the relationship between the
cost and output over a defined period of time, normally to represent the repetitive
task of an employee or worker. The learning curve was first described by
psychologist Hermann Ebbinghaus in 1885 and is used as a way to
measure production efficiency and to forecast costs.

In the visual representation of a learning curve, a steeper slope indicates initial

learning translates into higher cost savings, and subsequent learning’s result in
increasingly slower, more difficult cost savings.

 The learning curve is a visual representation of how long it takes to acquire

new skills or knowledge.
 In business, the slope of the learning curve represents the rate in which
learning new skills translates into cost savings for a company.
 The steeper the slope of the learning curve, the higher the cost savings per
unit of output.

Understanding Learning Curves

The learning curve also is referred to as the experience curve, the cost curve, the
efficiency curve, or the productivity curve. This is because the learning curve
provides measurement and insight into all the above aspects of a company. The
idea behind this is that any employee, regardless of position, takes time to learn
how to carry out a specific task or duty. The amount of time needed to produce the
associated output is high. Then, as the task is repeated, the employee learns how
to complete it quickly, and that reduces the amount of time needed for a unit of
output.

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That is why the learning curve is downward sloping in the beginning with a flat slope
toward the end, with the cost per unit depicted on the Y-axis and total output on the
X-axis. As learning increases, it decreases the cost per unit of output initially before
flattening out, as it becomes harder to increase the efficiencies gained through
learning.

Learning Curve Example

The learning curve phenomenon is often characterized as a constant percentage
decline in average costs as cumulative output increases. This percentage represents
the proportion by which unit costs decline as the cumulative quantity of total output
doubles. Suppose, for example, that average costs per unit for a new product were
$100 during 2001 but fell to $90 during 2002.

Learning Curve Long run Average Cost

Long-Run Average Cost Curve Effects of Learning

Furthermore, assume that average costs are in constant dollars, reflecting an

accurate adjustment for input/price inflation and an identical basic technology being
used in production. Given equal output in each period to ensure that the effects of
economies of scale are not incorporated in the data, the learning or experience rate,
defined as the percentage by which average cost falls as output doubles, is the
following:

Thus, as cumulative total output doubles, average cost is expected to fall by 10

percent. If annual production is projected to remain constant, it will take 2 additional
years for cumulative output to double again. One would project that average unit
costs will decline to $81 (90 percent of $90) in 2004. Because cumulative total output
at that time will equal 4 years’ production, at a constant annual rate, output will again

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double by 2008. At that time, the learning curve will have reduced average costs to
$72.90 (90 percent of $81).

Supply Function:

Law of supply states that when the price of a commodity increases its supply also
increases. Similarly, when the price of a commodity decreases its supply also
decreases. Hence, there is a direct relationship between price and supply of a
commodity. However, here we shall study the Supply Function in detail.

Supply Function

It explains the relationship between the supply of a commodity and the factors
determining its supply. We can better represent the supply function in the form of the
following equation:

Sx = f (Px, PI, T, W, GP)

Where,

Sx = supply of commodity x

Px = Price of commodity x

PI = Price of inputs

T = Technology

W = Weather conditions

GP = Government Policy

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Determinants of supply

The factors on which the supply of a commodity depends are known as the
determinants of demand. These are:

 Price of the Commodity

 Firm Goals

 Price of Inputs or Factors

 Technology

 Government Policy

 Expectations

 Prices of other Commodities

 Number of Firms

 Natural Factors

1. Price of the Commodity

It is the main and the most important determinant of demand. When the price of
the commodity is high, the producers or suppliers are willing to sell more commodities.

Thus, the supply of the commodity increases. Similarly, when the price is low the
supply of the commodity decreases owing to the direct relationship between the price
of a commodity and its supply.

2. Firm Goals
The supply of goods also depends on the goals of an organization. An organization
may have various goals such as profit maximization, sales maximization, employment
maximization, etc.

Where the firm’s objective is the maximization of profit, it will sell more goods when
profits are high and less quantity of goods when the profits are low.

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3. Price of Inputs or Factors

The price of inputs or the factors of production such as land, labor, capital, and
entrepreneurship also determine the supply of the goods. When the price of inputs is
low the cost of production is also low.

Thus, at this point, the firms tend to supply more goods in the market and vice-versa.

4. Technology
When a firm uses new technology it saves the inputs and also reduces the cost of
production. Thus, firms produce more and supply more goods.

5. Government Policy
The taxation policies and the subsidies given by the government also impact the supply
of goods.

When the taxes are high the producers are unwilling to produce more goods and thus,
the supply will decrease.

On the other hand, when the government grants various subsidies and gives financial
aids to the producers, they increase the production of goods. Thus, the supply also
increases.

6. Expectations
When the producers or suppliers expect that the price shall increase in future they
hoard the goods so that they can sell them at higher prices later. This will result in a
decrease in the supply of goods.

Similarly, in case they expect a fall in price, they will increase the supply of goods.

7. Prices of other Commodities

When the price of complementary goods increases their supply also increases. Thus,
this results in the increase in the supply of commodity also and vice-versa.

Also, when the price of the substitutes increases their supply also increases. This
results in a decrease in the supply of goods.

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8. Number of Firms
When the number of firms in the market increase the supply of goods also increases
and vice-versa.

9. Natural Factors
The factors like weather conditions, flood, drought, pests, etc. also affect the supply of
goods. When these factors are favorable the supply will increase.

Elasticity of Supply: Elasticity of supply of a commodity is defined as the

responsiveness of a quantity supplied to a unit change in price of that commodity.

ΔQs / Qs
Es = ------------
ΔP/P

ΔQs = change in quantity supplied

Qs = quantity supplied
ΔP = change in price
P = price

Kinds Of Supply Elasticity

Price elasticity of supply: Price elasticity of supply measures the responsiveness
of changes in quantity supplied to a change in price.
Perfectly inelastic: If there is no response in supply to a change in price. (Es = 0)
Inelastic supply: The proportionate change in supply is less than the change in
price (Es =0-1)
Unitary elastic: The percentage change in quantity supplied equals the change in
price (Es=1)
Elastic: The change in quantity supplied is more than the change in price (Ex= 1- ∞)
Perfectly elastic: Suppliers are willing to supply any amount at a given price (Es=∞)

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Unit-4

Pricing decision

Pricing decision:

Factors Affecting the Pricing Decisions

Price is the only element of marketing mix that helps in generating income.

Therefore, a marketer should adopt a well-planned approach for pricing decisions.

The marketer should know the factors that influence the pricing decisions before
setting the price of a product.

Pricing Objectives:

Pricing decisions are usually considered a part of the general strategy for achieving
a broadly defined goal. While setting the price, the firm may aim at one or more of
the following pricing objectives:

Pricing Objectives are:

1. Maximization of profits for the entire product line

2. Promotion of the long-range welfare of the firm
3. Adaptation of prices to fit the diverse competitive situations
4. Flexibility to vary prices in response to changing market condition
5. Stabilization of prices and margins
6. Market Penetration
7. Market Skimming
8. Early Cash Recovery
9. Satisfying

1. Maximization of profits for the entire product line

Firms set a price, which would enhance the sale of the entire product line rather than
yield a profit for one product only. In this process it is possible to maximize the profit
for the entire product line.

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Example: Starbucks raised the price of the tall size brew exclusively in order to
persuade customers to purchase larger sizes. The goal of the company is to use the
price increases to guide the customer towards your most profitable product.

2. Promotion of the long-range welfare of the firm

Promotion of the long-range welfare of the firm can also influence the pricing
decision The firm may decide to set a price, which looks unattractive to competitors,
and hence, the entry of competitors can be discouraged for a long period of time. In
this way the firm can take a decision for the long-term welfare of the firm rather than
the short-term profit maximization.

Example: The introduction of Low-priced burgers by Mc Donald’s has restricted

entry or success of many burger producers in India. There prolonged strategy to
remain stable in market is not giving boost to any other player.

3. Adaptation of prices to fit the diverse competitive situations:

The Company may decide to go for different kinds of pricing strategies depending on
the individual product’s product-market situation. The company will try to maximize
the profit from a market where it has cash cows and invests in other markets where it
has to stay put for long term benefits.

Example: HUL has launched its products at all the price points to cater to every
market segment. It has its products catering to every strata of the market ranging
from rural to urban and even for niches.

4. Flexibility to vary prices in response to changing market condition

One cannot decide about prices in isolation, as the firm is only a member of the
market. So it has to decide on prices in response to changing economic conditions.
The macro economic conditions also influence the pricing decision.

Example: Many airlines slash their prices when a dip in the market is observed.
They come up with low-frill packages for flyers and special packages for frequent
fliers in the market. Airline companies focus upon gaining customers in their stride.

5. Stabilisation of prices and margins

The firm may decide to stabilize the prices and margins for long term goals and price
the products in a different way than they would have done with a profit maximization
objective.

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Firms may pursue additional objectives as mentioned by Kotler. We present a small

list of these objectives to augment the above list:

[Link] Penetration:

The firm may decide in favor of a lower price to penetrate deeper into the market and
to stimulate market growth and capture a large market share.

Example: When telecom players like ‘Aircel’ and ‘MTS’ entered Indian market, they
found market already saturated. Hence, they adopted strategy of low tariffs to attract
the potential customer base.

[Link] Skimming

The firm may decide to charge high initial price to take advantage of the fact that
some buyers are willing to pay a much higher price than others as the product is of
high value to them.

Example: When a new highway is constructed connecting twocities or states, during

initial few years toll is charged to recover the cost of construction. Thereafter, either
the tax or toll is slashed or removed when the invested amount is recovered.

[Link] Cash Recovery

This is an aggressive form of skimming pricing. Some firms try to set a price, which
will enable them to recover the cash rapidly as they may be financially tight or may
regard the future as too uncertain to justify a delayed and smooth cash recovery.

Example: Apple when ever comes up with a new launch of its products, it
commands very high prices on its sales. By the time other mobile industry players
when copy their introduced technology, Apple usually tires to recover the money it
invested in the mobile’s R&D.

[Link]

Companies may pursue a pricing strategy if it satisfies a satisfactory rate of return,

although it is possible for another price level to give a higher return. The pricing
decisions depend on the motives of the manager. The motives of managers can be
of different types.

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Figure- shows the factors that affect the pricing decisions:

Now, let us discuss the factors affecting the pricing decisions (as shown in
Figure-) briefly:

i. Organizational Objectives:

Affect the pricing decisions to a great extent. The marketers should set the
prices as per the organizational goals. For instance, an organization has set a goal
to produce quality products, thus, the prices will be set according to the quality of
products. Similarly, if the organization has a goal to increase sales by 18% every
year, then the reasonable prices have to be set to increase the demand of the
product.

ii. Costs:
Influence the price setting decisions of an organization. The organization may sell
products at prices less than that of the competitors even if it is incurring high costs.
By following this strategy, the organization can increase sales volumes in the short
run but cannot survive in the long run. Thus, the marketers analyze the costs before
setting the prices to minimize losses. Costs include cost of raw materials, selling and
distribution overheads, cost of advertisement and sales promotion and office and
administration overheads.

iii. Legal and Regulatory Issues:

Persuade marketers to change price decisions. The legal and regulatory laws set
prices on various products, such as insurance and dairy items. These laws may lead
to the fixing, freezing, or controlling of prices at minimum or maximum levels.

iv. Product Characteristics:

Include the nature of the product, substitutes of the product, stage of life-cycle of the
product, and product diversification.

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v. Competition:
Affects prices significantly. The organization matches the prices with the competitors
and adjusts the prices more or less than the competitors. The organization also
assesses that how the competitors respond to changes in the prices.

vi. Pricing Objectives:

Help an organization in determining price decisions. For instance, an organization
has a pricing objective to increase the market share through low pricing. Therefore, it
needs to set the prices less than the competitor prices to gain the market share.
Giving rebates and discounts on products is also a price objective that influences the
customer’s decisions to buy a product.

vii. Price Elasticity of Demand:

Refers to change in demand of a product due to change in price.

