MANAGERIAL ECONOMICS

Study Material for

B.B.A. – 1th Semester

This module is written by

Shivani Agarwal
Department of Management

MI
NCR

MEWAR INSTITUTE
(Affiliated to C.C.S. University, Meerut)
Sector-4-C, Vasundhara, Delhi-Gzb. Link Road, Ghaziabad-201 012
Phone : (0120) 2698218, 19, 20 Telefax : (0120) 2698046

Study material based on the syllabus of B.B.A.

prescribed by C.C.S. University, Meerut
for internal circulation/discussion during the classes of MI, Ghaziabad.
 My Dear Students,

Much awaited study material is now in your hands. Through the scheme of
the study material, we want that the student should use this study material
for his/her day to day study. In the study material the entire course is covered
in a summarized manner. If a student wants to make a detailed study then
the prescribed reading from concerned books is mentioned at the end of
the unit.

The study material has been conveniently classified into units. The contents
have been prepared in such a manner that it becomes easy to understand
and learn. The students are advised to read it in depth and if they have any
suggestion to further improve it, the same must be given to the concerned
Head of the Department.

I hope that this study material will be very useful for the students. They will
not have to read so many books in order to cover the syllabus. I feel the
reading of the study material and referring to the reference books wherever
required will be sufficient for the students.

With best wishes,

(Ashok Kr. Gadiya)

Chairman

ii MEWAR INSTITUTE
I feel intense pleasure to offer you this long awaited study material. This
study material has been prepared to meet the present requirements of
prescribed syllabus by the C.C.S. University, Meerut. Keeping this in view,
this study material has been categorised into several units along with
reference books for detailed study. Each unit has been written in simple
and lucid style so that even an average student may get maximum benefit.

In this backdrop, Mewar Institute of Management & Mewar Law Institute were
established by the Mewar Education Society, Delhi, a non-profit making body,
registered under the Societies Registration Act, 1860. The Institute is guided
in its activities by an advisory board.

Both the Institutes are in affiliation with Ch. Charan Singh University, Meerut
and with the vision and expertise, have started the professional & career
oriented courses. Bar Council of India has also accorded its approval for
both the Law courses and National Council for Teacher Education has
approved the B.Ed. programme.

The courses at Mewar Institute have been well integrated with computer
education. A lot of emphasis is given to the personality development of the
students. Mewar Institute aims to be a centre of excellence in the years to
come. We aim to operate comprehensively at laser speed and are not
satisfied with becoming an ordinary college. We give a definite sociological
vision to our students.

(Dr. Alka Agarwal)

Director

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 Head, Publications Department : Dr. Alka Agarwal

Co-ordinator : Dr. Ashutosh Mishra

Members : Mr. S.B. Mukherjee

Ms. Jyoti Tripathi Shukla
Ms. Akanksha Gupta
Mr. Mohit Gupta
Ms. Shivani Agarwal
Mr. Amit Arora
Ms. Anjali Saluja

Computer Designing : Mr. Bhudev Singh Saini

Computer Typing : Mr. Sudhir Kumar

iv MEWAR INSTITUTE
 MANEGERIAL ECONOMICS
BBA-103
Unit – I

Definition, Nature, Scope & Limitation of Economics as an art or Science. Relevance of Economics in
Business Management, Nature and Scope of Managerial Economics, its relationship with other subjects.

Unit – II

Meaning of demand. Demand theory and objectives, Demand analysis. Demand schedule. Demand Curve,
Laws of Demand, Elasticity of Demand Types & Measurement, Supply Analysis, Demand Forecasting.

Unit – III

Market analysis-Nature of market, Types of markets and their characteristics pricing under different market
structures-Perfect, Monopoly, oligopoly and Monopolistic completion.

Unit – IV

Pricing methods and Pricing Policies, Price Discrimination, National Income: Concepts and Measurements.

Unit – V

Economic Growth and Development, Business Cycle, The balance of payments, Inflation.

Suggested Readings:

1. Adhikari M ; Management Economics

2. Gupta G.S. ; Managerial Economics

3. Lal S.M ; Principles of Economics

4. Vaish & Sunderm; Principles of Economics

5. Gupta, K.G.; Managerial Economics

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UNIT - 1 — INTRODUCTION OF MANAGERIAL ECONOMICS
 Economics as a Science 1
 Economics as an Art 2
 Meaning of Managerial Economics 2
 Relevance of Economics in Business Management 3
 The nature and scope of managerial economics 3
 Managerial economics in relation with other disciplines 5
Important Questions 8
UNIT - 2 — DEMAND AND DEMAND FORECASTING
 Demand Analysis 12
 Demand analysis 9
 Determinants of demand or factors affecting demand 9
 Demand function 11
 The law of demand 11
 The expectation of price change 15
 Elasticity of demand 16
 Degrees of price elasticity 16
 Measurement of price elasticity of demand 18
 Factors influencing elasticity of demand 22
 Income elasticity of demand 23
 Cross elasticity of demand 24
 Concept of revenue 25
 Demand forecasting 28
 Importance of demand forecast 29
 Methods of demand forecasting 29
 What is supply analysis? 31
Important Questions 33

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UNIT - 3 — PRICING
 Meaning and features of market 33

 Price determination under prefect competition 37

 Price determination under monopoly 41
 Price determination under monopolistic competition 43
 Determination of price and output in oligopolistic market 46
Important Questions 48
UNIT - 4 — PRICING METHODS
 Pricing methods 49
 National income or output 55
 Basic concepts income or in national output 55
 National income's related formulas 57
 Methods to calculate national income value added method or
production method 57
 Per capita income 59
 Problems of measurement of national income or problems in
calculating national income 59
 Importance of national income or its analysis 59
Important Questions 60
UNIT - 5 — PROFIT MANAGEMENT AND INFLATION
 What Is Economic Growth? 61
 Understanding Economic Growth 61
 Measurement 61
 Inflation 64
 Causes of Inflation in India 66
 Measures to Control Inflation 69
Important Questions 71
Suggested Readings 71

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 UNIT - I
Economics as a Science and an Art

There is a great controversy among the economists regarding the nature of economics, whether the
subject 'economics' is considered as science or an art. I

f it is a science, then either positive science or normative science.

Economics as a Science:

Before we start discussing whether economics is science or not, it becomes necessary to have a clear
idea about science. Science is a systematic study of knowledge and fact which develops the correlation-
ship between cause and effect. Science is not only the collection of facts, according to Prof. Poincare,
in reality, all the facts must be systematically collected, classified and analyzed.

There are following characteristics of any science subject, such as;

(i) It is based on systematic study of knowledge or facts;

(ii) It develops correlation-ship between cause and effect;

(iii) All the laws are universally accepted

(iv) All the laws are tested and based on experiments;

(v) It can make future predictions;

(vi) It has a scale of measurement.

On the basis of all these characteristics, Prof. Robbins, Prof Jordon, Prof. Robertson etc. claimed
economics as one of the subject of science like physics, chemistry etc. According to all these economists,
'economics' has also several characteristics similar to other science subjects.

(i) Economics is also a systematic study of knowledge and facts. All the theories and facts related
with both micro and macro economics are systematically collected, classified and analyzed.

(ii) Economics deals with the correlation-ship between cause and effect. For example, supply is a
positive function of price, i.e., change in price is cause but change in supply is effect.

(iii) All the laws in economics are also universally accepted, like, law of demand, law of supply, law
of diminishing marginal utility etc.

(iv) Theories and laws of economics are based on experiments, like, mixed economy to is an
experimental outcome between capitalist and socialist economies.
(v) Economics has a scale of measurement. According to Prof. Marshall, 'money' is used as the
measuring rod in economics. However, according to Prof. A.K. Sen, Human Development Index
(HDI) is used to measure economic development of a country.

Economics as an Art:

According to T.K. Mehta, 'Knowledge is science, action is art.' According to Pigou, Marshall etc.,
economics is also considered as an art. In other way, art is the practical application of knowledge for
achieving particular goals. Science gives us principles of any discipline however, art turns all these
principles into reality. Therefore, considering the activities in economics, it can claimed as an art also,
because it gives guidance to the solutions of all the economic problems.

Therefore, from all the above discussions we can conclude that economics is neither a science nor an
art only. However, it is a golden combination of both. According to Cossa, science and art are
complementary to each other. Hence, economics is considered as both a science as well as an art.

Meaning of Managerial Economics

Managerial economics refers to the management of business using economic theories, tools, and
concepts. It is simply the amalgamation of management principles and economic theories for better
problem solving and decision making. It is a branch of economics that applies economic theories for
analysis, assumption, and prediction of business conditions.

Managerial economics bridges the gap between economics in theory and economics in practice. It
assists the managers in logically solving business problems and rational decision making. The key
function of managerial economics is efficient decision making and chooses the most suitable action out
of two or more alternatives. It monitors and ensures that all scarce resources like labor, capital, land,
etc. are properly utilized to derive better results.

Managerial economics performs three important roles for business organizations: Demand analysis
and forecasting, capital management and profit management. Firms with the application of managerial
economics optimally decide what to produce, how to produce and for whom to produce.

DEFINITIONS

1. Mc Nair and Merian define managerial economics as "the use of economic models of thought to
analyse business situation."

2. E. Mansfield says, "Mangerial economics is concerned with application of economic concepts

and economic analysis to the problems of formulating material managerial decisions."

3. According to Davis and Chang, "Managerial economics applies the principles and methods of
economics to analyse problems faced by management of a business, or other types of
organisations and to help find solutions that advance the best interests of such organizations."

4. Hague believes that managerial economics is "a fundamental academic subject which seeks to
understand and to analyse the problems of business decision-making."

Although these definitions of managerial economics display the nature of managerial economics, it
would be beneficial to point out certain chief characteristics of managerial economics, as they throw
further light on the nature of the subject matter.

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1) Managerial economics is micro economics in character. This is because basically this studies a
small portion of an economy, for example - a firm, a producer etc. Managerial economics does
not deal with the entire economy as a unit of study.
2) Managerial economics is concerned with decision making, i.e. it deals with identification of
economic choices and allocation of scarce resources.
3) It is goal-oriented and prescriptive. It deals with how decisions should be made by business
firms to achieve the organisational goals.
4) Being prescriptive, it is concerned with those analytical tools which are useful in improving
decision-making.
5) Managerial economics is both conceptual and metrical.
6) Managerial economics is pragmatic. It avoids difficult abstract issues of economic theory but
involves complications ignored in economic theory to face the overall situation in which decisions
are made.
7) Managerial economics provides a link between traditional economics and the decision-sciences
for managerial decision-making.
Relevance of Economics in Business Management
1. Business Planning and Forecasting: Managerial economics plays an efficient role in formulating
business policies by forecasting future demands and uncertainties. It assists in the effective
decision making of an organization by supplying all information using economic tools and
techniques.
2. Analyze Cost and Production level: Managerial economics focuses on minimizing the cost of
business. It determines the cost associated with different business processes and finds out the
cost-minimizing level of output. Managerial economics enables business managers in ensuring
that there is no resource wastage which reduces the overall cost.
3. Formulate pricing policies: It helps in determining the right pricing policies for organizations.
Pricing method affects the profitability and revenue of the business organization and therefore
fixing the right price is essential. Managerial economics analyses the market pricing structure
and strategies for deciding the firm prices.
4. Manages profit: Managerial economics monitor and control the profitability of the business
organization. Profit is the ultimate goal of every business and determines its success or growth.
It ensures that the desired profit is earned by making an estimate of the revenue and expenses
of an organization at different levels of outputs.
5. Capital Management: Capital management is one of the important functions played by managerial
economics. It manages and analyses all capital expenditures of business which involves huge
expenditures. Before investing any amount anywhere it measures the profitability of such a
source for allocating funds
THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS
Generally, the scope of managerial economics includes all those economic concepts, theories and
tools of analysis which can be used to analyse the business environment and to find solutions to

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practical business problems. In other words, managerial economics is economics applied to the
analysis of business problems and decision making. Broadly speaking, it is applied economics.
As regards the scope of Managerial economics, no uniform pattern has been followed by various
authors. However, the following topics may be said to generally fall under Managerial economics. These
topics may also be called as the 'Subject - Matter of Managerial Economics'.
1) Demand Analysis and Forecasting
2) Cost and Production Analysis
3) Pricing Decisions, Policies and Practices
4) Profit Analysis and Profit Management
5) Capital Management
1) Demand Analysis and Forecasting: As we know, each firm wants to raise the demand of its
commodity in the market, but for achieving this goal it has to study theory of demand. Demand
theory explains the consumer's behaviour. It answers : How do the consumers decide whether
to buy or not to buy a commodity? What quantity should be purchased for gaining maximum
satisfaction? How do the consumers behave when price of the commodity, their income and
tastes, fashions etc. change? Thus knowledge of demand theory can be helpful in the choice of
commodities for production as well as quantity of production.
2) Cost and Production Analysis : The chief topics covered under cost and production analysis
are cost concepts and classification, cost-output relation, economies and diseconomies of
scale, production function and cost-control. Production theory explains the relationship between
inputs and output. It also explains under what conditions cost increases or decreases, how total
output increases when units of one factor are increased keeping other factors constant, or when
all factors are simultaneously increased. How can output be maximized from a given quantity of
inputs and how can optimum size of output be determined? On the other hand 'cost theory'
explains how cost can be controlled. Which production process or factor combination can be
employed for producing a given level of output of a commodity which minimises the cost of
production.
3) Pricing Decisions, Policies and Practices: Pricing is a very important area of Managerial
economics. Price theory explains how prices are determined under different market conditions;
when price discrimination is desirable, feasible and profitable; to what extent advertising can be
helpful in expanding sales in a competitive market. Thus price theory can be helpful in determining
the price policy of the firm. Thus, the important aspects dealt under this area are - Price
determination in various market forms, pricing, methods, differential pricing, product-line pricing
and price fore-casting.
4) Profit Analysis and Profit Management: Business firms are generally organised for the purpose
of making profits and in the long run it is profit which provides the chief measure of success. So,
profit making is the most common objective of all business undertakings. But making a satisfactory
profit is not always guaranteed because a firm has to carry out its activities under conditions of
uncertainty with regard to (i) demand for the product (ii) input prices in the factor market (iii)
nature and degree of competition in the product market (iv) price behaviour under changing
conditions in the product market, etc. In a world of uncertainty, expectations are not always

4 MEWAR INSTITUTE
 realized, so profit planning and measurement constitute the difficult area of managerial economics.
The crucial aspects covered under this area - Nature and measurement of profit, Profit Policies
and Techniques of Profit Planning like Break-Even Analysis. Profit theory guides firms in the
measurement and management of profit, in making allowances for the risk premium, in calculating
the pure return on capital and pure profit and also for future profit planning.
5) Capital Management : Today, capital plays the most crucial role to run a business. Capital is
the foundation of business. Its efficient allocation and management is one of the most important
tasks for the managers and a determinant of the success level of the firm. The major issues
related to capital are (i) choice of investment project (ii) assessing the efficiency of capital, and
(iii) most efficient allocation of capital. Knowledge of capital theory can contribute a great deal in
investment decision making, choice of projects, maintaining capital intact, capital budgeting etc.
Moreover, in recent years, there is a trend towards integration of Managerial economics and
operation research. Hence, techniques such as Linear programming, Inventory models, Theory
of Games etc. have also come to be regarded as part of managerial economics.
MANAGERIAL ECONOMICS IN RELATION WITH OTHER DISCIPLINES
Managerial economics has a close linkage with other disciplines and fields of study. The subject has
gained by the interaction with Economics, Mathematics and Statistics and has drawn upon Management
theory and Accounting concepts. Managerial economics integrates concepts and methods from these
disciplines and brings them to bear on managerial problems. Managerial Economics and Economics
Managerial Economics has been described as economics applied to decision making. It may be viewed
as a special branch of economics bridging the gulf between pure economic theory and managerial
practice.
Economics has two main divisions :-
(i) Microeconomics and
(ii) Macroeconomics.
Microeconomics has been defined as that branch of economics where the unit of study is an individual
or a firm.
Macroeconomics, on the other hand, is aggregate in character and has the entire economy as a unit of
study. Microeconomics, also known as price theory (or Marshallian economics) is the main source of
concepts and analytical tools for managerial economics. To illustrate various micro-economic concepts
such as elasticity of demand, marginal cost, the short and the long runs, various market forms, etc., all
are of great significance to managerial economics. The chief contribution of macroeconomics is in the
area of forecasting. The modern theory of income and employment has direct implications for forecasting
general business conditions. As the prospects of an individual firm often depend greatly on general
business conditions, individual firm forecasts depend on general business forecasts.
A survey in the U.K has shown that business economists have found the following economic concepts
quite useful and of frequent application :-
1. Price elasticity of demand,
2. Income elasticity of demand,
3. Opportunity cost,

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4. The multiplier,

5. Propensity to consume,

6. Marginal revenue product,

7. Speculative motive,

8. Production function,

9. Balanced growth, and

10. Liquidity preference.

Business economics have also found the following main areas of economics as useful in their work :-

1. Demand theory,

2. Theory of the firm-price, output and investment decisions,

3. Business financing,

4. Public finance and fiscal policy,

5. Money and banking,

6. National income and social accounting,

7. Theory of international trade, and

8. Economics of developing countries

Managerial Economics and Theory of Decision Making: The theory of decision making is relatively
a new subject that has a significance for managerial economics. In the process of management such
as planning, organising, leading and controlling, decision making is always essential. Decision making
is an integral part of today's business management. A manager faces a number of problems connected
with his/her business such as production, inventory cost, marketing, pricing, investment and personnel.

