Unit -1

Q.1- EXPLAINS THE BUSINESS ECONOMICS WITH ITS CHARACTERSTICS, NATURE,

IMPORTANTANCE AND SCOPE?
ANS:- Business Economics can be defined as amalgamation of economic theory with business practices so as
to ease decision-making and future planning by management. Business Economics assists the managers of a
firm in a rational solution of obstacles faced in the firm’s activities. It makes use of economic theory and concepts. It
helps in formulating logical Business decisions. The key of Business Economics is the micro-economic theory of the
firm. It lessens the gap between economics in theory and economics in practice. Business Economics is a science
dealing with effective use of scarce resources. It guides the managers in taking decisions relating to the firm’s
customers, competitors, suppliers as well as relating to the internal functioning of a firm. It makes use of statistical
and analytical tools to assess economic theories in solving practical business problems
According to MC’NAIR AND MERJAN
“Business economics consist of the use of economics modes of thought to the analysis of business situations”.
According to MANSFIELD
“Business economics is concerned with application of economics to the problem of formulating rational
Business decisions”

CHARACTERISTICS OF BUSINESS ECONOMICS

1. Micro- study level: - the unit of study is a firm it is the problems of a business or which are studied in it.
2. Problem solution: - It also use for various problem solution like what to produce? How to produce? For
whom to produce?
3. Pragmatic in nature: - it deals with something is based on practical consideration rather than theoretical
ones.
4. Conceptual: - it aim to analysis business problem on the basic of establishment concepts and market.
5. Normative approach: - Business economics belongs to normative economics rather than positive
economics. In other words it is persuasive than descriptive.
6. Guide to the management
7. Helps in decision – making
8. Integration of economics and business management>

IMPORTANCE OF BUSINESS ECONOMICS

1. Helps in decision making
2. Helps in future planning
3. Helps in problem solving
4. Coordinating with different departments
5. Build competent a variety of business decision in a complicated environment
6. Helps in attainment of social & economics welfare
7. Incorporate useful idea from other disciplines.

NATURE OF MANGERIAL ECONOMICS

1. Business economics is science:-
It studies the effects of a change in price of commodity factors and forces on the demand of a particular product. It
also studies the effects and implication of the plans, policies and programmers’ of a firm on its sales and profit.
2. Business Economics requires Art
Business economist is required to have an art of utilising his capability, knowledge and understanding to achieve the
organizational objective. Business economist should have an art to put in practice his theoretical knowledge
regarding elements of economic environment.
 3. Business Economics for administration of organization
Business economics helps the management in decision making. These decisions are based on the economic rationale
and are valid in the existing economic environment.
4. Business economics is helpful in optimum resource allocation
The resources are scarce with alternative uses. Managers need to use these limited resources optimally. Each
resource has several uses. It is manager who decides with his knowledge of economics that which one is the
preeminent use of the resource.
5. Business Economics has components of micro economics
Managers study and manage the internal environment of the organization and work for the profitable and long-term
functioning of the organization. This aspect refers to the micro economics study. The Business economics deals with
the problems faced by the individual organization such as main objective of the organization, demand for its
product, price and output determination of the organization, available substitute and complimentary goods, supply of
inputs and raw material, target or prospective consumers of its products etc.
6. Business Economics has components of macro economics
None of the organization works in isolation. They are affected by the external environment of the economy in which
it operates such as government policies, general price level, income and employment levels in the economy, stage of
business cycle in which economy is operating, exchange rate, balance of payment, general expenditure, saving and
investment patterns of the consumers, market conditions etc. These aspects are related to macro economics.
7. Business Economics is dynamic in nature
Business Economics deals with human-beings (i.e. human resource, consumers, producers etc.). The nature and
attitude differs from person to person. Thus to cope up with dynamism and vitality Business economics also changes
itself over a period of time.
Business Economics is not only applicable to profit-making business organizations, but also to non- profit
organizations such as hospitals, schools, government agencies, etc.
Scope of Business Economics:
The scope of Business economics is not yet clearly laid out because it is a developing       science. Even then the
following fields may be said to generally fall under Business Economics:
    1.  Demand Analysis and Forecasting
    2.  Cost and Production Analysis
    3.  Pricing Decisions, Policies and Practices
    4.  Profit Management
    5.  Capital Management
These divisions of business economics constitute its subject matter.
Recently, Business economists have started making increased use of Operation Research methods like Linear
programming, inventory models, Games theory, queuing up theory etc., have also come to be regarded as part of
Business Economics.
   1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming
productive resources into goods that are to be sold in the market. A major part of Business decision making depends
on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing
production schedules and employing resources. It will help management to maintain or strengthen its market
position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a
product. Demand analysis and forecasting occupies a strategic place in Business Economics.
  2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A wise manager
would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates
and choose the cost-minimising output level, taking also into consideration the degree of  uncertainty in production
and cost calculations. Production processes are under the charge of engineers but the business manager is supposed
 to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing
practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost
concepts, cost-output relationships, Economics and Diseconomies of scale and cost control.
  3. Pricing decisions, policies and practices: Pricing is a very important area of Business Economics. In fact, price is
the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of
the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market
forms, pricing methods, differential pricing, product-line pricing and price forecasting.
    4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit
which provides the chief measure of success of a firm. Economics tells us that profits are the reward for uncertainty
bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs
and revenues likely to accrue to the firm at different levels of output. The more successful a manager is in reducing
uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the
most challenging area of Business Economics.

   5. Capital management: The problems relating to firm’s capital investments are perhaps the most complex and
troublesome. Capital management implies planning and control of capital expenditure because it involves a large
sum and moreover the problems in disposing the capital assets off are so complex that they require considerable
time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection
of projects.

Q2. EXPLAIN THE FUNDAMENTAL CONCEPTS OF BUSINESS ECONOMICS PRINCIPLES AND

ALSO THE ROLE AND RESPONSIBILITIES OF BUSINESS ECONOMIST?

Principles of Business Economics

Economic principles assist in rational reasoning and defined thinking. They develop logical ability and strength of a
manager. Some important principles of Business economics are:
1. Marginal and Incremental Principle
This principle states that a decision is said to be rational and sound if given the firm’s objective of profit
maximization, it leads to increase in profit, which is in either of two scenarios-
 If total revenue increases more than total cost.
 If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal
generally refers to small changes. Marginal revenue is change in total revenue per unit change in output
sold. Marginal cost refers to change in total costs per unit change in output produced (While incremental
cost refers to change in total costs due to change in total output). The decision of a firm to change the price
would depend upon the resulting impact/change in marginal revenue and marginal cost. If the marginal
revenue is greater than the marginal cost, then the firm should bring about the change in price.
Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's
performance for a given Business decision, whereas marginal analysis often is generated by a change in
outputs or inputs. Incremental analysis is generalization of marginal concept. It refers to changes in cost
and revenue due to a policy change. For example - adding a new business, buying new inputs, processing
products, etc. Change in output due to change in process, product or investment is considered as
incremental change. Incremental principle states that a decision is profitable if revenue increases more than
costs; if costs reduce more than revenues; if increase in some revenues is more than decrease in others; and
if decrease in some costs is greater than increase in others.
2. Equi-marginal Principle
 Marginal Utility is the utility derived from the additional unit of a commodity consumed. The laws of equi-
marginal utility states that a consumer will reach the stage of equilibrium when the marginal utilities of
various commodities he consumes are equal. According to the modern economists, this law has been
formulated in form of law of proportional marginal utility. It states that the consumer will spend his money-
income on different goods in such a way that the marginal utility of each good is proportional to its price,
i.e.,
MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.
Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the technique of
production which satisfies the following condition:
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
Where, MRP is marginal revenue product of inputs and MC represents marginal cost.
Thus, a manger can make rational decision by allocating/hiring resources in a manner which equalizes the
ratio of marginal returns and marginal costs of various use of resources in a specific use.

3. Opportunity Cost Principle

By opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. If there
are no sacrifices, there is no cost. According to Opportunity cost principle, a firm can hire a factor of
production if and only if that factor earns a reward in that occupation/job equal or greater than it’s
opportunity cost. Opportunity cost is the minimum price that would be necessary to retain a factor-service
in it’s given use. It is also defined as the cost of sacrificed alternatives. For instance, a person chooses to
forgo his present lucrative job which offers him Rs.50000 per month, and organizes his own business. The
opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own business.
4. Time Perspective Principle
According to this principle, a manger/decision maker should give due emphasis, both to short-term and
long-term impact of his decisions, giving apt significance to the different time periods before reaching any
decision. Short-run refers to a time period in which some factors are fixed while others are variable. The
production can be increased by increasing the quantity of variable factors. While long-run is a time period
in which all factors of production can become variable. Entry and exit of seller firms can take place easily.
From consumers point of view, short-run refers to a period in which they respond to the changes in price,
given the taste and preferences of the consumers, while long-run is a time period in which the consumers
have enough time to respond to price changes by varying their tastes and preferences.
5. Discounting Principle
According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues
must be discounted to present values before valid comparison of alternatives is possible. This is essential
because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value.
Discounting can be defined as a process used to transform future dollars into an equivalent number of
present dollars. For instance, $1 invested today at 10% interest is equivalent to $1.10 next year.
FV = PV*(1+r)t
Where, FV is the future value (time at some future time), PV is the present value (value at t0, r is the
discount (interest) rate, and t is the time between the future value and present value.

Role of a Business Economist

A Business economist helps the management by using his analytical skills and highly developed techniques in
solving complex issues of successful decision-making and future advanced planning.
The role of Business economist can be summarized as follows:
1. He studies the economic patterns at macro-level and analysis it’s significance to the specific firm he is
working in.
2. He has to consistently examine the probabilities of transforming an ever-changing economic environment
into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
 5. He assists the management in the decisions pertaining to internal functioning of a firm such as changes in
price, investment plans, type of goods /services to be produced, inputs to be used, techniques of production
to be employed, expansion/ contraction of firm, allocation of capital, location of new plants, quantity of
output to be produced, replacement of plant equipment, sales forecasting, inventory forecasting, etc.
6. In addition, a Business economist has to analyze changes in macro- economic indicators such as national
income, population, business cycles, and their possible effect on the firm’s functioning.
7. He is also involved in advicing the management on public relations, foreign exchange, and trade. He guides
the firm on the likely impact of changes in monetary and fiscal policy on the firm’s functioning.
8. He also makes an economic analysis of the firms in competition. He has to collect economic data and
examine all crucial information about the environment in which the firm operates.
9. The most significant function of a Business economist is to conduct a detailed research on industrial
market.
10. In order to perform all these roles, a Business economist has to conduct an elaborate statistical analysis.
11. He must be vigilant and must have ability to cope up with the pressures.
12. He also provides management with economic information such as tax rates, competitor’s price and product,
etc. They give their valuable advice to government authorities as well.
13. At times, a Business economist has to prepare speeches for top management.

Q3. EXPLAIN THE RELATIONSHIP OF BUSINESS ECONOMICS WITH THE OTHER DISCIPLINE?

Relationship of Business economics with other disciplines:

Business economics is closely related to other subjects like micro economic theory, macro economic theory,
mathematics, statistics, accounting and operations research. Business economics,” as using the logic of economics,
mathematics and statistics to provide effective ways of thinking about business decision problems”.
Business economics and micro economics:
Business economics is mainly micro economic in character, making use of many of the concepts and tools provided
by micro-economic theory. The concept of elasticity of demand, marginal cost, market structures, the theory of the
firm and the theory of pricing of micro-economics are fully made use of by Business economics. Hence the study of
micro economics is essential for the better understanding of Business economics. All micro economic theories
which can be applied in business are made use of in Business economics.
Business economics and macro economics:
Macro economics is concerned with aggregates and macro economics concepts are used in Business economics in
the area of forecasting general business conditions. The theory of the firm, pricing policies etc have to be viewed in
the broad frame work of the economic system and it is essential that the business executives should have some
knowledge of the entire economic system. Macro economic concepts like national income, social accounting,
Business efficiency of capital, multiplier, business cycles, fiscal policies etc have to be studied in Business
economics for forecasting the business conditions.
Both micro and macro economics are closely related to Business economics. Business economics draws from micro
and macro economics, so that it can apply these principles to solve the day-to-day problems faced by businessmen.
Business economics and mathematics:
Business economics is becoming increasingly mathematical in character. Businessmen deal with various concepts
which are measurable. The use of mathematical logic provides clarity of concepts. It also gives a systematic frame-
work within which quantitative relationship maybe analyzed. Mathematics, therefore, is of great help to Business
economics. The major problem confronting businessmen is to minimize cost or maximize profit or optimize sales.
To find out the solution for the overall problems, mathematical concepts and techniques are widely used.
Mathematical techniques like linear programming, games theory etc help Business economists to solve many of
their problems.
Business economics and statistics:
Statistics is a science concerned with collection, classification, tabulation and analysis of data for some specified
purpose. Business economics and statistics are closely related as businessmen deal mainly with concepts that are
quantifiable for example: demand, price, cost of operation etc.
Statistics is useful to Business economics in many ways:
a. Business economics requires marshalling of quantitative data to find out functional relationship involved in
decision-making. This is done with the help of statistics.
b. Statistical methods are used for empirical testing in Business economics.
c. The business executives have to work and take decisions in an uncertainty frame-work. The theory of probability
evolved by statistics helps Business economists for taking a logical decision.
Thus statistical methods provides sound base for decision-making and help the businessmen to achieve the objective
without much difficulty. Statistical tools are extensively used in the solution of Business problems. Business
economists make use of various statistical techniques like the theory of probability, co-relation techniques,
regression analysis etc. in various business situations.
Business economics and accounting:
Accounting is concerned with recording the financial operations of a business firm. Accounting information is one
of the primary sources of data required for Business economists for the decision-making purpose. The information
it contains can be used by the Business economist to throw some light on the future course of action.
Business economics and operations research:
Operations research is the,” application of mathematical techniques in solving business problems”. It deals with
model building that is construction of theoretical-models that help the decision-making process. Though the roots of
operations research lie in military studies, it is now largely used in business administration, planning and control.
Linear programming and allied concepts of operations research are used in Business economics.
 UNIT-II

Q1. WHAT IS DEMAND? EXPLAIN THE LAW OF DEMAND ITS EXCEPTIONS AND ALSO THE
TYPES OF DEMAND?

Demand
Demand for a commodity refers to the quantity of the commodity that people are willing to purchase at a specific
price per unit of time, other factors (such as price of related goods, income, tastes and preferences, advertising, etc)
being constant. Demand includes the desire to buy the commodity accompanied by the willingness to buy it and
sufficient purchasing power to purchase it. For instance-Everyone might have willingness to buy “Mercedes-S class”
but only a few have the ability to pay for it. Thus, everyone cannot be said to have a demand for the car “Mercedes-s
Class”.
Demand may arise from individuals, household and market. When goods are demanded by individuals (for instance-
clothes, shoes), it is called as individual demand. Goods demanded by household constitute household demand (for
instance-demand for house, washing machine). Demand for a commodity by all individuals/households in the
market in total constitute market demand.
Demand Function
Demand function is a mathematical function showing relationship between the quantity demanded of a commodity
and the factors influencing demand.
Dx = f (Px, Py, T, Y, A, Pp, Ep, U)
In the above equation,
Dx = Quantity demanded of a commodity
Px = Price of the commodity
Py = Price of related goods
T = Tastes and preferences of consumer
Y = Income level
A = Advertising and promotional activities
Pp = Population (Size of the market)
Ep = Consumer’s expectations about future prices
U = Specific factors affecting demand for a commodity such as seasonal changes, taxation policy, availability of
credit facilities, etc.
Law of Demand
The law of demand states that there is an inverse relationship between quantity demanded of a commodity and it’s
price, other factors being constant. In other words, higher the price, lower the demand and vice versa, other things
remaining constant.
Demand Schedule
Demand schedule is a tabular representation of the quantity demanded of a commodity at various prices. For
instance, there are four buyers of apples in the market, namely A, B, C and D.
Demand schedule for apples
PRICE (Rs. per Buyer A (demand Buyer B (demand Buyer C (demand Buyer D (demand Market Demand
dozen) in dozen) in dozen) in dozen) in dozen) (dozens)
10 1 0 3 0 4
9 3 1 6 4 14
8 7 2 9 7 25
7 11 4 12 10 37
6 13 6 14 12 45
The demand by Buyers A, B, C and D are individual demands. Total demand by the four buyers is market demand.
Therefore, the total market demand is derived by summing up the quantity demanded of a commodity by all buyers
at each price.
Demand Curve
Demand curve is a diagrammatic representation of demand schedule. It is a graphical representation of price-
quantity relationship. Individual demand curve shows the highest price which an individual is willing to pay for
different quantities of the commodity. While, each point on the market demand curve depicts the maximum quantity
of the commodity which all consumers taken together would be willing to buy at each level of price, under given
demand conditions.

Demand curve has a negative slope, i.e, it slopes downwards from left to right depicting that with increase in price,
quantity demanded falls and vice versa. The reasons for a downward sloping demand curve can be explained as
follows-
1. Income effect- With the fall in price of a commodity, the purchasing power of consumer increases. Thus,
he can buy same quantity of commodity with less money or he can purchase greater quantities of same
commodity with same money. Similarly, if the price of a commodity rises, it is equivalent to decrease in
income of the consumer as now he has to spend more for buying the same quantity as before. This change
in purchasing power due to price change is known as income effect.

2. Substitution effect- When price of a commodity falls, it becomes relatively cheaper compared to other
commodities whose price have not changed. Thus, the consumer tend to consume more of the commodity
whose price has fallen, i.e, they tend to substitute that commodity for other commodities which have not
become relatively dear.

3. Law of diminishing marginal utility- It is the basic cause of the law of demand. The law of diminishing
marginal utility states that as an individual consumes more and more units of a commodity, the utility
derived from it goes on decreasing. So as to get maximum satisfaction, an individual purchases in such a
manner that the marginal utility of the commodity is equal to the price of the commodity. When the price of
commodity falls, a rational consumer purchases more so as to equate the marginal utility and the price
level. Thus, if a consumer wants to purchase larger quantities, then the price must be lowered. This is what
the law of demand also states.

