Managerial Economics

DEECO515

Edited by:
Dr. Vishal Sarin
Managerial Economics
Edited By
Dr. Vishal Sarin
 Fiscal Policy

CONTENTS

Unit 1: Nature and Scope of Managerial Economics 1

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Unit 2: Demand and Supply Analysis 19
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Unit 3: Demand Estimation 30
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Unit 4: Cost Theory and Estimation 43
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Unit 5: Production Theory 55
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Unit 6: Market Structure 69
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Unit 7: Oligopoly 88
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Unit 8: Game Theory 99
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Unit 9: Indian Economy since Colonialism 108
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Unit 10: Human Development 120
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Unit 11: Structure of Indian Economy 133
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Unit 12: Economic Reforms 147
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Unit 13: Monetary Policy 166
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Unit 14: Fiscal Policy 180
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Unit 01: Nature and Scope of Managerial Economics

Tanima Dutta, Lovely Professional University

Unit 01: Nature and Scope of Managerial Economics

CONTENTS
Objective
Introduction
1.1 Scope of Managerial Economics
1.2 Basic Terms and Concepts
1.3 Basic Economic Questions
1.4 Economic Principles
1.5 Firm and Forms of Ownership
Summary
Keywords
Self Assessment
Answer for Self Assessment
Review Questions
Further Reading

Objective
• Explain the nature and scope of managerial economics
• Identify the role of economics in decision making
• Discuss the concepts of economic analysis

Introduction
“The purpose of studying economics is not to acquire a set of ready-made answers to economic
questions, but to avoid being deceived by economists.” Joan Robinson
When we start studying about Managerial Economics, we are not sure about the subject matter. It
has both the words- Management and Economics which many a times confuses a student. Basically,
management cannot do without economics as management implies making choices and economics
helps in making those choices. Economics is a subject that del as with the study of households. The
activity performed by individuals is divided into economic and non-economic activity. Economics
can be divided into two broad categories, microeconomics, and macroeconomics. Macroeconomics
as the name suggests is the study of the overall economy and its aggregates such as Gross National
Product, Inflation, Unemployment, Exports, Imports, Taxation Policy etc.
Macroeconomics addresses questions about changes in investment, governments pending,
employment, prices, exchange rate of the rupee and so on. Importantly, only aggregate levels of
these variables are considered in the study of macroeconomics. But hidden in the aggregate data
are changes in output of several individual firms, the consumption decision of consumers like you,
and the changes in the prices of goods and services.
Although macroeconomic issues are important and occupy the time of media and command the
attention of the newspapers, micro aspects of the economy are also important and often are of more
direct application to the day-to-day problems facing a manager. Microeconomics deals with
individual actors in the economy such as firms and individuals. Managerial economics can be
thought of as applied microeconomics and its focus is on the interaction of firms and individuals in
markets

Definitions
Economics is “the study of the behavior of human beings in producing, distributing and consuming
material goods and services in a world of scarce resources.”- Campbell McConnel

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“Management is the discipline of organizing and allocating a firm’s scarce resources to achieve its
desired objectives.”Peter Drucker
Managerial Economics is, “the use of economic analysis in the formulation of business policies.”
Joel Dean
“The method of reasoning involved in the derivation of some economic theorem.”. William
Baumol
William H. Meckling, the former dean of the Graduate School of Management at the University of
Rochester, expressed a similar sentiment in an interview conducted by The Wall Street Journal. In
his view, “economics is a discipline that can help students solve the sort of problems they meet
within the firm.”
All these definitions point out that managerial
economics is a combination of economics and
Economics is a social science, since it management so as to facilitate the organisation to
deals with the society as a whole and make decisions with optimum results. Managerial
human behaviour in particular, and economics is a means to an end to managers in any
studies the production, distribution business, in terms of finding the most efficient way of
and consumption. allocating scarce organisational resources.

of goods and services.

1.1 Scope of Managerial Economics

Managerial economics encompasses all the subjects that are related to management, be it
marketing, finance, accounting, management science or strategy. As it has evolved in
undergraduate and graduate programs over the past half century, managerial economics is
essentially a course in applied microeconomics that includes selected quantitative techniques
common to other disciplines such as linear programming (management science), regression
analysis (statistics, econometrics, and management science), capital budgeting (finance), and cost
analysis (managerial and cost accounting). From our perspective as economists, we see that many
disciplines in business studies have drawn from the core of microeconomics for concepts and
theoretical support. For example, the economic analysis of demand and price elasticity can be
found in most marketing texts. The division of markets into four types—perfect competition, pure
monopoly, monopolistic competition, and oligopoly—is generally the basis for the analysis of the
competitive environment presented in books on corporate strategy and marketing strategy.

Figure 1: Managerial Economics and Other Disciplines

There are several other examples to be found. The economic concept of opportunity cost serves as
the foundation for the analysis of relevant cost in managerial accounting and for the use of the
“hurdle rate” in finance. Opportunity cost also plays an important part in understanding how

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firms create “economic value” for their shareholders. Finally, in recent years, certain authors have
linked their managerial economics texts thematically with strategy and human resources
Figure 1 shows the relationship of Managerial Economics with other business disciplines. Both the
subjects derive components and principles from each other. However, management being the
young partner in this partnership, it is much more dependent on economics for the theoretical
construct.

1.2 Basic Terms and Concepts

For purposes of study and teaching, economics is divided into two broad categories:
microeconomics and macroeconomics. The former concerns the study of individual consumers and
producers in specific markets, and the latter deals with the aggregate economy. Topics in
microeconomics include supply and demand in individual markets, the pricing of specific outputs
and inputs (also called factors of production, or resources), production and cost structures for
individual goods and services, and the distribution of income and output in the population. Topics
in macroeconomics include analysis of the gross domestic product (also referred to as “national
income analysis”), unemployment, inflation, fiscal and monetary policy, and the trade and financial
relationships among nations.
Microeconomics is the category that is most used in managerial economics. However, certain
aspects of macroeconomics must also be included because decisions by managers of firms are
influenced by their views of the current and future conditions of the macro economy. For example,
we can well imagine that the management of a company producing capital equipment (e.g.,
computers, machine tools, trucks, or robotic instruments) would indeed be remiss if they did not
factor into their sales forecast some consideration of the macroeconomic outlook. For these and
other companies whose businesses are particularly sensitive to the business cycle, a recession
would have an unfavourable effect on their sales, whereas a robust period of economic expansion
would be beneficial. However, for the most part, managerial economics is based on the variables,
models, and concepts that embody microeconomic theory.
As defined in the previous section, economics is the study of how choices are made regarding the
use of scarce resources in the production, consumption, and distribution of goods and services. The
key term is scarce resources. Scarcity can be defined as a condition in which resources are not
available to satisfy all the needs and wants of a specified group of people. Although scarcity refers
to the supply of a resource, it makes sense only in relation to the demand for the resource. For
example, there is only one Mona Lisa. Therefore, we can safely say that the supply of this work of
art by da Vinci is limited. Nevertheless, if for some strange reason no one wanted this magnificent
work of art, then in purely economic terms it would not be considered scarce. Let us take another
example: broken glass on the streets of Chandigarh City. Here we have a case of a “resource” that is
not scarce, not only because there is a lot of broken glass to be found, but also because nobody
wants it! Now if you have been to the Chandigarh rock garden, then you understand how this
resource has been optimally used. The once-plentiful resource would fast become a “scarce”
commodity.

Figure 2: Factors of Production and Scarcity

Lionel Robbins talked about scarcity of resources when he wrote, 'Economics is the science which
studies human behaviour as a relationship between ends and scarce means which have alternative
uses'. The factors of production- land, labour, capital and enterprise are all scarce resources with
multiple uses. They are used as per the priority of the use and the profitability associated with it.

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Figure 2 shows the scarcity of the resources and the demand & supply of these resources. The
demand is always greater than the supply of factors and therefore scarcity persists.

Case Study: Guns and butter is a classical example to show the trade-off between two
diametrically opposite goods in the allocation of resources. The study of budgets of various
countries all over the world show that though guns are a negative good, but the allocation
of resources is much higher as compared to butter which is a positive good. The intent of
the “guns versus butter” example is to illustrate that scarcity force a country to choose the
amounts of resources that it wants to allocate between defense and peacetime goods and
services. In so doing, its people must reckon with the opportunity cost of their decision.
This type of cost can be defined as the amount or subjective value that must be sacrificed in
choosing one activity over the next best alternative. In the “guns versus butter” example,
one activity involves the production of war goods and services, and the other pertains to
the production of peacetime goods and services. Because of the scarcity of resources, the
more that the country allocates to guns, the less it will have to produce butter, and vice
versa. The opportunity cost of additional units of guns are the units of butter that the
country must forgo in the resource allocation process. The opposite would apply as
resources are allocated more to produce butter than guns

1.3 Basic Economic Questions

The problem of scarcity leads us to the next set of process in decision making that is the basic
questions that are arise from the problem of scarcity. Because of the predominance of the market
process in the U.S. economy, our discussion of the allocation of scarce resources is based on the
assumption that managers operate primarily through the mechanisms of supply, demand, and
material incentive (i.e., the profit motive). Their decisions about what goods to produce, how they
should be produced, and for whom they should be produced are essentially market oriented. That
is, firms choose to produce certain goods and services because, given the demand for these
products and the cost of using scarce resources, they can earn sufficient profit to justify their
particular use of these resources. Moreover, they combine their scarce resources to produce
maximum output in the least costly way. Finally, they supply these goods and services to those
segments of the population expected to provide the most material reward for their efforts.
Table 1.1 compares the three basic questions from the standpoint of a country and from the
standpoint of a company, where they form the basis of the economic decisions for the firm. From
the firm’s point of view, question 1 is the product decision. At some particular time, a firm may
decide to provide new or different goods or services or to stop providing a particular good or
service. For example, consider Apple’s decision to get into the music business by offering its iPod
and iTunes music download service. Another good example is the various “non-computer-service”
businesses that have gotten into the market for providing cloud-computing services. For example,
telecom companies such as Verizon, AT&T, Deutsche Telecom, and British Telecom (BT) all provide
cloud-computing services. Even companies such as Amazon and Dell have gotten into this market.
Question 2 is a basic part of a manager’s responsibility. It involves personnel practices such as
hiring and firing, as well as questions concerning the purchase of items ranging from raw materials
to capital equipment. For example, the decision to automate certain clerical activities using a
network of personal computers results in a more capital-intensive mode of production. The
resolution to use more supplementary, part-time workers in place of full-time workers is another
example of a management decision concerning how goods and services should be produced. A
third example involves the selection of materials in the production of a certain item (e.g., the
combination of steel, aluminium, and plastic used in an automobile).
The firm’s decision concerning question 3 is not completely analogous to that of a country.
Actually, a firm’s decision regarding market segmentation (a term used in the marketing field) is
closely related to question 1 for a country. In deciding on what segment of the market to focus, the
firm is not literally deciding who gets the good or service. For example, suppose a firm decides to
target a certain demographic segment by selling only a “high-end” or premium version of a
product. However, the way in which a company markets the product (which includes its pricing
and distribution policies) makes certain segments of the market more likely to purchase the
product.

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Perhaps one of the best ways to link the economic problem of making choices under conditions of
scarcity with the tasks of a manager is to consider the view put forth by Professor Robert Anthony
that a manager is essentially a person who is responsible for the allocation of a firm’s scarce
resources. It is interesting to note that “managers” or “management skills” was not delineated as a
separate factor of production by early economic theorists. The four traditional categories of
resources are land, labor, capital, and entrepreneurship. The last category can be treated as broad
enough to include management, but the two classifications do involve different characteristics or
skills.
The term entrepreneurship is generally associated with the ownership of the means of production.
In addition, it implies willingness to take certain risks in the pursuit of goals (e.g., starting a new
business, producing a new product, or providing a different kind of service). Management, in
contrast, involves the ability to organize and administer various tasks in pursuit of certain
objectives. An important part of a manager’s jobis to monitor and guide people in an organization.

Peter Drucker, the father of management wrote about the role of management, “It is
“management” that determines what is needed and what has to be achieved (in an organization).
Management is work. Indeed, it is the specific work of a modern society, the work that
distinguishes our society from all earlier ones. . . . As work, management has its own skills, its own
tools, its own techniques.”

1.4 Economic Principles

Key economic principles that are relevant to managerial decisions are discussed in the following
sub-sections.

Division of Labour
I put the division of labor first mainly because Adam Smith did argue that division of labor is
the key cause of improving standards of living. Modern economics doesn’t do much with the
concept of division of labor, but two closely related concepts are important:

1. Returns to Scale: Returns to scale may be increasing, constant or decreasing. Increasing

returns to scale is the case that leads to special results, and division of labor is one cause
(arguably the main cause) of increasing returns to scale.
2. Virtuous Circles in Economic Growth: For Smith, a major consequence of division of labor
and resulting increasing productivity was a “virtuous circle” of continuing growth.
Modern “virtuous circle” theories have more dimensions, but division of labor and
increasing returns to scale are among them.

Opportunity Cost
The idea is that anything you must give up in order to carry out a particular decision is a cost of
that decision. This concept is applied again and again throughout modern economics.

1. Scarcity: According to modern economics, scarcity exists whenever there is an opportunity

cost, that is, where-ever a meaningful choice has to be made.
2. Production Possibility Frontier: The production possibility frontier is the diagrammatic
representation of scarcity in production.

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3. Comparative Advantage: A very important principle in itself and a key to understanding

of international trade the principle of comparative advantage is at the same time an
application of the opportunity cost principle to trade.
4. Discounting of Investment Returns: Another application of the opportunity cost principle
that is very important in itself, this one tells us how to handle opportunities that come at
different times.

Equimarginal Principle
This is the diagnostic principle for economic efficiency. It has wide applications in modern
economics. Two of the most important are key principles of economics in themselves:

1. The Fundamental Principle of Microeconomics: This principle describes the circumstances

under which market outcomes are efficient.
2. The Externality Principle: It describes some important circumstances in which the markets
are not efficient.
3. Marginal Analysis: It is also an important principle in itself and very widely applied in
Notes modern economics. There is no major topic in microeconomics that does not apply
marginal analysis and opportunity cost.

Market Equilibrium
The market equilibrium model could be broken down into several principles — the definitions
of supply, demand, quantity supplied and demanded and equilibrium, at least — but these all
complement one another so strongly that there is not much profit in taking them separately.
However, there are many applications and at least four important subsidiary principles:

1. Elasticity and Revenue: These ideas are a key to understanding how market changes
transform society.
2. The Entry Principle: This tells us that, when entry into a field of activity is free, profits
(beyond opportunity costs) will be eliminated by increasing competition. This has a
somewhat different significance depending on whether competition is “perfect” or
monopolistic.
3. Cobweb Adjustment: This might give the explanations when the market does not move
smoothly to equilibrium, but overshoots.
4. Competition vs. Monopoly: Why economists tend to think highly of competition, and
lowly of monopoly.

Diminishing Returns
Perhaps the best-known of major economic principles, the Principle of Diminishing Returns is
much more reliable in short-run than in long-run applications, so the Long Run/Short Run
dichotomy is an important subsidiary principle. Modern economists think of diminishing returns
mainly in marginal terms, so marginal analysis and the equimarginal principle are closely
associated.

Game Equilibrium
Game theory allows strategy to be part of the story. One result is that we have to allow for
several kinds of equilibriums.

1. Non-cooperative equilibrium
(a) Prisoners’ Dilemma (dominant strategy) equilibrium

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(b) Nash (best response) equilibrium, (but not all Nash equilibrium are dominant
strategy equilibrium),
2. Cooperative equilibrium
3. Oligopoly

Measurement Principles
Economics is multidimensional, and that creates some difficulties in measuring things like
production, incomes, and price levels. Some of the problems can be solved more or less fully.

1. Value Added and Double Counting: One for which we have a pretty complete solution is
the problem of double counting: the solution is, use value added.
2. “Real” Values and Index Numbers: Since we measure production and related quantities in
dollar terms, we have to correct for inflation. Index numbers are a pretty good workable
solution, but there are some problems and criticisms.
3. Measurement of Inequality: Another issue is that the “average income” may not mean
very much, because nobody is average and income is unequally distributed. Even if we
cannot correct for that we can get a rough measure of the relative inequality and see where
it is going.

Medium of Exchange
Money is whatever is generally acceptable as a medium of exchange. That means a bank,
or similar institution, can literally create money, so long as people trust the bank
enough to accept its paper as a medium of exchange. We might call this magical fact
the Fiduciary Principle.

Income-Expenditure Equilibrium
Like the market equilibrium principle, but even more so, this model pulls together a number of
subsidiary principles that complement one another and together constitute the “Keynesian”
theory of aggregate demand. The implications of this theory are less controversial than the
word “Keynesian” is — controversy has to do more with the details than the applications.
Among the subsidiary principles are

1. Coordination Failure
2. The income-consumption relationship
3. The Multiplier
4. Unplanned inventory investment
5. Fiscal Policy
6. The Marginal Efficiency of Investment
7. The influence of money on interest
8. Real Money Balances
9. Monetary Policy

Surprise Principle
People respond differently to the same stimuli if the
stimuli come as a surprise than they would if the stimuli
do not come as a surprise. This new economic principle
plays the key role with respect to aggregate supply that
“Income-Expenditure Equilibrium” plays with respect to
aggregate demand.
Rational Expectations: People don’t want too many
unpleasant surprises. If they use the information available
to them efficiently, then they won’t be surprised in the

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same way very often. This can lead to:

1. Policy ineffectiveness
2. Permanence
3. Path Dependence

1.5 Firm and Forms of Ownership

Economics as a subject is applicable to all types of organisations, though it finds special application
in business firms. This brings forth some pertinent questions like: what is a firm; who identifies the
factors of production; who collects the factors and puts them to productive use; and so on. A firm is
an entity that draws various types of factors of production in different amounts from the economy,
and converts them into desirable output(s),
through a process with the help of suitable
technology. Economists have identified five factors There are four main factors of
of production, namely land, labour, capital, production, namely, land, labour, capital,
enterprise and organisation, of which, enterprise and enterprise. In current scenario, we
and organisation are relatively new entrants. In add technology to it.
today’s world we add technology to it too because
it has become one of the most important parts of the production process. The factors of production
are supposed to produce optimally but that is only possible if they are used in the right proportion
and the right environment is created for them to function. The process of identifying the potential
sources of the factors such as land, labour, and capital, collecting them in required quantities and
assigning them specific tasks as per their skills is the subject matter of organisation. Using these
factors of production for economic activities, without any certainty of returns is the function of
enterprise, or the entrepreneur. Hence, we can say that an entrepreneur is a person (or group of
persons) who decide(s) to undertake the responsibility of the inherent risks in starting a business.
The focal point of understanding the functioning of
Firm is an entity that brings together all the factors of production is firms. There are various
the factors of production and provides types of firms, and they have their own unique
the environment for them to perform features. This section of the chapter is focused on
optimally. understanding the types of firms and how they
perform.

Types of Firms
The success of every business depends largely on its organisation; and the form of ownership is a
significant aspect of any organisation. Businesses may be organised in various forms, depending on
their size, nature and need for resources. Legal framework of the economy also plays a significant
role in choice of form of ownership. Figure 3 shows the various forms of ownership

Figure 3: Types of Ownership

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Private Sector
As per the classical thought of economics, the government sector should act as a facilitator for the
market. They believed in laissez faire economy which talks about the market forces maintain the
equilibrium in the economy. In such a situation the private sector is the core of the economy it
dominates the business frontier. The private sector may be defined as when ownership is in the
hands of individuals, whether independently, or as a small group, or in a large number, without
any investment from the government, then the setup is referred to as private sector.
In the early years of organised economic activities only the private sector existed, while other
sectors came at a very later stage. Proponents of private sector believe that businesses should
always be in the hands of individuals. The reason cited has been that the root of all economic
activities is profit making, and that governments cannot run organisations with profit motive. The
supporters of the public sector argue that private sector is selective in its investments. It invests
only in areas which are profitable, and this leads to exploitation of factors, especially of labour. The
government sector does equitable distribution of factors. It is inclusive in nature which leads to
balanced economic development.

Sole Proprietorship
Sole proprietorship is the most ancient form of ownership; its roots can be tracked back to the
development of civilised living, private ownership of resources and advent of the benefits of
exchange. Primitive societies were created based on sharing of resources, whether natural, or
manmade. This sense of sharing resulted in the advent of exchange, which emerged as the mother
of all economic activities. Then money was invented for
convenience and can undoubtedly be termed as one of Sole proprietorship firm is one in
the most wonderful inventions by mankind. Thus, began which an individual invests own (or
the process of private ownership of resources, borrowed) capital, uses own skills in
accumulation of wealth and capital formation. management, and is solely
responsible for the results of
You may find numerous proprietorship firms existing all
operations.
around you; kirana stores, retail outlets, restaurants,
hotels, small/cottage industries are only few examples of
such sole proprietorship. In fact, many of the modern big business houses were started as
ownership firms and were eventually converted into limited companies.
We may, thus, define sole proprietorship, or single owner, or proprietary firm as one in which an
individual invests own (or borrowed) capital, uses own skills in management, and is solely
responsible for the results of operations. The profits or losses are not shared with anyone.

Partnership
Due to the inherent limitations of a single owner organisation, investors invented another form of
organisation, which solved many of the problems of proprietorship and still could retain all its
advantages. This form is known as partnership, in which two or more individuals decide to start a
common business. As per Section 4 of Indian Partnership Act 1932, a partnership is “relation
between persons who have agreed to share the profits of a business carried on by all or any of them
acting for all”. Persons who have entered into partnership are individually regarded as ‘partners
‘and collectively as a ‘firm’. Here it is important to understand that the term “firm” is only a
commercial notion, and has no legal personality apart from the partners, except for purposes of
assessment of income tax. A partnership firm cannot become a member of another firm, though its
partners can join another firm as partners.
Limited Liability Partnership (LLP) The Limited Liability Partnership Act of India 2008, has
changed the face of partnership to promote entrepreneurship and innovation in the country. The
rules of Act of1932 are not applicable to the firms established under this Act. It is a legal entity with
an existence separate from its owners. It has perpetual existence. Any change in the partners shall
have no impact on the existence, rights or liabilities of the LLP firm.
Characteristics of Partnership As per the Act of 1932, partnership must simultaneously satisfy all of
the following aspects, also regarded as the essential conditions of partnership:

1. Association of two or more persons A partnership cannot exist unless at least two persons
join hands. At the same time, there is an upper limit to the number of members. A
partnership cannot have more than 20 partners.

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2. Agreement to voluntarily form partnership Partnership arises from a contract that all the
partners agree to form a fi rm. The agreement is to share the profits emerging from the
business, which also implies sharing the losses; however, agreement to share losses is not
essential. This contract may be explicit or implied, and would take either of the following
forms:
i. it may be for a certain specified period and a specific purpose, or
ii. it may be for a certain specified period and any purpose, or
iii. it may be for an uncertain period and a specific purpose, or
iv. it may be for an uncertain period and any purpose.
An heir of a partner does not automatically become a partner, unless other members agree to induct
the heir(s) as partners.

3. Business carried out by all or anyone acting for all Partners are mutual agents for each
other and principal for themselves. All of them may actively manage the business, or any
one of them may conduct the business under implied authority to do so by all other
partners. All the partners are bound by an actor decision taken by any one of them in
normal course of business.
4. Partnership deed Partnership is created as an agreement. It is not necessary to prepare this
agreement in writing, though it is strongly desired that the agreement is prepared in
writing, in order to avoid any dispute arising in future. The document, thus, created is
called a Partnership Deed. A typical partnership deed normally consists of following
information:
i. Name and location of firm, and nature of business
ii. Name of partners, their respective shares, powers, obligations and duties
iii. Date of commencement of partnership
iv. Duration of firm
v. Capital employed by different partners
vi. Manner in which profits (losses) are to be shared among partners
vii. Salaries (if any) payable to partners
viii. Rules regarding operation of bank accounts
ix. Interest on partners’ capital, loans, drawings, etc.
x. Provision for admission, retirement or expulsion of partners
xi. Settlements on dissolution of the firm

Joint Stock Company or Company

The most important type of business organisation today is the joint stock company, commonly
called “company”. A joint stock company gets this name from its characteristic that it is a business
entity in which stocks can be bought and owned by the shareholders. Each shareholder owns
company stock in proportion as per their shares
(certificates of ownership). This results in unequal A joint stock company in India is
ownership among the shareholders. Shareholders may sell established under Companies
their stock or transfer them without affecting the existence Act 1956, amended in 2013.
of the entity. In India a Joint Stock Company is established
under the Companies Act 1956, which was amended in 2013. The details of functions and scope of
the company are governed by Memorandum of Association signed among members. The
Memorandum contains the name of the company, the location of the head office, its aims and
objectives, the amount of share capital, the kind(s) and value(s) of shares and a declaration that the
liability is limited. Articles of Association, containing the rules and regulation of the company are
also drafted. These two documents are submitted to the Registrar of Joint Stock Company. The
company comes into existence only after the Registrar of Companies issues a certificate of
incorporation. The owners’ capital in a joint stock company is invested in the form of shares; hence
the owners are regarded as shareholders and there may be various categories of shareholders with
the two major ones being common shareholders and preference shareholders. These categories are

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on basis of the claim on dividend. The profit earned is divided in the form of dividends on the basis
of shares. Besides raising capital by shares, the company may also raise funds by bonds and
debentures, which have a priority in the claim for repayment, irrespective of profits or losses.
Owners of bonds and debentures are the creditors of the company. The liability of each shareholder
is limited to the proportion of shares held by him/her; therefore a joint stock company is also
known as a limited company. In the event of inability of a company y to repay loan or interest
amount the creditors can raise their claim on assets of the company and not on the personal
belongings of shareholders. This is the biggest advantage of a limited company over all other forms
of business. The overall governance of a company is in the hands of a Board of Directors, which is a
body elected by the shareholders.
A joint stock company is a legal entity and its existence is independent of its members. It has a
name, a seal and an authorised signatory; it has the right to own, buy, sell and transfer property; it
can sue and can be sued in its own name. For all practical purposes, a joint stock company is like a
person, but it exists only in contemplation of law, and is strictly governed by the clauses laid in the
Memorandum of Association. A joint stock company has two basic forms, namely, Private Limited
Company and Public Limited Company. Let us explain each in details.
Private Limited Company: The maximum number of shareholders in such a company is limited
to 50. The shares of the company are transferable only among the members. This type of company
is free from the necessity of submitting certain
returns to the Registrar. But a private limited The maximum number of shareholders in a
company has to operate under certain private limited company is limited to 50.
restrictions: it can neither issue a prospectus,
nor can it raise capital by selling its shares to outside public other than the members.
Public Limited Company: The joint stock company may take the form of a public limited
company, in which there is no limit on the maximum number of members, though the minimum
number of members is seven. Such a company
has to submit certain statements and its
There is no limit on the maximum number balance sheet to the Registrar of joint stock
of members in a public limited company, companies on an annual basis. It can invite the
though the minimum number of members public to buy shares by issuing a prospectus.
is 7. One feature of a public limited company is
that, its business cannot be started unless the
minimum capital laid down as per law has been
subscribed.
Cooperatives: A cooperative is a non-profit, non-political, non-religious, voluntary organisation,
formed with an economic objective. The main principles of cooperation are:

i. It is based on mutual help and self-reliance. This can be neatly summed up

as “each for all and all for each”.
ii. Dealings are confined to members only.
iii. Its objective is not earning profits but to encourage mutuality and
cooperation.
The principle of cooperation has been given a
much-extended application. Cooperative
societies have been formed for several purposes. A cooperative is a non-profit, non-political,
Primarily cooperation may be divided in two non-religious, voluntary organisation,
broad categories: producers’ cooperation and formed with an economic objective.
consumer’s cooperation. Let us explain both in
details.
Producers’ Cooperative In this form of cooperation, workers are their own masters i.e., the business
is owned by them. Surpluses (Profits), if any, are divided among all the members. Thus, profits go
to the actual workers instead of enriching a few individuals. Nothing could be more attractive and
fairer than this. You must have, by now, conceptualised a producers’ cooperation to be the
idealised form of company? Let us sound a warning bell here, as the claims of fair division of
profits are all theory; reality may be strikingly different! Unless all the members of cooperative
work in tandem with loyalty and beyond individual interests, a producers’ cooperative may not
work efficiently. For example, Indian Fertilisers and Farmers Cooperative (IFFCO) has proved to be
great success.

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Consumers’ Cooperative: Persons living in a particular place, or working in an establishment,
may combine together to open different types of cooperative societies. Typical examples are multi-
purpose stores, credit societies and housing societies. This form of cooperation has been very
successful. You can find around you many such types of consumers’ cooperatives; may be the
house you live in is part of such cooperative effort!

Cooperatives in India
Bhagini Nivedita Co-operative Bank Ltd. (BNCB) was established in the year 1974 at
Pune Maharashtra. This bank is mainly focused on women. The objective of this
cooperative bank was to encourage banking in the masses and specially amongst women.
The percentage of women shareholders in the bank is about 69 percent. The highlight of
this bank is that it provides loans at reasonable rates. The reason for targeting women is
that repayment rates is much higher from women, and they also do not have assets in
their name which makes them vulnerable, and they lack financial security. The recovery
rate of this bank is 98 percent. Bhagini
Nivedita Sahakari Bank believes that women have inherent and latent capacities in them,
which must be channelized properly and effectively to attain the desired goal. This
women run bank helps men too.
Source:Success-Book.pdf (ncui.coop)

Public Sector
Public sector is that segment of economy where government is the investor and the owner of a
business. The public sector came into existence as an outcome of two major revolutions:
Communism and Great Depression. Although deliberation on these two issues is out of scope of
this book, still we shall briefly touch them one by one. Karl Marx propounded the theory of public
ownership of all resources and gave the logic that the entire society is a community and all
resources, whether natural or manmade, should be owned by the community as a whole and not by
any individual. This is regarded as communism. Many countries were deeply influenced by the
Marxist theory and adopted Communism as national economic philosophy. Another major event
that had drawn the attention of economists and thinkers alike was the Great Depression. Another
great economist, John Maynard Keynes recommended that in order to break the impasse, the
government should enter into business activities, because only government can invest in the areas
where profits are not certain. As a result, governments of nations, the world over, forayed into
business activities, giving rise to another sector in the economy, regarded as the public sector. In
many countries, including India, the two sectors continue to coexist even today.
As we have discussed the various types of business organisations under private sector, we shall
hereafter learn about forms of organisations under public sector.

i. Corporate (or Company): Just like private sector when government invests in
production activities and enters the market, such firms are called Public Sector Units
(PSUs) or Public Sector Enterprise (PSEs). These PSUs (or PSEs) have to operate on the
same ground as any other joint stock company, with the single exception that there
are no shareholders, as the government owns the entire or controlling amount of
invested capital. These units play very significant role in many respects like:
employment generation; development of products where private sector does not want
to enter; balanced economic development and equitable distribution of national
wealth. In India, SAIL, ONGC, NTPC, GAIL, BSNL are some of the examples of PSUs.
ii. Corporation or Board: Another structure of organisation is in the form of a
corporation or a board. The corporation or the board normally controls some of the
economic activities, especially where the government feels that government
intervention is necessary for equal distribution of economic resources. Such a
corporation does not aim at revenue generation; it rather aims at optimum utilisation
of national resources and welfare maximisation of groups of small economic units like

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household and cottage industries. In India, typical examples are Khadi and Village
Industries Corporation (KVIC), Coir Board, Food Corporation of India and Railway
Board.
iii. Department A Department is run for a specific purpose related to social utility, such
as education, health, civil administration, etc. These Departments normally function
under the directives of relevant ministries, at the appropriate level. For example, in
India, police, excise and education (up to secondary) are the responsibility of State
Governments, whereas telecommunication, post and telegraph, customs, etc., are
under the Central Government. These Departments help the government in smooth
delivery of welfare measures, maintenance of law and order and equality of
opportunities. Though these are not part of economic activities, yet Departments
facilitate economic activities by providing a safe and constructive environment.

Case Study: Public Sector Enterprises in India

Public sector enterprises (PSEs), also known as state-owned enterprises
(SOEs), have been one of the key drivers of economic development in several
countries. They are more popular in emerging economies. In India, post-
independence, PSEs have played an important role in development and have
been responsible for creating a strong industrial base. After independence,
the government followed a socialist model with a public-sector led industrial
development – the Feldman- Mahalanobis model, which focused on
developing a strong capital base through PSEs in core sectors such as
railways, steel, power, oil, telecommunications, mining, and transportation.
Studies show that Indian PSEs have contributed to the development of
backward regions, environment protection, promotion of green and energy
efficient technologies, capacity building, promotion of social infrastructure
such as education and healthcare. PSEs have presence in several sectors
spanning both goods and services, and many of them are engaged in
international trade. They have helped to meet the country’s energy and food
security needs and have supported the implementation of government
schemes and policies.
Source:https://icrier.org/pdf/Working_Paper_388.pdf

Functions of a Firm
A firm performs a number of functions that are both economic and managerial in nature.
Production function
The Production function undertakes the activities necessary to provide the organisation’s products
or services. Its main responsibilities are: production planning and scheduling control and
supervision of the production workforce managing product quality (including process control and
monitoring maintenance of plant and equipment control of inventory deciding the best production
methods and factory layout.
Close collaboration will usually be necessary between Production and various other functions
within the organisation, for example:

• Research and Development, concerning the implications of product design for

production methods and cost
• Marketing, concerning desired product functionality, appearance, quality, durability and
so on
• Finance, concerning the availability of funds for purchase of new equipment and the
acceptability of inventory levels.

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Managerial Economics

• Human Resource Management, concerning staff motivation implications of job design

and production methods.

Purchasing function
The Purchasing function is concerned with acquiring goods and services for use by the
organisation. These will include, for example, raw materials and components for manufacturing
and also production equipment. The responsibilities of this function usually extend to buying
goods and services for the entire organisation (not just the Production function), including, for
example, office equipment, furniture, computer equipment and stationery. In buying goods and
services, purchasing managers must take into account a number of factors – collectively referred to
as ‘the Purchasing Mix’, namely, Quantity, Quality, Price and Delivery.

• Quantity: Buying in large quantities can attract price discounts and prevent inventory
running out. On the other hand, there are substantial costs involved in carrying a high
level of inventory.
• Quality: There will usually be a trade-off between price and quality in acquiring goods
and services. Consequently, Production, R&D and Marketing Functions will need to be
consulted to determine an acceptable level of quality which will depend on how important
quality is as an attribute of the final product or service of the organisation.
• Price: Other things being equal, the purchasing manager will look for the best price deal
when procuring goods and services, although price must be considered in conjunction
with quality and supplier reliability, in order to achieve best value, rather than lowest
price only.
• Delivery: The time between placing an order and receiving the goods or services, the lead
time, can be critical for production planning and scheduling and also has implications for
inventory control. Suppliers must therefore be evaluated in terms of their reliability and
capability for on time delivery.
In short, the ‘purchasing mix’ can be considered as making sure that the organisation has the right
amount, of the right quality, at the right price, in the right place at the right time.
Research and Development function
The Research and Development (R&D) function is concerned with developing new products or
processes and improving existing products/processes. R&D activities must be closely coordinated
with the organisation’s marketing activities to ensure that the organisation is providing exactly
what its customers want in the most efficient, effective and economical way.
Marketing Function
Marketing is concerned with identifying and satisfying customers needs at the right price.
Marketing involves researching what customers want and analysing how the organisation can
satisfy these wants. Marketing activities range from the ‘strategic’, concerned with the choice of
product markets (and how to compete in them, for example, on price or product differentiation) to
the operational, arranging sales promotions (e.g., offering a 25 per cent discount), producing
literature such as product catalogues and brochures, placing advertisements in the appropriate
media and so on. A fundamental activity in marketing is managing the Marketing Mix consisting of
the ‘4Ps’: Product, Price, Promotion and Place.

• Product. Having the right product in terms of benefits that customers value.
• Price. Setting the right price which is consistent with potential customers’ perception of
the value offered by the product.
• Promotion. Promoting the product in a way which creates maximum customer awareness
and persuades potential customers to make the decision to purchase the product.
• Place. Making the product available in the right place at the right time – including
choosing appropriate distribution channels.

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Human Resources function
The Human Resources function is concerned with the following:

• Recruitment and selection: Ensuring that the right people are recruited to the right jobs.
• Training and development: Enabling employees to carry out their responsibilities
effectively and make use of their potential.
• Employee relations: Including negotiations overpay and conditions.
• Grievance procedures and disciplinary matters: Dealing with complaints from employees
or from the employer.
• Health and Safety matters: Making sure employees work in a healthy and safe
environment.
• Redundancy procedures: Administering a proper system that is seen to be fair to all
concerned when deciding on redundancies and agreeing redundancy payments.
Accounting and Finance function
The Accounting and Finance function is concerned with the following:

• Financial record keeping of transactions involving monetary inflows or outflows.

• Preparing financial statements (the income statement, balance sheet and cash flow statement)
for reporting to external parties such as shareholders. The financial statements are also the
starting point for calculating any tax due on business profits.
• Payroll administration Paying wages and salaries and maintaining appropriate income tax
and national insurance records.
• Preparing management accounting information and analysis to help managers to plan,
control and make decisions.

Summary
Managerial economics is a discipline that combines microeconomic theory with management
practice. Microeconomics is the study of how choices are made to allocate scarce resources with
competing uses. It is the study of individual units and this is then combined with macroeconomics
which is the study of aggregates. An important function of a manager is to decide how to allocate a
firm’s scarce resources. Economics helps in the managers to make the decisions regarding the
allocation of these scarce resources. Firms are integral part of the business environment where the
principles of economics and management come together. Different forms of firms have different
characteristics which have different mix of these two academic streams. This chapter discusses the
concept of managerial economics and the basic economic questions that are answered. The
economic principles are dealt in detail with appropriate examples. The later part of the chapter
looks into firms and its types.

Keywords
Economics: Economics is a social science, since it deals with the society as a whole and human
behaviour in particular, and studies the production, distribution and consumption.
Microeconomics: It is the study of individuals which is the basic of classical economics.
Macroeconomics: It is the study of aggregates which emerged from Keynesian economics.
Managerial Economics: The use of economic analysis to make business decisions involving the best
useof a firm’s scarce resources.
Opportunity Cost: The amount or subjective value for gone in choosing one activity over the next
best alternative. This cost must be considered whenever decisions are made under conditions of
scarcity.
Scarcity: A condition that exists when resources are limited relative to the demand for their use. In
the market process, the extent of this condition is reflected in the price of resources or the goods
and services they produce

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Managerial Economics
Firm: It is an entity that brings together all the factors of production and provides the environment
for them to perform optimally.

Self Assessment
1. Which of the following is the best definition of managerial economics? Managerial
economics is
A. a distinct field of economic theory.
B. a field that applies economic theory and the tools of decision science.
C. a field that combines economic theory and mathematics.
D. none of the above.

2. The value of an economic theory in practice is determined by

A. how accurate the assumptions are
B. how well the theory can be represented by a graph.
C. how well the theory can predict or explain.
D. how parsimonious the model is.

3. Management decision problems are comprised of three elements. Which of the following is
not one of them?
A. Profitability
B. Alternatives
C. Constraint
D. Objectives
4. Which of the following areas of economic theory is the single most important element of
managerial economics?
A. Mathematical economics
B. Econometrics
C. Macroeconomics
D. Microeconomics

5. Which of the following is defined as the study of the aggregate economy studied as a whole?
A. Mathematical economics
B. Econometrics
C. Macroeconomics
D. Microeconomics

6. The first stage in the five-step decision process described in the text is to
A. define the problem.
B. select the best possible solution.
C. determine the objective.
D. identify possible solutions.

7. The economic term for the costs associated with negotiating and enforcing a contract is
A. opportunity costs.
B. real costs.
C. functional costs.
D. transaction costs.

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Unit 01: Nature and Scope of Managerial Economics

8. The tendency for managers to operate a firm in a way that maximizes their personal utility
rather than the firm's profits is referred to as the
A. consumer utility incentive.
B. principal-agent problem.
C. hidden agenda scenario.
D. Modigliani hypothesis.

9. The last stage in the five-step decision process described in the text is to
A. determine the objective.
B. select the best possible solution.
C. implement the decision.
D. explain the decision to managers.