Economist are interested in the efficient use of scarce resources hence they are naturally interested in
business decision problems and they apply economics in management of business problems. Hence
managerial economics is economics applied in decision making.

Managerial Economics and Operations Research: Mathematicians, statisticians, engineers and

others join together and developed models and analytical tools which have grown into a specialised
subject known as operation research. The basic purpose of the approach is to develop a scientific
model of the system which may be utilised for policy making. The development of techniques and
concepts such as Linear Programming, Dynamic Programming, Input-output Analysis, Inventory Theory,
Information Theory, Probability Theory, Queuing Theory, Game Theory, Decision Theory and Symbolic
Logic.

Managerial Economics and Statistics: Statistics is important to managerial economics. It provides

the basis for the empirical testing of theory. It provides the individual firm with measures of appropriate
functional relationship involved in decision making. Statistics is a very useful science for business
executives because a business runs on estimates and probabilities.

6 MEWAR INSTITUTE
Statistics supplies many tools to managerial economics. Suppose forecasting has to be done. For this
purpose, trend projections are used. Similarly, multiple regression technique is used. In managerial
economics, measures of central tendency like the mean, median, mode, and measures of dispersion,
correlation, regression, least square, estimators are widely used.
Statistical tools are widely used in the solution of managerial problems. For eg. sampling is very useful
in data collection. Managerial economics makes use of correlation and multiple regression in business
problems involving some kind of cause and effect relationship
Managerial Economics and Accounting: Managerial economics is closely related to accounting. It is
recording the financial operation of a business firm. A business is started with the main aim of earning
profit. Capital is invested / employed for purchasing properties such as building, furniture, etc and for
meeting the current expenses of the business.
Goods are bought and sold for cash as well as credit. Cash is paid to credit sellers. It is received from
credit buyers. Expenses are met and incomes derived. This goes on the daily routine work of the
business. The buying of goods, sale of goods, payment of cash, receipt of cash and similar dealings
are called business transactions.
The business transactions are varied and multifarious. This has given rise to the necessity of recording
business transaction in books. They are written in a set of books in a systematic manner so as to
facilitate proper study of their results.
There are three classes of accounts:
(i) Personal account,
(ii) Property accounts, and
(iii) Nominal accounts.
Management accounting provides the accounting data for taking business decisions. The accounting
techniques are very essential for the success of the firm because profit maximisation is the major
objective of the firm.
Managerial Economics and Mathematics: Mathematics is another important subject closely related
to managerial economics. For the derivation and exposition of economic analysis, we require a set of
mathematical tools. Mathematics has helped in the development of economic theories and now
mathematical economics has become a very important branch of economics.
Mathematical approach to economic theories makes them more precise and logical. For the estimation
and prediction of economic factors for decision making and forward planning, mathematical method is
very helpful. The important branches of mathematics generally used by a managerial economist are
geometry, algebra and calculus.
The mathematical concepts used by the managerial economists are the logarithms and exponential,
vectors and determinants, inputout tables. Operations research which is closely related to managerial
economics is mathematical in character.

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IMPORTANT QUESTIONS
Q.1. How Economics is both art and science
Q.2. What do you understand by term Managerial Economics.?
Q.3. What is the relevance of Economics in Business Management?
Q.4. What is the relationship of Managerial Economics with other subjects?

8 MEWAR INSTITUTE
 UNIT - II
DEMAND AND DEMAND FORECASTING

DEMAND ANALYSIS
Meaning of Demand: Conceptually, the term ‘demand’ implies a ‘desire’ for a commodity backed by
the ability and willingness to pay for it. Unless a person has adequate purchasing power or resources
and the preparedness to spend his resources, his desire for a commodity would not be considered as
his demand. For example, if a man wants to buy a car but he does not have sufficient money to pay for
it, his want is not his demand for the car. And, if a rich miserly person wants to buy a car but is not
willing to pay, his desire too is not his demand for a car. But if a man has sufficient money and is willing
to pay, his desire to buy a car is an effective demand.
The desires without adequate purchasing power and willingness to pay do not affect the market, nor do
they generate production activity.
Demand may be defined as the amount of a commodity purchased by a person at a given point of time
and at a given price.
Demand includes:
a) A desire to get a commodity
b) Ability to buy a commodity
c) Willingness to buy a commodity
According to Ferguson, “Demand refers to the quantities of a commodity that the consumers are
able and willing to buy at each possible price during a given period of time, other things being equal.”
Again it must consist,
a) Demand is always at a point of time
b) Demand is always at a price
DETERMINANTS OF DEMAND OR FACTORS AFFECTING DEMAND
1) Price of the Commodity : The most important factor affecting amount demanded is the price of
the commodity. The amount of a commodity demanded at a particular price is more properly
called price demand. The relation between price and demand is called the Law of Demand. It is
not only the existing price but also the expected changes in price which affect demand.
2) Price of Related Goods: Demand for a commodity is influenced by the change in the price of
related goods.
 There are two types of goods:
a) Substitute Goods: These are the goods which can replace each other in use like tea
and coffee.

b) Complementary Goods: These are those goods which are jointly demanded such as
petrol and car, pen and ink etc.

If the price of the car increases, demand for car will fall along with it the demand for petrol will
also fall and vice-versa.

3. Income of the Consumer: It is also another factor which influences the demand. There is a
direct relation between income of the consumer and its demand.

The demand for normal goods rises, with an increase in the income of the consumer and vice-
versa.

In case of Inferior goods, there is fall in demand with the increase in income and vice-versa.
That means there is an indirect relation in case of Inferior goods.

In case of necessities like salt, milk etc demand remains constant with the change in income.

4. Tastes and Preferences: Tastes and Preferences also influence the demand to a great extent.
This includes fashion, customs, advertisement, climate etc. Other things being equal, as the
taste of the commodity goes up, demand will also increase. And if the demand for the commodity
goes down that means the customers have no taste for that commodity.

5. Population: Increase in population increases demand for necessaries of life. The composition
of population also affects demand. Composition of population means the proportion of young
and old and children as well as the ratio of men to women.

Increase in Population leads to an increase in demand for all types of goods whereas decrease
in population means less demand for such commodities.

6. Government Policy: Government policy affects the demands for commodities through taxation.
Taxing a commodity increases its price and the demand goes down. Similarly, financial help for
the government increases the demand for a commodity while lowering its price.

7. Expectations Regarding the Future: If consumers expect changes in price of a commodity in

future, they will change the demand at present even when the present price remains the same.
Similarly, if consumers expect their incomes to rise in the near future they may increase the
demand for a commodity just now.

8. Climate and Weather: The climate of an area and the weather prevailing there has a decisive
effect on consumer’s demand. In cold areas woollen cloth is demanded. During hot summer
days, ice is very much in demand. On a rainy day, ice-cream is not so much demanded.

9. State of Business: The level of demand for different commodities also depends upon the
business conditions in the country. If the country is passing through boom conditions, there will
be a marked increase in demand. On the other hand, the level of demand goes down during
depression.

10 MEWAR INSTITUTE
DEMAND FUNCTION

The functional relationship between the demand for a commodity and its various

determinants may be expressed mathematically in terms of a demand function, thus:

Dx = f (Px, Py, I, T, E, U) where,

Dx = Quantity demanded for commodity X.

f = functional relation.

Px = The price of commodity X.

Py = The price of substitutes and complementary goods.

I = the income of the consumer.

E= Future expectations

T = The taste of the consumer.

U = Unknown variables or influences.

THE LAW OF DEMAND

The law of demand is one of the fundamental laws of economics. The law of demand states that the
demand for a commodity increases when its price decreases and falls when its price rises, other
things remaining constant. This is an empirical law, i.e., this law is based on observed facts and can be
verified with new empirical data. As the law states, there is an inverse relationship between the price
and quantity demanded. This law holds under the condition that “other things remain constant”. “Other
things” include other determinants of demand, viz., consumers’ income, price of the substitutes and
complements, tastes and preferences of the consumer, etc. These factors remain constant only in the
short run. In the long run they tend to change. The law of demand, therefore, holds only in the short run.

Assumptions:

1) There should be no change in the income of the consumer.

2) There should be no change in the taste and preferences of the consumer.

3) Price of related goods remains unchanged.

4) There should be no change in the size of the population.

5) There should be no expectation of rise in price of related goods.

Demand Schedule:

Demand Schedule refers to the response of amount demanded to change in price of a commodity. It
summarizes the information on prices and quantity demanded. It is of two types.

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1) Individual Demand Schedule

2) Market Demand Schedule

1) Individual Demand Schedule: Considering other things being equal individual demand schedule
refers to the quantities of the commodities demanded by the consumer at various prices. It can
be shown with the help of table given below:
Table – Individual Demand Schedule
Price of Mangoes Amount Demanded per Week
(Rs. per Kg.) (Quantities in kg.)
80 2
70 4
60 6
50 10
40 16

2) Market Demand Schedule: The demand side of the market is represented by the demand
schedule. It is tabular statement narrating the quantities of a commodity demanded in aggregate
by all the buyers in the market at different prices over a given period of time. A market demand
schedule, thus, represents the total market demand at various prices. Theoretically, the demand
schedule of all individual consumers of a commodity can be complied and combined to form a
composite demand schedule, representing the total demand for the commodity at various
alternative prices. The derivation of market demand from individual demand schedules is illustrated
in the table. Here is it is assumed that the market is composed only of three buyers, A, B and C.
Table – A Market Demand Schedule (Hypothetical Data)
Price (in Rs.) Units of Commodity X Demand per Day By Total or market demand
Individuals
A + B
4 1 1 2
3 2 3 5
2 3 5 8
1 5 9 14

Apparently, the market demand schedule is constructed by the horizontal additions of quantities
at various prices related in the individual demand schedules.

The Demand Curve

A demand curve is a graphical presentation of a demand schedule. When price quantity

information of a demand schedule is plotted on the graph, a demand curve is drawn. Demand
curve thus depicts the picture of the data contained in the demand schedule. It relates to the
amount the consumer is willing to pay at each alternative conceivable price for the commodity
over the given period of time.

12 MEWAR INSTITUTE
Derivation of Market Demand Curve
The market demand curve is derived by the horizontal summation of individual demand curves for a
given product. Following figure is drawn by plotting the data contained in the table.

It may be observed that the slope of the market demand curve is an average of the slopes of individual
demand curves.

Why the Demand Curve Slopes Downward?

The demand curve slopes downward due to following reasons:

1) Law of diminishing marginal utility:

A consumer always equalises marginal utility with price. The law states that a consumer derives less
and less satisfaction (utility) from the every additional increase in the stock of a commodity. When price
of a commodity falls the consumer’s price utility equilibrium is disturbed i.e. price becomes smaller
than utility.

The consumer in order to restore the new equilibrium between price and utility buys more of it so that
the marginal utility falls with the rise in the amount demanded. So long the price of a commodity falls,
the consumer will go on buying more amount of it so as to reduce the marginal utility and make it equal
with new price.

Thus the shape and slope of a demand curve is derived from the slope of marginal utility curve.

MEWAR INSTITUTE 13
(2) Income effect:

Another cause behind the operation of law of demand is income effect. As the price of a commodity
falls, the consumer has to buy the same amount of the commodity at less amount of money. After
buying his required quantity he is left with some amount of money.

This constitutes his rise in his real income. This rise in real income is known as income effect. This
increase in real income induces the consumer to buy more of that commodity. Thus income effect is
one of the reasons why a consumer buys more at falling prices.

(3) Substitution effect:

When the price of a commodity falls, it becomes relatively cheaper than other commodities. The
consumer substitutes the commodity whose price has fallen for other commodities which becomes
relatively dearer.

For example, with the fall in price of tea, coffee price being constant, tea will be substituted for coffee.
Therefore the demand for tea will go up.

(4) New consumers:

When the price of a commodity falls many other consumers who were deprived of that commodity at
the previous price become able to buy it now as the price comes within their reach. For example , the
units of colour TV. increases with a remarkable fall in price of it. The opposite will happen with a rise in
prices.

(5) Multiple use of commodity:

There are some commodities which have multiple uses. Their uses depend upon their respective,
prices. When their prices rise they are used only for certain selected purposes. That is why their
demand goes down.

For example electricity can be put to different uses like heating, lighting, cooling, cooking etc. If its price
falls people use it for other uses other than that. A rise in price of electricity will force the consumer to
minimise its use. Thus with a fall and rise in price of electricity its demand rises and falls accordingly.

Exceptions to the Law of Demand:

It is almost a universal phenomenon of the law of demand that when the price falls, the demand
extends and it contracts when the price rises. But sometimes, it may be observed, though of course,
very rarely, that with a fall in price, demand also falls and with a rise a price, demand also rises. This is
a paradoxical situation or a situation which apparently is contrary to the law of demand.

In this, demand curve slopes upward from the left to right. It appears that when there is increases in
price, the quantity demanded will also increase and vice-versa. It represents a direct functional relationship
between price and demand.

Such upward sloping demand curves are unusual and quite contradictory to the law of demand, as they
represent the phenomenon that ‘more will be at a higher price and vice versa. The upward sloping
demand curve thus, refers to the exceptions to the law of demand. There are a few such exceptional
cases, which may be categorized as follows:

14 MEWAR INSTITUTE
Giffen Goods

Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods are goods that are
inferior in comparison to luxury goods. However, the unique characteristic of Giffen goods is that as its
price increases, the demand also increases. And this feature is what makes it an exception to the law of
demand.

The Irish Potato Famine is a classic example of the Giffen goods concept. Potato is a staple in the Irish
diet. During the potato famine, when the price of potatoes increased, people spent less on luxury foods
such as meat and bought more potatoes to stick to their diet. So as the price of potatoes increased, so
did the demand, which is a complete reversal of the law of demand.

Veblen Goods

The second exception to the law of demand is the concept of Veblen goods. Veblen Goods is a concept
that is named after the economist Thorstein Veblen, who introduced the theory of “conspicuous
consumption”. According to Veblen, there are certain goods that become more valuable as their price
increases. If a product is expensive, then its value and utility are perceived to be more, and hence the
demand for that product increases. And this happens mostly with precious metals and stones such as
gold and diamonds and luxury cars such as Rolls-Royce. As the price of these goods increases, their
demand also increases because these products then become a status symbol.

The expectation of Price Change

In addition to Giffen and Veblen goods, another exception to the law of demand is the expectation of
price change. There are times when the price of a product increases and market conditions are such
that the product may get more expensive. In such cases, consumers may buy more of these products
before the price increases any further. Consequently, when the price drops or may be expected to drop
further, consumers might postpone the purchase to avail the benefits of a lower price.

For instance, in recent times, the price of onions had increased to quite an extent. Consumers started
buying and storing more onions fearing further price rise, which resulted in increased demand.

MEWAR INSTITUTE 15
Necessary Goods and Services

Another exception to the law of demand is necessary or basic goods. People will continue to buy
necessities such as medicines or basic staples such as sugar or salt even if the price increases. The
prices of these products do not affect their associated demand.

Change in Income

Sometimes the demand for a product may change according to the change in income. If a household’s
income increases, they may purchase more products irrespective of the increase in their price, thereby
increasing the demand for the product. Similarly, they might postpone buying a product even if its price
reduces if their income has reduced. Hence, change in a consumer’s income pattern may also be an
exception to the law of demand.

Consumer’s Psychological Bias or Illusion: When the consumer is wrongly biased against the quality
of the commodity with the price change, he may contract this demand with a fall in price.

ELASTICITY OF DEMAND

In law of Demand, we study the direction of change in demand and elasticity of demand has been
designed to measure the degree or speed of change in demand. The degree of responsiveness of
demand to the change in its determinants is called elasticity of demand.

The elasticity of demand is classified into three:

1) Price Elasticity of Demand

2) Income Elasticity of Demand

3) Cross Elasticity of Demand

Price Elasticity of Demand: The concept of price elasticity of demand was first of all introduced in
economics by Dr. Marshall. Price elasticity of demand is generally defined as the responsiveness or
sensitiveness of demand for a commodity to the changes in its price. More precisely, elasticity of
demand is the percentage change in demand as a result of percentage change in the price of the
commodity.

According to Alfred Marshall, “Elasticity of Demand may be defined as the percentage change in
quantity demanded to the percentage change in price.”

The formula for the Price Elasticity of Demand (ED) is:

ED = (% Change in Quantity Demanded)/(% Change in Price)

DEGREES OF PRICE ELASTICITY

1) Perfectly Elastic demand: It is said to happen when a little change in price leads to an infinite
change in quantity demanded. A small rise in price on the part of seller reduces the demand to
zero. In such a case the shape of the demand curve will be horizontal straight line. The elasticity
of demand in this case will be equal to infinity ( ed= )

16 MEWAR INSTITUTE
2) Perfectly Inelastic demand: Under the perfectly inelastic demand, irrespective of any rise or
fall in price of a commodity, the quantity demanded remains the same. The elasticity of demand
in this case is equal to zero. (ed=0)

3) Unitary Elastic Demand: The demand is said to be unitary elastic when a proportionate change
in the price level brings about an equal proportionate change in quantity demanded. The numerical
value of unitary elastic demand is exactly one i.e. ed = 1
This type of demand curve is also known as rectangular hyperbola.