Exceptions to Law of Demand

The instances where law of demand is not applicable are as follows-
 1. There are certain goods which are purchased mainly for their snob appeal, such as, diamonds, air
conditioners, luxury cars, antique paintings, etc. These goods are used as status symbols to display one’s
wealth. The more expensive these goods become, more valuable will be they as status symbols and more
will be there demand. Thus, such goods are purchased more at higher price and are purchased less at lower
prices. Such goods are called as conspicuous goods.
2. The law of demand is also not applicable in case of giffen goods. Giffen goods are those inferior goods,
whose income effect is stronger than substitution effect. These are consumed by poor households as a
necessity. For instance, potatoes, animal fat oil, low quality rice, etc. An increase in price of such good
increases its demand and a decrease in price of such good decreases its demand.
3. The law of demand does not apply in case of expectations of change in price of the commodity, i.e, in case
ofspeculation. Consumers tend to purchase less or tend to postpone the purchase if they expect a fall in
price of commodity in future. Similarly, they tend to purchase more at high price expecting the prices to
increase in future.
Determinants of (Factors affecting) demand

Innumerable factors and circumstances could affect a buyer's willingness or ability to buy a good. Some of the more
common factors are:
I. Good's own price: The basic demand relationship is between potential prices of a good and the quantities
that would be purchased at those prices. Generally the relationship is negative meaning that an increase in
price will induce a decrease in the quantity demanded. This negative relationship is embodied in the
downward slope of the consumer demand curve. The assumption of a negative relationship is reasonable
and intuitive. If the price of a new novel is high, a person might decide to borrow the book from the public
library rather than buy it.
II. Price of related goods: The principal related goods are complements and substitutes. A complement is a
good that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels,
automobiles and gasoline.(Perfect complements behave as a single good.) If the price of the complement
goes up the quantity demanded of the other good goes down. Mathematically, the variable representing the
price of the complementary good would have a negative coefficient in the demand function. For example,
Qd = a - P - Pg where Q is the quantity of automobiles demanded, P is the price of automobiles and P g is the
price of gasoline. The other main category of related goods are substitutes. Substitutes are goods that can be
used in place of the primary good. The mathematical relationship between the price of the substitute and
the demand for the good in question is positive. If the price of the substitute goes down the demand for the
good in question goes down.
III. Personal Disposable Income: In most cases, the more disposable income (income after tax and receipt of
benefits) a person has the more likely that person is to buy.
IV. Tastes or preferences: The greater the desire to own a good the more likely one is to buy the good. There
is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good
based on its intrinsic qualities. Demand is the willingness and ability to put one's desires into effect. It is
assumed that tastes and preferences are relatively constant.
 V. Consumer expectations about future prices, income and availability: If a consumer believes that the
price of the good will be higher in the future, he/she is more likely to purchase the good now. If the
consumer expects that his/her income will be higher in the future, the consumer may buy the good now.
Availability (supply side) as well as predicted or expected availability also affects both price and demand.
VI. Population: If the population grows this means that demand will also increase.
VII. Nature of the good: If the good is a basic commodity, it will lead to a higher demand
VIII. This list is not exhaustive. All facts and circumstances that a buyer finds relevant to his willingness or
ability to buy goods can affect demand. For example, a person caught in an unexpected storm is more likely
to buy an umbrella than if the weather were bright and sunny.
TYPES OF DEMAND
i) Direct and Derived Demands 
Direct demand refers to demand for goods meant for final consumption; it is the demand for
consumers’ goods like food items, readymade garments and houses. By contrast, derived demand
refers to demand for goods which are needed for further production; it is the demand for producers’
goods like industrial raw materials, machine tools and equipments.
 ii) Domestic and Industrial Demands:- The example of the refrigerator can be restated to distinguish
between the demand for domestic consumption and the demand for industrial use. In case of certain
industrial raw materials which are also used for domestic purpose, this distinction is very meaningful. 
iii) Autonomous and Induced Demand
When the demand for a product is tied to the purchase of some parent product, its demand is called
induced or derived.
For example, the demand for cement is induced by (derived from) the demand for housing.
Autonomous demand is not derived or induced. Unless a product is totally independent of the use of
other products, it is difficult to talk about autonomous demand. In the present world of dependence,
there is hardly any autonomous demand. Nobody today consumers just a single commodity; everybody
consumes a bundle of commodities. Even then, all direct demand may be loosely called autonomous. 
iv) Perishable and Durable Goods’ Demands
Both consumers’ goods and producers’ goods are further classified into perishable/non-durable/single-
use goods and durable/non-perishable/repeated-use goods.  
v) New and Replacement Demands
If the purchase or acquisition of an item is meant as an addition to stock, it is a new demand. If the
purchase of an item is meant for maintaining the old stock of capital/asset, it is replacement demand.
Such replacement expenditure is to overcome depreciation in the existing stock.
vi) Final and Intermediate Demands
This distinction is again based on the type of goods- final or intermediate. The demand for semi-
finished products, industrial raw materials and similar intermediate goods are all derived demands,
vii) Individual and Market Demands
 This distinction is often employed by the economist to study the size of the buyers’ demand,
individual as well as collective. A market is visited by different consumers, consumer differences
depending on factors
viii) Total Market and Segmented Market Demands
This distinction is made mostly on the same lines as above. Different individual buyers together may
represent a given market segment; and several market segments together may represent the total
market.
 x) Company and Industry Demands 
An industry is the aggregate of firms (companies). Thus the Company’s demand is similar to an
individual demand, whereas the industry’s demand is similar to aggregated total demand. You may
examine this distinction from the standpoint of both output and input.

Q2. EXPLAIN THE ELASTICITY OF DEMAND AND ITS TYPES AND DIFFERENT DEGREES?
1. PRICE ELASTICITY OF DEMAND
The responsiveness or sensitivity of consumers quantity demanded to a change in price is
measured by the Price Elasticity of Demand. The price elasticity of demand is a measure of the
extent to which the quantity demanded of a good changes when the price of the good changes and
all other influences on buyers’ plans remain the same
.

A. Percentage Change in Price

1. The midpoint method uses the average of the initial price and new price in the denominator when calculating a
percentage change. Because the average price is the same between two prices regardless of whether the price
falls or rises, the percentage change in price calculated by the midpoint method is the same for a price rise and a
price fall.

a. Using the midpoint formula, the percentage change in price equals

(New
( New price + Initial price )÷2 )
price − Initial price
× 100 .

B. . Percentage Change in Quantity Demanded

Use the midpoint method when calculating the percentage change in quantity.

(New
( New quantity + Initial quantity )÷2 )
quantity − Initial quantity
× 100 .

1. Minus Sign
Because a change in price causes an opposite change in quantity demanded, for the price elasticity of
demand we focus on the magnitude of the change by using the absolute value.

C. Influences on the Price Elasticity of Demand

1. Substitution Effect
If good substitutes are readily available, demand is elastic. If good substitutes are hard to find, demand is
inelastic.
2. Three factors determine how easy substitutes are to find:
a. Luxury versus necessity—there are few substitutes for necessities (so demand is price inelastic) and
there are many substitutes for luxuries (so demand is price elastic).
b. Narrowness of definition—the more narrowly defined the good is, the more elastic its demand. The
more broadly defined the good, the less elastic its demand.
c. Time elapsed since price change—the longer the time that has passed since the price change, the
more elastic is demand.
3. Income Effects
 The larger the proportion of income spent on the good, the more elastic is demand because a price
change has a large, noticeable impact on the budget. The smaller the proportion of income spent on the
good, the less elastic is demand.
D. Computing the Price Elasticity of Demand

1. The formula used to calculate the price elasticity of demand is:

Percentage change in quantity demanded
Price elasticity of demand= .
Percentage change in price
a. If the price elasticity of demand is greater than 1 (the numerator is larger than the denominator),
demand is elastic.
b. If the price elasticity of demand is equal to 1 (the numerator equals the denominator), demand is unit
elastic.
c. If the price elasticity of demand is less than 1 (the numerator is less than the denominator), demand is
inelastic.
E. Degrees of price elasticity
I. Elastic Demand –demand for a product is elastic if its price elasticity is greater than 1. (resulting
percentage change in quantity demanded is greater than the percentage change in price)
II. Inelastic Demand – demand for a product is inelastic if its price elasticity is less than 1. (resulting
percentage change in quantity demanded is less than the percentage change in price)
III. Unit Elasticity – The elasticity coefficient of demand or supply is equal to 1. (percentage change in
quantity is equal to percentage change in price)
IV. Perfectly Inelastic Demand – Quantity demanded does not respond to a change in price. Ed = 0

V. Perfectly Elastic Demand – Quantity demanded will go from 0 to infinity at a particular product
price. That is, if the price isn’t right, 0 is demanded, as soon as the price is right, infinite amounts
will be demanded. Ed = INFINTE
F. Determinants of price elasticity of demand
1. Substitutability – the greater the number of substitute goods that are available, the greater the price
elasticity of demand (more substitute goods = demand is more sensitive to price). Ex/ there is not a good
substitute for insulin, therefore it is relatively inelastic demand; however, there are many substitutes for
Fritos corn chips, therefore, demand for them is relatively elastic
2. Luxury versus Necessity – The more that a good is considered a luxury rather than a necessity, the
greater is the price elasticity of demand. Ex/ Heating, Food, water are all considered necessities, therefore
demand for them will be rather inelastic.
3. Proportion of Income – The higher the price of a good relative to consumers’ incomes, the greater the
price elasticity of demand. Ex/ a 100% increase in the price of a two penny box of matches is a very low
fraction of my annual salary, compared to a 100% increase in the price of a porshe boxter (60K to 12K)
So the price elasticity of demand on the match box will be much more inelastic than on the porshe boxter
4. Time – demand is more elastic the longer the period under consideration. Ex/ if the price of a CokaCola
goes up, I might not switch to Pepsi at first, but the more time I have to pay the higher price, the more
willing I am to try Pepsi and to determine whether Pepsi or other substitute products are good enough
2. CROSS ELASTICITY OF DEMAND
The cross elasticity of demand is a measure of the extent to which the demand for a good changes when the
price of a substitute or complement changes, other things remaining the same.

The formula used to calculate the cross elasticity of demand is:

 Percentage change in price of one ¿
Cross elasticity of demand = Percentage change in quantity demanded of a good¿ .¿
of its substitutes or complements ¿
The cross elasticity of demand for a substitute is positive.

The cross elasticity of demand for a complement is negative.

3. Income Elasticity of Demand

The income elasticity of demand is a measure of the extent to which the demand for a good changes when
income changes, other things remaining the same. The formula used to calculate the income elasticity of
demand is:
Percentage change in quantity demanded
Income elasticity of demand = .
Percentage change in income
For a normal good, the income elasticity of demand is positive.

When the income elasticity of demand is greater than 1, demand is income elastic.

When the income elasticity of demand is between zero and 1, demand is income inelastic. For an inferior
good, the income elasticity of demand is less than 0.
Q3. WHAT IS DEMAND FORECASTING? EXPLAIN THE TECHINQUES OF DEMAND
FORECASTING?
A forecast is a prediction or estimation of future situation. It is an objective assessment of future course of action.
Since future is uncertain, no forecast can be percent correct. Forecasts can be both physical as well as financial in
nature. The more realistic the forecasts, the more effective decisions can be taken for tomorrow.
In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a specified future period which
is tied to a proposed marketing plan and which assumes a particular set of uncontrollable and competitive forces”.
Therefore, demand forecasting is a projection of firm’s expected level of sales based on a chosen marketing plan and
environment.

TECHNIQUES OF DEMAND FORECASTING

1. Opinion Polling Method:

In this method, the opinion of the buyers, sales force and experts could be gathered to determine the emerging trend
in the market.
The opinion polling methods of demand forecasting are of three kinds:
(a) Consumer’s Survey Method or Survey of Buyer’s Intentions:
In this method, the consumers are directly approached to disclose their future purchase plans. I his is done by
interviewing all consumers or a selected group of consumers out of the relevant population. This is the direct method
of estimating demand in the short run. Here the burden of forecasting is shifted to the buyer. The firm may go in for
complete enumeration or for sample surveys. If the commodity under consideration is an intermediate product then
the industries using it as an end product are surveyed.
(i) Complete Enumeration Survey:
Under the Complete Enumeration Survey, the firm has to go for a door to door survey for the forecast period by
contacting all the households in the area. This method has an advantage of first hand, unbiased information, yet it
has its share of disadvantages also. The major limitation of this method is that it requires lot of resources, manpower
and time.
In this method, consumers may be reluctant to reveal their purchase plans due to personal privacy or commercial
secrecy. Moreover, at times the consumers may not express their opinion properly or may deliberately misguide the
investigators.
(ii) Sample Survey and Test Marketing:
Under this method some representative households are selected on random basis as samples and their opinion is
taken as the generalised opinion. This method is based on the basic assumption that the sample truly represents the
population. If the sample is the true representative, there is likely to be no significant difference in the results
obtained by the survey. Apart from that, this method is less tedious and less costly.
A variant of sample survey technique is test marketing. Product testing essentially involves placing the product with
a number of users for a set period. Their reactions to the product are noted after a period of time and an estimate of
likely demand is made from the result. These are suitable for new products or for radically modified old products for
which no prior data exists. It is a more scientific method of estimating likely demand because it stimulates a national
launch in a closely defined geographical area.
(iii) End Use Method or Input-Output Method:
This method is quite useful for industries which are mainly producer’s goods. In this method, the sale of the product
under consideration is projected as the basis of demand survey of the industries using this product as an intermediate
product, that is, the demand for the final product is the end user demand of the intermediate product used in the
production of this final product.
The end user demand estimation of an intermediate product may involve many final good industries using this
product at home and abroad. It helps us to understand inter-industry’ relations. In input-output accounting two
matrices used are the transaction matrix and the input co-efficient matrix. The major efforts required by this type are
not in its operation but in the collection and presentation of data.
(b) Sales Force Opinion Method:
This is also known as collective opinion method. In this method, instead of consumers, the opinion of the salesmen
is sought. It is sometimes referred as the “grass roots approach” as it is a bottom-up method that requires each sales
person in the company to make an individual forecast for his or her particular sales territory.
These individual forecasts are discussed and agreed with the sales manager. The composite of all forecasts then
constitutes the sales forecast for the organisation. The advantages of this method are that it is easy and cheap. It does
not involve any elaborate statistical treatment. The main merit of this method lies in the collective wisdom of
salesmen. This method is more useful in forecasting sales of new products.
(c) Experts Opinion Method:
This method is also known as “Delphi Technique” of investigation. The Delphi method requires a panel of experts,
who are interrogated through a sequence of questionnaires in which the responses to one questionnaire are used to
produce the next questionnaire. Thus any information available to some experts and not to others is passed on,
enabling all the experts to have access to all the information for forecasting.
The method is used for long term forecasting to estimate potential sales for new products. This method presumes
two conditions: Firstly, the panellists must be rich in their expertise, possess wide range of knowledge and
experience. Secondly, its conductors are objective in their job. This method has some exclusive advantages of saving
time and other resources.
2. Statistical Method:
Statistical methods have proved to be immensely useful in demand forecasting. In order to maintain objectivity, that
is, by consideration of all implications and viewing the problem from an external point of view, the statistical
methods are used.
The important statistical methods are:
(i) Trend Projection Method:
A firm existing for a long time will have its own data regarding sales for past years. Such data when arranged
chronologically yield what is referred to as ‘time series’. Time series shows the past sales with effective demand for
a particular product under normal conditions. Such data can be given in a tabular or graphic form for further
analysis. This is the most popular method among business firms, partly because it is simple and inexpensive and
partly because time series data often exhibit a persistent growth trend.
Time series has got four types of components namely, Secular Trend (T), Secular Variation (S), Cyclical Element
(C), and an Irregular or Random Variation (I). These elements are expressed by the equation O = TSCI. Secular
trend refers to the long run changes that occur as a result of general tendency.
Seasonal variations refer to changes in the short run weather pattern or social habits. Cyclical variations refer to the
changes that occur in industry during depression and boom. Random variation refers to the factors which are
generally able such as wars, strikes, flood, famine and so on.
When a forecast is made the seasonal, cyclical and random variations are removed from the observed data. Thus
only the secular trend is left. This trend is then projected. Trend projection fits a trend line to a mathematical
equation.
The trend can be estimated by using any one of the following methods:
(a) The Graphical Method,
(b) The Least Square Method.
a) Graphical Method:
This is the most simple technique to determine the trend. All values of output or sale for different years are plotted
on a graph and a smooth free hand curve is drawn passing through as many points as possible. The direction of this
free hand curve—upward or downward— shows the trend. A simple illustration of this method is given in Table 2.
Table 2: Sales of Firm
Year 1995 1996 1997 1998 1999 2000
Sales (Rs.
Crore) 40 50 44 60 54 62

In Fig. 1, AB is the trend line which has been drawn as free hand curve passing through the various points

representing actual sale values.

(b) Least Square Method:

Under the least square method, a trend line can be fitted to the time series data with the help of statistical techniques
such as least square regression. When the trend in sales over time is given by straight line, the equation of this line is
of the form: y = a + bx. Where ‘a’ is the intercept and ‘b’ shows the impact of the independent variable. We have
two variables—the independent variable x and the dependent variable y. The line of best fit establishes a kind of
mathematical relationship between the two variables .v and y. This is expressed by the regression у on x.
In order to solve the equation v = a + bx, we have to make use of the following normal equations:
Σ y = na + b ΣX
Σ xy =a Σ x+b Σ x2
(ii) Barometric Technique:
A barometer is an instrument of measuring change. This method is based on the notion that “the future can be
predicted from certain happenings in the present.” In other words, barometric techniques are based on the idea that
certain events of the present can be used to predict the directions of change in the future. This is accomplished by
the use of economic and statistical indicators which serve as barometers of economic change.
Generally forecasters correlate a firm’s sales with three series: Leading Series, Coincident or Concurrent
Series and Lagging Series:
(a) The Leading Series:
The leading series comprise those factors which move up or down before the recession or recovery starts. They tend
to reflect future market changes. For example, baby powder sales can be forecasted by examining the birth rate
pattern five years earlier, because there is a correlation between the baby powder sales and children of five years of
age and since baby powder sales today are correlated with birth rate five years earlier, it is called lagged correlation.
Thus we can say that births lead to baby soaps sales.
(b) Coincident or Concurrent Series:
The coincident or concurrent series are those which move up or down simultaneously with the level of the economy.
They are used in confirming or refuting the validity of the leading indicator used a few months afterwards. Common
examples of coinciding indicators are G.N.P itself, industrial production, trading and the retail sector.
(c) The Lagging Series:
The lagging series are those which take place after some time lag with respect to the business cycle. Examples of
lagging series are, labour cost per unit of the manufacturing output, loans outstanding, leading rate of short term
loans, etc.
(iii) Regression Analysis:
It attempts to assess the relationship between at least two variables (one or more independent and one dependent),
the purpose being to predict the value of the dependent variable from the specific value of the independent variable.
The basis of this prediction generally is historical data. This method starts from the assumption that a basic
relationship exists between two variables. An interactive statistical analysis computer package is used to formulate
the mathematical relationship which exists.
For example, one may build up the sales model as:
Quantum of Sales = a. price + b. advertising + c. price of the rival products + d. personal disposable income +u
Where a, b, c, d are the constants which show the effect of corresponding variables as sales. The constant u
represents the effect of all the variables which have been left out in the equation but having effect on sales. In the
above equation, quantum of sales is the dependent variable and the variables on the right hand side of the equation
are independent variables. If the expected values of the independent variables are substituted in the equation, the
quantum of sales will then be forecasted.