10. Which of the following is an example of a resource constraint?

A. Pollution control laws
B. Inadequate demand
C. Excessive production costs
D. Inadequate financial capital

11. A large organization with separate legal entity is known as

A. Sole proprietorship
B. Partnership
C. Joint Stock Company
D. None of the above

12. Deferred shares are generally issued to

A. Promoters
B. Government
C. General public
D. Managing agents

13. The minimum members in public limited company are

A. Four
B. Two
C. Eight
D. Seven

14. Provision of residential accommodation to the members at reasonable rates is the objective
of
A. Consumer cooperative
B. Credit cooperative
C. Housing cooperative
D. Producer’s cooperative

15. The maximum number of partners allowed in the banking business are
A. Two

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Managerial Economics

B. Twenty
C. No limit
D. Ten

Answer for Self Assessment

1. B 2. C 3. A 4. C 5. D

6. A 7. A 8. B 9. B 10. D

11. C 12. B 13. D 14. C 15. D

Review Questions
1. What are the principles of Managerial Economics?
2. “Managerial Economics is a combination of management and economics”. Elaborate the
statement.
3. In case of sole proprietorship, if the person dies then what happens to her assets.
4. What are the various types of firms? Which of them is the most common in emerging
economies and why?
5. How has the Public Sector Units helped the Indian economy?

Further Reading
1. Managerial Economics- Principles and Worldwide Applications By
Salvatore, Dominick and Rastogi, Siddhartha K., Oxford University
Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by
Keat Paul G, Young Philip K. Y, Erfle Stephen and Banerjee Sreejata.,
Pearson Education, India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy
Choudhary, McGraw Hill Education (India) Private Limited

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Unit 02: Demand and Supply Analysis

Tanima Dutta, Lovely Professional University

Unit 02: Demand and Supply Analysis

CONTENTS
Objectives
Introduction
2.1 Demand
2.2 Law of Demand
2.3 Exceptions to the Law of Demand
2.4 Market Supply
2.5 Determinants of Supply
2.6 Law of Supply
2.7 Equilibrium
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Reading

Objectives
• Introduce the basics of demand and supply and their relevance in economic decision-
making.
• Explain the law of demand and exceptions to the law.
• Analyse the different determinants of demand and supply and their effects on demand
and supply curves.
• Develop an understanding of demand and supply functions in determining market
equilibrium.
• Introduce the concepts of market equilibrium and disequilibrium.

Example: India is a country where people mainly travel for work or pilgrimages.
Religious tourism comprises of about 60 percent of total internal tourism in India. For
such type of travel people require affordable places which are clean and safe. The new
found spending capacity of people because of the opening up of the economy also has
increased travel and needing hotels.

Introduction
The pandemic situation all over the world has created an economic crisis and the growth rates of
countries have plummeted. People in millions have lost their jobs or taken pay cuts which has
affected their purchasing power. On the other hand, the producers also got affected because of the
lockdown which impacted both production and the supply chain. In this chapter, we will discuss
these two important concepts of microeconomics which forms the basis for more complex concepts.
Demand and supply form the basis for most of the major decisions made in business. We will
initiate the discussion by introducing terms like wants, desire and then we will move to demand.
The determinants of demand and all the dimensions of law of demand will be discussed in detail.
We will then move to the components of supply. The interplay between demand and supply which
leads to equilibrium price will be discussed in the last part of the chapter.

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2.1 Demand
There are three terms that are used interchangeably by common people while talking about the
goods and services they purchase- want, desire and demand. However, in economics all the three
terms have different meaning. A person may desire
to have a multi-story house in a posh locality, but
this desire will only turn into demand if the Demand is quantity of goods or service
individual has enough money to buy it. Demand purchased at a given price within a
for a good or service is defined as “quantity of fixed period and other things remaining
goods or service purchased at a given price within the same
a fixed period and other things remaining the
same (ceteris paribus)”. The willingness to buy the product backed by the ability to buy makes a
want or a desire a demand. Demand is effective desire as it is backed by the willingness and ability
to pay.

Determinants of demand
The various determinants of demand are the following

Price of the good

The price of the good and the demand generally have a negative
relationship. It is considered to be the most important
Price and demand have
determinant of demand. If other determinants are held
negative relationship.
constant, if the price of the good goes up then the demand for
the product will go down and if the price goes down then the
demand will increase. This is a very common phenomenon which we observe in all the markets.
For example, tomato ketchup is made when tomato prices are low, people shop more when sales
are announced etc. The inverse relationship between price and demand is also known as the Law
of Demand (this will be discussed in the next part).

Income of the consumer

There is a direct relationship between demand and income of the consumer. As the income of the
consumer increases, demand for goods and services also go
Income and demand have up. There is a limit to which the consumption will increase
positive relationship. with the increase in income. Engel (1857) first mentioned the
fact that with increase in income after a point, there is a
decline in consumption expenditure, especially of food. This has given rise to two types of goods-
normal goods and inferior goods. Normal goods are the
ones whose demand has positive relationship with
Normal goods have positive
income. Inferior goods are the ones whose demand falls
relationship between income and
with the increase in income. Classic example from India
demand. Inferior goods have
is the demand for coarse grains which has gone down
negative relationship with income.
amongst the low-income group as they have started
consuming wheat with increase in income. People also
substitute better quality of goods like ghee for oil, real gold or silver jewellery in place of brass or
other cheap metal jewellery.

Price of related goods

This is the third most important factor which determines demand. In this the demand for a
commodity is dependent on another commodity which may be a substitute or complementary.
Substitute goods are those which can be used in place of another. Example is toothpaste and
toothpowder. Complementary goods are those which must be used together to enjoy complete
satisfaction of consumption. Example pen and ink which need to be consumed together. The
behaviour of demand in response to price changes depending on whether they are substitutes or
complementary. In case of substitutes, there is direct
relationship between price and demand that is if
In case of substitutes, there is direct the price of toothpaste increases, then the demand
relationship between demand and for toothpowder will go up. In case of
price. In case of complementary goods, complementary goods, there is inverse relationship
there is inverse relationship between between price and demand. It means that if the
the two variables. price of pen goes up, then the demand for ink goes
down.

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Unit 02: Demand and Supply Analysis

Taste and preferences
This is a qualitative factor that impacts the demand for a product. Factors like age, gender, place of
residence, education, profession, advertising etc impact the taste and preference of the consumer
which in turn effects the demand for a product. Many a times we see an exception to the law of
demand because of the taste and preferences of the consumers. The companies in the free market
advertise to influence the taste and preferences of the consumers.

Advertising
Advertising has gained remarkable grounds as a determinant of demand especially in the modern
age of cutthroat competition among brands. Firms make heavy expenditure on advertising to
generate awareness about the various features of the product like price, quality, and its placement
in the society. The primary motive behind advertising is to stimulate demand for the brand. There
are instances when advertisement has changed the tastes and preferences of the people to such an
extent that the lifestyles of changed. In India it is very common to gift sweets on any happy
occasions however Cadbury India roped in Amitabh Bachchan as a celebrity endorser with the
tagline kuchh meetha ho jaaye. This brought about a change in the consumption pattern where
people have started moving away from traditional sweets to chocolates as gifts during festive
occasions. Another example is of Virat Kohli endorsing Too Yum, a baked snack which is
considered to be a healthy alternative to other fried snacks. A factor which needs to be kept in mind
regarding advertisement is that it is very expensive and adds to the cost of the product. Therefore,
it must be used very judiciously so as to balance out the negatives from the benefits of
advertisement.

Consumer’s expectation of future income and price

Consumers do not make purchases only based on current income and current price structure. In
case of durables when demand can be postponed, consumers decide their purchase based on future
price and income. If they expect their income to increase or price to fall in future, they will postpone
the demand; on the other hand, if they expect prices to increase in future they will hasten the
purchase. An example is the purchase of cars which is influenced by the announcements made in
the budget.

Population
Size of the population, age distribution and gender distribution affect aggregate demand.If the
population of a country is constantly increasing, more food items and other goods and services are
required to satisfy the needs of the people.Age distribution determines what kind of commodities
will be demanded if the population is mostly young as in the case of India, the demand for
development goods like education, employment, FMCG will be high.On the other hand, if we have
old population then the demand for health-related products will be high.

2.2 Law of Demand

Table1: Market Demand Schedule
Price 𝑄𝐷1 𝑄𝐷2 𝑄𝐷3 𝑄𝑀
20 0 2 3 5
15 1 2 5 8
10 2 3 7 12
5 3 4 8 15

This table shows the demand for samosa in three different markets and then the combined demand
is shown as market demand. It is very evident from this example that there is an inverse
relationship between demand and price. We can observe that as the price of samosa is going down,
the demand is increasing in all the markets. This is the law of demand.
The Law of demand explains the functional relationship between price of a commodity and the
quantity demanded of the commodity. It is observed that the price and the demand are inversely
related which means that the two move in the opposite direction. An increase in the price leads to a
fall in quantity demanded and vice versa. This relationship can be stated as “Other things being
equal, the demand for a commodity varies inversely as the price”.

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Price

Quantity
Fig.1 Demand Curve
This figure is a graphical representation of the law of demand. The demand curve DD is downward
sloping because of the inverse relationship between the two variables.

Changes in Demand
The demand for a product can change on two accounts, firstly if the price of the commodity
changes and secondly if factors other than price change.In case of the price changing there is a
movement along the demand curve.It leads to expansion or contraction in demand which shows
the effect of change in price on change in demand.

Price
D

P B

P1 A

X X1 D’ Quantity

Fig.2: Expansion and Contraction in Demand

This graph shows the relationship between price and demand when the price is P the demand is X
when the price reduces to P1 the demand increases to X1.There is a movement from point B to
point A in the same demand curve DD’. This shows the expansion in demand.
On the other hand, if factors other than price change the effect of demand is shown by a shift in the
demand curve. The demand curve shift outwards in case of an increase and it may shift inwards in
case of a decrease in demand. An important point that needs to be kept in mind when there is an
increase or decrease in demand is that the price of the product remains constant at the same price
the demand curve shifts which shows the impact on demand
D2
Price
D

D1

X X1 D1 X2 D’ D2
Quantity

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Unit 02: Demand and Supply Analysis

Fig. 3: Increase and Decrease in Demand
The above figure shows the change in demand because of factors other than price. It is evident from
this figure that the original demand curve is DD and when the price is P the demand for the
product is X1.The demand curve then shifts to D1D1 and there is no change in price but the
quantity demanded comes down to X. Similarly the demand curve shift to be to D2D2 and again
there is no change in price but there is increase in demand to X2.This shift in the demand curve
from DD to D1D1 and D2D2 shows the increase or decrease in the demand because of factors other
than price.

2.3 Exceptions to the Law of Demand

Giffen goods
The case of Giffen goods needs to be introduced to understand it in the correct context.This is a
concept that was given by Sir Robert Giffen and it has been named after him.These are the goods
which are considered inferior by the consumers but in the individual consumption basket they
occupy a significant place. Historically the example that was given was from Ireland regarding the
consumption of meat and bread. Bread was the inferior commodity and with the increase in price
the consumption of bread went up as it was still the cheapest food. In India we often give the
example of wheat and bajra because as the price of the coarse grains increased the consumption
also increased till the time the price of wheat did not come down.

Snob appeal
It is the opposite of Giffen goods these are those goods for which the consumer measure measures
the satisfaction not by their utility but by the social status it is an example of vicious consumption
where the demand for the social status of the product the most common example of this is the
diamonds which are which do not have any resale value but they are both because of their status of
social value there are similar products in the market another example is iPhone which is consumed
more for its social value than its real value. These goods are also known as Veblen goods which has
been named after the famous economist Thorstein Veblen who gave the concept of Veblen paradox.

Demonstration effect
These are those goods which are consumed by the behaviour of others. When a person's behaviour
is influenced by observing the behaviour of others then it is known as demonstration effect. One of
the very common examples is fashion where people buy clothes by looking at the consumption
pattern of others. The demand for most of the luxury products are governed by the demonstration
effect. In all these cases price is not a governing parameter but rather the people around you who
consume it influence the behaviour.

Future expectation of prices

It has been observed that when the prices are rising and it is expected that they will continue to rise
in future, consumers buy more to keep a stock of the good. This happens when there is a natural
calamity like a famine or a flood. People expect that because of these natural calamities there will be
a shortage of supply of goods, and they anticipate an increase in the prices, so they stock a good
amount of this commodity. Mainly the product that is stocked is food grains. Share market is
another example where the demand of the shares is directly related to the share prices. As per the
rules of speculation it is anticipated that if the prices are going up for a particular stock, then the
demand would increase and does become an exception to the law of demand.

Insignificant proportion of income spent

Things which are of very low value like Salt, Matchbox, Pitambari (substance used to clean brass
metals in India) are not impacted by the price of the product they have got limited use and
therefore a very insignificant amount of the income spent on them even if there is a large increase in
the price of these products it has negligible impact on the money spent as these goods have limited
use the people cannot increase their consumption significantly.

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2.4 Market Supply
Supply is the specific quantity of output that the producers are willing and able to make available
to consumers at a particular price over a given period. In one sense, supply is the mirror image of
demand. Individuals’ supply of the factors of production or inputs to market mirrors other
individuals’ demand for these factors. For example, if we want to rest instead of weeding the
garden, we hire someone: we demand labour. For many goods, however, the supply process is
more complicated than demand.

Supply is not simply the number of a commodity a shopkeeper has on the shelf, such as10 oranges
or 10 packet of chips, because supply represents the entire relationship between the quantity
available for sale and all possible prices charged for that good. The specific quantity Notes desired
to sell of a good at a given price is known as the quantity supplied. Typically, a time period is also
given when describing quantity supplied. For example, when the price of an umbrella is 100, the
quantity supplied is 500 umbrellas a week.

The supply of produced goods (tangibles) is usually indirect, and the supply of non-produced
goods (intangibles) are more direct. Individuals supply their labour in the form of services directly
to the goods market. For example, an independent contractor may repair a washing machine. The
contractor supplies his labour directly.

2.5 Determinants of Supply

These are the following determinants of supply.

Price of the commodity

Just like demand the most important determinant of supply is price. But unlike demand supply is
positively related to price of the commodity. With all the factors remaining the same if the price of
product rises supplies would find it profitable to sell more. Thus, price has a positive effect on
quantity supplied. Relation between price and quantity supplied is the basis of law of supply.

Cost of production
Production requires the transformation of various inputs into output and involves cost that
includes price of all the inputs like wages, rent, interest and profit.If the cost of production
increases because of the increase in the price of all or certain raw material supply will automatically
get reduced. For example, there is a manufacturer of cotton shirts. If the price of raw cotton
increases, then the cost of production of shirts would go up and as a result the supply of shirts will
come down.

State of technology
Technology has positive relation with supply and improved technology reduces the cost of
production per unit of output which enhances the productivity and in turn increases the supply of
the product. In current times there has been mechanization in agriculture and therefore the
productivity has gone up. As a result, the production of food grains has increased exponentially in
India.

Number of firms
With increase in the number of producers of a particular product the supply of the product in the
market will increase if the entries and restricted new forms will continue to enter the market does
increasing the supply and degree of competition this is an example of a perfectly competitive
market however in an imperfect market like a monopolistic competition where the supply when the
entry of firms is relaxed the supply of products goes on increasing in the long run the aggregate
supply of the product curve shifts right due to an increase in the supply of the product which is
visible in a perfectly competitive market

2.6 Law of Supply

According to the Law of Supply, other things remaining constant, higher the price of a
commodity,higher will be the quantity supplied and vice versa. There is a positive relationship
between supply and price of a commodity.
As in the case of quantity demanded, price is the major
determinant of quantity supplied. In graphical terms The Law of Supply states that
other things remaining the
same, the higher the price of a
commodity, the greater is the
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Unit 02: Demand and Supply Analysis

supply refers to the entire supply curve because a supply curve tells us how much of a commodity
will be offered for sale at various prices. Quantity supplied refers to a point on a supply curve. In
case, the price of a good rises, individuals and firms can rearrange their activities in order to supply
more of that good to the market, substituting production of that good for production of other
goods.
With the firms, there is another explanation. Assuming firm’s costs are constant, higher price means
higher profits (the difference between a firm’s revenues and its costs). The expectation of those
higher profits leads it to increase output as price rises, which is what the law of supply states.
Fig. 4: Law of Supply

Shift in Supply Curve

2.7 Equilibrium
You must have understood by now that demand and supply are interrelated. Ata particular price
the quantity bought by the buyer as well as the quantity sold by the seller are both performed
willingly. We know the prices of the goods before we buy them. Similarly, the seller knows the
prices of the goods before he supplies it to the market. Naturally, a point of meeting of the demand
and supply has to be there and this is the point of market equilibrium (Fig.7). The market
equilibrium is a point where the supply and demand are balanced, other things remaining constant.
Graphically, it can be represented as given below. We can notice that the equilibrium is achieved at
Rs. 30, (Table.2) when both the quantity supplied and the quantity demanded are in equilibrium or
perfectly matched.
Table 2: Relationship between Price and Quantity Supplied and Quantity Demanded

Price per pen Demand Supply

10 200 75

20 175 115

30 150 150

40 100 200

When the market price is less than equilibrium price, the demand for the commodity will be more
than what can be supplied. In the above example if the price is Rs.20 per pen, the demand will be
175 numbers while the supply will be 115numbers. More consumers will want to buy it at that price
but the supplier will not supply at such a low price. When the price is above or more than the
equilibrium price, the demand will come down, as people will not be willing to pay that much and

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Managerial Economics
wait for the prices to fall. When the market price increases to Rs.40, the demand will fall to 100
numbers even though the suppliers will be willing to supply 200. An excess supply will in this case
lead to losses as the consumers will not buy it.

Summary
Why is the analysis of demand and supply so important? The analysis of the demand for a
particular commodity determines the quantity to be supplied into the market. We have seen that
various factors affect the demand as well as supply. A sum total of all the factors or influences,
determine the demand as well as the supply. We know the goods are always scarce or limited and
the wants are unlimited. All other things remaining unchanged, i.e., income, government, policies
and special influences, price is the major fact that distributes the scarce goods among the demand
of various consumers. When the production falls, supply falls, prices rise and the demand gets
adjusted accordingly. When there is increase in production as a result of better technology or
reduction in the cost of production, prices fall and the demand gets adjusted accordingly. Analysis
of the demand and supply is thus crucial while studying any sector.

Keywords
Demand Curve: The graphical representation of the demand schedule is called the demand curve.
Demand Schedule: The tabular representation of quantity, demand and price.
Demand: Demand is the quantity of goods (or services) that can be purchased by buyer at a
particular price.
Equilibrium Price: The price at which the demand and supply are in equilibrium.
Law of Demand: The law of demand states that demand is inversely proportional to price, i.e., for
an increase in price the quantity demanded decreases.
Law of Supply: The law of supply states that for an increase in price the supply also increases.
Market Demand: The sum of all individual demand is called the market demand.
Supply Curve: The graphical representation of the supply schedule is called the supply curve.
Supply Schedule: The tabulation representation of quantity supplied and price.
Supply: Supply refers to the quantity of good or commodities that are supplied to the market at a
particular price.

Self Assessment
1. Which of the following is not a determinant of a consumer's demand for a commodity?
A. Income

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Unit 02: Demand and Supply Analysis

B. Population
C. Prices of related goods
D. Tastes
2. The law of demand refers to them
A. inverse relationship between the price of a commodity and the quantity demanded of the
commodity per time period.
B. direct relationship between the desire a consumer has for a commodity and the amount
ofthe commodity that the consumer demands.
C. inverse relationship between a consumer's income and the amount of a commodity that
the consumer demands.
D. direct relationship between population and the market demand for a commodity.

3. If the price of a good increases, then

A. the demand for complementary goods will increase.
B. the demand for the good will increase.
C. the demand for substitute goods will increase.
D. the demand for the good will decrease.

4. If consumer income declines, then the demand for

A. normal goods will increase.
B. inferior goods will increase.
C. substitute goods will increase.
D. complementary goods will increase.

5. Which of the following will cause a decrease in quantity demanded while leaving demand
unchanged?
A. An increase in the price of a complementary good.
B. An increase in income when the good is inferior.
C. A decrease in the price of a substitute good.
D. An increase in the price of the good.

6. The market supply curve shows

A. the effect on market demand of a change in the supply of a good or service.
B. the quantity of a good that firms would offer for sale at different prices.
C. the quantity of a good that consumers would be willing to buy at different prices.
D. All of the above are correct.

7. If automobile manufacturers are producing cars faster than people want to buy them,
A. there is an excess supply and price can be expected to decrease.
B. there is an excess supply and price can be expected to increase.
C. there is an excess demand and price can be expected to decrease.
D. there is an excess demand and price can be expected to increase.
8. If a computer software company introduces a new program and finds that orders from
wholesalers far exceed the number of units that are being produced,
A. there is an excess supply and price can be expected to decrease.
B. there is an excess supply and price can be expected to increase.
C. there is an excess demand and price can be expected to decrease.

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Managerial Economics

D. there is an excess demand and price can be expected to increase.

9. An increase in the supply of a good will cause

A. an increase in equilibrium price and quantity.
B. a decrease in equilibrium price and quantity.
C. an increase in equilibrium price and a decrease in equilibrium quantity.
D. a decrease in equilibrium price and an increase in equilibrium quantity.

10. Assume that firms in an industry observe a 10% increase in the productivity of labor, but
to get there they had to increase the cost of labor by 5%. What should be expected to
happen in the output market as a result of this development?
A. The supply should increase
B. The supply should decrease
C. The supply should remain unchanged
D. The demand should increase

11. Market equilibrium refers to a situation in which market price

A. is high enough to allow firms to earn a fair profit.
B. is low enough for consumers to buy all that they want.
C. is at a level where there is neither a shortage nor a surplus.
D. is just above the intersection of the market supply and demand curves.

12. If the price of a good increases while the quantity of the good exchanged on markets
increases, then the most likely explanation is that there has been
A. an increase in demand.
B. a decrease in demand.
C. an increase in supply.
D. a decrease in supply.

13. If the price of a good decreases while the quantity of the good exchanged on markets
increases, then the most likely explanation is that there has been
A. an increase in demand.
B. a decrease in demand.
C. an increase in supply.
D. a decrease in supply.

14. If the price of a good increases while the quantity of the good exchanged on markets
decreases, then the most likely explanation is that there has been
A. an increase in demand.
B. a decrease in demand.
C. an increase in supply.
D. a decrease in supply.

15. If the price of a good decreases while the quantity of the good exchanged on markets
decreases, then the most likely explanation is that there has been
A. an increase in demand.
B. a decrease in demand.

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Unit 02: Demand and Supply Analysis

C. an increase in supply.
D. a decrease in supply.

Answers for Self Assessment

1. B 2. A 3. D 4. B 5. D

6. B 7. A 8. D 9. D 10. A

11. C 12. A 13. C 14. D 15. B

Review Questions
1. Define demand giving suitable examples example.
2. Distinguish between complementary goods and substitute goods and give suitable examples
from the Indian market.
3. Explain the concept of supply and what are the determinants of law of supply.
4. What are the factors that cause a shift in the demand curve?
5. If the demand is fixed but the supply of the product increases what happens to equilibrium
price and quantity.
6. What are the various exceptions to the law of demand apart from the examples given in this
reading material?
7. Explain the concept of equilibrium.

Further Reading
1. Managerial Economics- Principles and Worldwide Applications By Salvatore,
Dominick and Rastogi, Siddhartha K., Oxford University Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul
G, Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education,
India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary,
McGraw Hill Education (India) Private Limited

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Tanima Dutta, Lovely Professional University Unit 03: Demand Estimation

Unit 03: Demand Estimation

CONTENTS
Objectives
Introduction
3.1 Levels of Demand Forecasting
3.2 Time Horizon for Demand Forecasting
3.3 Categorization by Nature of Goods
3.4 Methods Of Forecasting- Demand
3.5 Nominal Croup Technique
3.6 Methods of Trend Projection
Summary
Keywords
Self Assessment
Answer for Self Assessment
Review Questions
Further Reading

Objectives
• understand the basics of business forecasting
• understand the various methods of forecasting
• evaluate the methods of forecasting

Introduction
Emerging competition in marketplace is propelling managements to hear the voice of their
customers. To survive in the market, management must be forward-looking and carry out market
and demand analyses of products and develop strategic business policies. However, when it comes
to working out methods and methodologies of demand forecasting, it presents a strange dilemma.
Demand Burke had said that "You can never plan the future by the past", whereas Patrick Henry
opines that, "I know of no way of judging the future but by the past". As an essential part of project
formulation and appraisal, market and demand analysis is vital so that capacity and facility
location can be planned and implemented in line with the market requirements. A major error in
demand forecast can throw painstaking capital expenditure on plant capacity and other hardware
facility totally out of gear. Such decisions are not easily reversible. Metal Box of India, a premier
company in the field of metal, plastic and cardboard packaging became kick owing to ill-timed
diversification into manufacture of bearings.

3.1 Levels of Demand Forecasting

Demand forecasting can be at the level of a firm or an industry or at the national or national or
international level:

Firm Level
If the exercise aims at forecasting demand of firm's products locally at state, region or national
level, it is a micro-level of demand forecasting. Sometimes, forecasts are required for company's
products in specific industry or market segment.

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Industry Level
Such a demand forecasting exercise focuses on an industry for the region and/or national level.
These forecasts may be undertaken by a group of companies or by industry/trade associations.

National Level
Demand forecasts at national level include parameters like national income, expenditure, index of
industrial and/or agricultural production etc. Estimating aggregate demand of products at national
level facilitates governmental decisions for imports, exports, pricing policy etc.

International Level
Companies operating in multinational markets would require similar forecasting of demands for its
products, trends in consumption etc. at international level Managerial Economists play a leading
role in masterminding these forecasts at firm, industry, national and international levels. Time
horizon of these demand forecasts usually varies from 1 to 5 years and in rare instances up to 10
years.

3.2 Time Horizon for Demand Forecasting

Market and demand analysis of various types are undertaken to meet specific requirements of
planning and decision making. For example, short-term decisions in production planning,
distribution etc. and selling individual products would require short-term forecast, up to one year
time horizon, which must be fairly accurate for specific product items. For long-term planning, time
horizon being four to five years, information required from demand analysis would be for broad
product groups for facilitating choice of technology, machine tools and other hardware’s and their
location. Various time horizons and corresponding information requirements are as below:

Short Term Forecasting

Time period is less than one year. Some inputs are fixed, and the others are variable. Manager must
take decision regarding the combination of the variable input and fixed input. The aim is to avoid
overproduction or underproduction in short period.

Long Term Forecasting

Longer-term forecasting is also undertaken to determine trends in technology development to
choose the technology for backing up and funding its research and development. It helps in taking
long term decisions regarding capacity building, investment, manpower planning.

3.3 Categorization by Nature of Goods

The categorization by nature of goods is of two types- Consumer goods and Capital goods.

Consumer Goods
Consumer goods these are the goods which are consumed by people in their natural course. These
are the final product which is ready for consumption. In terms of economics there are intermediate
goods and consumer goods. When we are talking about demand forecasting we talk about the final
consumption goods which are the consumer goods. Examples of consumer goods are clothing food
white products and other such goods which are used in daily life.

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Capital Goods
Capital goods are man-made equipment to produce goods and series. Demand of consumer goods
is autonomous and is forecast by direct measurements. However, demand forecast for capital goods
is indirect and derived. Their demand is dependent upon profitability of the industries using this
equipment and the ratio for production to installed capacity (also called occupacity). For example,
demand for cement manufacturing machinery will depend not only on the profitability of cement
industry by also on the current surplus capacity in the industry. If surplus capacity is low or
negligible, one can expect major expansion of existing cement manufacturing units. Similarly,
demand for commercial vehicles is dependent upon

• growth of Indian economy

• growth pattern of different modes of transport-rail, river, air and sea
• availability of bank finance for leasing etc.
• growth of replacement market of commercial vehicles

Why to go for Demand Forecasting?

All business planning starts with forecasting. Capital investment, like procurement of raw materials
and production planning, must relate to demand forecasting. High volume, high technology, mass
production systems have further high-lighted the importance of accurate demand forecasts. Even in
a batch type production, any major mismatch between forecast and manufacture will lead to higher
capital tied up in finished products which are slow in selling. If we segregate the advantages of
demand forecasting, then the following are the few advantages.

Increase Supply Chain Efficiency

Demand forecasting helps to create a smooth supply chain. When the suppliers are aware of the
demand in the market for their product, they can organize the sales in a non-disruptive manner.
The amount of stock that must be held is also known which ensures efficient utilization of the
resources. The production is better scheduled which helps to schedule the maintenance and
shutdown in a more efficient manner without disturbing the flow of goods. Demand forecasting is
also needed to take advantage of periods when there is spike in demand. When the producers
know the demand pattern in advance, they book raw materials and other inputs in adequate
quantity during high sale season so that supply chain is not disrupted.

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Improve Labour Management

Demand forecasting ensures that labour is used optimally by the organization. The labour use is to
be matched with the sales of the organization. If during the peak season of sales, there is labour
shortage then it poses a problem as buyers would switch to other sellers. This switch might be
temporary but will certainly lead to loosing out certain probable customers. Similarly, if labour is
abundant in comparison to sales, then revenue loss takes place. An important point to be noted
here is that labour management is effective in case of temporary workers. In case of permanent
workers, they cannot be terminated in case of seasonal swing in sales. However, demand
forecasting helps to know the lean periods when labour can be trained, and their skills upgraded.

Insure Adequate Cash Flow

The cash flow of the organization can be maintained adequately when there is demand forecasting.
Inadequate cash hampers the payment to the vendors, and it affects the supply in the organization.
On the other hand, if there is excess cash with the organization it shows ineffective utilization of the
resources. Demand forecasting helps to understand the trend of sales and supply which enables the
organization to maintain adequate cash balance with themselves.

Create Accurate Budgeting

Accurate demand forecasting helps to prepare an accurate budget. Along with the master budget,
an organization should prepare sub budgets for marketing, overheads, cash flow, production, sales.
If the demand has been forecasted with minimal error, then the flexible budget helps the
organization to manage their funds in the most appropriate manner and to shift the funds to the
areas where they are much needed. The payment to the various vendors can also be timed well if
the timing of the sales has been forecasted. If you have a flexible budget, such as tying marketing
spending to sales, you can shift paid marketing efforts such as advertising and free marketing
efforts such as a social media campaign between slow and busy periods.

Criteria for Good Forecasting Method

Accuracy in forecast
Accuracy in forecast is measured in terms of past forecasts against current sales and by the
percentage of deviation from actual demand. It is important to not only check the accuracy of past
forecasts but also the validity of assumptions in practice. Forecasts being future-oriented, cannot be
always accurate although accuracy is the most important criterion.

Plausibility of forecasts
Forecasts of demand must be reasonable, consistent and plausible. Assumptions made should stand
scrutiny and techniques adopted must be commensurate. Explanatory note on these aspects must
be available in the write-up on methods and methodology employed in forecasting.

Economy of forecasts
Forecasting exercise should not be expensive in terms of efforts and costs. Additional costs of ways
and means for improving the accuracy of forecasts should not exceed the extra gain expected.

Quick Results
Method of forecasting chosen should be capable of yielding quick and useful results. If method
selected takes fat too long a time to yield accurate forecast, it may not be conducive for taking quick
and effective decisions. Always remember not to make best enemy of `good'.

Availability and Timeliness

Methodology of forecasting should be such that it can easily be updated when changes occur in the
demand relationships.

Durability
Demand forecasts should not be changed frequently. Durability of forecast is subject to the
followings:

• Simple and reasonable relationship between price and demand, advertisement and sales,
level of income and volume of sales etc
• Stability of relationship between the above variables

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Flexibility
Flexibility of forecast is an added advantage. It is desirable to be able to adjust `coefficient' of
variables from time to time to cope with the changing conditions.

3.4 Methods Of Forecasting- Demand

To facilitate proper and reliable appraisal of investment proposal, we require a reasonably accurate
forecast of demand. Starting with qualitative methods like surveyof collective opinions, buyers'
intention, Delphi approach and its variant, a number of quantitative methods are used for
compiling and computing demand forecasts as detailed below:

Collective Opinion Survey

Sales personnel are closest to the customers and
have an intimate feel of the market. Thus they are
most suited to assess consumers reaction to In consumers’ opinion survey, buyers are
company's products. Herein each salesperson asked about their future buying
makes an estimate of the expected sales in their intentions of products.
respective area, territory, state and/or region,
These estimates are collated, reviewed and revised
to take into account changes in design/features of products, changes in selling prices, projected
advertising and sales promotion campaigns and anticipated changes in competitors: marketing
policies covering product, people, price, promotion and place. Opinions of all managers involved at
various levels of sales organisation are also included in the survey. Thus "collective opinion survey
forms the basis of market analysis and demand forecasting.
Although this method is simple, direct, firsthand, and most acceptable, it suffers from following
weaknesses:

1. Estimates are based n personal judgement which may not be free from bias
2. Adding together demand estimates of individual salespersons to obtain total demand of
the country maybe risky as each person has knowledge about a small portion of market
only
3. Salesperson may not prepare the demand estimates with the requisite seriousness and care
Project Formulation and Appraisal
4. Owing to limited experience, usually in their employment, salesperson may not have the
requisite knowledge and experience
This method may be useful for long-term forecasts. It is also used for new products or new variants
of existing products.

Survey of Customers Intention

Another method of demand forecasting is to carry out a survey of what consumers prefer and
intend to buy. If the product is sold to a few large industrial buyers, survey would involve
interviewing them. If it is a consumer durable product, a sample survey is carried out for
questioning a few representative consumers about what they are planning or intending to buy. It is
neither realistic nor desirable to query all consumers either through direct contact or through
printed questionnaire by mail.
These surveys serve useful purpose in establishing relationships between:

• demand and price

• demand and income of consumers
• demand and expenditure on advertisement etc.
This method is preferred when bulk of the sales is to institutions and industrial buyers and only a
few of them must be contacted.
Disadvantages are that customers may not know total requirements; in some cases, they are not
certain about quantity to be purchased. Besides during shortages there is a tendency to inflate their
requirements. Survey method is not useful for households - interviewing them is not only difficult

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out but also expensive. They are not able to give precise idea about their intentions particularly
when alternative products are available in the market.

Sales force Composite Method

Salespeople are in direct contact with the customers and therefore they are in the best position to
forecast demand. In the sales force composite method, each salesperson is asked about their
estimated sales targets in their respective zones and then the estimated sales of all the salespersons
are added together to get a forecast of future sales. Estimates may also be made by surveying the
sales manager, sales representatives, salespersons, distributors, and others who are directly in
contact with the sales process. This method is preferred because it is easy to administer and is very
cost effective. However, there can be serious issues if the sales targets are over ambitious or the
salesperson is biased. This method is best suited for short term forecasting.

Expert opinion method

in this method opinion is seat from expert regarding demand forecasting there are various sub
methods by which data can be collected and polluted to get the exact figures regarding future
demand.

Group Discussion Method

In this method the people at managerial posts form a group and carry out brainstorming process.
This is a method which was developed by Osborne in 1953. The group discussion may be both
positive as well as negative. Many organizations encourage negative brainstorming to know the
shortcomings of future techniques for augmenting sales. In the current pandemic situation this
method has been widely used as physical presence of experts was not required and brain storming
could be carried over various online platforms.

Delphi Method of Demand Forecasting

This method was developed by RAND Corporation at the beginning of the cold war. Delphi
method is a group process and aims at achieving a `consensus ‘of the members. Herein experts in
the field of marketing research and demand forecasting are engaged in

• analyzing economic conditions

• carrying out sample surveys of market conducting opinion polls
Based on the above, demand forecast is worked out in following steps:

1. Coordinator sends out a set of questions in writing to all the experts co-opted on the panel
who are requested to write back a brief prediction.
2. Written predictions of experts are collated, edited, and summarized together by the
coordinator.
3. Based on the summary, Coordinator designs a new set of questions and gives them to the
same experts who answer back again in writing.
4. Coordinator repeats the process of collating, editing, and summarizing the responses.
5. Steps 3 and 4 are repeated by the coordinator to experts with diverse backgrounds until
consensus is reached.
If there is divergence of opinions and hence conclusions, Coordinator has to sort it out through
mutual discussions. Coordinator has to have the necessary experience and background as he plays
a key role in designing structured 'questionnaires and synthesizing the data.
Direct interaction among experts is avoided nor their identify is disclosed. Procedure also avoids
inter-personnel conflicts nor strong-willed experts are able to dominate the group. This method is
also used for technology forecasting.

Market simulation
Market simulation is a method where laboratory is created to understand the behaviour of the
customers. The organisation creates a virtual market, and the customers are asked to shop with
some given money. In this virtual market which is created the organization of the behaviour off the
consumers to understand their buying pattern. This is different from a survey method because here

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Unit 03: Demand Estimation

it is not asked what the consumer will buy but rather the consumer is observed to get a real time
analysis of the behavioural pattern of the consumer.
Grabor-Granger test is a very commonly used method for market stimulation this is a method that
was developed in the 1960s where the customers were divided into two groups. One group was
shown the current product first and then they were shown the new product. On the other hand, the
other group was shown the new product right away and their behaviour was observed.
The market simulation method is very useful because it tells the actual behaviour of the customers
and how they react to changes in the product, their packaging, the size of the product, their
placement in the market, and other changes which the organization wants to bring about in the
product.

3.5 Nominal Croup Technique

This is a further modification of Delphi method of forecasting. A panel of seven to ten experts is
formed and allowed to interact, discuss 'and rank all the suggestions in descending order as per the
following procedure:

1. Experts sit around a table in full view of one another and are asked to speak to each other.
2. Facilitator hands over copies of questionnaire needing a forecast and each expert are
expected to write down a list of ideas about the questions.
3. After everyone has written down their ideas, Facilitator asks each expert to share one idea
out of own list with the group. The idea shared is written on the `flip chart' which
everyone can see.
4. Experts give ideas in rotation until all of them are written on the `flip chart'. No discussion
takes place in this phase and usually 15 to 25 ideas emerge from this format.
5. In the next phase, experts discuss ideas presented by them. Facilitator ensures that all
ideas have been adequately discussed. During discussions similar ideas are combined and
paraphrased appropriately. This reduces the number of ideas.
6. After completing group discussions, experts are asked to give in writing ranks to ideas
according to their perception of priority.

Simple Average Method

Among the quantitative techniques for demand analysis, simple Average Method is the first one
that comes to one's mind. Herein, we take simple average of all past periods - simple monthly
average of all consumption figures collected every month for the last twelve months or simple
quarterly average of consumption figures collected for several quarters in the immediate past. Thus
𝑆𝑢𝑚 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑𝑠 𝑜𝑓 𝑎𝑙𝑙 𝑝𝑒𝑟𝑖𝑜𝑑𝑠
𝑆𝑖𝑚𝑝𝑙𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

Moving Average Method

Method of Simple Average is faulted because of all past periods are given same importance
whereas it is justifiable to accord higher importance to recent past periods. Moving Average
Method takes a fixed number of periods and after the elapse of each period, data for the oldest time
period is discarded and the most recent past period is included. Whatever the period selected, it
must be kept constant – it may be three, four or twenty periods by once it decided, we must
continue with same number of periods.
𝑆𝑢𝑚 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑𝑠 𝑜𝑓 𝑐ℎ𝑜𝑠𝑒𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠
𝑆𝑖𝑚𝑝𝑙𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐ℎ𝑜𝑠𝑒𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

Weighted Moving Average

In Moving Average Method, weighted given to the selected number of periods is same. This has
been refined to include the Weighted Moving Average which allows varying weightages for
demands in old periods. Depending upon the age of the period, with-age can be varied:

𝑊𝑒𝑖𝑔𝑡𝑒𝑑 𝑀𝑜𝑣𝑖𝑛𝑔 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑊1𝐷1 + 𝑊2𝐷2 + ⋯ . 𝑊𝑛𝐷𝑛

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Managerial Economics

Where W1, W2, ..Wn are the weights for the different time periods in percentages so that
W1+W2+….Wn=1
This method has the advantage that it allows forecaster to compensate for some known trend in
demand or seasonality of demand by carefully fitting appropriate coefficients of weighted to those
periods. The weightages have to be decided by the forecast analysts and this decision is critical to
the accuracy of demand forecast.