There are three situations that arise under it:

a. Products that have inelastic demand will be highly priced

b. Products that have more than elastic demand will be priced low

c. Products that have elastic demand will be reasonably priced.

viii. Competitor’s pricing Policies:

Influence the pricing policies of the organizations. The price of a product should be
determined in such a way that it should easily face price competition.

ix. Distribution Channels:

Implies a pathway through which the final products of manufacturers reach the end
users. If the distribution channel is large, price of the product will be high and if the
distribution channel is short, the price of the product will be low. Thus, these are the
major factors that influence the pricing decisions.

Classification Of Market Structure Based On The Nature Of Competitor:

1. Perfect market
2. Imperfect market

The imperfect market in turn can be classified as

1) Monopoly market
2) Duopoly market
3) Oligopoly market

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4) Monopolistic market/competition
The number and relative size of firms producing a good vary across industries.
Market structures range from perfect competition to monopoly. Most real-world firms
are along the continuum of imperfect competition. Market structure affects market
outcomes, ie., the price and quantity of goods supplied.

Imperfect Competition

Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly

The above chart tells us that there are four types of imperfect competition existing
in the present market environment. It is classified based on the number of buyers,
sellers and competitors in the market. This chapter explains the price
determination and profit maximization methods followed in these markets. Let us
understand the meaning of each competition.

 Monopoly market: a market with only one seller and a large number of
buyers.
 Monopolistic competition: a market in which firms can enter freely, each
producing its own brand or version of a differentiated product.
 Oligopoly market: market in which only a few firms compete with one
another and entry by new firms is impeded/restricted.
 Duopoly: market in which two firms compete with each other.
 Monophony: is a market with only one buyer, and a few/large sellers.

Perfect Market:

Perfect competition is a market structure characterized by a complete absence of

rivalry among the individual firms. A perfectly competitive firm is one whose output is
so small in relation to market volume that its output decisions have no perceptible
impact on price. No single producer or consumer can have control over the price or
quantity of the product.
Characteristic features of perfect market:
1) Large number of buyers and sellers
2) Homogeneous product

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3) Perfect knowledge about the market

4) Ruling prices
5) Absence of transport cost
6) Perfect mobility off actors
7) Profit maximization
8) Freedom in decision making

In perfect market, the price of the commodity is determined based on the

demand for and supply of the product in the market. The equilibrium price and
output determination is as shown in the graph.

Graph - Price And Output Determination In The Perfect Market

The demand curve (D) and the supply curve (S) intersect each other at a particular
point which is called the equilibrium point. At the equilibrium point ‘E’ the quantity
demanded and the quantity supplied are equal (that is OQ quantity of commodity is
demanded and the same level is suppliedetc).Based on the equilibrium the price
of the commodity is fixed as OP. This is the fundamental pricing strategy followed
in the perfect market.

Monopoly Market:

Mono means single, poly means seller and hence monopoly is a market structure
where only one sells the goods and many buyers buy the same. Monopoly lies at the
opposite extreme from perfect competition on the market structure continuum. A firm
produces the entire supply of a particular good or service that has no close
substitute.

Characteristic Features:

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 A single seller in the market

 There are no close substitutes
 There is a restriction for the entry and exit for the firms in the market
 Imperfect dissemination of information

This does not mean that the monopoly firms are large in size. For example a doctor
who has a clinician a village has no other competitor in the village but in the
town there may be more doctors. Therefore the barrier to the entry is due to
economies of scale, economies of scope, cost complementarities, patents and
other legal barriers.
Profit maximization under Monopoly Competition

For monopolist there are two options for maximizing the profit:
i.e. maximize the output and the limit the price or limit the production of the
goods and services and fix a higher price (market driven price). In monopoly
competition, the demand curve of the firm is identical to the market demand curve
of that product. In monopoly the MR is always less than the price of the commodity.

Profit Maximization Rule:

Produce at that rate of output where MR =MC. From the graph we can understand
the profit maximization under monopoly. ‘X’ axis indicates the output and ‘Y’ the
price/cost and revenue. The marginal revenue curve is denoted as MR. The
average revenue curve is AR which is also the demand curve. MC is the marginal
cost curve, It looks like a tick mark and average cost curve AC is boat shape.

Graph- Profit Maximization Under Monopoly Market

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From the above graph it is seen that the demand curve D and average revenue
curve AR are depicted as a single curve. The marginal revenue curve MR also
slopes the same but the MR curve is below the AR curve. The short run marginal
cost curve SMC looks like a tick mark and the boat shaped average cost curve
SAC is also seen in the graph .The profit maximization criteria of MR=MC is
followed in the monopoly market and the equilibrium point ‘E’ is derived from the
intersection of
MR and SMC curves in the short run .i.e. .MC curve or SM Cheer intersects the MR
curve from below. Based on the equilibrium point, the output is the optimum level of
production i.e., at OM quantity. The price of the commodity is determined as OP.
On an average the firm receives MQ amount as revenue. The total revenue of
selling OM quantity gives OMQP amount of total revenue (OM quantity x OP price).
The firm has spent MR as an average cost to produce OM quantity and the total
cost of production is OMRS (OM quantity x MR cost per unit)

Profit = TR – TC
= OMQP – OMRS
= PQRS (the shaded portion in the
graph)

In the short run the monopoly firm will earn profit continuously even with various
returns.

Graph- Monopoly Profit With Increasing Cost

From the above graph it can be understood that the cost of production (MC, AC) is
increasing along with the output but even withthe increasing scale the firm earns
PQRS as profit which is the shaded portion in thegraph.

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The graph given below explains clearly that the firms cost curves of Marginal cost
(MC) and Average cost (AC) are declining with this slope. The organization earns
PQRS profit but the profit is comparatively lesser than the previous situation.
Graph – Monopoly Profit Under Decreasing Cost

The third situation explains that the organizations’ marginal cost and average cost
curves are horizontal and parallel to the X axis. Even with the constant scale, the
firms earns profit as PQRS.

Graph – Monopoly Profit Under Constant Cost

Therefore we can conclude by saying that under monopoly market structure the
firm will earn profit even under different cost conditions and profit maximization
takes place. They follow the price determination condition as MC=MR and never
incur loss.
Difference Between Perfect And Monopoly Market:

Perfect market is unrealistic in practical life. But slowly certain commodities are
moving towards it. Monopoly market exists in real-time.

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Under perfect market only homogenous products are sold but on the other hand
monopoly market deals with different products.
Under perfect competition, price is determined by demand and
supply of the market. But in monopoly the seller determines the price of the good.
Monopolist can control the market price but in perfect competition the sellers have
no control over the market price.
There is no advertisement cost in perfect market. In other markets it is essential
and it is included in the cost of production and is reflected in the price.
Monopolist sell their products higher than the perfect competitors except when
there is government regulation or adverse public opinion.

Oligopoly Market:

This is a market consisting of a few firms relatively large firms, each with a
substantial share of the market and all recognizing their interdependence. It is a
common form of market structure. The products may be identical or differentiated.
The price determination and profit maximization is based on how the competitors will
respond to price or output changes.

There Are Different Types Of Oligopoly:

 Pure and perfect oligopoly: if the firm produced homogeneous products it

is perfect oligopoly. If there is product differentiation then it is called as
imperfect or differentiated oligopoly.

 Open and closed oligopoly: entry is not possible. When it is closed to the
new entrants then it is closed oligopoly. On the other hand entry is accepted
in open oligopoly.

 Partial and full oligopoly: under partial oligopoly industry is dominated by

one large firm who is a price leader and others follow. In full oligopoly no
price leadership.

 Syndicated and organized oligopoly: where the firms sell their products
through a centralized syndicate. On the other hand firms organize
themselves into a central association for fixing prices ,output and quotas.

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Characteristic Features Of An Oligopoly Market:

1. Few sellers
2. Lack of uniformity in the product
3. Advertisement cost is included
4. No monopoly competition
5. Firms struggle constantly
6. There is interdependency
7. Experience of Group behavior
8. Price rigidity
9. Price leadership
10. Barriers to entry

Price rigidity: the price will be kept unchanged due to fear of retaliation and prices
tend to be strict and inflexible. No firm would indulge in price cutting as it would
eventually lead to a price war with no benefit to anyone.

Reasons for rigidity are: firms know ultimate outcome of price cutting; large firms
incur more expenditure than others; keeping the price low to reduce the new
entrants; increased price rise leads to reduction in number of customers.

The oligopoly prices are indeterminate. The demand function is then an

important ingredient in the price determination mechanism. Several theories of
oligopoly prices have been developed and each one of them is based on a
particular assumption about the reactions of the rival firms and the firms’ actions.
The popular models and appropriate classifications are discussed below.

Oligopoly Models:

Cournot oligopoly: There are few firms producing differentiated or homogeneous

products and each firm believes that competitors will hold their output constant if it
changes its output.

Stackelberg oligopoly: Few firms and differentiated or homogeneous product.

The leader chooses an output and others follow.
Bertrand oligopoly: Few firms produce identical product. Firms compete in price
and react optimally to competitor’s prices.

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Sweezy oligopoly: An industry in which there are few firms serving many
consumers. Firms produce differentiated products and each firm believes
competitors will respond to a price reduction but they will not follow a price
increase.

Price Discrimination:

Price discrimination means that the producer charges different prices for different
consumers for the same goods and service. Price discrimination occurs when
prices differ even though costs are same. For
example,[Link] charge
different prices in different markets, people go to the market where price is low.
Then it gets equalized in the long run.
There are various types of price discrimination:
1. Personal Discrimination
2. Place Discrimination
3. Trade Discrimination
4. Time Discrimination
5. Age Discrimination
6. Sex Discrimination
7. Location Discrimination
8. Size Discrimination
9. Quality Discrimination
10. Special Service
11. Use of services
12. Product Discrimination

Objectives Of Price Discrimination:

1. To dispose the surpluses

2. To develop new market
3. To Maximize use of unutilized capacity
4. To Earn monopoly profit
5. To Retain export market
6. To Increase the sales

Degrees Of Price Discrimination:

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First Degree Price Discrimination:

Firm charges a different price to each of its customers. The maximum willingness
to pay is fixed as price which is called as reservation price. In perfect market the
difference between demand and marginal revenue is the profit (for additional unit
producing and selling). Firms do not know the customers willingness, therefore
different prices. In imperfect market it is not possible to price for each and every
customer.

Graph – First Degree Price Discrimination

Second Degree Discrimination:

Firm charges different prices per unit for different quantities of the same goods or
service. They follow block pricing method. The units in a particular block will be
uniformly priced. The possible maximum price is charged for some given minimum
block of output purchased by the buyers and then the additional blocks are sold at

lower prices.

Graph – Second Degree Price Discrimination

Third Degree Discrimination:

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Firm segments the customers into groups with separate demand curves and charges
different prices from each group.

In first degree price discrimination, in case of unit wise differing prices, the second
degree price discrimination is a case of block wise differing prices. In second
degree discrimination a part of consumer’s surplus is captured. But the third degree
is commonly used. The firm divides its total output into many submarkets and sets
different prices for its product in each market in relation to the demandelasticity.
Graph – Third Degree Price Discrimination

There are two markets I and II their demand curves D1 and D2 is given. D1 is less
elastic and D2 is more elastic demand curve. The firm distributes OQ1 to market - I
at OP1 price and OQ2 to the market II at OP2 price. Market- I has less elastic

demand therefore higher price is charged.

The pricing mechanism different market structures provide a sound theoretical

base to understand how price and output decisions are made. There are several

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other methods commonly followed in practice. However, price discrimination does

not receive social and moral justification in the society.