4) Greater than Unitary Elastic Demand: It refers to a situation in which a small change in price
leads to a big change in quantity demanded. In such a case elasticity of demand is said be more
than one (ed > 1).

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5) Less than Unitary Elastic Demand: It refers to a situation in which a given percentage of
change in price produces a relatively less percentage change in quantity demanded. In such a
case elasticity of demand is said to be less than one (ed<1).

MEASUREMENT OF PRICE ELASTICITY OF DEMAND

Three methods have been devised by the economists to measure price elasticity. They are (a) Total
outlay method (b) Point method, and (c) Arc method.
a) Total Outlay Method: This method is associated with the name of Alfred Marshall. According to
this method, we may say that the elasticity of demand is one, if a small fall in price will cause an
equal proportionate increase in the quantity demanded; or as we may say roughly, a fall of one
percent in price will increase the sales by one percent; if a fall of one percent in price makes an
increase of two or one and a half percent respectively in the quantity demanded and so on. In
this method we consider the change in price and the consequent change in the outlay on the
purchase of the commodity. If for instance, a given change in price does not cause any change
in the total amount of money spent on the commodity (i.e., the total outlay on the commodity
remains constant), elasticity of demand said to be equal to unity. If as a result of a given change
in price the total outlay is increased, elasticity of demand is said to be greater than unity. On the
contrary, if as a result of a given change in price, the total outlay is diminished, then elasticity of
demand is said to be less than unity. In short, TQ = pq, where TQ stands for outlay, p and q for
price and quantity demanded respectively. This provides us with three different measurements
of the elasticity of demand which are as follows :
a) Less than unit elastic (< 1),
b) Unit elastic (= 1),

18 MEWAR INSTITUTE
 c) More than unit elastic (> 1).

1) Demand is less than unit elastic or inelastic when,

i) With a fall in price total outlay also falls; or

ii) With a rise in price, total outlay also rises.

2) Demand is unit elastic when total outlay does not vary with change in price of the
commodity as illustrated by demand schedule of cloth in table (B). With a fall in price,
demand for the commodity increases. The household continues to spend as much on
the commodity as before. With rise in price, demand contracts, but the total outlay
remains unchanged.

3) Demand is more than unit elastic when:

i) With a fall in price, total outlay increases; or

ii) With a rise in price, total outlay falls. Demand for butter in table (C) is of this
outlay.
We can tabulate these various results as follows :
Effect on Outlay
Change in price Type of elasticity of demand
=1 <1 >1
Fall in Price TQ remains TQ falls TQ rises
constant
Rise in Price TQ remains TQ rises TQ falls
Constant
The main weakness of the total outlay method is that it does not help us to measure elasticity in
numerical terms. It simply classifies price demand into elastic, inelastic and unitary elastic
demands.

B) Proportionate Method: This method is also associated with the name of Dr. Marshall. According
to this method, “price elasticity of demand is the ratio of percentage change in the amount
demanded to the percentage change in price of the commodity. It is also known as the Percentage
Method, Flux Method, and Ratio Method.

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a) Point Method: Measuring Elasticity Of Demand on a Linear demand Curve : Let a straight
line demand curve DD’ be given and we have to measure price elasticity of demand at the point
R on this demand curve.

The measure of price elasticity of demand is given by : Ep =(“q/”p) (p/q) The first term in this
formula ,(“q/”p) is the reciprocal of the slope of the demand curve DD’(slope of the demand
curve is equal to Change in price divided by change in quantity demanded and will be the same
all along the straight line demand curve). The second term is the original price divided by the
Original Quantity. Thus

Ep =(1/slope)(p/q)

Now at point R in the diagram, Original price p = OP and Original quantity q = OQ. Further,
slope of the demand curve DD’ is “p/”q = PD/PR

Substituting these in the above formula we have

Ep =[ 1/(PD/PR)](OP/OQ) = (PR/PD)(OP/OQ)

However PR =OQ and they will get cancelled and therefore

Ep = OP/PD

This represents the ratio of the distances on the vertical axis.

In a right angled triangle ODD’,PR is parallel to OD’.

Therefore

Ep = OP/PD =RD’/RD

RD’ is the lower segment of the demand curve DD’ at point R and RD is its upper segment.

Therefore,

Ep = RD’/RD =Lower segment/Upper segment.

20 MEWAR INSTITUTE
Measuring Price elasticity on a non –linear demand curve.

In order to measure elasticity in case of a non linear curve we draw a tangent at the given point R on
the demand curve DD’ and then measure price elasticity by finding out the value of RT’/RT.
On a Linear Demand curve price elasticity varies from Zero to infinity. This can be represented
diagrammatically as follows.In this diagram elasticity is being calculated at five points D,S,R,Land D’.

D) Arc Elasticity Method

Arc Elasticity of demand When price changes are large or we have to measure elasticity over an arc of
the demand curve rather than at a specific point on the demand curve, the point elasticity method does
not provide a true or correct measure of price elasticity of demand . Further, in such cases, the
elasticity would be different depending on whether we choose original price and original demand or the
subsequent price and quantity demanded as the basis for measurement of elasticity of demand. The
outcome would be different under the two situation . Hence , when the change in price is quite large

MEWAR INSTITUTE 21
then accurate measure of price elasticity can be obtained by taking the average of original price and
new price as well as average of the old quantity and new quantity as the basis of measurement of
percentage changes in price and quantity. Thus if the price of a good declines from p1 to p2 and as a
result the quantity demanded increases from q1 to q2 the average of the two prices is given by (p1+p2)/
2 and Average of the two quantities is given by (q1+q2)/2 . Thus the formula for measuring Arc elasticity
Is given by
E p = {“q/(p1+p2)/2} /{“p/(q1+q2)/2}
= { “q/(q1+q2)} {“p/(p1+p2)}
= ( “q/”p) {(p1+p2)/(q1+q2)}
FACTORS INFLUENCING ELASTICITY OF DEMAND
When the demand for a commodity is elastic or inelastic will depend on a variety of factors. The major
factors affecting elasticity of demand are :
1) Nature of Commodity : According to the nature of satisfaction the goods give, they may be
classified into luxury, comfort or necessary goods. In general, luxury and comfort goods are
price elastic, while necessary goods are price inelastic. Thus, for example, the demand for food
grains, cloth, salt etc. is generally inelastic while that for radio, furniture, car, etc. is elastic.
2) Availability of Substitutes : Where there exists a close substitute in the relevant price range,
its demand will tend to be elastic. But in respect of commodities having no substitutes, their
demand will be somewhat elastic. Thus, for example, demand for salt, potatoes, onions etc. is
highly inelastic as there are no close effective substitute for these commodities. On the other
hand, commodities like tea, coffee or beverages such as Thums - Up, Mangola, Gold Spot,
Fanta, Sosyo etc. having a wide rage of substitutes , have a more elastic demand in general.
3) Number of Uses : Single use goods will have generally less elastic demand as compared to
multi-use goods, e.g. for commodities like coal or electricity having a composite demand,
elasticity is relatively high. With the fall in price, these commodities may be demanded increasingly
for various uses. It may be elastic in some of the uses, and may be inelastic in some other
uses, e.g. coal is used by the railways and consumers as fuel. But the former’s demand is
inelastic as compared to the latter’s. Technically, thus the demand for a multi use commodity in
those uses where marginal utility is low, the demand will be elastic.
4) Height of Price and Range of Price Change : There are certain goods like costly luxury items
or bulky goods such as refrigerators, T.V. sets etc., which are highly priced in general. In their
case, a small change in price will have an insignificant effect on their demand. Their demand
will, therefore, be elastic. However, if the price change is large enough, then their demand will
be elastic. Similarly, there are perishable goods like potatoes, onions etc., which are relatively
low priced and bought in bulk, so a small variation in their prices will not have much effect on
their demand, hence their demand tends to be inelastic.
5) Proportion of Expenditure : Items that constitute a smaller amount of expenditure in a
consumer’s family budget tend to have a relatively inelastic demand, e.g., a cinegoer who sees
a film every fortnight is not likely to give it up when the ticket rates are raised. But one who sees
a film every alternate day perhaps may cut down his number of films. So is the case with
matches, sugar, kerosene, etc. Thus, cheap or small, expensive or large expenditure items
tend to have more demand inelasticity than expensive or large expenditure items.

22 MEWAR INSTITUTE
6) Durability of the Commodity : In the case of durable goods, the demand generally tends to be
elastic, in the short run,e.g.. furniture ,bicycle, radio, etc. In the case of perishable commodities
, on the other hand, demand is relatively elastic, e.g. milk, vegetables, etc.
7) Habit : There are certain articles which have demand on account of habit and in these cases,
elasticity is less than unity, e.g. cigarettes to a smoker have inelastic demand.
8) Complementary Goods : Goods which are jointly demanded have less elasticity e.g., ink, petrol
have inelastic demand for this reason.
9) Time : In the short period, demand in general will be less elastic, while in the long period, it
becomes more elastic. This is because it takes some time for the news of a price change to
become known to all the buyers. Consumers may expect a further change, so they may not
react to an immediate change in price . People are reluctant to change their habits all of a
sudden. When durable goods are worn out, these are demanded more . Demand for a certain
commodities may be postponed for sometime, but in the long run , it has to be satisfied.
10) Recurrence of Demand : It the demand for a commodity is of a recurring nature , its price
elasticity is higher than that of a commodity which is purchased only once. For instance,
bicycles, tape recorders, transistors, etc are purchased only once, hence their price elasticity
will be less. But the demand for the fast-food item such as pizza, burger etc. would be more
price elastic.
II) Possibility of Postponement : When the demand for a product is postponable, it will tend to be
price elastic. In the case of consumption goods which are urgently and immediately required, their
demand will be in elastic.
INCOME ELASTICITY OF DEMAND
Income elasticity of demand shows the way in which a consumer’s purchase of any good changes as
a result of change in his income. It means the ratio of percentage change in the quantity demanded to
the percentage in income.
Ie = %change in demand/ %change In income
Degrees of Income Elasticity of Demand:
1) Positive Income elasticity of demand: It is said to occur when with the increase in the income
of the consumer, his demand for goods and services also increases and vice-versa. Income
elasticity of demand is positive in case of normal goods.

2) Negative Income elasticity of Demand: It is said to occur when increase in the income of the

MEWAR INSTITUTE 23
 consumer is accompanied by fall in demand of goods and services and vice-versa. It is the
case of giffen goods.

3) Zero Income elasticity of Demand: It is said to exist when increase or decrease in income has
no impact on the demand of goods and services.

In short income elasticity is greater than one for luxuries but less than one for necessaries.
CROSS ELASTICITY OF DEMAND
The responsiveness of demand to changes in prices of related commodities is called cross elasticity of
demand. Prof. Watson defines it as, “Cross elasticity of demand is the rate of change in quantity
associated with a change in the price of related goods.” Thus cross elasticity of demand is the
responsiveness of demand for commodity X to change in price of commodity Y.

24 MEWAR INSTITUTE
Types of Cross Elasticity of Demand
1) Positive Cross Elasticity of Demand: When goods are substitute of each other, then cross
elasticity of demand is positive. In other words, when an increase in the price of Y leads to an
increase in the demand of X.

e ofX
Pric

2) Negative Cross Elasticity of Demand: In case of Complementary goods, cross elasticity of

demand is negative. A proportionate increase in the price of one commodity leads to a
proportionate fall in the demand of another commodity because both are demanded jointly.

3) Zero Cross elasticity of Demand: Cross elasticity of demand is zero when two goods are not
related to each other. For instance, increase in the price of car does not effect the demand for
cloth. Thus cross elasticity is zero.

MEWAR INSTITUTE 25
CONCEPT OF REVENUE
The term revenue refers to the income obtained by a firm through the sale of goods at different prices.
In the words of Dooley, “The revenue of a firm is its sales, receipts or income.”
Total Revenue: The income earned by a seller or producer after selling the output is called the total
revenue. In fact, total revenue is the multiple of price and output.
TR = AR X Q
Average Revenue: It refers to the revenue obtained by the seller by selling the per unit commodity. It
is obtained by dividing the total revenue by total output.
AR= TR/Q
Or
AR=P and p=f(Q) is an average curve which shows that price is a function of quantity demanded. It is
also a demand curve.
Marginal Revenue: It is the net revenue obtained by selling an additional unit of a commodity.
In the words of Ferguson,” Marginal revenue is the change in total revenue which results from the
sale of one more unit of output.”

Or
MR= TRn-TRn-1
Relation Between AR and MR Curves
1. Under Ideal Rivalry – The average revenue curve is a horizontal straight line parallel to X axis
and the marginal revenue curve coincides with it. This is since under ideal rivalry the number of

26 MEWAR INSTITUTE
 firms selling an identical product is very huge. The price is determined the market forces of
supply and demand so that only one price tends to prevail for the whole industry.

In the diagram 1, each firm can sell as much it wishes at the market price OP. Thus the
demand for the firm’s product becomes infinitely elastic.
In the diagram 2, since the demand curve is the firm’s average revenue curve, the shape of AR
curve is horizontal to the X axis at price OP and the MR curve coincides with it. Any change in
the demand and supply circumstances will change the market price of the product and
consequently the horizontal AR curve of the firm.
2. Under Monopoly or Imperfect Competition: The average revenue curve is the downward
inclining industry demand curve and its related marginal revenue curve lies below it. The marginal
revenue is lower than the average revenue. Given the demand for his product the monopolist
can increase his sales by lowering the price, marginal revenue also falls but the rate of fall in
marginal revenue is greater than that in average revenue.

In the diagram 3, the MR curve falls below the AR curve and lie half a way on the perpendicular
drawn from AR to Y axis. This relation will always exist amidst straight line downward sloping AR
and MR curves.
In diagram 4, AR curve is convex to the origin, the MR curve will cut any perpendicular from a
point on the AR curve at more than half –way to he Y axis. MR passes to the left of the mid point
B on the CA.

MEWAR INSTITUTE 27
 Alternatively, if the AR curve is concave to the origin, MR will cut the perpendicular at less than
half way towards y axis, in the diagram 5, MR passes to the right of the mid point B on the CA.
3. Monopolistic Competition : The relationship between AR and MR is the same as under
monopoly. But there is an exclusion that the AR curve is more elastic and it is represented in the
diagram 6. This is since products are close substitutes under monopolistic competition. The
firm can hikes sales by a reduction in its price.
Importance of Revenue Costs
The AR and MR curves form significant tool for economic analysis.
 Profit Determinants – The A curve is the price line for the producer in all market situations. By
relating the AR curve to the AC curve of a firm, it can ascertain whether it is earning supernormal
or normal profits or incurring losses. If the AR curve is tangent to the AC curve at the point of
equilibrium, the firm earns normal profits. If the AR curve is above AC curve, it makes super
normal profits. In case, AR curve is below the AC curve at the equilibrium point, the firm incurs
losses.
 Determination of Full capacity – It can also be known from their relationship whether the firm
is producing at is full capacity or under capacity. If the AR curve is tangent to the AC curve at its
minimum point, under perfect rivalry, the firm produces its full capacity. Where it is not so, under
monopolistic competition, the firm posses idle capacity.
 Equilibrium Determination – The MR curve when intersected by the MC curve determines the
equilibrium position of the firm under all market conditions. Their point of intersection in fact
determines price, output, and profit and loss of a firm.
 Factor Pricing Determination – The use of the average marginal revenue helps in determining
factor prices. In factor pricing they are inverted U shaped and the average and marginal revenue
curves become the average revenue productivity and marginal revenue productivity curves ARP
and MRP, also they are useful device in describing the equilibrium of the firm under different
market conditions.
DEMAND FORECASTING
Demand forecasting entails forecasting and estimating the quantity of a product or service that consumers
will purchase in future. It tries to evaluate the magnitude and significance of forces that will affect future
operating conditions in an enterprise. Demand forecasting involves use of various formal and informal