The regression equation can also be written in a multiplicative form as given below:
Quantum of Sales = (Price)a + (Advertising)b+ (Price of the rival products) c + (Personal disposable income Y + u
In the above case, the exponent of each variable indicates the elasticities of the corresponding variable. Stating the
independent variables in terms of notation, the equation form is QS = P°8. Ao42 . R°.83. Y2°.68. 40
Then we can say that 1 per cent increase in price leads to 0.8 per cent change in quantum of sales and so on.
If we take logarithmic form of the multiple equation, we can write the equation in an additive form as
follows:
log QS = a log P + b log A + с log R + d log Yd + log u
In the above equation, the coefficients a, b, c, and d represent the elasticities of variables P, A, R and
Yd respectively.
The co-efficient in the logarithmic regression equation are very useful in policy decision making by the
management.
(iv) Econometric Models:
Econometric models are an extension of the regression technique whereby a system of independent regression
equation is solved. The requirement for satisfactory use of the econometric model in forecasting is under three
heads: variables, equations and data.
The appropriate procedure in forecasting by econometric methods is model building. Econometrics attempts to
express economic theories in mathematical terms in such a way that they can be verified by statistical methods and
to measure the impact of one economic variable upon another so as to be able to predict future events.
Criteria of a Good Forecasting Method:
There are thus, a good many ways to make a guess about future sales. They show contrast in cost, flexibility and the
adequate skills and sophistication. Therefore, there is a problem of choosing the best method for a particular demand
situation.
There are certain economic criteria of broader applicability. They are:
(i) Accuracy, (ii) Plausibility, (iii) Durability, (iv) Flexibility, (v) Availability, (vi) Economy, (vii) Simplicity and
(viii) Consistency.
(i) Accuracy:
The forecast obtained must be accurate. How is an accurate forecast possible? To obtain an accurate forecast, it is
essential to check the accuracy of past forecasts against present performance and of present forecasts against future
performance. Accuracy cannot be tested by precise measurement but buy judgment.
(ii) Plausibility:
The executive should have good understanding of the technique chosen and they should have confidence in the
techniques used. Understanding is also needed for a proper interpretation of results. Plausibility requirements can
often improve the accuracy of results.
(iii) Durability:
Unfortunately, a demand function fitted to past experience may back cost very greatly and still fall apart in a short
time as a forecaster. The durability of the forecasting power of a demand function depends partly on the
reasonableness and simplicity of functions fitted, but primarily on the stability of the understanding relationships
measured in the past. Of course, the importance of durability determines the allowable cost of the forecast.
(iv) Flexibility:
Flexibility can be viewed as an alternative to generality. A long lasting function could be set up in terms of basic
natural forces and human motives. Even though fundamental, it would nevertheless be hard to measure and thus not
very useful. A set of variables whose co-efficient could be adjusted from time to time to meet changing conditions in
more practical way to maintain intact the routine procedure of forecasting.
(v) Availability:
Immediate availability of data is a vital requirement and the search for reasonable approximations to relevance in
late data is a constant strain on the forecasters patience. The techniques employed should be able to produce
meaningful results quickly. Delay in result will adversely affect the Business decisions.
(vi) Economy:
Cost is a primary consideration which should be weighted against the importance of the forecasts to the business
operations. A question may arise: How much money and Business effort should be allocated to obtain a high level of
forecasting accuracy? The criterion here is the economic consideration.
(vii) Simplicity:
Statistical and econometric models are certainly useful but they are intolerably complex. To those executives who
have a fear of mathematics, these methods would appear to be Latin or Greek. The procedure should, therefore, be
simple and easy so that the management may appreciate and understand why it has been adopted by the forecaster.
(viii) Consistency:
The forecaster has to deal with various components which are independent. If he does not make an adjustment in
one component to bring it in line with a forecast of another, he would achieve a whole which would appear
consistent.

UNIT-III
Q1. WHAT IS PRODUCTION ANALYSIS? EXPLAIN THE LAWS OF PRODUCTION?
PRODUCTION ANALYSIS

PRODUCTION
                   Production is concerned with the way in which resources or inputs such as land, labor, and machinery
are employed to produce a firm’s product or output. Production may be either services or goods.  To produce the
goods we use inputs. Basically inputs are divided into two types. those are fixed inputs and variable inputs. Fixed
inputs are the inputs that remain constant in short-term.  Variable inputs are inputs, which are variable in both short-
term and long-term.

Production Function

           Production function expresses the relationship between inputs and outputs.  Production function is an
equation, a table, a graph, which express the relationship between inputs and outputs.  Production function explains
that the maximum output of goods or services that can be produced by a firm in a specific time with a given amount
of inputs or factors of production.
Production Function:  Q = f (K, L)
                   We are producing Q quantities of goods by employing K capital and L labor.
Here
          Q       Represents quantity of goods
          K        Represents Capital employed
          L        Represents Labor employed

Production Function:

                   “Production Function” is that function which defines the maximum amount of output that can be
produced with a given set of inputs.
 –     Michael R Baye
“Production Function” is the technical relationship, which reveals the maximum amount of output
capable of being produced by each and every set of inputs, under the given technology of a
firm.                -   Samuelson

                   From the above definitions, it can be concluded that the production functions is more concerned with
physical aspects of production, which is an engineering relation that expresses the maximum amount of output that
can be produced with a given set of inputs.
                   Production function enables production manager to understand how better he can make use of
technology to its greatest potential.
                   The production function is purely a relationship between the quantity of output obtained or given out by
a production process and the quantities of different inputs used in the process.  Production function can take many
forms such as linear function or cubic function etc.

Assumptions for Production Function:

1.           Technology is assumed to be constant.

2.           It is related to a particular or specific period.
3.           It is assumed that the manufacturer is using the best technology.
4.           All inputs are divisible.
5.           Utilization for inputs at maximum level of efficiency.
                  
Significance / Importance of Production Function :

1.   Production function shows the maximum output that can be produced by a specific set of combination of input
factors.
2.   There are two types of production function, one is short-run production function and the other is long-run production
function.  The short-run production explains how output change is relation to input when there are some fixed
factors.  Similarly, long run production function explains the behaviors of output in relation to input when all inputs
are variable.
3.   The production function explains how a firm reaches the most optimum combination of factors so that the unit costs
are the lowest.
4.   Production function explains how a producer combines various inputs in order to produce a given output in an
economically efficient manner.
5.   The production function helps us to estimate the quantity in which the various factors of production are combined.

Short-Term production function

Short-Term production function is a function, which we are producing goods in the short-term by employing two
inputs that are :
          Capital (K) :  It is fixed input which is constant in the short-term.
          Labor (L)   :  It is variable input in the short-term.
                     In the short-term we are producing only one product by employing two inputs
                     The two inputs are K capital and L is labor.
                     In the short term we will increase L input and we will keep K as constant.

Law of Variable Proportions: Meaning, Definition, Assumption and Stages!

Meaning:
Law of variable proportions occupies an important place in economic theory. This law examines the production
function with one factor variable, keeping the quantities of other factors fixed. In other words, it refers to the input-
output relation when output is increased by varying the quantity of one input.
When the quantity of one factor is varied, keeping the quantity of other factors constant, the proportion between the
variable factor and the fixed factor is altered; the ratio of employment of the variable factor to that of the fixed factor
goes on increasing as the quantity of the variable factor is increased.
Since under this law we study the effects on output of variation in factor proportions, this is also known as the law of
variable proportions. Thus law of variable proportions is the new name for the famous”Law of Diminishing
Returns” of classical economics. This law has played a vital role in the history of economic thought and occupies an
equally important place in modern economic theory. This law has been supported by the empirical evidence about
the real world.
The law of variable proportions or diminishing returns has been stated by various economists in the following
manner:
As equal increments of one input are added; the inputs of other productive services being held constant, beyond a
certain point the resulting increments of product will decrease, i.e., the marginal products will diminish,” (G. Stigler)
“As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then the
average product of that factor will diminish.” (F. Benham)
“An increase in some inputs relative to other fixed inputs will, in a given state of technology, cause output to
increase; but after a point the extra output resulting from the same addition of extra inputs will become less.” (Paul
A. Samuelson)
Marshall discussed the law of diminishing returns in relation to agriculture. He defines the law as follows: “An
increase in the capital and labour applied in the cultivation of land causes in general a less than proportionate
increase in the amount of product raised unless it happens to coincide with an improvement in the arts of
agriculture.”
It is obvious from the above definitions of the law of variable proportions (or the law of diminishing returns) that it
refers to the behaviour of output as the quantity of one factor is increased, keeping the quantity of other factors fixed
and further it states that the marginal product and average product will eventually decline.
Assumptions of the Law:
The law of variable proportions or diminishing returns, as stated above, holds good under the following
conditions:
1. First, the state of technology is assumed to be given and unchanged. If there is improvement in the technology,
then marginal and average products may rise instead of diminishing.
2. Secondly, there must be some inputs whose quantity is kept fixed. This is one of the ways by which we can alter
the factor proportions and know its effect on output. This law does not apply in case all factors are proportionately
varied. Behaviour of output as a result of the variation in all inputs is discussed under “returns to scale”.
3. Thirdly the law is based upon the possibility of varying the proportions in which the various factors can be
combined to produce a product. The law does not apply to those cases where the factors must be used in fixed
proportions to yield a product.
When the various factors are required to be used in rigidly fixed proportions, then the increase in one factor would
not lead to any increase in output, that is, the marginal product of the factor will then be zero and not diminishing. It
may, however, be pointed out that products requiring fixed proportions of factors are quiet uncommon. Thus, the
law of variable proportion applies to most of the cases of production in the real world.
The law of variable proportions is illustrated in Table 16.1.and Fig. 16.3. We shall first explain it by considering
Table 16.1. Assume that there is a given fixed amount of land, with which more units of the variable factor labour, is
used to produce agricultural output.
With a given fixed quantity of land, as a farmer raises employment of labour from one unit to 7 units, the total
product increases from 80 quintals to 504 quintals of wheat. Beyond the employment of 8 units of labour, total
product diminishes. It is worth noting that up to the use of 3 units of labour, total product increases at an increasing
rate.
This fact is clearly revealed from column 3 which shows successive marginal products of labour as extra units of
labour are used. Marginal product of labour, it may be recalled, is the increment in total output due to the use of an
extra unit of labour.
It will be seen from Col. 3 of Table 16.1, that the marginal product of labour initially rises and beyond the use of
three units of labour, it starts diminishing. Thus when 3 units of labour are employed, marginal product of labour is
100 and with the use of 4th and 5th units of labour marginal product of labour falls to 98 and 62 respectively.
Beyond the use of eight units of labour, total product diminishes and therefore marginal product of labour becomes
negative. As regards average product of labour, it rises upto the use of fourth unit of labour and beyond that it is
falling throughout.
Three Stages of the Law of Variable Proportions:
The behavior of output when the varying quantity of one factor is combined with a fixed quantity of the other can be
divided into three distinct stages. In order to understand these three stages it is better to graphically illustrate the
production function with one factor variable.
This has been done in Fig. 16.3. In this figure, on the X-axis the quantity of the variable factor is measured and on
the F-axis the total product, average product and marginal product are measured. How the total product, average
product and marginal product a variable factor change as a result of the increase in its quantity, that is, by increasing
the quantity of one factor to a fixed quantity of the others will be seen from Fig. 16.3.
In the top Danel of this figure, the total product curve TP of variable factor goes on increasing to a point and alter
that it starts declining. In the bottom pane- average and marginal product curves of labour also rise and then decline;
marginal product curve starts declining earlier than the average product curve.
The behavior of these total, average and marginal products of the variable factor as a result of the increase in
its amount is generally divided into three stages which are explained below:
Stage 1:
In this stage, total product curve TP increases at an increasing rate up to a point. In Fig. 16.3. from the origin to the
point F, slope of the total product curve TP is increasing, that is, up to the point F, the total product increases at an
increasing rate (the total product curve TP is concave upward upto the point F), which means that the marginal
product MP of the variable factor is rising.
From the point F onwards during the stage 1, the total product curve goes on rising but its slope is declining which
means that from point F onwards the total product increases at a diminishing rate (total product curve TP is concave
down-ward), i.e., marginal product falls but is positive.
The point F where the total product stops increasing at an increasing rate and starts increasing at the diminishing rate
is called the point of inflection. Vertically corresponding to this point of inflection marginal product is maximum,
after which it starts diminishing.
Thus, marginal product of the variable factor starts diminishing beyond OL amount of the variable factor. That is,
law of diminishing returns starts operating in stage 1 from point D on the MP curve or from OL amount of the
variable factor used.
This first stage ends where the average product curve AP reaches its highest point, that is, point S on AP curve or
CW amount of the variable factor used. During stage 1, when marginal product of the variable factor is falling it still
exceeds its average product and so continues to cause the average product curve to rise.
Thus, during stage 1, whereas marginal product curve of a variable factor rises in a part and then falls, the average
product curve rises throughout. In the first stage, the quantity of the fixed factor is too much relative to the quantity
of the variable factor so that if some of the fixed factor is withdrawn, the total product will increase. Thus, in the
first stage marginal product of the fixed factor is negative.
Stage 2:
In stage 2, the total product continues to increase at a diminishing rate until it reaches its maximum point H where
the second stage ends. In this stage both the marginal product and the average product of the variable factor are
diminishing but remain positive.
At the end of the second stage, that is, at point M marginal product of the variable factor is zero (corresponding to
the highest point H of the total product curve TP). Stage 2 is very crucial and important because as will be explained
below the firm will seek to produce in its range.
Stage 3: Stage of Negative Returns:
In stage 3 with the increase in the variable factor the total product declines and therefore the total product curve TP
slopes downward. As a result, marginal product of the variable factor is negative and the marginal product curve MP
goes below the X-axis. In this stage the variable factor is too much relative to the fixed factor. This stage is called
the stage of negative returns, since the marginal product of the variable factor is negative during this stage.
It may be noted that stage 1 and stage 3 are completely symmetrical. In stage 1 the fixed factor is too much relative
to the variable factor. Therefore, in stage 1, marginal product of the fixed factor is negative. On the other hand, in
stage 3 the variable factor is too much relative to the fixed factor. Therefore, in stage 3, the marginal product of the
variable factor is negative.
The Stage of Operation:
Now, an important question is in which stage a rational producer will seek to produce. A rational producer will
never choose to produce in stage 3 where marginal product of the variable factor is negative. Marginal product of
the variable factor being negative in stage 3, a producer can always increase his output by reducing the amount of
the variable factor.
It is thus clear that a rational producer will never be producing in stage 3. Even if the variable factor is free, the
rational producer will stop at the end of the second stage where the marginal product of the variable factor is zero.
At the end point M of the second stage where the marginal product of the variable factor is zero, the producer will be
maximising the total product and will thus be making maximum use of the variable factor. A rational producer will
also not choose to produce in stage 1 where the marginal product of the fixed factor is negative.
A producer producing in stage 1 means that he will not be making the best use of the fixed factor and further that he
will not be utilising fully the opportunities of increasing production by increasing quantity of the variable factor
whose average product continues to rise throughout the stage 1. Thus, a rational entrepreneur will not stop in stage 1
but will expand further.
Even if the fixed factor is free (i.e., costs nothing), the rational entrepreneur will stop only at the end of stage 1 (i.e.,
at point N) where the average product of the variable factor is maximum. At the end point N of stage 1, the producer
they will be making maximum use of the fixed factor.
It is thus clear from above that the rational producer will never be found producing in stage 1 and stage 3. Stage 1
and 3 may, therefore, be called stages of economic absurdity or economic non-sense. The stages 1 and 3 represent
non-economic regions in production function.
A rational producer will always seek to produce in stage 2 where both the marginal product and average product of
the variable factor are diminishing. At which particular point in this stage, the producer will decide to produce
depends upon the prices of factors. The stage 2 represents the range of rational production decisions.
We have seen above how output varies as the factor proportions are altered at any given moment. We have also
noticed that this input-output relation can be divided into three stages. Now, the question arises as to what causes
increasing marginal returns to the variable factor in the beginning, diminishing marginal returns later and negative
marginal returns to the variable factor ultimately.
Causes of Initial Increasing marginal Returns to a Factor:
In the beginning, the quantity of the fixed factor is abundant relative to the quantity of the variable factor. Therefore,
when more and more units of a variable factor are added to the constant quantity of the fixed factor, the fixed factor
is more intensively and effectively utilized.
This causes the production to increase at a rapid rate. When, in the beginning the variable factor is relatively smaller
in quantity, some amount of the fixed factor may remain unutilized and therefore when the variable factor is
increased fuller utilisation of the fixed factor becomes possible with the result that increasing returns are obtained.
The question arises as to why the fixed factor is not initially taken in an appropriate quantity which suits the
available quantity of the variable factor. Answer to this question is provided by the fact that generally those factors
are taken as fixed which are indivisible. Indivisibility of a factor means that due to technological requirements a
minimum amount of that factor must be employed whatever the level of output.
Thus, as more units of variable factor are employed to work with an indivisible fixed factor, output greatly increases
in the beginning due to fuller and more effective utilisation of the latter. Thus, we see that it is the indivisibility of
some factors which causes increasing returns to the variable factor in the beginning.
The second reason why we get increasing returns to the variable factor in the initial stage is that as more units of the
variable factor are employed the efficiency of the variable factor itself increases. This is because when there is a
sufficient quantity of the variable factor, it becomes possible to introduce specialisation or division of labour which
results in higher productivity. The greater the quantity of the variable factor, the greater the scope of specialisation
and hence the greater will be the level of its productivity or efficiency.
Causes of Diminishing marginal Returns to a Factor:
The stage of diminishing marginal returns in the production function with one factor variable is the most important.
The question arises as to why we get diminishing marginal returns after a certain amount of the variable factor has
been added to a fixed quantity of the other factor.
As explained above, increasing returns to a variable factor occur initially primarily because of the more effective
and fuller use of the fixed factor becomes possible as more units of the variable factor are employed to work with it.
Once the point is reached at which the amount of the variable factor is sufficient to ensure the efficient utilisation of
the fixed factor, then further increases in the variable factor will cause marginal and average products of a variable
factor to decline because the fixed factor then becomes inadequate relative to the quantity of the variable factor.
In other words, the contributions to the production made by the variable factor after a point become less and less
because the additional units of the variable factor have less and less of the fixed factor to work with. The production
is the result of the co-operation of various factors aiding each other. Now, how much aid one factor provides to the
others depends upon how much there is of it.
Eventually, the fixed factor is abundant relative to the number of the variable factor and the former provides much
aid to the later. Eventually, the fixed factor becomes more and more scarce in relation to the variable factor so that
as the units of the variable factor are increased they receive less and less aid from the fixed factor. As a result, the
marginal and average products of the variable factor decline ultimately.
The phenomenon of diminishing marginal returns, like that of increasing marginal returns, rests upon the
indivisibility of the fixed factor. As explained above, the important reason for increasing returns to a factor in the
beginning is the fact that the fixed factor is indivisible which has to be employed whether the output to be produced
is small or large.
When the indivisible fixed factor is not being fully used, successive increases in a variable factor add more to output
since fuller and more efficient use is made of the indivisible fixed factor. But there is generally a limit to the range
of employment of the variable factor over which its marginal and average products will increase.
There will usually be a level of employment of the Variable factor at which indivisible fixed factor is being as fully
and efficiently used as possible. It will happen when the variable factor has increased to such an amount that the
fixed indivisible factor is being used in the “best or optimum proportion” with the variable factor.
Once the optimum proportion is disturbed by further increases in the variable factor, returns to a variable factor (i.e.,
marginal product and average product) will diminish primarily because the indivisible factor is being used too
intensively, or in other words, the fixed factor is being used in non-optimal proportion with the variable factor.
Just as the marginal product of the variable factor increases in the first stage when better and fuller use of the fixed
indivisible factor is being made, so the marginal product of the variable factor diminishes when the fixed indivisible
factor is being worked too hard.
If the fixed factor was perfectly divisible, neither the increasing nor the diminishing returns to a variable factor
would have occurred. If the factors were perfectly divisible, then there would not have been the necessity of taking a
large quantity of the fixed factor in the beginning to combine with the varying quantities of the other factor.
In the presence of perfect divisibility, the optimum proportion between the factors could have always been achieved.
Perfect divisibility of the factors implies that a small firm with a small machine and one worker would be as
efficient as a large firm with a large machine and many workers.
The productivity of the factors would be the same in the two cases. Thus, we see that if the factors were perfectly
divisible, then the question of varying factor proportions would not have arisen and hence the phenomena of
increasing and diminishing marginal returns to a variable factor would not have occurred. Prof. Bober rightly
remarks: “Let divisibility enter through the door, law of variable proportions rushes out through the window.”
Joan Robinson goes deeper into the causes of diminishing returns. She holds that the diminish ing marginal returns
occur because the factors of production are imperfect substitutes for one another. As seen above, diminishing returns
occur during the second stage since the fixed factor is now inadequate relatively to the variable factor. Now, a factor
which is scarce in supply is taken as fixed.
When there is a scarce factor, quantity of that factor cannot be increased in accordance with the varying quantities of
the other factors, which, after the optimum proportion of factors is achieved, results in diminishing returns.
If now some factors were available which perfect substitute of the scarce fixed factor was, then the paucity of the
scarce fixed factor during the second stage would have been made up by the increase in supply of its perfect
substitute with the result that output could be expanded without diminishing returns.
Thus, even if one of the variable factors which we add to the fixed factor were perfect substitute of the fixed factor,
then when, in the second stage, the fixed factor becomes relatively deficient, its deficiency would have been made
up the increase in the variable factor which is its perfect substitute.
Thus, Joan Robinson says, “What the Law of Diminishing Returns really states is that there is a limit to the extent to
which one factor of production can be substituted for another, or, in other words, that the elasticity of substitution
between factor is not infinite.
If this were not true, it would be possible, when one factor of production is fixed in amount and the rest are in
perfectly elastic supply, to produce part of the output with the aid of the fixed factor, and then, when the optimum
proportion between this and other factors was attained, to substitute some other factor for it and to increase output at
constant cost.” We, therefore, see that diminishing returns operate because the elasticity of substitution between
factors is not infinite.