Monopolistic Competition:

The perfect competition and monopoly are the two extreme forms. To bridge the
gap the concept of monopolistic competition was developed by Edward
Chamberlin. It has both the elements like many small sellers and many small
buyers. There is product differentiation. There foreclose substitutes are available
and at the same time it is easy to enter and easy to exit from the market. Therefore
it is possible to incur loss in this market. The profit maximization for each firm, for
each product depends upon the differentiation and advertising expenditure. As
every firm is acting as a monopoly the same logic of monopoly is followed. Each
and every firm will have their own set of cost and revenue curves and the price
determination is based on the rule of MR=MC and they incur varied profits
according to their market structure. But in the monopolistic competition number of
monopoly competitors will be there in different levels. They monopolize in a small
geographical area or a segment or a model.

The demand curve of a monopolistically competitive firm would be more elastic

than that of a purely monopolistic firm. The cost function of a firm would be that
there will not be any significant difference across different types of structures in the
product market. Given the function, and the corresponding AR and MR curves,
and the cost function, and the corresponding SAC and SMC curves, the price and
output determination of a profit – maximizing monopolistically competitive firm
could be as follows.
Graph – Pricing Under Monopolistic Competition With Profit

From the above graph we can understand that under monopolistic competition
firms incur profit which is PP1BB1 the pricing and profit determination are
similar to the monopoly market. MR is marginal revenue curve AR is average
revenue and demand curve .At point ‘E’ both MR and marginal cost curve MC
inter sects. Based on this equilibrium the product is sold at OP price in the
market. The Average cost curve indicates that the firm has spent QB 1 amount
per unit but it receives QB through its sale. Therefore the difference between
the two BB1 is the profit margin which should be multiplied with the total
quantity sold OQ which gives PP1BB1 amount of profit.

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Graph – Pricing under Monopolistic competition with loss

The marginal revenue curve MR and the average revenue curve AR that is the
demand curve is also represented in the graph. The condition for product decision
is MR=MC. The MR and MC intersect at point ‘E’ based on the equilibrium. It is
decided to produce OM quantity and the price of the commodity is fixed at OP in
the market. Therefore the total revenue by selling OM quantity in the market for OP
price is equal to OM x OP = OPRM. But to produce OM quantity the firm has spent
MQ as average cost. Therefore the total cost of production = OM x MQ =OMQS.

Therefore the profit = TR –TC

= ORPM –OMQS
= - PQRS. (Negative)
That means the cost of production per unit is more than the average revenue earned
per unit. Average revenue = MR and the Average cost = MQ which is more than the
revenue. Therefore the difference QR is the loss per unit multiplied with OM quantity.
PQRS is the total loss to the organization.

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Comparison Of Various Market Structure:

Perfect Monopoly Monopolistic Oligopoly

Market

Number of Many small buyers Single seller Many sellers

competitors and sellers

Product differentiation Homogeneous High Differentiation

differentiation, among
no close competitors
substitutes

Information Complete and free Less Less Restricted

information information information access to price
and product
information

Conditions of entry Easy to enter and High barriers Easy to enter High barriers to
and exit exit due to and exit entry
economies of
scale
Profit potential Normal profit in long Economic Economic Economic profit
run, economic profit profit in long profit in short in both short and
in short run run and short runand long run
run
normal in long
run

Example Agricultural Railways Clothing Automobiles

products

Various Pricing Strategies – Explained With Diagram:

In our daily lives, almost everything, such as the petrol we use for transportation,
food we eat, clothes we wear, and movie we watch has a price.

Every organization whether it aims to gain profit or not has to fix price for its
products. An organization follows various pricing strategies to attract the customers.

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A pricing strategy can be defined as an action, task, or approach to achieve the

pricing objectives of the organization.

Figure- shows various pricing strategies adopted by organizations:

These pricing strategies are discussed in detail below:

1. Multiple Product Pricing:

Generally, organizations produce more than one product in their line of production.
Even a single product of an organization can differ in styles and sizes. For example,
a refrigerator manufacturing organization produces refrigerators in different colors,
sizes, and features. Similarly, an automobile organization manufactures vehicles in
different colors, sizes, and mileage. The pricing in case of multiple products is called
multiple product pricing.

The demand curve for multiple products would be different. However, the MC curve
of these products is same as these are produced under interchangeable production
facilities. Therefore, AR and MR curves are different for each product. On the other
hand, AC and MC are inseparable. Therefore, the condition of MR=MC cannot be
applied directly to fix the prices of each product.

The solution of this problem was provided by E.W. Clemens who stated how the
multi-product organizations fix prices of their products. Suppose there are four
differentiated products. A, B, C, and D produced by an organization.

Figure-6 shows multiple product pricing:

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The AR (price) and MR curves for four products are shown as four different curves
and MC curve is shown as the total of MC of all the products. Suppose the
aggregate MR curve, which is the total of all individual MR curves, passes through
point E on the MC curve.

From point E, a parallel line, equal marginal revenue (EMR) is drawn towards Y- axis
(parallel to X-axis). This parallel line passes through the M Rs of A, B, C, and D. The
output and prices of these four products are determined at the points where their
respective MC and MR curves intersect each other.

As shown in Figure-6, OQa, QaQb, QbQc, QcQd are the output levels of products A,
B, C, and D and PaQa, PbQb, PcQc, PdQd are the prices of the products
respectively. These are the maximum price and output levels of an organization.

[Link] Pricing:

Differential pricing implies charging different prices from different customers for same
products. This type of pricing strategy is used in the market where the multiple
customer segments exist to avoid confusion regarding the different prices of
products. In these types of markets, customers purchasing the product at the lower
prices cannot resell the product at higher price in another market. An example of
differentiated pricing can be selling Coca-Cola at Rs. 10 in supermarkets, Rs. 15 in
theatres, and Rs .20 in restaurants.

Figure-7 shows the four types of differential pricing:

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The discussion of the types of differential pricing (as shown in Figure-7) is as

follows:

i. Negotiated Pricing:
Implies pricing strategy in which a price is decided through bargaining between the
customer and seller.

ii. Secondary Market Pricing:

Implies setting different prices for different markets. The price for a primary market is
different from the price in the secondary market. The primary market is the target
market where the product is introduced for the first time; whereas, the secondary
market is the target market where the product is introduced after it has gained
success in the primary market.

The price in the primary market is generally higher than the secondary market.
However, if the cost of serving the secondary market is higher as compared to the
cost of primary market then the price charged in the secondary market is higher. The
example of secondary market can be an isolated area in the domestic and foreign
country markets.

A secondary market also involves a segment that buys the product during off-peak
rimes. For instance, the restaurants give several discount options to early customers
of the day during the off-peak season. The customers are offered early bird menus
that offer food items at lower prices.

iii. Periodic Discounting:

Refers to the type of pricing strategy that involves a temporary reduction in the prices
of products. This reduction is done on a systematic basis. For instance, many
clothing outlets offer discounts in festive seasons or on a seasonal basis. The main
problem with periodic discounting is that the customers easily predict the reduction in
the prices; therefore, they delay their purchases. For example, Big Bazaar has
introduced a famous Wednesday bazaar concept, in which it provides discount on
almost all of its products on every Wednesday.

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iv. Random Discounting:

Implies giving discounts on an unsystematic basis so that customers cannot predict

the discount easily. When the prices are reduced randomly, then the customers
cannot predict the reduction in prices. The random discounting is mainly used to
attract new customers.

[Link] Pricing:

Promotional pricing refers to a pricing strategy that helps in promoting the product. It
is defined as a policy of reducing the prices to attract customers towards a product.

Figure-8 shows the types of promotional pricing:

Now, let us discuss the types of promotional pricing in brief:

i. Price Leaders:
Refer to a policy that involves setting the prices of a product less or equal to its cost.
This type of pricing is generally used in supermarkets. The marketers believe that
this strategy helps in increasing sales. However, this type of pricing is also called
loss leader pricing as sometimes the product is sold at loss.

ii. Special Event Pricing:

Involves reduction in the prices of a product according to special events, such as
festivals or seasons. The organizations follow this strategy to gain revenue. The
sales gap in organizations is filled by this type of pricing.

iii. Comparison Discounting:

Involves setting the price of a product at a specific level and simultaneously
comparing it with the higher price. The higher price can be the product’s last price,
price of competitor’s brand, or price of the same brand at the other retail outlet. For
example, marketer while demonstrating his/her product to the customer tells the
competitor’s high price of the same product to induce sale of his/her product.

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Comparison discounting is a kind of informative pricing method as it helps customers

to make purchase decisions.

[Link] Line Pricing:

Product line pricing can be defined as the setting of prices of all the high priced and
low priced products in a way that maximizes the profit on whole product line. It is a
pricing method that studies price determination of those products that are identical to
each other or used for the same purpose. For instance, Hindustan Unilever Limited
offers a wide price range for its hair care product line that include oil, shampoo, and
conditioner to optimize the profit on its hair care product line.

Setting prices in product fine pricing requires a relationship between the products in
the product line. For instance, computer hardware and software are complementary
products. The increase in demand for one leads to the increase in the demand for
the other. If both the products are in the same product line then the high price of
software will lead to low demand for software as well as hardware. Thus, a marketer
should carefully set the prices in the product fine.

Figure-9 shows the different types of product line pricing:

The types of product line pricing are discussed as follows:

i. Captive Pricing:
Refers to a pricing where the price of the basic product is kept at a lower level;
whereas, the price of the items that are required with the basic product is high. For
instance, a marketer may set the low price of a video camera; whereas, the price of
film used to operate camera is high.

ii. Premium Pricing:

Implies pricing for the different versions of same products. The product with
enhanced feature is priced high than the product with basic features. For instance, a
simple vanilla ice-cream costs less than the ice-cream enriched with dry fruits.

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Similarly, in the hospitality industry, the rooms with luxurious facilities are priced high
than ordinary’ rooms with basic facilities.

iii. Bait Pricing:

Refers to a tactic that involves luring customers by setting low prices of some of the
items in the product line with the intention of selling high priced products. This type of
pricing strategy is adopted when there is high competition in the market. Thus,
organizations advertise low-price products to attract the customers. Sometimes,
advertisements show the low prices of products with attached terms and conditions,
which force customers to visit the shop.

iv. Price Lining:

Implies setting a single price for all the products in the store. For example, a store
can set Rs. 100 for all the items. This type of pricing was started in North America’s
Five & Dime General stores where everything costs 5 or 10 cents. Price lining helps
customers in making the easy selection of products as prices of all the products are
same.

[Link] Pricing:

Psychological pricing tries to influence the perception of customers about the price of
a product. It is used when a marketer wants customers to respond emotionally rather
than rationally. Psychological pricing is based on the fact that some prices have
psychological impact on customers. Some customers believe that high price is an
indicator of the good quality of a product. For example, products, such as high
quality perfumes are more costly than normal perfumes. The price becomes a good
factor to judge the quality of a product if no other information is available regarding a
product.

There are five types of psychological pricing, which are shown in Figure-10:

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The discussion of the types of psychological pricing is as follows:

i. Reference Pricing:
Refers to a pricing in which the marketer sells the product at the price lower than the
price of competitor’s product. The competitor’s product seems less attractive to the
customers. The price of the competitor s product is called reference price. While
buying a product, the customers compare the price of a product with the reference
price.

ii. Bundle Pricing:

Refers to packaging two or more complementary products together and selling them
at a single price. The bundle pricing is seen as a profitable option by the customers
as the price of the bundled products is less than the total price of the products taken
individually. This type of pricing helps in saving the packaging cost of the
organization.

v. Prestige Pricing:
Implies a pricing strategy where the prices of products are kept at higher level to
express the quality of the product. This is used for customers who think that high
prices denote high quality. The products whose prices are set as per the prestige
pricing are perfumes, jewelry, cars, and liquor.