28 MEWAR INSTITUTE
forecast techniques such as informed guesses, use of historical sales data or current field data
gathered from representative markets. Demand forecasting may be used in making pricing decisions,
in assessing future capacity requirements, or in making decisions on whether to enter a new market.
Thus, demand forecasting is estimation of future demand.
According to Cardiff and Still, “Demand forecasting is an estimate of sales during a specified future
period based on a proposed marketing plan and a set of particular uncontrollable and competitive
forces”. As such, demand forecasting is a projection of firm’s expected future demands.
IMPORTANCE OF DEMAND FORECAST
1. Management Decisions: An effective demand forecast facilitates the management to take
appropriate steps in factors that are pertinent to decision making such as plant capacity, raw-
material requisites, space and building requirements and availability of labour and capital.
Manufacturing schedules can be drafted in compliance with the demand requisites; in this
manner cutting down on the inventory, production and other related costs.
2. Evaluation: Demand forecasting furthermore smoothes the process of evaluating the efficiency
of the sales department.
3. Quality and Quantity Controls: Demand forecasting is an essential and valuable instrument in
the control of the management of an organisation to provide finished goods of correct quality
and quantity at the correct time with the least amount of expenditure.
4. Financial Estimates: As per the sales level as well as production functions, the financial
requirements of an organisation can be calculated using various techniques of demand
forecasting. In addition, it needs a little time to acquire revenue on practical terms. Sales
forecasts will, as a result, make it possible for arranging adequate resources on practical terms
and in advance as well.
5. Avoiding Surplus and Inadequate Production: Demand forecasting is necessary for the old
and new organisations. It is somewhat essential if an organisation is engaged in large scale
production of goods and the development period is extremely time-consuming in the course of
production. In such situations, an estimate regarding the future demand is essential to avoid
inadequate and surplus production.
6. Recommendations for the future: Demand forecast for a specific commodity furthermore
provides recommendations for demand forecast of associated industries.
7. Significance for the government: At the macro-level, demand forecasting is valuable to the
government as it aids in determining targets of imports as well as exports for various products
and preparing for the international business
METHODS OF DEMAND FORECASTING
Broadly speaking, there are two approaches to demand forecasting- one is to obtain information
about the likely purchase behavior of the buyer through collecting expert’s opinion or by conducting
interviews with consumers, the other is to use past experience as a guide through a set of statistical
techniques. Both these methods rely on varying degrees of judgment. The first method is usually found
suitable for short-term forecasting, the latter for long-term forecasting. There are specific techniques
which fall under each of these broad methods

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Sample Survey Method
1) Experts Opinion Poll: In this method, the experts are requested to give their ‘opinion’ or ‘feel’
about the product. These experts, dealing in the same or similar product, are able to predict the
likely sales of a given product in future periods under different conditions based on their
experience. If the number of such experts is large and their experience-based reactions are
different, then an average-simple or weighted –is found to lead to unique forecasts. Sometimes
this method is also called the ‘hunch method’ but it replaces analysis by opinions and it can thus
turn out to be highly subjective in nature.
2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here is an
attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly
until the responses appear to converge along a single line. The participants are supplied with
responses to previous questions (including seasonings from others in the group by a coordinator
or a leader or operator of some sort). Such feedback may result in an expert revising his earlier
opinion. This may lead to a narrowing down of the divergent views (of the experts) expressed
earlier. The Delphi Techniques, followed by the Greeks earlier, thus generates “reasoned opinion”
in place of “unstructured opinion”; but this is still a poor proxy for market behavior of economic
variables.
3) End-user Method of Consumers Survey: Under this method, the sales of a product are
projected through a survey of its end-users. A product is used for final consumption or as an
intermediate product in the production of other goods in the domestic market, or it may be
exported as well as imported. The demands for final consumption and exports net of imports
are estimated through some other forecasting method, and its demand for intermediate use is
estimated through a survey of its user industries.
Complex Statistical Methods
1) Time series analysis or trend method: Under this method, the time series data on the under
forecast are used to fit a trend line or curve either graphically or through statistical method of
Least Squares. The trend line is worked out by fitting a trend equation to time series data with
the aid of an estimation method. The trend equation could take either a linear or any kind of non-
linear form. The trend method outlined above often yields a dependable forecast
The advantage in this method is that it does not require the formal knowledge of economic
theory and the market, it only needs the time series data. The only limitation in this method is
that it assumes that the past is repeated in future. Also, it is an appropriate method for long-run
forecasts, but inappropriate for short-run forecasts. Sometimes the time series analysis may
not reveal a significant trend of any kind. In that case, the moving average method or exponentially
weighted moving average method is used to smoothen the series
2) Barometric techniques or lead or leg methods: This consists in discovering a set of series
of some variables which exhibit a close association in their movement over a period or time.
For example, it shows the movement of agricultural income (AY series) and the sale of tractors
(ST series). The movement of AY is similar to that of ST, but the movement in ST takes place
after a year’s time lag compared to the movement in AY. Thus if one knows the direction of the
movement in agriculture income (AY), one can predict the direction of movement of tractors’
sale (ST) for the next year. Thus agricultural income (AY) may be used as a barometer (a

30 MEWAR INSTITUTE
 leading indicator) to help the short-term forecast for the sale of tractors.
Generally, this barometric method has been used in some of the developed countries for
predicting business cycles situation. For this purpose, some countries construct what are
known as ‘diffusion indices’ by combining the movement of a number of leading series in the
economy so that turning points in business activity could be discovered well in advance. Some
of the limitations of this method may be noted however. The leading indicator method does not
tell you anything about the magnitude of the change that can be expected in the lagging series,
but only the direction of change. Also, the lead period itself may change overtime. Through our
estimation we may find out the best-fitted lag period on the past data, but the same may not be
true for the future. Finally, it may not be always possible to find out the leading, lagging or
coincident indicators of the variable for which a demand forecast is being attempted.
3) Simultaneous equations Methods : Here is a very sophisticated method of forecasting. It is
also known as the ‘complete system approach’ or ‘econometric model building’. In your earlier
units, we have made reference to such econometric models. Presently we do not intend to get
into the details of this method because it is a subject by itself. Moreover, this method is normally
used in macro-level forecasting for the economy as a whole; in this course, our focus is limited
to micro elements only. Of course, you, as corporate managers, should know the basic elements
in such an approach.The method is indeed very complicated. However, in the days of computer,
when package programmes are available, this method can be used easily to derive meaningful
forecasts. The principle advantage in this method is that the forecaster needs to estimate the
future values of only the exogenous variables unlike the regression method where he has to
predict the future values of all, endogenous and exogenous variables affecting the variable under
forecast. The values of exogenous variables are easier to predict than those of the endogenous
variables. However, such econometric models have limitations, similar to that of regression
method.
The method is indeed very complicated. However, in the days of computer, when package
programmes are available, this method can be used easily to derive meaningful forecasts. The
principle advantage in this method is that the forecaster needs to estimate the future values of
only the exogenous variables unlike the regression method where he has to predict the future
values of all, endogenous and exogenous variables affecting the variable under forecast. The
values of exogenous variables are easier to predict than those of the endogenous variables.
However, such econometric models have limitations, similar to that of regression method.
WHAT IS SUPPLY ANALYSIS?
Supply Analysis is a research and analysis done to understand the supply trends and responses to
changing market and production variables. Supply Analysis takes into account the production costs,
raw material costs, technology, labour wages etc. The analysis helps the manufacturers and companies
to understand the impact of these variables on supply and eventually demand.
The goal of demand-supply chain is to make sure that the supply and demand work properly. The
demand should be met and supply should not be more than what expected. There are lot of variables
which are considered in demand analysis and supply analysis.
Importance of Supply Analysis
Supply Analysis helps manufacturers to analyse the impact of production changes, policies on increase

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or decrease in supply of finished goods. e.g. newer upcoming technology can help produce more
goods in same amount of time. The analysis can help determine if this new technology should be
adopted or not. Also if this technology can help produce more, is the demand there for more products.
What impact will it have on the current labour and how would be it impact supply in the market.
Another example can be impact of increase in wages in the market on supply. The labour cost would go
up and it will drive the costs of product along with it. If the supply has to be kept constant, the costs
would go up and if costs have to be kept constant the supply would go down hence driving the prices
up if the demand is unchanged. These are some questions which the supply analysis tries to answer.

Supply Analysis Parameters

Some of the key parameter which determine supply are:
1. Product's own price
2. Input prices
3. Technology
4. Expectations of the market
5. Number of producers present
Supply and demand, in economics, relationship between the quantity of a commodity that producers
wish to sell at various prices and the quantity that consumers wish to buy. It is the main model of price
determination used in economic theory. The price of a commodity is determined by the interaction of
supply and demand in a market. The resulting price is referred to as the equilibrium price and represents
an agreement between producers and consumers of the good. In equilibrium the quantity of a good
supplied by producers equals the quantity demanded by consumers.

32 MEWAR INSTITUTE
Supply curve
The quantity of a commodity that is supplied in the market depends not only on the price obtainable for
the commodity but also on potentially many other factors, such as the prices of substitute products, the
production technology, and the availability and cost of labour and other factors of production. In basic
economic analysis, analyzing supply involves looking at the relationship between various prices and the
quantity potentially offered by producers at each price, again holding constant all other factors that
could influence the price. Those price-quantity combinations may be plotted on a curve, known as a
supply curve, with price represented on the vertical axis and quantity represented on the horizontal axis.
A supply curve is usually upward-sloping, reflecting the willingness of producers to sell more of the
commodity they produce in a market with higher prices. Any change in non-price factors would cause a
shift in the supply curve, whereas changes in the price of the commodity can be traced along a fixed
supply curve.

Decrease in Supply
Illustration of an increase in equilibrium price (p) and a decrease in equilibrium quantity (q) due to a shift
in supply (S).

IMPORTANT QUESTIONS
Q.1. What is Demand? Explain the factors affecting demand. Also explain the law of demand.
Q.2. What is Price Elasticity of Demand? How can Price Elasticity of Demand be measured?
Q.3. Explain the concept of Revenue. What is the Relationship beween AR and MR?
Q.4. What is Demand Forecasting? What are the various methods of demand forecasting?

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 UNIT - III
PRICING

MEANING AND FEATURES OF MARKET

What is a Market? : In Economics, the term market is used in a special sense. In the ordinary
language the term market means a particular place where buyers and sellers meet each other and buy
and sell the commodities. However, in Economics, the term market does not mean any particular place
but it means the entire area where buyers and sellers of a commodity are in such close contact with
each other that price of the same commodity tends to be one throughout that area. Moreover, it is not
necessary that buyers and sellers may contact each other face to face. They can establish this contact
by different modes of communication, namely, telephone, telegraph, letter or through their agents.
Definitions
1) In the words of Prof. Chapman, “The term market refers not necessarily to place but always to
a commodity and the buyers and the sellers who are in direct competition with one another.”
2) According to Prof. J.C. Edwards, “A market is that mechanism by which buyers and sellers are
brought together. It is nor necessarily a fixed place.”
Features of Market: The above definitions underline the following features of market:
1) Area: Market in economics does not mean any particular place where buyers and sellers meet,
rather it means the entire area over which buyers and sellers are spread and have close contact
with one another. For instance, Dalda has its market all over India because its buyers and
sellers are found in every state and city.
2) Buyers and Sellers: Both buyers and sellers are needed in the market. If one of the two does
not exist in any region it will not be called a market. It is not necessary that buyers and sellers be
physically present to bargain or transact business. They may establish contact among themselves
on phone or other available mode of communication.
3) One Commodity: In Economics, every commodity has its own market e.g., wheat market,
sugar market etc. as many commodities so many markets.
4) Free Competition: There should be free competition between buyers and sellers. In such a
market, buyers try to buy at the cheapest rate and the sellers try to sell at the highest rate. As a
result of it there will be one price for one commodity throughout the market.
Main Forms of Market: On the basis of competition, market may be divided into the following forms:
1) Perfectly competitive market.
2) Monopoly.
3) Imperfect competition.
4) Oligopoly.
5) Duopoly
Perfectly Competitive Market: Perfect Competition refers to a market situation in which there are
large number of buyers and sellers of homogenous products. The price of the product is determined by
industry with the forces of demand and supply. For instance, if you require pen, there should be several
shops selling pens. Under conditions of perfect competition, every seller should be selling the same
quality of pens at the uniform prevailing price in the market. You may buy a pen from any shop at price
Rs.10. If another shopkeeper charges Rs.12 for same quality of pen, no body will buy from him. But if
a shopkeeper charges Rs.9 all will buy pens from the particular shop. But, both these situations are
unrealistic. There must be one price prevailing throughout the market. Thus, perfect competition in a
market structure is characterised by the complete absence of rivalry among individual firms.
Definition
a) In the words of Leftwitch, “Perfect competition is a market in which there are many firms selling
identical products with no firm large enough relative to the entire market to be able to influence
market price.’
b) In the words of Prof. Lim Chong Yah, “Perfect competition is a market situation where there is a
large number of sellers and buyers, a homogeneous product, free entry of firms into the
industry, perfect knowledge among buyers and sellers of existing market conditions and free
mobility of factors of production among alternative uses.”
Assumptions or Features of Perfect Competition: Main assumptions or features of perfect competition
are as under:
a) Large number but small size of Buyers and Sellers: The number of buyers and sellers of a
commodity is very large under perfect competition, but each buyer and each seller is so small in
comparison with the entire market of the product that by changing the quantity of the product
bought and sold by him, he cannot influence its price.
b) Homogeneous Products : The other assumption of perfect competition is that all sellers sell
homogeneous units of a given product, The units sold by Ram & Co. are exactly similar to the
units sold by Sham & Co. Consequently, buyers have no reason to prefer the product of one
seller to the another seller.
c) Perfect Knowledge : Buyers and sellers are fully aware of the price of the product prevailing in
the market. Buyers have perfect knowledge about the price being charged by the sellers for a
given product. Sellers also know well, where and from which buyer, they can charge more price.
d) Free Entry and Exit of Firms : Under perfect competition, in the long-run, any new firm can
enter any industry and any old firm can withdraw from any industry.
e) Free from Checks : Buyers and sellers are free from any checks or restrictions with regard to
their buying and selling of any product.
f) Perfect Mobility : Another important assumption of perfect competition is that in such a market
there is perfect mobility of factors as well as goods and services.

34 MEWAR INSTITUTE
g) Lack of Transport Costs : In a perfect competitive market cost of transport does not influence
the price of the product.

h) Lack of Selling Costs : Under perfect competition, a seller does not spend on advertisement
and publicity etc. It is so because all firms sell homogeneous product.

Monopoly: It is that situation of market in which there is a single seller of a product. It is explained with
the help of an example. There is only one firm dealing in the sale of cooking gas in your town. You get
your electricity supply from one agency, that is, State Electricity Board; you travel by railway train owned
and run by government of India. All these are examples of monopoly. This situation of market, where a
single (mono) firm controls (poly) the production of a commodity is called monopoly. Hence, monopoly
is a market situation in which there is only one producer of a commodity with no close substitutes.

Definition

According to Koutsoyiannis, “Monopoly is a market situation in which there is a single seller, there are
no close substitutes for commodity it produces, there are barriers to entry.”

Features: Main features of monopoly are as follows:

a) One Seller and a Large Number of Buyers : Under monopoly there should be a single
producer of the commodity. He may be a sole - proprietor or there may be a group of partners or
a joint - Stock company or a state.

b) Monopoly is also an Industry : Under monopoly situation, there is only one firm and the
difference between firm and industry disappears.

c) Restrictions on the Entry of the New Firms : Under monopoly, there are some restrictions on
the entry of new firms into monopoly industry.

d) No close Substitutes : The commodity produced by the firm should have no close substitute,
otherwise the monopolist will not be able to determine the price of his commodity as per his
discretion.

e) Price Maker: A monopolist has full control over the supply of the commodity. On the other hand,
there are large number of buyers, but the demand of a single buyer constitutes only a small
portion of the total market demand. Hence, the buyers have to pay the same price as fixed by
the monopolist.

Imperfect Competitive Market : Imperfect competition is the real situation of the market. In practical
life, perfect competition and pure monopoly are rare situations. Real markets are imperfectly competitive.
They have some features of both perfect competition and monopoly.

Thus, imperfect competition is a wide term that includes, the following situations of market: (1)
Monopolistic Competition, wherein the number of sellers is quite large; (2) Oligopoly, wherein the sellers
are few in number ; (3) Duopoly, where there are only two sellers.

Monopolistic Competition: The concept of monopolistic competition was presented by American

Economist Prof. E.H. Chamberlin in his book “Theory of Monopolistic Competition” published in 1933. It
is that situation of market in which there are many sellers of a commodity, but the product of each seller
differs from that of the other sellers in one respect or the other. Thus product differentiation is the hall-
mark of monopolist competition. This product differentiation manifests itself in several ways, for example,

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different brands of the product, different trade marks, difference in shape, colour and quality. It can also
be in the form of difference in services and facilities offered to the consumers by the sellers.

In reality, monopolistic competition is a situation that is in between perfect-competition and monopoly.

Under perfect competition number of sellers is very large i.e., unlimited and under monopoly there is
only one seller. Under monopolistic competition, number of firms or sellers is large but it is limited.

Assumptions of Monopolistic Competition : Main assumptions of monopolistic competition are as

under :

a) Large number of Firms and Buyers : Under monopolistic competition there are large number
of firms producing the product and also large number of buyers, as in case of perfect competition.
But the size of each firm is small.

b) Product Differentiation : Product differentiation is a salient feature of monopolistic competition.

Product differentiation refers to that situations wherein the buyers can distinguish one product
from the other. Number of firms is large but their products differ in one respect or the other.

c) Freedom of Entry and Exit of Firms : As in case of perfect competition, firms are free to enter
and leave the industry under monopolistic competition, but this freedom of entry into industry is
not absolute on the part of new firms. They are to face so many difficulties.

d) Selling Cost : Each firm spends a lot of funds on advertisement and publicity of its products.
With a view to selling more and more units of the product it gives wide publicity of its products
in newspapers, cinemas, journals, radio, T.V. etc. The expenses so incurred are called selling
cost.

e) Less Mobility : Under monopolistic competition neither the factors of production nor goods and
services are perfectly mobile.

f) Imperfect Knowledge : Buyers and sellers are ignorant about the price of the product. It is so
because it is not possible to compare the products of different firms due to product differentiation.

g) Non-price Competition : Another feature of monopolistic competition is that different firms

compete with one another without changing the price of the product.