Regression Analysis
Past data is used to establish a functional relationship between two variables. For example, demand
for consumer goods has a relationship with disposable income of individuals and family; demand
for tractors is linked to the agriculture income and demand for cement, bricks etc. is dependent
upon value of construction contracts at any time. Forecasters collect data and build relationship
through co-relation and regression analysis of variables.

Econometric Models
Econometric models are more complex and comprehensive as they interweave different factors
together simultaneously. For example, demand for passenger transport is not only dependent upon
the population of the city, geographical area, industrial units, their location etc.

Time Series Analysis

In this section, we continue to explore time series forecasting. However, instead of visual
estimation, a more precise statistical technique will be employed: the method of least squares. This
method was introduced earlier in this chapter and was used to estimate demand. Whereas demand
estimation requires the use of one or more independent variables, and the interactive relationship
between these variables is of great importance, in the context of time series analysis there is only
one independent variable: time. Thus, this system of forecasting is “naive” because it does not
explain the reason for the changes; it merely says that the series of numbers to be projected changes
as a function of time.

Despite the mechanical nature of this type of forecast, time series analysis has much to recommend
it:
1. It is easy to calculate. A large number of software packages is available.
2. It does not require much judgment or analytical skill by the analyst.
3. It describes the line with the best possible fit and provides information regarding
statistical errors and statistical significance.
4. It is usually reasonably reliable in the short run, unless an absolute turn in the series
occurs.

The fact that time series analysis does not take into consideration causative factors does not mean
that an analyst using this method should not consider additional information about changes in the
underlying forces. Any analyst using this naïve method of prediction should try to fine-tune the
conclusions based on information that could alter the results.

When data are collected over several periods in the past, they usually exhibit four different
characteristics:

Trend
This is the direction of movement of the data over a relatively long period of time, either upward or
downward.

Cyclical fluctuations
These are deviations from the trend due to general economic conditions. For instance, if one were to
observe data for the GDP over time, a long-run upward trend would be evident. Also evident in
this series would be movement around that trend as the economy rises more quickly or less quickly
(or actually declines).

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Unit 03: Demand Estimation

Seasonal fluctuations
A pattern that repeats annually is characteristic of many products. Fashions have spring and fall
seasons. In the soft drink industry, the expectation is for higher sales during the warmer period’s of
the year (i.e., June through September). Thus, time series in which data are collected more
frequently than annually (monthly, quarterly) can exhibit seasonal variations.

Irregular
Departures from norm may be caused by special events or may just represent “noise” in the series.
They occur randomly and thus cannot be predicted.

3.6 Methods of Trend Projection

There are three methods by which the trend can be projected they are the graphical method the
least square method and the ARIMA(Box Jenkins method).

Graphical Method
In the graphical method the past values of the variables are shown on the vertical axis and time is
taken on the horizontal axis. The data is then plotted on a graph and a line is passed through them
the movements of the series is assessed and future values off the variable of forecasted.

Sales
300 260
225
250
175 190
200 150 162
Sales

150
100
50
0
2015 2016 2017 2018 2019 2020
Year

In the above figure the sales data for six years have been plotted. dub graph shows that sales has
been increasing over the period of time. The problem with this method is that the projections are
not very accurate as it's very simple method without applying much technique.

Least square method

least square method is a very powerful play to estimate the coefficients off a linear function it is a
statistical method which uses the minimizations of squared deviations between the line of best fit
and the original observations. It is an algebraic method baby fit the data on a variable and time in
the form of an equation and then we predict demand for a future period. These equations are
turned as normal equations and the task of least squares method is to find the values of the
coefficients in these equations.
the equation for linear trend is given as follows
𝒀 = 𝒂 + 𝒃𝑿
where a is the intercept of the demand curve, be is the slope of the curve which is also termed as the
regression coefficient and ex is the deviation from mean of the independent variable, in this case
time. the normal equation in this model would be
Ʃ𝒀 = 𝒏𝒂 + 𝒃ƩX
ƩXY= a Ʃ𝐗 + 𝐛ƩX2
In order to solve the trend equation, we need to solve these two simultaneous equations by the
principle of least square. the values of the coefficients as obtained on solving the normal equations
are

a= 𝑌 − 𝑏𝑋

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Managerial Economics

Ʃ(𝑌 − 𝑌)(𝑋 − 𝑋)
𝑏=
Ʃ(𝑋 − 𝑋)
once the coefficients of the trend equation are estimated we can easily predict the trend for future.
Least square estimation is also used extensively to estimate regression equations.

ARIMA method
the autoregressive integrated moving average (ARIMA) method has been given by Box and Jenkins
and therefore it is also known as the Box-Jenkins method. It is considered to be one of the most
sophisticated techniques of forecasting as it combines moving average and autoregressive
technique. This method is very useful when the series are very complicated and there is no definite
pattern to the data. However, we need sophisticated computer software to use this method, we can
use Eviews software for the calculation, but this makes it a bit complex and is not very popular
among people.

Summary
Economic and financial evaluation of an investment proposal must always-be used on reasonably
accurate market and demand analysis for forecasting. Depending upon demand pattern,
length/time horizon of forecast, level of noise and degree of accuracy required, a suitable method
of demand forecasting should be selected as cost of operating not-so-accurate forecast can be
exorbitant. Although forecasts are usually made with the help of statistical models, individuals can
use the past data intuitively and forecast future events. The experience confirms that with a host of
factors impacting on demand pattern --- noise level, complexity of operation etc., subjective
approach decreases the level of accuracy. Forecasting models are more reliable methods of
ascertaining demand although a few individuals can consistently forecast better than models.

Keywords
Compound growth rate: Forecasting by projecting the average growth rate of the past into the
future.
Delphi method: A form of expert opinion forecasting that uses a series of written questions and
answers to obtain a consensual forecast, most employed in forecasting technological trends.

Econometric forecasting model: A quantitative, causal method that uses several independent
variables to explain the dependent variable to before cast. Econometric forecasting employs both
single- and multiple-equation models.

Economic indicators: A barometric method of forecasting in which economic data are formed
into indexes to reflect the state of the economy. Indexes of leading, coincident, and lagging
indicators are used to forecast changes in economic activity.

Moving average method: A smoothing technique that compensates for seasonal fluctuations.
Naive forecasting: Quantitative forecasting that projects past data without explaining the
reasons for future trends.

Self Assessment
1. Which of the following is not true for forecasting?
A. Forecasts are rarely perfect
B. The underlying casual system will remain same in the future
C. Forecast for group of items is accurate than individual item
D. Short range forecasts are less accurate than long range forecasts

2. A qualitative forecast
A. predicts the quality of a new product.
B. predicts the direction, but not the magnitude, of change in a variable.
C. is a forecast that is classified on a numerical scale from 1 (poor quality) to 10 (perfect
quality).

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Unit 03: Demand Estimation

D. is a forecast that is based on econometric methods.

3. Which of the following is not a qualitative forecasting technique?

A. Surveys of consumer expenditure plans
B. Perspectives of foreign advisory councils
C. Consumer intention polling
D. Time-series analysis

4. The first step in time-series analysis is to

A. perform preliminary regression calculations.
B. calculate a moving average.
C. plot the data on a graph.
D. identify relevant correlated variables.

5. Forecasts are referred to as naive if they

A. are based only on past values of the variable.
B. are short-term forecasts.
C. are long-term forecasts.
D. generally, result in incorrect forecasts.

6. Time-series analysis is based on the assumption that

A. random error terms are normally distributed.
B. there are dependable correlations between the variable to be forecast and other independent
variables.
C. past patterns in the variable to be forecast will continue unchanged into the future.
D. the data do not exhibit a trend.

7. Which of the following is not one of the four types of variation that is estimated in time-
series analysis?
A. Predictable
B. Trend
C. Cyclical
D. Irregular

8. The cyclical component of time-series data is usually estimated using

A. linear regression analysis.
B. moving averages.
C. exponential smoothing.
D. qualitative methods.

9. In time-series analysis, which source of variation can be estimated by the ratio-to-trend

method?
A. Cyclical
B. Trend
C. Seasonal
D. Irregular

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Managerial Economics

10. Trend projection is an example of which kind of forecasting?

A. Qualitative
B. Time-series
C. Barometric
D. Econometric

11. Turning points in the level of economic activity can be forecast by using
A. Time-series analysis
B. Exponential smoothing
C. Barometric methods
D. Moving average

12. Econometric forecasts require

A. accurate estimates of the coefficients of structural equations.
B. forecasts of future values of exogenous variables.
C. appropriate theoretical models.
D. all of the above.

13. Delphi method is used for

A. Judgmental forecast
B. Time series forecast
C. Associative model
D. All of the above

14. A linear trend equation has the form

A. X=a-bt
B. X=a+bt
C. X=2a-bt
D. X=2a+bt

15. If regression analysis is used to estimate the linear relationship between the natural
logarithm of the variable to be forecast and time, then the slope estimate is equal to
A. the linear trend.
B. the natural logarithm of the rate of growth.
C. the natural logarithm of one plus the rate of growth.
D. the natural logarithm of the square root of the rate of growth.

Answer for Self Assessment

1. D 2. B 3. D 4. C 5. A

6. C 7. A 8. D 9. C 10. B

11. C 12. D 13. A 14. B 15. C

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Unit 03: Demand Estimation

Review Questions
• Why is demand forecasting important for organizations?
• What are the qualitative methods of forecasting?
• Critically evaluate the qualitative and quantitative techniques of forecasting?
• How is the market simulation method better than the survey method?
• If you have to forecast the sale of besan (chickpea flour) for your organization, what
method would you use and why?

Further Reading
• Managerial Economics- Principles and Worldwide Applications by Salvatore,
Dominick and Rastogi, Siddhartha K., Oxford University Press.
• Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul G,
Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education, India
• Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary, McGraw
Hill Education (India) Private Limited

42 LOVELY PROFESSIONAL UNIVERSITY

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Tanima Dutta, Lovely Professional University Unit 04: Cost Theory and Estimation

Unit 04: Cost Theory and Estimation

CONTENTS
Objectives
Introduction
4.1 Kind of costs
4.2 Short Run Cost
4.3 Long Run Cost
4.4 Economies of scale
4.5 Learner curve
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further readings

Objectives
Define the cost function and explain the difference between a short-runand a long-run cost
function.
Define the various types of cost
Analyse costing in the short run and long run
Evaluate the concept of economies of scale
Analyse Learner Curve

Introduction
Ms Tulika was opening a new Oxygen plant looking at the business opportunity and
the social requirement. She had approached a company manufacturing the machine
for oxygen making and the price quoted by the firm was INR 2 crores. Her bank
approved her loan for the said amount. Suddenly while surfing the net for business
opportunities to learn more about oxygen plants, she came across another firm from
New Delhi which is manufacturing and supplying oxygen making plants. She spoke to
her other business partners and they decided to contact the new vendor. She visited
their website but was not able to get much information from there. She then called at
the number that was given in the website. She spoke to Swati who informed her that it
was her father who carried out the dealing part. on contacting they found out that this
firm was supplying the same machine for rupees 1,00,00,000. Initially the partners
were surprised about the validity of this new firm as there was a 50% reduction in the
cost. They then decided to contact the firm
in person and went to New Delhi to have
Cost is a sacrifice orforegoing that
a look at their office. On visiting the site
hasoccurred or has potential to
define and out that this new firm was
occur in future,measured in
assembling the plant and one of the parts
monetary terms.
was being imported from Germany.
However, as deva buying things in bulk
quantity and they had a higher sales turnover than the previous vendor they were able
to cut costs.

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Managerial Economics

Whatever we are buying repay a particular price for the product. The product that what buy us go
through a production process and at every step of this process some value addition is done. There
are costs that must be bornefor the value addition which may be monetary or non-monetary. Cost is
the sacrifice that is made to produce a product. In economics we take both the costs to have a better
understanding of the production process add this also helps with the firms to realise their objective
which may be profit maximization or sales maximization. In either case the cost plays a very
important role to determine the price of the product.The total cost along with the total revenue help
to determine the profit of a firm. The price of the product is determined on the basis of the cost of
the firm.

4.1 Kind of costs

There are variety of costs which arises in an organization as per the circumstances. The cost may be
monetary cost or non monetary costs. There are number of implicit costs as well in the organization
specially if the organization is a sole proprietorship or a small firm which is just starting up.Asper
deep concepts of economics cost is a function of output and there is difference between accounting
cost and economic cost. In this section we will discuss the various types of costs which accrue to a
firm.

1. Accounting costs: the accounting section of an organization only takes into account that
cost those costs which can be measured in terms of money they are also known as nominal
costs a few examples of these costs are the wages and salaries paid rent paid advertising
expenses selling expenses, interest on loans, stationary charges, telephone charges, etc.
another names given for these type of course is explicit costs which means that these costs
are tangible and the organization is aware of them. These costs are recorded in the books
of accounts.
2. Real cost: the real costs are much wider in scope and cover all the aspects regarding costs
for the production of a unit of the product it also includes the non monetary costs all the
psychological costs which accrue to a firm. for example if a new start up is Bing organized
the owners sacrifices on his time with his family his friends, uses his own resources. These
sacrifices cannot be measured in terms of money but they are cost to the production. They
are known as real costs. however, as per the accounting principles it does not qualify as
cost because there is no flow of cash in these transactions and therefore they do not
become a part of the book of accounts. in modern time the real costs have become very
significant because the compensation paid to the employees is based on the principle of
real cops.
3. Opportunity cost: this is one of the most important concepts of economics and a lot of
micro economic concepts are based on opportunity cost this is the cost of the next best
alternative available to a producer or a person. Money has got different users as does all
the other girls. For example if an individual has ₹10000 it has alternative users like buying
a kindle, saving the money, investing it into equity or starring the cash in hand.
4. Out of pocketcosts: are those costs that improve current cash payments to outsiders. For
example, wages and salaries paid to the employees are out-of pocket costs. Other
examples of out-of-pocket costs are payment of rent, interest, transport charges, etc. On
the other hand, book costs are those business costs, which do not involve any cash
payments but for them a provision is made in the books of account to include them in
profit and loss accounts and take tax advantages. For example, salary of owner manager, if
not paid, is a book cost. The interest cost of owner’s own fund and depreciation cost are
other examples of book cost.
5. Past costs are actual costs incurred in the past and they are always contained in the
income statements. Their measurement is essentially a record keeping activity. These costs
can only be observed and evaluated in retrospect. If they are regarded as excessive,

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Unit 04: Cost Theory and Estimation

management can indulge in post-mortem checks just to find out the factors responsible for
the excessive costs, if any, without being able to do anything about reducing them.
6. Future costs are those costs that are likely to be incurred in future periods. Since the
future is uncertain, these costs have to be estimated and cannot be expected to be
absolutely correct figures. Past costs serve as the basis for projecting future costs. In
periods of inflation and deflation, the two cost concepts differ significantly.
7. Sunk costs are expenditures that have been made in the past or must be paid in the
future as part of contractual agreement or previous decision. For example, the money
already paid for machinery, equipment, inventory and future rental payments on a
warehouse that must be paid as part of a long-term lease agreement are sunk costs. In
general, sunk costs are not relevant to economic decisions. For example, the purchase of
specialized equipment designed to order for a plant. We assume that the equipment can be
used to do only what it was originally designed for and cannot be converted for
alternative use. The expenditure on this equipment is a sunk cost. Also, because this
equipment has no alternative use its opportunity cost is zero and, hence, sunk costs are not
relevant to economic decisions. Sometimes the sunk costs are also called as non-avoidable
or non-escapable costs.
8. Fixed costs are that part of the total cost of the firm which does not change with output.
Expenditures on depreciation, rent of land and buildings, property taxes, and interest
payment on bonds are examples of fixed costs. Given a capacity, fixed costs remain the
same irrespective of actual output.
9. Variable costs, on the other hand, change with changes in output. Examples of variable
costs are wages and expenses on raw material.

4.2 Short Run Cost

The short run is defined as a period in which the supply of at least one element of the inputs cannot
be changed. To illustrate, certain inputs like machinery, buildings, etc., cannot be changed by the
firm whenever it so desires. It takes time to replace, add or dismantle them. Short-run costs are the
costs that can vary with the degree of utilisation of plant and other fixed factors. In other words,
these costs relate to the variation in output, given plant capacity. Short-run costs are, therefore, of
two types: fixed costs and variable costs. In the short-run, fixed costs remain unchanged while
variable costs fluctuate with output.
To analyse the short run cost functions, it is necessary to understand the three main classification of
cost.

Total Costs
Three concepts of total cost in the short run must be considered: total fixed cost (TFC), total variable
cost (TVC), and total cost (TC). Total fixed costs are the total costs per period of time incurred by
the firm for fixed inputs. Since the amount of the fixed inputs is fixed, the total fixed cost will be the
same regardless of the firm’s output rate. Table 9.1 shows the costs of a firm in the short run.
According to this table, the firm’s total fixed costs are Rs. 100.

Quantity TFC TVC TC MC AFC AVC ATC

0 100 0 100

1 100 50 150 50 100 50 150

2 100 90 190 40 50 45 95

3 100 120 220 30 33 40 73.3

4 100 140 240 20 25 35 60

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Managerial Economics

5 100 150 250 10 20 30 50

6 100 156 256 6 16.7 26 42.7

7 100 175 275 19 14.3 25 39.3

8 100 208 308 33 12.5 26 38.5

9 100 270 370 62 11.1 30 41.1

10 100 350 450 80 10 35 45

TC

Cos TVC
t

AFC

Output

Total variable costs are the total costs incurred by the firm for variable inputs. To obtain total
variable cost we must know the price of the variable inputs. Suppose if we have two variable inputs
viz. labour (V1) and raw material (V2) and the corresponding prices of these inputs are P1 and P2,
then the total variable cost (TVC) = P1 * V1 + P2 * V2. They go up as the firm’s output rises, since
higher output rates require higher variable input rates, which mean bigger variable costs.
Finally, total costs are the sum of total fixed costs and total variable costs. To derive the total cost
column in Table 4.1, add total fixed cost and total variable. cost at each output. The firm’s total cost
function corresponding to the data given in Table 4.1 is shown graphically in Figure 4.1. Since total
fixed costs are constant, the total fixed cost curve is simply a horizontal line at Rs.100. And because
total cost is the sum of total variable costs and total fixed costs, the total cost curve has the same
shape as the total variable cost curve but lies above it by a vertical distance of Rs. 100.

Corresponding to our discussion above we can define the following for the short run:

TC = TFC + TVC

Where,

TC = total cost

TFC = total fixed costs

TVC = total variable costs

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Unit 04: Cost Theory and Estimation
Average Fixed Costs
While the total cost functions are of great importance, managers must beinterested as well in the
average cost functions and the marginal cost functionas well. There are three average cost concepts
corresponding to the three totalcost concepts. These are average fixed cost (AFC), average variable
cost(AVC), and average total cost (ATC). Figure 4.2 show typical average fixedcost function
graphically. Average fixed cost is the total fixed cost divided byoutput. Average fixed cost declines
as output (Q) increases. Thus we canwrite average fixed cost as:
AFC = TFC/Q

Average Variable Costs

Average variable cost is the total variable cost divided by output. Figure 9.2shows the average
variable cost function graphically. At first, output increases resulting in decrease in average
variable cost, but beyond a point, they result in higher average variable cost.
𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄
Q = output
TVC = total variable costs
AVC = average variable cost

Average Total Cost

Average total cost (ATC) is the sum of the average fixed cost and average variable cost. In other
words, ATC is total cost divided by output. Thus,
𝑇𝐶
𝐴𝑇𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶 =
𝑄
Figure 4.2 shows the average total cost function graphically. Since ATC is sum of the AFC and
AVC, ATC curve always exceeds AVC curve. Also, since AFC falls as output increases, AVC and
ATC get closer as output rises. Note that ATC curve is nearer the AFC curve at initial levels of
output, but is nearer the AVC curve at later levels of output. This indicates that at lower levels of
output fixed costs are more important part of the total cost, while at higher levels of output the
variable element of cost becomes more important.

Marginal Cost
Marginal cost (MC) is the addition to either total cost or total variable cost resulting from the
addition of one unit of output. Thus,
∆𝑇𝐶 ∆𝑇𝑉𝐶
𝑀𝐶 = =
∆𝑄 ∆𝑄

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Managerial Economics
Where,
MC = marginal cost
∆ Q = change in output
∆ TC = change in total cost due to change in output
∆TVC = change in total variable cost due to change in output
The two definitions are the same because, when output increases, total cost increases by the same
amount as the increase in total variable cost (since fixed cost remains constant). Figure 4.2 shows
the marginal cost function graphically. At low output levels, marginal cost may decrease with
increase in output, but after reaching a minimum, it goes up with further increase in output. The
reason for this behavior is found in diminishing marginal returns. The marginal cost concept is very
crucial from the manager’s point of view. Marginal cost is a strategic concept because it designates
those costs over which the firm has the most direct control. More specifically, MC indicates those
costs which are incurred in the production of the additional unit of output and therefore, also the
cost which can be “saved” by reducing total output by the additional unit. Average cost figures do
not provide this information. A firm’s decisions as to what output level to produce is largely
influenced by its marginal cost. When coupled with marginal revenue, which indicates the change
in revenue from one more or one less unit of output, marginal cost allows a firm to determine
whether it is profitable to expand or contract its level of production.

Relationship between Marginal Cost and Average Costs

The relationships between the various average and marginal cost curves are illustrated in Figure
4.2. The figure shows typical AFC, AVC, ATC, and MC curves but is not drawn to scale for the data
given in Table 4.1. The MC cuts both AVC and ATC at their minimum. When both the MC and
AVC are falling, AVC will fall at a slower rate. When both the MC and AVC are rising, MC will rise
at a faster rate. As a result, MC will attain its minimum before the AVC. In other words, when MC
is less than AVC, the AVC will fall, and when MC exceeds AVC, AVC will rise. This means that as
long as MC lies below AVC, the latter will fall and where MC is above AVC, AVC will rise.
Therefore, at the point of intersection where MC = AVC, AVC has just ceased to fall and attained its
minimum but has not yet begun to rise. Similarly, the MC curve cuts the ATC curve at the latter’s
minimum point. This is because MC can be defined as the addition either to TC or TVC resulting
from one more unit of output. However, no such relationship exists between MC and AFC, because
the two are not related; MC by definition includes only those costs which change with output, and
FC by definition is independent of output.

4.3 Long Run Cost

Long run is defined as a period in which all inputs are changed with changes in output. Long-run
costs, are costs that can vary with the size of plant and with other facilities normally regarded as
fixed in the short-run. In fact, in the long-run there are no fixed inputs and therefore no fixed costs,
i.e., all costs are variable. The long run cost curve is also known as Planning Cost function the Long
Run Cost Curve is known as Planning Curve.

LMC LAC
MC
AC
MC
AC

MC
AC

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The long run cost output relationship can be shown with the help of a long run cost curve. The long
run average cost curve (LRAC) is derived from short run average cost curves (SRAC).
Most firms will have many alternative plant sizes to choose from, and there is a short run average
cost curve corresponding to each. A few of the short run average cost curves for these plants are
shown in Figure 4.3, although many more may exist. Only one point of a very small arc of each
short run cost curve will lie on the long run average cost function. Thus long run average cost curve
can be shown as the smooth U-shaped curve. Corresponding to this long run average cost curve is a
long run marginal cost (LRMC) curve, which intersects LRAC at its minimum point, which is also
the minimum point of short run average cost curve.
SRC=SRMC and LRAC=LRMC

4.4 Economies of scale

We have seen in the preceding section that larger plant will lead to lower average cost in the long
run. However, beyond some point, successively larger plants will mean higher average costs.
Exactly, why is the long run average cost (LRAC) curve U-shaped? What determines the shape of
LARC curve?
This point needs further explanation. It must be emphasized here that the law of diminishing
returns is not applicable in the long run as all inputs are variable. Also, we assume that resource
prices are constant. What then, is our explanation? The U-shaped LRAC curve is explainable in
terms of what economists call economies of scale and diseconomies of scale.
Economies and diseconomies of scale are concerned with behaviour of average cost curve as the
plant size is increased. If LRAC declines as output increases, then we say that the firm enjoys
economies of scale. If, instead, the LRAC increases as output increases, then we have diseconomies
of scale.
Finally, if LRAC is constant as output increases, then we have constant returns to scale implying we
have neither economy of scale nor diseconomies of scale. Economies of scale explain the down
sloping part of the LRAC curve. As the size of the plant increases, LRAC typically declines over
some range of output for several reasons. The most important is that, as the scale of output is
expanded, there is greater potential for specialization of productive factors. This is most notable
about labour but may apply to other factors as well. Other factors contributing to declining LRAC
include ability to use more advanced technologies and more efficient capital equipment;
managerial specialization: opportunity to take advantage of lower costs (discounts) for some inputs
by purchasing larger quantities; effective utilization of by products, etc.
But, after sometime, expansion of a firm’s output may give rise to diseconomies, and therefore,
higher average costs. Further expansion of output beyond a reasonable level may lead to problems
of overcrowding of labour, managerial inefficiencies, etc., pushing up the average costs. In this
section, we examined the shape of the LRAC curve. In other words, we have analysed the
relationship between firm’s output and its long run average costs. The economies of scale and
diseconomies of scale are sometimes called as internal economies of scale and internal
diseconomies of scale respectively. This is because the changes in long run average costs result
solely from the individual firm’s adjustment of its output. On the other hand, there may exist
external economies of scale. The external economies also help in cutting down production costs.
With the expansion of an industry, certain specialized firms also come up for working up the by-
products and waste materials. Similarly, with the expansion of the industry, certain specialized
units may come up for supplying raw material, tools, etc., to the firms in the industry. Moreover,
they can combine to undertake research etc., whose benefit will accrue to all firms in the industry.
Thus, a firm benefit from expansion of the industry. These benefits are external to the firm, in the
sense that these have arisen not because of any effort on the part of the firm but have accrued to it
due to expansion of industry. All these external economies help in reducing production costs

4.5 Learner curve

Learning Curve is a modern concept which came in the post Keynesian era. Kenneth J. Arrow was
one of the pioneers who gave this concept and called it “learning by doing”. The learning curve
effect is usually expressed as a constant percentage. This percentage represents the proportion by
which cost per unit of output declines with the increase in cumulative output in each successive
time period.

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Costper
unit

L
C
Cumulative Total Output

The algebraic expression of the relationship is

𝑪 = 𝒂𝑨𝒃
Where
C=input cost of Qth unit of output,
Q = successive unit of output produced,
a = input cost per unit of output in the first period
b= rate of decline in cost per unit of output in the successive period.
Since the learning curve is downward sloping, the value of b is negative.

Effects of Learning Curves on Variable Costs per Unit and Profit

A common form of learning curve is based on reduction of labour hours per extra unit of output by
a constant fraction each time the total output is doubled.

Suppose the labour requirement is reduced by 10% with each doubling of output.
Incremental labour requirement for the ith unit is 0.9 times the incremental labour needed for the
ith unit. The factor 0.9 is called the learning rate for the particular work process.The equation for
the learning curve in the above example is Li — 0.9Li,/2, in which L is incremental labour per unit.
If the first unit of output requires 1,000 labour hours, the second will need 900 units, the fourth 810
units, and so on.

Increm
ental
labour 6
hours
of 5
themar
ginal 4
unit
LR = 0.9

2 LR = 0.8

1 1 2 3 4 5 6
Total Units Produced

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Unit 04: Cost Theory and Estimation
The learning curve is often made use of in developing new products and projecting the profitability
of such products in the face of rapid technological change. Various other costs such as indirect
labour, power, etc. depend on the time re-quired to complete a job.

Summary
In this chapter we have understood the concept of cost and how it evolves in various time frame.
Afirm should be aware of the environment in which it is working so as to estimate the cost because
it becomes the pivot for the determination of price and also helps an organization to estimate the
growth. The objective of the firm that is whether it wants to maximise profit or sales also has an
impact on the costing of the firm. If the organization is profit oriented, then opportunity cost and
accounting costs play a major role in maximising profits. On the other hand, if the objective is to
maximise sales then the firm would try to minimised it pause so as to have optimum utilization of
all the resources.
In short run, the total cost consists of fixed and variable costs. A firm’s marginal cost is the
additional variable cost associated with each additional unit of output. The average variable cost is
the total variable cost divided by the number of units of output. When there is a single variable
input, the presence of diminishing returns determines the shape of cost curves. In particular, there
is an inverse relationship between the marginal product of the variable input and the marginal cost
of production. The average variable cost and average total cost curves are U-shaped. The short run
marginal cost curve increases beyond a certain point, and cuts both average total cost curve and
average variable cost curve from below at their minimum points.
In the long run, all inputs to the production process are variable. Thus, in the long run, total costs
are identical to variable costs. The long run average cost function shows the minimum cost for each
output level when a desired scale of plant can be built. The long run average cost curve is important
to managers because it shows the extent to which larger plants have cost advantages over smaller
ones.
Economies or diseconomies of scale arise either due to the internal factors pertaining to the
expansion of output by a firm, or due to the external factors such as industry expansion. In contrast,
economies of scope result from product diversification. Thus, the scale-economies have reference to
an increase in volume of production, whereas the scope-economies have reference to an
improvement in the variety of products from the existing plant and equipment. These cost concepts
and analysis have a lot of applications in real world decision-making process such as optimum
output, optimum product-mix, breakeven output, profit contribution, operating leverage, etc.

Keywords
Average fixed cost (AFC). The fixed cost per unit of output
Average variable cost (AVC). The variable cost per unit of output.
Average total cost (AC or ATC). The total cost per unit of output.
Economies of scale, also called increasing returns to scale, IRTS. The reduction in the unit cost of
production as the firm increases its capacity (i.e., increases all its inputs). It is considered a long run
phenomenon.
Learning curve. The relationship between the unit cost of labor and the total amount of output
produced by labor that is directly associated with the production process (i.e., “direct labor”).
Essentially this concept is based on the principle that one improves with practice. The resulting
productivity gains lead to a reduction in the direct labor cost of producing a unit of output.
Marginal cost (MC). The cost to a firm of producing an additional unit of an output.
Opportunity cost. The amount of subjective value forgone in choosing one activity over the next
best alternative
Total cost (TC). The total cost of production, including both total variable and total fixed costs.

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Self Assessment
1. Which of the following is a variable cost?
A. Interest payments
B. Raw materials costs
C. Property taxes
D. All of the above are variable costs

2. Which of the following is an implicit cost?

A. The salary earned by a corporate executive
B. Depreciation in the value of a company-owned car as it wears out
C. Property taxes
D. All of the above are implicit costs.

3. If the output levels at which short-run marginal and average cost curves reach a minimum
are listed in order from smallest to greatest, then the order would be
A. AVC, MC, ATC
B. ATC, AVC, MC
C. MC, AVC, ATC
D. AVC, ATC, MC

4. The long-run average cost curve is at a minimum at a level of output where

A. the firm is experiencing constant returns to scale.
B. it is equal to long-run marginal cost.
C. the long-run average cost curve is tangent to the lowest point on a short-run average total
cost curve.
D. all of the above occur.

5. If a firm has a downward sloping long-run average cost curve, then

A. it is experiencing decreasing returns to scale.
B. it is experiencing decreasing returns.
C. it is a natural monopoly.
D. marginal cost is greater than average cost.

6. One reason that a firm may experience increasing returns to scale is that greater levels of
output make it possible for the firm to
A. employ more specialized machinery.
B. obtain bulk purchase discounts.
C. employ a greater division of labor.
D. all of the above are correct.

7. One reason that a firm may experience decreasing returns to scale is that greater levels of
output can result in
A. a greater division of labor.
B. an increase in meetings and paperwork.
C. smaller inventories per unit of output.

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Unit 04: Cost Theory and Estimation

D. all of the above are correct.

8. Economies of scale exist when

A. the firm is too large and too diversified
B. a firm's decision to hire additional inputs does not result in an increase in the price of inputs
C. the long-run cost of producing a unit of output falls as the output increases
D. the firm is too small and too specialized

9. Economies of scope exist when

A. a fall in wages reduces average cost
B. greater experience in producing the product reduces average cost
C. doubling factor input doubles output
D. changing the mix of production reduces average cost.

10. Economies of scale is also known as

A. Benefitting scale
B. Returns to scale
C. Law of variable proportions
D. None of the above

11. The concept that occurs when some activity is being performed outside a firm but within an
industry is known to be
A. Economies of scale
B. Internal economies of scale
C. External economies of scale
D. Diseconomies of scale

12. Learning curves represent the relationship between

A. average variable cost and the number of units produced per time period.
B. average variable cost and the cumulative number of units produced.
C. total cost and technology.
D. average variable cost and the rate of increase in technology.

13. A learning curve describes

A. the increase in production time as the total number of units produced increases.
B. the rate at which an organization acquires new information.
C. the amount of production time per unit as the total number of units produced increases.
D. the increase in number of units produced per unit time as the total number of units
produced increases.

14. Limitations of the learning-curve approach include

A. learning curves are only valid when considering relatively simple production processes.
B. learning curves are only valid when the total number of units produced is relatively small.
C. learning curves must be redeveloped whenever the product or production process is
modified.
D. learning curves are only applicable when considering a highly automated process.

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Managerial Economics

15. Another name for the learning curve is a(n)

A. experience curve.
B. exponential curve.
C. production curve.
D. growth curve.

Answers for Self Assessment

1. B 2. B 3. C 4. D 5. C

6. D 7. B 8. C 9. D 10. B

11. B 12. B 13. C 14. C 15. A

Review Questions
1. Explain why short run marginal cost is greater than long run marginal cost beyond the
point at which they are equal?
2. Explain long run cost curves.
3. What is more important for the firm, external or internal economies and why?
4. How does the concept of Lerner curve help in cost estimation?
5. “In the long run all the costs are variable”. Explain the concept.
6. Explain the concept of opportunity cost and why is it important in economics.

Further readings
1. Managerial Economics- Principles and Worldwide Applications By
Salvatore,Dominick and Rastogi, Siddhartha K., Oxford University Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul G,
Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education, India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary, McGraw
Hill Education (India) Private Limited

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Tanima Dutta, Lovely Professional University Unit 05: Production Theory

Unit 05: Production Theory

CONTENTS
Objective
Introduction
5.1 Production Function
5.2 Production function with one variable input
5.3 Law of Variable Proportions
5.4 Production with two variable inputs
5.5 The Optimal Combination of Inputs
5.6 Returns to Scale
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further readings

Objective
• To understand the concept of Production.
• To analyse the production function in the various time frames.
• To evaluate the concept of learner curve

Introduction
The production function is a statement of the relationship between a firm’s scarce resources (i.e., its
inputs) and the output that results from the use of these resources. Economic cost analysis can then
be seen as the application of a monetary unit such as rupees to measure the value of this input
usage in the production process. Production process involves the transformation of inputs into
output. The inputs could be land, labour, capital, entrepreneurship etc. and the output could be
goods or services. In a production process managers take four types of decisions: (a) whether to
produce or not, (b) how much output to produce,(c) what input combination to use, and (d) what
type of technology to use.
In this chapter we will discuss the production function with single variable and then two variables.
The law of diminishing returns will be discussed with one factor as variable, and all the other
factors are fixed. In case of two inputs, the isoquants will be discussed. We will then move to
finding the optimum combination of inputs to get a particular level of output. The long run
production function with all the variables changing-returns to scale will be discussed.

5.1 Production Function

If we want to produce bread, we will need a baker, flour, baking oven, a room and some other
tools. All of these are the factors of production or inputs that is land, labour, capital, enterprise, and
technology. The produce is bread. The production function is the functional relationship between
these inputs and output. It shows the maximum output which can be obtained for a given
combination of inputs. It expresses the technological relationship between inputs and output of a
product.
Q= f (X1, X2, ..., Xk)
Where,

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Q= level of output
X1, X2, ..., Xk= inputs used in production
The production function can be rewritten so as to include the various factors of production.
𝐐=𝐟(𝐋,𝐊, 𝐥, 𝐄, 𝐓)
Where L: Labour
K: Capital
l: Land
E: Enterprise
T: Technology

5.2 Production function with one variable input

If there are only two factors of production, labour and capital then the production function in the
short run will be:

𝑸 = 𝒇 (𝑳, 𝑲)
where Q = output
L = labour

𝐾= fixed capital
The variable input can be combined with the fixed input to produce different levels of output.

Total, Average, and Marginal Product

The production function given above shows us the maximum total product (TP) that can be
obtained using different combinations of quantities of inputs. Suppose the metal parts company
decides to know the output level for different input levels of labour using fixed five machine tools.
Table 5.1 explains the total output for different levels of variable input. In this example, the TP rises
with increase in labour up to a point (six workers), becomes constant between sixth and seventh
workers, and then declines.
Table 5.1 TP, AP and MP of labour with capital fixed at 5 units

Number of Labour Total Product (TP) Average Product Marginal Product

(AP=TP/Q) (MP=∆TP/∆Q)

0 0 0 0

1 10 10 10

2 28 14 18

3 54 18 26

4 76 19 22

5 90 18 14

6 96 16 6

7 96 13.5 0

8 92 11.5 -4

Two other important concepts are the average product (AP) and the marginal product (MP) of an
input.

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Average Product
The AP of an input is the TP divided by the amount of input used to produce this amount of
output. Thus, AP is the output-input ratio for each level of variable input usage. The MP of an input
is the addition to TP resulting from the addition of one unit of input, when the amounts of other
inputs are constant. In our example of machine parts production process, the AP of labour is the TP
divided by the number of workers.
𝑇𝑃
𝐴𝑃𝐿 =
𝐿
As shown in Table 5.1, the APL first rises, reaches maximum at 19, and then declines thereafter.

Marginal Product
The MP of labour is the additional output attribute able to using one additional worker with use of
other input (service of five machine tools) fixed.
∆𝑇𝑃
𝑀𝑃𝐿 =
∆𝐿

The graphical representation between the three is shown in Fig. 5.1

Fig. 5.1 Relationship between Total Product,

Average Product and Marginal Product
120

100 y z
Total Product

80
X
60

40

20

0
0 1 2 3 4 5 6 7 8 9
Units of labour

Average Product (AP=TP/Q) Marginal Product (MP=∆TP/∆Q)

30
AVERAGE PRODUCT, MARGINAL

25
20
15
PRODUCT

10 AP
5
0
0 1 2 3 4 5 6 7 8
-5
MP
-10
UNITS OF LABOUR

Relationship between TP, MP and AP Curves

Examine Table 5.1 and its graphical presentation in Figure 5.1. We canestablish the following
relationship between TP, MP, and AP curves.

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1. A. If MP > 0, TP will be rising as L increases. The TP curve begins at the origin, increases at
an increasing rate over the range 0 to 3, and then increases at a decreasing rate. The MP
reaches a maximum at 3, which corresponds to an inflection point (x) on the TP curve. At
the inflection point, the TP curve changes from increasing at an increasing rate to
increasing at a decreasing rate.
B. If MP = 0, TP will be constant as L increases. The TP is constant between workers 6
and 7.
C. If MP < 0, TP will be declining as L increases. The TP declines beyond7. Also, the TP
curve reaches a maximum when MP = 0 and then starts declining when MP < 0.
2. MP intersects AP (MP = AP) at the maximum point on the AP curve. This occurs at labour
input rate 4.5. Also, observe that whenever MP >AP, the AP is rising (upto number of
workers 4.5) — it makes no difference whether MP is rising or falling. When MP < AP
(from number of workers 4.5), the AP is falling. Therefore, the intersection must occur at
the maximum point of AP. It is important to understand why. The key is that AP increases
as long as the MP is greater than AP. And APdecreases as long as MP is less than AP.
Since AP is positively or negatively sloped depending on whether MP is above or below
AP, it follows that MP = AP at the highest point on the AP curve.
This relationship between MP and AP is not unique to economics. The same can be applied to
sports as well.

If there is a shooter say Abhinav Bindra who in his 30 shots has an average score of 8 points.
In his next shot if he gets 9.5, then the marginal product is 9.5 and the average product shifts to 8.04
(249.5/31). Thus, marginal product is more than the average product.