Explanation of Negative Marginal Returns to a Factor:

As the amount of a variable factor continues to be increased to a fixed quantity of the other factor, a stage is reached
when the total product declines and the marginal product of the variable factor becomes negative.
This phenomenon of negative marginal returns to the variable factor in stage 3 is due to the fact that the number of
the variable factor becomes too excessive relative to the fixed factor so that they obstruct each other with the result
that the total output falls instead of rising.
Besides, too large a number of the variable factor also impairs the efficiency of the fixed factor. The proverb “too
many cooks spoil the broth” aptly applies to this situation. In such a situation, a reduction in the units of the variable
factor will increase the total output.
The Laws of Returns to Scale: Production Function with two Variable Inputs!
The laws of returns to scale can also be explained in terms of the isoquant approach. The laws of returns to scale
refer to the effects of a change in the scale of factors (inputs) upon output in the long run when the combinations of
factors are changed in the same proportion.
If by increasing two factors, say labour and capital, in the same proportion, output increases in exactly the same
proportion, there are constant returns to scale. If in order to secure equal increases in output, both factors are
increased in larger proportionate units, there are decreasing returns to scale. If in order to get equal increases in
output, both factors are increased in smaller proportionate units, there are increasing returns to scale.
The returns to scale can be shown diagrammatically on an expansion path “by the distance between successive
‘multiple-level-of-output” isoquants, that is, isoquants that show levels of output which are multiples of some base
level of output, e.g., 100, 200, 300, etc.”
Increasing Returns to Scale:
Figure 8 shows the case of increasing returns to scale where to get equal increases in output, lesser proportionate
increases in both factors, labour and capital, are required.
It follows that in the figure:
100 units of output require 3C + 3L
200 units of output require 5C + 5L
300 units of output require 6C + 6L
So that along the expansion path OR, OA > AB > BC. In this case, the production function is homogeneous of
degree greater than one. The increasing returns to scale are attributed to the existence of indivisibilities in machines,
management, labour, finance, etc. Some items of equipment or some activities have a minimum size and can not be
divided into smaller units. When a business unit expands, the returns to scale increase because the indivisible factors
are employed to their full capacity.
Increasing returns to scale also result from specialisation and division of labour. When the scale of the firm expands
there is wide scope for specialisation and division of labour. Work can be divided into small tasks and workers can
be concentrated to narrower range of processes. For this, specialized equipment can be installed.
Thus with specialization efficiency increases and increasing returns to scale follow:
Further, as the firm expands, it enjoys internal economies of production. It may be able to install better machines,
sell its products more easily, borrow money cheaply, procure the services of more efficient manager and workers,
etc. All these economies help in increasing the returns to scale more than proportionately.
Not only this, a firm also enjoys increasing returns to scale due to external economies. When the industry itself
expands to meet the increased long-run demand for its product, external economies appear which are shared by all
the firms in the industry. When a large number of firms are concentrated at one place, skilled labour, credit and
transport facilities are easily available.
Subsidiary industries crop up to help the main industry. Trade journals, research and training centres appear which
help in increasing the productive efficiency of the firms. Thus these external economies are also the cause of
increasing returns to scale.
Decreasing Returns to Scale:
Figure 9 shows the case of decreasing returns where to get equal increases in output, larger proportionate increases
in both labour and capital are required.
It follows that:
100 units of output require 2C + 2L
200 units of output require 5C + 5L
300 units of output require 9C + 9L
So that along the expansion path OR, OG < GH < HK.
In this case, the production function is homogeneous of degree less than one. Returns to scale may start diminishing
due to the following factors. Indivisible factors may become inefficient and less productive. Business may become
unwieldy and produce problems of supervision and coordination.
Large management creates difficulties of control and rigidities. To these internal diseconomies are added external
diseconomies of scale. These arise from higher factor prices or from diminishing productivities of the factors. As the
industry continues to expand the demand for skilled labour, land, capital, etc. rises.
There being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw materials also go up.
Transport and marketing difficulties emerge. All these factors tend to raise costs and the expansion of the firms leads
to diminishing returns to scale so that doubling the scale would not lead to doubling the output.
Constant Returns to Scale:
Figure 10 shows the case of constant returns to scale. Where the distance between the isoquants 100, 200 and 300
along the expansion path OR is the same, i.e., OD = DE = EF. It means that if units of both factors, labour and
capital, are doubled, the output is doubled. To treble the output, units of both factors are trebled.

It follows that:
100 units of output require
1 (2C + 2L) = 2C + 2L
200 units of output require
2 (2C + 2L) = 4C + 4L
300 units of output require
3 (2C + 2L) = 6C + 6L
The returns to scale are constant when internal economies enjoyed by a firm are neutralised by internal
diseconomies so that output increases in the same proportion. Another reason is the balancing of external economies
and external diseconomies.
Constant returns to scale also result when factors of production are perfectly divisible, substitutable, homogeneous
and their supplies are perfectly elastic at given prices. That is why, in the case of constant returns to scale, the
production function is homogeneous of degree one.
Alternative Method:
We have explained above the three laws of returns to scale separately on the assumption that there are three
processes and each process shows the same returns over all ranges of output. “However, the technological
conditions of production may be such that returns to scale may vary over different ranges of output. Over some
range, we may have constant returns to scale, while over another range we may have increasing or decreasing
returns to scale.”
To explain it we draw an expansion path OR from the origin in Fig. 11 This are divided into segments by the
successive isoquants representing equal increments in output, i.e., 100, 200, 300 and so on. As we move along the
expansion path, the distance between the successive isoquants diminishes, it is a case of increasing returns to scale.
This stage is shown in the figure from К to M. The distance between KL and Z.M becomes smaller LM<KL. The
firm, therefore, requires smaller increases in the quantities of labour and capital to produce equal increments of
output.
If the segments between two isoquants are of equal length, there are constant returns to scale. If labour and capital
are doubled, the output would also be doubled. Thus, when output increases from 300 to 400 and to 500 units, the
isoquants representing these output levels mark off equal distances along the scale line, up to point P, i.e., MN = NP.
If these are decreasing returns to scale, the distance between a pair of isoquants would become longer on the
expansion path. ST is longer than PS. It shows that to increase output larger increases in quantities of labour and
capital are required. Thus, on the same expansion path from К to M, there are increasing returns to scale, from M to
P, there are constant returns to scale and from P to T, and there are diminishing returns to scale.

Q2. WHAT ARE ISO-QUANTS? DESCRIBE THE CHARACTERISTICS OF ISO-QUNATS.COMPARE

ISO-QUANTS WITH THE PROPERTIES OF INDIFFERENT CURVES?
Iso-Quant Curve: Definitions, Assumptions and Properties!
The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or product = output.
Thus it means equal quantity or equal product. Different factors are needed to produce a good. These factors may be
substituted for one another.
A given quantity of output may be produced with different combinations of factors. Iso-quant curves are also known
as Equal-product or Iso-product or Production Indifference curves. Since it is an extension of Indifference curve
analysis from the theory of consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations of two factors yielding
the same total product. Like, indifference curves, Iso- quant curves also slope downward from left to right. The
slope of an Iso-quant curve expresses the marginal rate of technical substitution (MRTS).
Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm can produce equal
amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a given output.” Samuelson
“An Iso-quant curve may be defined as a curve showing the possible combinations of two variable factors that can
be used to produce the same total product.” Peterson
“An Iso-quant is a curve showing all possible combinations of inputs physically capable of producing a given level
of output.” Ferguson
Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.
3. Constant Technique:
Technique of production is constant or is known before hand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function is of ‘variable
proportion’ type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule shows the different
combination of these two inputs that yield the same level of output as shown in table 1.

The table 1 shows that the five combinations of labour units and units of capital yield the same level of output, i.e.,
200 metres of cloth. Thus, 200 metre cloth can be produced by combining.
(a) 1 units of labour and 15 units of capital
(b) 2 units of labour and 11 units of capital
(c) 3 units of labour and 8 units of capital
(d) 4 units of labour and 6 units of capital
(e) 5 units of labour and 5 units of capital

Iso-Product Curve:
From the above schedule iso-product curve can be drawn with the help of a diagram. An. equal product curve
represents all those combinations of two inputs which are capable of producing the same level of output. The Fig. 1
shows the various combinations of labour and capital which give the same amount of output. A, B, C, D and E.
Iso-Product Map or Equal Product Map:
An Iso-product map shows a set of iso-product curves. They are just like contour lines which show the different
levels of output. A higher iso-product curve represents a higher level of output. In Fig. 2 we have family iso-product
curves, each representing a particular level of output.
The iso-product map looks like the indifference of consumer behaviour analysis. Each indifference curve represents
particular level of satisfaction which cannot be quantified. A higher indifference curve represents a higher level of
satisfaction but we cannot say by how much the satisfaction is more or less. Satisfaction or utility cannot be
measured.

An iso-product curve, on the other hand, represents a particular level of output. The level of output being a physical
magnitude is measurable. We can therefore know the distance between two equal product curves. While indifference
curves are labeled as IC1, IC2, IC3, etc., the iso-product curves are labelled by the units of output they represent -100
metres, 200 metres, 300 metres of cloth and so on.

Properties of Iso-Product Curves:

The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When we increase labour, we have to
decrease capital to produce a given level of output.
The downward sloping iso-product curve can be explained with the help of the following figure:

The Fig. 3 shows that when the amount of labour is increased from OL to OL1, the amount of capital has to be
decreased from OK to OK1, The iso-product curve (IQ) is falling as shown in the figure.
The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the help of the following
figure 4:
(i) The figure (A) shows that the amounts of both the factors of production are increased- labour from L to Li and
capital from K to K1. When the amounts of both factors increase, the output must increase. Hence the IQ curve
cannot slope upward from left to right.
(ii) The figure (B) shows that the amount of labour is kept constant while the amount of capital is increased. The
amount of capital is increased from K to K1. Then the output must increase. So IQ curve cannot be a vertical straight
line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour increases, although the quantity
of capital remains constant. When the amount of capital is increased, the level of output must increase. Thus, an IQ
curve cannot be a horizontal line.
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have to understand
the concept of diminishing marginal rate of technical substitution (MRTS), because convexity of an isoquant implies
that the MRTS diminishes along the isoquant. The marginal rate of technical substitution between L and K is
defined as the quantity of K which can be given up in exchange for an additional unit of L. It can also be defined as
the slope of an isoquant.
It can be expressed as:
MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.
Equation (1) states that for an increase in the use of labour, fewer units of capital will be used. In other words, a
declining MRTS refers to the falling marginal product of labour in relation to capital. To put it differently, as more
units of labour are used, and as certain units of capital are given up, the marginal productivity of labour in relation to
capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C to D along an isoquant,
the marginal rate of technical substitution (MRTS) of capital for labour diminishes. Everytime labour units are
increasing by an equal amount (AL) but the corresponding decrease in the units of capital (AK) decreases.
Thus it may be observed that due to falling MRTS, the isoquant is always convex to the origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut each other. In Fig. 6, two Iso-
product curves intersect each other. Both curves IQ1 and IQ2 represent two levels of output. But they intersect each
other at point A. Then combination A = B and combination A= C. Therefore B must be equal to C. This is absurd. B
and C lie on two different iso-product curves. Therefore two curves which represent two levels of output cannot
intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:

A higher iso-product curve represents a higher level of output as shown in the figure 7 given below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital. IQ 1 represents an output
level of 100 units whereas IQ2 represents 200 units of output.
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be necessarily equal. Usually
they are found different and, therefore, isoquants may not be parallel as shown in Fig. 8. We may note that the
isoquants Iq1 and Iq2 are parallel but the isoquants Iq3 and Iq4 are not parallel to each other.
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with the help of labour alone
without using capital at all. These logical absurdities for OL units of labour alone are unable to produce anything.
Similarly, OC units of capital alone cannot produce anything without the use of labour. Therefore as seen in figure
9, IQ and IQ1cannot be isoquants.

7. Each Isoquant is Oval-Shaped.

It means that at some point it begins to recede from each axis. This shape is a consequence of the fact that if a
producer uses more of capital or more of labour or more of both than is necessary, the total product will eventually
decline. The firm will produce only in those segments of the isoquants which are convex to the origin and lie
between the ridge lines. This is the economic region of production. In Figure 10, oval shaped isoquants are shown.
Curves OA and OB are the ridge lines and in between them only feasible units of capital and labour can be
employed to produce 100, 200, 300 and 400 units of the product. For example, OT units of labour and ST units of
the capital can produce 100 units of the product, but the same output can be obtained by using the same quantity of
labour T and less quantity of capital VT.
Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100. The dotted segments of an
isoquant are the waste- bearing segments. They form the uneconomic regions of production. In the up dotted
portion, more capital and in the lower dotted portion more labour than necessary is employed. Hence GH, JK, LM,
and NP segments of the elliptical curves are the isoquants.
Difference between Indifference Curve and Iso-Quant Curve:
The main points of difference between indifference curve and Iso-quant curve are explained below:
1. Iso-quant curve expresses the quantity of output. Each curve refers to given quantity of output while an
indifference curve to the quantity of satisfaction. It simply tells that the combinations on a given indifference curve
yield more satisfaction than the combination on a lower indifference curve of production.
2. Iso-quant curve represents the combinations of the factors whereas indifference curve represents the combinations
of the goods.
3. Iso-quant curve gives information regarding the economic and uneconomic region of production. Indifference
curve provides no information regarding the economic and uneconomic region of consumption.
4. Slope of an iso-quant curve is influenced by the technical possibility of substitution between factors of
production. It depends on marginal rate of technical substitution (MRTS) whereas slope of an indifference curve
depends on marginal rate of substitution (MRS) between two commodities consumed by the consumer.
Q3. DISCUSS IN BRIEFLY THE VARIOUS COST CONCEPTS RELEVANT TO BUSINESS DECISIONS
REGARDING PLANNING AND CONTROL?