Main types of Imperfect Competition : Two main types of Imperfect Competition are :

a) Duopoly : It is that situation of market in which there are only two producers. While fixing the
price, firm takes into consideration the price charged by the other firm producing similar product.
If there is no difference between the products of the two firms, then fixation of prices of their
products will be governed by firms’ mutual relation. If both the firms enter into some sort of
agreement then they can fix high price like Monopolist. On the contrary, if they do not arrive at
any agreement, then they will compete with one another as under perfect competition and both
will get minimum price. If there exists product differentiation in their products, then the firm
having a quality product will be able to charge higher price.

b) Oligopoly : An oligopoly is a market in which there are few producers of a product. For
instance, there are only five firms of India, manufacturing Cars. Hence car-market will be called
oligopoly. In this case also each firm has to take into account the price being charged by the
other. To that extent, firms are inter-dependent. If they enter into some sort of agreement they

36 MEWAR INSTITUTE
 can charge high price. On the contrary, if they do not conclude any agreement among themselves,
then they suffer losses. There is no set principle to determine price under oligopoly.

Main Features of Oligopolistic Market : Main features of oligopolistic market are as follows :

a) Few Sellers : In case of oligopoly, the number of sellers is very small but that of the buyers is
very large.

b) Inter-dependence : If one firm reduces the price, the other firms also bring down their price.
On the other hand, if one firm raises the price, it is quite possible the other firms may not like to
raise their price.

c) Selling Cost : Each firm under oligopoly incurs lot of expenditure on different modes of
advertisement in order to push the sale of its product.

d) Group Behaviour : Under oligopoly there is inter-dependence as well as competition among

the firms. Each firm intends to maximize its profit.

e) Uncertainty of Demand Curve : Demand curve is uncertain under oligopoly. Demand curve is
perfectly elastic under perfect competition. It means a firm can sell as much of the commodity
at the prevailing price as it desires. Selling more or less of the commodity will have no effect on
the demand curve. Demand curve of the firm is certain. Demand curve of a monopolist is also
certain because he has no competitor. In case of monopolistic competition also a firm’s demand
curve is certain. However, demand curve of a firm operating under oligopoly is uncertain, it is so
because the changes effected by it in price are very much influenced by similar changes made
by other firms.

PRICE DETERMINATION UNDER PREFECT COMPETITION

Under perfect competition, price of a commodity is determined by the relative forces of demand and
supply. It is important in this regard that in this reference the term ‘demand’ means the demand of whole
industry and the term ‘supply’ means the supply of whole industry. Under perfect competition, an
individual producer cannot influence supply.

Demand Force : A commodity is demanded by consumers. They demand it because it provides them
utility. Every consumer wants to purchase a commodity at minimum price but the maximum price at
which he can agree to purchase a commodity shall be equal to its marginal utility. Demand of a
commodity will be more at a lower price and less at a higher price.

Supply Force : A commodity is supplied by producers. They supply it because they collect revenue by
selling it. Every producer wants to get maximum price for his product but the minimum price at which
he can agree to supply it, will be equal to its marginal cost of production. Supply of a commodity will be
more at a higher price and less at a lower price.

Price Determination: Price of a commodity is determined at the point where demand curve intersects
supply curve. This point is known as equilibrium point and the price is known as equilibrium price. At
this point, demand and supply of the commodity are equal. There is neither surplus nor shortage of the
commodity at equilibrium price. It can be illustrated with the help of following diagram:

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Price Determination under Perfect Competition
In this diagram, quantities of demand and supply have been shown on x-axis and price on y-axis. DD is
demand curve, it intersects SS supply curve at point E. Thus point E is the equilibrium point and OP is
the equilibrium Price.
Equilibrium of the Firm
In the words of Watson, “A firm is a unit engaged in the production for sale at a profit and with the
objective of maximising the profit.”
Meaning of Firm’s Equilibrium: A firm is in equilibrium when it is satisfied with its existing amount of
output. A firm in equilibrium has no tendency either to increase or to decrease its output. The firm will be
in this situation when either it will be earning maximum profit or incurring minimum loss. In the words of
Hanson, “A firm will be in equilibrium when it is of no advantage to increase or decrease its output.” In
the words of Koutsoyiannis, “A firm is in equilibrium when it maximises its profits.”
Conditions of the Equilibrium of the Firm: Main conditions of the equilibrium of a firm are as under–
1) Maximum Profit: Profit of a firm is equal to the difference between its total revenue (TR) and
total cost (TC). One of the conditions of the equilibrium of the firm is that its profit (P = TR –
TC) should be maximum.
2) Marginal cost should be equal to marginal revenue (MC = MR)
3) MC curve cuts MR curve from below.

38 MEWAR INSTITUTE
In the above diagram equilibrium points are shown with the help of MR and MC approach and TR and
TC approach. In the MR and MC approach, it is clear from the figure that initially MC curve cuts the MR
curve at point X. But here only one condition is fulfilled that is MC=MR but at point X MC is not cutting
MR curve from below. The equilibrium output is OM1 because with this output marginal cost is equal to
marginal revenue and MC curve intersects the MR curve from below.
In the TR and TC approach, the equilibrium will said to exist where there is maximum difference
between total revenue and total cost. So it is clear from the figure that the largest profits which the firm
could make will be earned when the vertical distance between the total revenue and total cost is
greatest.
Determination of Short-run Equilibrium of the Firm : It is not necessary that a firm in equilibrium
must earn super-normal profits or normal profits. A firm in equilibrium may face any of the three
situations : (1) It may earn super-normal profits, because in the short-run new firms cannot enter the
industry. (2) It may earn normal profits. (3) It may even suffer minimum losses, because in the short-
run firm may not stop production even when price of the product falls.
All firms are equally efficient, as such, they have identical cost curves. Under the circumstances, each
firm of a given industry, in equilibrium may get either (i) Super-normal profits or (ii) Normal profits or (iii)
Suffer losses. All the three situations depend upon the price determined by the industry. All the three
situations faced by the firms in equilibrium in short-run are explained diagrammatically.
1) Super Normal Profit : A firm in equilibrium when its marginal cost is equal to marginal revenue
(MC = MR) and marginal cost curve cuts marginal revenue curve from below.

A firm in equilibrium earns super normal profit, when average revenue (price per unit) determined
by the industry is more than its average cost. This situation is shown in fig. In this figure, output
of the firm is shown on OX-axis and Cost/Revenue on OY-axis. MC is marginal cost and AC is
average cost curve. PP is average revenue and marginal revenue curve (AR = MR), because
under perfect competition AR = MR. Supposing OP is the price determined by the industry. At

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 this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue
and marginal cost curve cuts marginal revenue curve from below.
2) Normal Profit: A firm in equilibrium earns normal profit when its average cost (AC) is equal to
the price (AR) determined by the industry i.e., AC = AR. It is shown in following figure. At OP
price determined by industry, firm’s equilibrium is at point E and OM is the equilibrium output. At
point E, marginal cost and marginal revenue are equal and marginal cost curve cuts marginal
revenue curve from below. Firm earns normal profits at OM output because at this output it MC
= MR = AR = AC. In other words, average cost and price per unit (average revenue) are equal.

3) Minimum Loss: A firm in equilibrium may incur minimum loss when the average cost of
equilibrium output is more than price (AR) determined by industry, by an amount equal to fixed
cost. i.e, when price (AR) is equal to average variable cost (AR = AVC). Even if the firm
discontinues its production, in the short period, it will have to bear the loss of fixed costs. Loss
of fixed costs is the minimum loss of the firm. As long as price (AR) is more than or equal to
average variable cost (AVC), the firm will prefer to shut down the unit. In this figure, AC is
average cost and AVC is average variable cost. Supposing, price (AR) determined by industry is
OP. At this price, firm is in equilibrium at point E, where marginal cost is equal to marginal
revenue and marginal cost cuts marginal revenue from below. At equilibrium point E when firm
produces OK equilibrium output then its average cost is SK while its average revenue (price) is
NK (OP). In other words, average cost is more than average revenue by AE per unit. As such
firm’s total loss is shown by the shaded area i.e. PTSN. The firm will continue producing till the
price covers the average variable cost. Thus the firm will continue producing so long as
price exceeds average variable cost.

In the short period, study of all the four above situations leads to the following conclusion–
i) If AR = AC, the firm earns normal profit.

40 MEWAR INSTITUTE
 ii) If AR > AC, the firm earns super normal profit.
iii) If AR < AC, the firm incurs loss.
iv) If AR < AVC, the firms will stop production.
Determination of Long-run Equilibrium of the Firm: Long-period refers to that period in which the
producer get sufficient time to adjust their supplies according to the changed conditions of demand.
New firms can enter and the existing firms can leave the industry. The existing firms in the industry can
increase or decrease the size of the plant, as required. In the long-run also, the firm will be in
equilibrium when its long-run marginal cost (LMC) curve is equal to marginal revenue curve and long-
run marginal cost (LMC) curve cuts marginal revenue curve from below. In the long-run, ordinarily all
firms in equilibrium will be earning only normal profit. If they earn super-normal profit in the long-run,
then the existing firms will increase their production and new firms will enter the industry. Consequently,
total supply of the product will increase and price fall down. Due to fall in price firms will get only the
normal profit. On the contrary, if in the long run firms are incurring losses, then some marginal firms will
leave the industry. This will reduce the total supply. Due to decrease in supply, price will rise and once
again firms will begin to earn normal profit. A firm in long-run equilibrium will earn only normal profit
while in short-run equilibrium a firm may earn (1) super-normal profit, or (2) normal profit or (3) incur
minimum losses.

PRICE DETERMINATION UNDER MONOPOLY

Price Determination Under Short Period or Short-run Equilibrium: Short-run refers to that period
in which time is so short that a monopolist cannot change fixed factors, like machinery, plant etc.
Monopolist can increase his output in response to increase in demand by changing his variable factors.
No doubt fixed factors will also be utilized to their maximum capacity to increase the output. Similarly,
when demand decreases the monopolist will reduce his output by reducing variable factors and by
slowing down the intensive use of fixed factors. A monopolist will be in equilibrium when he produces
that amount of output at which (i) marginal cost is equal to marginal revenue and (ii) marginal cost
curve cuts marginal revenue curve from below. A monopolist in equilibrium may face three situations in
the short period, viz, (1) Super Normal Profit (2) Normal Profit and (3) Minimum Loss. These are
described with the help of the following diagrams.
1) Super Normal Profit: If the price (AR) fixed by the monopolist in equilibrium is more than his
average cost (AC) then he will get super normal profits. The monopolist will produce up to the
extent where MC = MR. This limit will indicate equilibrium output. If the price of equilibrium output

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 is more than average cost AR > AC then the monopolist will earn super-normal profits. It is
shown in figure. In this figure, the monopolist is in equilibrium at point E, because at this point
marginal cost is equal to marginal revenue. The monopolist will produce OQ units of output and
sell it at AQ price which is more than average cost BQ. (AQ - BQ = AB). Thus in this situation
the total super normal profit of the monopolist will be ABCP.

2) Normal Profit: If in the short run equilibrium (MC = MR) the monopolist price (AR) is equal to its
average cost (AC) i.e. AR = AC, then he will earn only normal profit.
Equilibrium of the monopoly firm in the short-run is shown in following figure. In this figure, the
firm is in equilibrium at point E where MC = MR and OB is the equilibrium output. At this output,
average cost (AC) curve touches average revenue (AR) curve at point A. Thus, at point ‘C’ price
OP (CB) is equal to the average cost (CB) of the product. Monopoly firm, therefore, earns only
normal profits in equilibrium situation, as at equilibrium output its AC = AR.

3) Minimum Loss: In the short run, the monopolist may incur loss also. If in the short-run price
falls due to depression or fall in demand, the monopolist may continue his production so long as
the low price covers his average variable cost (AVC). In case the monopolist is obliged to fix a
price which is less than average variable cost, then he will prefer to stop production Accordingly,
a monopolist in equilibrium, in the short period, may bear minimum loss equivalent to fixed
costs. In this situation equilibrium price (AR) is equal to average variable cost (AVC) and the
monopolist bears the loss of fixed costs. The monopolist will have to bear this loss even if he
chooses to discontinue production in the short period. Thus, minimum loss = AR - AVC. The

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 losses will incur when Average Cost is more than the Average Revenue.

Determination of Long-run Price or Long-run Equilibrium: In the long-run, the monopolist will be in
equilibrium at a point where his long-run marginal cost is equal to marginal revenue (LMC = MR). In the
long run because of sufficiently long period at the disposal of the monopoly firm, all costs can be varied
and supply can be increased in response to increase in demand. In the short run, equilibrium price can
be more than, equal to or less than the average cost, but in the long-run, price (AR) is more than the
long-run average cost. If price is less than long-run average cost, the monopolist would like to close
down the unit rather than suffer the loss. In the long-run, a monopolist earns super normal profit.
Monopoly firm in the long-run is not contented with normal profit alone, as the firms under perfect
competition do, rather it is in a position to earn super normal profit. Thus, in the long-run the monopolist
will fix the price in such a way as to earn super-normal profit. Super-normal profit refers to a situation
where AR > LAC.

Long-run equilibrium of the monopolist is explained with the help of above figure. In this figure, point E
indicates the equilibrium of the monopolist. At point E, MR = LMC hence OQ is the equilibrium output
and KO (= PQ) is the equilibrium price. HQ is the long-run average cost. Price (average revenue) PQ
being more than long-run average cost HQ (AR > LAC) the monopolist will get super-normal profits.
Accordingly, the monopolist earns PQ - HQ = PH super normal profit per unit. His total super-normal
profit will be NHPK.
PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION
Under monopolistic competition, following points should be considered under the process of price
determination.
1. In case of monopolistic competition, every firm attempts to maximise its profit. Profit of a firm
can be maximum at the point of equilibrium of marginal revenue and marginal cost (MR = MC).

MEWAR INSTITUTE 43
2. Under monopolistic competition, average revenue curve (AR curve) slopes downwards. It implies
that if a monopolistically competitive firm wants to sell more quantity of its product, it will have to
lower the price.
3. Since many firms producing homogeneous product work under monopolistic competition, demand
of the product of a particular firm will depend not only upon the tastes and preferences of
consumers but also upon the price-output decisions of competitive producers.
4. Under monopolistic competition, the firms do not depend only upon price competition but adopt
non-price competition also. In other words, the firms spend heavy amount on advertisement and
salesmanship. These costs are included in marginal cost and average cost.
Equilibrium of a Firm Under Monopolistic Competition During Short-Run or, Short-Run
Equilibrium of Firm Under Monopolistic Competition
In short-run, a firm may earn high profit or normal profit or may suffer loss. If the demand of the product
of a firm is high and there is no substitute of the product, the firm may earn high profit by fixing higher
price for its product. If the demand of the product is not so high, the firm will earn only normal profit. If
the demand of the product is poor, the firm may have to suffer a loss.
1) Super Normal Profits: Under monopolistic competition, a firm earns maximum profits or is in
equilibrium when MC=MR and MC must MR from below.

In the above figure, the firm is in equilibrium at OX1 level of output and at point E, at which MR
and MC are equal and MC must MR from below. The firm is earning super-normal profits since
average revenue is greater than average cost i.e. AR>AC. The main reason for this abnormal
profit is that, the other rival firms are not able to produce closely competitive substitutes. Hence,
they are not able to attract consumers towards their product. At point E both the conditions are
fulfilled. OX1 is the equilibrium level of output. OP is the price. Corresponding to this price,
average cost is MX1 i.e. profit per unit is LM whereas average revenue is equal to LX1. In this
way, the firm will enjoy super-normal profits equal to the shaded area PLMN.
2) Normal Profits: If under monopolistic competition, the price of product is equal to AC, the firm
will be earning normal profits. In Figure MC is equal to MR at point E. This is the equilibrium
point. At equilibrium point, the equilibrium output is OX1 and price is OP1. At this point, AC is
NX1 and AR is also NX1 i.e. AC=AR. Thus the firm will be earning normal profits.

44 MEWAR INSTITUTE
3) Sustaining Losses: However, it is also possible that the demand may not be favourable to firm
under monopolistic competition. i.e. it may not be able to attract the consumer towards its
product, if it fixes price equal to its SAC. But it is compelled to sell its product at the price which
is less than even its short period average cost. Hence, it may incur losses. Such firm, in the
long run may leave the industry, if it is not possible for it to change its demand relative to its cost
conditions through product differentiation and advertisement.