5.3 Law of Variable Proportions

The slope of the MP curve in Figure 5.1 illustrates an important principle, the law of diminishing
marginal returns. As the number of units of the variable input increases, the other inputs held
constant (fixed), there exists a point beyond which the MP of the variable input declines. Table 5.1
illustrates this law. Observe that MP was increasing up to the addition of 4th worker (input);
beyond this the MP decreases. What this law says is that MP may rise or stay constant for some
time, but as we keep increasing the units of variable input, MP should start falling. It may keep
falling and turn negative, or may stay positive all the time. Consider another example for clarity.
Single application of fertilizers may increase the output by 50%, a second application by another
30% and the third by 20% and so on. However, if you were to apply fertilizer five to six times in a
year, the output may drop to zero Three things should be noted concerning the law of diminishing
marginal returns.

1. This law is an empirical generalization, not a deduction from physical or biological laws.
2. It is assumed that technology remains fixed. The law of diminishing marginal returns
cannot predict the effect of an additional unit of input when technology is allowed to
change.
3. It is assumed that there is at least one input whose quantity is being held constant (fixed).
In other words, the law of diminishing marginal returns does not apply to cases where all
inputs are variable.

Stages of Production
Based on the behaviour of MP and AP, economists have classified production into three stages:
Stage 1: MP > 0, AP rising. Thus, MP > AP.
Stage 2: MP > 0, but AP is falling. MP < AP but TP is increasing (because MP > 0).
Stage 3: MP < 0. In this case TP is falling.

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These results are illustrated in Figure 5.1. No profit-maximising producer would produce in stages I
or III. In stage I, by adding one more unit of labour, the producer can increase the AP of all units.
Thus, it would be unwise on the part of the producer to stop the production in this stage. As for
stage III, it does not pay the producer to be in this region because by reducing the labour input the
total output can be increased and the cost of a unit of labour can be saved.
Thus, the economically meaningful range is given by stage II. In Figure5.1 at the point of inflection
(x), we saw earlier that MP is maximised. At point y, since AP is maximized, we have AP = MP. At
point z, TP reaches a maximum. Thus, MP = 0 at this point. If the variable input is free then the
optimum level of output is at point z where TP is maximized. However, in practice no input will be
freely available. The producer has to pay a price for it. Suppose the producer pays Rs. 200 per
worker per day and the price of a unit of output (say one apple) is Rs. 10. In this case the producer
will keep on hiring additional workers as long as (price of a unit of output) * (marginal product of
labour) > (price of a unit of labour)
That is, marginal revenue of product (MRP) of labour > PLOn a similar analogy,(price of a unit of
output) * (marginal product of capital) > (price of a unit of capital). That is, marginal revenue of
product (MRP) of capital > PK
The left side denotes the increase in revenue and the right side denotes the increase in the cost of
adding one more unit of labour. As long as the increment to revenues exceeds the increment to
costs, the profit of the producer will increase. As we increase the units of labour, we see that MP
diminishes. We assume that the prices of inputs and output do not change. In this case, as MP
declines, revenues will start falling, and a point will come when the increase in revenue equals the
increase in cost. At this point the producer will stop adding more units of input. With further
addition, since MP declines, the additional revenues would be less than the additional costs, and
the profit of the producer would decline.
Thus, profit maximization implies that a producer with no control over prices will increase the use
of an input until—
Value of marginal product (MP) = Price of a unit of variable input

5.4 Production with two variable inputs

Now we turn to the case of production where two inputs (say capital and labour) are variable.
Although, we restrict our analysis to two variable inputs, all of the results hold for more than two
also. We are restricting our analysis to two variable inputs because it simply allows us the scope for
graphical analysis. When analysing production with more than one variable input, we cannot
simply use sets of AP and MP curves, because these curves were derived holding the use of all
other inputs fixed and letting the use of only one input vary. If we change the level of fixed input,
the TP, AP and MP curves would shift. In the case of two variable inputs, changing the use of one
input would cause a shift in the MP and Upcurve’s of the other input. For example, an increase in
capital would probably result in an increase in the MP of labour over a wide range of labour use.

Production Isoquants
In Greek the word ‘iso’ means ‘equal’ or ’same’. A production isoquant (equal output curve) is the
locus of all those combinations of two inputs which yields a given level of output. With two
variable inputs, capital and labour, the isoquant gives the different combinations of capital and
labour, that produces the same level of output. For example, 15 units of output can be produced
using either 28 units of capital (K) or 7 units of labour (L) or K=18 and L=8 or any other
combination. These four combinations of capital and labour are four points on the isoquant
associated with 5 units of output as shown in Figure 5.2. And if we assume that capital and labour
are continuously divisible, there would be many more combinations on this isoquant.
If we want to write the production function, we write it as follows

𝑄 = 𝑓(𝐿, 𝐾)

where 𝑄 = constant output

L = Labour
K = Capital

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Fig. 5.2 Production Isoquant showing production of 15 units of output with various labour and
capital combinations

ISOQUANT
45
40
35
30
CAPITAL

25
20
15
10
5
0
6 7 8 9 10
LABOUR

Fig 5.3: Isoquant Map

Cap
ita
l

IQ3

IQ2

IQ1

Now let us assume that capital, labour, and output are continuously divisible in order to set forth
the typically assumed characteristics of isoquants. Figure 5.3illustrates three such isoquants.
Isoquant I show all the combinations of capital and labour that will produce 10 units of output.
Similarly, isoquant II shows the various combinations of capital and labour that can be used to
produce 15 units of output. Isoquant III shows all combinations that can produce 20 units of output.
Each capital-labour combination can be on only one isoquant. That is, isoquants cannot intersect.
These isoquants are only three of an infinite number of isoquants that could be drawn. A group of
isoquants is called an isoquant map. In an isoquant map, all isoquants lying above and to the right
of a given isoquant indicate higher levels of output. Thus, in Figure 5.3 isoquant II indicates a
higher level of output than isoquant I, and isoquant III indicates a higher level of output than
isoquant II.

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Marginal Rate of Technical Substitution

The rate, at which one input can be substituted for another input, if output remains constant, is
called the marginal rate of technical substitution (MRTS). It is defined in case of two inputs, capital
and labour, as the amount of capital that can be replaced by an extra unit of labour, without
affecting total output.
∆𝑲 𝑴𝑷𝑳
𝑴𝑹𝑻𝑺𝑳𝑲 = - 𝒐𝒓 𝑴𝑹𝑻𝑺𝑳𝑲 =
∆𝑳 𝑴𝑷𝑲

It is customary to define the MRTS as a positive number, since ∆K/∆L, them slope of the isoquant, is
negative. Over the relevant range of production, the MRTS diminishes. That is, more and more
labour is substituted for capital while holding output constant, the absolute value of ∆K/∆L
decreases.

For example, let us assume that 10 pairs of shoes can be produced using either 8units of
capital and2 units of labour or 4 units each of capital and of labour or 2 units of capital and 8 units
of labour. From Figure 5.4 the MRTS of labour for capital between points a and b is equal to ∆K/∆L
= (4–8) / (4–2)= –4/2 = –2 or | 2 |. Between points b and c, the MRTS is equal to –2/4 =–½ or | ½ |.
The MRTS has decreased because capital and labour are not perfect substitutes for each other.
Therefore, as more of labour is added, less of capital can be used (in exchange for another unit of
labour) while keeping the output level constant.

There is a simple relationship between MRTS of labour for capital and them marginal product MPK
and MPL of capital and labour respectively. Since along an isoquant, the level of output remains the
same, if ∆L units of labour are substituted for ∆K units of capital, the increase in output due to ∆L
units of labour namely, ∆L * MPL should match the decrease in output due to a decrease of ∆K units
of capital (namely, ∆K * MPK). In other words, along an isoquant,

∆𝑳 ∗ 𝑴𝑷𝑳 = ∆𝑲 ∗ 𝑴𝑷𝑲
Which is equal to
∆𝐾 𝑀𝑃𝐿
| |=
∆𝐿 𝑀𝑃𝐾
However, as we have seen earlier ∆K/∆L is equal to MRTS of L for K, and hence, we get the
following expression for MRTS of L for K as the ratio of the corresponding marginal products.
𝑀𝑃𝐿
𝑀𝑅𝑇𝑆𝐿 𝑓𝑜𝑟 𝐾 =
𝑀𝑃𝐾

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Different Types of Isoquants

There are vast differences among inputs in how readily they can be substituted for one another. For
example, in some extreme production process, one input can perfectly be substituted for another;
whereas in some other extreme production process no substitution is possible. On the other hand,
in most of the production processes what we see is imperfect substitution of inputs. These three
general shapes that an isoquant might have are shown in Figure 5.5. In panel I, the isoquants are
right angles implying that the two inputs a and b must be used in fixed proportion and they are not
at all substitutable. For instance, there is no substitution possible between the tyres and a battery in
an automobile production process. The MRTS in all such cases would, therefore, be zero. The other
extreme case would be where the inputs a and b are perfect substitutes as shown in panel II. The
isoquants in this category will bea straight line with constant slope or MRTS. A good example of
this type would be natural gas and fuel oil, which are close substitutes in energy production.
Fig. 5.5 Different shapes of Isoquants

Economic region of Production

Fig. 5.6 Economic Region of Production

The economic region of production is when the slope of the isoquants is negative. Beyond the
economic region, the slope of the isoquants become positive which means that the quantity of both
the inputs must be increased to increase the output. Above OA and below OB, the slope of the
isoquants is positive, which implies that increase in both capital and labour are required to
maintain a certain output rate. If this is the case, the MP of one or other input must be negative.
Above OA, the MP of capital is negative. Thus, output will increase if less capital is used, while the
amount of labour is held constant. Below OB, the MP of labour is negative. Thus, output will
increase if less labour is used, while the amount of capital is held constant. The lines OA and OB are
called ridge lines. And the region bounded by these ridge lines is called economic region of
production. This means the region of production beyond the ridge lines is economically in-efficient.

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5.5 The Optimal Combination of Inputs

The discussion on Isoquants and production function reveals that various quantity of output can be
produced by changing the quantity of inputs or the input combinations. The manager is now
confronted with the question of which input combination to use which gives optimal results. She
must find the optimal combination of inputs. While all the input combinations are technically
efficient, the final decision to employ a particular input combination is purely an economic decision
and rests on cost (expenditure). Thus, the production manager can make either of the following two
input choice decisions:

1. Choose the input combination that yields the maximum level of output with a given level
of expenditure.
2. Choose the input combination that leads to the lowest cost of producing a given level of
output
Thus, the decision is to minimize cost subject to an output constraint or maximize the output
subject to a cost constraint. We will now discuss these two fundamental principles. Before doing
this we will introduce the concept is cost, which shows all combinations of inputs that can be used
for a given cost.

Isocost Line
Recall that a universally accepted objective of any firm is to maximise profit. If the firm maximises
profit, it will necessarily minimise cost for producing a given level of output or maximise output for
a given level of cost. Suppose there are 2 inputs: capital (K) and labour (L) that are variable in the
relevant time period. What combination of (K,L) should the firm choose in order to maximise
output for a given level of cost? If there are 2 inputs, K,L, then given the price of capital (Pk) and
the price of labour (PL), it is possible to determine the alternative combinations of (K,L) that can be
purchased for a given level of expenditure. Suppose C is total expenditure, then

𝑪 = 𝑷𝑳 ∗ 𝑳 + 𝑷𝑲 ∗ 𝑲
This linear function can be plotted on a graph

Fig. 5.7 Isocost line

If only capital is purchased, then the maximum amount that can be bought is by point A in figure
5.7. If only labor is purchased, then the maximum amount of labor that can be purchased is C/PL
shown by point B in the figure. The 2 points A and B can be joined by a straight line. This straight
line is called the isocost line or equal cost line. It shows the alternative combinations of (K,L) that
can be purchased for the given expenditure level C. Any point to the right and above the isocost is
not attainable as it involves a level of expenditure greater than C and any point to the left and
below the iso-cost such as N is attainable, although it implies the firm is spending less than C.

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Optimal Combination of Inputs: The Long Run

When both capital and labour are variable, determining the optimal input rates of capital and
labour requires the technical information from the production function i.e. the isoquants be
combined with market data on input prices i.e. the isocost function. If we superimpose the relevant
isocost curve on the firm’s isoquant map, we can readily determine graphically as to which
combination of inputs maximise the output for a given level of expenditure.
Consider the problem of minimising the cost of a given rate of output. Specifically, if the firm wants
to produce 100 units of output at minimum cost. Two production isoquants have been drawn in
Figure 5.8. Three possible combinations (amongst several more combinations) are indicated by
points A, Z and B in Figure 5.8. Obviously, the firm should pick the point on the lower isocost that
is point Z. In fact, Z is the minimum cost combination of capital and labour. At Z the isocost is
tangent to the 100-unit isoquant.
Alternatively, consider the problem of maximising output subject to a given cost amount. You
should satisfy yourself that among all possible output levels, the maximum amount will be
represented by the isoquant that is tangent to the relevant isocost line. Suppose the budget of the
firm increases to the amount shown by the higher of the two isocost lines in Figure 5.8, point Q or
150units of output is the maximum attainable given the new cost constraint in Figure 5.8.

Fig. 5.8. Optimal Combination of Inputs

Regardless of the production objective, efficient production requires that the isoquant be tangent to
the isocost function. If the problem is to maximise output, subject to a cost constraint or to minimise
cost for a given level of output, the same efficiency condition holds true in both situations.
Intuitively, ifit is possible to substitute one input for another to keep output constant while
reducing total cost, the firm is not using the least cost combination of inputs. In such a situation, the
firm should substitute one input for another.

5.6 Returns to Scale

Another important attribute of production function is how output responds in the long run to
changes in the scale of the firm that is when all inputs are increased in the same proportion (by say
20percent), how does output change. Clearly, there are 3 possibilities. If output increases by more
than an increase in inputs (by more than 20 percent), then the situation is one of increasing returns
to scale (IRS). If output increases by less than the increase in inputs, then it is a case of decreasing
returns to scale (DRS). Lastly, output may increase by the same proportion as inputs. For example,
a doubling of inputs may lead to a doubling of output. This is a case of constant returns to scale
(CRS).

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Fig. 5.9 Returns to Scale using Isoquants

These three figures are showing constant returns to scale, increasing returns to scale and decreasing
returns to scale respectively (starting from the first figure on the left in the previous page).

Summary
This chapter looks at the production function which tells us about the output with the given level of
inputs. There is various level of output with the change in the combination of inputs. The task of
the manager is to choose the optimum combination which maximises profit with a given cost.
The law of diminishing marginal returns states that as equal increments of variable input are added
to fixed input, a point will eventually be reached where corresponding increments to output begin
to decline. We have also seen the relations between the marginal product, average product, and
total product.
There are three stages of production. Stage I is characterized by MP>0 and MP>AP. Stage II is
characterized by MP>0 and MP<AP. Stage III is characterized by MP<0. The economically
meaningful range is Stage II. The production manager maximizes the profit at a point where the
value of marginal product equals the price of the output.
A production isoquant consists of all the combinations of two inputs that will yield the same
maximum output. The marginal rate of technical substitution is WK/WL, holding output constant.
The law of diminishing marginal rate of substitution implies the rate at which one input can be
substituted for another input if output remains constant. An isocost line consists of all the
combinations of inputs which have the same total cost. The absolute slope of the isocost line is the
input price ratio. Returns to scale, a long run concept, involves the effect on output of changing all
inputs by same proportion and in the same direction.

Keywords
Inputs: The resources used in the production process. Examples in economic analysis generally
involve the inputs capital (representing the fixed input) and labor (representing the variable input).
Other terms used in reference to these resources are factors and factors of production.
Isocost: A line representing different combinations of two inputs that a firm can purchase with the
same amount of money. In production analysis, the isocost indicates a firm’s budget constraint.

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Isoquant: A curve representing different combinations of two inputs that produce the same level of
output.
Law of diminishing returns: A law stating that as additional units of a variable input are added to
a fixed input, at some point the additional output (i.e., the marginal product) will start to diminish.
Because at least one input is required to be fixed for this law to take effect, this law is considered a
short-run phenomenon.
Long-run production function: The maximum quantity of a good or service that can be produced
by a set of inputs, assuming the firm is free to vary the amount of all inputs being used.
Production function: The maximum quantity of a good or service that can be produced by a set of
inputs. Production functions are divided into two types: short run and long run.
Returns to scale: The increase in output that results from an increase in all of a firm’s inputs by
some proportion. If the output increases by a greater proportion than the increase in inputs, the
firm
is experiencing increasing returns to scale. If the output increases by the same proportion as the
inputs, the firm is experiencing constant returns to scale. Finally, if the output increases by a
smaller proportion than the increase in inputs, the firm is experiencing decreasing returns to scale.

Self Assessment
1. Which of the following is an example of a capital input?
A. Money.
B. Shares of stock.
C. Long-term bonds.
D. A hammer.

2. Which of the following is an example of an intermediate product?

A. A personal computer.
B. A barrel of crude oil.
C. A sports car.
D. A house.

3. Which of the following is an assumption associated with the definition of a production

function?
A. Technology remains constant.
B. Both inputs and outputs are measured in monetary units.
C. The function shows the maximum level of output possible with a given combination of
inputs.
D. All units of the inputs are homogeneous.

4. The marginal product of labor is equal to

A. the additional labor required to produce one more unit of output.
B. average product when average product is at a minimum.
C. the additional output produced by hiring one more unit of labor.
D. the slope of a ray drawn from the origin to a point on the total product curve.

5. The average product of labor is equal to

A. the additional labor required to produce one more unit of output.
B. marginal product when average product is at a minimum.
C. the additional output produced by hiring one more unit of labor.

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D. the slope of a ray drawn from the origin to a point on the total product curve.

6. An isoquant that is
A. further from the origin represents greater output.
B. flatter represents the trade-offs between inputs that are poor substitutes.
C. negatively sloped represents input combinations associated with Stage I of production.
D. All of the above are correct.

7. The absolute value of the slope of a convex isoquant

A. is equal to the marginal rate of technical substitution.
B. is equal to the ratio of the marginal products of the two inputs.
C. decreases from left to right.
D. All of the above are correct.

8. The combination of inputs is optimal

A. at points of tangency between isoquants and isocosts.
B. if the marginal revenue product is equal to the marginal resource cost for all inputs.
C. if the marginal rate of technical substitution between every pair of inputs is equal to the ratio
of the prices of those inputs.
D. All of the above are correct.

9. An isocost line will be shifted further away from the origin

A. if the prices of both inputs increase.
B. if total cost increases.
C. if there is an advance in technology.
D. All of the above are correct.

10. If isoquants are plotted on a graph with capital measured on the vertical axis and labor on
the horizontal axis, then an increase in the wage rate will cause the isocost line
A. to become steeper and the optimal quantity of labor will decrease.
B. to become steeper and the optimal quantity of labor will increase.
C. to become flatter and the optimal quantity of labor will decrease.
D. to become flatter and the optimal quantity of labor will increase.

11. The long-run average cost curve is at a minimum at a level of output where
A. the firm is experiencing constant returns to scale.
B. it is equal to long-run marginal cost.
C. the long-run average cost curve is tangent to the lowest point on a short-run average total
cost curve.
D. all of the above occur.

12. If a firm has a downward sloping long-run average cost curve, then
A. it is experiencing decreasing returns to scale.
B. it is experiencing decreasing returns.
C. it is a natural monopoly.
D. marginal cost is greater than average cost.

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13. One reason that a firm may experience increasing returns to scale is that greater levels of
output make it possible for the firm to
A. employ more specialized machinery.
B. obtain bulk purchase discounts.
C. employ a greater division of labor.
D. All of the above are correct.

14. One reason that a firm may experience decreasing returns to scale is that greater levels of
output can result in
A. a greater division of labor.
B. an increase in meetings and paperwork.
C. smaller inventories per unit of output.
D. All of the above are correct.

15. Economies of scope refers to the decrease in average total cost that can occur when a firm
A. produces more than one product.
B. has monopoly power in world markets.
C. controls the raw materials used as inputs.
D. narrows the scope of its regional markets.

Answers for Self Assessment

1. D 2. B 3. B 4. C 5. D

6. A 7. D 8. D 9. B 10. A

11. D 12. C 13. D 14. B 15. A

Review Questions
1. Define an isoquant. Can it be concave to the origin?
2. Explain the concept of Marginal rate of Technical Substitution.
3. Differentiate between straight line and right-angled isoquants.
4. Explain the optimum input combination concept.
5. Explain the three phases of returns to scale.

Further readings
1. Managerial Economics- Principles and Worldwide Applications By Salvatore,
Dominick and Rastogi, Siddhartha K., Oxford University Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul G,
Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education, India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary, McGraw
Hill Education (India) Private Limited

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Tanima Dutta, Lovely Professional University Unit 06: Market Structure

Unit 06: Market Structure

CONTENTS
Objective
Introduction
6.1 The Meaning of Competition
6.2 Price and Output Determination in Perfect Competition
6.3 Monopoly
6.4 Types of Monopoly
6.5 Monopolistic Competition
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objective
To understand the concept of the market
To evaluate output and price in perfect competition
To evaluate output and price in Monopoly and Monopolistic

Introduction
Market structure refers to arrangements that bring buyers and sellers together. The market for a
product may also refers to the whole region where buyers and sellers of that product are spread
and there is such free competition that one price for the product prevails in the entire region.
Whether a firm can be regarded as competitive depends on several factors such as the number of
firms in the industry, degree of rivalry, degree of homogeneity of the product, economies of scale
and easiness with which any firm can enter in the market and exit from it. In previous times a
market meant a physical place where the buyers and sellers interacted with each other. However, in
today’s age, e-commerce has taken over and virtual markets have become the new normal.
Markets are classified based on place, nature of products, area served and competition. Economics
classifies markets based on competition. Based on these characteristics, especially in terms of
degree of competition, a market can be classified as a perfectly competitive market, monopoly,
duopoly, oligopoly, and monopolistic competition. In this chapter we will study the different forms
of the market and investigate how price and output are determined in them.
The features of the four main types of markets on the basis of competition are showcased in Fig. 6.1.
Perfect competition and Monopoly are two different poles in competitive market. Perfect
competition is the representation of a laissez faire market where customer is the king and only
those sellers survive who compete and capture the market. Monopoly on the other hand is a market
which has one seller and represents a sellers’ market as she dictates the terms of sales. There are no
substitutes available to the customer.
In terms of market power, monopolistic competition and oligopoly are somewhere between the two
extremes of perfect competition and monopoly. From pedagogical standpoint, it is easier to
understand and appreciate the particulars of monopolistic competition and oligopoly if there is first
a thorough understanding of perfect competition and monopoly. This explains why we first cover
perfect

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Fig. 6.1 Different Types of Market

competition and monopoly in this chapter and the other two market types separately in the next
one. Before proceeding to our first case of pricing and output decisions in perfect competition, let us
elaborate further on market structure and the meaning of competition in economic analysis.

6.1 The Meaning of Competition

In economic analysis, the most important indicator of the degree of competition is the ability of
firms to control the price and use it as a competitive weapon. The extreme form of competition is
“perfect” competition. In this market, the competition is so intense, and the firms are so evenly
divided that no one seller or group of sellers can exercise any control over the price. That is, they
are all price takers.
A second key measure of competition in economic analysis is the ability of a firm to earn an “above
normal” or “economic” profit in the long run. Market entry and exit most directly affects the ability
of a firm to earn economic profit in the long run. In perfect competition, entry into the market is
easy. Therefore, if firms are observed to be earning economic profit, over time the entry of new
firms eager to partake in these profits quickly reduces the ability of both incumbents and new
entrants to earn economic profit. The same applies to monopolistic competition.
Non price competition plays a secondary role in determining the degree of competition in economic
analysis. However, we recognize that non price factors often come to mind first when people think
about how firms compete with one another. Non price competition involves firms trying to gain an
advantage over one another by differentiating their products using such means as advertising,
promotion, the development of new products and product features, and customer service.

Example: In India if we look at the competition between the mobile brands like Oppo and
Samsung, we witness the use of celebrity endorsement. It is much clear in case of Coke and
Pepsi where big Hindi film stars are used to pitch for the brand.

The extent to which buyers and sellers have information about the price of the product and the
product itself (e.g., product quality, reliability, and integrity) can also be a factor in determining a
firm’s market power or competitive advantage.

Example: Romila goes to a shop to buy her groceries and buys a bottle of 1 kg honey. The
next day she sees the advertisement of the particular brand of honey which is giving free
one kilogram of basmati rice with it. She feels cheated and wants to go back to the shop to
speak to the shopkeeper. But the shopkeeper was able to do this because of the lack of
information with Romila and other such buyers which gives market power to the seller.

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6.2 Price and Output Determination in Perfect Competition

It is the most basic type of market which represents free competition in the market. The markets for
agricultural products (e.g., corn, wheat, coffee, pork bellies), financial instruments (e.g., stocks,
bonds, foreign exchange), precious metals (e.g., gold, silver, platinum), and the global petroleum
industry provide good examples of this type of market. In each market, the products are
standardized commodities, and supply and demand are clearly the primary determinants of their
market price.2 Of course, it is precisely because of this those sellers sometimes form cartels in order
to raise the price or to keep it from falling. OPEC and the International Coffee Growers Association
are good examples of this.

Features of Perfect Competition

1. Presence of large number of buyers and sellers

2. Homogeneous product
3. Freedom of entry and exit
4. Perfect knowledge
5. Perfect mobility of resources
6. Firms are price taker
7. Perfectly elastic demand curve
8. Perfect mobility of factors of production
9. Price determined by market and firm is a price taker.
10. No selling costs

Assumptions of Perfect Competition

Let us summarize the key assumptions made in analysing the
firm’s output decision in perfect competition.

1. The firm operates in a perfectly competitive market and therefore is a price taker.
2. The firm makes the distinction between the short run and the long run.
3. The firm’s objective is to maximize its profit in the short run. If it cannot earn a profit,
then it seeks to minimize its loss.
4. The firm includes its opportunity cost of operating in a particular market as part of its
total cost of production.

Demand and Revenue of a Firm

As per the assumption of rationality, the firms aim at profit maximisation. In a perfectly
competitive market, the firms are price taker, and they aim at selling to their maximum capacity so
as to maximise their profits. The price is given to a firm and they can only adjust their quantity. The
Total Revenue (TR) depends only on quantity and not on price. Total Revenue is the multiplication
of Price and Quantity
𝑇𝑅=𝑃𝑋𝑄
Marginal Revenue is the additional revenue earned divided by selling an extra unit of the good.
𝑀𝑅= ∆𝑇𝑅/∆𝑄
In Perfect Competition the average revenue is equal to marginal revenue is equal to price
𝐴𝑅=𝑀𝑅=𝑃
To know the quantity that each firm is ready to sell at the given price, the concept of cost is introduced.
TR is the total revenue curve which is increasing.TC curve has been drawn on the assumption of the
Law of Variable Proportions. Profit is the difference between total revenue and total cost.

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Profit curve begins from the negative, which means any output less than Q1 is not profitable for the
firm, similarly any output more than Q2 is also not profitable. The point of maximum profit is the
point of least cost. The total cost of producing any output less than Q1 is more than the revenue
earned and therefore, it is not profitable for the firm. At point A, TR and TC become equal. The firm
starts earning profit as it goes beyond point A and the profit continues till point Q2. However, the
profit is maximum at Q* where the total revenue is maximum and total cost is minimum. Any
rational firm will produce at this level of production.

Profit Maximisation- Marginal Revenue- Marginal Cost Approach

To determine equilibrium for perfectly competitive firm, we need to find the level of output that
would maximise its profit. To maximise its profits for each unit of increased output, firm compares
additional revenue generated by selling that unit of output [that is marginal revenue (MR)] with
additional cost incurred in producing that unit of output [the marginal cost (MC)]. As long as,

• MR > MC, additional production adds to profit, thus firm should produce this additional
unit of output.
• MR < MC, additional production reduces profit, thus firm should not produce this
additional unit of output, instead decreasing production would add to firm’s profits.
• MR = MC, additional production does not impact profit, hence it provides a point where
firm is indifferent in increasing or decreasing level of output, hence defines its equilibrium
level of output.
In Fig. 6.2, MR and MC curves intersects at
point E giving equilibrium level of output Q.
At point E, both necessary and sufficient
conditions are fulfilled. Thus, we get profit
maximising level of output.

Fig.6.2Equilibrium of a firm using Marginal Revenue and Marginal Cost approach

Equilibrium under Perfect Competition

Short run equilibrium

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A perfectly competitive firm faces constant prices and horizontal demand curve. Firm has to decide
in the short-run whether to produce or shut-down temporarily and how much to produce? In the
long-run firm has to decide, whether to enter, stay or leave the industry; also whether to increase or
decrease the plant size.
The two conditions for equilibrium are:

1. The Marginal Revenue should be equal to Marginal Cost.

2. The slope of Marginal Cost curve should be greater than the slope of the Marginal
Revenue curve.
These two conditions are not enough to let us know whether the firm will close down or will
continue producing the goods. To know this we have to find out whether the firm is earning profit
or loss.
If at the equilibrium level the Average Revenue is greater than Average Cost then the firm enjoys
profit and if it is reverse then the firm faces a loss.

Fig. 6.3 Firms profit and loss with equilibrium

The obvious question that comes to our mind is that should a firm continue to remain in the market
if it is suffering losses. To make this point clear it is essential to differentiate between fixed cost and
variable cost. Fixed cost is the cost we incur on the fixed factor of production. While variable cost is
the cost incurred on the variable factors of production. If a firm is producing continuously then it
incurs both- the fixed cost and the variable cost. So as long as firm is recovering its variable cost,
firm will continue to produce. Now, consider the following expression for Total cost:
Total Cost = Total Fixed Cost + Total Variable Cost
On dividing this equation by Q, we get the expression for the Average total cost (ATC) as a linear
function of average fixed cost (AFC) and average variable cost (AVC).
ATC = AFC + AVC

Fig. 6.4 Shut down point of a firm

A perfectly competitive firm takes prices as given because it does not have any control over prices.
Consider Fig. 6.4 above. A firm facing market price P < SATC (Short-run Average Total Cost),
suffers losses in the short-run. It may decide to continue or shut-down the production. This
dilemma results because in the short-run firm incurs not only the variable cost but also the fixed

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cost. On shutting down, firm will get rid of the variable cost, but it will still have to bear the fixed
cost. The Short-run Average Variable Cost (SRAV) curve represents the variable cost incurred in the
production process. As long as, AR is greater than SAVC, firm is able to recover variable cost. Here,
P < SATC, but it is equal to minimum SAVC. Thus, this firm though suffers a loss, will minimise its
losses by continuing production, as it may recover some component of fixed cost. Point A(where
MC = minimum SAVC) represents the Shut-down point. If prices (AR) become less than SAVC at
equilibrium level of output; firm will minimise its losses by shutting down, as now it is not able to
recover even its variable cost. By shutting down, it will just have to suffer the loss from fixed costs
and not any additional variable costs.

Long-run Equilibrium
In the long-run, all factors of production are variable, which means that there is no difference
between variable cost and fixed cost, hence ATC becomes important in making production
decisions. In the long-run firm faces decisions like— whether to enter, stay or leave the industry;
and whether to increase or decrease the plant size.
If price (AR) is greater than AC then firms would be making super-normal profit, this would attract
new firms to enter the industry and push the price down because of increased supply in the
industry. On the other hand, if price (AR) is lower than AC, then some firms would leave industry
because they are unable to recover their opportunity cost, in such case there will be a decline in
supply which will push the price up. Hence in either situation, whether P (AR) is greater or lower
than AC, firms would keep entering or leaving respectively till P or AR is equal to AC.
So in long-run, we have the following two conditions giving the equilibrium level of output:

1. P (or AR or MR) = MC and

2. AR = AC
From these two equations we get, P = MC = AC. And since, MC and AC are equal only at the
minimum of AC, so price line (or AR curve) should be tangent to AC curve at the long-run
equilibrium level of output.

Fig. 6.5 Long run equilibrium of a firm

Since in the long-run firm operates at the minimum of AC curve, this signifies that firm is operating
with the plant of optimum size. When firm operates with optimum size, it means that it is enjoying
all possible economies of scale or it has exhausted the economies of scale, and has no incentive to
move to any other point.

6.3 Monopoly
Monopoly can be described as a market situation where a single firm controls the entire supply of a
product which has no close substitutes. The market structure characteristics of monopoly are listed
below:

1. Presence of large number of buyers and single seller

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2. Single product
3. Restricted entry
4. No difference between industry and firm
5. Independent decision making
Though perfect competition and monopoly are the two extreme cases of market structure, they both
have one thing in common – they do not have to compete with other individual participants in the
market. Sellers in perfect competition are so small that they can ignore each other. At the other
extreme, the monopolist is the only seller in the market and has no competitors. The market or
industry demand curve and that of the individual firm are the same under monopoly since the
industry consists of only one firm.
Managers of firms in a perfectly competitive market facing a horizontal demand curve would have
no control over the price and they simply choose the profit maximising output. However, the
monopoly firm, facing a downward-sloping demand curve (see Figure 6.6) has power to control the
price of its product. If the demand for the product remains unchanged, the monopoly firm can raise
the price as much as it wishes by reducing its output. On the other hand, if the monopoly firm
wishes to sell a larger quantity of its product it must lower the price because total supply in the
market will increase to the extent that its output increases. While an individual firm under perfect
competition is a price-taker, a monopolist firm is a price-maker. It may, however, be noted that to
have price setting power a monopoly must not only be the sole seller of the product but also sell a
product which does not have close substitutes.

Fig.6.5 Demand Curve under Monopoly

Reasons for Monopoly

Restriction by Law
Such a barrier emerges when the government makes it a law not to allow any competition in the
production and distribution of a particular product. Majority of the State Electricity Boards in India
can be cited as a typical example of such a barrier.

Control Over Key Raw Materials

When the strategic raw material to produce a particular commodity is scarce and is fully controlled
by a single firm, this firm may not be allowing the use of this important raw material by any other
firm and may acquire the monopoly status. Many governments restrict private players and
monopolies, especially in strategic sectors.

Specialised know how

Like the key raw material, the specific techniques of production of a particular commodity may not
be available to any other form and use of this technique by others will be restricted through patents,
trademarks another intellectual property rights. There are many companies especially in the field of
technology who patent their process and from monopolies. One such firm is Intel who manufacture
integrated chips that are patented, and it has a monopoly in the IC market.

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Economies of scale
A very important reason behind creation of monopolies is the attainment of economies of scale. It is
often referred as innocent of structural barriers. If a firm long run minimum cost of production or
its most efficient scale of production coincides with the size of the market, then the large size firms
find profitable to eliminate competition in the long run through price cutting in the short run. Once
monopoly is established it becomes almost impossible for new firms to enter the market and
survive. Thus, economies of scale play a major role in restricting entry of new players or removing
existing players from the market.

Small market size

Another possibility is with the market size is so small that there is no scope for multiple players and
hence the most efficient player attains a monopoly status.

6.4 Types of Monopoly

On the basis of the different barriers various types of monopoly are created which are elaborated
here.

1. Legal monopoly: Some monopoly is a created by the laws of a country in the greater
public interest. If the government of the nation feels that private control may lead to
disparity in distribution of wealth or imbalance growth of the economy it may keep the
resources in its own control by imposing legal restrictions on the entry of other players.

2. Economic monopoly: whenever competition is eliminated due to economic or

managerial inefficiency of other players or due to superior efficiency of a particular player
the monopoly thus created is regarded as economic monopoly. commits monopoly or trust
exists when an individual or firm can explicitly force competition competitors out of
business by slashing prices buying up and holding supplies bribery or
intimidation(Clayton antitrust act of 1914).

Example- in the Field of computers operating systems Microsoft or MSOffice has become a
very popular name and it has acquired a virtual monopoly go to superior efficiency. there are other
substitutes like Linux but they are not close competitors of Microsoft.

3. Natural monopoly: when the size of the market is so small that it can accommodate only
one player A natural monopoly is formed. A natural monopoly is formed. In other words
in other words when only one views the entire profit maximising output due to the small
size of the market and other firms may not be able to survive in that market a natural
monopoly is created.

4. Regional monopoly: sometimes geographical or territorial aspects also help in creation

of monopolies even W go under geographical indicators clause of trips has allowed
protection of intellectual property rights emerging from possession of a natural resource
especially to a region. GIS tagging off Kolhapur chappals, Banarsi saree etc op current
examples.

Demand And Marginal Revenue Curves for A Monopoly Firm

The demand curve of the monopolist is highly price inelastic because there is no close substitute
and consumers have no or very little choice. Hence, if consumers want to consume the product,
they would have to buy it at the price charged by the monopolist. Does this imply that monopoly
price will be high? To a large extent, yes but not always. Monopoly is also governed by market
demand for its product and the forces affecting demand also affect the monopoly not perfectly
inelastic because pure monopoly does not exist in real life. Hence, it faces a normal downward
sloping curve. The bottom line is thus clear, the monopolist cannot set both price and quantity at its
own will.

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Fig. 6.6 Demand and Marginal Revenue Curve of a Monopoly firm

The Average Revenue curve is the demand curve of the firm and it also determines the slope of MR
curve. In case of perfect competition, the demand curve is perfectly elastic; hence the AR curve of a
perfectly competitive firm is parallel to the X axis and coincides with MR curve. In monopoly,
however, the AR and MR curves would look like those given in Figure 6.6. The reason is that a
monopoly firm faces a normal demand curve which is highly inelastic, therefore, AR curve would
be downward sloping, and the MR curve would lie below the AR curve. Letus explain the reason.
As mentioned before, the monopolist has to lower the price of all units of its product, if it wants to
sell an additional unit. As such, the addition to revenue resulting from selling this additional unit
would be less than price the firm would receive for the unit. The addition to the total revenue is
marginal revenue. Hence for a monopolist, MR is less than price and the MR curve would lie below
the AR curve. In fact, for a linear demand curve, the slope of MR is twice that of AR and the MR
curve would lie halfway between the AR curve and price axis.

Price and output decision in short run

We assume here that in order to maximise profit a monopoly form follows the rule of Marginal
Revenue equating Marginal Cost when Marginal Cost is rising. Similar, to the case of perfect
competition a monopoly firm may earn super normal profit or normal profit or even losses in the
short run. However, it is a negative slope of the demand curve that is instrumental for chances of
monopoly profits in the short run. If the firm earns super normal profit in short run the reason
would be reaping up of benefits of supplying a product which not only is unique but also has
negligible cross elasticity.

Case of Super Normal Profit

The first case that is discussed is that of super normal profits. Following the conditions of profit
maximization, the point of equilibrium is E and the equilibrium output is OQ as shown in the
figure 6.7 now what will be the price at which monopoly firm would reach equilibrium?

Fig. 6.7 Super Normal Profits of a Monopoly Firm

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This price would be determined by the forces of demand because the monopolist would like to sell
its entire product and hence it would charge a price which is the equilibrium price. Since this
equilibrium price is more than average cost the firm earns super normal profits. The total revenue
earned by the firm by selling OQ at OP is given by the rectangular area OPBQ where the total cost
incurred is given by the rectangular area OACQ. Therefore, the total profit earned with a firm is
given by the rectangular region APBC.

Case of Normal Profit

There may be situations when a monopoly firm may earn just Normal Profits in the short run. This
is technically possible because in the earlier years of operations the firm may be producing at high
cost and maybe just able to manage normal profit.

Fig. 6.8 Normal Profits of a Monopoly Firm

Graphically it can be shown when the average cost curve is tangent to the average revenue curve.
At E the output that maximise profits is OQ and the equilibrium price is OP. The total revenue
earned by the firm by selling OQ is the rectangular area OPBQ and the total cost of producing OQ
is also given by the same area. Profit is the difference between the total revenue and total cost is
therefore here it is zero.

Case of Loss
There is a general perception amongst readers that as monopoly firm has single seller therefore, it
does not suffer from losses, but this is a myth. The conditions under which a monopoly firm may
have losses are firstly in the early years Monopoly firm may not be very efficient to attain low cost
of production. Moreover, the size of the market in the early years may be small. Hence, in order to
sell the entire output the firm may have to suffer losses. Another reason maybe a monopoly firm to
strengthen its position in the market and to discourage competitors from entering the market may
charge a low price to capture the market. But this is only a short run phenomenon as in the long run
firm with either start earning economies of scale thus reducing its average cost or would close
down altogether.