Types of Pricing Methods :

An organization has various options for selecting a pricing method. Prices are based
on three dimensions that are cost, demand, and competition.

The organization can use any of the dimensions or combination of dimensions to set
the price of a product.

Figure-4 shows different pricing methods:

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The different pricing methods (Figure-4) are discussed below;

[Link]-based Pricing:

Cost-based pricing refers to a pricing method in which some percentage of desired

profit margins is added to the cost of the product to obtain the final price. In other
words, cost-based pricing can be defined as a pricing method in which a certain
percentage of the total cost of production is added to the cost of the product to
determine its selling price. Cost-based pricing can be of two types, namely, cost-plus
pricing and markup pricing.

These two types of cost-based pricing are as follows:

i. Cost-plus Pricing:
Refers to the simplest method of determining the price of a product. In cost-plus
pricing method, a fixed percentage, also called mark-up percentage, of the total cost
(as a profit) is added to the total cost to set the price. For example, XYZ organization
bears the total cost of Rs. 100 per unit for producing a product. It adds Rs. 50 per
unit to the price of product as’ profit. In such a case, the final price of a product of the
organization would be Rs. 150.

Cost-plus pricing is also known as average cost pricing. This is the most commonly
used method in manufacturing organizations.

In economics, the general formula given for setting price in case of cost-plus
pricing is as follows:

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P = AVC + AVC (M)

AVC= Average Variable Cost

M = Mark-up percentage

AVC (m) = Gross profit margin

Mark-up percentage (M) is fixed in which AFC and net profit margin (NPM) are
covered.

AVC (m) = AFC+ NPM

For determining average variable cost, the first step is to fix prices. This is done by
estimating the volume of the output for a given period of time. The planned output or
normal level of production is taken into account to estimate the output.

The second step is to calculate Total Variable Cost (TVC) of the output. TVC
includes direct costs, such as cost incurred in labor, electricity, and transportation.
Once TVC is calculated, AVC is obtained by dividing TVC by output, Q. [AVC=
TVC/Q]. The price is then fixed by adding the mark-up of some percentage of AVC to
the profit [P = AVC + AVC (m)].

The advantages of cost-plus pricing method are as follows:

a. Requires minimum information

b. Involves simplicity of calculation

c. Insures sellers against the unexpected changes in costs

The disadvantages of cost-plus pricing method are as follows:

a. Ignores price strategies of competitors

b. Ignores the role of customers

ii. Markup Pricing:

Refers to a pricing method in which the fixed amount or the percentage of cost of the
product is added to product’s price to get the selling price of the product. Markup
pricing is more common in retailing in which a retailer sells the product to earn profit.
For example, if a retailer has taken a product from the wholesaler for Rs. 100, then
he/she might add up a markup of Rs. 20 to gain profit.

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It is mostly expressed by the following formulae:

a. Markup as the percentage of cost= (Markup/Cost) *100

b. Markup as the percentage of selling price= (Markup/ Selling Price)*100

For example, the product is sold for Rs. 500 whose cost was Rs. 400. The mark up
as a percentage to cost is equal to (100/400)*100 =25. The mark up as a percentage
of the selling price equals (100/500)*100= 20.

[Link]-based Pricing:

Demand-based pricing refers to a pricing method in which the price of a product is

finalized according to its demand. If the demand of a product is more, an
organization prefers to set high prices for products to gain profit; whereas, if the
demand of a product is less, the low prices are charged to attract the customers.

The success of demand-based pricing depends on the ability of marketers to analyze

the demand. This type of pricing can be seen in the hospitality and travel industries.
For instance, airlines during the period of low demand charge less rates as
compared to the period of high demand. Demand-based pricing helps the
organization to earn more profit if the customers accept the product at the price more
than its cost.

[Link]-based Pricing:

Competition-based pricing refers to a method in which an organization considers the

prices of competitors’ products to set the prices of its own products. The organization
may charge higher, lower, or equal prices as compared to the prices of its
competitors.

The aviation industry is the best example of competition-based pricing where airlines
charge the same or fewer prices for same routes as charged by their competitors. In
addition, the introductory prices charged by publishing organizations for textbooks
are determined according to the competitors’ prices.

Other Pricing Methods:

In addition to the pricing methods, there are other methods that are discussed
as follows:

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i. Value Pricing:

Implies a method in which an organization tries to win loyal customers by charging

low prices for their high- quality products. The organization aims to become a low
cost producer without sacrificing the quality. It can deliver high- quality products at
low prices by improving its research and development process. Value pricing is also
called value-optimized pricing.

ii. Target Return Pricing:

Helps in achieving the required rate of return on investment done for a product. In
other words, the price of a product is fixed on the basis of expected profit.

iii. Going Rate Pricing:

Implies a method in which an organization sets the price of a product according to
the prevailing price trends in the market. Thus, the pricing strategy adopted by the
organization can be same or similar to other organizations. However, in this type of
pricing, the prices set by the market leaders are followed by all the organizations in
the industry.

iv. Transfer Pricing:

Involves selling of goods and services within the departments of the organization. It
is done to manage the profit and loss ratios of different departments within the
organization. One department of an organization can sell its products to other
departments at low prices. Sometimes, transfer pricing is used to show higher profits
in the organization by showing fake sales of products within departments.

Multiple Product pricing:

The traditional theory of price determination is based on the assumption that the firm
produces a single homogeneous product. But firms usually produce more than one
product. When firms produce several products, managers must consider the
interrelationships between those products.

Such products may be joint products or multi-products. Joint products are those
where inputs are common in productive process. Multi-products, are creation of the
product line activity with independent inputs but common overhead expenses.
Pricing of multi-product or joint product requires little extra caution and care.

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For evolving price policy for multi-product firm, certain basic considerations
involved in decision making are:
(i) Price and cost relationship in product line,

(ii) Demand relationship in product line, and

(iii) Competitive differences.

They are explained as follows:

(i) Price and Cost Relationship:

For evolving a price policy for any product, price and cost relationship is the basic
consideration. Cost conditions determine price. Therefore, cost estimates should be
correctly made. Although a firm must recover its common costs, it is not necessary
that prices of each product be high enough to cover an arbitrarily apportioned share
of common costs.

Proper pricing does require, however, that prices at least cover the incremental cost
of producing each good. Incremental costs are additional costs that would not be
incurred if the product were not produced.

As long as the price of a product exceeds its incremental costs, the firm can increase
total profit by supplying that product. Hence decisions should be based on an
evaluation of incremental costs. A price that offers maximum contribution over costs
is generally acceptable but in multi-product cases, incremental cost becomes more
essential to make such decisions.

A set of alternative price policies should be considered and they are:

(i) Prices of multi-products may be proportional to full cost. This price may produce
equal percentage of profit margin for all products. If the full cost for all products are
assumed equal then the pricing will be equal.

(ii) Pricing for multi-products may be proportional to incremental cost.

(iii) Prices of multi-products may be assessed with reference to their contribution

margin as proportional to conversion cost.

(iv) Prices of multi-product may be fixed differently keeping into consideration market
segments.

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(v) Prices for multi-products may be fixed as per the product life cycle of each
product.

(ii) Inter-relation of Demand for Multi-product:

Demand inter-relationships arise because of competition in which case they become

substitutes or they may be complementary goods. Sale of one product may affect the
sale of another product. Different demand elasticity of different consumers may allow
the firm to follow policies of price discrimination in different market segments. Two
products of the same price may be substitutes to each other with cross elasticity of
demand due to high degree of competitiveness.

In such a situation, pricing of the multi-products will have to be done in such a long
way that maximum return could be obtained from each market segments by selling
maximum products. Demand inter-relationships in the case of multiple products
make it clear that we should take into account a thorough analysis of the total effect
of the decision on the firm’s revenues.

(iii) Competitive Differences:

Yet another important point should be considered for making price decisions, for a
product line is the assessment of degree of competitiveness. Such an assessment
will set up market share for each product. A product having large market share can
stand a high markup and can contribute to bear the losses.

There is competition among a few sellers of a relatively homogeneous product that

has enough cross elasticity of demand so that each seller must in his pricing
decisions take account of rivals’ reaction. Each producer is actually aware of the
disastrous effects that an announced reduction of his own price would have on the
prices charged by competitors. The firm should also analyse whether the competitors
have free entry to the market or not.

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Unit –IV

National income

Concept of National Income

The National Income is the total amount of income accruing to a country

from economic activities in a years time. It includes payments made to all resources
either in the form of wages, interest, rent, and profits.

The progress of a country can be determined by the growth of the national income of
the country

National Income Definition:

There are two National Income Definition

 Traditional Definition

 Modern Definition

Traditional Definition
According to Marshall: “The labor and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or revenue
of the country or national dividend.”

The definition as laid down by Marshall is being criticized on the following grounds.

Due to the varied category of goods and services, a correct estimation is very difficult.

There is a chance of double counting, hence National Income cannot be estimated

correctly.

For example, a product runs in the supply from the producer to distributor
to wholesaler to retailer and then to the ultimate consumer. If on every movement
commodity is taken into consideration then the value of National Income increases.

Also, one other reason is that there are products which are produced but not marketed.

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For example, In an agriculture-oriented country like India, there are commodities which
though produced but are kept for self-consumption or exchanged with other
commodities. Thus there can be an underestimation of National Income.

Simon Kuznets defines national income as “the net output of commodities and
services flowing during the year from the country’s productive system in the hands of
the ultimate consumers.”

Following are the Modern National Income definition

 GDP

 GNP

Gross Domestic Product:

The total value of goods produced and services rendered within a country during a year
is its Gross Domestic Product.

Further, GDP is calculated at market price and is defined as GDP at market prices.
Different constituents of GDP are:

1. Wages and salaries

2. Rent

3. Interest

4. Undistributed profits

5. Mixed-income

6. Direct taxes

7. Dividend

8. Depreciation

Gross National Product:

For calculation of GNP, we need to collect and assess the data from all productive
activities, such as agricultural produce, wood, minerals, commodities, the contributions
to production by transport, communications, insurance companies, professions such
(as lawyers, doctors, teachers, etc). at market prices.

It also includes net income arising in a country from abroad. Four main constituents of
GNP are:

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1. Consumer goods and services

2. Gross private domestic income

3. Goods produced or services rendered

4. Income arising from abroad.

GDP and GNP on the basis of Market Price and Factor Cost

a) Market Price:
The Actual transacted price including indirect taxes such as GST, Customs duty etc.
Such taxes tend to raise the prices of goods and services in the economy.

b) Factor Cost
It Includes the cost of factors of production e.g. interest on capital, wages to labor, rent
for land profit to the stakeholders. Thus services provided by service providers and
goods sold by the producer is equal to revenue price.

Alternatively,

Revenue Price (or Factor Cost) = Market Price (net of) Net Indirect Taxes

Net Indirect Taxes = Indirect Taxes Net of Subsidies received

Hence,

Factor Cost shall be equal to

(Market Price) LESS (Indirect Taxes ADD Subsidies)

Net Domestic Product:

The net output of the country’s economy during a year is its NDP. During the year a
country’s capital assets are subject to wear and tear due to its use or can become
obsolete.

Hence, we deduct a percentage of such investment from the GDP to arrive at NDP.

So NDP=GDP at factor cost LESS Depreciation.

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The Accumulation of all factors of income earned by residents of a country and

includes income earned from the county as well as from abroad.

What is National Income?

Simply understand what National Income is, it can be represented as -

National Income defines a country's wealth. This income depicts the value of goods
and services which are produced by an economy. This gives effect to the net result
of all the economic activities performed in the country.

Imagine how you would define a country’s wealth without any economic
term? In that case, there would be no accountability and responsibility linked with the
production in the country. The resources would go uncalculated and there would be
a vague economic atmosphere. Thus, let us indulge in this study which talks about
National Income.