Long-Run Equilibrium of a Firm: In long-run, a firm can earn only normal profit because if in short-
run, a firm earns high profit, it will attract new firms in the industry and only normal profit can be
available to the firm. It can be made clear with the help of following diagram:

MEWAR INSTITUTE 45
In this diagram, AR is average revenue curve, MR is marginal curve, AC is average cost curve, LMC is
long run marginal cost curve and E is the equilibrium point. Price will be determined at this point
because MC = MR. At this point, AC = AR, therefore, firm can earn only normal profit.
Oligopoly
Oligopoly is the theory of imperfect competition among the few; it refers to an industry that contains
only a few competing firms .
Classification of Oligopoly
1) Perfect or Imperfect Oligopoly: Perfect oligopoly is that situation in which all the firms produce
homogenous products. It is also known as pure oligopoly.
On the other hand imperfect or differentiated oligopoly is that market situations in which all firms
produce differentiated but close substitutes.
2) Open or Closed Oligopoly: Open oligopoly is that market situation in which there is no barrier
on the entry of the firm in the industry. The entry of the firm is free.
But in the situation of closed oligopoly , there is barrier on the entry of the firm in the industry.
The barrier may be technological, legal or of any other type.
3) Partial or Full Oligopoly: Partial oligopoly is that situation in which there is a dominant firm in
the industry. This dominant firm is called the price leader. The dominant firm or the price leader
fixes the price and others follow that price.
Full Oligopoly, on the other hand, is that situation in which there is no dominant firm or price
leader.
4) Collusive and Non-collusive Oligopoly: Collusive Oligopoly is that oligopoly in which the
firms cooperate with each other in determining the price. They follow a common price policy and
do not compete with each other.
Non-collusive oligopoly is that oligopoly in which the firms act independently. They compete with
each other and determine independently the price of their products.
DETERMINATION OF PRICE AND OUTPUT IN OLIGOPOLISTIC MARKET
a) If an industry is composed of few firms each selling identical or homogenous products and
having powerful influence on the total market, the price and output policy of each is likely to
affect the other appreciably, therefore they will try to promote collusion.
b) In case there is product differentiation, an oligopolist can raise or lower his price without any
fear of losing customers or of immediate reactions from his rivals. However, keen rivalry among
them may create condition of monopolistic competition.
There is no single theory which satisfactorily explains the oligopoly behaviour regarding price and output
in the market. There are set of theories like Cournot Duopoly Model, Bertrand Duopoly Model, the
Chamberlin Model, the Kinked Demand Curve Model, the Centralised Cartel Model, Price Leadership
Model, etc., which have been developed on particular set of assumptions about the reaction of other
firms to the action of the firm under study.
Economists have established a number of price-output models to explain an oligopolistic market structure,

46 MEWAR INSTITUTE
depending upon the possible behavior pattern of the members of the group.
Owing to a wide variety of possible behavior patterns, a large variety of models have been evolved over
time. These models are broadly classified in three categories depending on the basic approach in their
formulation.
Models Category I
In this model, the oligopolistic structure of the market ignoring interdependence among the oligopolist
firms. Now, when interdependence disappears from decision making, the demand curve facing the
oligopolist becomes determinate and can be ascertained. Once the demand curve becomes determinate,
we can easily find the equilibrium price and output of a particular oligopolist firm by equating its marginal
revenue with its marginal cost.
Models Category II
This model provides a determinate solution to the price and output problem of oligopoly, is based on the
assumption that the oligopolist is able to predict the reaction patterns and counter moves of his rivals.
In this connection various reaction patterns of the rivals have been propounded. Famous among these
are “Cournot’s model, Chamberline Model and Sweezy Model”.
Models Category III
In this model the oligopolist assumes that the firms realizing their common interest will form a collusion,
formal or tacit. So, they enter into an agreement and work in such a way, that their joints profits are
maximum. They will share the profits,market or output as agreed upon.
Example: OPEC ( Organisation of Petroleum Exporting Countries) is the best example of such type of
agreement among oligopolist.
Sweezy’s Kinked Demand Curve Model- Non Collusive
The Kinked demand curve model was developed by Paul Sweezy (1939). According to him, the firms
under oligopoly try to avoid any activity which could lead to price wars among them. The firms mostly
make efforts to operate in non price competition for increasing their respective shares of the market
and their profit An analytical device which is used to explain the oligopolistic price rigidity is the Kinked
Demand Curve.
This model operates on fulfilling certain conditions which, in brief, are as under:
(1) All the firms in the industry are quite developed with or without product differentiation:
(2) All the firms are selling the goods on fairly satisfactory price in the market.
(3) If any one firm lowers the price of its product to capture a larger share of the market, the other
firms follow and reduce the price of their goods in order to retain their share of the market.
(4) If one firm raises the price of its goods, the other firms will not follow the price increase. Some
of the customers of the price raising firm will shift to the relatively low priced firms.
Mr. Paul Sweezy used two demand curve concepts to explain the model. These are reproduced
below.

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In the figure 17.5, DD’ is a kinked demand curve. It is made up of two segments DB and BD’. The
demand curve is kinked or has a bend at point B. The kink is formed at the prevailing market price level
BM (Rs. 10 per unit). The segment of the demand curve above the prevailing price level (Rs.10) is
highly elastic and the segment of the demand curve below the prevailing price level is fairly inelastic.
This is explained now in brief.
Price increase: If an oligopolist raises the price of his products from Rs. 10 per unit to Rs. 12 per unit,
he loses a large part of the market and his sale comes down to 40 units from 120 units. There is a loss
of 80 units in sale as most of his customers are now purchasing goods from his competitor firms who
are selling the goods at Rs. 10 per units. So an increase in price above the prevailing level -shows that
the demand curve to the left of and above point B is fairly elastic.
Price reduction: If an oligopolist reduces the prices of its goods below the prevailing price level BM
(Rs. 10 per unit) for increasing his sales, his competitors will also match price changes So that their
customers do not go away from them. Let us assume that oligopolist has lowered the price to Rs. 4.0
per unit. Its competitors in the industry match the price cut. The sale of the oligopolist with a big price
cut of Rs.6.0 per unit has increased by only 40 units (160 — 120 = 40). The firm does not gain as the
total revenue decreases with the price cut. The BD’ portion of the demand curve which lies on the right
side and below point B is fairly inelastic.
Rigid Prices: The firms in the oligopolist market have no incentive to raise or lower the prices of the
goods. They prefer to sell the goods at the prevailing price level due to reaction function. The price BM
(Rs. 10 per unit) will, therefore, tend to remain stable or rigid, as every member of the oligopoly does
not see any gain by lowering or raising the price of his goods.

IMPORTANT QUESTIONS
Q.1. What is Market. What are the features of market and explain the various forms of market.
Q.2. Explain the short run price determination under perfect competition.
Q.3. Whatis Price? What are the various pricing method?
Q.4. What is Oligopoly? Explain the Sweezy's Kinked Demand Curve Model.

48 MEWAR INSTITUTE
 Unit IV
PRICING METHODS
PRICING METHODS
Formulating price policies and setting the price are the most important aspects of managerial decision
making. Price in fact, is the source of revenue which the firm seeks to maximize. Again, it is the most
important device a firm can use to expand the market. If the price is set too high, a seller may price
himself out of the market. If it is too low, his income may not cover costs, or at best, fall short of what
it could be. In other words, if the Company prices too much, it will make fewer sales. If it charges too
little, it will sacrifice profits. So the price must be fixed judiciously.
Meaning of price:
Price is the money value of the goods and services. In other words, it is the exchange value of a
product or service in terms of money. To the seller, price is a source of revenue. To the buyer, price is
the sacrifice of purchasing power.
Objectives of Pricing Policy:
1. Profit maximization: Since the primary motive of business is to earn maximum profit, pricing
always aim at maximization of profit through maximization of sales.
2. Market share: For maximizing market share a firm may lower its price in relation to the
competitors product.
3. Target return in investment: The firm should fix the price for the product in such a way that it
will satisfy expected returns for the investment.
4. Meet or prevent competition: In order to discourage competition a firm may adopt a low price
policy.
5. Price stabilization: Another objective of pricing is to stabilize the product prices over a
considerable period of time.
6. Resource mobilization: Company may fix their prices in such a way that sufficient resources
are made available for the firms expansion, developmental investment etc.
7. Speed up cash collection: Some firms try to set a price which will enable rapid cash recovery
as they may be financially tight or may regard future is too uncertain to justify patient cash
recovery.
8. Survival and growth: An important objective of pricing is survival and achieving the expected rate
of growth. Profit is less important than survival.
Methods of Pricing: Cost-Oriented Method and Market-Oriented Method
The two methods of pricing are as follows:
A. Cost-oriented Method
B. Market-oriented Methods.

There are several methods of pricing products in the market. While selecting the method of fixing
prices, a marketer must consider the factors affecting pricing. The pricing methods can be broadly
divided into two groups-cost-oriented method and market-oriented method.

A. Cost-oriented Method:

Because cost provides the base for a possible price range, some firms may consider cost-oriented
methods to fix the price.

Cost-oriented methods or pricing are as follows:

1. Cost plus pricing: Cost plus pricing involves adding a certain percentage to cost in order to fix
the price. For instance, if the cost of a product is Rs. 200 per unit and the marketer expects 10
per cent profit on costs, then the selling price will be Rs. 220. The difference between the selling
price and the cost is the profit. This method is simpler as marketers can easily determine the
costs and add a certain percentage to arrive at the selling price.

2. Mark-up pricing: Mark-up pricing is a variation of cost pricing. In this case, mark-ups are
calculated as a percentage of the selling price and not as a percentage of the cost price. Firms
that use cost-oriented methods use mark-up pricing.

Since only the cost and the desired percentage markup on the selling price are known, the
following formula is used to determine the selling price:

Average unit cost/Selling price

3. Break-even pricing: In this case, the firm determines the level of sales needed to cover all the
relevant fixed and variable costs. The break-even price is the price at which the sales revenue is
equal to the cost of goods sold. In other words, there is neither profit nor loss.

For instance, if the fixed cost is Rs. 2, 00,000, the variable cost per unit is Rs. 10, and the
selling price is Rs. 15, then the firm needs to sell 40,000 units to break even. Therefore, the firm
will plan to sell more than 40,000 units to make a profit. If the firm is not in a position to sell
40,000 limits, then it has to increase the selling price.

The following formula is used to calculate the break-even point:

Contribution = Selling price - Variable cost per unit

4. Target return pricing: In this case, the firm sets prices in order to achieve a particular level of
return on investment (ROI).

The target return price can be calculated by the following formula:

Target return price = Total costs + (Desired % ROI investment)/ Total sales in units

For instance, if the total investment is Rs. 10,000, the desired ROI is 20 per cent, the total cost
is Rs.5000, and total sales expected are 1,000 units, then the target return price will be Rs. 7
per unit as shown below:

5000 + (20% X 10,000)/ 7000

50 MEWAR INSTITUTE
 Target return price = 7

The limitation of this method (like other cost-oriented methods) is that prices are derived from
costs without considering market factors such as competition, demand and consumers' perceived
value. However, this method helps to ensure that prices exceed all costs and therefore contribute
to profit.

5. Early cash recovery pricing: Some firms may fix a price to realize early recovery of investment
involved, when market forecasts suggest that the life of the market is likely to be short, such as
in the case of fashion-related products or technology-sensitive products.

Such pricing can also be used when a firm anticipates that a large firm may enter the market in
the near future with its lower prices, forcing existing firms to exit. In such situations, firms may
fix a price level, which would maximize short-term revenues and reduce the firm's medium-term
risk.

B. Market-oriented Methods:

1. Perceived value pricing: A good number of firms fix the price of their goods and services on
the basis of customers' perceived value. They consider customers' perceived value as the
primary factor for fixing prices, and the firm's costs as the secondary.

The customers' perception can be influenced by several factors, such as advertising, sales on
techniques, effective sales force and after-sale-service staff. If customers perceive a higher
value, then the price fixed will be high and vice versa. Market research is needed to establish the
customers' perceived value as a guide to effective pricing.

2. Going-rate pricing: In this case, the benchmark for setting prices is the price set by major
competitors. If a major competitor changes its price, then the smaller firms may also change
their price, irrespective of their costs or demand.

The going-rate pricing can be further divided into three sub-methods:

a. Competitors 'parity method: A firm may set the same price as that of the major
competitor.

b. Premium pricing: A firm may charge a little higher if its products have some additional
special features as compared to major competitors.

c. Discount pricing: A firm may charge a little lower price if its products lack certain
features as compared to major competitors.

The going-rate method is very popular because it tends to reduce the likelihood of price wars
emerging in the market. It also reflects the industry's coactive wisdom relating to the price that
would generate a fair return.

3. Sealed-bid pricing: This pricing is adopted in the case of large orders or contracts, especially
those of industrial buyers or government departments. The firms submit sealed bids for jobs in
response to an advertisement.

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 In this case, the buyer expects the lowest possible price and the seller is expected to provide
the best possible quotation or tender. If a firm wants to win a contract, then it has to submit a
lower price bid. For this purpose, the firm has to anticipate the pricing policy of the competitors
and decide the price offer.

4. Differentiated pricing: Firms may charge different prices for the same product or service.

The following are some the types of differentiated pricing:

a. Customer segment pricing: Here different customer groups are charged different prices
for the same product or service depending on the size of the order, payment terms, and so on.

b. Time pricing: Here different prices are charged for the same product or service at
different timings or season. It includes off-peak pricing, where low prices are charged during
low-demand tunings or season.

c. Area pricing: Here different prices are charged for the same product in different market
areas. For instance, a firm may charge a lower price in a new market to attract customers.

d. Product form pricing: Here different versions of the product are priced differently but
not proportionately to their respective costs. For instance, soft drinks of 200,300, 500 ml, etc.,
are priced according to this strategy.

Advantages:

1. Fair method: It is a fair method of price fixation. The business executives are convinced that
the price fixed will cover the cost.

2. Assured Profit: If price is greater than cost, the risk is covered. This is true when normal
expected capacity basis of cost estimation is used.

3. Reduced risks and uncertainties: A decision maker has to take decisions in the face of many
uncertainties. He may accept a pricing formula that seems reasonable for reducing uncertainty.

4. Considers market factors: This sort of pricing does not mean that market forces areignored.
The mark up added to the cost to make a price reflect the well established customs of trade,
which guide the price fixer towards a competitive price

Disadvantages:

1. Ignores demand: It ignores demand. It fails to take into account the buyers' needs and willingness
to pay which govern the sales volume obtainable at each series of prices.

2. Ignores competition: It fails to reflect competition adequately.

3. Arbitrary cost allocation: It takes for granted that the costs have been estimated with exact
accuracy which is not often true particularly in multi-product firms because the common costs
are allocated arbitrarily.

4. Ignores opportunity cost: For many decisions incremental costs rather than full costs play a
vital role in pricing. This aspect is ignored.

5. Price-Volume relationships: Since the fixed overheads are apportioned on the basis of volume

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 of production, the cost will be more if a sales volume is less and cost will be less if sales
volume is more. The increase or decrease in sales volume again is dependent of price. Thus it
is a vicious circle-cost plus mark up is price based on sales volume and sales volume is based
on price.

Pricing Strategy- Pricing a New Product

1) Skimming Strategy: Skimming is the process of setting high prices based on value. Instead of
basing your prices on your competition, a skimming price comes from within the company and
the (financial) value your product represents to your customer. This strategy can be employed in
emerging markets, where certain customers will always want the newest, most advanced
product available. It also works well in a mature market, where customers have already realized
the value of your product and are willing to pay for what they see as a worthwhile investment.
Surprisingly, skimming also works in declining markets, as your diehard customers are willing to
pay big bucks for what they see as an older but superior product with a dwindling supply.

2) Penetration Strategy: A penetration strategy is the price war; this strategy goes for the deepest
price cuts, driving at every moment to have your price be the lowest on the market. Penetration
strategies only work in one of the four lifecycle periods: growth. During growth, your sales are
continuing to expand, as your customers want the newest product but still a product that has
already tested by others in the emerging period. This is when your average customer buys a
product and when the sales numbers will be the biggest. A penetration strategy works here, and
only here, because you're attracting customers to a new but proven product with cheap
productions. You're developing relationships with new customers willing to try the new product
but who will only come for a lower price.

Penetration strategies fail in the other lifecycle periods by leaving possible profits in the hands of
the customers. In an emerging market, your product is brand new and customers who want it
first should (and will) pay for that right. In a mature market, a price war will simply start the
process of endless and useless competition, destroying your profit margin. In a declining market,
only those who still must have your product will purchase it, and just like in an emerging period,
they should (and will) pay for that right.

What Is Price Discrimination?

Price discrimination is a selling strategy that charges customers different prices for the same product
or service based on what the seller thinks they can get the customer to agree to. In pure price
discrimination, the seller charges each customer the maximum price they will pay. In more common
forms of price discrimination, the seller places customers in groups based on certain attributes and
charges each group a different price.

Price discrimination is practiced based on the seller's belief that customers in certain groups can be
asked to pay more or less based on certain demographics or on how they value the product or service
in question.

Price discrimination is most valuable when the profit that is earned as a result of separating the
markets is greater than the profit that is earned as a result of keeping the markets combined. Whether
price discrimination works and for how long the various groups are willing to pay different prices for the
same product depends on the relative elasticities of demand in the sub-markets. Consumers in a

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relatively inelastic submarket pay a higher price, while those in a relatively elastic sub-market pay a
lower price.

Types of Price Discrimination

There are three types of price discrimination: first-degree or perfect price discrimination, second-
degree, and third-degree. These degrees of price discrimination are also known as personalized pricing
(1st-degree pricing), product versioning or menu pricing (2nd-degree pricing), and group pricing (3rd-
degree pricing).