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Fig. 6.9 Loss of a Monopoly Firm

The case of loss is shown in figure 6.9 in which the equilibrium point is E and the equilibrium level
of output is OQ with the price at OP. The firm earns a total revenue given by the rectangular area
OPTQ. But the cost of producing OQ level of output is given by the rectangular area ONMQ. Thus,
the total cost of producing is more than total revenue and hence the losses for the firm.

Price and Output Decision in the Long Run

Monopolised is in full control of the market price therefore they do not incur losses in the long run.
It would instead try to reduce its cost of production by increasing control of raw materials and
other inputs or else it would close down just like a loss-making firm under perfect competition. In
fact, the monopolist would try to earn at least normal profit in the long run and may earn super
normal profit due to entry restrictions in the market. This is to say the time in apply firm would
either normal profit or super normal profit but would not incur loss in the long run.
Suppose in the long run monopoly firm earns super normal profit. Since it charges a high price, this
would attract competition and this high price would make it possible for a new entrant to survive.
In this case the market situation would change to competition and would no longer remain a
monopoly. Therefore, to retain its monopoly power the firm may have to resort to a low price and
earn only normal profit even in the long run so as to create an economic barrier to new entrant.
Consider the case in which a monopoly is created due to small size of market in which only one
firm can optimally operate or in which the firm has complete control over important inputs or
technical know-how then the firm would continue to retain its monopoly power and earn super
normal profit in the long run.

Supply curve of a Monopoly firm

From our previous discussion on demand and supply you must recollect the supply curve tells us
the quantity that the firm chooses to supply at a particular price. In perfect competition firms
equate price of the product with their individual marginal cost of production and thus, determine
the supply curve in the short run. But a monopolist is a price maker, the firm itself sets the price of
the product it sells, instead of taking the price. Thus, it does equate marginal cost with marginal
revenue for profit maximization, but unlike perfect competition, it cannot equate its price to
marginal revenue. Supply of the good by the monopolist at a given price would be determined by
both the market demand and the marginal cost curve. As such there is no supply curve for a
monopolist.

Price and Output Decision of a Multi-Plant Monopoly

So far we have assumed that the monopoly firm produces its entire output in one plant and thus
faces a single cost function. However, in real life it is possible that the monopolist produces a
homogeneous product in different plants. In such a situation how would the firm determine the
total output at which it can maximise its profit? This assumes paramount significance because even
though the firm has different cost functions from multiple plans it faces the same demand function
for the entire market. A multi plant monopolist must take decisions: first like a single plant firm it
has to decide on how much to produce and what price to sell at, so as to maximise its profit; second,
it has to decide on how to allocate the profit maximising output between the plants. It is assumed
that the monopolist faces the same demand curve and hence the same average revenue and
marginal revenue curve for the entire market.

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To understand this phenomenon, let us take the case of monopoly firm which produces into plants,
and. Two plants may appear simplistic, but it would certainly not affect the understanding of the
decision-making process even when there are more than two plants. Let us further assume that
each of these two plants face different cost functions. Marginal cost would then be summation of
cost functions of the two plants.
MC=MCA +MCB (1)
Given the marginal revenue and marginal cost curves, the firm decide the profit maximising level
of output and would allocate this output between the two plants on the basis of principles of
marginalism:
MR=MCA=MCB
In other words, the monopolist would be able to maximise its profit by producing an output where
marginal cost of plant A is equal to marginal revenue and marginal cost of plant B is also equal to
marginal revenue. Now how would this happen? If MCA<MCB, the monopolist would increase
production in plant A, which has lower marginal cost and reduce production and plant B, which
has a higher marginal cost, till the conditions given an equation (1) is satisfied. The equilibrium of
multi-plant monopolist can be understood with the help of the diagrams figure 6.10
In the first part of figure 6.10, the market demand for the product of monopolist as shown by OQ
which is the profit maximising output satisfying the condition MR=MC, when MC is rising. OP is
the equilibrium price and APBE is the total profit of the firm. In the next section the cost function of
plant A in which marginal cost is lesser is shown and the last part of the figure shows the cost
function of plant B in which marginal cost is greater. Since the market is one hence only one price
prevails. This is shown by the line P which determines average revenue in both the plants. In order
to decide how much the output will be produced individually in A and B, the firm produces till
MCA and MCB are individually equal to MR, which is naturally same for both plants.
QA+QB= OQ

Price Discrimination under Monopoly

A seller indulges in price discrimination when he sells the same product at different prices to
different buyers. Price discrimination is 'personal' when different prices are charged from different
persons, 'local' when different prices are charged from people living in different localities, and
'according to use' when, for example, higher rates are charged for commercial use of electricity as
compared to domestic use.
Price discrimination is possible when the seller is able to distinguish individual units bought by
single buyer or to separate buyers into classes where resale among classes is not possible. Thus,
price discrimination is possible in case of personal services of doctors and lawyers. It is also
possible when markets are too distant or are separated by tariff barriers. There may be a legal
sanction for price discrimination as in the case of electricity charges from domestic and industrial

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users. It is also possible when some people are prejudiced against a particular market and prefer a
posh market or when some people are too lethargic to move away from the nearest shopping
centre.

Case 1: Equilibrium under Price Discrimination

A monopolist firm sells a single product in two different markets either different elasticity of
demand. Resale among the customers is not possible. The firm must decide how much total output
should be produced and how it should be distributed between sub-markets and what prices should
be charged in the two sub-markets. It is assumed that production takes place at the same point.

Fig. 6.11 Price Discrimination

Figure 6.11 shows the equilibrium of a monopolist under the two sub-markets. It may be observed
that the monopolist faces a less elastic demand curve in sub-market 1 as compared to2. The
aggregate demand and MR curves are shown in part (c). Profits are maximised where MC curve
meets the MR curve from below, i.e., at point E. The total profits are represented by the shaded area
EFG lying between the MR and MC curves. The monopolist would produce Q units of output. In
order to know the distribution of Q in two sub-markets the equilibrium aggregate MR is equated to
MR1 and MR2 at points E1 and E2 respectively. The monopolist would sell amount Q1 in sub-market
1 at a price P1. He would sell amount Q2 at a price P2 in sub-market 2.It should be noted that Q =
Q1+Q2.

Case 2: Dumping
This is a special case when the firm is a monopolistic in the domestic market but faces perfect
competition in the world market. Figure 10.7 shows the equilibrium of such a firm. ARH and MRH
are the average and marginal revenue curves respectively which the firm faces in the home market.
ARW or MRW is horizontal straight line at the level of prices Pw, prevailing in the world market.
MC denotes the marginal cost curve. The aggregate MR curve is given by the curve AFEG which is
the lateral summation of MRW and MRH. The profits are maximised when aggregate MR=MC, i.e.,
at point E. The firm would sell total output Q. In the home market, the firm would equate MRH to
the equilibrium MC. Thus, the firm would sell QH units in the domestic market at a price PH which
is higher than the international price PW. The remaining amount (Q-QH) would be sold in the
world market at price PW. The area AFED denotes the total profits of this firm. The producer is said
to be 'dumping' in the world market since he is charging less price in the world market than in the
home market.

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Fig.6.12 Dumping in Monopoly Firm

6.5 Monopolistic Competition

Monopolistic competition has an element of product differentiation. We can define a monopolistic
competitive market as a market in which there are a large number of firms and the products in the
market are close but not perfect substitute. The real world is widely populated by monopolistic
competition. Perhaps half of the economy's total production comes from monopolistically
competitive firms. The best examples of monopolistic competition come can be retail trade
including restaurants, clothing stores, and convenience stores.

Features of Monopolistic Competition

Monopolistic competition is a form of market structure in which a large number of independent
firms are supplying products that are slightly differentiated from the point of view of buyers. Thus,
the products of the competing firms are close but not perfect substitutes because buyers do not
regard them as identical. This situation arises when the same commodity is being sold under
different brand names, each brand being slightly different from the others. For example, Luxor,
Cello, Reynolds, Linc, Parker, Pik are the brands for pens. Each firm is, therefore, the sole producer
of a particular brand or "product". It is a monopolist as far as that particular brand is concerned.
However, since the various brands are close substitutes, a large number of "monopoly" producers
of these brands are involved in keen competition with one another. This type of market structure,
where there is competition among a large number of "monopolists" is called monopolistic
competition.
The differentiation among competing products or brands may be based on real or imaginary
differences in quality. Real differences among brands refer to palpable differences in quality such as
shape, flavour, colour, packing, after sales service, warranty period, etc. In contrast, imaginary
differences mean quality differences which are not really palpable but buyers are made to imagine
or are "conditioned" to believe that such differences exist and are important. Advertising often has
the effect of making buyers imagine or believe that the advertised brand has different qualities.
When there is product differentiation, each firm has some degree of control over price.
As a result, under monopolistic competition, the demand or average revenue curve of an individual
firm is a gradually falling curve. It is highly elastic but not perfectly so. Therefore, the marginal
revenue curve of the firm is also falling and lies below the average revenue curve at all levels of
output. It is in this respect that monopolistic competition differs from perfect competition.
In addition to product differentiation, the other three basic characteristics of monopolistic
competition are:

1. There are a large number of independent sellers (and buyers) in the market.
2. The relative (proportionate) market shares of all sellers are insignificant and equal. That is,
seller concentration in the market is almost non-existent.

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3. There are neither any legal nor any economic barriers against the entry of new firms into
the market. New firms are free to enter the market and existing firms are free to leave the
market.
In other words, product differentiation is the only characteristic that distinguishes monopolistic
competition from perfect competition. Firms selling slightly differentiated products under different
brand names compete not only through variations in price but also through variations in product
quality (product variation) and changes in advertising or selling costs. Thus, under monopolistic
competition, an individual firm has to maximise profits in relation to variations in three policy
variables, namely, price, product quality, and selling costs. (In contrast, under perfect competition
there is competition only through price variation).

Assumptions in Analysing Firm Behaviour

We analyse the conditions and process of long run equilibrium under monopolistic competition
with the assumption that competing firms keep their selling costs and product quality constant and
compete only through price variation. We then assume that
1. The demand curve of each individual firm has the same shape (elasticity) and position
(distance from the y-axis). That is, we assume the demand curves of all firms to be
symmetrical. This assumption implies that market share of every firm is the same and
equal to a constant proportion of total market demand. That is, if total market demand is
Q and an individual firm's demand is q then q=KQ, where K is a constant fraction for all
firms.
2. The cost curves, both average and marginal, are symmetrical for each firm.

These two assumptions are 'heroic' or unrealistic, but we need to make them for logical convenience
in order to analyse the long run equilibrium of a typical firm under monopolistic competition.

Price and Output Decisions

Short-Run Equilibrium Under the Monopolistic Competition
Firms under monopolistic competition attain equilibrium when (1) MC = MR and (2) slope of MC >
slope of MR. The firm's equilibrium is defined at the point E in the following figure. At this price
OP, AR > AC, the firm earns a profit of PQRS. The firm may earn a profit or incurs loss or be at a no
loss no profit position depending upon the demand condition and the position of the cost-curves;

Fig. 6.13 Short Run Equilibrium of Monopolistic Firm

Long-Run Equilibrium Under the Monopolistic Competition

In the long-run, price cutting, expansion and contraction of output and new entry are possible, i.e.,
firms may compete with one another through price or non-price competition. The abnormal profit
earned in the short-run will attract new entries, therefore the amount sold at any given price will
fall resulting in the shift of demand curve until the abnormal profits are wiped out. There is no
profit no loss situation since the total cost and the total revenue are equal.

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Fig.6.14 Long run equilibrium of Monopolistic Firm

However, because the firm's demand or average revenue curve is falling, the price is higher than
marginal revenue. Hence, under monopolistic competition, even though the long run equilibrium
price is = LAC, it is greater than LMC. This is because, at equilibrium, MR = LMC but price is
greater than MR. (Under perfect competition, price = minimum LAC = LMC). Moreover, since the
firm's demand or average revenue AR2 is falling on account of product differentiation, it can be a
tangent to the U-shaped LAC curve only when LAC is also falling. As shown in Figure 6.14, the
long run equilibrium position E will be at a point which is to the left of the minimum LAC. Thus,
the long run equilibrium output Q is less than optimum output, QF (where LAC is at its minimum).
The difference between E and Q = (F – OQ) shows the extent of excess or underutilised capacity.
Equilibrium with excess capacity is therefore the necessary consequence of product differentiation
and monopolistic competition.

Summary
This chapter examines the pricing and output decisions faced by firms in perfect competition,
monopoly and monopolistic competition. In the case of perfect competition, the firm has virtually
no power to set the price and is only able to decide to what extent (if at all) it wants to produce in
this market, given the going market price. In the case of a monopoly, the firm is the entire market
supply. This monopoly of supply gives the firm the power to set any price that it desires. In certain
cases, this monopoly power is regulated by the government. In monopolistic competition, there is
product differentiation, and it contains the features of both perfect competition and monopoly.

Keywords
Economic cost: All cost incurred to attract resources into a company’s employ. Such cost includes
explicit cost usually recognized on accounting records and opportunity cost.

Economic profit: Total revenue minus total economic cost. An amount of profit earned in a
particular endeavour above the amount of profit that the firm could be earning in its next-best
alternative activity. Also referred to as abnormal profit or above or mal profit.

Monopoly: A market in which there is only one seller for a particular good or service. There may
be legal barriers to entry into this type of market (e.g., railway).

Monopolistic competition: A market distinguished from perfect competition in that each seller
attempts to differentiate its product from those of its competitors (e.g., in terms of location,
efficiency of service, product attributes, advertising, or promotion). Good examples of this type of
market can be found in small businesses, particularly those in the retail trades.

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Perfect competition: A market with four main characteristics:

(1) many relatively small buyers and sellers,
(2) a standardized product,
(3) easy entry and exit, and
(4) complete information by all market participants about the market price.
Firms in this type of market have absolutely no control over the price and must compete on the
basis of the market price established by the forces of supply and demand.

Shutdown point: The point at which the firm must consider ceasing its production activity because
the short-run loss suffered by operating would be equal to the short-run loss suffered by not
operating (i.e., the operating loss 5 total fixed cost). In a perfectly competitive situation, this point is
found at the lowest point of a firm’s average variable cost curve. If the market price falls to this
point, the firm should consider shutting down its operations. Any price lower than this would
dictate that the firm should cease its operations in the short run.

Self Assessment
1. Which of the following is not a type of market structure?
A. Competitive monopoly
B. Oligopoly
C. Perfect competition
D. All of the above are types of market structures.

2. If the market demand curve for a commodity has a negative slope, then the market
structure must be
A. perfect competition.
B. monopoly.
C. imperfect competition.
D. The market structure cannot be determined from the information given.

3. If a firm sells its output on a market that is characterized by many sellers and buyers, a
homogeneous product, unlimited long-run resource mobility, and perfect knowledge, then
the firm is a
A. a monopolist.
B. an oligopolist.
C. a perfect competitor.
D. a monopolistic competitor.

4. If one perfectly competitive firm increases its level of output, market supply
A. will increase and market price will fall.
B. will increase and market price will rise.
C. and market price will both remain constant.
D. will decrease and market price will rise.

5. Which of the following markets comes close to satisfying the assumptions of a perfectly
competitive market structure?
A. The stock markets.
B. The market for agricultural commodities such as wheat or corn.
C. The market for petroleum and natural gas.
D. All of the above come close to satisfying the assumptions of perfect competition.

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6. A perfectly competitive firm should reduce output or shut down in the short run if market
price is equal to marginal cost and price is
A. greater than average total cost.
B. less than average total cost.
C. greater than average variable cost.
D. less than average variable cost.

7. A monopolized market is in long-run equilibrium when

A. zero economic profit is earned by the monopolist.
B. production takes place where price is equal to long-run marginal cost and long-run
average cost.
C. production takes place where long-run marginal cost is equal to marginal revenue and
price is not below long-run average cost.
D. All of the above are correct.

8. A natural monopoly refers to a monopoly that is defended from direct competition by

A. economies of scale over a broad range of output.
B. a government franchise.
C. control over a vital input.
D. a patent or copyright.

9. Which of the following is a barrier to entry that typically results in monopoly?

A. The firm controls the entire supply of a raw material.
B. Production of the industry's product is subject to economies of scale over a broad range of
output.
C. Production of the industry's product requires a large initial capital investment.
D. The firm holds an exclusive government franchise.

10. Which of the following is an example of price discrimination?

A. It costs more to make a long-distance phone call during the day than it does late at night.
B. A ticket to the zoo costs less for a child than it does for an adult.
C. Regular gasoline costs less than premium gasoline.
D. All of the above are examples of price discrimination.

11. A firm that is engaging in price discrimination will

A. charge a higher price to consumers with a higher price elasticity of demand.
B. charge a higher price to consumers with a lower price elasticity of demand.
C. earn lower profits than a similar firm that does not engage in price discrimination.
D. generally be a perfectly competitive firm.

12. Persistent dumping refers to the practice of

A. international price discrimination.
B. charging a lower price on foreign markets where demand is more price elastic.
C. taking advantage of the segmentation of markets that results from domestic restrictions on
imports.
D. All of the above are correct.

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13. Which of the following industries is most likely to be monopolistically competitive?

A. The automobile industry
B. The steel industry
C. The car repair industry
D. The electrical generating industry

14. Which of the following is a characteristic of monopolistic competition?

A. Few sellers.
B. A differentiated product.
C. Easy entry into and exit from the industry.
D. All of the above are characteristics of monopolistic competition.

15. The demand curve faced by a monopolistically competitive firm is

A. perfectly elastic.
B. elastic.
C. unit elastic.
D. inelastic.

Answers for Self Assessment

1. A 2. D 3. C 4. C 5. D

6. D 7. C 8. A 9. B 10. C

11. B 12. D 13. C 14. A 15. B

Review Questions
1. Why do economists consider zero economic profit to be “normal”?
2. Explain why the demand curve facing a perfectly competitive firm is assumed to be perfectly
elastic (i.e., horizontal at the going market price).
3. In the short run, firms that seek to maximize their market share will tend to charge a lower
price for their products than firms that seek to maximize their profit. Do you agree with
this statement? Explain
4. Explain the key difference between perfect competition and monopolistic competition.

Further Readings
1. Managerial Economics- Principles and Worldwide Applications By Salvatore,
Dominick and Rastogi, Siddhartha K., Oxford University Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul G,
Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education, India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary,
McGraw Hill Education (India) Private Limited

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Tanima Dutta, Lovely Professional University Unit 07: Oligopoly

Unit 07: Oligopoly

CONTENTS
Objectives
Introduction
7.1 Features of Oligopoly Market
7.2 Causes for the Existence of Oligopoly
7.3 Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence
7.4 Cartelisation
7.5 Price leadership
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
• Examine the nature of Oligopoly Market
• Understand the features and assumptions of Oligopoly market
• Comprehend the various models of price determination in this market, with detailed
analysis of cartelisation
• Identify the practice of price leadership

Introduction
Oligopoly refers to a market wherein only a few firms account for most or all of total production.
Oligopoly refers to the presence of few sellers in the market selling the homogeneous or
differentiated products. In other words, the Oligopoly market structure lies between the pure
monopoly and monopolistic competition, where few sellers dominate the market and have control
over the price of the product.
Under the Oligopoly market, a firm either produces homogeneous or heterogeneous products:

1. Homogeneous Product: The firms producing the homogeneous products are called as
Pure or Perfect Oligopoly. It is found in the case of industrial products such as cement,
copper, steel, zinc, iron, etc. In case of agricultural products, it can be seen in case of su
2. Heterogeneous Product: The firms producing the heterogeneous products are called as
Imperfect or Differentiated Oligopoly. Such type of Oligopoly is found in the production
of consumer goods such as automobiles, soaps, detergents, television, refrigerators, etc.

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7.1 Features of Oligopoly Market

1. Few Sellers: Under the Oligopoly market, the sellers are few, and the customers are
many. Few firms dominating the market enjoy a considerable control over the price of
the product.
2. Interdependence: It is one of the most important features of an Oligopoly market,
wherein, the seller has to be cautious with respect to any action taken by the
competing firms. Since there are few sellers in the market, if any firm makes a change
in the price or promotional scheme, all other firms in the industry have to comply
with it to remain in the competition. Thus, every firm remains alert to the actions of
others and plan their counterattack beforehand to escape the turmoil. Hence, there is a
complete interdependence among the sellers with respect to their price-output
policies.
3. Advertising: Under Oligopoly market, every firm advertises their products on a
frequent basis with the intention to reach more and more customers and increase their
customer base. This advertising makes the competition intense. If any firm does a lot
of advertisement while the other remained silent, then you will observe that his
customers are going to the firm which is continuously promoting its product. Thus, in
order to be in the race, each firm spends lots of money on advertisement activities.
4. Competition: It is genuine that with a few players in the market, there will be an
intense competition among the sellers. Any move by one firm will have a considerable
impact on its rivals. Thus, every seller keeps an eye over its rivals and be ready with
the counterattack.
5. Entry and Exit Barriers: The firms can easily exit the industry whenever they
want, but has to face certain barriers to enter into it. These barriers could be
Government license, Patent, large firm’s economies of scale, high capital requirement,
complex technology, etc. Also, sometimes the government regulations favour the
existing large firms, thereby acting as a barrier for the new entrants.
6. Lack of Uniformity: There is a lack of uniformity among the firms in terms of their
size, some are big, and some are small. Since there are less number of firms, any
action taken by one firm has a considerable effect on the other. Thus, every firm must
keep a close eye on its counterpart and plan the promotional activities accordingly.

7.2 Causes for the Existence of Oligopoly

There are certain reasons which have led to the emergence of oligopoly. These are:

Large Investment of Capital: The number of firms in an industry may be small due to the large
requirements of capital. No entrepreneur will like to venture into investing large sums in an
industry in which addition to output to the existing level may depress prices. Further, the new
entrant may also fear of provoking a price-war by the established firms in the industry. This is
always true that in the midst of differentiated products, it is difficult to introduce a new product.

Control of Indispensable Resources: A few firms may control some indispensable resources
which may enable them to secure several advantages in costs over all others. This enables them to
operate profitably at a price at which others cannot survive.

Legal Restriction and Patents: In public utility sector, the entry of new firms is closely regulated
through the grant of certificate by the State. This policy of exclusion of rivals may be due to
diseconomies of small scale or of duplication of services. Another factor for the emergence of
oligopoly is the patent right which a few firms acquire in matter of some goods. Patents have led to
many important industrial monopolies in America and elsewhere.

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Economies of Scale: Another factor responsible for emergence of oligopoly is the operations at
large scale. In some industries, a few firms can meet the entire demand for the product. It is
possible that the demand may be satisfied by a large number of firms, but small firms cannot secure
the economies of large scale production. In the industries where there is a lot of mechanisation and
where economies of large scale are considerable, only a few firms will survive. The firms attain
such a huge size that just a few of them can satisfy the entire demand. For example, automobiles,
steel industry, petroleum etc. Oligopolies are also found in local markets. In small towns, a few
firms may be sufficient to satisfy the demand, e.g., petrol, banks, building material suppliers etc.
The market is small and therefore can be satisfied by a few firms.

Superior Entrepreneurs: In some industries there may be some superior entrepreneurs whose
costs are lower than inferior rivals. These entrepreneurs under sell and eliminate most of their
rivals.

Mergers: Many oligopolies have been created by combining two or more independent firms. The
combination of two or more firms into one firm is known a merger. The main motives of mergers
include increasing market powers, more resources, economies of scale and market extensions etc.

Difficulties of Entry into the Industry: Lastly, oligopoly may come to exist because of
difficulties of entry into the industry. One big difficulty in some industries is the large requirements
of capital. Businessmen do not like to venture into those industries entry to which, even of one firm,
is likely to depress prices to such an extent as to make it unprofitable for all. They may also be
afraid of the price war that their entry may provoke from the established firms in the industry.
Prospective entrants to an industry are also deterred by the difficulty of marketing new products or
new brands in the presence of already well-established, well-entrenched brands.

7.3 Pricing in an Oligopolistic Market: Rivalry and Mutual

Interdependence
Whether the sellers in an oligopolistic market compete against each other by differentiating their
product, dominating market share, or both, the fact that there are relatively few sellers creates a
situation where each is carefully watching the other as it sets its price. Economists refer to this
pricing behaviour as mutual interdependence. This means that each seller is setting its price while
explicitly considering the reaction by its competitors to the price that it establishes.
In the 1930s, economist Paul Sweezy provided an early insight into the pricing dynamics of mutual
interdependence among oligopoly firms by developing a kinked demand curve model. The basic
assumption of the Sweezy model is that a competitor (or competitors) will follow a price decrease
but will not make a change in reaction to a price increase. Thus, the firm contemplating a price
change may refrain from doing so for fear that quantities sold will be affected in such a way as to
decrease profits.
If a firm lowers its price, this may have an immediate impact on the competition. This firm takes its
action to increase sales by drawing customers away from the higher-priced competitors, but when
competitors realize what is happening (i.e., their sales are declining), they will quickly follow the
price cut to maintain their market share. If this firm undertakes the opposite action—a price
increase—incorrectly assuming competitors will follow suit, its sales will drop markedly if
competitors fail to do so.
It is easy to demonstrate the “kink” in such a demand curve with the graph in Figure 7.1. Let us
assume the original price and quantity are found at point A. If the firm lowers its price, expecting
that quantity demanded will move along the more elastic demand curve Df and this result
materializes, then it will gain a relatively large quantity of additional sales for a relatively small
decrease in price. If it lowers its price from P to P1, it will expect to increase its sales from Q to Q1.
This is the relevant demand curve for the firm if other companies do not retaliate. Our firm would
thus gain customers at the expense of competition. However, if competitors do react and match the
price cut, our company will increase its sales only to Q 2, along demand curve Di; this is the
relevant demand curve when all companies in the industry decrease their price equally. There will
be a relatively small increase in sales because all prices in the industry are lower, but not nearly as
much as the company expected when it reduced its price.

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Fig. 7.1 Demand Curves for Oligopoly

In contrast, suppose our company decides to raise its price, anticipating that competitors will
follow the increase. It thus expects to move along Di to Q3 when it boosts its price to P3. It would
thus sustain some loss in sales while benefiting from a significantly higher price. However, suppose
its competitors refuse to play along and keep their prices unchanged. The company’s situation now
becomes more precarious because its quantity sold drops to Q4: The demand curve for the firm
alone is much more elastic than if all firms raise their prices in unison.
The prospect of being stung by such action will make the company much more loath to change its
price from P. From that vantage point, it will appear to the company that the appropriate demand
curve is Di if price is lowered and Df if the price is increased. The upper portion of Df and the lower
portion of Di can be seen to form a kinked demand curve around point A; thus, the name of
Sweezy’s model. These relevant portions of the two demand curves are boldly outlined in Figure
7.1
Now that we have developed a demand curve for this oligopolist, we can also derive a marginal
revenue curve. This marginal revenue curve will be discontinuous: there will be a gap at the point
where the kink occurs. As we know, a company will maximize its profits at the point where
marginal cost equals marginal revenue. The two marginal cost curves drawn in Figure 7.2 both
imply the same price and quantity at point A. Thus, a significant change in costs could occur for our
firm, but it will not react by changing its price. The price may remain unchanged even if the
demand curve moves to the right or left, as long as the kink remains at the same price level. Hence,
it can be concluded that under the circumstances described, a kinked demand curve will result in
price rigidities despite changes in demand and cost.

Fig. 7.2. Kinked demand curve

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Over the years, the kinked demand curve has been challenged by other economists. In particular,
Nobel Prize laureate George Stigler investigated several oligopolistic industries and found little
empirical support for Sweezy’s model. Stigler found that in these industries, price increases were
followed as quickly as were price decreases. Such findings, of course, contradict the existence of the
kink. Further, the model does not explain how the price was originally set at the kink. Was it
originally set where marginal revenue equalled marginal cost, or was it by some other means, such
as tradition?

7.4 Cartelisation
Competition is a very tough taskmaster. To survive in competition in the long run, a company must
operate at its most efficient (minimum) cost point, and it will earn no more than a normal return.
Thus, there is always an incentive for a company to try to become more powerful than its
competitors—in the extreme, to become a monopolist. In an oligopolistic type of industry, where
there are several powerful firms, it would probably be impossible for one firm to eliminate all the
others. So, to reap the benefits of a monopoly (i.e., higher profits and the general creation of a more
certain and less competitive environment), it may be advisable for companies in the industry to act
together as if they were a monopoly. In other words, they all agree to cooperate with one another;
they form a cartel. Cartel arrangements may be tacit, but in most cases some sort of formal
agreement is reached. The motives for cartelization have been recognized for many years. Indeed,
an early recognition can be found in a passage in Adam Smith’s famous book written in 1776:
“People of the same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation.
The Organisation of Petroleum Exporting Countries (OPEC) is perhaps the best-known example of
an international cartel. OPEC members meet regularly to decide how much oil each member of the
cartel will be allowed to produce.
Cartels may not flourish in all oligopolistic markets. Following are some of the conditions that
influence the formation of cartels.

1. The existence of a small number of large firms facilitates the policing of a collusive agreement.
2. Geographic proximity of the firms is favourable.
3. Homogeneity of the product makes it impossible for cartel participants to cheat on one another
by emphasizing product differences.
4. The role of general business conditions presents somewhat contradictory arguments. Cartels
are often established during depressed industry conditions, when companies attempt to
forestall what they consider to be ruinous price cutting. However, it also appears that cartels
disintegrate as demand for the product falls, and each member thinks it can do better outside
the cartel. The cartel may then re-establish itself during the recovery period. Thus, cartels can
form or fall apart during either phase of the business cycle.
5. Entry into the industry must be difficult. The case of OPEC is a good example. It is impossible
for countries that do not possess the basic resource to begin petroleum production and
compete for monopoly profits.
6. If cost conditions for the cartel members are similar and profitability thus will not differ greatly
among members, cartels will be easier to maintain. Product homogeneity, mentioned earlier,
will contribute to cost uniformity.
The ideal cartel will be powerful enough to establish monopoly prices and earn maximum
monopoly profits for all the members combined. This situation is illustrated in Figure 7.3. For
simplicity, assume there are only two firms in this oligopolistic industry. The total industry
demand curve is shown in Figure 7.3 c. The marginal revenue curve is constructed for this demand
curve in the usual manner. Each of the two competitors (illustrated in Figure 10.1a and b) has its
respective average total cost and marginal cost curves, which can differ.

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The two individual marginal cost curves are then added horizontally, and the result is plotted on
the industry graph (MCT). Industry output will take place where MCT equals the industry
marginal revenue, and the price charged will be found by drawing a vertical line to the demand
curve (point A). This is, of course, the classic monopoly situation, and monopoly profits will be
maximized at this point. The next step is to establish how much each of the two companies will sell
at this price. For the entire industry output to be sold, each company will sell that output
corresponding to the point at

Fig. 7.3 Ideal Cartel

which a horizontal line drawn from the MCT = MRT intersection on the industry graph crosses the
marginal cost curve of each of the two firms. It can be seen that each firm will produce different
quantities and achieve different profits, depending on the level of the average total cost curve at the
point of production. Generally, the lower average cost company will be the more profitable one
(profits for the two companies are shown by the hatched areas in Figure 7.3). This result, although
maximizing combined profits, may also be one of the reasons for the subversion of cartels. A very
efficient company with low average costs, and most likely with excess capacity under cartel
conditions, may find it profitable to cheat by offering its product at a lower price and capturing a
larger share of the total business.
Such a cartel may be unstable. Unless strictly enforced, cartels will have a tendency to break down.
Secret price cuts may be extremely profitable because (if the product is undifferentiated) the
demand curve for an individual firm in a cartel will be quite elastic. Cartel subversion often occurs
during slumps in demand because individual members will be looking to increase their share to
avoid significant quantity decreases.
It must also be remembered that collusion is costly. First, there is the cost of forming the cartel.
Second, there is a cost of monitoring the actions of the cartel members and of enforcing the rules to
minimize cheating. There is also the potential cost of punishment by authorities. Thus, in the end,
cartelization may not necessarily be profitable. In short, the additional revenues obtained by cartel
members due to collusion must exceed the costs just described. We can, therefore, state that,
although profit maximization is the incentive that leads to collusion, it may also be the cause of a
cartel’s breakdown.
Cartels often have agreements specifying the market share of each participant. Such allotments may
be based on history, or they can be arranged to give each member a certain geographic area.
Collusion can also exist in much more informal ways. Thus, physicians within a geographic area
coincidentally charge similar fees for their services. Trade associations are often suspected of
collecting and conveying information that will lead to the fixing of prices.

7.5 Price leadership

When collusive arrangements are not easily achieved, another type of pricing practice may occur
under oligopolistic market conditions. This is the practice of price leadership, in which there is no
formal or tacit agreement among the oligopolists to keep prices at the same level or change them by

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the same amount. However, when a price movement is initiated by one of the firms, others will
follow. Examples of such practices abound. You may have observed that at two or more gasoline
stations at the same intersection, prices for each grade of gasoline are either identical or almost the
same most of the time. Another example is automobile companies, which in recent years have come
up with rebate programs. Surely you have seen advertisements offering “$1,000 cash or 3.9 percent
financing.” One company is usually the first to announce such a program; the others follow in short
order. Another case is IBM. For many years, in the 1950s and 1960s, IBM was considered to be the
price leader in the computer industry. In fact, IBM’s prices were considered to form an “umbrella”
for industry pricing. It was said that IBM would establish a price, and because it was the most
powerful and preferred manufacturer and thus could command a higher price (an umbrella over
the others), its competitors would tend to set their prices at some slightly lower level for similar
equipment.
We just described two major variants of the price leadership phenomenon: barometric and
dominant price leadership.

Barometric Price Leadership

There may not be a firm that dominates all the others and sets the price each time. One firm in the
industry—and it does not always have to be the same one—will initiate a price change in response
to economic conditions, and the other firms may or may not follow the leader. If the barometric
price leadership model has misjudged the economic forces, the other companies may not change
their prices or may effect changes of a different, possibly lesser, magnitude. If the firm has correctly
gauged the sentiment of the industry, all the firms will settle in comfortably at the new price level.
But if this does not happen, the price leader may have to retract the price change, or a series of
iterations may be set in motion until a new price level, agreeable to all, is reached. Such a pattern of
price changes has been observed in many industries, including automobiles, steel, and paper.
In more recent years, the airline industry has furnished several examples of price leadership that
was not followed. An almost bizarre example occurred in August 1998. First, Delta Air Lines and
American Airlines raised leisure fares by 4 percent. When Northwest Airlines refused to match the
increase, it was rescinded. A few days later, Northwest raised its fares and was matched by the
others. Two days later Northwest rescinded the increase, and within a day other airline followed.
Then Northwest raised some of its fares again, only to pull some of them back, and actually
decreased leisure fares in some of its markets. Other airlines then realigned their fares with those of
Northwest. A similar case occurred more recently. Due to the increases in fuel costs in the summer
of 2004, American Airlines announced that it was increasing prices on domestic flights by $5 on
one-way trips and $10 on roundtrips. Some airlines went along with this increase. However, some
low-cost airlines, including Southwest and JetBlue, refused to increase their fares. A day later,
American and the other airlines retracted the increases.

Dominant Price Leadership

When an industry contains one company distinguished by its size and economic power relative to
other firms, the dominant price leadership model emerges. The dominant company may well be the
most efficient (i.e., lowest-cost) firm. It could, under certain circumstances, force its smaller
competitors out of business by undercutting their prices, or it could buy them out on favourable
terms. But such action could lead to an investigation and eventual suit by the U.S. Department of
Justice under the Sherman Anti-Trust Act. To avoid such difficulties, the dominant company may
actually act as a monopolist, setting its price at the point where it will maximize its profits, and it
will permit the smaller companies to continue to exist and sell as much as they want at the price set
by the leader. The theoretical explanation of the dominant price leadership model is quite
straightforward and is presented in all microeconomics textbooks. We follow its development in
figure 7.4.

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Fig. 7.4 Dominant Price Leadership

The demand curve for the entire industry is DT. The marginal cost curve of the dominant firm is
MCD, and the sum of all the marginal cost curves of the follower firms is represented by MCR. The
demand curve for the leader, DD, is derived by subtracting at each point the marginal cost curve of
the followers from the total demand curve, DT. The reason is that if the small firms supply the
product along their combined marginal cost curve, MCR, then the dominant firm will be left with
product demand shown along DD. When the leader’s
marginal revenue curve, MRD, is drawn in the usual manner, the leader can establish its profit-
maximizing output A and its price at point B. This price is then accepted by the smaller firms in the
industry, which will supply the rest of the market at this price. The followers are thus actually faced
by a horizontal demand curve at price P.

Summary
Oligopoly is the most popular form of imperfect market system which has led to the development
of advertising, sales promotion, and more complex structures. The basis of Oligopoly is stiff
competition with the number of sellers limited and the goods are very close substitutes of each
other. Paul Sweezy gave the kinked demand curve model to show price rigidity in the market and
the reasons for it. Cartelisation and price leadership are two forms of cooperation. Cartels are
formed to avoid the uncertainties of a possible reaction by one competitor to price and production
actions by another. The firms in the industry agree on unified pricing and production actions to
maximize profits. However, as history shows, such arrangements are not always stable. Price
leadership exists when one company establishes a price and others follow. Two types of price
leadership were discussed: barometric and dominant

Keywords
Barometric price leadership: In an oligopolistic industry, a situation in which one firm, perceiving
that demand and supply conditions warrant it, announces a price change, expecting that other
firms will follow.

Cartel: A collusive arrangement in oligopolistic markets. Producers agree on unified pricing and
Production actions to maximize profits and to eliminate the rigors of competition.

Dominant: price leadership. In an oligopolistic industry, a firm, usually the largest in the industry,
sets a price at which it will maximize its profits, allowing other firms to sell as much as they want at
that price.

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Oligopoly: A market with few sellers selling differentiated product. Advertisement cost are very
high and demand curve is not defined

Self Assessment
1. The market for automobiles is an example of
A. monopolistic competition.
B. duopoly.
C. differentiated oligopoly.
D. pure oligopoly.

2. According to the kinked demand curve model, a firm will assume that rival firms will
A. keep their rates of production constant.
B. keep their prices constant.
C. match price cuts but not price increases.
D. match price increases but not price cuts.

3. The refrigerator industry is an example of

A. monopolistic competition.
B. monopoly.
C. oligopoly.
D. perfect competition.

4. The petroleum industry is an example of

A. monopolistic competition.
B. pure oligopoly.
C. duopoly.
D. differentiated oligopoly.

5. Which of the following is a form of non price competition?

A. Advertising
B. Quality of service
C. Product quality
D. All of the above are forms of non price competition.

6. A cartel that gives each member the exclusive right to operate in a particular geographic
area is a
A. market-sharing cartel.
B. centralized cartel.
C. price leadership cartel.
D. None of the above is correct.

7. A cartel that operates like a multi-plant monopolist is a

A. market-sharing cartel.
B. centralized cartel.
C. price leadership cartel.

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D. None of the above is correct.

8. Under the price leadership model

A. Rivals will follow price decreases but not increases.
B. Rivals will follow both price increases and decreases.
C. The leader is the largest firm.
D. None of the above are accurate of the price leadership model.

9. Important sources of non-price competition include:

A. Advertising to affect preferences.
B. Market segmentation.
C. Limited time pricing events.
D. Both 1 and 2 are examples of non-price competition.

10. Under the dominant-firm price leadership model,

A. all firms but the dominant firm are price takers.
B. the dominant firm acts as the residual monopolistic supplier.
C. the demand curve faced by the dominant firm is flatter than the market demand curve.
D. All of the above are correct.