The analysis of cost is important in the study of Business economics because it provides a basis for two important
decisions made by managers:
 

(a) whether to produce or not and

 
(b) how much to produce when a decision is taken to produce. 

In this Unit, we shall discuss some important cost concepts that are relevant for Business decisions. We analyse the
basic differences between these cost concepts and also, examine how accountants and economists differ on
treating different cost concepts. We will continue the discussion on cost concepts and analysis .

1. ACTUAL COSTS AND OPPORTUNITY COSTS

 Actual costs are those costs, which a firm incurs while producing or acquiring a good or service like raw
materials, labour, rent, etc. Suppose, we pay
Rs. 150 per day to a worker whom we employ for 10 days, then the cost of labour is Rs. 1500. The economists
called this cost as accounting costs
because traditionally accountants have been primarily connected with collection of historical data (that is the
costs actually incurred) in reporting a firm’s
financial position and in calculating its taxes. Sometimes the actual costs are also called acquisition costs or
outlay costs. On the other hand, opportunity cost is defined as the value of a resource in its next best use. For
example, Mr. Ram is currently working with a firm and earning Rs. 5 lakhs per year. He decides to quit his job
and start his own small business. Although, the accounting cost of Mr. Ram’s labour to his own business is 0,
the opportunity cost is Rs. 5 lakhs per year. Therefore, the opportunity cost is the earnings he foregoes by
working for his own firm. One may ask you that whether this opportunity cost is really meaningful in
the decision making process. As we see that the opportunity cost is important simply because, if Mr. Ram
cannot recover this cost from his new business, then he will probably return to his old job. Opportunity cost can
be similarly defined for other factors of production. For example, consider a firm that owns a building and
therefore do not pay rent for office space. If the building was rented to others, the firm could have earned rent.
The foregone rent is an opportunity cost of utilizing the office space and should be included as part of the cost
of doing business. Some times these opportunity costs are called as alternative costs.

2. EXPLICIT AND IMPLICIT COSTS

Explicit costs are those costs that involve an actual payment to other parties. Therefore, an explicit cost is the
monitory payment made by a firm for use of an input owned or controlled by others. Explicit costs are also
referred to as accounting costs. For example, a firm pays Rs. 100 per day to a worker and engages 15 workers
for 10 days, the explicit cost will be Rs. 15,000 incurred by the firm. Other types of explicit costs include
purchase of raw materials,
renting a building, amount spent on advertising etc. On the other hand, implicit costs represent the value of
foregone opportunities but do not involve an actual cash payment. Implicit costs are just as important as explicit
costs but are sometimes neglected because they are not as obvious. For example, a manager who runs his own
business fore goes the salary that could have been earned working for someone else as we have seen in
our earlier example. This implicit cost generally is not reflected in accounting statements, but rational decision-
making requires that it be considered. Therefore, an implicit cost is the opportunity cost of using resources that
are owned or controlled by the owners of the firm. The implicit cost is the foregone return, the owner of the
firm could have received had they used their own resources in their best alternative use rather than using the
resources for their own firm’s production.

3. ACCOUNTING COSTS AND ECONOMIC COSTS

for a long time, there has been a considerable disagreement among economists and accountants on how costs should
be treated. The reason for the
difference of opinion is that the two groups want to use the cost data for dissimilar purposes. Accountants always
have been concerned with firms’
financial statements. Accountants tend to take a retrospective look at firms finances because they keep trace of
assets and liabilities and evaluate past
performance. The accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the
firm. On the other hand,
economists take forward-looking view of the firm. They are concerned with what cost is expected to be in the future
and how the firm might be able to
rearrange its resources to lower its costs and improve its profitability. They must therefore be concerned with
opportunity cost. Since the only cost that
matters for business decisions are the future costs, it is the economic costs that are used for decision-making.
Accountants and economists both include explicit costs in their calculations. For accountants, explicit costs are
important because they involve direct payments made by a firm. These explicit costs are also important
for economists as well because the cost of wages and materials represent money that could be useful elsewhere. We
have already seen, while discussing actual costs and opportunity costs, how economic cost can differ from
accounting cost. In that example we have seen how a person who owns business chooses not to consider his/her own
salary. Although, no monitory transaction has occurred (and thus would not appear as an accounting cost), the
business nonetheless incurs an opportunity cost because the owner could have earned a competitive salary by
working elsewhere. Accountants and economists use the term ‘profits’ differently. Accounting profits are the firm’s
total revenue less its explicit costs. But economists define profits differently. Economic profits are total revenue less
all costs (explicit and implicit costs). The economist takes into account the implicit costs (including a
normal profit) in addition to explicit costs in order to retain resources in a given line of production. Therefore, when
an economist says that a firm is just
covering its costs, it is meant that all explicit and implicit costs are being met, and that, the entrepreneur is receiving
a return just large enough to retain his/her talents in the present line of production. If a firm’s total receipts
exceed all its economic costs, the residual accruing to the entrepreneur is called an economic profit, or pure
profit. Example of Economic Profit and Accounting Profit Mr. Raj is a small store owner. He has invested Rs. 2
lakhs as equity in the store and inventory. His annual turnover is Rs. 8 lakhs, from which he must deduct the cost of
goods sold, salaries of hired staff, and depreciation of equipment and building to arrive at annual profit of the store.
He asked help of a friend who is an accountant by profession to prepare annual income
statement. The accountant reported the profit to be Rs. 1.5 lakhs. Mr. Raj could not believe this and asked the help
of another friend who is an economist
by profession. The economist told him that the actual profit was only Rs. 75,000 and not Rs. 1.5 lakhs. The
economist found that the accountant
had underestimated the costs by not including the implicit costs of time spent as Manager by Mr. Raj in the business
and interest on owner’s equity. The twoincome statements are shown below:

4. Controllable and Non-Controllable costs

Controllable costs are those which are capable of being controlled or regulated by executive vigilance and,
therefore, can be used for assessing
executive efficiency. Non-controllable costs are those, which cannot be subjected to administrative control and
supervision. Most of the costs are
controllable, except, of course, those due to obsolescence and depreciation. The level at which such control can
be exercised, however, differs: some costs (like, capital costs) are not controllable at factory’s shop level, but
inventory costs can be controlled at the shop level. Out-of-pocket costs and Book costs Out of pocket costs are
those costs that improve current cash payments to outsiders. For example, wages and salaries paid to the
employees are out-of pocket costs. Other examples of out-of-pocket costs are payment of rent, interest, transport
charges, etc. On the other hand, book costs are those
business costs, which do not involve any cash payments but for them a provision is made in the books of
account to include them in profit and loss accounts and take tax advantages. For example, salary of owner
manager, if not paid, is a book cost. The interest cost of owner’s own fund and
depreciation cost are other examples of book cost. The out-of-pocket costs are also called explicit costs and
correspondingly book costs are called implicit or imputed costs. Book costs can be converted into out-of-pocket
costs by selling assets and leasing them back from buyer. Thus, the difference between these two categories of
cost is in terms of whether the company owns it or not. If a factor of production is owned, its cost is a book cost
while if it is hired it is an out-of-pocket cost. Past and Future costs Past costs are actual costs incurred in the
past and they are always contained in the income statements. Their measurement is essentially a record
keeping activity. These costs can only be observed and evaluated in retrospect. If they are regarded as
excessive, management can indulge in post-mortem checks just to find out the factors responsible for the
excessive costs, if any,
without being able to do anything about reducing them. Future costs are those costs that are likely to be incurred
in future periods. Since the future is uncertain, these costs have to be estimated and cannot be  expected to be
absolutely correct figures. Past costs serve as the basis for projecting future costs. In periods of inflation and
deflation, the two cost concepts differ significantly. Business decisions are always forward looking and
therefore they require estimates of future costs and not past costs. Unlike past costs, future costs are subject to
management control and they can be planned or avoided. If the future costs are considered too high,
management can either plan to reduce them or find out ways and means to meet them. Management needs
to estimate future costs for a variety of reasons such as expense control pricing, projecting future profits and
capital budgeting decisions. When historical costs are used instead of explicit projections, the assumption is
 made that future costs will be the same as past costs. In periods of significant price variations, such an
assumption may lead to wrong Business decisions.

5. Historical and Replacement costs

The historical cost of an asset is the actual cost incurred at the time, the  asset was originally acquired. In
contrast to this, replacement cost is the cost, which will have to be incurred if that asset is purchased now.
The difference between the historical and replacement costs results from price changes over time. Suppose a
machine was acquired for Rs. 50,000 in the year 1995 and the same machine can be acquired for Rs. 1,20,000 in
the year 2001. Here Rs. 50,000 is the historical or original cost of the machine and Rs. 1,20,000 is its
replacement cost. The difference of Rs.70,000 between the two costs has resulted because of the price change of
the machine during the period. In the conventional financial accounts the value of assets is shown at their
historical costs. But for decision-making, firms should try to adjust historical costs to reflect price level
changes. If the price of the asset does not change over time, the historical cost will be the same as the
replacement cost. If the price raises the replacement cost will exceed historical cost and vice versa. During
periods of substantial price variations, historical costs are poor indicators of actual costs Historical costs and
replacement costs represent two ways of reflecting the costs of assets in the balance sheet and establishing the
costs that are used to determine net income. The assets are usually shown in the conventional accounts at their
historical costs. These must be adjusted for price changes for a correct estimate of costs and profits. Business
decisions must be based on replacement cost rather than historical costs. The historical cost of an asset
is known, for it is actually incurred while acquiring that asset. Replacement cost relates to the current price of
that asset and it will be known only if an enquiry
is made in the market.

6. Private Costs and Social Costs

A further distinction that is useful to make - especially in the public sector - is between private and social costs.
Private costs are those that accrue directly to the individuals or firms engaged in relevant activity. Social costs, on
the\ other hand, are passed on to persons not involved in the activity in any direct way (i.e., they are passed on to
society at large). Consider the case of a manufacturer located on the bank of a river who dumps the waste into
water rather than disposing it of in some other manner. While the private cost to the  firm of dumping is zero, it is
definitely harmful to the society. It affects adversely the people located down current and incur higher costs in terms
of treating the water for their use, or having to travel a great deal to fetch potable  water. If these external costs were
included in the production costs of a producing firm, a true picture of real, or social costs of the output would
be obtained. Ignoring external costs may lead to an inefficient and undesirable allocation of resources in society.

7. Relevant Costs and Irrelevant Costs

The relevant costs for decision-making purposes are those costs, which are incurred as a result of the decision
under consideration. The relevant costs are
also referred to as the incremental costs. Costs that have been incurred already and costs that will be incurred in
the future, regardless of the present
decision are irrelevant costs as far as the current decision problem is concerned.
There are three main categories of relevant or incremental costs. These are the present-period explicit costs, the
opportunity costs implicitly involved in the decision, and the future cost implications that flow from the
decision. For example, direct labour and material costs, and changes in the variable overhead costs are the
natural consequences of a decision to increase the output level. Also, if there is any expenditure on capital
equipments incurred as a result of such a decision, it should be included in full, not withstanding that the
equipment may have a useful life remaining after the present decision has been carried out. Thus, the
incremental costs of a decision to increase output level will include all present-period explicit costs, which will
be incurred as a consequence of this decision. It will exclude any present-period explicit cost that will be
incurred regardless of the present decision. The opportunity cost of a resource under use, as discussed earlier,
becomes a relevant cost while arriving at the economic profit of the firm. Many decisions will have implications
for future costs, both explicit and implicit. If a firm expects to incur some costs in future as a consequence of
the present analysis, such future costs should be included in the present value terms if known for certain.
8. Sunk Costs and Incremental Costs

Sunk costs are expenditures that have been made in the past or must be paid in the future as part of contractual
agreement or previous decision. For
example, the money already paid for machinery, equipment, inventory and future rental payments on a
warehouse that must be paid as part of a long term lease agreement are sunk costs. In general, sunk costs are not
relevant to economic decisions. For example, the purchase of specialized equipment designed to order for a
plant. We assume that the equipment can be used to do only what it was originally designed for and cannot be
converted for alternative use. The expenditure on this equipment is a sunk cost. Also, because this equipment
has no alternative use its opportunity cost is zero and, hence, sunk costs are not relevant to economic decisions.
Sometimes the sunk costs are also called as non-avoidable or non-escapable costs.
On the other hand, incremental cost refers to total additional cost of implementing a Business decision. Change
in product line, change in output
level, adding or replacing a machine, changing distribution channels etc. are examples of incremental costs.
Sometimes incremental costs are also called as avoidable or escapable costs. Moreover, since incremental costs
may also be regarded as the difference in total costs resulting from a contemplated change, they are also called
differential costs. As stated earlier sunk costs are irrelevant for decision making, as they do not  vary with the
changes contemplated for future by the management.

9. Direct Costs and Indirect Costs

There are some costs, which can be directly attributed to production of a given product. The use of raw material,
labour input, and machine time involved in the production of each unit can usually be determined. On the other
hand, there are certain costs like stationery and other office and administrative expenses, electricity charges,
depreciation of plant and buildings, and other such expenses that cannot easily and accurately be separated and
attributed to individual units of production, except on arbitrary basis. When referring to the separable costs of first
category accountants call them the direct, or prime costs per unit. The accountants refer to the joint costs of the
second category as indirect or overhead costs. Direct and indirect costs are not exactly synonymous to what
economists refer to as variable costs and fixed costs. The criterion used by the economist to divide cost into either
fixed or variable is whether or not the cost varies with the level of output, whereas the accountant divides the cost on
the basis of whether or not the cost is separable with respect to the production of individual output units. The
accounting statements often divide overhead expenses into ‘variable overhead’ and ‘fixed overhead’ categories. If
the variable overhead expenses per unit are added to the direct cost per unit, we arrive at what economists call as
average variable cost

10. Separable Costs and Common Costs

Costs can also be classified on the basis of their traceability. The costs that can be easily attributed to a product,
a division, or a process are called
separable costs. On the other hand, common costs are those, which cannot be traced to any one unit of
operation. For example, in a multiple product firm
the cost of raw material may be separable (traceable) product-wise but electricity charges may not be separable
product-wise. In a university the
salary of a Vice-Chancellor is not separable department-wise but the salary of teachers can be separable
department-wise. The separable and common costs are also referred to as direct and indirect costs respectively.
The distinction between direct and indirect costs is of particular significance in a multi-productfirm for setting
up economic prices for different products.

11. Total Cost, Average Cost and Marginal Cost

Total cost (TC) of a firm is the sum-total of all the explicit and implicit expenditures incurred for producing a
given level of output. It represents the
money value of the total resources required for production of goods and services. For example, a shoe-maker’s
total cost will include the amount she/
he spends on leather, thread, rent for his/her workshop, interest on borrowed capital, wages and salaries of
 employees, etc., and the amount she/he charges for his/her services and funds invested in the business. Average
cost (AC) is the cost per unit of output. That is, average cost equals the total cost divided by the number of units
produced (N). If TC = Rs. 500 and N = 50 then AC = Rs. 10. Marginal cost (MC) is the extra cost of producing
one additional unit. At a given level of output, one examines the additional costs being incurred in producing
one extra unit and this yields the marginal cost. For example, if TC of producing 100 units is Rs. 10,000 and the
TC of producing 101 units is Rs. 10,050, then MC at N = 101 equals
Rs.50. Marginal cost refers to the change in total cost associated with a one-unit change in output. This cost
concept is significant to short-term decisions about profit maximizing rates of output. For example, in an
automobile manufacturing plant, the marginal cost of making one additional car per production period would be
the labour, material, and energy costs directly associated with that extra car. Marginal cost is that sub category
of incremental cost in the sense that incremental cost may include both fixed costs and marginal costs
However, when production is not conceived in small units, management will be interested in incremental cost
instead of marginal cost. For example, if a firm produces 5000 units of TV sets, it may not be possible to
determine the change in cost involved in producing 5001 units of TV sets. This difficulty can be resolved by
taking units to significant size. For example, if the TV sets produced is measured to hundreds of units and total
cost (TC) of producing the current level of three hundred TV sets is Rs. 15,00,000 and the firm decides to
increase the production to four hundred TV sets and estimates the TC as Rs. 18,00,000, then the incremental
cost of producing one hundred TV sets (above the present production level of three hundred units) is Rs.
3,00,000. The total cost concept is useful in break-even analysis and finding out whether a firm is making profit
or not. The average cost concept is significant for calculating the per unit profit. The marginal and incremental
cost concepts are needed in deciding whether a firm needs to expand its production or not. In fact, the relevant
costs to be considered will depend upon the situation or production problem faced by the manager.

12. Fixed and Variable Costs

Fixed costs are that part of the total cost of the firm which does not change  with output. Expenditures on
depreciation, rent of land and buildings, property taxes, and interest payment on bonds are examples of fixed
costs. Given a capacity, fixed costs remain the same irrespective of actual output. Variable costs, on the other
hand, change with changes in output. Examples of variable costs are wages and expenses on raw
material. However, it is not very easy to classify all costs into fixed and variable. There are some costs, which
fall between these extremes. They are called semi variable costs. They are neither perfectly variable nor
absolutely fixed in relation to changes in output. For example, part of the depreciation charges is fixed, and part
variable. However, it is very difficult to determine how much of depreciation cost is due to the technical
obsolescence of assets and hence fixed cost, and how much is due to the use of equipments and hence
variable cost. Nevertheless, it does not mean that it is not useful to classify costs into  fixed and variable. This
distinction is of great value in break-even analysis and pricing decisions. For decision-making purposes, in
general, it is the variable cost, which is relevant and not the fixed cost. To an economist the fixed costs are
overhead costs and to an accountant these are indirect costs. When the output goes up, the fixed cost per unit of
output comes down, as the total fixed cost is divided between larger units of output.