First-degree Price Discrimination

First-degree discrimination, or perfect price discrimination, occurs when a business charges the
maximum possible price for each unit consumed. Because prices vary among units, the firm captures
all available consumer surplus for itself, or the economic surplus. Many industries involving client
services practice first-degree price discrimination, where a company charges a different price for every
good or service sold.

Second-degree Price Discrimination

Second-degree price discrimination occurs when a company charges a different price for different
quantities consumed, such as quantity discounts on bulk purchases.

Third-degree Price Discrimination

Third-degree price discrimination occurs when a company charges a different price to different consumer
groups. For example, a theater may divide moviegoers into seniors, adults, and children, each paying a
different price when seeing the same movie. This discrimination is the most common.

Examples of Price Discrimination

Many industries, such as the airline industry, the arts and entertainment industry, and the pharmaceutical
industry, use price discrimination strategies. Examples of price discrimination include issuing coupons,
applying specific discounts (e.g., age discounts), and creating loyalty programs. One example of price
discrimination can be seen in the airline industry. Consumers buying airline tickets several months in
advance typically pay less than consumers purchasing at the last minute. When demand for a particular
flight is high, airlines raise ticket prices in response.

By contrast, when tickets for a flight are not selling well, the airline reduces the cost of available tickets
to try to generate sales. Because many passengers prefer flying home late on Sunday, those flights
tend to be more expensive than flights leaving early Sunday morning. Airline passengers typically pay
more for additional legroom too.

Primary Requirements for a Successful Price Discrimination

For a firm to employ this pricing strategy, there are certain conditions that must be met:

1. Imperfect competition : The firm must be a price maker (i.e., operate in a market with
imperfect competition). There must be a degree of monopoly power to be able to employ price
discrimination. If the company is operating in a market with perfect competition, this pricing
strategy would not be possible, as there would not be sufficient ability to influence prices.

54 MEWAR INSTITUTE
2. Prevention of resale: The firm must be able to prevent resale. In other words, consumers who
already purchased a good or service at a lower price must not be able to re-sell it to other
consumers who would've otherwise paid a higher price for the same good or service.

3. Elasticity of demand: Consumer groups must demonstrate varying elasticities of demand (i.e.,
low-income individuals being more elastic to airplane tickets compared to business travelers). If
consumers all show the same elasticity of demand, this pricing strategy will not work.

NATIONAL INCOME OR OUTPUT

 It is the money value of all the final goods and services produced by an economy (or a Country)
in a specific period of time.

 The value of all goods and services produced is measured in money. For example, if the value
of meter cloth is Rs.20 and the total cloth produced is 100 meters , then the money value of
cloth is Rs. 2000. In this way we can find out the value of other goods and services and the total
value of all the goods and services produced during one year. This gives us a single measure of
the final goods and services produced by the country in that year which is nothing but the value
of national income or national product.

BASIC CONCEPTS INCOME OR IN NATIONAL OUTPUT

1. Gross Domestic Product (GDP) : Gross domestic product is the money value of all final
goods and services produced in the domestic territory has special meaning in national income
accounting. Domestic territory is defined to include the following:

i) Territory lying within the political frontiers, including territorial waters of the countries.

ii) Ships and aircrafts operated by the residents of the country between two or more
countries.

iii) Fishing vessels, oil and natural gas rigs, and floating platforms operated by the residents
of the country in the international waters or engaged in extraction in areas in which the
country has exclusive rights of exploitation.

iv) Embassies, consulates and military establishments of the country located abroad.

2. GDP at Constant Prices and at Current Prices: GDP can be estimated at current prices and
at constant prices. If the domestic product is estimated on the basis of the prevailing prices.
Thus when we say that GDP of India at current prices in 1989-99 is Rs. 16,12,383 crores, we
are measuring GDP on the basis of the prices prevailing at a point of time or in some base year
it is known as GDP at constant prices or real gross domestic product.

Thus when we say that GDP in 1989-99 is Rs. 10,81,834 crores at 1993-94 prices, we are
measuring GDP on the basis of the prices prevailing in 1993-94.

3. GDP at Factor Cost and GDP at Market Price : The contribution of each producing unit to the
current flow of goods and services is known as the net value added. GDP at factor cost is
estimated as the sum of net value added by their different producing units and the consumption
of the fixed capital. Since the net value added gets distributed as income to the owners of
factors of production, we can also estimate GDP as the sum of domestic factor incomes and

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 consumption of fixed capital. Conceptually, the value of GDP whether estimated at market price
or factor cost must be identical. This is because the final value of goods and services (i.e.
market price) must be equal to the cost involved in their production (factor cost). However, the
market value of goods and services is not the same as the earnings of the factors of the
production. GDP at market price includes indirect taxes from and add subsidies to GDP at
market price.

In brief ^^ GDPFC = GDPMP - IT + S

where IT = Indirect Taxes, S = Subsidies

4. Net Domestic Product : While calculating GDP no provision is made for depreciation allowance
(also called consumption allowance). In such a situation Gross Domestic Product will not reveal
complete flow of goods and services through various sectors.

It is matter of common knowledge that capital goods like machines equipment , tools, buildings,
tractors etc., get depreciated during the process of production. After sometime these capital
goods need replacement. A part of capital is therefore, set aside in the form of depreciation
allowance . When depreciation allowance is subtracted from gross domestic product we get net
domestic product.

In brief

NDP = GDP - Depreciation

5. Gross National Product (GNP): Gross Domestic Product however, includes the contribution
made by non-resident producers by way of wages, rent, interest and profits. The non-residents
work in the domestic territory of some other country and earn factor incomes. For example,
Indian residents go abroad to work, Indian banks are functioning abroad. In other words, it is
factor income earned from abroad by the residents of India by rendering factor services abroad.
Similarly, factor services are rendered by non-residents within the domestic territory of India. Net
Factor Income from Abroad (NFIA) is the difference between the income received from the
abroad for rendering factor services rendered by non-residents in the domestic territory of a
country.

Gross National Product is defined as the sum of the Gross Domestic Product and Net Factor
Incomes from Abroad. Thus in order to estimate the Gross National Product of India we have to
add Net Factor Income from Abroad.

In brief:

GNP = GDP + NFIA (where NFIA is the net factor income from abroad)

6. Net National Product (NNP) : It can be derived by subtracting Depreciation allowance from
GNP. It can also be found out by adding the net factor income from abroad to the net domestic
product. If the net factor income from abroad is positive i.e. the inflow of factor income from
abroad is more than the outflow, NNP will be more than NDP, conversely, if net factor income
from abroad is negative, NNP will be less than NDP and it would be equal to NDP in case the
net factor income from abroad is zero.

56 MEWAR INSTITUTE
 Symbolically,

NNPFC = National Income = FID + NFIA where FID is Factor Income earned in the Domestic
territory of a country and NFIA is the Net Factor Income from Abroad.

7. Personal Income: Personal income is the sum of all incomes actually received by individuals
during a given year. In order to estimate it, we subtract from national income the sum total of
social security contribution and corporate income taxes and undistributed corporate profits and
add personal payments which are incomes received but not currently earned.

8. Personal Disposable Income: After the deduction of personal taxes from personal income of
the individuals what is left is called personal disposable income which is equal to consumption
plus saving.

NATIONAL INCOME'S RELATED FORMULAS

1. GNP at market price - Depreciation = NNP at market price

2. GNP at market price - Net Income from Abroad = GDP at market price

3. GNP at market price - Net Indirect Taxes = GNP at factor cost

4. NNP at market price - Net Income from Abroad = NDP at market price

5. NNP at market price-Net Indirect Taxes = NNP at factor cost

6. GDP at market price- Net Indirect Taxes=GDP at factor cost

7. GNP at factor price - Depreciation = NNP at factor cost

8. NDP at market price - Net Indirect Taxes = NDP at factor cost

9. GDP at factor cost - Depreciation = NDP at factor cost

METHODS TO CALCULATE NATIONAL INCOME VALUE ADDED METHOD OR PRODUCTION

METHOD

Value added method measures the contribution of each producing enterprise in the domestic territory of
the country. This method involves the following steps:

a) Identifying the producing enterprise and classifying them into individual sectors according to
their activities.

b) Estimating net value added by each producing enterprise as well as each industrial sector and
adding up the net value added by all the sectors.

As the producing enterprise are broadly classified into three main sectors namely.

(1) Primary sectors which includes agriculture and allied activities.

(2) Secondary sector which includes manufacturing units and

(3) Tertiary sectors which includes services like banking, insurance, transport and communications,
trade and professions.

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For an individual unit, we subtract from the value of its gross output, the value of the raw material and
intermediate goods and services used by it and from this, we subtract the amount of depreciation to get
net product or value added by each unit. Adding value-added by all the units in one sub-sector, we get
value added or net product of that sector. For the economy as a whole, we add net products contributed
by each sector to get Net Domestic Product.

If we add or subtract net income from abroad we get Net National Product at factor cost which is
nothing but National Income.

Second hand products selling will not be included in Value Added Method, Commission on this selling
will be included.

What ever is produced by a producing unit is distributed among the factors of production of all the
producing units from the subject matter of calculation of national income by income method.

The factors of production, in return, are paid for their services in the form of factor incomes. Thus
labour gets wages, land gets rent, capital gets interest and entrepreneur gets profits.

National income is calculated not from incomes received by the people but from data regarding incomes
paid out by producers. To arrive at national income, net income from abroad should be added to
domestic income (paid by Producers).

Total expenditure in an economy consists of expenditure on financial assets, on good produced in

preceding periods, on raw materials and intermediate goods and services and on final goods and
services produced in the current period.

Thus, only expenditure on final goods and services produced in the period for which national income is
to be measured and net foreign investment are included in the expenditure method of calculating
national income.

1. Gross national expenditure = Consumption expenditure + Net Domestic Investment + Net

Foreign Investment + replacement expenditure (i.e. expenditure on replacement investment).

2. Net National Expenditure = Consumption Expenditure + Net Domestic Investment + Net Foreign
Investment.

3. Net Domestic Expenditure = Consumption Expenditure + Net Domestic Investment.

Real Income

Real income is national income expressed in terms of a general level of prices of a particular year
taken as base, National income is the value of goods and services produced as expresses in terms of
money at current prices. But it does not indicate the real state of the economy. It is possible that the net
national product of goods and services this year might have been less than that of last year, but owing
to an increase in prices, the NNP might be higher this year. On the contrary, it is also possible that NNP
might have increased but the price level might have fallen as a result of which national income would
appear to be less than that of the last year. In both the situations, the national income does not depict
the real state of the country, to rectify such as mistake; the concept of real income has been propounded.

58 MEWAR INSTITUTE
PER CAPITA INCOME

The average income of the people of a country in a particular year is called per Capita Income for that
year. This concept also refers to the measurement of income at current prices and at constant prices.
For instance, in order to find out the per capita income for 2001 at current prices, the national income
of a country in that year. This concept enables us to know the average income and the standard of
living of the people. But it is not very reliable, because in every country due to unequal distribution of
national income a major portion of it goes to the richer sections of the society and thus income received
by the common man is lower than the per capita income.

PROBLEMS OF MEASUREMENT OF NATIONAL INCOME OR PROBLEMS IN CALCULATING

NATIONAL INCOME

1. Non-monetised Sector: large portion of production is partly exchanged for the other goods and
is partly kept for personal consumption, Such production and consumption cannot be calculated
in NI.

2. Lack of Occupational Specialisation: lack of occupational specialisation makes the calculation

of national income by product method difficult. Besides the crop, farmers in a developing
country are engaged in supplementary occupations like dairying poultry, cloth making etc. But
income from such productive activities is not included in the national income estimates.

3. Non-market Transactions: People living in rural areas in a developing country are able to avoid
expenses by building their own huts, tools, implements, garments and other essential commodities.
Similarly, people in urban areas having kitchen gardens produce vegetables which they consume
themselves. All such productive activities do not enter the market transactions and hence are
not included in the national income estimates.

4. Illiteracy: The majority of people in such a country are illiterate and they do not keep any
accounts about the production and sales of their products.

5. Non-availability of data: Adequate and correct production and cost data are not available in a
developing country. Such data relate to crops, forestry, fisheries, animal husbandry, and the
activities of petty shopkeeper, small enterprises construction workers etc.

IMPORTANCE OF NATIONAL INCOME OR ITS ANALYSIS

1. National income data are of great importance for the economy of a country. These days the
national income data are regarded as accounts of the economy which are known as social
accounts.

2. The basis of national policies such as employment policy.

3. For economic planning it is essential that the data pertaining to a country's gross income,
output, saving, consumption from different sources should be available.

4. Research scholars of economics make use of the various data of the country's input. Output,
income, saving, consumption, investment, employment etc, which are obtained from social
accounts.

5. For a country's per capita income.

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6. National income statistics enable us to know about the distribution of income in the country from
the data pertaining to wages, rent, interest and profits we learn of the disparities in the incomes
of different sections of the society. Similarly, the regional distribution of income is revealed.

IMPORTANT QUESTIONS
Q.1. What do you mean by Price? What are the objective of pricing policy?

Q.2. Short note on

a. Break even pricing

b. Going rate pricing

c. Slimming strategy

Q.3. What is Price discrimination? What are its types?

Q.4. What is National Income? What are the problem in calculating National Income?

60 MEWAR INSTITUTE
 UNIT - V
ECONOMIC GROWTH AND DEVELOPMENT

What Is Economic Growth?

Economic growth is an increase in the production of economic goods and services, compared from
one period of time to another. It can be measured in nominal or real (adjusted for inflation) terms.
Traditionally, aggregate economic growth is measured in terms of gross national product (GNP) or
gross domestic product (GDP), although alternative metrics are sometimes used.
 It is the persistent increase in the real GDP of a country.
 In other words it is the increase of the potential output or GDP
 It can be shown as an outward shift of PPC
 Here the production, output, income, expenditure, demand, employment levels increase or
appreciate leading the economy to grow
 Economic growth is a journey(dynamic process) but not a destination
Understanding Economic Growth
In simplest terms, economic growth refers to an increase in aggregate production in an economy.
Often, but not necessarily, aggregate gains in production correlate with increased average marginal
productivity. That leads to an increase in incomes, inspiring consumers to open up their wallets and buy
more, which means a higher material quality of life or standard of living.
In economics, growth is commonly modeled as a function of physical capital, human capital, labor
force, and technology. Simply put, increasing the quantity or quality of the working age population, the
tools that they have to work with, and the recipes that they have available to combine labor, capital, and
raw materials, will lead to increased economic output.
MEASUREMENT
The economic growth rate is calculated from data on GDP estimated by countries' statistical agencies.
The rate of growth of GDP per capita is calculated from data on GDP and people for the initial and final
periods included in the analysis of the analyst.
GDP = the total amount of final goods nd services produced in one year within a country
Business Cycle
A business cycle, sometimes called a "trade cycle" or "economic cycle," refers to a series of stages in
the economy as it expands and contracts. Constantly repeating, it is primarily measured by the rise and
fall of gross domestic product (GDP) in a country.
Business cycles are universal to all nations that have capitalistic economies. All such economies will
experience these natural periods of growth and declines, though not all at the same time. However,
given the increased globalization, business cycles tend to happen at similar times across countries
more often than they did before.
Stages of a business cycle
Think of business cycles like the tides: a natural, never-ending ebb and flow from high tide to low tide.
And the same way the waves can suddenly seem to surge even when the tide's going out or seem low
when the tide's coming in, there can be interim, contrarian bumps - either up or down - in the midst of
particular phase.

Expansion: Expansion, considered the "normal" - or at least, the most desirable - state of the economy,
is an up period. During an expansion, businesses and companies are steadily growing their production
and profits, unemployment remains low, and the stock market is performing well. Consumers are
buying and investing, and with this increasing demand for goods and services, prices begin to rise too.
Peak: Once these numbers start to increase outside of their traditional bands, though, then the economy
is considered to be growing out of control. Companies may be expanding recklessly. Investors are
overconfident, buying up assets and significantly increasing their prices, which are not supported by
their underlying value. Everything is starting to cost too much. The peak marks the climax of all this
feverish activity. It occurs when the expansion has reached its end and indicates that production and
prices have reached their limit. This is the turning point: With no room for growth left, there's nowhere
to go but down. A contraction is forthcoming.
Contraction: A contraction spans the length of time from the peak to the trough. It's the period when
economic activity is on the way down. During a contraction, unemployment numbers typically spike,
stocks enter a bear market, and GDP growth is below 2%, indicating that businesses have cut back
their activities.
When the GDP has declined for two consecutive quarters, the economy is often considered to be in a
recession.
Trough: As the peak is the cycle's high point, the trough is its low point. It occurs when the recession,
or contraction phase, bottoms out and starts to rebound into an expansion phase - and the business
cycle starts all over again. The rebound is not always quick, nor is it a straight line, along the way
towards full economic recovery.