11. Price leadership is an example of tacit collusion.

A. True
B. False
12. The dominant-firm price leadership model describes a market structure in which a
dominant firm is the price maker and all other firms are price takers.
A. True
B. False

13. Limit pricing refers to the oligopolistic practice of charging a price so low that new firms are
discouraged from entering the industry.
A. True
B. False

14. The sources of oligopoly are generally the same as for monopoly, i.e., barriers to entry.
A. True
B. False

15. Which of the following statement about price leadership is false?

A. Price leadership is a form of tacit collusion
B. With dominant price leadership, the leader in an industry is the biggest firm
C. With barometric price leadership, the leader may change even if the relative size of each
firm stays the same
D. Price leadership breaks down if input prices or demand conditions change

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Answers for Self Assessment

1. C 2. C 3. C 4. B 5. D

6. A 7. B 8. D 9. D 10. D

11. A 12. A 13. A 14. A 15. D

Review Questions
1. What are the special features of Oligopoly?
2. What is the difference between price leadership and cartelisation?
3. Explain the Kinked demand curve model of Oligopoly.
4. Explain how price leadership works.
5. Explain how cartels are formed and the reason for their formation.

Further Readings
1. Managerial Economics- Principles and Worldwide Applications By Salvatore,
Dominick and Rastogi, Siddhartha K., Oxford University Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul G,
Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education, India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary, McGraw
Hill Education (India) Private Limited

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Tanima Dutta, Lovely Professional University Unit 08: Game Theory

Unit 08: Game Theory

CONTENTS
Objectives
Introduction
8.1 Assumptions
8.2 Structure of a Game
8.3 Dominant and Dominated Strategy
8.4 Nash Equilibrium
8.5 The Prisoners’ Dilemma
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
Understand the concept of Game Theory
Discuss the terms and strategies of Game Theory
Determine Nash Equilibrium
Discuss the Game of Prisoner’s Dilemma
Apply the Game theory in real market

Introduction
Economists have extended and refined the analysis of oligopoly markets using game theory to
examine strategic interaction. A game is distinguished by the number of players in the game and
the number of options or strategies available to each player. A game involves players making
strategic decisions from an available set of options. Players are the decision-making units that play
games. Each player chooses among various strategies or options. A strategy is an option available
to a player.
Game theory is a method of analysing strategic interaction. It analyses the way in which two or
more interacting parties choose strategies that jointly affect each participant in some way. In the fi
rst place, what is a game? Game, the name itself hints at mysteries and challenges of unknown
moves and unanticipated outcomes. A game
between two or more players is a formal
Game theory is a mathematical tool that example of a strategic situation, in which
helps to study strategic situations in players optimise their maximum gains,
which players optimise a variable not depending on the response of other players.
only on the basis of their own preferences, Game theory is a mathematical tool that helps to
but also on other players’ decisions and study strategic situations in which players
reactions. optimise a certain variable not only based on
their own preferences, but also on the other
players’ decisions and reactions. It is that branch
of applied mathematics that formally structures a situation in the form of a game and studies the
behaviour of conflict (competition) and cooperation (collaboration) between players.

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Games are characterised by several players or decision makers who interact, and even “threaten”
each other, and at times establish coalitions and take actions under uncertain conditions. As an
outcome, these players receive some benefit (or even loss) or reward (or punishment). The different
types of moves taken by different players in various games are systematically and structurally used
by economic theorists and mathematicians to explain economic analysis in a distinct branch of
economics, known as game theory.

8.1 Assumptions
Game theory provides a mathematical process for selecting an optimum strategy in the face of
opponents who have their own strategies. In game theory, one usually makes the following
assumptions:

1. Each decision maker (or player) has two or more well specified choices or sequences of choices
(plays).
2. Every possible combination of plays available to the players leads to a well-defined end state
(win, loss, or draw) that terminates the game.
3. A specified payoff for each player is associated with each end state (zero sum, constant sum or
non-zero sum).
4. Each decision maker has perfect knowledge of the game, including the rules of the game as
well as the payoffs of all other players.
5. All decision makers are rational, that is, each player, given two alternatives, will select the one
that yields him the greater payoff (or which minimises the losses).

8.2 Structure of a Game

In order to understand game theory, it is essential to first understand the structure of a game. For
this, you need to be conversant with the various concepts associated with a game.

Players
They are the participants in the game; they may include individuals, firms, or even the government
with some policy variables. The underlying assumption is that the player is rational and chooses
the strategy or action which provides the most preferred outcome, conditioned on what its
opponents are anticipated or expected to do.

Strategy
It is the precise course of action with clearly defined objectives, either having complete knowledge
about the other player, or predicting its behaviour. A strategy fully determines the player’s
behaviour. Various types of strategies are discussed in subsequent sections. It is a set of strategies
for each player that fully specifies all the actions in a game.

Payoff
The “payoff” of a strategy is the net utility or gain to a player for any given counter strategy of the
other player. This gain is measured in terms of the objectives of the player, and is generally denoted
by a number. If, for example, the objective of the firm is to maximise profit, then the payoff of the
strategy will be measured in terms of the profit it earns. If the goal is optimising market share, then
the payoff will be measured by the shares that the strategy will yield to the firm opting for it.

Payoff Matrix
Given the strategies of all the players in a game, the payoff matrix will represent the set of
outcomes for the game. It is a table showing the payoffs accruing to player owing to each possible
combination of strategies adopted by him/her and the other players. You will learn more about
payoff matrix in subsequent sections.

Outcome
It is the end result accruing to different players by opting for different strategies of the game.
Equilibrium A specific outcome is regarded as equilibrium if no player in the game can take any

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action to make its payoff any better, and when all the other players continue to follow their optimal
strategies.

Pure and Mixed Strategies

When a strategy specifies one and the same particular action at each decision point in a game, it is a
pure strategy. You know that Jasprit Bumrah is a pacer with unorthodox action. His yorkers
usually dip very late and his slower deliveries are hard to deal with by batsmen in aggressive
mode. If Bumrah bowls all yorkers in an over, that would be an example of a pure strategy!
However, it may also be possible that a player would avoid being predictable, and would prefer
randomness in actions at various decision points in a game. Such a strategy would be a mixed one.
Bumrah had bowled 10 yorkers in the Australia–India Twenty20 International series, giving only
four runs and taking two wickets! Obviously that must have kept the opponent batsmen
wondering what would be his next ball, a Yorker, or a short pitch one, or one on the leg stump! You
got it right, a mixed strategy would always keep the rival player alert and wondering about the
next move of a player!
The study of games is based on two principles:

1. Choices of the players are motivated by their own well defined preferences, and
2. Players take their preferences into consideration in relation to the choices of other players.
Or stated differently, players act strategically, taking decisions with well stated objectives, and also
with the perception of the expected behaviour of other players. Therefore, these concepts of game
theory are applied only when the actions and strategies of the players are interdependent. These
concepts are used to formulate, structure and analyse distinct strategic situations of different
players and consequently the possible outcomes derived from the game.

8.3 Dominant and Dominated Strategy

So far it must be clear to you that in a game the players, being rational, take those actions that result
in their preferred outcome, contingent on what their opponents do. Suppose, in a game a player has
two strategies A and B available to it. Suppose also that given all possible combinations of
strategies of the other players, the outcome derived by a player from strategy A is better than that
of strategy B. This implies that strategy A dominates strategy B; in other words, strategy A is the
dominant strategy and B is the dominated strategy. A rational player will always choose the
dominant strategy, no matter what the strategies of other players are.
Thus, the dominant strategy is the optimum strategy taken by a player which maximises its
outcomes, whatever is the strategy of its opponents. This strategy yields the best payoff, no matter
what the strategies other players choose. If one player has a dominant strategy in a game, then all
other strategies are dominated strategies. A dominant strategy equilibrium is one in which all
players have a dominant strategy.

8.4 Nash Equilibrium

In 1951, John Nash developed the equilibrium concept which is known by his name. Nash
equilibrium proposes a strategy for each player such that no player has the incentive to change its
action unilaterally, given that the other players follow the proposed action. It is the optimal
collective strategy in a game involving two or more players, where no player has anything to gain
by changing his/her strategy. Let us explain this with the same example given in the previous
section. The only difference is in the payoff of Ring, when both Ring and Tone do not advertise.
It is assumed here that when both Ring and Tone do not advertise, Ring gets a payoff of 65 and
Tone gets a payoff of 25. The new payoff matrix is given in Table 8.1. The new assumption here is
that Ring uses an expensive advertising agency, and would shift the burden of increased cost to the
consumer by increasing the price of the product; so the company gets a lesser market share when it
advertises, as compared to when it does not advertise. Thus, if Tone does not advertise, then it is
better for Ring not to advertise and get the larger share of the market.

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Table 8.1 Payoff Matrix

As per Nash equilibrium, both the players would try to take the best possible action given the
opponent’s action; hence Ring would try to speculate Tone’s action and Tone would anticipate
Ring’s action. Since Ring presumes that Tone will advertise, it is better for Ring to advertise (payoff
50) than not to advertise (payoff 40). Similarly, Tone knows that Ring will advertise because it is in
its interest, therefore, Tone will also advertise (payoff is 20) because if Tone does not advertise
given that Ring advertises the payoffs are less (10).
Therefore, the Nash equilibrium in this advertising game is that both companies advertise. Why?
Because it represents a set of strategies for both Ring and Tone, in which neither the players would
benefit anything by changing its strategy, while its rival kept its strategy unchanged. As you can
see it is a suboptimal equilibrium, which is so due to lack of communication and cooperation
between the players.
Let us again play this advertising game with a little change in the payoffs. The change is that if both
Ring and Tone do not advertise, then Ring gets a payoff of 65 and Tone gets a payoff of 35. The new
payoff matrix is given in Table 8.2.

Table 8.2 Payoff Matrix of Ring and Tone

In this case, if Ring advertises, Tone will advertise, because it gets a better payoff by advertising
(payoff 20) than by not advertising (payoff 10). But if Ring does not advertise, Tone will not
advertise, because advertising leads to a lesser preferred (payoff 30) than not advertising (payoff
35). Therefore, Tone advertises when Ring advertises, and Tone does not advertise when Ring does
not advertise. We can easily conclude that the decision of Tone to advertise or not depends on
whether Ring advertises or not. In other words, Tone does not have a dominant strategy in this
game.
Let us now consider the other player. From Ring’s point of view, as in the previous game, if Tone
advertises, it is better for Ring to advertise, because it gets a greater market share by advertising
(payoff 50) than by not advertising (payoff 40). However, if Tone does not advertise, it is better for
Ring not to advertise, because it provides a better payoff (65) than by advertising (payoff 60). Thus,
it is always better for Ring to advertise when Tone advertises, and not advertise when Tone does
not advertise. You can infer quite easily that Ring does not have a dominant strategy in this
example; Ring’s action depends on what Tone does in this case.
Let us now summarize, both Ring and Tone do not have dominant strategies. What would happen
to the equilibrium outcome in this case? This situation is a little complicated. In this case, there are
two Nash equilibriums: the first Nash equilibrium occurs when both companies advertise; the
second occurs when both do not advertise. Now, each firm is better off if it plays the same strategy
as the other firm, and both the Nash equilibriums occur when both the firms simultaneously play
the same strategy.

8.5 The Prisoners’ Dilemma

In 1984, Axelrod gave a new dimension to game theory by presenting “Prisoner’s Dilemma” which
talks of importance of cooperation. The two players in the game can choose between two moves,
either “cooperate” or “defect”. The idea is that each player gains when both cooperate, but if only
one of them cooperates, the other one, who defects, will gain more. If both defect, both lose (or gain
very little) but not as much as the “cheated” cooperator, whose cooperation is not returned.

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Suppose two individuals, White and Gray, are suspected of jointly committing a crime, and there is
weak evidence to support this suspicion. For example, both have been caught trying to fence (sell)
goods that were stolen in an armed robbery. The prosecutors would like to convict the suspects on
the more serious charge, but the evidence linking the individuals to that charge is weak. The
suspects are picked up and put in separate interrogation rooms, where prosecutors provide each
suspect with the following options:

➢ If neither suspect confesses, both will be convicted of possession of stolen propertyand

receive a 1-year sentence.

Table 8.3 The Prisoners Dilemma Game

➢ If only one suspect confesses and is willing to testify at the trial of the other, the one who
confesses will get probation on the stolen property charge and receive no jail time. The
other will receive a 15-year sentence.
➢ If both suspects confess, both will be put away for 10 years.
The dilemma is that confession is a dominant strategy for both parties. Confession dominates not
confessing for White regardless of what Gray does, and confession dominates not confessing for
Gray regardless of what White does. Put in terms of the discussion in this chapter, the set of
strategies (confess, confess) represents a dominant strategy equilibrium. Certainly, both parties
would be better off if they could communicate with one another and agree not to confess. And that
is the reason that prosecutors try to “sweat” each suspect separately. But even if they could
communicate and reach an agreement, there is an incentive to cheat on the bargain. How can you
trust the agreement you have made with your accomplice, especially when you are being told that
he or she is being offered the same deal and you know how trustworthy he or she is from past
experience? It is not surprising then, that such a strategy leads to confessions with sufficient
regularity that it is a standard interrogation technique.
Many oligopolistic interactions have the structure of a prisoners’ dilemma. The nightclub game in
Table 8.4 is a prisoners’ dilemma: Both nightclubs could earn $100 extra in profit by using a deejay
rather than using a live band. The model discussed in the previous chapter where firms face a
choice of restricting output and acting like a joint profit-maximizing cartel (JπMax) versus cheating
on that bargain by expanding output and capturing higher individual profits (Cheat) is easy to
model as a prisoners’ dilemma. Consider the numbers in Table 8.5. Although the numbers in Table
8.5 look quite different from Table 8.3, the two tables have the same qualitative structure. Cheating
is the dominant strategy for each player, but it is not the best that the firms could do. Both firms
would be better served if each could agree to restrict their production in order to achieve joint
profit maximum, but each has an incentive to cheat on the bargain. And, as we already noted,
bargains that attempt to restrain trade are illegal according to U.S. antitrust laws, so tacit
coordination techniques must be employed.

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Table 8.4 Payoff Matrix of a Nightclub Game

Table 8.5 Analyzing Cartel Behaviour as a Game

Some oligopolistic prisoners’ dilemma games are more problematic than others. A key determining
factor in being able to avoid the dominant strategy of confession is playing the game more than
once. The prisoners’ dilemma is a dilemma for the prisoners precisely because they are caught only
once, and the prosecutors offer them the deal only once. Similarly, entry into a new market segment
can be analyzed as a one-shot game. By contrast, firms that are considering the pricing game or the
quantity game play that game repeatedly. When a game is repeated, the players can learn from
their mistakes and they can learn from their rivals; they can engage in bargaining with their rivals,
which often allows them to avoid the prisoners’ dilemma.

Summary
Game theory is a mathematical tool that helps to study strategic situations in which players
optimise a certain variable not only on the basis of their own preferences, but also on the other
players’ decisions and reactions. As per Knight’s definition of risk, game theory falls in the category
of analysing risk, as through this method mathematical probabilities are assigned to situations.
Games are characterised by number of players or decision makers who interact, and even “threaten
“each other, and at times establish coalitions and take actions under uncertain conditions. As an
outcome, they receive some benefit (or even loss) or reward (or punishment).The “payoff” of a
strategy is the net utility or gain to a player for any given counter strategy of the other player. A
pure strategy specifies one and the same particular action at each decision point in a game; a mixed
strategy would have randomness in the actions of the player at various decision points in a game.
Dominant strategy is the optimum strategy taken by a player which maximises its outcomes,
whatever is the strategy of its opponents. If one player has a dominant strategy in a game, then all
other strategies are dominated strategies. Nash equilibrium proposes a strategy for each player
such that no player has the incentive to change its action unilaterally, given that the other players
follow the proposed action. It is the optimal collective strategy in a game involving two or more
players, where no player has anything to gain by changing his strategy.“ Prisoner’s Dilemma” is a
celebrated game that talks of the importance of cooperation. Each player gains when both
cooperate, but if only one of them cooperates, the other one, who defects, will gain more.

Keywords
Dominant strategy: A strategy that produces the optimal outcome regardless of what the other
players do.
Game: Players making strategic decisions from an available set of options.
Nash equilibrium: A type of equilibrium that occurs if every player’s strategy is optimal given its
Competitors’ strategies.
Payoff matrix: A table that describes the outcome to each player for each set of strategic choices.
Payoffs: The outcomes associated with a set of strategies. Each player will have a payoff for each
set of
alternatives.
Players: The decision-making units that play games. Each player chooses among various strategies
or
options.
Zero sum game: A game where the sum of pay-outs is constant, also called a constant sum game.

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Self Assessment
1. Which of the following is an example of a game theory strategy?
A. you scratch my back and I’ll scratch yours
B. if the shoe fits, wear it.
C. monkey see, monkey do
D. none of the above

2. A game that involves multiple moves in a series of identical situations is called a

A. sequential game.
B. repeated game.
C. zero-sum game.
D. non-zero-sum game.

3. In game theory, a situation in which one firm can gain only what another firm loses is
called a
A. non-zero-sum game.
B. prisoners’ dilemma.
C. zero-sum game.
D. cartel temptation

4. An oligopolist may engage in short-run behaviour that results in lower profits if

A. it leads to a Nash equilibrium.
B. it is a dominant strategy.
C. it is not involved in a repeated game.
D. it lends credibility to the firm's threats.

5. In game theory, the outcome or consequence of a strategy is referred to as the

A. payoff.
B. penalty.
C. reward.
D. end-game strategy.

6. Which of the following describes a Nash equilibrium?

A. a firm chooses its dominant strategy, if one exists.
B. every competing firm in an industry chooses a strategy that is optimal given the choices of
every other firm.
C. market price results in neither a surplus nor a shortage.
D. all firms in an industry are earning zero economic profits.

7. If each player in a game has a strictly dominant strategy, then:

A. the game cannot be played repeatedly.
B. there cannot be multiple equilibria.
C. the Nash equilibrium is Pareto efficient.
D. each player chooses a strategy which gives him the highest payoff, given the strategies
chosen by the other players

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8. If each player in a game has a strictly dominant strategy, then:

A. there are multiple equilibria.
B. the equilibrium is strict.
C. the game cannot be played repeatedly.
D. the equilibrium is unique.

9. If a strategy is dominated for a player, then:

A. the player would never choose it.
B. it is the player's best choice.
C. there must be more than one pure strategy Nash equilibrium.
D. there must be one pure strategy Nash equilibrium.
10. A prisoners' dilemma is a game with all of the following characteristics except one. Which
one is present in a prisoners' dilemma?
A. Players cooperate in arriving at their strategies.
B. Both players have a dominant strategy.
C. Both players would be better off if neither chose their dominant strategy.
D. The payoff from a strategy depends on the choice made by the other player.

11. Which of the following legal restrictions, if enforced effectively, would be likely to solve a
prisoners' dilemma type of problem for the firms involved?
A. A law that prevents a cartel from enforcing rules against cheating.
B. A law that makes it illegal for oligopolists to engage in collusion.
C. A law that prohibits firms in an industry from advertising their services.
D. All of the above would be likely to solve a prisoners' dilemma for the firms.

12. Until recently, medical doctors and lawyers have been prohibited from engaging in
competitive advertising. If the prisoners' dilemma applies to this situation, then the
presence of this restriction would be likely to
A. increase profits earned by individuals in these professions.
B. reduce profits earned by individuals in these professions.
C. have no effect on the profits earned by individuals in these professions.
D. increase the profits of some and reduce the profits of other individuals in these
professions.

13. A firm that is threatened by the potential entry of competitors into a market builds excess
production capacity. This is an example of
A. prisoners’ dilemma.
B. collusion.
C. a credible threat.
D. tit-for-tat.

14. If there is a mixed strategy equilibrium, then:

A. at least one player must not be optimizing.
B. the players must be forgoing better choices in order to achieve coordination.
C. there must be more than one pure strategy Nash equilibrium.
D. the players cannot be choosing Nash strategies.

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15. In a mixed strategy, each player should optimize the

A. maximum payoffs.
B. lower value of the game.
C. minimum loss.
D. maximum loss.

Answers for Self Assessment

1. A 2. B 3. C 4. D 5. A

6. B 7. D 8. A 9. A 10. A

11. C 12. A 13. C 14. C 15. A

Review Questions
1. Is a prisoners’ dilemma game a zero sum or variable sum game?
2. Is the prisoners’ dilemma more of a problem for a one-shot or a repeated game?
3. ‘The distinction between risk and uncertainty is uncalled for.’ Comment.
4. Can we apply game theory to explain the behaviour of firms in perfect competition or
monopoly or monopolistic competition? Give logic to support your answer.

Further Readings
1. Managerial Economics- Principles and Worldwide Applications By Salvatore,
Dominick and Rastogi, Siddhartha K., Oxford University Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul G,
Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education, India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary, McGraw
Hill Education (India) Private Limited

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Tanima Dutta, Lovely Professional University Unit 09: Indian Economy Since Colonialism

Unit 09: Indian Economy since Colonialism

CONTENTS
Objectives
Introduction
9.1 Features of Indian Economy during Colonial Period
9.2 Evolution of Colonial Rule
9.3 Impact of British Rule
9.4 National Income of India in Pre-Colonial Era
9.5 Sectoral Analysis of National Income
9.6 Economic change in India
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
Discuss the origins of colonialism
Discuss the calculation of National Income during colonial time
Analyse the components of National Income
Evaluate the development and change in economy

Introduction
India was a direct colony of the British and the impact of this colonial rule over the economy,
society and polity of India has been quite deep. Many serious consequences of the British Colonial
Rule are still persisting and this makes the study of colonial phase of India very relevant for
understanding many contemporary aspects of the Indian society. It must be stated at the outset that
direct colonial rule leaves a total impact on the colonized society because every aspect of social life
is influenced by colonia policies of the colonizers. A direct colony (as was the case with India) is
under the complete control of the colonizers and colonial policies and interests penetrate every
aspect of social life of a colony. Another important fact about India is that the colonial rule lasted
for a very long time and this longevity of the colonial rule over India affected the vitals of the
Indian society. The long period of British rule over India provided enough time to the British to
establish strong and stable institutions for the governance of India. The journey of British
occupation of India was slow and steady and it passed through various stages. This evolutionary
process provided the British an opportunity to evolve their policies and change their policies on the
basis of experience gained through practice. But before we go into that, we should have a look at
the nature of Indian economy prior to British rule.

9.1 Features of Indian Economy during Colonial Period

In the pre-colonial period India was an agrarian economy with a very strong trade base which
provided stability to the economy. The trading system was well developed with well-developed
ports and exchange system. We will in the next part look at agriculture and trade in detail.

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Agriculture
Agricultural operations were carried on in India by subsistence farmers, organised in small village
communities. Village was more or less a self-sufficient economic unit and its business contacts with
the outside world were limited to payment of land revenue (generally in kind) and the purchase of
a few necessary things from the town nearby. The farmer raised only those crops which he needed
for his own use and shared the same with the village artisan who supplied him with simple
manufacture that he needed for his domestic consumption. Means of communication were of a
primitive type. Therefore, trade in agricultural produce, was somewhat limited. The farmer usually
raised enough produce to feed himself and the non-agricultural members of the village community.
If his crop yielded more than the consumption needs, due to favourable climatic conditions, he
stored that surplus for use in the lean years. Storage of food grains was a common practice among
the pre-colonial agriculturists and constituted, under these conditions, the only remedy against
famines. This pattern of agriculture continued throughout the medieval times. However, towards
the end of the 18th century the village communities began to break up, under pressure from new
forces which imparted dynamism to the Indian rural economy. This happened mainly because of
two factors, (1) The change in the property relations brought by the introduction of new forms of
land tenure which you will study a little later in this unit, and (2) the development of an active
export trade in agricultural produce of India. The contact with the west through the establishment
of the British rule was responsible for both these developments.

Trade
Although the Indian villages were largely self-sufficient units, and the means of communication
were primitive, India enjoyed extensive trade both within the country and with other countries of
Asia and Europe. A balance of the imports and exports was maintained. The items imported into
India were pearls, wool, dates, dried fruits and rosewater from the Persian Gulf; coffee, gold, drugs
and honey from Arabia; tea, sugar and silk from China; gold, musk and woolen cloth; metals like
copper, iron and lead, and paper from Europe. The main items exported from India were cotton
textiles. Besides cotton textiles which were famous the world over, India also exported raw silk,
indigo, opium, rice, wheat, sugar, pepper and other spices, precious stones, and drugs. The major
features of Indian trade in pre-colonial times were (i) a favourable balance of trade and (ii) a foreign
trade most suitable to the level of manufacturing in India. A favourable balance of trade meant an
excess of exports over imports, i.e., India exported more than it needed to import. Since the
economy was overall self-sufficient in handicrafts and agricultural products, India did not need
imports on a large scale and continued to enjoy a healthy trade. Secondly, India's foreign trade
suited its requirements very well. In other words, the commodity pattern, so important to any
country's foreign trade, was in India's favour. India exported the items it specialised in; and
imported the ones it needed. One major change that occurred in India's foreign trade from pre-
colonial to colonial times was in its commodity pattern. Although India continued to have an
export surplus, the pattern of foreign trade turned upside down. For instance, from an exporter of
cotton textiles, India was converted into an importer of cotton textiles, thereby ruining India's rich
traditional handicrafts.

Handicrafts
As discussed above India was a land of extensive manufactures. Indian artisans were famous for
their skills the world over. In fact, the reason for India's favourable foreign trade was its excellence
in indigenous production. India indulged in a large-scale manufacture of cotton and silk fabrics,
sugar, jute, dyestuffs, mineral and metallic products like arms, metal wares and oil. Towns like
Dacca and Murshidabad in Bengal; Patna in Bihar; Surat and Ahmedabad in Gujarat; Chanderi in
Madhya Pradesh; Burhanpur in Maharashtra; Jaunpur, Varanasi, Lucknow, and Agra in U.P.;
Multan and Lahore in the Punjab; Masulipatnam, Aurangabad and Visakhapatnam in Andhra;
Bangalore in Mysore and Coimbatore and Madurai in Madras were flourishing centres of textile
industry. Kashmir specialised in woolen manufactures. Maharashtra, Andhra, and Bengal were
prominent centres of ship building industry. India's ships were bought by many European
companies for their use. India, towards the end of the 18th century was, undoubtedly one of the
main centres of world trade and industry. This status of India was completely destroyed under
colonial times. Its beginnings can be traced to the aftermath of the industrial Revolution in England.
The machine-made cloth of England began to replace the indigenous manufactures. India's artisans
were forced out of production. It was this pressure from the British goods which led to the decline
of the traditional India's centres of economic activity listed above. The number of weavers also
declined.

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9.2 Evolution of Colonial Rule

The British East India Company got a legal charter for trade from the Mughal ruler in 1600, and
soon this trading company started conquering India. The conquests began in 1757 with the defeat of
the Nawab of Bengal by Robert Clive. The East India Company ruled India for a century, i.e., from
the decisive Battle of Plassey in 1757 to 1857 when Indians fought a war of independence. The
British defeated the Indians in this war and in 1858 Queen Victoria assumed the responsibility of
direct rule over India. The rule of East India Company ended and the British Parliament became
directly responsible for the governance of India and this continued till 1947.

9.3 Impact of British Rule

Destruction of Indian Handicrafts
The Industrial Revolution in England created a serious impact on Indian economy as it reversed the
character and composition of India’s foreign trade. This led to destruction of Indian handicrafts
although there was no substantial growth of modern factory industry.
The factors which were responsible for the gradual decay of Indian handicrafts were—
disappearance of princely courts and their patronage, aggressive trade policy of the East India
Company and the British Government, increasing competition of British machine—made goods
and increasing demand for Western commodities as a result of foreign influence.
The destruction of Indian handicrafts created a vacuum in Indian markets which was subsequently
fed by British manufactured goods. The destruction of Indian handicrafts led to serious
unemployment problem and the weavers were most seriously affected.
Moreover, this unemployed craftsmen and artisans could not find any alternative occupation open
to them and thus they had to return to agricultural sector leading to ‘progressive ruralisation of
India’. Thus, this dependence of population on agriculture gradually increased from 55 per cent in
1901 to 72 per cent in 1931 and this led to progressive sub-division and fragmentation of
agricultural holdings.

New Land System

New land system of the British ruler also created a serious impact on the Indian economy. During
the East India Company rule, the company administrators imposed land revenue at exorbitant rates
and thereby realised larger returns from land.
Thereafter, the British Government introduced the land settlement in 1793. Permanent settlement
was introduced in Bengal and other neighbouring areas, and then gradually extended to other
states. This settlement led to introduction of zamindary system where zamindars were responsible
for collecting and remitting the land revenue to the British rulers.
Later on, another system known as ryotwari settlement was also introduced in Bombay and Madras
and then subsequently to north-eastern and north-western India where peasant landlords were
directly responsible to the state for the annual payment of land revenue.
Under both these systems, the land revenue or the rent fixed was excessively high and this led to
destruction of the organic village community in India.
In this connection, Daniel and Alice Thorner wrote, “Whereas the zamindary system made the
landlords masters of the village communities, the Ryotwari system cut through the heart of the
village communities by making separate arrangement between each peasant cultivator and the
state”.
Thus, the new land system of the British created a class of absentee landlords making way for
exploitation of the peasants. Thus, both the zamindary system and the Ryotwari system introduced
by the British led to the concentration of economic power in the hands of few. This resulted total
depression in agriculture and industry.

Commercialisation of Agriculture
Commercialisation of Indian agriculture during the British period created a serious impact on the
Indian economy. Commercialisation of agriculture indicates production of various crops not for

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home consumption but for sale. Industrial revolution in Britain had raised the demand for agro-
raw-materials, especially raw cotton, jute, sugarcane, groundnuts etc. for British industries.
As the British industries were offering higher prices for commercial crops the peasants gradually
started to shift their cropping pattern substituting commercial crops for food crops. In some areas
commercialisation of agriculture reached to such an extent that the peasants even could not
produce food crops for their home consumption and started to purchase foodstuff from the mandis.
Moreover, the development of irrigation also intensified the commercialisation of agriculture in
India.

Development of Railway Network

The development of an elaborate railway network primarily intensified the commercialisation of
agriculture and on the other hand brought foreign machine made manufactures to India. This
sharpened the competition of machine made goods with Indian handicrafts which resulted into
total destruction of Indian handicrafts industry.

Occurrence of Famines
Indian economy was facing occurrence of famines too frequently during the British rule.
Commercialisation of agriculture reduced the production of food grains by transferring land from
the cultivation of food crops to non-food crops like industrial raw materials. The new land system
worked as a built-in-depressor as it retarded the process of agricultural development.
Moreover, the destruction of Indian handicrafts increased the pressure of population on land. All
these led to frequent occurrence of famines in India causing untold misery and suffering for the
Indian cultivators and general people.

Transforming Trade Pattern

Colonial exploitation of the Indian economy by the British transformed the pattern of trade in India
to become an exporter of raw materials and foodstuffs and an importer of manufactures. Moreover,
colonial exploitation through the entry of British capital and finance capital and also through the
payment for the costs of administration led to huge economic drain of India weakening the base of
Indian economy. Thus, the British rule in India was a long history of systematic exploitation of
Indian people by the imperialistic Government.

9.4 National Income of India in Pre-Colonial Era

National income is an important indicator of a country’s economy. It tells about the income
generated by the various sectors allocation of resources and about their utilization. The idea of
national income can be traced back to the 17th century when Sir William Petty of England made the
first known estimate in 1665. Gregory King followed Petty in giving a breakdown of national
income, as well as aggregate figures for 1688. His estimates included the national income, the
national expenditure, and the national saving as well as the distribution of these aggregates among
the different social and occupational classes.
In France, Boisguilleberts introduced the concept of measurable national income and prepared the
first estimate of national income of his country in the last quarter of seventeenth century. A number
of estimates were published during the 18th and the 19th century by different researchers for
England, France and some other European countries. England was, however, the acknowledged
leader in this field. This tendency of preparing estimates of national income continued for the first
two decades of the 20th century. England was, however, the acknowledged leader in this field. This
tendency of preparing estimates of national income continued for the first two decades of the 20th
century. In United States the initial estimates were made only in 1843 by George Tucker. Adam
Smith, Karl Marx, Alfred Marshall, A.A. Walras and J.M. Keynes laid the modern theoretical
groundwork for national income analysis.
In the inter-war decades of the twenties and thirties, national income estimates were stimulated by
the problems of reconstruction and the Great Depression. In 1918, estimates were being prepared
for 13 countries, and by 1939 for thirty three countries. Most of these were private efforts, with aids
from non-governmental institutes. Among the pioneering individuals are Simon Kuznets in the
U.S., Colin Clark in England and Ragnar Friesch in Norway.

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National Income Estimates of India in Pre-Independence Era

The estimate of National Income in India was, for the first time, prepared by Dada Bhai Naoroji for
the year 1867-68. Since then, various estimates have been prepared from time to time by different
persons. Estimates for seven points of time are available for the second half of the 19th century and
35-point estimates are available for the pre-independence period of the 20th century. In addition, a
few time-series estimates have been prepared for the first half of the 20th century or a part of the
period. The following table gives certain broad details about the more important of the estimates
prepared by different researchers

Source: Rao, V.K.R.V., (1940), The National Income of British India, 1931-32, Pub: Macmillan and
Co. London, p.2

Measurement of National Income in Colonial India

Agriculture, plantations, mining and modern factory-based production has detailed production
statistics. The production figure was derived by multiplying the total cropped area with estimated
yield.
Estimated yield = Normal or “Standard Yield” x condition factor
Condition factor = index of the quality of the season
It has been debated that there was a downward bias in the condition/seasonality index but there is
a consensus that if there was a ‘bias’ then it was offset by possible over-estimation of ‘standard
yield’. For all the other sectors, income method was followed. In Public Administration,
employment was multiplied by standard earnings. Employment was taken from decennial census.
Average wages of people employed in small scale industry was taken.
Table 9.1 Growth Rate of Real National Income
Table 9.1 presents estimated
growth rates of national income
for different sub periods.
Different authors produced these
estimates using slightly different
methods. But the basic conclusion
is not too sensitive to the
variations. Between 1865 and
1920-25 growth rates of total
income and average income are
positive and attained Sources: M Mukherjee, (1965), Heston, S Sivasubramonian (2000)
quite respectable levels by international comparison. Between 1920-25 and 1947 national income
grew at approximately 1% per year, which rate, when adjusted for population growth yielded near
zero per cent rate of growth of average income. The pace was unquestionably slow in relation to
what was needed for a rapid improvement in living standards, in relation to growth rates of post-
independence India, and by selective international comparisons. By contrast with income growth,

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rates of employment did not change between these 2 regimes. Average annual growth rate of
employment was 0.5% between 1875 and 1900 and 0.5% between 1919 46 however the same rate in
two periods had different meanings between the growth rate of output and income decelerated.
The first lesson from national income statistics therefore is that pre-war phase of expansion had
come to an end shortly after World War I coinciding with a decisive upward turn in the population
curve.

9.5 Sectoral Analysis of National Income

Between 1900 and 1947 the share of non-agriculture in national income was increasing (Table 9.2
and Table 9.3). The extent of increase was small in the first quarter of the century, and greater in the
second quarter. the employment share of major sector shows no significant trend. What direction
there was between sub periods cannot be trusted to be completely authentic, given the many
difficulties of reading the occupational statistics of the senses. Still there is some sign here that the
employment shares changed in the same direction as the income shares. Were good industry
industrial income data available from 1875 and 1900 we might find that agriculture gained and
industry loss between 1875 and 1900, since the period saw increased present expose and possibly
some loss of craft employment. On the other hand, agriculture loss in industry gained between 1925
and 1946, in terms of both income and employment. But there was number precise overlap between
the trends in income share and trends in employment share. In short, movements of people
between agriculture and non-agriculture occurred more slowly than did changes in their relative
productive power.
Table9.2 Growth of Non-Agricultural Sectors

Industry Other Non-

Agricultural Sectors

Large Scale Small Scale

NDP (in millions

1900 298 1400 4237

1925 845 1838 6938

1946 2173 1732 8979

NDP Per Worker (in

Rupees at 1938-39
price

1900 2249 489 224

1925 1976 727 355

1946 2812 514 375

Sources: Sivasubramonian, National Income; Statistical Abstract for British India

National income can be seen as an aggregate of different types of goods and services.
Conventionally four main types are distinguished consumption goods, capital goods, net export
and goods and services purchased by the government sector. This breakup is shown in table 9.4.
The table shows that colonial India was Annette exporter at a small government invested little and
was characterised by a high proportion of consumption in national income.
National income per head captures an average. To make sense of what people really earn and how
much they consumed we need to look at wage and earnings of play interest are the poor, or the
wage earners for the form most earners.
Table: 9.3 Sectoral Share of National Income (in %)

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Source: S
Sivasubramonian, National Income of India
Table 9.4: Components of National Income, 1900-1946

Source: Tirthankar Ray, 3rd ed. 2000

9.6 Economic change in India

In 1947, British colonial rule in South Asia ended and the regions of the creation of several
independent nations principally India, Pakistan and Sri Lanka. The map of the region was redrawn
in 1971 with the birth of Bangladesh. The partition of India has been a traumatic episode involving
the largest forced migration the world had seen affecting possibly a million people and on the
Bengal frontier generating the dislocation that continued on a milder scale for many years. When
the dust settled, and the immediate economic and human crisis subsided, the new government
began to design strategies of economic development. In the Indian Union these discussions had
roots going back to internal debates within the Congress late in the inter war period, rethinking on
Indian development in temporary circles and even further back to the formation of an economic
nationalism.

Three Phases
Most analysis of economic development of post-colonial India would divide the 70 odd years that
distance 2020 from 1947 into several segments. There is no agreed convention and cutting up the
whole-time span into bite size pieces, though quite often the implicit intention is to suggest that
post reform India is a qualitatively different entity from the pre reform one. The aim is to suggest
that, after the statist-autarkic regime often mistakenly designated as Nehruvian has ended, India
experienced a pattern of economic growth unprecedented in its history. On this principle, the big
dividing line falls in 1992 when some of the most dramatic reforms were undertaken. However,
other analysts observe that such a sharp disjuncture misreads the gradualist element in the process
and overlooks a built up that had begun in the 1980s. Nevertheless, one break falling somewhere
between 1985 and 1992 seems to be an order. What was the regime like before the 1980s?
Although the epithet, Nehruvian is sometimes loosely applied to the entire pre reform era, serious
students of the Indian development would consider adding a dividing line in the mid-1960s when a
relatively stable pattern of state planned industrialization, under the leadership of Nehru was

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derailed by a series of external domestic shocks. The 1970s followed this phase with its own kind of
oil shocks. During much of the 20 years that spanned the beginning of this unstable phase at the
beginning of the economic reforms, the Prime Minister of India was Indira Gandhi who became the
head of state soon after death of Nehru in 1964. It can be argued persuasively that her role lead to
economic structure that was quite different from the one Nehru had wanted, being more rural
biased and more state control. Gandhi in other words was hardly Nehruvian herself. It was only in
the early years of the 1980s that a few hesitant steps to reform the system were taken but Mrs
Gandhi did not live long enough to assess the effects of these reforms to consider a more decisive
change of direction either forward or backward.
Falling up this line of thought this part is divided into post-colonial India into 3 segments -1950 to
64 phase I, 1965 to 85 Phase II and 1986 to 2020 phase III.

Phase I- Birth of a regime (1950 to 64)

Policy
Already before independence intellectuals close to Congress, business leadership and writings that
emanating from the national stable had expressed desire for plan industrialization. There were
points of disagreement between these groups but one shared ground was a need to restrain trade
and implement import substitution. In 1938 document of national planning committee of Congress
set out state planning as a principle means available for managing development in
industrialization. The document expressed Nehru’s vision of India though it was prepared by a
team of Congressman, principally Subhash Chandra Bose. The Bombay plan document of 1944 was
prepared by seven leading industrialists of the city saw the main form of government regulation to
come in the shape of protective tariffs. It proposal broadly deregulated domestic economy but
allowed scope for public investment in industries of strategic importance. There was however
another stand within the Congress the one inspired by Mahatma Gandhi with in fluent in Hindi
bold vocal following among the business leadership of Ahmedabad. This approach considered that
rural regeneration should be the main goal of development and saw the village community as a
good tradition threatened by industrialism for stop internal debates on policy leading up to the first
five-year plan in 1950 so repeated conflicts comprise between these two visions. The intellectual
rules of protectionism can be traced to number of sources outside India in the Congress. With the
world economy in disarray after the Great Depression in World War II faith and trade and
investment as instruments of development was at lowest ebb. In the newly created discipline of
development export pessimism want to the argument that poorer countries that have specialised in
the export of primary goods for vulnerable to price fluctuation a long time decline in the relative
price of primary goods sold stop globally the 19th century European examples of protected
industrialization the infant industry the ideology of the Soviet example had much appeal. The
public face of nationalism held that free trade and non-interventionist state, both tenets of classical
political economy to which the colonial government adhered, had de-industrialised India,
impoverished its people and drained its resources. Within analytical development economics
varied forms of indirect sanction to state lead industrialization strategy could be found, from
theories of balanced growth economic development with unlimited supply of labour; all of these
identified economic development with the policy of raising aggregate investments by discrete
jump, a step that would be impossible with exclusive reliance on the capital market.