Understanding National Income:

National income is the sum total of the value of all the goods and services
manufactured by the residents of the country, in a year., within its domestic
boundaries or outside. It is the net amount of income of the citizens by production in
a year.
To be more precise, national income is the accumulated money value of all
final goods and services produced in a country during one financial year.
Computation of National Income is very vital as it indicates the overall health of our
economy for that particular year.

The aggregate economic performance of a nation is calculated with the help

of National income data. The basic purpose of national income is to throw light on
aggregate output and income and provide a basis for the government to formulate its
policy, programs, to maximize the national welfare of the people. Central Statistical
Organization calculates the national income in India.

Definition of National Income:

The definition of National Income if of two types-

 Traditional Definition of National Income
 Modern Definition

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Traditional Definition of National Income-

According to Marshall: “The labor and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or
revenue of the country or national dividend.”

Modern Definition

This definition has two subparts

 GDP

 GNP

Gross Domestic Product

Gross Domestic Product, abbreviated as GDP, is the aggregate value of goods and
services produced in a country. GDP is calculated over regular time intervals, such
as a quarter or a year. GDP as an economic indicator is used worldwide to measure
the growth of countries economy.

Goods are valued at their market prices, so:

 All goods measured in the same units (e.g., dollars in the U.S.)
 Things without exact market value are excluded.

Constituents of GDP

 Wages and salaries

 Rent
 Interest
 Undistributed profits
 Mixed-income
 Direct taxes
 Dividend
 Depreciation

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The Formula for Calculation of GDP

GDP = consumption + investment + government spending + exports - imports.

Gross National Product

Gross National Product (GNP) is an estimated value of all goods and services
produced by a country’s residents and businesses. GNP does not include the
services used to produce manufactured goods because its value is included in the
price of the finished product. It also includes net income arising in a country from
abroad.

Components of GNP

 Consumer goods and services

 Gross private domestic income
 Goods produced or services rendered
 Income arising from abroad.

Formula to Calculate GNP

GNP = GDP + NR (Net income from assets abroad or Net Income Receipts) - NP
(Net payment outflow to foreign assets).

Importance of National Income:

[Link] Economic Policy

National Income indicates the status of the economy and can give a clear picture of
the country’s economic growth. National Income statistics can help economists in
formulating economic policies for economic development.

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[Link] and Deflationary Gaps

For timely anti-inflationary and deflationary policies, we need aggregate data of

national income. If expenditure increases from the total output, it shows inflammatory
gaps and vice versa.

[Link] Preparation

The budget of the country is highly dependent on the net national income and its
concepts. The Government formulates the yearly budget with the help of national
income statistics in order to avoid any cynical policies.

[Link] of Living

National income data assists the government in comparing the standard of living
amongst countries and people living in the same country at different times.

[Link] and Development

National income estimates help us to bifurcate the national product between defense
and development purposes of the country. From such figures, we can easily know,
how much can be set aside for the defense budget.

Sets of methods for measuring National Income

There are four methods of measuring national income. The type of method to be
used depends on the availability of data in a country and the purpose which is
attempted for.

[Link] Method:

In this method, we add net income payments received by all citizens of a country in a
particular year. Net incomes that result in all the factors of production like net rents,
wages, interest, and profits are all added together, but income received in the form of
transfer payments are omitted.

[Link] Method:

According to this method, the aggregate value of final goods and services produced
in a country during a financial year is computed at market prices. To find out GNP,
the data of all the productive activities-agricultural products, Minerals, Industrial
products, the contributions to production made by transport, insurance,
communication, lawyers, doctors, teachers. Etc are accumulated and assessed.

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[Link] Method:

The total expenditure by the society in a financial year is summed up together and
includes personal consumption expenditure, net domestic investment, government
expenditure on goods and services, and net foreign investment. This concept is
backed by the assumption that national income is equal to national expenditure.

[Link] Added Method

The distinction between the value of material outputs and material inputs at every
stage of production is Value added.

[Link] Vs GNP

The Gross Domestic Product and the Gross National Product are the two most
widely used measures in a country’s calculation of aggregate economic unit.

GDP is the measure of the value of goods and services that are being produced
within a country's borders, by the citizens and the non-citizens. While GNP
determines the value of goods and services that are being produced by the country's
citizens in the domestic and abroad spectrum. GDP is popularly used by the global
economies at large. While, the United States eliminated the use of GNP in the year
1991, thereby adopting GDP as the measure to compare their economy with other
economies.

India’s Richness: National Income of India 2020-2021

In the year 2020-2021, India had a total NI of 135.13 lakh crore, well this is a
provisional estimate only. However, in the round of the fourth quarter (in the month of
January-March), the country had an economic growth of 1.6%, while the GDP was
calculated at Rs. 38.96 lakh crore in the fourth quarter in the year 2020-21, this is
count is slightly different to Rs 38.33 lakh crore in the fourth quarter of 2019-20.
Is this page helpful.
National income is the final outcome of total economic activities of a nation.
Economic activities generate two kinds of flow in a modern economy namely,
product-flow and money-flow. Product-flow refers to flow of goods and services from
producers to final consumers. Money flow refers to flow of money in exchange of
goods and services. In this exchange of goods and services, money income is
generated in the form of wages, rent, interest and profits, which is known as factor
earning. Based on these two kinds of flows, national income is defined in terms of:

 Product flow
 Money flow

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National Income in Terms of Product Flow:

National income is the sum of money value of goods and services generated from
total economic activities of a nation. Economic activities result into production of
goods and services and make net addition to the national stock of capital. These
together constitute the national income of closed economy’. Closed economy refers
to an economy, which has no economic transactions with the rest of the world.
However, in an open economy, national income also includes the net results of
its transactions with the rest of the world, i.e., exports less imports.

Economic activities should be distinguished from the non-economic activities from

national income point of view. Broadly speaking, economic activities include all
human activities, which create goods and services that can be valued at market
price. Economic activities include production by farmers (whether for household
consumption or for market), production by firms in industrial sector, production of
goods and services by the government enterprises, and services produced by
business intermediaries (wholesaler and retailer , banks and other financial
organizations, universities, colleges and hospitals. On the other hand, non economic
activities are those activities, which produce goods and services that do not have
economic value. The non-economic activities include spiritual, psychological, social
and political services, hobbies, service to self, services of housewives services of
members of family to other members and exchange of mutual services between
neighbors.

National Income in Terms of Money Flow

While economic activities generate flow of goods and services, on the other hand,
they also generate money-flow in the form of factor payments such as, wages,
interest, rent, profits and earnings of self-employed. Thus, national income can
also be obtained by adding the factor earnings after adjusting the sum for indirect
taxes, and subsidies. The national income thus obtained is known as national
income at factor cost.

The concept of national income is linked to the society as a whole. However, it

differs fundamentally from the concept of private income. Conceptually, national
income refers to the money value of the final goods and services resulting from all
economic activities of a country. However, this is not true for the private income in
addition, there are certain receipts of money or of goods and services that are not
ordinarily included in private incomes but are included in the national incomes and
vice versa. National income includes items such as employer’s contribution to the
social security and welfare funds for the benefit of employees, profits of public
enterprises and services of owner occupied houses. However, it excludes the
interest on war-loans, social security benefits and pensions. Instead, these items are
included in the private incomes. The national income is therefore, not merely an
aggregation of the private incomes. However, an estimate of national income can be
obtain by summing up the private incomes after making necessary adjustment for
the items excluded from the national income.

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Measurement of National Income

National income is the value of the aggregate output of the different sectors during a
certain time period. In other words, it is the flow of goods and services produced in an
economy in a particular year. Thus, the measurement of National Income becomes
important.

Measurement of National Income

There are three ways of measuring the National Income of a country. They are from the
income side, the output side and the expenditure side. Thus, we can classify these
perspectives into the following methods of measurement of National Income.

Methods of Measuring National Income

 Product Method

 Income Method

 Expenditure Method
1. Product Method

Under this method, we add the values of output produced or services rendered by the
different sectors of the economy during the year in order to calculate the National
Income.

In this method, we include only the value added by each firm in the production process
in the output figure.

Hence, we use the value-added method. The value-added output of all the sectors of
the economy is the GNP at factor cost.

However, this method is unscientific as it adds the value of only those goods and
services that are sold in the market or are available for sale in the market

2. Income Method

Under this method, we add all the incomes from employment and ownership of assets
before taxation received from all the production activities in an economy.

Thus, it is also the Factor Income method. We also need to add the
undistributed profits of the private sector and the trading surplus of the public sector
corporations.

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However, we need to exclude items not arising from productive activities such as
sickness benefits, interest on the national debt, etc.

3. Expenditure Method

This method measures the total domestic expenditure of the economy. It consists of
two elements, viz. Consumption expenditure and Investment expenditure.

Consumption expenditure includes consumption expenditure of the household sector

on goods and services and consumption outlays of the business sector and public
authorities.

Investment expenditure refers to the expenditure on the making of fixed capital such as
Plant and Machinery, buildings, etc.

Difficulties in Measurement of National Income

Following are the difficulties in estimating the National Income

 Conceptual difficulties

 Statistical difficulties

A. Conceptual difficulties:

1. It is difficult to calculate the value of some of the items such as services rendered
for free and goods that are to be sold but are used for self-consumption.

2. Sometimes, it becomes difficult to make a clear distinction between primary,

intermediate and final goods.

3. What price to choose to determine the monetary value of a National Product is

always a difficult question?

4. Whether to include the income of the foreign companies in the National Income
or not because they emit a major part of their income outside India.

B. Statistical difficulties:

1. In case of changes in the price level, we need to use the Index numbers which
have their own inherent limitations.

2. Statistical figures are not always accurate as they are based on the sample
surveys. Also, all the data are not often available.

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3. All the countries have different methods of estimating National Income. Thus, it is
not easily comparable.

National income refers to the monetary value over a period of time of the output flow
of goods and services produced in an economy.

The Uses of National Income Statistics

Measuring the level and rate of growth of national income (Y) is essential to keep
track of:
 The rate of economic growth
 Changes to living standards
 Changes to the distribution of income b/w groups

Gross Domestic Product

The total value of output in an economy is the Gross Domestic Product (GDP) and is
used to measure economic activity changes. GDP encompasses the production of
foreign-owned enterprises located in a country following the foreign direct
investment.

There are three different ways to calculate GDP that should all add up to the same
amount: The national output is equal to national expenditure (Aggregate demand)
which in turn is equal to national income.

The equation for GDP using this approach is

GDP = C(Household spending) + I(Capital investment spending) + G(Government
spending) + (X(Exports of Goods and Services)-M(Imports of Goods and Services)
The three different ways to measure GDP are - Product Method, Income Method,
and Expenditure Method.
These three calculating GDP methods yield the same result because National
Product = National Income = National Expenditure.

1. The Product Method:

In this method, all goods and services produced during the year in various industries
are added up. This is also known as value-added to GDP or GDP at the sector of
origin's cost factor. India includes the following items: agriculture and allied services;
mining; development, construction, the supply of electricity, gas, and water,
transport, communication, and trade; banking and insurance; real estate and
property ownership of residential and commercial services and public administration
and defence and other services (or government services). It is, in other words, the
amount of the added gross value.

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2. The Income Method:

In a nation that produces GDP during a year, people earn income from their jobs.
Thus the sum of all factor incomes is GDP by revenue method: wages and salaries
(employee compensation) + rent + interest + benefit.

3. Expenditure Method:

This approach focuses on products and services generated during one year within
the region.
GDP is subtracted from the portion of consumption, investment, and government
spending expended on imports. Likewise, all manufactured components, such as
raw materials used in the manufacture of products for sale, are also exempt.
Thus GDP by expenditure method at market prices is net export, which can be
positive or negative.
1. GDP at Factor Cost:

GDP is the amount of net value added by all producers within the country at the cost
factor. Since the net value added is allocated as revenue to the owners of production
factors, the sum of domestic factor incomes and fixed capital consumption is GDP
(or depreciation).
Thus,
GDP at Factor Cost is equal to the sum of Net value added and Depreciation.
GDP at factor cost includes -
1. Compensation of employees, i.e., wages, salaries, etc.
2. Operational surplus, which is both incorporated and unincorporated
companies' business profit.
3. Mixed-Income of Self- employed.