13. Short-Run and Long-Run Costs

The short run is defined as a period in which the supply of at least one element of the inputs cannot be changed.
To illustrate, certain inputs like
machinery, buildings, etc., cannot be changed by the firm whenever it so desires. It takes time to replace, add or
dismantle them. Long run, on the
other hand, is defined as a period in which all inputs are changed with changes in output. In other words, it is
that time-span in which all adjustments and
changes are possible to realise. Thus, in the short run, some inputs are fixed  (like installed capacity) while
others are variable (like the level of capacity
utilisation); but in the long run all inputs, including the size of the plant, are variable. Short-run costs are the
costs that can vary with the degree of utilisation of plant and other fixed factors. In other words, these costs
relate to the variation in output, given plant capacity. Short-run costs are, therefore, of two types: fixed costs
and variable costs. In the short-run, fixed costs remain unchanged while variable costs fluctuate with output.
Long-run costs, in contrast, are costs that can vary with the size of plant and with other facilities
normally regarded as fixed in the short-run. In fact, in the long-run there are no fixed inputs and therefore no
 fixed costs, i.e. all costs are variable. Both short-run and long-run costs are useful in decision-making. Short-run
cost is relevant when a firm has to decide whether or not to produce and if a decision is taken to produce then
how much more or less to produce with a given plant size. If the firm is considering an increase in plant size, it
must examine the long-run cost of expansion. Long-run cost analysis is useful in investment decisions.

UNIT-IV

Q1. WHAT IS MARKET STRUCTURES? EXPLAIN THE DIFFERENT TYPE OF MARKETS?

 Market is a place where buyers and sellers meet and exchange goods or services. And now if we extend this concept
a little more, there are certain conditions which create the structure of a market. Such conditions can be condensed in
the following –
 Number of Buyers
 Number of sellers
 Buyer Entry Barriers
 Seller Entry Barriers
 Size of the firm
 Product Differentiation/ Homogeneous Product
 Market Share
 Competition
In market economies, there are a variety of different market systems that exist, depending on the industry and the
companies within that industry. It is important for small business owners to understand what type of market system
they are operating in when making pricing and production decisions, or when determining whether to enter or leave a
particular industry.

Classification of Market Structure

As there are lot many factors deciding on the market structure, there are lot many variations as well determining the
particular market structure in the economy. If we try to explore that individually it might not crystallize our concept.
Thus, let’s look at the following chart to understand the varied market structures –
From the above chart now it’s clear that how the market structure can be defined by the various factors and their
way of exercising certain power over the market. However if we consider the gradual increase of competition from
least to maximum, we will come up to the following conclusions –
1. Monopoly
2. Oligopoly
3. Monopolistic Competition
4. Perfect Competition

1. Perfect Competition
 Perfect competition is a market system characterized by many different buyers and sellers. In the classic
theoretical definition of perfect competition, there are an infinite number of buyers and sellers. With so many
market players, it is impossible for any one participant to alter the prevailing price in the market. If they attempt
to do so, buyers and sellers have infinite alternatives to pursue.  Though in concept perfect competition exists,
however in real life only near perfect competition can exist. And the staple food and vegetables we buy from the
market is perfect competition. However when they start branding they move toward oligopoly.
 In case of Monopsony and Oligopsony there are almost no practical examples though they are just the opposite
of monopoly and oligopoly respectively (buyers rule).
 Perfect competition, a theoretical market structure that features no barriers to entry, an unlimited number of
producers and consumers, and a perfectly elastic demand curve
2. Monopoly
A monopoly is the exact opposite form of market system as perfect competition. In a pure monopoly, there is only
one producer of a particular good or service, and generally no reasonable substitute. In such a market system, the
monopolist is able to charge whatever price they wish due to the absence of competition, but their overall revenue
will be limited by the ability or willingness of customers to pay their price.  Companies which are state owned and
entry for other players are not allowed. If we take example from Indian perspective there is one example we can
think of is Indian railway which is the monopoly as there is no other contributor exercising in the same market.
where there is only one provider of a product or service.
 Natural monopoly, a monopoly in which economies of scale cause efficiency to increase continuously with the
size of the firm. A firm is a natural monopoly if it is able to serve the entire market demand at a lower cost than
any combination of two or more smaller, more specialized firms.
In which a market is run by a small number of firms that together control the majority of the market share. Let’s take
a common example. Look around your locality. There are some good numbers of restaurants serving their
customers. Though they might be producing same kind of recipes, the branding would be different. And that’s the
catch of monopolistic competition. Many buyers, many sellers, almost same product but different branding and
fierce competition.
3. Monopolistic Competition
Monopolistic competition is a type of market system combining elements of a monopoly and perfect competition.
Like a perfectly competitive market system, there are numerous competitors in the market. The difference is that
each competitor is sufficiently differentiated from the others that some can charge greater prices than a perfectly
competitive firm. An example of monopolistic competition is the market for music. While there are many artists,
each artist is different and is not perfectly substitutable with another artist
In monopolistic competition, we still have many sellers (as we had under perfect competition). Now, however, they
don’t sell identical products. Instead, they sell differentiated products—products that differ somewhat, or
are perceived to differ, even though they serve a similar purpose. Products can be differentiated in a number of
ways, including quality, style, convenience, location, and brand name. Some people prefer Coke over Pepsi, even
though the two products are quite similar. But what if there was a substantial price difference between the two? In
that case, buyers could be persuaded to switch from one to the other. Thus, if Coke has a big promotional sale at a
supermarket chain, some Pepsi drinkers might switch (at least temporarily).

How is product differentiation accomplished? Sometimes, it’s simply geographical; you probably buy gasoline at the

station closest to your home regardless of the brand. At other times, perceived differences between products are

promoted by advertising designed to convince consumers that one product is different from another—and better than

it. Regardless of customer loyalty to a product, however, if its price goes too high, the seller will lose business to a

competitor. Under monopolistic competition, therefore, companies have only limited control over price.
4. Oligopoly

An oligopoly is similar in many ways to a monopoly. The primary difference is that rather than having only one

producer of a good or service, there are a handful of producers, or at least a handful of producers that make up a

dominant majority of the production in the market system. While oligopolists do not have the same pricing power as

monopolists, it is possible, without diligent government regulation, that oligopolists will collude with one another to

set prices in the same way a monopolist would.  In US and other countries people buy their automobiles from

different companies. Here the buyers are many, sellers are few, and competition is high. Oligopoly means few

sellers. In an oligopolistic market, each seller supplies a large portion of all the products sold in the marketplace. In

addition, because the cost of starting a business in an oligopolistic industry is usually high, the number of firms

entering it is low.

Companies in oligopolistic industries include such large-scale enterprises as automobile companies and airlines. As

large firms supplying a sizable portion of a market, these companies have some control over the prices they charge.

But there’s a catch: because products are fairly similar, when one company lowers prices, others are often forced to
follow suit to remain competitive. You see this practice all the time in the airline industry: When American Airlines

announces a fare decrease, Continental, United Airlines, and others do likewise. When one automaker offers a

special deal, its competitors usually come up with similar promotions.

Q2. EXPLAIN THE CONCEPT OF FIRM, INDUSTRY, AND PRICE UNDER PERFECT COMPETITION

AND MONOPOLISTICS MARKET?

Meaning of Firm and Industry:

It is essential to know the meanings of firm and industry before analyzing the two. A firm is an organization which

produces and supplies goods that are demanded by the people. According to Prof. S.E. Lands-bury, “Firm is an

organization that produces and sells goods with the goal of maximizing its profits. In the words of Prof. R.L.

Miller, “Firm is an organization that buys and hires resources and sells goods and services.”

Industry is a group of firms producing homogeneous products in a market. In the words of Prof. Miller, “Industry is

a group of firms that produces a homogeneous product.” For example, Raymond, Maffatlal, Arvind, etc., are cloth

manufacturing firms, whereas a group of such firms is called the textile industry.
Equilibrium of the Firm:

a) Meaning:

A firm is in equilibrium when it has no tendency to change its level of output. It needs neither expansion nor

contraction. It wants to earn maximum profits. In the words of A.W. Stonier and D.C. Hague, “A firm will be in

equilibrium when it is earning maximum money profits.”

Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can earn the maximum

profits in the short run or may incur the minimum loss. But in the long run, it can earn only normal profit.
b) Short-run Equilibrium of the Firm:

The short run is a period of time in which the firm can vary its output by changing the variable factors of production

in order to earn maximum profits or to incur minimum losses. The number of firms in the industry is fixed because

neither the existing firms can leave nor new firms can enter it.

It’s Conditions:
The firm is in equilibrium when it is earning maximum profits as the difference between its total revenue and total

cost.

For this, it essential that it must satisfy two conditions:

(1) MC = MR, and (2) the MC curve must cut the MR curve from below at the point of equality and then rise

upwards.

The price at which each firm sells its output is set by the market forces of demand and supply. Each firm will be able

to sell as much as it chooses at that price. But due to competition, it will not be able to sell at all at a higher price

than the market price. Thus the firm’s demand curve will be horizontal at that price so that P = AR = MR for the

firm.
1. Marginal Revenue and Marginal Cost Approach:

The short-run equilibrium of the firm can be explained with the help of the marginal analysis as well as with total

cost-total revenue analysis. We first take the marginal analysis under identical cost conditions.

This analysis is based on the following assumptions:

1. All firms in an industry use homogeneous factors of production.

2. Their costs are equal. Therefore, all cost curves are uniform.

3. They use homogeneous plants so that their SAC curves are equal.

4. All firms are of equal efficiency.

5. All firms sell their products at the same price determined by demand and supply of the industry so that the price

of each firm is equal to AR = MR.

Determination of Equilibrium:

Given these assumptions, suppose that price OP in the competitive market for the product of all the firms in the

industry is determined by the equality of demand curve D and the supply curve S at point E in Figure 1(A) so that

their average revenue curve (AR) coincides with the marginal revenue curve (MR).

At this price, each firm is in equilibrium at point L in Panel (B) of the figure where (i) SMC equals MR and AR, and

(ii) the SMC curve cuts the MR curve from below. Each firm would be producing OQ output and earning normal
profits at the maximum average total costs QL. A firm earns normal profits when the MR curve is tangent to the

SAC curve at its minimum point.

If the price is higher than these minimum average total costs, each firm will be earning supernormal profits. Suppose

the price rises to 0Рг where the SMC curve cuts the new marginal revenue curve MR 2 (=AR2) from below at point A

which now becomes the equilibrium point. In this situation, each firm produces OQ 2 output and earns supernormal

profits equal to the area of the rectangle P2 ABC.

If the price falls below OP1the firm would make a loss because the SAC would be higher than the price. In the short-

run, it would continue to produce and sell OQ 1 output at OP1price so long as it covers its AVC. S is thus the shut-

down point at which the firm is incurring the maximum loss equal to SK per unit of output. If the price falls below

OP1 the firm will close down because it would fail to cover even the minimum average variable cost. OP 1 is thus the

shut-down price.

We may conclude from the above discussion that in the short-run each firm may be making either supernormal

profits, or normal profits or losses depending upon the price of the product.
2. Total Cost Revenue Analysis:

The short-run equilibrium of the firm can also be shown with the help of total cost and total revenue curves. The

firm is able to maximize its profits at that level of output where the difference between total revenue and total cost is

the maximum. This is shown in Figure 2 where TR is the total revenue curve and TC total cost curve.

The total revenue curve is an upward sloping straight line curve starting from O. This is because the firm sells small

or large quantities of its product at a constant price under perfect competition. If the firm produces nothing, total
revenue will be zero. The more it produces, the larger is the increase in total revenue. Hence the TR curve is linear

and slopes upward.

The firm will maximize its profits at that level of output where the gap between the TR curve and the 1C curve is the

maximum. Geometrically, it is that level at which the slope of a tangent drawn to the total cost curve equals the

slope of the total revenue curve. In Figure 2, the maximum amount of profit is measured by TP at OQ output. At

outputs smaller or larger than OQ between A and В points, the firm’s profits shrink. If the firm produces

OQ1 output, its losses are the maximum because the TC curve is i above the TR curve. At Q 1 its profits are zero.

Similar situation prevails at Q2.

Since the marginal revenue equals the slope of the total о revenue curve and the marginal cost equals the slope of the

tangent to the total cost curve, it follows that where the slopes of the total cost and revenue curves are equal as at P

and T, the marginal cost equals the marginal revenue. It should be clear of that the point of maximum profits lies in

the region of rising marginal cost (when TC is below TR) and of maximum loss in the falling marginal cost region

(where TC is above TR).

The explanation of the equilibrium of the firm by using total cost-revenue curves does not throw more light than is

provided by the marginal cost-marginal revenue analysis. It is useful only in the case of certain marginal decisions

where the total cost curve is also linear over a certain range of output.
But it makes the equilibrium of the firm a cumbersome and difficult analysis particularly when one has to compare

the change in cost and revenue resulting from a change in the volume of output. Further, maximum profits cannot be

known at once. For this, a number of tangents are required to be drawn which is a real difficulty
3Long-run Equilibrium of the Firm:

In the long-run, it is possible to make more adjustments than in the short-run. The firm can adjust its plant capacity

and scale of operations to the changed circumstances. Therefore, all costs are variable. Firms must earn only normal

profits. In case the price is above the long-run AC curve firms will be earning supernormal profits.

Attracted by them, new firms will enter the industry and supernormal profits will be competed away. If the price is

below the LAC curve firms will be incurring losses. As a result, some of the firms will leave the industry so that no

firm earns more than normal profits. Thus “in the long-run firms are in equilibrium when they have adjusted their

plant so as to produce at the minimum point of their long-run AC curve, which is tangent (at this point) to the

demand (AR) curve defined by the market price” so that they earn normal profits.

It’s Assumptions:

This analysis is based on the following assumptions:

1. Firms are free to enter into or leave the industry.

2. All firms are of equal efficiency.

3. All factors are homogeneous. They can be obtained at constant and uniform prices.

4. Cost curves of firms are uniform.

5. The plants of firm: are equal having given technology.

6. All firms have perfect knowledge about price and output.

Determination:

Given these assumptions, each firm of the industry will be in the following two conditions.

(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run marginal cost (LMC) as well as its

short-run average cost (SAC) and its long-run average cost (LAC) and both should be equal to MR=AR=P. Thus the

first equilibrium condition is:

SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and

(2) LMC curve must cut MR curve from below.

Both these conditions of equilibrium are satisfied at point E in Figure 3 where SMC and LMC curves cut from

below SAC and LAC curves at their minimum point E and SMC and LMC curves cut AR = MR curve from below.

All curves meet at this point E and the firm produces OQ optimum quantity and sell it at OP price.

Since we assume equal costs of all the firms of industry, all firms will be in equilibrium m the long-run. At OP price

a firm will have neither a tendency to leave nor enter the industry and all firms will earn normal profit.
Equilibrium of the Industry under Perfect Competition:

Conditions of Equilibrium of the Industry:

An industry is in equilibrium:

(i) When there is no tendency for the firms either to leave or enter the industry, and (ii) when each firm is also in

equilibrium. The first condition implies that the average cost curves coincide with the average revenue curve of all

the firms in the industry. They are earning only normal profits, which are supposed to be included in the average

cost curves of the firms. The second condition implies the equality of MC and MR. Under a perfectly competitive

industry, these two conditions must be satisfied at the point of equilibrium, i.e.,

SMC = MR

SAC = AR

P = AR = MR

SMC = SAC = AR = P

Such a situation represents full equilibrium of the industry.

Short-Run Equilibrium of the Industry:

An industry is in equilibrium in the short run when its total output remains steady, there being no tendency to

expand or contract its output. If all firms are in equilibrium, the industry is also in equilibrium. For full equilibrium

of the industry in the short run, all firms must be earning only normal profits. The condition for this is SMC = MR =

AR = SAC. But full equilibrium of the industry is by sheer accident because in the short run some firms may be

earning supernormal profits and some incurring losses.

Even then, the industry is in short- run equilibrium when its quantity demanded and quantity supplied are equal at

the price which clears the market. This is illustrated in Figure 4, where in Panel (A), the industry is in equilibrium at

point E where its demand curve D and supply curve S intersect which determine OP price at which its total output

OQ is cleared. But at the prevailing price OP some firms are earning supernormal profits PE 1ST as shown in Panel

(B), while some other firms are incurring FGE2P losses as shown in Panel (C) of the figure.

Long-Run Equilibrium of the Industry:

The industry is in equilibrium in the long run when all firms earn normal profits. There is no incentive for firms to

leave the industry or for new firms to enter it. With all factors homogeneous and given their prices and the same

technology, each firm and industry as a whole are in full equilibrium where LMC = MR =AR(=p) =LAC at its

minimum. Such an equilibrium position is attained when the long-run price for the industry is determined by the

equality of total demand and supply of the industry.

The long-run equilibrium of the industry is illustrated in Figure 5(A) where the long-run price op and OQ output are

determined by the intersection of the demand curve d and the supply curve s at point E. At this price op, the firms

are in equilibrium at point A in Panel (B) at OM level of output where LMC =SMC= MR= p (=AR) =SAC= LAC at

its minimum. At this level, the firms are earning normal profits and have no incentive to enter or leave the industry.

It follows that when the industry is in long-run equilibrium, each firm in the industry is also in long-run equilibrium.

If both the industry and the firms are in long-run equilibrium, they are also in short-run equilibrium.

Even though all firms in a perfectly competitive industry in the long run have the same cost curves, the firms can be

of different efficiency. Firms using superior resources or inputs such as superior management must pay them higher

rewards, otherwise they will shift to new firms which offer them higher prices.

So the forces of competition will force the more efficient firms to pay superior resources higher prices at their

opportunity cost. As a result, the lac curve of the more efficient firms will shift upwards and they will benefit in the

form of higher output at the higher long-run equilibrium price set by the industry.
Unable to pay higher prices to resources or inputs, less efficient firms will be competed away. New firms which are

able to pay more and attracted by the new higher market price will enter the industry. But at the new long-run

equilibrium price of the industry, all firms will be producing at the minimum LAC.

This is illustrated in Figure 6 where the industry is in initial equilibrium at point E with price OP m Panel (A) and

the more efficient firms like all other firms are in equilibrium at point A in Panel (B). As the industry is in

equilibrium, the new firms do not exist as they are not in a position to cover their costs at OP price.

When the more efficient firms pay higher prices to resources or inputs, their LAC curve rises to LAC 1 At the new

long-run equilibrium price of the industry set at OP 1 the more efficient firms are in equilibrium where P 1 = LAC1 at

its minimum point A1 in Panel (B). They are now producing larger output OM1 even though they earn normal

profits. The new firms also earn normal profits at point A 2, as shown in Panel (C). But they produce less output

OM2 than OM1 produced by the more efficient firms.