Crisis contradiction and Critique: 1965-1985

Policy
The 1960s ended the consolidation of power of Mrs. Indira Gandhi. The famine had underscored
the dismal state of the rural poor who had voted her to power. It was her turn to do them a favour.
The policy of Garibi Hatao was implemented which increased the supply of public goods in the
rural areas. Infrastructure was taken to the remotest part of the country to have a spillover effect in
other parts.
In the sphere of industry and labour, more restrictions were imposed. The role of the state was
magnified, and a more socialistic approach was adhered to. In 1969, 14 banks were nationalized in
the name of having more resources at the disposal of the state to improve the conditions of the
masses. In 1972, the insurance sector went through the phase of nationalization. Regional Rural
Banks were established which made along with the nationalisation of banks led to the fourfold
increase in the number of branches between 1969 and 1981.
Monopolies and Restrictive Trade Practices Act was introduced in 1969 where an `upper cap was
set to stop the big firms from growing beyond a certain a size. In the later half of 1970s, amidst

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political uncertainty a lot of private enterprises were nationalized which were troubles. The tariff
rates were exorbitant, and the exporters were compensated with export bonus for overvalued
exchange rate.
In 1966, devaluation of rupee was done which was hailed by a segment of economists as forward
looking and market friendly. However, the positivity was short lived as industrialists and trade
unions were unwilling to accept a pro-market open regime. The general stance of Parliament
towards foreign investment was hostile during this period.
With all these twists and turns, Phase II produced the worst performance by every benchmark. If
oil is expected, India's trade was pushed together greater insularity. Since exports did not pay for
foreign loans and foreign investment was negligible, the major part of the new aid contracted went
into debt service. Over and above of persistent exchange shortage, there began a seemingly
permanent downwards slide in average growth rates. The downward drift of GDP growth owed to
industrial stagnation. Growth rates in manufacturing have been 7% per year between 1956 and 1966
and dropped to less than 5% in 1966-75. The decline being lasting one, it could not be explained by
the variable usually invoked to explain short term fluctuations such as crop failure or budgetary
crisis leading to sudden changes in government investment.

Transition: 1986 to 2020

Policy and Performance
There was a definite transition from a centralised policy making to decentralised policy making,
from state owned businesses to privately owned businesses. Today Government of India brought
about a changes in the policy making because of the debacles of the 70s which included the oil
crisis. There was exchange foreign there was foreign exchange problems which led to the loan from
IMF in the early 80s which included structural changes in the economy. In 1984 with the change in
regime head at the centre there was more liberalization introduced, with industries being included
in the open general license list relaxation in the MRTP Act, relaxation in the textile act and other
areas where the state took a back step and let the private entrepreneurs take over. We look at the
rate of growth of the GDP we find that there was a marked increase in the mid 80s when we moved
out of the so called Hindu rate of growth. However this optimism was short lived and in the late
80s the GDP growth rate dipped and the exchange crisis reached its zenith with the Government of
India pawning its gold to get money. The structural reforms introduced in the new economic policy
of 1991 was the first hand and not a conscious decision of the state. However there was a growing
demand for liberalising the economy as the growth rates of the South Asian countries was edging
towards a more privatise liberalised economy which would help the private businesses. Only the
statistic cannot show the structural break in the growth rates and from there to derive the policies
responsible for it, a broader outlook of how the economy performed during the socialist era and the
lessons learned have to be imbibed in the narrative.
The open economy regime saw considerable success in the export of manufacturing and notably,
export of skilled services showing up in the invisible account of the balance of payments. Foreign
investment flows increased more than 20 times over between 1990 and 2008 and its character
changed from mainly investment in firm ownership to mainly technological collaboration. On the
other hand, the liberal regime saw, for better or worse, a retreat of the state from industrial
investment even infrastructural investment even though foreign concessional loans which in recent
years flowed into infrastructure and public goods, partially compensated for the retreat.
The problem of state finance afflicted the regional state governments especially badly. In the first
half of the 1990s, the fabric of federalism, so far held together by dominant government at the
center, became strained as coalition of regional parties called the shots in the new regime. Problems
owed to combination between the legacies of phase two and the reforms themselves. The major part
of the state’s own tax income was derived from the sales tax which were often waived in a
competitive bid to attract industry. The states’ power to borrow was limited and was curbed in the
early 1990s. Division of assistance was based upon distributional rules that gave greater weight to
poverty and levels of backwardness in effect discriminating against fiscal and economic health.
Some of the industrially endowed states paid the price for the reckless nationalisation of bankrupt
enterprises, and expansion in public undertakings, that they had indulged in phase two.
The intense focus in phase I on industrialization and in phase II upon rural infrastructure and
subsidies had left in neglect roads, railways, ports, electricity, telecommunication, financial
services, schools, and hospitals. Quantity of service providers had grown but the quality of service
had become steadily poorer. Much of this infrastructure was in charge of the states who found

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themselves bankrupt, at least partly owing to the fiscal burden that rural development and
providing security to rural incomes imposed on them.
Connected with the fiscal and regulatory policy issue, there was also evidence of an increased
regional inequality. Foreign investment was originally biased. Regions with a higher capital
endorsement were more attractive destinations for both domestic and foreign capital. There was
also perhaps increase in personal income inequality.

Summary
The economy of India went through many changes in the past centuries- from a trade dominated
collection of states to an agrarian state under the rule of various rulers and plunderers. During the
colonial period the economy became more organised and people were skilled in areas which were
beneficial for the British. National Income was calculated to show the drain of wealth and the
contribution made by locals and their share in the allocation. It was only after independence that
formal calculation of national income was started. In terms of sectoral share in National Income,
agriculture slowly came down, with the increase of the share of the secondary and tertiary sector.
The transmission of the sectors has been gradual but not in terms of developing countries. The
tertiary sector grew at a much faster rate than the secondary sector.

Keywords
National Income: It is the value of the goods and services produced by a country in a year along
with the net income from abroad.
Liberalisation: Liberalisation is the process or means of the elimination of control of the state over
economic activities. It provides a greater autonomy to the business enterprises in decision-making
and eliminates government interference.
Privatisation: Privatization is the transfer of publicly owned or publicly operated means of
production to private ownership or operation.
Globalisation: Globalization is the spread of products, technology, information, and jobs across
national borders and cultures. In economic terms, it describes an interdependence of nations
around the globe fostered through free trade.
State: State is a polity that maintains a monopoly on the legitimate use of violence

Self Assessment
1. Who among the following first cited the 'Drain of Wealth' in his book?
A. Dadabhai Naoroji
B. RC Dutta
C. Jadunath Sarkar
D. None of the above

2. The East India Company made a concerted effort to transform India's society and
Institutions to reflect British tastes.
A. True
B. False

3. Which of the following industries was destructed by the British rule?

A. Railways
B. Handicrafts
C. Agriculture
D. Brick making

4. Did imperialism have the power to de-industralise India?

A. True
B. False

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5. Who among the following introduced Ryotwari System in India?

A. Lord Cornwallis
B. Thomas Munro
C. Warren Hasting
D. Lord Wellesley

6. Permanent Settlement system was introduced in which year?

A. 1791
B. 1792
C. 1793
D. 1794

7. The permission for the establishment of Railways was given in which year?
A. 1856
B. 1845
C. 1875
D. 1846

8. Where was the Permanent Settlement firstly introduced?

A. Orissa (Odisha) and Bengal
B. Orissa (Odisha) and Andhra Pradesh
C. Bengal and Bihar
D. Orissa (Odisha) and Bihar

9. After the Great Depression of 1930s, the real wages in Indian agriculture remained
stagnant for how long?
A. 10 years
B. 20 years
C. 30 years
D. Cannot say

10. Who was the first to estimate National Income of India?

A. M. N Roy
B. G D Birla
C. Dadabhai Naoroji
D. Ram Manohar Lohia

11. The early estimates of National Income used what as the base?
A. Land estimates
B. Labour employed
C. Census data
D. None of the above

12. Which method was common in estimating National Income in India before independence?
A. Production Method
B. Income Method

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C. Expenditure Method
D. All the above

13. Which of the following was not an obstacle in the estimation of National Income?
A. Deficiency of data on natives
B. Predominance of informal activities
C. British officers
D. Bias towards revenue generating activities

14. Which sector contributed the most to the National Income in the pre-independence
period?
A. Industry
B. Agriculture
C. Trade
D. Small Scale sector

15. During colonial India, poverty increased in the country

A. True
B. False

Answers for Self Assessment

1. A 2. A 3. B 4. A 5. B

6. C 7. B 8. C 9. C 10. C

11. A 12. B 13. C 14. B 15. A

Review Questions
1. Did the industralisation of India suffer because of colonial rule or was it the consequence
of the colonial rule? Discuss.
2. The socialist pattern of growth during the second phase was far away from the Nehruvian
model. Discuss
3. Explain the various components of National Income during the colonial period.
4. Write a note on Phase I of the Indian economy.
5. In the current context, is there a need to correct the economic policy where the role of the
state needs to be relooked at. Discuss.

Further Readings
B R Tomlinson, The Economy of Modern India: From 1860 to The Twenty First Century,
Cambridge University Press.
Tirthankar Roy, The Economic History of India: 1857-1947, Oxford University Press

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Tanima Dutta, Lovely Professional University Unit 10: Human Development

Unit 10: Human Development

CONTENTS
Objectives
Introduction
10.1 Human Development and its Approaches
10.2 Capability Approach to Human Development
10.3 Human Development Index
10.4 Other Human Development Indices
10.5 Human Development and India
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
• Describe the concept of Human Development
• Discuss the Human Development Index
• Analyse the features of developing countries
• Discuss the state of Human Development in India

Introduction
The World Bank classifies the countries into four categories based on purchasing power parity or
PPP as it is popularly known as. This classification is based on the economic development of the
country but fails to show the distribution of the income. The per capita income indicator of
development is criticised because it is just an average and as per statistical rules it is affected by
outliers. If someone is interested to know the well being of individuals of a country, then she has to
turn to HDI as it is an index that measures human development. Prior to 1990, there was no
measure for human development. It was only after 1990 that United Nations Development Program
(UNDP) started measuring the human development index for all the countries and ranking them. It
forced the countries to work on these indicators so as to improve their ranks. It is an approach that
is focused on people and their opportunities and choices.
People: human development focuses on improving the lives people lead rather than assuming that
economic growth will lead, automatically, to greater wellbeing for all. Income growth is seen as a
means to development, rather than an end in itself.
Opportunities: human development is about giving people more freedom to live lives they value.
In effect this means developing people’s abilities and giving them a chance to use them. For
example, educating a girl would build her skills, but it is of little use if she is denied access to jobs,
or does not have the right skills for the local labour market. Three foundations for human
development are to live a long, healthy and creative life, to be knowledgeable, and to have access to
resources needed for a decent standard of living. Many other things are important too, especially in
helping to create the right conditions for human development, and some of these are in the table
below. Once the basics of human development are achieved, they open up opportunities for
progress in other aspects of life.

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Choice: human development is, fundamentally, about more choice. It is about providing people
with opportunities, not insisting that they make use of them. No one can guarantee human
happiness, and the choices people make are their own concern. The process of development –
human development - should at least create an environment for people, individually and
collectively, to develop to their full potential and to have a reasonable chance of leading productive
and creative lives that they value.
As the international community moves toward implementing and monitoring the 2030 agenda, the
human development approach remains useful to articulating the objectives of development and
improving people’s well-being by ensuring an equitable, sustainable and stable planet.

10.1 Human Development and its Approaches

Meaning of Human Development
The human development aims to enrich people’s lives by widening their choices. Through
investing in people, in terms of education, health, safety, and so on, this discipline attempts to build
human capability. Capability is basically what people are actually able to do and to be. Equality,
sustainability, productivity, and empowerment are the four pillars of human development. This
approach emphasizes the belief that though economic growth is essential, its quality and
distribution determine the extent to which it enriches people’s lives in a sustainable manner. The
attempt is to create an environment in which people can enjoy long, healthy, and creative lives. The
idea of human development is also linked with the concepts of rights, liberty and justice.
Seeing humans as ends of development process was not the sole purview of human development
paradigm. The UN Declaration on Human Rights (1948) put forward that all humans should be free
and equal in dignity and rights, such as the right to work, the right to education, the right to health,
the right to vote, the right to non-discrimination, the right to decent standard of living etc. It was
written in the hope that the atrocities committed during the Second World War would never be
repeated. There are significant connections between human rights approach and that of human
development and capability. According to the Human Development Report (2000), “Human Rights
and Human Development share a common vision and a common purpose – to secure freedom,
wellbeing and dignity of all people everywhere”. A human right is claimed to be a fundamental
benefit that should be enjoyed universally by all people everywhere based on equality and non-
discrimination.
The evolution of the concept of human development can be traced to the writings of renowned
thinkers and philosophers of ancient times. Aristotle, the great philosopher reflected in his writing
that “wealth is not the good that we are seeking for; it is merely for the sake of something else”.
Another great philosopher, Immanuel Kant argues that human beings are ends in themselves,
rather than the means to other ends. Adam Smith, Robert Malthus, Karl Marx, John Stuart Mill, and
many other modern economists have also come forward with the similar idea of treating human
beings as the real end of all activities. However the undeniable reality is that human beings are the
beneficiaries of progress, and, at the same time, they are directly or indirectly, the primary means of
production.
Thus, human beings are the means through which a productive progress is brought about.
Human Development has been accepted in development economics literature as

• An expansion of human capabilities

• A widening of choices
• An enhancement of freedoms
• A fulfilment of human rights

Approaches to Human Development

The human development approach is inherently multidimensional. The central goal of human
development is to enable people to become direct agents in their own lives. People are not passive
objects of social welfare provisions but are active subjects with the power to determine how they
choose to live. They should be empowered so that they can define their respective priorities, as well
as choose the best means to achieve them. Thus, agency and expansion of freedom go hand in hand.
In order to be agents of their own lives, people need the freedom to be educated, to speak in public
without fear, or have freedom of expression and association.

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The four main pillars of human development are

i. equity
ii. efficiency and productivity
iii. participation and empowerment
iv. sustainability

Equity: The principle of equity encompasses the ideal of equality whereby all human beings
should have equal rights and entitlements to human, social, economic, and cultural development,
and an equal voice in civic and political life. It also recognizes that those who have unequal
opportunities due to various disadvantages may require preferential treatment, or affirmative
action. For example, the utility derived from same levels of income or investment will vary for
different individuals, depending upon their personal attributes, initial endowments or conversion
factors, which facilitate transformation of inputs into outcomes. Since the opportunities available to
different sections of society vary, ensuring that the sections deprived of basic opportunities such as
health and education are provided access to these benefits, is the goal of equality. Thus, equity aims
at equality, not only of economic resources, but of education, health, employment opportunities,
democratic participation, etc, too. Realization of the goal of equal opportunities leads to equity
outcomes.
Efficiency and Productivity: Efficiency is defined as the least costly method of reaching goals
through the optimal use of human, material, and institutional resources to maximize opportunities
for individuals and communities, thereby enhancing productivity. Efficient use of scarce national
resources leads, for instance, to the building of infrastructure like roads and dams, which in turn
lead to better outcomes for human beings. Productivity can be enhanced through efficient use of
resources. It also requires investment in people and enabling macroeconomic environment for them
to achieve their maximum potential. For human development, people must be enabled to increase
their productivity and to participate fully in the process of maximizing opportunities so that they
become effective agents of growth.
Participation and Empowerment: Participation and engagement in social and political life is an
important aspect of human development. People’s participation is crucial in community
programmes and government interventions. Mobilization of grassroots support through
decentralization in planning will increase people’s participation in decision making because it
brings government closer to people. Participation also enables people to seek answers from
authorities and can go a long way in improving the quality of social service delivery. It pressurizes
local authorities to take swift remedial action in situations where gaps or shortfalls are identified in
the functioning of institutions. Empowerment can occur through enhanced participation and
involvement. For instance, reservations of women in various elected bodies are made to empower
them through such participation. Involvement of parents, guardians and/or communities in village
education committees is another example.
Sustainability: Human development questions the long-term sustainability of economic growth
and aims to ensure that resources are utilized in a manner that meets present day human needs
while preserving the environment, so that the needs of future generations can also be met with.
Hence, use of resources without degrading the environment is essential to ensure that the
improvements made are not temporary in nature and have the potential for future growth as well.
For instance, if the development process does not create institutions that are supportive of people’s
rights, it cannot be sustainable in the long run.

10.2 Capability Approach to Human Development

The human development approach has been profoundly inspired by Amartya Sen’s pioneering
works in welfare economics, social choice, poverty, and famine and development economics. While
Sen’s works cover an extremely wide range of topics, his ‘capability approach’ has led to a critical
evolution in the field of economics, and in social sciences in general. The roots of the capability
approach go back to Aristotle, Adam Smith, and Karl Marx. Aristotle made extensive use of his
own analysis of human beings and linked it with his examination of the functions of man. Adam
Smith and Karl Marx discussed the importance of functioning’s’ and ‘capability’ as determinants of
well-being. If life is a set of doings and beings that are valuable, the exercise of assessing the quality
of life takes the form of evaluating these functioning’s and the capability to function.

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But what actually are ‘capability’ and ‘functioning’? According to Amartya Sen, “Capability is a
vector of functioning’s, reflecting the person’s freedom to lead one type of life or another….to
choose from possible livings”. In other words, capabilities are the substantive freedoms he, or she,
enjoys leading the kind of life he, or she, has reason to value. Just as a person with a pocket full of
coins can buy many different things, a person with many capabilities can enjoy many different
activities and pursue different life paths. Functioning’s are valuable activities and states that
constitute people’s wellbeing such as healthy body, being safe, being educated, and so on.
Functioning is, thus, an achievement of a person: what he or she manages to do, or to be. For
example, when people’s basic need for food is met, they enjoy the functioning of being well
nourished. Apart from capability and functioning, the third core concept of the capability approach
is “agency”. It refers to a person’s ability to pursue and realize goal she, or she, has reason to value.
However, Martha Nussbaum argues that Sen’s ‘Capability Approach’ is incomplete. Since what
people consider to be valuable and relevant can often be the product of structures of inequality and
discrimination, and because not all human freedoms are equally valuable – for example, the
freedom to pollute is not of equal value to the freedom to care for the environment - she argues that
one needs to overcome these limitations, and to go beyond this ambiguity, so that equal freedom
for all can be respected. In this context she has proposed a list of ten central human capabilities
which constitute the evaluative space for public
policy.
The capability approach advocates the removal of obstacles in people’s lives, increasing their
freedom to achieve the functioning that they value. It recommends progressive social policies
which would foster the development of human capabilities, such as improved health, knowledge,
skills and also ensure equitable access to human opportunities.

10.3 Human Development Index

The HDI was created to emphasize that people and their capabilities should be the ultimate criteria
for assessing the development of a country, not economic growth alone. The HDI can also be used
to question national policy choices, asking how two countries with the same level of GNI per capita
can end up with different human development outcomes. These contrasts can stimulate debate
about government policy priorities.
The Human Development Index (HDI) is a summary measure of average achievement in key
dimensions of human development: a long and healthy life, being knowledgeable and have a
decent standard of living. The HDI is the geometric mean of normalized indices for each of the
three dimensions.
The health dimension is assessed by life expectancy at birth, the education dimension is measured
by mean of years of schooling for adults aged 25 years and more and expected years of schooling
for children of school entering age. The standard of living dimension is measured by gross national
income per capita. The HDI uses the logarithm of income, to reflect the diminishing importance of
income with increasing GNI. The scores for the three HDI dimension indices are then aggregated
into a composite index using geometric mean.
The HDI simplifies and captures only part of what human development entails. It does not reflect
on inequalities, poverty, human security, empowerment, etc. The HDRO offers the other composite
indices as broader proxy on some of the key issues of human development, inequality, gender
disparity and poverty.
A fuller picture of a country's level of human development requires analysis of other indicators and
information presented in the statistical annex of the report.
Fig. 10.1 Human Development Index

Source: UNDP

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Steps to Calculate Human Development Index Values

There are two steps in calculating the HDI.

Step 1. Creating the dimension indices

Minimum and maximum values (goalposts) are set in order to transform the indicators expressed
in different units into indices between 0 and 1. These goalposts act as “the natural zeros” and
“aspirational targets”, respectively, from which component indicators are standardized (see
equation 1 below). They are set at the following values:

The justification for placing the natural zero for life expectancy at 20 years is based on historical
evidence that no country in the 20th century had a life expectancy of less than 20 years (Maddison
2010; Oeppen and Vaupel 2002; Riley 2005). Maximum life expectancy is set at 85, a realistic
aspirational target for many countries over the last 30 years. Due to constantly improving living
conditions and medical advances, life expectancy has already come very close to 85 years in several
economies: 84.9 years in Hong Kong, China (Special Administrative Region) and 84.6 years in
Japan.
Societies can subsist without formal education, justifying the education minimum of 0 years. The
maximum for expected years of schooling, 18, is equivalent to achieving a master’s degree in most
countries. The maximum for mean years of schooling, 15, is the projected maximum of this
indicator for 2025.
The low minimum value for gross national income (GNI) per capita, $100, is justified by the
considerable amount of unmeasured subsistence and nonmarket production in economies close to
the minimum, which is not captured in the official data. The maximum is set at $75,000 per capita.
Kahneman and Deaton (2010) have shown that there is virtually no gain in human development
and wellbeing from annual income above $75,000 per capita. Currently, only three countries
(Liechtenstein, Qatar and Singapore) exceed the $75,000 income per capita ceiling.
Having defined the minimum and maximum values, the dimension indices are calculated as:
𝐴𝑐𝑡𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 − 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑉𝑎𝑙𝑢𝑒
𝐷𝑖𝑚𝑒𝑛𝑠𝑖𝑜𝑛 𝐼𝑛𝑑𝑒𝑥 =
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑉𝑎𝑙𝑢𝑒 − 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑉𝑎𝑙𝑢𝑒
For the education dimension, equation 1 is first applied to each of the two indicators, and then the
arithmetic mean of the two resulting indices is taken. Using the arithmetic mean of the two
education indices allows perfect substitutability between expected years of schooling and mean
years of schooling, which seems to be right given that many developing countries have low school
attainment among adults but are very eager to achieve universal primary and secondary school
enrolment among school-age children. Because each dimension index is a proxy for capabilities in
the corresponding dimension, the transformation function from income to capabilities is likely to be
concave (Anand and Sen 2000)—that is, each additional dollar of income has a smaller effect on
expanding capabilities. Thus, for income the natural logarithm of the actual, minimum and
maximum values is used.

Step 2. Aggregating the dimensional indices

The HDI is the geometric mean of the three-dimensional indices:

𝐻𝐷𝐼 = (𝐼𝐻𝑒𝑎𝑙𝑡ℎ , 𝐼𝐸𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛 , 𝐼𝐼𝑛𝑐𝑜𝑚𝑒 )1/3

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Example: India

Indicator Value

Life Expectancy at Birth (in Years) 69.7

Expected Years of Schooling 12.2

Mean Years of Schooling 6.5

Gross National Income Per Capita (2017 PPP $) 6681

65.3 − 20
𝐻𝑒𝑎𝑙𝑡ℎ 𝐼𝑛𝑑𝑒𝑥 = = 0.76
85 − 20
12.2 − 0
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑌𝑒𝑎𝑟𝑠 𝑜𝑓 𝑆𝑐ℎ𝑜𝑜𝑙𝑖𝑛𝑔 = = 0.67
18 − 0
6.5 − 0
𝑀𝑒𝑎𝑛 𝑌𝑒𝑎𝑟𝑠 𝑜𝑓 𝑆𝑐ℎ𝑜𝑜𝑙𝑖𝑛𝑔 = = 0.43
15 − 0
0.67 + 0.43
𝐸𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛 𝐼𝑛𝑑𝑒𝑥 = = 0.55
2
𝑙𝑛6681 − 𝑙𝑛100
𝐼𝑛𝑐𝑜𝑚𝑒 𝐼𝑛𝑑𝑒𝑥 = = 0.936
𝑙𝑛75000 − 𝑙𝑛100
Methodology used to express income
The World Bank’s 2020 World Development Indicators database contains estimates of GNI per
capita in constant 2017 purchasing power parity (PPP) terms for many countries. For countries
missing this indicator (entirely or partly), the Human Development Report Office (HDRO)
calculates it by converting GNI per capita in local currency from current to constant
terms using two steps. First, the value of GNI per capita in current terms is converted into PPP
terms for the base year (2017). Second, a time series of GNI per capita in 2017 PPP constant terms is
constructed by applying the real growth rates to the GNI per capita in PPP terms for the base year.
The real growth rate is implied by the ratio of the nominal growth of GNI per capita in current local
currency terms to the GDP deflator.
For several countries without a value of GNI per capita in constant 2017 PPP terms for 2019
reported in the World Development Indicators database, real growth rates of GDP per capita
available in the World Development Indicators database or in the International Monetary Fund’s
Economic Outlook database are applied to the most recent GNI values in constant PPP terms.
Official PPP conversion rates are produced by the International Comparison Program, whose
surveys periodically collect thousands of prices of matched goods and services in many countries.
The last round of this exercise refers to 2017 and covered 176 economies.

Human Development Index aggregates

Aggregate HDI values for country groups (by human development category, region and the like)
are calculated by applying the HDI formula to the weighted group averages of component
indicators. Life expectancy and GNI per capita are weighted by total population, expected years of
schooling is weighted by population ages 5–24 and mean years of schooling is weighted by
population ages 25 and older.

10.4 Other Human Development Indices

Over the years, the HDR sought to enrich the concept, analyse one specific aspect of human
development critically, and develop more elegant measures of wellbeing. Among the many indices
introduced in the HDR, some have become annual features, while others have been discarded for
want of data, and the feasibility of calculating indices across countries (the Human Freedom Index
is one such measure).Among the indices that have gained popularity and widespread acceptance,
despite a significant share of critique and debates, are the HDI, the Gender-related Development
Index (GDI), the Gender Empowerment Measure (GEM), and the Human Poverty Index (HPI-1 for
developing countries, and HPI-2 for selected OECD countries).Each of these indices is based on a

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set of chosen indicators. The HPI-1, designed for developing countries, considers the same three
dimensions through four identified indicators. As opposed to the HDI, which measures the overall
progress in a country in achieving human development, the HPI reflects the distribution of
progress, and measures the backlog of deprivations that still exists. HPI-1 based on

• the probability at birth of not surviving to age 40

• the adult illiteracy rate
• deprivation in overall economic provisioning, public and private, reflected by the
percentage of population without sustainable access to an improved water source
• the percentage of children under five years who are underweight.HPI-2, devised as a
measure of human poverty in industrial countries, since human deprivation varies with
social and economic conditions of a community, is also based on 4 indicators. They are:
• the probability at birth of not surviving to age 60
• the percentage of adults lacking literacy skills
• the percentage of people living below the poverty line
• the long-term unemployment rate.
Another two new indices were introduced in 1995. These are the Gender-related Development
Index (GDI), and a Gender Empowerment Measure (GEM). The GDI measures achievements in the
same dimensions and variables as the HDI but takes into account inequality in achievements
between women and men. The greater the gender disparity in human development, the lower is a
country’s GDI compared to its HDI.
GEM exposes inequality in opportunities in selected areas – the participation of women in
economic and political life, and in decision making. This index focuses on women’s opportunities
and agency, and captures gender inequality in three key areas

• political participation and decision-making power, as measured by women’s and men’s

percentage share of parliamentary seats
• economic participation and decision-making power, as measured by two indicators—
women’s and men’s percentage shares of positions as legislators, senior officials, and
managers and women’s and men’s percentage shares of professional and technical
positions
• power over economic resources, as measured by women’s earned income share as a
percentage of men’s (PPP in US $).
In the context of the efforts being made to bring gender issues to centre stage, GDI and GEM
proved important tools to establish the prevalence of gender inequality across the world. With
these indices, the HDRs emphasized the importance of mitigating gender disparities as being
critical for overall development (HDR, 1995). HDR 1995 argues that achieving gender equality is
not a technocratic goal. It is a political process requiring struggle and radical shifts in mindsets.
The HDRs, over the years, admit that while the concept of human development is much broader
the measures of HDI remain limited. Admittedly, the “HDI is not a substitute for the fuller
treatment of the richness of the concerns of the human development perspective”. To come up with
a comprehensive measure is a daunting task and, in fact, impossible, given the fact that many vital
dimensions of human development are non-quantifiable.

10.5 Human Development and India

India ranked 131 in the HDI as per the Human Development Report of 2019 This is a slip of two
ranks when compared to the earlier year. If we look at the absolute value of HDI then India’s score
improved from 0.642 to 0.645 but in terms of ranking it has lost two positions. We have to look at
the expenditure made by the government on social sector. In the next part we will be discussing the
social sector expenditure by the government and human development indicators. The data shared
here has been taken from Economic Survey of 2021.

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Trends in Social Sector Expenditure

The expenditure on social services (education, health and other social sectors) by Centre and States
combined as a proportion of GDP increased from 6.2 to 8.8 per cent during the period 2014-15 to
2020-21 (BE). This increase was witnessed across all social sectors. For education, it increased from
2.8 per cent in 2014-15 to 3.5 per cent and for health, from 1.2 per cent to 1.5 per cent during the
same period. Relative importance of social services in government budget, as measured in terms of
the share of expenditure on social services out of total budgetary expenditure, has also increased to
26.5 per cent in 2020-21 (BE) from 23.4 per cent in2014-15 (See Table 10.1).
A clarion call for 'Atma Nirbhar Bharat' was announced to revive the economy and to address the
pandemic. A special economic and comprehensive package of ` 20 lakh crore - equivalent to 10 per
cent of India’s GDP was announced in May 2020. In subsequent announcements, additional
support cumulating to ` 29.88 lakh crore up to November 2020 was announced. Of these, provision
for ` 4.31 lakh crore made for social sector includes PMGKY and PMGKY Anna Yojana, housing
and health (including R & D Grant for COVID-19 Suraksha), EPF support to worker & employers,
street vendors, MGNREGS workers and ABRY etc.

Human Development
India’s rank in Human Development Index (HDI)1 was 131 in 2019, compared to 129 in 2018, out of
a total 189 countries according to UNDP Human Development Report, 2020. It may be mentioned
that the decline in HDI ranking by two points in 2019 as compared to 2018 is relative to other
countries. By looking at the sub-component wise performance of HDI indicators, India's ‘GNI per
capita (2017 PPP $)’ has increased from US$ 6,427 in 2018 to US$6,681 in 2019, and ‘life expectancy
at birth’ has improved from 69.4 years in 2018 to 69.7 years in 2019, respectively. However, the
‘mean years of schooling’ and ‘expected years of schooling’ remained unchanged in 2019 compared
to 2018. However, considering the value of Planetary pressures adjusted HDI (PHDI), India was
positioned 8 ranks better than HDI rank. If a country puts no pressure on the planet, its PHDI and
HDI would be equal, but the PHDI falls below the HDI as pressure rises. PHDI values are very
close to HDI values for countries with an HDI value of 0.7 or lower (See Table 10.2).

Table 10.2 Trends in HDI Value

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Table 10.1 Trends in Social Sector Expenditure

The value of HDI for India has increased from 0.579 in 2010 to 0.645 in 2019. The average annual
HDI growth during 2010-2019 was 1.21 per cent as compared to 1.58 per cent during the period
2000-2010. Cross country comparison of average annual HDI growth shows India is ahead of BRICS
countries (Figure 10.1). To sustain this momentum and overcome possible fallouts of COVID-19 on
human development, the thrust on access to social services such as education and health is critical.

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Fig.10.1 Average Annual HDI Growth Rate (in %) 2010-2019

These trends and figure shows that India has been spending on social infrastructure and in
improving education, health and income of individuals so as to have an equitable distribution of
income. The purpose of the government is to invite everyone to participate in the growth story of
the country. However, disparities continue and huge efforts have to be made to bring millions of
people above the poverty line and improve the employment situation of the country.

Summary
Economic development has remained the focus of all the governments around the world. The post-
World War period witnessed the emergence of countries who were hitherto colonies and they
modelled themselves after the developed countries. This saw an increase in the economic wealth of
these countries, and they recorded high economic growth rate. But the problem of inequality rose
manifold which called for focus on human development. Since 1990s, human development index
was introduced to measure inequality and factors that contribute to human development. Over the
years the countries have worked hard to improve their ranking as human development is now
related to investment opportunities as well. India has improved its performance over time to
reduce inequalities.

Keywords
Economic Growth: Economic growth refers to the rate of expansion in the quantity of goods and
services produced in the economy
Gender Development Index: The GDI measures gender gaps in human development achievements
by accounting for disparities between women and men in three basic dimensions of human
development—health, knowledge and living standards using the same component indicators as in
the HDI. The GDI is the ratio of the HDIs calculated separately for females and males using the
same methodology as in the HDI.
Human Development Index: The Human Development Index (HDI) is a summary measure of
average achievement in key dimensions of human development: a long and healthy life, being
knowledgeable and have a decent standard of living.
Life Expectancy: Life expectancy is a statistical measure of the average time an organism is
expected to live, based on the year of its birth, its current age, and other demographic factors
including sex.
Mean Years of Schooling: Mean years of schooling (MYS), the average number of completed years
of education of a population, is a widely used measure of a country's stock of human capital
UNDP: The United Nations Development Programme is a United Nations organization tasked with
helping countries eliminate poverty and achieve sustainable economic growth and human

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development. Headquartered in New York City, it is the largest UN development aid agency, with
offices in 170 countries.

Self Assessment
1. Who releases the Human Development Report?
A. World bank
B. World economic forum
C. United Nations
D. UNCTAD

2. Which of the following is not a part of HDI?

A. Real GNP per capita
B. Education
C. Health
D. Employment

3. Which one of the following helps to make real GNP per head figures more meaningful when
comparing standards of living across different countries?
A. Human Development Index (HDI)
B. Human Poverty Index (HPI)
C. Endogenous Growth Theory
D. Purchasing Power Parities (PPP's)

4. The Human Development Index (HDI) pays no attention to economic variables such as real
GNP per capita.
A. True
B. False

5. Who gave the concept of HDI?

A. Mehbub-ul- Haq
B. Amartya Sen
C. Both Mehbub-ul-Haq and Amartya Sen
D. Maurice Dobb

6. Which is the fastest growing economy in the North African region as per World Economic
Situation and Prospects 2020?
A. Egypt
B. Algeria
C. Morocco
D. Mauritania

7. In the East African peace treaty which of the following country was not a part of it?
A. Djibouti
B. Eritrea
C. Ethiopia
D. Kenya

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8. Which of the following country will have negative growth rate in the coming years?
A. Angola
B. Malawi
C. South Africa
D. Zimbabwe

9. The Gender Inequality Index ranges between

A. +1 and -1
B. 0 and 1
C. There is no limit
D. None of the above

10. What is the rank of India in the inequality index 2020?

A. 127
B. 128
C. 129
D. 130

11. What is the current rank of India in HDI (year 2020)?

A. 130
B. 131
C. 132
D. 133

12. What is the Life expectancy in India as per HDI 2020?

A. 69 years
B. 69.7 years
C. 70 years
D. 70.7 years

13. In terms of GDI value, Bangladesh is ahead of India (as per 2020 data)
A. True
B. False

14. What is the mean years of schooling for males in India as per the 2020 HDI report?
A. 8 years
B. 8.7 years
C. 9 years
D. 9.7 years

15. What is the Gender Development Index score of India as per the 2020 HDI report?
A. 0.80
B. 0.81
C. 0.82
D. 0.83

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Answers for Self Assessment

1C 2D 3D 4B 5C

6A 7D 8C 9B 10 C

11 B 12 B 13 A 14 B 15 C

Review Questions
1. Why was the Human Development Index started?
2. What are the indicators of Human Development?
3. How are the various indicators of HDI estimated?
4. Write a note on HDI ranking of India over the years.
5. Is the size of the population an impediment in human development?
6. “Education is the key to human development” Explain

Further Readings
Parr S.F. and A.K. Shiva Kumar (2003), Readings in Human Development, New York:
Oxford University Press.
UNDP Report 1990
UNDP (2009), Overcoming Barriers: Human Mobility and Development, Human
Development Report, New York: Oxford University Press

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Tanima Dutta, Lovely Professional University Unit 11: Structure of Indian Economy

Unit 11: Structure of Indian Economy

CONTENTS
Objectives
Introduction
11.1 Agriculture Sector
11.2 Industrial Sector
11.3 Service Sector
11.4 Emerging Energy-Economy-Environment Regulatory Framework
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
• Review the economy since independence
• Evaluate the role of agriculture, industry, and service sector in the Indian economy
• Analyse the emerging energy-economy-environment regulatory framework

Introduction
The structure of the Indian economy has transformed over the years, though there is debate over
the sequence of transmission. In the modern period, industralisation and its pace is the pivot on
which the extent of development depended. Countries that got industrialized in the earlier periods
transmitted into the zone of developed nations the first. India was an agrarian economy and the
contribution of this sector to the GDP showcases this fact. However, the pace of industralisation is
slow in India and tertiary sector took off in the post liberalisation period. However, in terms of
livelihood, agriculture remains in the numero-uno position followed by the tertiary sector. The
unorganised sector in manufacturing that was encouraged during the 1960s and 1970s has also had
an impact on industralisation.

11.1 Agriculture Sector

Agriculture occupies a key position in all economies irrespective of their level of development. It
satisfies certain basic needs of human beings by fulfilling their food and non-food demands. It
supplies: i) food grains such as rice, wheat, coarse cereals and pulses, ii) commercial crops such as
oilseeds, cotton and sugarcane, iii) plantation crops such as tea and coffee, and iv) horticultural
crops such as fruits, vegetables, flowers, spices, cashew and coconut. In addition to these, certain
allied activities such as milk and dairy products, poultry products and fishery are included in the
agricultural sector.
Most of the developed and industrialised countries received their initial spurt for industrial
advancement from agriculture.

Importance of Agriculture
To make an assessment of the role and importance of agriculture it is necessary to examine its
contribution to development of the economy. Such contribution may be measured in terms of its

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share in Gross Domestic Product (GDP), employment generation, exports, etc. Another dimension
of the role of agriculture is the support it renders to the industrial sector by supplying raw
materials on the one hand and food for the workforce engaged in this sector on the other.
Moreover, it generates demand for the industrial products. All these aspects have to be studied in
order to analyse the role and importance of agriculture in an economy.

Contribution to GDP
Agriculture has been observed to contribute a very large share to GDP of most of the economies
before industrial development takes place in them. As the process of industrial development
accelerates, the share of non-agricultural sectors in GDP tends to increase steadily. Simultaneously,
the relative share of agriculture shrinks and yields place to that of manufacturing and services
sectors. This does not imply that the agricultural production does not increase. It only implies that
the growth in the production of industrial and services sectors is faster than the growth in
agricultural sector. This process of change is the consequence of a change in the structure of the
economy which steadily becomes more industrialised. Quite often such a change in the
composition of GDP is cited as an indicator of economic development.

Contribution to Employment
An equally relevant criterion for examining the role of agriculture is its share in the total workforce.
Number of workers engaged in agriculture is usually very high before industrial development
takes place in an economy. This share tends to decline with industrialisation of the economy as
employment opportunities grow rapidly in sectors other than agriculture. Steady changes in the
occupational distribution of workforce have been observed in most economies as they experience
industrial growth and diversification. Generally, the trend is towards a steady decline in the share
of workforce engaged in agriculture and an increase in the proportion of workforce engaged in
manufacturing and services sectors.

Contribution to Exports
Another indicator of the role of agriculture in an economy is the contribution it makes to exports.
As industrial growth takes place and there is a steady change in the composition of exports, in
favour of manufactures and services. The share of agriculture in the exports of the economy
undergoes a decline.