Conceptually, GDP at the cost factor and GDP at the market price must be
equivalent since the cost factor (payments to factors) of the products produced must
be equal to the final value at market prices of the goods and services. The retail
value of products and services, however, varies from the earnings of the output
factors.
2. Net Domestic Product (NDP):

The NDP is the value of the economy's net production throughout the year. During
the manufacturing process, some of the country's capital equipment wears out or
becomes redundant each year. A certain percentage of the gross expenditure
removed from GDP is the amount of this capital consumption.
Net Domestic Product = GDP at the expense of Factor - Depreciation
3. Nominal and Real GDP:

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It is referred to as GDP at current prices or nominal GDP when GDP is calculated

based on the current price. On the other hand, if GDP is measured in a given year
based on fixed costs, it is referred to as GDP at constant prices, or actual GDP.
Nominal GDP is the value of the goods and services produced in a year, calculated
at the current market) prices in terms of rupees (money).

Methods of Estimation of GDP:

Back series can be generated in three ways, the Committee on Real Sector
Statistics said

 based on the new GDP methodology by using the base data wherever
available;
 based on a production shift approach;
 by projecting the old series using the base year 2004-05 forward and then
adjusting it to the 2011- 12 base by comparing it with the new series. The third
approach is yet to be tried, the Committee said.
Rebasing the GDP of India

 This is done by the government often to ensure that the GDP represents the
true picture of the economy in terms of structural changes, the importance of
the various sectors’ contributions of the agriculture sector, etc.
 The Present rebasing has been done by CSO taking into consideration the
recommendations given the SNA (System of National Accounts) published by
the UN in 2008.
Old Method of Estimation of GDP vs New Method of Estimation of GDP

 In the older system, IIP was used to measure manufacturing and trading
activity. This accounted for the volume changes but not value changes. In the
newer methodology, we use the concept of GVA – Gross Value Added, which
measures the value addition done to the economy.
 In the older system, GDP was first estimated by using the IIP data and then
updated using the ASI data (Annual Survey of Industries). ASI accounted only
for those firms which were registered under the Factories Act. In the newer
system, data from MCA 21 is used (MCA 21 is an e-governance initiative of
the Ministry of Corporate Affairs, launched in 2006, it allows the
firms/companies to electronically file their financial results. Under this data
from more than 5,00,000 firms is collected)
 In the older system, farm produce was taken as a proxy for the calculation of
agricultural income. The new methodology has widened the scope for
calculating value addition in the agricultural sector.
 In the older system, very few mutual funds and NBFCs were considered for
considering the financial activity. In the new methodology, the coverage has
been expanded by including stockbrokers, asset management funds, pension
funds, stock exchanges, etc
 In the older system, the trading income data was used from the NSSO’s 1999
establishment survey against this new series uses the 2011-12 survey.

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Issues/Concerns with the New Methodology

 The revised data does not reflect the other macroeconomic parameters – tax
revenues, credit growth, trade performance, corporate sales, profits, more
importantly, the level of investment in the economy, etc.
 The MCA21 data was collected only from 2008, then how can it be used to
compare the earlier growth/ production.
 The Bank Credit Growth has averaged 20.3% between FY07 to FY12 and
12.3% between FY13 to FY18, during the same tenure the GDP growth rates
have averaged 6.7% and 6.9% respectively (against the older growth rates of
8% and 6.9% respectively).
 There has been inconsistency even in the case of Investment Growth.
Between FY07 to FY12, the growth rate of investment was 10.7% and 5.3%
between FY13 to FY18.
 Tax collections between FY07 to FY12 has grown by 16.5% and then post
that by 13.8%. There is a close relation between GDP growth and tax
collection growth. With higher growth, tax collections increase.
 The inflation rate averaged 9.6% between FY07 to FY12 and 6.4% thereafter.
If the growth was driven by higher demand then, there should have been a
higher inflation rate in the second part.
 The gross investment to GDP ratio was peaking at 38% (FY08 to FY11)
during the UPA government against the 30.3% (FY15 to FY18) in the present
government (as per the economic theory, higher investments, the higher and
the growth in the GDP). So how can the GDP growth during the present
government be higher than the previous government. This could happen in
cases where the production becomes very efficient leading to lower ICOR
(Incremental Capital Output Ratio). But during the present government the
twin shocks – Demonetization and GST – have ensured that this is not the
case.
 The exports during the UPA government boomed at an average growth rate of
over 20% against the zero growth rates in the last four years.
 The data has been prepared from 2004-05 to 2010-11 and this coincides with
the period of UPA govt.
Arguments in favor of the new methodology.

 The decline in bank credit growth can be explained by Increased capital

efficiency. Bank facilitating credit to the corporate through instruments such as
commercial papers, bonds, etc
 Inconsistency in investment, increased economic efficiency, Decreased ICOR
(Incremental Capital Output Ratio – measures higher/incremental amount of
capital needed to increase the production by a unit). There is no uniform
relationship between growth and investment. The cycle is revived through
consumption and then investment kicks in.
 The tax collections could also have been varied because of various other
factors such as higher compliance, changes in tax rates, etc.

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The Concept of Planning in Management

Planning means deciding in advance what to do, why to do it, and when to do it. It is
one of the foremost managerial functions. Before initiating a task, the manager must
formulate an idea of how to perform a particular task. Hence, this function of
management is closely related to creativity and innovation. A manager can only
know where he has to go if he first sets an objective as planning bridges a gap
between where we stand today and where we want to reach. Planning is all about
what managers at all levels perform. It requires adopting a decision as it involves
making a choice from an alternative course of action.

Thus, planning involves setting the target and developing an appropriate method or
strategy to attain the desired objective. Planning provides an intellectual approach
for attaining the organization’s predetermined goals. Hence, all members need to
work together toward achieving organizational goals. These goals set the target
which needs to be achieved and against which actual performance is measured.
Therefore, planning means setting objectives and targets and developing an action
plan to attain them.

The planning that is formulated has a given time frame but time is a limited resource.
It needs to be used intelligently. If the timing is not considered, the conditions in the
environment may change and all the business plans may go unproductive. Planning
may go in vain if it is not implemented.

Planning Definition:

Planning is defined as setting an objective for a given time period, developing

various strategies or methods to attain them, and then selecting the best possible
alternatives from the various methods available.

Feature/ Nature/ Characteristics of Planning:

1. Planning Contributes to the Objective- Planning helps in achieving the

objective. We cannot think of achieving any objective without any kind of
planning. Planning is one of the primary functions of management that
contributes immensely to the achievement of predetermined objectives.
Planning is The Primary Function of Management- Planning is the first step
that any manager or anyone adapts to use to move towards any goal.
2. Pervasive- Planning is universal. Planning is there in every organization,
whether it is a small size, mid-size or large size or at whatever level it is, every
manager, every individual employee plans on at his/her level.
3. Planning is Futuristic- We do planning for the future. Hence it is called a
futuristic process. We always stay in the present and plan for the future.
Planning is never done in the past.

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4. Planning is Continuous- We plan to achieve any goal. Planning is done for

a specific period of time. It may be for a month, a quarter, or a year. There is
always a need for a new plan after the expiry of that period. Hence it is called
a continuous process. The continuation of planning is related to the business
cycle. It implies that once the plan is framed and implemented, it is followed
by another plan and so on.
5. Planning Involves Decision Making- In planning, function managers
evaluate various alternatives and select the most appropriate way to manage
things.
6. Planning is a Mental Exercise- In planning, assumptions and predictions
regarding the future are made by scanning the environment properly. This
activity requires a higher level of intelligence.

Importance/ Significance of Planning:

1. Planning Provides Direction- Planning provides us with direction. How to

work in the future includes planning. By stating in advance, how work has to
be done, planning provides direction for action.
2. Planning Reduces the Risk of Uncertainties- Uncertainty means any
events in the future that change our course of action. Planning helps the
manager to face uncertainty. We cannot remove such uncertainty from our
life. However, due to planning, we can work on such uncertainty. Just like an
unforeseen event is going to come in which we are going in loss. So, if we are
already ready, we have made funds for it, then we will be able to use it to fight
that unforeseen situation.
3. Planning Reduces Overlapping and Wasteful Activity- Overlapping means
the working relationship has not been allocated specifically. If we plan, our
time will not be wasted.
4. Planning Promotes Innovative Ideas- If you are planning, then you get
feedback from your senior managers or juniors, from there you can get
innovative ideas. Besides, if you make your employees part of the decision-
making, then you can get new creative ideas from there too.
5. Planning Facilitates Decision- Planning helps in decision-making. The more
efficient you plan, the more right you will be in the decision. With good
planning, our decision-making gets accurate, it becomes feasible and it also
gets improved.
6. Planning Establishes a Standard for Controlling- Controlling is incomplete
without planning and planning is incomplete without controlling. If you have
done the planning but you do not know if the thing is happening or not, then
the planning is useless. In case, there is no planned output then the
controlling manager will have no base to compare whether the actual output is
adequate or not.

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7. Focuses Attention on Objectives of that Company- Through planning,

efforts of all the employees are directed towards the achievement of
organizational goals and objectives.

Limitations of Planning:

1. Planning Leads to Rigidity- Once the planning is made, then it gets very
difficult to change something in it.
2. Planning May Not Work in a Dynamic Environment- If continual changes
are happening in the environment, then planning will not be effective as things
will not run according to the plan we have prepared. We have made a plan
according to the situation. But If there are continual changes occurring in the
environment, then the right prediction, right planning becomes almost
impossible.
3. It Reduces Creativity- Planning reduces the creativity of employees of any
organization because employees just have to implement the plan which is
already decided by the top management. Hence, they do not get the
opportunity to show their creativity or their innovativeness. Therefore, much of
the initiative or creativity inherent in employees get lost or reduced, and also
innovative ideas stop coming.
4. Planning Involves Huge Costs- When plans are formulated, huge costs are
involved in their formulation. These may be in terms of time and money. For
example, lots of time is spent checking the accuracy of facts. Detailed plans
demand scientific calculations to verify facts and figures. The costs incurred
sometimes may not justify the benefits derived from the plans. Several
incidental costs are also involved, like expenses on boardroom meetings,
discussions with professional experts, and preliminary investigations to find
out the feasibility of the plan.

Sometimes the plans that are formulated take so much time that there is no
time left for their implementation.
5. Planning Does Not Guarantee Success- Planning only provides a base for
analyzing for the future. It is not a solution for the future course of action.
6. Lack of Accuracy- In planning, many assumptions are made to decide about
the future course of action. Sometimes planning is not accurate. Assuming for
the future cannot be 100% accurate.

Planning Process:

 Setting up the Objective- Till the manager does not have an objective, he
cannot do the planning, so the goal should always be clear.

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 Developing Premises- As we know the future is certain, therefore planning is

always made keeping the future in mind. Hence in the function of
management, certain assumptions are required to be made. These
assumptions are known as premises. Premises means making assumptions
for the future. The manager can make the assumption by studying the past
decisions, policies, studying the facts, and existing plans.
 Listing the Various Alternatives for Achieving the Objectives- After
setting up objectives, the managers make a list of alternatives through which
the organization can achieve its objectives.
 Evaluation of Different Alternatives- In this step of the planning process,
managers evaluate and closely examine each of the alternative plans. Every
alternative will go through an examination where all its pros and cons will be
weighed. The alternative plans need to be examined taking into account the
organizational objectives.
 Selecting an Alternative- This is the stage of planning in which the manager
has to adopt a decision. Here, the manager will choose the best and most
feasible plan to implement. The ideal alternative that is selected by the
manager should be the most profitable one with the least amount of negative
consequences and is also adaptable to dynamic situations.
 Implement the Plan- This is the step where other managerial functions are
also considered. The step is concerned with putting the plan into action, i.e.,
doing what is required. For example, if a manager makes a plan to increase
production then more labor, and more machinery will be required. Hence, this
step would also involve arranging for labor and the purchase of machinery.
 Follow Up- To find out whether plans that are formulated are being
implemented and activities are performed according to schedule is also part of
the planning process. To stick with the plan and follow it in a given time frame
is equally important to ensure that organization objectives are attained.