MONOPOLISTIC COMPETITION

PRICE AND OUTPUT DETERMINATION INSHORT RUN

In monopolistic competition, every firm has a certain degree of monopoly power i.e.every firm can take initiative to

set a price. Here, the products are similar but notidentical, therefore there can never be a unique price but the prices

will be in agroup reflecting the consumers’ tastes and preferences for differentiated products.In this case the price of

the product of the firm is determined by its cost function,demand, its objective and certain government regulations,

if there are any. 

As the price of a particular product of a firm reduces, it attracts customers from its rival groups (as defined by

Chamberlin). Say for example, if ‘Samsung’ TV reduces its price by a substantial amount or offers discount, then

the customers from the rival group who have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung’ TV sets. As

discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes downwards. 
The market has many firms selling similar products, therefore the firm’s output is quite small as compared to the

total quantity sold in the market and so its price and output decisions go unnoticed. Therefore, every firm

acts independently and for a given demand curve, marginal revenue curve and cost curves, the firm maximizes profit

or minimizes loss when marginal revenue is equal to marginal cost. Producing an output of Q selling at price P

maximizes the profits of the firm. 

In the short run, a firm may or may not earn profits. Figure  shows the firm, which is earning economic profits. The
equilibrium point for the firm is at price P and quantity Q and is denoted by point A. Here, the economic profit is
given as area PAQR. The difference between this and the monopoly case is that here the barriers to entry are low or
weak and therefore new firms will be attracted to enter. Fresh entry will continue to enter as long as there are profits.
As soon as the super normal profit is competed away by new firms, equilibrium will be attained in the market and no
new firms will be attracted in the market. This is the situation corresponding to the long run and is discussed in the
next section.

PRICE AND OUTPUT DETERMINATION IN LONG RUN

We have discussed the price and output determination in the short run. We now discuss price and output
determination in the long run. You will notice that the long run equilibrium decision is similar to perfect
competition. The core of the discussion under this head is that economic profits are eliminated in the long run, which
is the only equilibrium consistent with the assumption of low barriers to entry. This occurs at an output where price
is equal to the long run average cost. Thedifference between monopolistic competition and perfect competition is
that in monopolistic competition the point of tangency is downward sloping and does not occur at minimum of the
average cost curve and this is because the demand curve is downward sloping.
Looking at figure , under monopolistic competition in the long run we see that LRAC is the long run average cost
curve and LRMC the long run average marginal curve. Let us take a hypothetical example of a firm in a
typical monopolistic situation where it is making substantial amount of economic profits.
Here it is assumed that the other firms in the market are also making profits. This  situation would then attract new
firms in the market. The new firms may not sell the same products but will sell similar products. As a result, there
will be an increase in the number of close substitutes available in the market and hence the demand curve would
shift downwards since each existing firm would lose market share. The entry of new firms would continue as long as
there are economic profits. 
The demand curve will continue to shift downwards till it becomes tangent to LRAC at a given price P1 and output
at Q1 as shown in the figure. At this point of equilibrium, an increase or decrease in price would lead to losses. In
this case the entry of new firms would stop, as there will not be any economic profits. 
Due to free entry, many firms can enter the market and there may be a condition where the demand falls below
LRAC and ultimately suffers losses resulting in the exit of the firms. Therefore under the monopolistic competition
free entry and exit must lead to a situation where demand becomes tangent to LRAC, the price becomes equal to
average cost and no economic profit is earned. It can thus be said that in the long run the profits peter out
completely. 
One of the interesting features of the monopolistically competitive market is the variety available due to product
differentiation. Although firms in the long run do not produce at the minimum point of their average cost curve, and
thus there is excess capacity available with each firm, economists have rationalized this by attributing the higher
price to the variety available. Further, consumers are willing to pay the higher price for the increased variety
available in the market.

UNIT-V

Q1. EXPLAIN THE VARIOUS CONCEPTS OF NATIONAL INCOME. INDER WHAT

CIRCUMSTANCES DOES NATIONAL INCOME TEND TO BE UNDER ESTIMATED?

DEFINITION OF NATIONAL INCOME

National income is the final outcome of all economic activities of a nation valued in terms of money. National

income is the most important macroeconomic variable and determinant of the business level and environment of a
country. The level of national income determines the level of aggregate demand for goods and services. Its

distribution pattern determines the pattern of demand for goods and services, i.e., how much of which good is

demanded. The trend in national income determines the trends in aggregate demand, i.e., the demand for the goods

and services, and also the business prospects. Therefore, business decision makers need to keep in mind these

aspects of the national income, especially those having long-run implications. National income or a relevant

component of it is an indispensable variable considered in demand forecasting. Conceptually, national income is the

money value of the end result of all economic activities of the nation. Economic activities generate a large number

of goods and services, and make net addition to the national stock of capital. These together constitute the national

income of a ‘closed economy’—an economy which has no economic transactions with the rest of the world. In an

‘open economy’, national income includes also the net results of its transactions with the rest of the world (i.e.,

exports less imports).

MEASURES OF NATIONAL INCOME

 Gross National Product (GNP) Of the various measures of national income used in national income

analysis, GNP is the most important and widely used measure of national income. It is the most

comprehensive measure of the nation’s productive activities. The GNP is defined as the value of all final

goods and services produced during a specific period, usually one year, plus incomes earned abroad by the

nationals minus incomes earned locally by the foreigners. The GNP so defined is identical to the concept of

gross national income (GNI). Thus, GNP = GNI. The difference between the two is only of procedural

nature. While GNP is estimated on the basis of product-flows, the GNI is estimated on the basis of money

income flows, (i.e., wages, profits, rent, interest, etc.).

 Gross Domestic Product (GDP ) The Gross Domestic Product (GDP) is defined as the market value of all

final goods and services produced in the domestic economy during a period of one year, plus income

earned locally by the foreigners minus incomes earned abroad by the nationals. The concept of GDP is

similar to that of GNP with a significant procedural difference. In case of GNP the incomes earned by the
 nationals in foreign countries are added and incomes earned locally by the foreigners are deducted from the

market value of domestically produced goods and services. In case of GDP, the process is reverse –

incomes earned locally by foreigners are added and incomes earned abroad by the nationals are deducted

from the total value of domestically produced goods and services

 Net National Product (NNP) NNP is defined as GNP less depreciation, i.e.,

NNP = GNP – Depreciation. Depreciation is that part of total productive assets which is used to replace the capital

worn out in the process of creating GNP. Briefly speaking, in the process of producing goods and services

(including capital goods), a part of total stock of capital is used up. ‘Depreciation’ is the term used to denote the

worn out or used up capital. An estimated value of depreciation is deducted from the GNP to arrive at NNP. The

NNP, as defined above, gives the measure of net output available for consumption and investment by the society

(including consumers, producers and the government). NNP is the real measure of the national income. NNP = NNI

(net national income). In other words, NNP is the same as the national income at factor cost. It should be noted that

NNP is measured at market prices including direct taxes. Indirect taxes are, however, not a point of actual cost of

production. Therefore, to obtain real national income, indirect taxes are deducted from the NNP. Thus, NNP–

indirect taxes = National Income.

National Income: Some Accounting Relationships

1. Accounting Indentifies at Market Price

A) GNP ≡ GNI (Gross National Income)

B) GDP ≡ GNP less Net Income from Abroad

C) NNP ≡ GNP less Depreciation NDP (Net Domestic Product) ≡ NNP less net income from abroad

2. Some Accounting Identities at Factor Cost

A. GNP at factor cost ≡ GNP at market price less net indirect taxes

B. NNP at factor cost ≡ NNP at market price less net indirect taxes

C. NDP at factor cost ≡ NNP at market price less net income from abroad

D. NDP at factor cost ≡ NDP at market price less net indirect taxes
 E. NDP at factor cost ≡ GDP at market price less Depreciation

METHODS OF MEASURING NATIONAL INCOME

For measuring national income, the economy through which people participate in economic activities, earn their

livelihood, produce goods and services and share the national products is viewed from three different angles.

(1) The national economy is considered as an aggregate of producing units combining different sectors such as

agriculture, mining, manufacturing, trade and commerce, etc.

(2) The whole national economy is viewed as a combination of individuals and households owning different kinds of

factors of production which they use themselves or sell factor-services to make their livelihood.

(3) The national economy may also be viewed as a collection of consuming, saving and investing units (individuals,

households and government).

Following these notions of a national economy, national income may be measured by three different corresponding

methods:

(1) Net product method—when the entire national economy is considered as an aggregate of producing units;

(2) Factor-income method—when national economy is considered as combination of factor-owners and users;

(3) Expenditure method—when national economy is viewed as a collection of spending units. The procedures

which are followed in measuring the national income in a closed economy—an economy which has no economic

transactions with the rest of the world—are briefly described here. The measurement of national income in an open

economy and adjustment with regard to income from abroad will be discussed subsequently.

 Net Output or Value-Added Method The net output method is also called the value added method. In its

standard form, this method consists of three stages: (i) Estimating the gross value of domestic output in the

various branches of production;

(ii) Determining the cost of material and services used and also the depreciation of physical assets; and

(iii) Deducting these costs and depreciation from gross value to obtain the net value of domestic output…”

The net value of domestic product thus obtained is often called the value added or income product which is
 equal to the sum of wages, salaries, supplementary labour incomes, interest, profits, and net rent paid or

accrued.

 Factor-Income Method This method is also known as income method and factor-share method. Under this

method, the national income is calculated by adding up all the “incomes accruing to the basic factors of

production used in producing the national product”. Factors of production are conventionally classified as land,

labour, capital and organization. Accordingly, the national income equals the sum of the corresponding factor

earning. Thus, National income = Rent + Wages + Interest + Profit. Thus, the total factor-incomes are

grouped under three categories:

(i) Labour Incomes included in the national income have three components:

(a) Wages and salaries paid to the residents of the country including bonus and commission, and social

security payments;

(b) Supplementary labour incomes including employer’s contribution to social security and employee’s

welfare funds, and direct pension payments to retired employees

(c) Supplementary labour incomes in kind, e.g., free health and education, food and clothing, and

accommodation, etc. Compensations in kind in the form of domestic servants and such other free-of-cost

services provided to the employees are included in labour income.

(ii) Capital Incomes According to Studenski, capital incomes include the following capital earnings:

(a) dividends excluding inter-corporate dividends;

(b) undistributed before-tax profits of corporations;

(c) interest on bonds, mortgages, and saving deposits (excluding interests on war bonds, and on consumer-

credit);

(d) interest earned by insurance companies and credited to the insurance policy reserves;

(e) net interest paid out by commercial banks

(iii) Mixed Incomes.;. Mixed Income. Mixed incomes include earnings from

(a) farming enterprises,

 (b) sole proprietorship (not included under profit or capital income); and

(c) other professions, e.g., legal and medical practices, consultancy services, trading and transporting etc.

 Expenditure Method The expenditure method, also known as final product method, measures national

income at the final expenditure stages. In estimating the total national expenditure, any of the two following

methods are followed: first, all the money expenditures at market price are computed and added up together,

and second, the value of all the products finally disposed of are computed and added up, to arrive at the total

national expenditure. The items of expenditure which are taken into account under the first method are

(a) private consumption expenditure;

(b) direct tax payments;

(c) payments to the non-profitmaking institutions and charitable organizations like schools, hospitals,

orphanages, etc.; and

(d) private savings.

CHOICE OF METHODS

There are three standard methods of measuring the national income, viz., net product (or value added) method,

factor-income or factor cost method and expenditure method. All the three methods would give the same measure of

national income, provided requisite data for each method is adequately available. Therefore, any of the three

methods may be adopted to measure the national income. But all the three methods are not suitable for all the

economies simply for non-availability of necessary data and for all purposes. Hence, the question of choice of

method arises. The two main considerations on the basis of which a particular method is chosen are:

A) the purpose of national income analysis, and B) availability of necessary data. If the objective is to

analyse the net output or value added, the net output method is more suitable. In case the objective is to

analyse the factor-income distribution, the suitable method for measuring national income is the income

method. If the objective at hand is to find out the expenditure pattern of the national income, the

expenditure or final products method should be applied. However, availability of adequate and

appropriate data is a relatively more important consideration is selecting a method of estimating national
 income. Nevertheless, the most common method is the net product method because: (i) this method

requires classification of the economic activities and output thereof which is much easier than to classify

income or expenditure; and (ii) the most common practice is to collect and organize the national income

data by the division of economic activities. Briefly speaking, the easy availability of data on economic

activities is the main reason for the popularity of the output method. It should be however borne in mind

that no single method can give an accurate measure of national income since the statistical system of no

country provides the total data requirements for a particular method. The usual practice is, therefore, to

combine two or more methods to measure the national income. The combination of methods again

depends on the nature of data required and sectoral break-up of the available data.

Q2. DESCRIBE IN BRIEF INFLATION? REASON FOR INFLATION AND ITS EFFECTS?
Inflation: Meaning

Inflation is a highly controversial term which has undergone modification since it was first defined by the neo-

classical economists. They meant by it a galloping rise in prices as a result of the excessive increase in the quantity

of money. They regarded it “as a destroying disease born out of lack of monetary control whose results undermined

the rules of business, creating havoc in markets and financial ruin of even the prudent.” Inflation is fundamentally a

monetary phenomenon. In the words of Friedman, “Inflation is always and everywhere a monetary phenomenon…

and can be produced only by a more rapid increase in the quantity of money than output.’” But economists do not

agree that money supply alone is the cause of inflation. As pointed out by Hicks, “Our present troubles are not of a

monetary character.” Economists, therefore, define inflation in terms of a continuous rise in prices. Johnson defines

“inflation as a sustained rise” 4 in prices. Brooman defines it as “a continuing increase in the general price

level.”5 Shapiro also defines inflation in a similar vein “as a persistent and appreciable rise in the general level of

prices.” Demberg and McDougall are more explicit when they write that “the term usually refers to a continuing rise

in prices as measured by an index such as the consumer price index (CPI) or by the implicit price deflator for gross

national product.”

However, it is essential to understand that a sustained rise in prices may be of various magnitudes. Accordingly,

different names have been given to inflation depending upon the rate of rise in prices.
 TYPES OF INFLATION

1. Creeping Inflation:

When the rise in prices is very slow like that of a snail or creeper, it is called creeping inflation. In terms of speed, a

sustained rise in prices of annual increase of less than 3 per cent per annum is characterised as creeping inflation.

Such an increase in prices is regarded safe and essential for economic growth.

2. Walking or Trotting Inflation:

When prices rise moderately and the annual inflation rate is a single digit. In other words, the rate of rise in prices is

in the intermediate range of 3 to 6 per cent per annum or less than 10 per cent. Inflation at this rate is a warning

signal for the government to control it before it turns into running inflation.

3. Running Inflation:

When prices rise rapidly like the running of a horse at a rate or speed of 10 to 20 per cent per annum, it is called

running inflation. Such an inflation affects the poor and middle classes adversely. Its control requires strong

monetary and fiscal measures, otherwise it leads to hyperinflation.

4. Hyperinflation:

When prices rise very fast at double or triple digit rates from more than 20 to 100 per cent per annum or more, it is

usually called runaway ox galloping inflation. It is also characterised as hyperinflation by certain economists. In

reality, hyperinflation is a situation when the rate of inflation becomes immeasurable and absolutely uncontrollable.

Prices rise many times every day. Such a situation brings a total collapse of monetary system because of the

continuous fall in the purchasing power of money.

The speed with which prices tend to rise is illustrated in Figure 1. The curve С shows creeping inflation when within

a period of ten years the price level has been shown to have risen by about 30 per cent. The curve W depicts walking

inflation when the price level rises by more than 50 per cent during ten years. The curve R illustrates running

inflation showing a rise of about 100 per cent in ten years. The steep curve H shows the path of hyperinflation when

prices rise by more than 120 per cent in less than one year.
5. Semi-Inflation:

According to Keynes, so long as there are unemployed resources, the general price level will not rise as output

increases. But a large increase in aggregate expenditure will face shortages of supplies of some factors which may

not be substitutable. This may lead to increase in costs, and prices start rising. This is known as semi-inflation or

bottleneck inflation because of the bottlenecks in supplies of some factors.

7. Open Inflation:

Inflation is open when “markets for goods or factors of production are allowed to function freely, setting prices of

goods and factors without normal interference by the authorities. Thus open inflation is the result of the

uninterrupted operation of the market mechanism. There are no checks or controls on the distribution of

commodities by the government. Increase in demand and shortage of supplies persist which tend to lead to open

inflation. Unchecked open inflation ultimately leads to hyperinflation.

8. Suppressed Inflation:

Men the government imposes physical and monetary controls to check open inflation, it is known as repressed or

suppressed inflation. The market mechanism is not allowed to function normally by the use of licensing, price

controls and rationing in order to suppress extensive rise in prices. So long as such controls exist, the present

demand is postponed and there is diversion of demand from controlled to uncontrolled commodities. But as soon as

these controls are removed, there is open inflation. Moreover, suppressed inflation adversely affects the economy.
9. Stagflation:

Stagflation is a new term which has been added to economic literature in the 1970s. It is a paradoxical phenomenon

where the economy expedience’s stagnation as well as inflation. The word stagflation is the combination of‘ stag’

plus ‘flation’ taking ‘stag’ from stagnation and ‘flation’ from inflation. Stagflation is a situation when recession is

accompanied by a high rate of inflation. It is, therefore, also called inflationary recession. The principal cause of this

phenomenon has been excessive demand in commodity markets, thereby causing prices to rise, and at the same time

the demand for labour is deficient, thereby creating unemployment in the economy.

10. Mark-up Inflation:

The concept of mark-up inflation is closely related to the price-push problem. Modem labour organizations possess

substantial monopoly power. They, therefore, set prices and wages on the basis of mark-up over costs and relative

incomes. Firms possessing monopoly power have control over the prices charged by them. So they have

administered prices which increase their profit margin. This sets off an inflationary rise in prices. Similarly, when

strong trade unions are successful in raising the wages of workers, this contributes to inflation.

12. Sectoral Inflation:

Sectoral inflation arises initially out of excess demand in particular industries. But it leads to a general price rise

because prices do not fall in the deficient demand sectors.

13. Reflation:

Is a situation when prices are raised deliberately in order to encourage economic activity. When there is depression

and prices fall abnormally low, the monetary authority adopts measures to put more money in circulation so that

prices rise. This is called reflation.