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How long does a business cycle last?
Business cycles have no defined time frames. A business cycle can be short, lasting a few months, or
long, lasting several years
How supply and demand drives the business cycle
 In the beginning: The expansion happens because consumers are confident in the economy.
They believe that employment is steady and income is guaranteed. As a result, they spend
more, which leads to increased demand, which leads to businesses hiring more employees and
increasing capital expenditures to meet that demand. Investors allocate more capital to assets,
increasing stock prices.
 Getting overheated: The expansionary phase hits a peak when the demand is greater than
the supply, and businesses take on additional risks to meet increased demand and remain
competitive.
 Scaling back: When interest rates rise quickly, inflation increases too fast, or a financial crisis
occurs, an economy enters a contraction. The confidence that stimulated it quickly evaporates,
replaced with dwindling consumer confidence. Individuals save money rather than spend, reducing
demand, and businesses cut production and layoff employees as their sales dry up. Investors
sell stocks to avoid a drop in the value of their portfolios.
 Hitting bottom: During the trough phase, demand and production are at their lowest point. But
eventually, needs reassert themselves. Consumers slowly start to gain confidence as production
and business activity starts to improve, often spurred on by government policies and action.
They begin to buy and invest, and the economy enters a new expansion phase.
How governments influence business cycles
The fact that business cycles move in natural phases doesn't mean they can't be influenced. Countries
can and do try to manage the various stages - slowing them down or speeding them up - using
monetary policy and fiscal policy. Fiscal policy is carried out by the government; monetary policy is
carried out by a nation's central bank.
For example, when an economy is in a contraction, particularly a recession, governments use
expansionary fiscal policy, which consists of increasing expenditures on projects or cutting taxes.
These moves provide increased levels of disposable income that consumers can spend, which in turn
stimulates economic growth.
Balance of Trade vs Balance of Payments - Key differences
Here are the key differences between the balance of trade and balance of payments -
 The balance of trade can be calculated by deducting the value of imports of goods from the
value of exports of goods. Balance of payments, on the other hand, can be calculated by adding
the balance of payments at the current account and balance of payments at a capital account or
by finding out the net balance between inflow of foreign exchange and outflow of foreign exchange.
 The balance of trade portrays a partial picture of foreign exchange. The balance of payments, on
the other hand, provides a holistic picture.
 The net effect of the balance of trade can be positive, negative, or zero. The net effect of the

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 balance of payments would always be zero.
 Capital and unilateral transfers are not included in the balance of trade. Capital and unilateral
transfers are major parts of the balance of payments.
 The balance of trade is a sub-set of the balance of payments. Without calculating the balance of
trade, we would not be able to see the net effect of export and import in the balance of
payments.
Balance of Trade vs Balance of Payments (Comparison Table)

INFLATION
Meaning : Generally, inflation means a rise in prices. To be more clear, we can say that when prices of
commodities rise and the value of money falls, it is the condition of money inflation. Thus, inflation
refers to a persistent upward trend in the general price level; it results in a decline of the purchasing
power.
Definition : Brooman defines inflation as “a continuing increase in the general price level”.
Shapiro also defines inflation in a similar vein “as a persistent and appreciable rise in the general level
of prices.”

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Depending upon the specific causes, three types of inflation have been distinguished :

1) Demand Pull inflation

2) Cost-Push inflation

3) Structural inflation

1) Demand Pull Inflation : Basically, inflation is caused by a situation whereby the pressure of
aggregate demand for goods and services exceeds the available supply of output. In such a
situation, the rise in price level is the natural consequence. Demand pull inflation can be
illustrated with aggregate demand and supply curves.

In figure aggregate demand and aggregate supply have been shown on the x-axis and general
price level on the y-axis curve. AS represents the aggregate supply which rises upward in the
beginning but when full employment level of aggregate supply ‘OYF’ is reached, aggregate
supply curve ‘AS’ takes a vertical shape.

This is because after the level of full employment, supply of output cannot be increased. On
the other hand if aggregate demand increases to AD2, price level also rises to OP2. If the
aggregate demand further increases to AD3 the price level rises to OP3 under the pressure of
more demand. But since the aggregate supply curve is yet sloping upward, increase in aggregate
demand from AD2 to AD3 has caused the increase in output from OY2 to OYF. If aggregate
demand further increases to AD4, only price level rises to OP4 with output remaining constant at
YF.

This type of inflation will be demand pull inflation.

2) Cost Push Inflation : Cost push inflation is the situation where there is no increase in aggregate
demand; prices may still rise. This may happen if there is increase in costs. Three such
autonomous increases in costs which generate cost push inflation have been suggested. They
are :

a) Wage-push inflation

b) Profit-push inflation

c) Increase in prices of raw materials, especially energy inputs such as rise in crude oil
prices.

a) Wage-Push Inflation : The growth of powerful trade union is responsible for the spread
of inflation. When trade unions push for higher wages for labour without any increase in
its productivity, cost of product increases and consequently prices also rise. If this
happens we have cost-push inflation.

b) Profit-Push Inflation : Besides the increase in wages of labour without any increase in
its productivity, there is another factor responsible for cost push inflation. This is the
increase in the “profit margin” by the firms working under monopolistic or oligopolistic
conditions, and as a result charge higher prices from the consumers. When the cause
of cost-push inflation is the rise in profit margins, it is called profit-push inflation.

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 c) Rise in Raw Material Prices : Another factor responsible for cost-push inflation is
increment in the prices of raw material. During the seventies, hike in crude oil prices was
made by OPEC, resulting in rise in prices of petroleum products.
3) Structural Inflation : There is another important theory of inflation known as “structural inflation”
which explains inflation in the developing countries in a slightly different way. The economists
consider that increase in investment expenditure and the expansion of money supply are only
proximate and not ultimate factors responsible for inflation in the developing countries. According
to them, one should go deeper into the question why aggregate output, especially of foodgrains
and consumer goods does not increase in an adequate quantity so that it could match the
increase in demand. Further, they argue why investment expenditure has not been fully financed
by voluntary saving and as a result excessive deficit financing has been done.
Myrdal and Streeten have argued that it is not correct to apply the highly aggregative demand -
supply model for explaining inflation in the developing countries. According to them, there is a
lack of balanced integrated structure in them where substitution possibilities between consumption
and production and inter-sectoral flows of resources between different sectors of the economy
are not quite smooth and swift. So the inflation in them can not be reasonably explained in terms
of aggregate demand and aggregate supply.
In developing countries, as the demand for agricultural goods rises, their domestic supply
being inelastic, the prices of agricultural goods rise. To prevent the continuous rise in prices of
food products, they can be imported. But it is not possible to import them in large quantities due
to foreign exchange constraint. Therefore, price level rises.
Another cause of structural inflation is that the rate of export growth in a developing economy is
slow and unstable which is not sufficient to support the required growth rate of the economy.
Moreover, the nature of the tax system and budgetary process also help in increase the inflation.
So far as the money supply is concerned, it automatically expands when prices rise in a
developing economy. As prices rise, firms need larger funds from banks and the government
needs more moeny to finance larger deficits in order to meet its expanding expenditure and
wages of its employees. For this, it borrows from the central bank which leads to monetary
expansion and to a further rise in the rate of inflation.
Thus, structural inflation may result from supply inelasticities leading to rise in agricultural
prices, costs of import substitutes, deterioration of the terms of trade and exchange rate
devaluation.
Causes of Inflation in India
1) Inadequate Increase in Consumer Goods : In developing countries like India, there is not
much excess capacity in the system. The supply of consumers’ goods can not be increased
sufficiently to match the increase in demand for them. This leads to inflationary rise in prices.
2) Increase in Public Expenditure : Investment expenditure made by the government under the
development plans not only generates the additional demand for goods, it also increases the
productive capacity. Investment has a dual effect. On the one hand, it generates demand or
income, on the other, it increases the productive capacity. But, in the earlier stages of development
investment expenditure is largely made on huge dams, steel plants and other heavy and basic
industries which have long gestation periods. In other words, the long-term projects can help in

66 MEWAR INSTITUTE
 increasing the supply of consumers’ goods only in long run. In the short run, prices generally
shoot up under the pressure of excessive demand for goods.
3) Agricultural Price Policy of the Government : In underdeveloped countries like India which
are predominantly agricultural, the prices of agricultural commodities, especially of foodgrains,
hold the key position in the price structure of the country. Any rise in agricultural prices leads to
a distortion in the whole price structure. A steep rise in food prices increases the cost of living of
the people. Workers whose cost of living rises press for higher wages. Moreover, some agricultural
products are raw materials for industries, and increase in their prices will directly increase the
cost of production of industrial goods. Thus once the prices of agricultural goods rise they are
likely to cause inflationary spiral in the economy.
4) Deficit Financing : The developing countries are not in a position to finance their plans fully
through voluntary savings of the people and taxes by the government. They have often made
resort to deficit financing as a method of financing their development plans. Due to deficit
financing, sharp increase in the money supply creates aggregate demand for consumers’
goods. The pressure of demand leads to the inflationary rise in prices.
5) Large Scale Tax Evasion and Avoidance : When people do not pay their taxes faithfully, the
extent of money increases with them which increases their purchasing power. Consequently
they demand and that leads to the inflationary rise in prices.
6) Imbalance between Demand and Supply : It is often said that inflation in India is due to the
emergence of imbalance between demand and supply. As mentioned above, increase in
aggregate demand is due to the increase in government expenditure, which has been financed
largely by deficit financing Besides, commercial banks have also created a good amount of
bank money or credit to finance private investment. As a result, the public expenditure increased
very much and has brought about a huge expansion in aggregte demand. On the other hand,
the production of foodgrains and other consumer goods industries did not increase adequately
and this has brought about a rapid rise in prices.
It may however be noted that “Strategy of Economic Development”, adopted in our five year
plans, which gave high priority to basic heavy industries and relatively neglected agriculture and
consumer goods industries is the structural reason not to increase the output of fodgrains and
other essential consumer goods adequately to meet the rising demand for them, resulting in
inflation.
Effects of Inflation : Opinion surveys conducted in India, the U.S.A. and other countries show that
inflation is the most important concern of the people as it badly affects their standard of living.
A high rate of inflation makes the life of the poor very miserable. So, it is described as anti-poor. By
making the rich richer and the poor poorer, it militates against social justice. The effects of inflation can
be divided into five categories :
1) Effect on real income
2) Effect on distribution of income and wealth
3) Effect on output
4) Effect on long-run economic growth

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5) Other effects
1) Effect on Real Income : Inflation erodes real income of the people. To examine the impact of
inflation it is important to understand the difference between money income and real income.
Money income which is also called ‘nominal income’ means the income such as wages,
interest, and rent received in terms of money. On the other hand, real income implies the
amount of goods and services which you can buy. In other words, real income means the
purchasing power of your income. If money income increases at a lower rate than the rate of
rise inthe general price level, you will be able to buy less goods and services, that is your real
income will decline. Real income will rise only if nominal income rises faster than the rate of
inflation. For example, you deposit your saving of Rs.100 in a saving account which carries 5
percent rate of interest. After a year you will receive Rs.105. However, if during that year rate of
inflation has been 12 percent, you will be loser in real terms. In fact, your real interest income
will be negative as with 12 percent rate of inflation, Rs.105 after a year will buy less goods and
services that what you can buy today with Rs.100. Thus, this example shows that inflation
reduces the purchasing power of money and thereby adversely affects real income of the
people.
2) Effect on Distribution of Income and Wealth : Inflation adversely affects those who receive
relatively fixed incomes and benefits businessmen, producers, traders and others who retain
flexible incomes. Inflation brings windfall profits for the producers and traders. We examine
below how inflation redistributes income and wealth and thereby harms some people and
benefits others.
a) Creditors and Debtors : For creditors who provide loans at fixed nominal rate of
interest suffer loss because the real value of money which they will receive at the end of
the period would be much less if during the period prices rise sharply. Thus, the debtors
or borrowers gain because they would return the loan-money when its real value has
declined greatly due to the unexpected rapid rate of inflation.
b) Fixed Income Groups : Workers and salaried people who earn fixed wages and salaries
are hit hard by inflation, because, wages and salaries remain constant while the price
level increases. The purchasing power of their nominal income falls greatly causing a
decline in their level of living.
c) Businessmen – Producers and Traders : Businessmen that is entrepreneurs and
traders, stand to gain by inflation. During periods of inflation, the prices of goods produced
by entrepreneurs rise relatively faster than the cost of production because wages lag
behind the rise in prices of goods. Consequently, inflation increases the profits of
businessmen.
d) Wealth Holders of Cash, Bonds and Debentures : Inflation also adversely affects
wealth holders who hold their wealth in the form of cash money, demand deposits,
saving and fixed deposits and interest-bearing bonds and debentures. Saving and demand
deposits, bonds and debentures represent assets whose value is fixed in terms of
money. The rise in prices reduces the purchsing power of these fixed-value money
assets. Inflation also reduces the real rate of interest earned on bonds and debentures.
3) Effect on Output : The impact of inflation on output depends on whether it has been caused by

68 MEWAR INSTITUTE
 demand pull or cost push factors. Demand pull inflation creates a tonic effect on the level of
investment and employment of labour and output. In the cost push rise in price level is associated
with a fall in aggregate output.
4) Effects of Inflation on Long-run Economic Growth : Some economists have argued that
inflation of a creeping or mild variety has a tonic effect on the long-run economic growth. The
driving force in the process of economic growth according to them has been high profit margins
created by inflation. The businessmen and industrialists who retain profits as income belong to
the upper income group. The propensity to save of these people is higher than that of workers.
As a result, savings go up which ensures higher rate of investment. With greater rate of
investment more accumulation of capital is made possible. More rapid capital accumulation
generates a higher rate of long-run economic growth.
5) Other Effects : Inflation leads to a number of other effects which are discussed as :
a) 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, government collects that, in the form of taxes on incomes and commodities.
Thus the revenues of the government increase during inflation.
b) Balance of Payments : Inflation involves the sacrificing of the advantages of international
specialisation and division of labour. It affects adversely the balance of payments of the
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 the balance of payments becomes unfavourable for
the country. But there is no adverse effect on the balance of payments if the country is
on the flexible exchange rate system.
c) Exchange Rate : When prices rise more rapidly in the home country than in foreign
countries, it lowers the exchange rate in relation to foreign countries.
d) 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 happend in Germany after World War I.
e) Social : Inflation is socially harmful because it makes the poor poorer and the rich
richer. On the other hand, workers resort to get increased wages which lead to loss in
production.
Measures to Control Inflation
As it has been explained above, inflation occurs due to the emergence of excess demand for goods
and services relative to their supply of output at the prevailing prices. Various fiscal and monetary
measures can be adopted to check the inflation.
1) Monetary Measures : Monetary measures aim at reducing money income :
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.
Quantitative measures are :

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 i) Increase in bank rate
ii) Increase in cash reserve ratio (CRR)
iii) Increase in statutory liquidity ratio (SLR)
iv) Sale of securities in the open market.
Qualitative measures are :
i) Increase in margin requirements and regulating consumer credit.
ii) Rationing of credit
iii) Direct Action
b) Issue of New Currency: The most extreme monetary measure is the issue of new
currency in place of the old currency. Such a measure is adopted when there is an
excessive issue of notes and there is hyper inflation in the country. It is a very effective
measure.
2) Fiscal Measures: Only monetary policy is not adequate to control inflation. So it should be
supplemented by fiscal measures. Fiscal measures are highly effective for controlling government
expenditure, personal consumption expenditure and private and public investment. The basic
fiscal measures are the following :
a) Reduction in Unnecessary Expenditure: Government should reduce unnecessary
expenditure on non-development activities in order to curb inflation. But it is not easy to
cut govt. expenditure, because it is too tough to distinguish between essential and non-
essential expenditure. Therefore, this measure should be supplemented by taxation.
b) Increase in Taxes: To curb personal-consumption expenditure, the rates of personal,
corporate and commodity taxes should be increased, but the rates of taxes should not
be so high as to discourage saving, investment and production.
c) Increase in Savings: Another measure is to increase savings on the part of the people.
For this purpose the government should encourage the public to save by starting saving
schemes with prize money or providing high rates of interest. 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 adopt the policy of
surplus budgets.
e) Public Debt. : During inflation period government should stop repayment of public debt
and postpone it to some future date till inflationary pressures are controlled within the
economy.
Like the monetary measures, fiscal measures alone can not control inflation. They should be
supplemented by monetary, non-monetary and non-fiscal measures.
3) Other Measures : The other types of measures are those whose objective is to increase
aggregate supply and reduce aggregate demand directly.

70 MEWAR INSTITUTE
 a) Increase Production : Production should be increased so that there could be attained
an equilibrium between demand and supply.
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 govt.
should freeze wages, incomes profits, dividends, bonus etc.
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 such as wheat, rice, sugar, kerosene oil etc.
If the govt. adopts all measures simultaneously, it is clear that inflation can be controlled.

IMPORTANT QUESTIONS
Q.1. What is Economic growth and Development.
Q.2. What is Inflation? What are the causes of Inflation? What are the various measures to control
inflation?
Q.3. What is Business cycle.
Q.4. Write short notes on :
a) Goverment influence in Business cycle
b) Balance of Payment
c) Difference between Balance of Payment and Balanace of Trade

SUGGESTED READINGS
1. Managerial Economics, P.N. Chopra
2. Micro Economics, Dr. Deepashree
3. Micro Economics, A. Koutsoyiannis
4. Principles of Micro Economics, T.R. Jain & V.K. Ohri

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