Conclusion
In simple terms, planning is the process of formulating key decisions for an
organization to grow successfully in the next few years.

Introduction to the Sectors of Indian Economy:

India is one of the largest, if not the largest economy in the world. It is predicted to be
the second largest economy in the world by 2050. So, what contributes to the Indian
economy? To answer this, we need to divide India’s economy into three parts and study
the sectors of Indian economy in detail. We will also discuss the problems faced by each
sector and solutions to these sectors respectively.

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Indian Economy

They are three sectors in the Indian economy, they are; primary economy, secondary
economy, and tertiary economy. In terms of operations, the Indian economy is divided
into organized and unorganized. While for ownership, it is divided into the public sector
and the private sector. But today, we are only going to talk about the sectors of Indian
economy and what consists of these sectors.

The Indian economy was in distress at the brink of the country’s

independence. Being a colony, she was fulfilling the development needs not of
herself, but of a foreign land. The state, that should have been responsible for
breakthroughs in agriculture and industry, refused to play even a minor role in this
regard. On the other hand, during the half century before India’s independence, the
world was seeing accelerated development and expansion in agriculture and
industry - on the behest of an active role being played by the states.
British rulers never made any significant changes for the benefit of the
social sector, and this hampered the productive capacity of the economy. During
independence, India’s literacy was only 17 percent, with a life expectancy of 32.5
years. Therefore, once India became independent, systematic organisation of the
economy was a real challenge for the government of that time. The need for
delivering growth and development was in huge demand in front of the political
leadership - as the country was riding on the promises and vibes of national fervour.
Many important and strategic decisions were taken by 1956, which are still shaping
India’s economic journey.
Today India is ranked the seventh largest economy, and third largest in
terms of Purchasing Power Parity (PPP). The Indian economy’s GDP is pegged at $
2.9 tn. At a press conference, Finance Minister Arun Jaitley commented, ‘We keep
oscillating between the fifth and the sixth largest economy, depending on the dollar
rate. As we look at the years ahead, we will be $ 5 tn by 2024 and $ 10 tn by 2030 or
2031.’
The GDP per capita in India was $ 1963.55 in 2017. The GDP per Capita
in India is equivalent to 16% of the world's average, and averaged $ 693.96 from
1960 until 2017. It reached an all - time high of $ 1963.55 in 2017.

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As per a recent WEF report titled 'Future of Consumption in Fast-Growth Consumer

Market – India', India’s market size is pegged to grow at a thriving $ 6 tn in the
coming years.

Performing Sectors of Indian Economy

The adoption of the New Economic Policy in 1991 saw a landmark shift in the Indian
economy, as it ended the mixed economy model and license raj system - and
opened the Indian economy to the world. An overview of the top performing sectors
of the Indian economy is given below -

1. Agricultural Sector:

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One of the most important sectors of the Indian economy remains Agriculture. Its
share in the GDP of the country has declined and is currently at 14%. However,
more than 50% of the total population of the country is still dependent on agriculture.
Keeping this in mind, the Union Budget 2017 - 18 gave high priority to
the agricultural sector and aimed to double farmers’ incomes by 2022.

• Government subsidies to agriculture are at an all - time high.

• Further, cropping patterns have shifted in favour of cash crops such as
sugarcane and rubber.
• Introduction of cooperative farming like – e - choupal etc.
• Rise of SHGs such as Lijjat Papad.
• Agricultural land is being brought under industrial and commercial use,
thereby straining the remaining agricultural land.
• Many export sectors have been opened for agricultural goods.
• Food processing is emerging as a ‘Sunrise Industry’

2. Industry Sector:

Another important part of the Indian economy is the Industry sector. Changes such
as the end of the ‘Permit Raj’ and opening up of the economy were welcomed in the
country with great enthusiasm and optimism. As a result of these changes, the
industrial potential of the economy has increased since 1991.

• Proliferation of industries, from traditional iron and steel to jute

and automobiles.
• Autonomy in production, marketing and distribution.
• Reduced red - tapism.
• Encouragement to private investments, both domestic as well as FDI.
• Transfer of technology and benefits of research and development to the
advantage of the economy.
• Arrival of investment models such as joint ventures, public-private
partnerships, MNCs.
• Private players got an opportunity to enter new sectors, which were earlier
under government monopoly.

3. Services Sector:

The sector that benefited most from the New Economic Policy was the services
sector. Banking, Finance, Business Process Outsourcing - and most
importantly Information Technology services - have seen double - digit growth.

• Indian IT giants such as Infosys, WIPRO and TCS have made their mark
on the global platform.
• 60 percent of the GDP contribution comes from the services sector.
• India, with its huge demographic dividend potential, has emerged as the IT
hub of the world.
• New employment opportunities are being created in this sector.
• Opening of transportation, tourism and medical sectors have led to the
growth of service sector competencies.

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• RBI has transitioned from being a regulator to a facilitator.

• Product diversity of financial investments.
• Wider penetration of services such as insurance, banking, stock market
etc.
• Considerable improvement in forex reserves.

4. Food Processing:

Food processing has emerged as a high - growth, high - profit sector and is one of
the focus sectors of the ‘Make in India’ initiative. The vast availability of raw
materials, resources, favourable policy measures and numerous incentives have led
India to be considered as a key attractive market for the sector. With a population of
1.3 bn and an average age of 29, as well as a rapidly growing middle - class
population that spends a high proportion of their disposable income on food, India
boasts of a large consumer base. The total consumption of the food and beverage
segment in India is expected to increase from $ 369 bn to $ 1.14 tn by 2025. The
output of the food processing sector (at market prices) is expected to increase to $
958 bn during the same period. India is the second largest producer of food grains in
the world, second only to China. This sector has huge potential in India due to
increasing urbanization, income levels and a high preference for packaged and
processed food. Visit the sectors category to read more about the food processing
industry.

5. Manufacturing Sector:

The manufacturing sector is the second largest contributor to India’s GDP after the
Services sector. Various government initiatives like Make in India, MUDRA,
Sagarmala, Startup India, Freight Corridors, along with a whole - hearted
contribution from states, will raise the share of the manufacturing sector in the
foreseeable future.
However, if India aims to raise its share of manufacturing in GDP to around 25%, the
industry will have to significantly step up its research and development expenditure.
The quantum of value addition has to be increased at all levels and the government
needs to offer attractive remuneration to motivate people to join the manufacturing
sector.

Recent Developments in the Economy of India

Besides these developments and reforms, it is imperative to bear in mind that in

order to tap the highest potential of the economy and ensure good governance, an
optimal level of synergy is required between the central and state government. This
will not only add strength to our cooperative federal structure but will also strengthen
India’s economy. Initiatives such as –

• Goods and Services Tax (GST)

• Insolvency and Bankruptcy Code (IBC)
• Startup India
• Digital India

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These, among others, have helped the Indian economy jump 65 ranks (in the last
four years) in the World Bank’s Ease of Doing Business Report.
These measures cemented India’s reputation as one of the few bright spots in an
otherwise grim global economy. India is among the fastest growing major
economies, underpinned by a stable macro - economy with declining inflation and
improving fiscal and external balances. Not only that, it was also one of the few
economies enacting major ‘structural reforms’, that have positioned India as a
competitive player in the international market.

Future of Indian Economy

To make India a $ 5 tn economy by 2030, and to achieve consistent 8% growth, NITI
Aayog has released a comprehensive document titled ‘Strategy for New India. Its
main objectives are

1. Doubling farmers’ incomes.

2. Creating an all India talent pool for the entre and States together - such as the
All India Services.
3. Providing a major boost to the ‘Make in India’ campaign.
4. Achieving 22% tax to GDP ratio by 2023 - up from the current 17%.
5. Achieving 36% of investment rate by 2023 - up from the current 29%.

Guided by unwavering democratic credentials and strong government leadership,

India is an emerging superpower with a vibrant economic climate. Under Prime
Minister Narendra Modi, India’s growth rate in the last quarter has been pegged at
7.7%. And with an ever - expanding middle - class base and youth demographic, the
opportunity for business has never been better.
To know more about foreign trade & FDI in India, visit our resources section.

Business Cycle

Introduction

A study of fluctuations in business activity is called business cycle. Business

cycle can be defined as a periodically recurring wave like movements in
aggregate economic activity (like national income, employment, investment, profits,
prices) reflected in simultaneous, fluctuations in major macro economic variables.

R A Gordon defined business cycle as consisting of “recurring alteration of

expansion and contraction in aggregate economic activity, the alternating
movements in each direction being self-reinforcing and prevailing virtually all parts
of the economy”.

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What is a Business Cycle?

A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP)

around its long-term natural growth rate. It explains the expansion and contraction
in economic activity that an economy experiences over time.

Characteristic Features Of Business Cycle:

 It occurs periodically: the fluctuations in economic activities occur

periodically but not at a fixed period of interval.
 It is international in character: the changes in any economic activity of a
country have impact on economies of the world (for example financial
crisis in US had impact on various other countries economic activities).
 It is wave like: the fluctuations indicate ups and downs in various economic
indicators of a country.
 The process is cumulative: the process is cumulative in nature, that
means change in income level, savings or any other activity will be in
aggregates.
 The cycles will be similar but not identical: the cycle has ups and downs
but not identical spacing that means the time period of occurrence will
differ.

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A business cycle is completed when it goes through a single boom and a single
contraction in sequence. The time period to complete this sequence is called the
length of the business cycle. A boom is characterized by a period of rapid economic
growth whereas a period of relatively stagnated economic growth is a recession.
These are measured in terms of the growth of the real GDP, which is inflation-
adjusted.

Stages of the Business Cycle:

In the diagram above, the straight line in the middle is the steady growth line. The
business cycle moves about the line. Below is a more detailed description of each
stage in the business cycle:

1. Expansion

The first stage in the business cycle is expansion. In this stage, there is an increase
in positive economic indicators such as employment, income, output, wages, profits,
demand, and supply of goods and services. Debtors are generally paying their debts
on time, the velocity of the money supply is high, and investment is high. This
process continues as long as economic conditions are favorable for expansion.

2. Peak

The economy then reaches a saturation point, or peak, which is the second stage of
the business cycle. The maximum limit of growth is attained. The economic
indicators do not grow further and are at their highest. Prices are at their peak. This
stage marks the reversal point in the trend of economic growth. Consumers tend to
restructure their budgets at this point.

3. Recession

The recession is the stage that follows the peak phase. The demand for goods and
services starts declining rapidly and steadily in this phase. Producers do not notice
the decrease in demand instantly and go on producing, which creates a situation of
excess supply in the market. Prices tend to fall. All positive economic indicators such
as income, output, wages, etc., consequently start to fall.

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4. Depression

There is a commensurate rise in unemployment. The growth in the economy

continues to decline, and as this falls below the steady growth line, the stage is
called a depression.

5. Trough

In the depression stage, the economy’s growth rate becomes negative. There is
further decline until the prices of factors, as well as the demand and supply of goods
and services, contract to reach their lowest point. The economy eventually reaches
the trough. It is the negative saturation point for an economy. There is extensive
depletion of national income and expenditure.