2. Demand-Pull Inflation

Demand-Pull or excess demand inflation is a situation often described as “too much money chasing too few goods.”

According to this theory, an excess of aggregate demand over aggregate supply will generate inflationary rise in

prices. Its earliest explanation is to be found in the simple quantity theory of money.
The theory states that prices rise in proportion to the increase in the money supply. Given the full employment level

of output, doubling the money supply will double the price level. So inflation proceeds at the same rate at which the

money supply expands.

In this analysis, the aggregate supply is assumed to be fixed and there is always full employment in the economy.

Naturally, when the money supply increases it creates more demand for goods but the supply of goods cannot be

increased due to the full employment of resources. This leads to rise in prices.

Modem quantity theorists led by Friedman hold that “inflation is always and everywhere a monetary phenomenon.

The higher the growth rate of the nominal money supply, the higher the rate of inflation. When the money supply

increases, people spend more in relation to the available supply of goods and services. This bids prices up. Modem

quantity theorists neither assume full employment as a normal situation nor a stable velocity of money. Still they

regard inflation as the result of excessive increase in the money supply.

The quantity theory version of the demand-pull inflation is illustrated in Figure 3. Suppose the money supply is

increased at a given price level OP as determined by the demand and supply curves D and S 1 respectively. The

initial full employment situation OY F at this price level is shown by the interaction of these curves at point E. Now

with the increase in the quantity of money, the aggregate demand increase which shifts the demand curve D to D 1to

the right. The aggregate supply being fixed, as shown by the vertical portion of the supply curve SS 1 the D1 curve

intersects it at point E1. This raises the price level to OP1.

The Keynesian theory on demand-pull inflation is based on the argument that so long as there are unemployed

resources in the economy; an increase in investment expenditure will lead to increase in employment, income and

output. Once full employment is reached and bottlenecks appear, further increase in expenditure will lead to excess

demand because output ceases to rise, thereby leading to inflation.

4. The Inflationary Gap

In his pamphlet How to pay for the War published in 1940, Keynes explained the concept of the inflationary gap. It

differs from his views on inflation given in his General Theory. In the General Theory, he started with

underemployment equilibrium. But in How to Pay for the War, he began with a situation of full employment in the

economy.
He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base

prices. According to Lipsey, “The inflationary gap is the amount by which aggregate expenditure would exceed

aggregate output at the full employment level of income.” The classical economists explained inflation as mainly

due to increase in the quantity of money, given the level of full employment.

Keynes, on the other hand, ascribed it to the excess of expenditure over income at the full employment level. The

larger the aggregate expenditure, the larger the gap and the more rapid the inflation. Given a constant average

propensity to save, rising money incomes at full employment level would lead to an excess of demand over supply

and to a consequent inflationary gap. Thus Keynes used the concept of the inflationary gap to show the main

determinants that cause an inflationary rise of prices.

CAUSES OF INFLATION

Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and services. We analyse the

factors which lead to increase in demand and the shortage of supply.

Factors Affecting Demand

1. Increase in Money Supply:

Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand. The higher

the growth rate of the nominal money supply, the higher is the rate of inflation. Modem quantity theorists do not

believe that true inflation starts after the full employment level. This view is realistic because all advanced countries

are faced with high levels of unemployment and high rates of inflation.

2. Increase in Disposable Income:

When the disposable income of the people increases, it raises their demand for goods and services. Disposable

income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people.

3. Increase in Public Expenditure:

Government activities have been expanding much with the result that government expenditure has also been

increasing at a phenomenal rate, thereby raising aggregate demand for goods and services. Governments of both

developed and developing countries are providing more facilities under public utilities and social services, and also

nationalising industries and starting public enterprises with the result that they help in increasing aggregate demand.

4. Increase in Consumer Spending:

The demand for goods and services increases when consumer expenditure increases. Consumers may spend more

due to conspicuous consumption or demonstration effect. They may also spend more whey they are given credit

facilities to buy goods on hire-purchase and installment basis.

5. Cheap Monetary Policy

Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply which raises the

demand for goods and services in the economy. When credit expands, it raises the money income of the borrowers

which, in turn, raises aggregate demand relative to supply, thereby leading to inflation. This is also known as credit-

induced inflation.

6. Deficit Financing:

In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from the public

and even by printing more notes. This raises aggregate demand in relation to aggregate supply, thereby leading to

inflationary rise in prices. This is also known as deficit-induced inflation.

7. Expansion of the Private Sector:

The expansion of the private sector also tends to raise the aggregate demand. For huge investments increase

employment and income, thereby creating more demand for goods and services. But it takes time for the output to

enter the market.

8. Black Money:

The existence of black money in all countries due to corruption, tax evasion etc. increases the aggregate demand.

People spend such unearned money extravagantly, thereby creating unnecessary demand for commodities. This

tends to raise the price level further.

9. Repayment of Public Debt:

Whenever the government repays its past internal debt to the public, it leads to increase in the money supply with

the public. This tends to raise the aggregate demand for goods and services.

10. Increase in Exports:

When the demand for domestically produced goods increases in foreign countries, this raises the earnings of

industries producing export commodities. These, in turn, create more demand for goods and services within the

economy.

MEASURE TO CONTROL INFLATION

The various methods are usually grouped under three heads:

Monetary measures, fiscal measures and other measures.

1. Monetary Measures:

Monetary measures aim at reducing money incomes.

(a) Credit Control:

One of the important monetary measures is monetary policy. The central bank of the country adopts a number of

methods to control the quantity and quality of credit. For this purpose, it raises the bank rates, sells securities in the

open market, raises the reserved ratio, and adopts a number of selective credit control measures, such as raising

margin requirements and regulating consumer credit.

Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors. Monetary

policy can only be helpful in controlling inflation due to demand-pull factors.

(b) Demonetization of Currency:

However, one of the monetary measures is to demonetise currency of higher denominations. Such a measure is

usually adopted when there is abundance of black money in the country.

(c) Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system,

one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed

accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyperinflation in the

country. It is a very effective measure. But is inequitable for it hurts the small depositors the most.
2. Fiscal Measures:

Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by fiscal measures.

Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and

private and public investment.

The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure:

The government should reduce unnecessary expenditure on non-development activities in order to curb inflation.

This will also put a check on private expenditure which is dependent upon government demand for goods and

services. But it is not easy to cut government expenditure. Though economy measures are always welcome but it

becomes difficult to distinguish between essential and non-essential expenditure. Therefore, this measure should be

supplemented by taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and

even new taxes should be levied, but the rates of taxes should not be so high as to discourage saving, investment and

production. Rather, the tax system should provide larger incentives to those who save, invest and produce more.

Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by imposing heavy

fines. Such measures are bound to be effective in controlling inflation. To increase the supply of goods within the

country, the government should reduce import duties and increase export duties.
(c) Increase in Savings:

Another measure is to increase savings on the part of the people. This will tend to reduce disposable income with the

people, and hence personal consumption expenditure. But due to the rising cost of living, people are not in a position

to save much voluntarily. Keynes, therefore, advocated compulsory savings or what he called ‘deferred payment’

where the saver gets his money back after some years.

For this purpose, the government should float public loans carrying high rates of interest, start saving schemes with

prize money, or lottery for long periods, etc. It should also introduce compulsory provident fund, provident fund-

cum-pension schemes, etc. compulsorily. All such measures to increase savings are likely to be effective in

controlling inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government should give

up deficit financing and instead have surplus budgets. It means collecting more in revenues and spending less.

(e) Public Debt:

At the same time, it should stop repayment of public debt and postpone it to some future date till inflationary

pressures are controlled within the economy. Instead, the government should borrow more to reduce money supply

with the public.

Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They should be

supplemented by monetary, non-monetary and non-fiscal measures.

3. Other Measures:

The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand

directly:

(a) To Increase Production:

The following measures should be adopted to increase production:

(i) One of the foremost measures to control inflation is to increase the production of essential consumer goods like

food, clothing, kerosene oil, sugar, vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported on preferential basis to increase the production

of essential commodities.

(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be maintained

through agreements with trade unions, binding them not to resort to strikes for some time.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there is a wage-

price spiral. To control this, the government should freeze wages, incomes, profits, dividends, bonus, etc. But such a

drastic measure can only be adopted for a short period and by antagonising both workers and industrialists.

Therefore, the best course is to link increase in wages to increase in productivity. This will have a dual effect. It will

control wages and at the same time increase productivity, and hence increase production of goods in the economy.

(c) Price Control:

Price control and rationing is another measure of direct control to check inflation. Price control means fixing an

upper limit for the prices of essential consumer goods. They are the maximum prices fixed by law and anybody

charging more than these prices is punished by law. But it is difficult to administer price control.

(d) Rationing:

Rationing aims at distributing consumption of scarce goods so as to make them available to a large number of

consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to

stabilise the prices of necessaries and assure distributive justice. But it is very inconvenient for consumers because it

leads to queues, artificial shortages, corruption and black marketing. Keynes did not favour rationing for it “involves

a great deal of waste, both of resources and of employment.”

Effects of Inflation

Inflation affects different people differently. This is because of the fall in the value of money. When prices rise or

the value of money falls, some groups of the society gain, some lose and some stand in between. Broadly speaking,

there are two economic groups in every society, the fixed income group and the flexible income group.

People belonging to the first group lose and those belonging to the second group gain. The reason is that price

movements in the case of different goods, services, assets, etc. are not uniform. When there is inflation, most prices
are rising, but the rates of increase of individual prices differ much. Prices of some goods and services rise faster, of

others slowly, and of still others remain unchanged. We discuss below the effects of inflation on redistribution of

income and wealth, production, and on the society as a whole.

1. Effects on Redistribution of Income and Wealth:

There are two ways to measure the effects of inflation on the redistribution of income and wealth in a society. First,

on the basis of the change in the real value of such factor incomes as wages, salaries, rents, interest, dividends and

profits.

Second, on the basis of the size distribution of income over time as a result of inflation, i.e. whether the incomes of

the rich have increased and that of the middle and poor classes have declined with inflation. Inflation brings about

shifts in the distribution of real income from those whose money incomes are relatively inflexible to those whose

money incomes are relatively flexible.

2. Effects on Production:

When prices start rising, production is encouraged. Producers earn wind-fall profits in the future. They invest more

in anticipation of higher profits in the future. This tends to increase employment, production and income. But this is

only possible up to the full employment level.

Further increase in investment beyond this level will lead to severe inflationary pressures within the economy

because prices rise more than production as the resources are fully employed. So inflation adversely affects

production after the level of full employment.

3. Other Effects:

Inflation leads to a number of other effects which are discussed as under:

(1) Government:

Inflation affects the government in various ways. It helps the government in financing its activities through

inflationary finance. As the money income of the people increases, the government collects that in the form of taxes

on incomes and commodities. So the revenues of the government increase during rising prices.

Moreover, the real burden of the public debt decreases when prices are rising. But the government expenses also

increase with rising production costs of public projects and enterprises and increase in administrative expenses as
prices and wages rise. On the whole, the government gains under inflation because rising wages and profits spread

an illusion of prosperity within the country.

(2) Balance of Payments:

Inflation involves the sacrificing of the advantages of international specialisation and division of labour. It adversely

affects the balance of payments of a country. When prices rise more rapidly in the home country than in foreign

countries, domestic products become costlier compared to foreign products. This tends to increase imports and

reduce exports, thereby making the balance of payments unfavourable for the country. This happens only when the

country follows a fixed exchange rate policy. But there is no adverse impact on the balance of payments if the

country is on the flexible exchange rate system.

(3) Exchange Rate:

When prices rise more rapidly in the home country than in foreign countries, it lowers the exchange rate in relation

to foreign currencies.

(4) Collapse of the Monetary System:

If hyperinflation persists and the value of money continues to fall many times in a day, it ultimately leads to the

collapse of the monetary system, as happened in Germany after World War I.

(5) Social. Inflation is socially harmful:

By widening the gulf between the rich and the poor, rising prices create discontentment among the masses. Pressed

by the rising cost of living, workers resort to strikes which lead to loss in production. Lured by profit, people resort

to hoarding, black-marketing, adulteration, manufacture of substandard commodities, speculation, etc. Corruption

spreads in every walk of life. All this reduces the efficiency of the economy.

(6) Political:

Rising prices also encourage agitations and protests by political parties opposed to the government. And if they

gather momentum and become unhandy they may bring the downfall of the government. Many governments have

been sacrificed at the alter of inflation.

Q3. EXPLAIN THE PROFIT CONCEPT AND MAJOR THEORIES OF PROFITS?

 Theories of Profit in Economics

In economics, profit is called pure profit, which may be defined as a residual left after all contractual costs have
been met, including the transfer costs of management insurable risks, depreciation and payment to shareholders,
sufficient to maintain investment at its current level.

There are various theories of profit in economics, given by several economists, which are as follows:
1. Walker’s Theory of Profit as Rent of Ability

This theory is pounded by F.A. Walker. According to Walker, “Profit is the rent of exceptional abilities that an

entrepreneur may possess over others”. Rent is the difference between the yields of the least and the most efficient

entrepreneurs. In formulating this theory, Walker assumed a state of perfect completion in which all firms are

presumed to possess equal Business ability each firm receives only the wages which in Walker view forms no part

of pure profit. He considered wages of management as ordinary wages thus, under perfectly competitive conditions,

there would be no pure profit and all firms would earn only wages, which is known as normal profit.
2. Clark’s Dynamic Theory

This theory is propounded by J.B. Clark According to him, “Profits arise in a dynamic economy and not in static

economy.”

A static economy and the firms under it, has the following features:

 Absolute freedom of competition.

 Population and capital are stationary.

 Production process remains unchanged over time.

 Homogeneous goods.

 Factors of production enjoy freedom of mobility but do not move because their marginal product in very

industry is the same.

 There is no uncertainly and risk. If there is any risk, it is insurable

 All firms make only normal profit.

A dynamic economy is characterized by the following features:

 Increase in population.

 Increase in capital.

 Improvement in production techniques.

 Changes in the forms of business organization.

The major function of entrepreneurs or managers in a dynamic economy is to take the advantage of all of the above

features and promote their business by expanding their sales and reducing their costs of production.

According to J.B. Clark, “Profit is an elusive sum, which entrepreneurs grasp but cannot hold. It slips through their

fingers and bestows itself on all members of the society”.  This result in rise in demand for factors pf production and

therefore rises in factor prices and subsequent rise in the cost of production. On the other hand, because of rise in

cost of production and the subsequent fall in selling price of the commodities, the profit disappears. Disappearing of

profit does not mean that profit arise in dynamic economy once only, but it means that the managers take the

advantage of the changes taking place in the economy and thereby making profits.
3. Hawley’s Risk Theory of Profit

The risk theory pf profit is propounded by F.B. Hawley in 1893. Risk in business may arise due to obsolescence of a

product, sudden fall in prices, non-availability of certain materials, introduction of a better substitute by a competitor

and risks due to fire, war, etc. Hawley’s considered risk taking as an inevitable element of production and those who

take risk are more likely to earn larger profits. According to Hawley, Profit is simply the price paid by society

assuming business risks. In his opinion in excess of predetermined risk. They also look for a return in excess of the

wags for bearing risk is that the assumption of risk is irrelevant and gives to trouble and anxiety. According to

Hawley, Profit consists of two part, which are as follows:

 One Part represents compensation for actual or average loss supplementing the various classes of risk.

 The other part represents a penalty to suffer the consequences of being exposed to risk in the entrepreneurial

activities.

Hawley believed that profits arise from factor ownership as long as ownership involves risk. According to Hawley,

an entrepreneur has to assume risk to earn more and more profit. In case of absence of risks, an entrepreneur would
cease to be an entrepreneur and would not receive any profit. In this theory, profits arise out of uninsured risks. The

amount of reward cannot be determined, until the uncertainly ends with the sale of entrepreneur products profit in

his opinion is a residue and therefore Hawley theory is also called as Residual theory.

4. Knight’s Theory of Profit

This theory of profit is propounded by frank H. Knight who treated profit as a residual return because of uncertainly,

and not because of risk bearing. Knight made a distinction between risk and uncertainly by dividing risk into two

categories, calculable and non-calculable risks. They are explained as below:

 Calculable risks are those, the prodigality of occurrence of which van be calculated on the basis of available

data. For example risk, due to fire theft accidents etc. are calculable and such risks are insurable.

 Incalculable risks are those the probability of occurrence of which cannot be calculated. For Instance there may

be a certain elements of cost, which may not be accurately calculable and the strategies of the competitors may

not be precisely assessable. These risk are called includable risks. The risk element of such incalculable costs is

also insurable.

It is in the area of uncertainly which makes decision-making a crucial function for an entrepreneur. If his decisions

prove to be right, the entrepreneur makes profit, Thus according to knight profit arises from the decisions taken and

implemented under the conditions of uncertainly. The profits may arises as a result of decision related to the state of

market such as decision, which increase the degree of monopoly, decisions regarding holding of stocks that give rise

to windfall  gains and the decisions taken to introduce  new techniques or innovations.
5. Schumpeter’s Innovation Theory of Profit

Joseph A. Schumpeter developed the innovation theory of Profit. According to Schumpeter, factors like emergence

of interest and profits, recurrence of trade cycles only supplement the distinct process of economic development. To

explain the phenomenon of economic development and profit, Schumpeter starts from the state of a stationary

equilibrium, which is characterized by the equilibrium in all the spheres. Under these conditions stationary

equilibrium, the total receipts from the business are exactly equal to the cost. This means that there will be no profit.
The profit can be earned only by introducing innovations in manufacturing technique and the methods of supplying

the goods innovations may include the following activities.

 Introduction of a new commodity or new quality goods.

 Introduction of a new method of production.

 Introduction of a new market.

 Finding the new sources of raw material.

 Organizing the industry in an innovative manner with the new techniques.

The factor prices tend to increase while the supply of factors remains the same. As a result, cost of production

increase. On the other hand with other firms adopting innovations, supply of goods and services increases resulting

in a fall in their prices. Thus, on one hand, cost per unit of output goes up and on the other revenue per unit decrease.

Finally, a stage comes when there is no difference between costs and receipts. As a result there are no profits at all.

Here, economy has reached a state of equilibrium, but there is the possibility of existence of profits. Such profits are

in the nature of quasi-rent arising due to some special characteristics of productive services. Furthermore, where

profits arise due to factors such as patents, trusts, etc. they will be in the nature of monopoly revenue rather than

entrepreneurial profits.