6. Recovery

After the trough, the economy moves to the stage of recovery. In this phase, there is
a turnaround in the economy, and it begins to recover from the negative growth rate.
Demand starts to pick up due to low prices and, consequently, supply begins to
increase. The population develops a positive attitude towards investment and
employment and production starts increasing.

Employment begins to rise and, due to accumulated cash balances with the bankers,
lending also shows positive signals. In this phase, depreciated capital is replaced,
leading to new investments in the production process. Recovery continues until the
economy returns to steady growth levels.

This completes one full business cycle of boom and contraction. The extreme points
are the peak and the trough.

Theories On Business Cycle:

1. Sunspot theory / climate theory: depending on climatic changes

agricultural products are produced. Based on the production other ancillary
units will function therefore the base for any change in economic activity of
the country isclimate.
2. Psychological theory: during depression or crisis of any business
organization it is completely based on the psychology of the entrepreneur as
to whether the organization can be revived or shutdown.

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3. Monetary theory: means the demand and supply of money is the primary
reason for economic fluctuations of a country.
4. Over investment theory: if the organizations and individuals save more
and invest a huge amount then their expectations on increase in their
returns.
5. Over savings/ under consumption theory: As per this theory the increase
in savings and investment will bring down the consumption which will reduce
the demand for goods in the market.
6. Innovation theory: According to this theory more innovations lead to new
technology and new business that leads to prosperity in the economy.

There are two types of business cycle models, they are (i) Exogenous model; due
to economic shocks like war. (ii) Endogenous model; trade cycle because of
factors which lie within the economic system.

A monetarist explanation: business cycles are essentially monetary phenomena

caused by changes in the money supply. Change in money supply leads to change
in employment and national income which increases the price. The path to an
increased price level is cyclical. The link between changes in money supply and
changes in income is known as the transmission mechanism.

New Economic Policy of 1991: Objectives, Features and Impacts:

New Economic Policy of India was launched in the year 1991 under the leadership of
P. V. Narasimha Rao. This policy opened the door of the India Economy for the
global exposure for the first time. In this New Economic Policy P. V. Narasimha Rao
government reduced the import duties, opened reserved sector for the private
players, devalued the Indian currency to increase the export. This is also known as
the LPG Model of growth.
New Economic Policy refers to economic liberalisation or relaxation in the import
tariffs, deregulation of markets or opening the markets for private and foreign
players, and reduction of taxes to expand the economic wings of the country.

Former Prime Minister Manmohan Singh is considered to be the father of New

Economic Policy (NEP) of India. Manmohan Singh introduced the NEP on July
24,1991.

Objectives of New Economic Policy 1991:

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1. Enter into the field of ‘globalization’ and make the economy more market-
oriented.
2. Reduce the inflation rate and rectify imbalances in payment.
3. Increase the growth rate of the economy and create enough foreign exchange
reserves.
4. Stabilize the economy and convert the economy into a market economy by
the removal of unwanted restrictions.
5. Allow the international flow of goods, capital, services, technology, human
resources, etc. without too many restrictions.
6. Enhance the participation of private players in all sectors of the economy. For
this, the reserved sectors for the government were reduced to just 3.

Branches of New Economic Policy 1991:

1. Liberalisation
2. Privatisation
3. Globalisation

Liberalisation

1. All commercial banks were now free to fix their interest rates. This was
previously done by the RBI.
2. Investment limit for small-scale industries was increased to Rs. 1 Crore.
3. Indian industries were given the freedom to import capital goods.
4. Companies were given the freedom to expand and diversify their production
capacities based on market requirements. Previously, the government used to
fix the maximum limit of production capacity.
5. Restrictive trade practices were abolished. Licensing was removed in the
private sector and only a few industries were required to obtain licenses,
namely, liquor, cigarette, industrial explosives, defence equipment, hazardous
chemicals and drugs.

Learn the difference between globalization and liberalization in the linked article.
Privatisation

1. Under this, many public sector undertakings (PSUs) were sold to private
players.
2. PSU shares were sold to private players.
3. PSUs were disinvested.
4. The number of industries reserved for the public sector was reduced to 3
(mining of atomic minerals, railway and transport, and atomic energy).

Globalisation

1. Tariffs were reduced – reduction of customs duties in import and export to

attract global investors.
2. Foreign trade policy was for the long-term – Liberal and open policy was
enforced.
3. The Indian currency was made partially convertible.

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4. The equity limit of foreign investment was increased.

The main characteristics of new Economic Policy 1991 are:

1. Delicencing. Only six industries were kept under Licencing scheme.

2. Entry to Private Sector. The role of public sector was limited only to four

industries; rest all the industries were opened for private sector also.

3. Disinvestment. Disinvestment was carried out in many public sector enterprises.

[Link] of Foreign Policy. The limit of foreign equity was raised to 100% in

many activities, i.e., NRI and foreign investors were permitted to invest in Indian

companies.

5. Liberalisation in Technical Area. Automatic permission was given to Indian

companies for signing technology agreements with foreign companies.

6. Setting up of Foreign Investment Promotion Board (FIPB). This board was set up

to promote and bring foreign investment in India.

7. Setting up of Small Scale Industries. Various benefits were offered to small scale

industries.

Three Major Components or Elements of New Economic Policy:

There are three major components or elements of new economic policy-

Liberalisation, Privatisation, Globalisation.

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1. Liberalisation:

Liberalisation refers to end of licence, quota and many more restrictions and controls

which were put on industries before 1991. Indian companies got liberalisation in the

following way:

(a) Abolition of license except in few.

(b) No restriction on expansion or contraction of business activities.

(c) Freedom in fixing prices.

(d) Liberalisation in import and export.

(e) Easy and simplifying the procedure to attract foreign capital in India.

(f) Freedom in movement of goods and services

(g) Freedom in fixing the prices of goods and services.

2. Privatisation:

Privatisation refers to giving greater role to private sector and reducing the role of

public sector. To execute policy of privatisation government took the following steps:

(a) Disinvestment of public sector, i.e., transfer of public sector enterprise to private

sector

(b) Setting up of Board of Industrial and Financial Reconstruction (BIFR). This board

was set up to revive sick units in public sector enterprises suffering loss.

(c) Dilution of Stake of the Government. If in the process of disinvestments private

sector acquires more than 51% shares then it results in transfer of ownership and

management to the private sector.

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3. Globalisation:

It refers to integration of various economies of world. Till 1991 Indian government

was following strict policy in regard to import and foreign investment in regard to

licensing of imports, tariff, restrictions, etc. but after new policy government adopted

policy of globalisation by taking following measures:

(i) Import Liberalisation. Government removed many restrictions from import of

capital goods.

(ii) Foreign Exchange Regulation Act (FERA) was replaced by Foreign Exchange

Management Act (FEMA)

(iii) Rationalisation of Tariff structure

(iv) Abolition of Export duty.

(v) Reduction of Import duty.

As a result of globalisation physical boundaries and political boundaries remained no

barriers for business enterprise. Whole world becomes a global village.

Globalisation involves greater interaction and interdependence among the various

nations of global economy.

Impact of Changes in Economic Policy on the Business or Effects

of Liberalisation and Globalisation:

The factors and forces of business environment have lot of influence over the

business. The common influence and impact of such changes in business and

industry are explained below:

1. Increasing Competition:

After the new policy, Indian companies had to face all round competition which
means competition from the internal market and the competition from the MNCs. The

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companies which could adopt latest technology and which were having large number

of resources could only survive and face the competition. Many companies could not

face the competition and had to leave the market.

For example, Weston Company which was a leader in Т. V. market with more than

38% share in T.V. market lost its control over the market because of all round

competition from MNCs. By 1995-96, the company almost became unknown in the

T.V market.

2. More Demanding Customers:

Prior to new economic policy there were very few industries or production units.
As a result there was shortage of product in every sector. Because of this shortage

the market was producer-oriented, i.e., producers became key persons in the

market. But after new economic policy many more businessmen joined the

production line and various foreign companies also established their production units

in India.

As a result there was surplus of products in every sector. This shift from shortage to

surplus brought another shift in the market, i.e., producer market to buyer market.

The market became customer- oriented and many new schemes were made by

companies to attract the customer. Nowadays products are produced/manufactured

keeping in mind the demands of the customer.

3. Rapidly Changing Technological Environment:

Before or prior to new economic policy there was a small internal competition only.

But after the new economic policy the world class competition started and to stand

this global competition the companies need to adopt the world class technology.

To adopt and implement the world class technology the investment in R & D

department has to increase. Many pharmaceutical companies increased their

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investment in R and D department from 2% to 12% and companies started spending

a large amount for training the employees.

4. Necessity for Change:

Prior to 1991 business enterprises could follow stable policies for a long period of

time but after 1991 the business enterprises have to modify their policies and

operations from time to time.

5. Need for Developing Human Resources:

Before 1991 Indian enterprises were managed by inadequately trained personnel’s.

New market conditions require people with higher competence skill and training.

Hence Indian companies felt the need to develop their human skills.

6. Market Orientation:

Earlier firms were following selling concept, i.e., produce first and then go to market

but now companies follow marketing concept, i.e., planning production on the basis

of market research, need and want of customer.

7. Loss of Budgetary Support to Public Sector:

Prior to 1991 all the losses of Public sector were used to be made good by

government by sanctioning special funds from budgets. But today the public sectors
have to survive and grow by utilising their resources efficiently otherwise these

enterprises have to face disinvestment. On the whole the policies of Liberalisation,

Globalisation and Privatisation have brought positive impacts on Indian business and

industry. They have become more customer focus and have started giving

importance to customer satisfaction.

8. Export a Matter of Survival:

The Indian businessman was facing global competition and the new trade policy

made the external trade very liberal. As a result to earn more foreign exchange many

Indian companies joined the export business and got lot of success in that. Many
companies increased their turnover more than double by starting export division. For

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example, the Reliance Company, Videocon, MRF, Ceat Tires, etc. got a great hold in

the export market.

Steps Taken with Respect to Liberalization.

The licensing-permit system which prevailed in the country during first three decades

of development was abolished (expect for a list of 18 industries).

Considering rise in demand due to growth of middle class, white goods, cars, raw

hides, skins and washing machines were removed from the list of reserved items.

Earlier, large business houses and industrial units were refrained from venturing into

big projects due to Monopolistic and Restrictive Trade Practices (MRTP) Act,

1970. The policy was abolished to encourage private investment in core industries

like iron & steel, petrochemicals, infrastructure etc must be promoted.

The certain economic sectors were largely reserved for the public sector. These

sectors enjoyed monopoly and were immune from competitive environment. Thus

government introduced policy changes to enable increased private participation in

this sector.

Steps Taken with. Respect to Privatization.

Government has been increasingly dis-investing in PSUs. Some of the areas have

been restricted for public sector like high-end technology, strategic and essential

infrastructure (transport and communication). Sensitive sectors like defense have

been also reserved for public sector.

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The management in public enterprises are given more autonomy for taking

decisions. Management is also made more professional to handle changes in

business environment in a more competent manner.

Public sector management will be allowed to raise funds from mutual fund and other

banking and non-banking financial companies to meet their fund requirement.

Public sector units were made to enter in a MOU with government to make them

accountable, while being autonomous. Public private partnership models of business

venture are being increasingly popularized.

Steps Taken with Respect to Globalization.

Portfolios of PSUs were reviewed with emphasis on adoption of high technology,

strategic planning and essential infrastructure to attain global standards as a long

term approach.

Business restructuring to identifying the core competencies of a business unit and

improving upon the underlying processes with change in business environment.

Technical restructuring helps in improving existing technology or adoption of new

technology to improve competitive position of business.

Government has reduced trade barriers to enable free flow of goods and services.

Investment norms (by private and foreign players) have been reworked to enable

increased capital flow.

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Globalization aims to create an environment in which free flow of labor (human

talent) to can take place.

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