Contribution to Other Sectors

An equally significant criterion to gauge the role and importance of agriculture is the contribution it
makes to the growth of the non-agricultural sectors. As it is the source of raw materials for a
number of industries and also supplier of food for the workers who are engaged in non-agricultural
sectors, agricultural sector becomes crucial for industrial growth and expansion. As a major sector
of an economy, it plays an important role in generating demand for the products of the other
sectors. The extent of dependence of the other sectors of the economy on agriculture is a vital
criterion for assessing the role of agriculture in an economy.

Share of Agriculture in Indian economy

In the previous section we identified some criteria to assess the role and importance of agriculture
in an economy. On the basis of these criteria now let us examine the trends that have emerged in
the role of agriculture in India particularly since Independence.

Share in GDP
Some broad estimates of the share of agriculture in GDP of India suggest that in the first quarter of
the twentieth century (1901-1925) the share of agriculture in GDP was about two-third. At the time
of Independence (1947) this share declined to nearly one-half. As expected, this share has steadily
declined to about 20.2 per cent in 2020-21.

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Table: 11.1: Value and Percentage Share of Agriculture in GVA at 2011-12 Price

Year Value of Output in Per cent share of

Crores (2011-12 Price) Agriculture in GVA
(2011-12 Price)

53082 61.71
1950-51

73243 56.68
1960-61

90942 49.56
1970-71

106367 42.46
1980-81

150741 35.13
1990-91

196942 26.48
2000-01

304475 18.32
2010-11

536035 14.62
2018-19

Source: MOSPI
From Table 11.1 we see that there has been a steady decline in the share of agriculture in GDP. Even
thought the value of agricultural production has increased from 53082 crores in 1950-51 to 536035
crores in 2018-19, the percentage share of agriculture in the GVA of the country went down which
is a positive sign for any country. It means that resources are now more engaged in non-
agricultural activities.

Share in Workforce
Agriculture in India absorbs a very large proportion of the labour-force. The proportion of
workforce engaged in agriculture in India even in the 1990s is more than 60 percent. According to
the 1991 population census 67 per cent of the workforce was engaged in agriculture. This
proportion was marginally lower than the earlier census figure which was 72 per cent.

Share in Exports
Agricultural sector has been a major contributor to India’s export earnings. For a long time the
agro-based products namely tea, cotton textiles and jute textiles accounted for more than 50 per
cent of the export earnings of the country. By adding to the list other products like spices, coffee,
tobacco, cashew, sugar, etc., the share of agriculture in total exports was almost 70 per cent. This
share has, however, declined over time with economic growth and diversification of the economy.
For example, the share of agriculture and allied products in the total exports in 1960-61 was nearly
44 per cent. It has continued to decline and for the year 2000-01 this share was only 13.5 percent. As
per WTO’s Trade Statistics, India’s share in agricultural export and import in the world were 2.46%
and 1.46% respectively in 2014. During this year, India’s total global agriculture & allied export and
import were at US$ 43.47 billion and US$ 27.31 billion respectively. Agricultural exports decreased
from Rs. 2,62,778 crores in 2013-14 to Rs. 2,13,555 crores in financial year 2015-16 with a decline of
nearly 18%. During 2015-16 marine products, basmati & non-basmati rice, buffalo meat, spices and
cotton were top commodities of India’s agriculture exports. The share of agricultural exports in

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total exports of the country decreased from 13.79 % in 2013-14 to 12.46% in 2015-16.

Table 2: India’s Top 15 Agricultural Export Commodities

Assessment of the Trends

A review of the direct contribution of agriculture to GDP, to employment and to exports reveals
that agriculture is a very important sector of the Indian economy. Even though the share of
agriculture in GDP, employment as well as export earnings has declined over time, agriculture
continues to remain a crucial sector in terms of its contribution to the economy. We may note that
while a steady and significant decline in the contribution of agriculture to GDP and export earnings
of India has taken place, the fall in the share of workforce engaged in agriculture has not been as
significant.

11.2 Industrial Sector

Growth in the industrial sector is one of the vital figures that affect the Gross Domestic Product
(GDP) in India. This section provides information about the initiatives taken by the Union and state
Governments to facilitate the industrial growth in the country. Details of industries like insurance,
Micro, Small and Medium Enterprises, chemical, fertilizer, defence products, cottage, retail textile,
pharmaceutical, manufacturing, etc. are provided for the users. The section also highlights schemes,
documents, forms, acts, rules, policies, reports related to various industries and corporate
governance.

Key Sector Focus Areas

• The proliferation of digital technologies will accelerate adoption and drive productivity gains in
the overall business. Industrial leaders in India are embarking on digital transformation of their
vertical and horizontal value chains from product development and purchasing to
manufacturing, logistics and services. The need to repair, rethink, reconfigure and re-innovate
existing business models have become imperative in the Covid world.
• Efforts are on forming multinational partnerships, alliances and joint ventures in order to secure
FDI, benefit from advanced technologies, and improve productivity through factory automation.
Companies are trying to move beyond functional cuts and focus on strategic remobilisation of the
cost base allowing reinvestment to critical areas of a business in concert with new tools and
levers.

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• Organisations are recognising that many of the disruptions of today - technology, customer
shifts, digitisation, M&A, etc - are opportunities for growth. While focus continues on
penetrating the domestic market, Indian manufacturers are also looking to gain a foothold in the
global market by increasing sales in existing markets and by identifying new geographies.
• With the Government of India having unveiled the Production Linked Incentive Scheme (PLI) to
boost manufacturing and increase India’s global competitiveness, global manufacturers are
looking to scale up their India operations, build new capabilities and increase the incremental
investments and sales of goods. New investors are also perceiving India as an advantageous
investment destination.
• Building resiliency and agility in supply chains to respond to the ongoing disruptive forces of
Covid and broader strategic decisions is a key imperative. Supply chain control towers, move
from physical only to physical and digital operations, simulation models to stress test resilience,
machine-learning enabled demand sensing, adoption of AI and other emerging technologies are
now mainstream.
• Climate change, environmental compliance and social responsibility, green growth, responsible
finance and sustainability have become key issues. Companies are trying to understand
contemporary challenges, associated impacts and opportunities that arise from embracing ESG.
Knowing how to measure/report ESG metrics and design net zero and de-carbonisation
strategies and roadmaps to get there, whilst customers expect more on sustainability and
transparency, is the conversation topic in boardrooms.
• Organisations are facing a shortage of talent and skills to keep up with digitisation and need to
rethink the role of humans. Enhancing workforce capability is a priority - digital upskilling and
workforce transformation rank top as the factory floor activity is most likely to increase and
companies plan their “return to work” strategy.
• Cyber risks are viewed as the one of the biggest challenges for industrial product companies
driven by digitisation and closely linked to cloud transformation. Aside from IT, threats to OT
infrastructure and product security issues have become operational priorities for firms.

Contribution of Industry in Gross Value Added

As per the latest estimates on Gross Value Added (GVA), the industrial sector is expected to record
a growth of -9.6 per cent with an overall contribution in GVA of 25.8 per cent in2020-21 (FY21). The
contribution of the industrial sector has been constantly declining since2011-12 (Figure 1). The fall
in share is across the board except in case of ‘Electricity, gas, water supply & other utility services’
whose share in GVA has increased from 2.3 per cent in FY12 to2.7 per cent in FY21. The
performance of the various components of the industrial sector namely, manufacturing, mining and
quarrying, electricity, and construction is presented in Table 3.
Table 3: Rate of Growth of GVA in Industry and Its Components (Per cent)

Fig. 1: Share of Industry and its Components in GVA (Current Prices, Per cent)

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Government Initiatives
11.3 Service Sector
The growth of the Services Sector in India is a unique example of leap-frogging traditional models
of economic growth. Within a short span of 50 years since independence, the contribution of the

Ease of Doing Business

The GoI is committed to facilitating a pro-business environment to enable the country to become
the global hub of manufacturing and economic activities. Several measures have been taken
resulting in the simplification and rationalization of many existing and age-old rules and
regulations. The introduction of information technology and single window clearance to make
governance more efficient and effective were some of the other concrete steps taken by the
Government to improve the environment of doing business. As per the Doing Business Report
(DBR), 2020, the rank of India in the Ease of Doing Business (EoDB) Index for 2019 has moved
upwards to the 63rd position amongst 190 countries from a rank of 77 in 2018. India has
improved its position in 7 out of 10 indicators, inching up to the international best practices. The
DBR, 2020 acknowledges India as one of the top 10 improvers, the third time in a row, with an
improvement of 67 ranks in three years. It is also the highest jump by any large country since
2011.
Atmanirbhar Bharat is the vision of the GoI of making India a self-reliant nation. The
announcements under the Atmanirbhar Bharat Abhiyan were made in three tranches. The key
measures pertaining to industry and infrastructure are summarized below: Atmanirbhar Bharat
1.0 I. Relief and credit support to MSMEs to fight against COVID-19.
Atmanirbhar Bharat is the vision of the GoI of making India a self-reliant nation. The
announcements under the Atmanirbhar Bharat Abhiyan were made in three tranches. The key
measures pertaining to industry and infrastructure are summarized below:
Atmanirbhar Bharat 1.0 I. Relief and credit support to MSMEs to fight against COVID-19.

1. ` 3 lakh crores Collateral-free Automatic Loans for Businesses, including MSMEs

2. 20,000 crores Subordinate Debt for Stressed MSMEs:
3. ` 50,000 crores equity infusion through MSME Fund of Funds
4. New definition of MSME
5. Relief of ` 1500 crores to MUDRA- Shishu loans
6. Ease of doing business for business including MSMEs
Atmanirbhar Bharat 2.0 (second tranche of measures) provided ` 25,000 crores as additional
capital expenditure to the Ministry of Road Transport and Ministry of Defence

service sector in India to the country’s GDP is a lion’s share of over 60%. However, it still employs
only 25% of the labour force. Consequently, agriculture (which is stagnant) and manufacturing
(which has not yet risen to its full potential) continue to sustain the majority of our employed
population. This presents a unique challenge to future economic growth in India and requires out

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of the box solutions that will help rapidly harness the potential of the service industry in India.
Invest India takes a look at the contribution of the services sector in the Indian economy, its
successes and also explores potential enablers for future equitable economic growth.

Market Size of Service Industry

A quick comparison with the American and Chinese economy reveals the unique nature of India’s
GDP growth from the contribution of the Service sector and its linkages to employment and income
distribution (Figures in bracket indicate employment). Over time, a robust manufacturing and
productive agriculture sector leads to the Service industry in India becoming the mainstay of GDP
and employment. In our context, the Service sector has become extremely important to grow not
only our GDP, as well as make it the key vehicle for employment generation. However, the
question is - how to increase value add to GDP from Service companies in India, while reducing
employment dependency from agriculture, as well as boosting the manufacturing industry.
Table 4: Contribution of Service Sector to GDP

The current growth of service

sector in India is based mainly on
labour market arbitrage. Moving
forward, India can no longer rely
on ‘low cost’ for ‘low value
added’ services. Therefore, we
need solutions that address
these:
i) Boosting the manufacturing
sector with both direct and
indirect spin - off benefits for the
growth of the service sector in
India (e.g. Make in India)
ii) Moving up the value chain,
especially in the IT/ ITeS sector.
iii) Broad - basing the Indian
Services offering platform into
sectors beyond the traditional
IT/ ITeS by identifying the
global demand for such services,
and meeting these demands
based on our natural competencies and comparative advantages.

Services with Future Prospects

IT-BPM/ Fintech
The IT/ITeS & Fintech segments provide over $ 155 bn in gross value add and have the potential to
grow between 10 -15% p.a. Exports form its largest component. So far, our key advantage has been
low - cost labour arbitrage in a predominantly English - speaking country. Going forward, the IT
and ITeS segments require significant upskilling to move beyond a ‘low - cost low value add
service provider’ to a ‘high value add partner’.
Indian IT companies can also leverage their skill sets to provide fintech solutions to global financial
customers. Financial risk management services, insurance, natural disaster modelling and
underwriting are examples of high value add services performed within India for a global
audience.

Healthcare & Tourism

The current contribution of the healthcare industry is over $ 110 bn and is expected to touch $ 280
bn by 2020. Availability of world - class medical facilities, skilled doctors, technicians and
pharmaceuticals are some of our advantages. With digital communication and interfaces,
diagnostic medicine can also be tapped into as a service for global customers.

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Similarly, for tourism, India is renowned for its places of natural beauty and historical significance.
Tourism presently contributes $ 47 bn to the country’s GD, compared with $ 115 bn for China.
Thus, tourism has exponential possibilities to boost the Indian services sector in the next decade.
To attract significant revenues, improved customer experience (medical or tourism) is the key factor
that will determine its future growth. In this context, government initiatives such as e - Visas, better
infrastructure facilities, safety, connectivity etc. are enablers in the right direction.

Space
India captured the world's attention last February when it broke the record for launching the most
number of satellites into space. Moreover, this was done at a fraction of the cost incurred by other
space powers.
Indian services in the space domain, with proven expertise in multiple launch technologies, provide
it with a significant advantage over its peers in the global space transportation industry. Our launch
capabilities have a near 100% track record. Many countries are actively looking to piggyback on
India’s launch facilities. This demonstrates great potential. The government is actively proving its
ability, but more can be done to build capacity in military and non - military space applications. In
this context, public - private participation is key to ensure the flow of capital, as well as to
strengthen competencies in this area.

Logistics & Transportation

India’s natural coastline and vast river network give it a competitive edge in providing
transportation and logistics services, both domestically and internationally. These can be classified
into ports and ports services, warehousing, trans - shipment services, e - logistics, inland waterways
for freight and passengers, expressways and dedicated freight corridors. India’s logistics service
sector itself is expected to grow from $ 115 bn to $ 360 bn by 2032.
India should closely look into the development of the service industry, given the potential and need
for sustained large scale investment. Investments typically have a long gestation period. However,
once the infrastructure is created, linkages to the rest of the economy provide significant multiplier
effects. For example, the Mumbai - Pune expressway and the development of service industries in
Pune.

Other services
Media & Entertainment (animation, gaming, dubbing), Education (online platforms such as
MOOC), and Sports (IPL, IFL, Sports Management), Legal/ Paralegal services, Risk management
and advisory functions, etc. are areas that can lead to an immense contribution of service industry
in the Indian economy.

Prospects of the Service Sector in India

The service sector in India has the highest employment elasticity among all sectors. Thus, it has the
potential for huge growth as well as the capability to deliver highly productive jobs - leading to
revenue generation. To address the challenge of job creation, the Skill India program aims to
achieve its target of skilling/ up - skilling 400 million people by 2022. It aims to do this mainly by
fostering private sector initiatives in skill development programs, and by providing them with the
necessary funding.
Similarly, the Make in India program - while attempting to bolster the manufacturing sector - will
cause a multiplier effect in adding to the portfolio of the Service Sector. In this context, the Start-up
India initiative is a key enabler for both the manufacturing as well as service industry in India - by
offering to support innovative start-ups.

11.4 Emerging Energy-Economy-Environment Regulatory Framework

With a population of 1.4 billion and one of the world’s fastest-growing major economies, India will
be vital for the future of the global energy markets. The Government of India has made impressive
progress in recent years in increasing citizens’ access to electricity and clean cooking. It has also
successfully implemented a range of energy market reforms and carried out a huge amount of
renewable electricity deployment, notably in solar energy. Looking ahead, the government has laid
out an ambitious vision to bring secure, affordable and sustainable energy to all its citizens. This in-
depth review aims to assist the government in meeting its energy policy objectives by setting out
arrange of recommendations in each area, with a focus on energy system transformation, energy

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security and energy affordability. The review also highlights a number of important lessons from
the rapid development of India’s energy sector that could help inform the plans of other countries
around the world.

India is making great strides towards affordable, secure and cleaner energy
Ensuring Indian citizens have access to electricity and clean cooking has been at the top of the
country’s political agenda. Around 750 million people in India gained access to electricity between
2000 and 2019, reflecting strong and effective policy implementation. The IEA highly commends the
Government of India for this outstanding result and supports its efforts to shift the focus towards
reaching isolated areas and ensuring round-the-clock reliability of electricity supply.
The government of India has also made significant progress in reducing the use of traditional
biomass in cooking, the chief cause of indoor air pollution that particularly affects women and
children. The government has encouraged clean cooking with liquefied petroleum gas. India
continues to promote cleaner cooking and off-grid electrification solutions, including a shift toward
using solar photovoltaics (PV) for cooking and charging batteries.

Major energy reforms lead to greater efficiency

The IEA commends India for its continuous pursuit of market opening and greater use of market-
based solutions through ambitious energy sector reforms. Increased access to affordable energy has
raised the living standards of all segments of the population. India now has the institutional
framework it needs to attract more investment for its growing energy needs. The IEA welcomes the
government’s decisions to allow private-sector investment in coal mining, and to open up the
country’s oil and gas retail markets. The creation of functioning energy markets will ensure
economic efficiency in the management of the coal, gas and power sectors, which is critical to
achieving energy security and supporting the country’s economic growth. This will be increasingly
important in the future, as energy demand and investment needs increase in line with India’s
economic expansion.
Reform of India’s electricity sector will need to be comprehensive to achieve these goals. The IEA
welcomes the reforms proposed by the Central Energy Regulatory Commission (CERC) and
progress made towards improved real-time markets. A country-wide wholesale market is very
much needed as a backbone for the national grid. Key to this success will be building a joint vision
and a common reform roadmap among a broad range of central government agencies, state
authorities, system operators and utilities. India also faces the challenge of ensuring the financial
health of its power sector which is dealing with surplus capacity, lower utilisation of coal and
natural gas plants, and increasing shares of variable renewable energy. The government is working
to improve the financial viability of the power sector. Faced with the challenge of some “stressed
assets” in coal and gas-fired generation, it has been implementing a package of measures to
enhance the economic efficiency of coal and gas supply for power generation and the availability of
finance. The creation of a competitive wholesale power market will be vital for improving the
utilisation of India’s generation capacity. India is making energy security a priority
India’s electricity security has improved markedly through the creation of a single national power
system and major investments in thermal and renewable capacity. India’s power system is
currently experiencing a major shift to higher shares of variable renewable energy, which is making
system integration and flexibility priority issues. The Government of India has supported greater
interconnections across the country and now requires the existing coal fleet to operate more
flexibly. It is also promoting affordable battery storage. International experience suggests that a
diverse mix of flexibility investments is needed for the successful system integration of wind and
solar PV. This flexibility is available not only from the coal fleet – it can also come from natural gas
capacity, variable renewables themselves, energy storage, demand-side response and power grids.
Many of these solutions are not yet fully utilised in India. To fully activate a diverse set of flexibility
options, it is critical for the government to put in place electricity market reforms that enable the
appropriate price signals and create a robust regulatory framework.
India’s coal supply has increased rapidly since the early 2000s, and coal continues to be the largest
domestic source of energy supply and electricity generation. Amid more stringent air pollution
regulations, new coal power plants that are more efficient, flexible and relatively lower in emissions
will be better positioned for their economic viability. By contrast, old and inefficient plants, which
require expensive retrofits to comply with environmental standards, are in a difficult position. The
government is identifying those plants that can and will need to run more flexibly in the system. It
is also examining changes to market design to improve the remuneration of the system services

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they can provide. An efficient coal sector is critically important not only for electricity generation,
but also for industrial development in areas such as steel, cement and fertilisers.
India is the world’s third-largest consumer of oil, the fourth-largest oil refiner and a net exporter of
refined products. The rate of growth of India’s oil consumption is expected to surpass that of the
People’s Republic of China in the mid-2020s, making India a very attractive market for refinery
investment. To maintain India’s position as refining hub, the government is pursuing a very
ambitious long-term roadmap to expand its refining capacity in line with the country’s projected
demand growth through 2040. As proven oil reserves are limited compared with domestic needs,
India’s import dependency (above 80% in 2018) is going to increase significantly in the coming
decades.
To improve oil security, the government has prioritised reducing oil imports, increasing domestic
upstream activities, diversifying its sources of supply and increasing Indian investments in
overseas oil fields in the Middle East and Africa. Commendably, India is
promoting domestic production with a major upstream reform, the Hydrocarbon Exploration and
Licencing Policy (HELP), and is progressively building up dedicated emergency oil stocks. India’s
strategic petroleum reserve supplements the commercial storage available at refineries. India’s
current strategic reserve capacity of 40 million barrels can cover just over 10 days of current net
imports. However, given the expected growth in oil consumption, the same volume may cover only
four days of net imports in 2040. Therefore, it is important that the government pursue the second
phase of its strategic stockholding policy, which would add an additional 50 million barrels, and
also prepares subsequent phases. The IEA welcomes the government’s efforts to intensify
discussions with potential investors and supports India’s collaboration with countries that have
varied and comprehensive experience in stockholding and response capabilities.
The government aims to increase the share of natural gas in the country’s energy mix to 15% by
2030, from 6% today. The IEA welcomes this ambition, which would allow India to improve the
environmental sustainability and flexibility of its energy system. Increasing domestic gas
production has been a key government priority, as output has unexpectedly come in below forecast
levels over the past few years. India has five operating terminals for liquefied natural gas. Projects
under construction could result in up to 11 additional terminals over the next seven years.
The role of gas has grown in India’s residential and transport sectors but fallen in power
generation, where imported natural gas remains squeezed by cheap renewables and coal. The
government is committed to further liberalising the country’s natural gas market. Strengthening
regulatory supervision of upstream, midstream and downstream activities should be part of the
market reforms, as it is likely to bring greater efficiency and drive up demand for gas and
investment in gas transport infrastructure. A liquid and well-functioning domestic gas market
would be a strong pillar for India’s security of gas supply.

Summary
Indian economy is primarily an agrarian economy though the government initiated a number of
programs and policies to industrialise the economy. The lack of skilled labour and huge
investments did not lead to the take-off of industralisation in the required pace. The opening up of
the economy in 1991 did not do much for the manufacturing sector but the service sector got a huge
boost. The contribution of the service sector is maximum in the GVA of the country followed by
industries and then the primary sector. Employment is still generated from the primary sector as it
does not require specific skills. Climate change and environment has become the prime focus at the
international level. The Paris Accord of 2015 and COP26 of 2021 have univocally demanded the
countries to integrate environment in all their policies. India has been a frontrunner in using
alternative energy and has also committed to bring down the consumption of coal. India has opted
for open market solutions to energy issues which have been commended by IEA.

Keywords
Agriculture: the science, art, or practice of cultivating the soil, producing crops, and raising
livestock and in varying degrees the preparation and marketing of the resulting products

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Industry: An industry is a group of companies that are related based on their primary business
activities. In modern economies, there are dozens of industry classifications. Industry classifications
are typically grouped into larger categories called sectors.
Service sector: The service sector, also known as the tertiary sector, is the third tier in the three
sector economy. Instead of the product production, this sector produces services maintenance and
repairs, training, or consulting. Examples of service sector jobs include banking, insurance, nursing,
and teaching.
Climate change: Climate change refers to long-term shifts in temperatures and weather patterns.
These shifts may be natural, but since the 1800s, human activities have been the main driver of
climate change, primarily due to the burning of fossil fuels (like coal, oil, and gas), which produces
heat-trapping gases.
IEA: The International Energy Agency is a Paris-based autonomous intergovernmental
organisation established in the framework of the Organisation for Economic Co-operation and
Development in 1974 in the wake of the 1973 oil crisis.
Aatmanirbhar Bharat: Atmanirbhar Bharat which translates to 'self-reliant India', is a phrase used
and popularized by the Prime Minister of India and the Government of India in relation to the
economic vision and economic development in the country.
Make in India: Make in India is an initiative by the Government of India to make and encourage
companies to develop, manufacture and assemble products made in India and incentivize
dedicated investments into manufacturing.

Self Assessment
1. Which of the following is the commercial crop in India?
A. Mustard
B. Tobacco
C. Jute
D. All of the above

2. Which Indian state produces the largest quantity of pulses?

A. Maharashtra
B. Uttar Pradesh
C. Madhya Pradesh
D. Rajasthan

3. Which of the following is not matched correctly?

A. Rabi Crop………Mustard, Cucumber
B. Rabi Crop………Mustard, Barley
C. Zaid Crop………Moong, vegetables
D. Kharif Crop…..Cotton

4. Which agency is responsible for procurement, distribution and storage of food grain
production in India?
A. Ministry of Agriculture
B. Food Corporation of India
C. NAFED
D. TRIFED

5. Which one of the following cities has emerged as the ‘electronic capital’ of India?
A. Delhi

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B. Kolkata
C. Bengaluru
D. Hyderabad

6. Which of the following industries is not a heavy industry?

A. Cotton textile
B. Cement
C. Iron and Steel
D. Ship building

7. Which industry is termed as the sunshine industry by the government of India?

A. Food Processing Industry
B. Mobile Industry
C. Real Estate sector
D. Automobile Industry

8. What was the contribution of the service sector to the GVA in the financial year 2019-20?
A. 52%
B. 53%
C. 54%
D. 55%

9. Which of the following is not considered as a social indicator of poverty?

A. Less no. of means of transport
B. Illiteracy level
C. Lack of access to health care
D. Lack of job opportunities.

10. Which of the following is not a major reason for the lack of effectiveness of targeted anti-
poverty programmes?
A. Lack of proper implementation
B. Lack of right targeting
C. Overlapping of schemes
D. All the above.

11. Calorie requirement in rural areas is more than in the urban areas because:
A. rural people eat more
B. rural people have high bodies
C. rural people do more hard physical work
D. rural people have to take more rest.

12. Agenda 21 was given in which earth summit?

A. Stockholm summit
B. Rio De Janeiro summit
C. Kyoto summit
D. Paris summit

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13. The Nationally Determined Contributions had to be submitted by which year?

A. 2015
B. 2018
C. 2020
D. 2025

14. Afforestation and clean energy is ________goal under the SDG?

A. Fifth
B. Sixth
C. Seventh
D. Eighth

15. By 2030 the Indian government wants to increase the share of natural gas in the energy mix
to what level?
A. 27%
B. 29%
C. 30%
D. 31%

Answers for Self Assessment

1. D 2. C 3. A 4. B 5. C

6. A 7. A 8. D 9. A 10. D

11. C 12. B 13. C 14. C 15. C

Review Questions
1. In spite of the low share of agriculture in the GVA of the country, agriculture is still
considered the most important sector of the economy. Why?
2. Industralisation is required to create employment and to increase the consumption of
manufactured goods by the masses. Comment
3. In the light of changes in environmental laws, international pressure to reduce carbon
emission, how is the Indian industry compete at the international level.
4. How is the tertiary sector of an economy different than the other sectors in the economy?
What role does the tertiary sector perform in the development process of an economy?
5. “The sequence of the growth process in India is different than what most of the other
countries experienced during the transition from a developing to a developed nation”.
Examine this statement and account for the causes of rapid growth of the tertiary sector in
India.

Further Readings
Basu Kaushik (ed.) (2010): The Oxford Companion to Economics in India, Oxford

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University Press, New Delhi.

Dev, S. M., 1998, Regional Variations in Agricultural Performance in the Last Two Decades,
Indian Journal of Agricultural Economics, January-March.
Dhingra Ishwar C. (2012): The Indian Economy Environment and Policy, Sultan Chand,
New Delhi.

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Tanima Dutta, Lovely Professional University Unit 12: Economic Reforms

Unit 12: Economic Reforms

CONTENTS
Objectives
Introduction
12.1 Historical background of the Reforms
12.2 Rationale of Economic Reforms of the Nineties
12.3 Characteristics of Economic Reforms
12.4 Banking Sector Reforms
12.5 Economic reforms and Agriculture
12.6 Economic Reforms and Industry
12.7 Economic Reforms and Service Sector
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
• Understand the chronology and process of economic reforms
• Analyse the reforms in agriculture, industry, service sector and financial sector
• Evaluate the reforms and its impact on the Indian economy

Introduction
After attainment of independence, India adopted the regime of economic planning with a glorious
vision of a resurgent India. It aimed to marching firmly on the path of progress while ensuring an
equitable distribution of the nation’s wealth. Policies relating to licensing focussed on public sector,
putting infant industry argument for imposing trade barriers, import-substitution policies, etc. This
gamut of policies led to over-protection, inefficient resource utilisation, high revenue deficits,
mismanagement of firms and economy, poor technological development and shortage of foreign
exchange.
The resultant stress and pressures compelled the government to revisit the policy framework. The
outcome came to be a set of changes in economic policies, which in a broad sense came to be
identified as economic reforms. The principal aim of economic reforms was to enter an era of
globalisation which meant a) free flow of goods and services, b) free flow of technology, c) free flow
of capital, and) free movement of human beings, especially labour from one country to another.
Economic reforms, therefore, required integrating the Indian economy with world economy and
the emphasis in economic reforms shifted to export-led growth strategy from import substitution
strategy.

12.1 Historical background of the Reforms

The popular opinion is that reforms in India started in 1991 with the announcement of the New
Economic Policy but the truth is that the base for these reforms were laid down in the eighties. The
oil crisis of the seventies had brought about a change in the economic structuring of the country.

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The second oil crisis of the seventies was not handled properly in terms of policy making which led
to the country approaching the International Monetary Fund for the first time for structural loans.
The then government of India understood the fact that it was difficult to continue with the
socialistic pattern of the economy. There was a need to introduce the private sector in areas hitherto
reserved for the public sector. Another significant development of the seventies that prompted the
liberalisation of the economy in the eighties was industrialists themselves were beginning to find
the strict regime counterproductive and started pressing the government for the relaxation of
controls. A domestic lobby in favor of liberalization of imports of raw materials and machinery had
come to exist. At the same time, in the case of raw materials and machinery imports that had no
import substitutes, there was no counter lobby. The improved export performance and remittances
from overseas workers in the Middle East had led to the accumulation of a comfortable level of
foreign-exchange reserves. These reserves lent confidence to policymakers and bureaucrats who
had lived in the perpetual fear of a balance of payments crisis.
Broadly, the reforms of the 1980s, which were largely in place by early 1988, can be divided into
five categories. First, the OGL list was steadily expanded. Having disappeared earlier, this list was
reintroduced in 1976 with 79 capital goods items on it. The number of capital goods items included
in the OGL list expanded steadily reaching 1,007 in April 1987, 1,170 in April 1988, and 1,329 in
April 1990. In parallel, intermediate inputs were also placed on the OGL list and their number
expanded steadily over the years. Based on the best available information, this number had reached
620 by April 1987 and increased to 949 in April 1988. According to Pursell (1992, p. 441)), ‘imports
that were neither canalized not subject to licensing (presumably mainly OGL imports) increased
from about 5 percent in 1980–81 to about 30 percent in 1987–88.’ The inclusion of an item into the
OGL list was usually accompanied by an “exemption,” which amounted to a tariff reduction on
that item. In almost all cases, the items on the list were machinery or raw materials for which no
substitutes were produced at home. As such their contribution to increased productivity was likely
to be significant.
The second source of liberalization was the decline in the share of canalized imports. Canalization
refers to monopoly rights of the government for the import of certain items. Between 1980–81 and
1986–87, the share of these imports in total imports declined from 67 to 27 percent. Over the same
period, canalized non-POL (petroleum, oil and lubricants) imports declined from 44 to 11 percent of
the total non-POL imports. This change significantly expanded the room for imports of machinery
and raw materials by entrepreneurs.
Third, several export incentives were introduced or expanded, especially after 1985, which helped
expand imports directly when imports were tied to exports and indirectly by relaxing the foreign
exchange constraint. Replenishment (REP) licenses, which were given to exporters and could be
freely traded on the market, directly helped relax the constraints on some imports. Exporters were
given REP licenses in amounts that were approximately twice their import needs and thus
provided a source of input imports for goods sold in the domestic market. The key distinguishing
feature of the REP licenses was that they allowed the holder to import items on the restricted (and
therefore those outside of the OGL or canalized) list and had domestic import-competing
counterparts. Even though there were limits to the import competition provided through these
licenses, as exports expanded the volume of these imports expanded as well. This factor became
particularly important during 1985–90 when exports expanded rapidly.
The fourth source of liberalization was a significant relaxation of industrial controls and related
reforms. Several steps are worthy of mention:
• Delicensing received a major boost in 1985 with 25 industries delicensed.14 By 1990, this
number reached 31. The investment limit below which no industrial license would be
required was raised to Rs 500 million in backward areas and Rs. 150 million elsewhere,
provided the investments were located in both cases at stipulated minimum distances
from urban areas of stipulated sizes. Traditionally, the industrial licensing system had
applied to all firms with fixed capital in excess of Rs 3.5 million. There remained 27 major
industries subject to licensing regardless of the size and location of investment. These
included a number of major industries like coal, large textile units using power, motor
vehicles, sugar, steel, and a large number of chemicals. Products subject to Small Scale
Industries (SSI) reservation were also off limits though the asset ceiling of firms designated
as SSI units was raised from Rs. 2 million to Rs. 3.5 million.
• Broad banding, which allowed firms to switch production between similar production
lines such as trucks and cars, was introduced in January 1986 in 28 industry groups. This

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provision was significantly expanded in the subsequent years and led to increased
flexibility in many industries. In some industries, the impact was marginal, however, since
a large number of separate product categories remained due to continued industrial
licensing in those products.
• In 1986, firms that reached 80 percent capacity utilization in any of the five years
preceding 1985 were assured authorization to expand capacity up to 133 percent of the
maximum capacity utilization reached in those years.
• Firms that came under the purview of the Monopolies and Restrictive Trade Practices
(MRTP) Act were subject to different rules and could not take advantage of the above
liberalizing policy changes. To relax the hold of the licensing and capacity constraints on
these larger firms, in 1985–86 the asset limit above which firms were subject to MRTP
regulations was raised from Rs. 200 million to Rs. 1,000 million. As a result, as many as 90
out of 180 large business houses registered under the MRTP Act were freed from
restrictions on growth in established product lines. Requirement of MRTP clearances for
27 industries was waived altogether. MRTP firms in a number of industries were exempt
from industrial licensing provided they were located 100 kilometers away from large
cities. MRTP firms were allowed to avail themselves of the general delicensing measures
in sectors in which they were not considered dominant undertakings. These measures
significantly enhanced the freedom of large firms (with assets exceeding Rs. 1,000 million)
to enter new products.
• Price and distribution controls on cement and aluminum were entirely abolished.
Decontrol in cement eliminated the black market and through expanded production
brought the free-market price down to the controlled levels within a short time. New
entrants intensified competition, which led to improvements in quality along with the
decline in the price.
• There was a major reform of the tax system. The multi-point excise duties were converted
into a modified value-added (MODVAT) tax, which enabled manufacturers to deduct
excise paid on domestically produced inputs and countervailing duties paid on imported
inputs from their excise obligations on output. By 1990, MODVAT came to cover all
subsectors of manufacturing except petroleum products, textiles, and tobacco. This change
significantly reduced the taxation of inputs and the associated distortion. In parallel, a
more smoothly graduated schedule of excise tax concessions for small-scale-industries
(SSI) firms was introduced, which reduced incentives for them to stay small.

The relaxation of industrial controls reinforced the ongoing import liberalization. In the presence of
these controls, firms had to have an investment license before they could approach the import-
licensing authority for machinery and raw-material imports. For products freed of industrial
licensing, this layer of restrictions was removed. More importantly, under industrial licensing, even
for products on the OGL list, machinery imports were limited by the approved investment capacity
and raw material imports by the requirements implied by the production capacity. With the
removal of licensing, this constraint was removed.
The final and perhaps the most important source of external liberalization was a realistic exchange
rate. At least during the years of rapid growth, there is strong evidence of nominal depreciation of
the rupee correcting the overvaluation of the real exchange rate. According to the charts provided
in Pursell (1992), both the import-weighted and export weighted real exchange rates depreciated
steadily from 1974–75 to 1978–79 with the approximate decline of the former being 30 percent and
of the latter 27 percent. It bears reminding that this was also a period of rapid export expansion (see
below) and foreign exchange reserves accumulation that paved the way for import liberalization
subsequently. The years 1977–79 also registered the hefty average annual GDP growth of 6.5
percent. The real exchange rate appreciated marginally in the following two years, stayed more or
less unchanged until 1984–85, and once again depreciated steadily thereafter.

12.2 Rationale of Economic Reforms of the Nineties

Indian economy was highly regulated during the first four decades of economic planning (1950-
1990). The five-year plan objectives were focussed on development of public sector for setting up
heavy and basic industries, self-reliance, import substitution strategies, nationalisation and state-

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interventionist regime. While on one hand it helped in setting up some key industries like SAIL,
ONGC, IOC, BHEL, etc., on the other hand it restricted the growth of private sector, private
business plans and brought about bureaucracy-led corruption, sick public sector enterprises,
deteriorating trade balance, economic and financial crisis in early 1990s.
India had to borrow foreign exchange from IMF and comply with the conditionality imposed by it
such as stabilisation and structural stability programme, reduction of trade barriers, revision of
fiscal and monetary policies, active role of market and integration of the Indian economy with the
world economy. In a nutshell, the three basic elements of economic reforms were liberalisation,
privatisation and globalisation (also known as LPG strategy) of the Indian economy.

12.3 Characteristics of Economic Reforms

The New Economic Policy (NEP) during the economic reforms process reflected neo-liberalism. The
rationale of economic reforms was provided by the IndustrialPolicy announced by the Government
in 1991. Its basic philosophy was summedup as ‘continuity with change’. The key objectives can be
summarised as:

i. to set free the Indian industrial economy from the hassles of unnecessary bureaucratic
controls;
ii. to introduce liberalisation with a view to integrate the Indian economy with the world
economy;
iii. to remove restrictions on foreign direct investment (FDI) and also to lessen the restrictions
of Monopolies and Restrictive Trade Practices (MRTP) Act for the domestic entrepreneur;
iv. to dilute the monopoly of public sector enterprises and encourage competition from new
private enterprises.

Liberalisation
A liberal policy adopted on both domestic and external fronts aimed to counter the financial crisis
during early 1990’s included the following measures

i. All industrial licensing was abolished except for 18 industries relating to security and
strategic concerns, social sectors, hazardous chemicals, environmental reasons and items
of elitist consumption industries. (Presently, only five industries are subject to licensing)
ii. To promote domestic and global competition, reservation of Small-scale industry (SSI)
items is being reduced gradually since 1990s. Currently, the number of items facing
reservation stands only 21, a marked decline from836 in 1996.
iii. MRTP Act was amended to account for removal of pre-entry restrictions, concentration of
economic power, threshold limits of assets in respect of dominant undertakings and
MRTP companies. (Subsequently, the MRTP Acthas been withdrawn and the MRTP
commission stands disbanded)

Privatisation
Privatisation refers to any process that reduces the involvement of the state/public sector in
economic activities of a nation. Contrary to the post-independence thruston enlargement of public
sector, the economic reforms of 1991 recognised private sector as the engine of growth. Policies
were framed to increase the role of private sector in the process of development. Privatisation in a
mixed economy like India can take several forms such as:

1. Total denationalisation, implying complete transfer of state ownership of productive

assets into private hands. Some prominent examples in India were of Allwyn Nissan,
Mangalore Chemical and Fertilisers, Maharashtra Scooters– transferred to private hands.

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2. Joint venture, implying partial induction of private ownership from 25 to 50per cent or
even more in a public sector enterprise, depending upon the nature of the enterprise and
state policy in this regard. The basic aim is to improve efficiency, productivity and
profitability of the firms. Three kinds of proposals are put forward in it:
- 26 per cent ownership by the private sector (banks, mutual funds, corporations,
individuals). Workers also to be included and equity to the extent of 5 per cent to be
transferred to them.
- 51 per cent equity to be retained by the Government and 49 per cent to be sold to private
sector.
- 74 per cent of the equity transferred to the private sector and Government retains 26 per
cent.
3. Worker’s co-operative is another form of privatisation where a loss-making public
sector firm is transferred to the workers. A classic example of the Indian case is the Indian
Coffee Houses run by a chain of worker cooperative societies, retained from the British
rule post-independence. However, it did not assume a significant role in economic reforms
due to requirement of investments for expansion of businesses.
4. Token Privatisation, also known as deficit privatisation or disinvestment, implying sale
of 5-10 per cent shares of a profit-making public sector enterprise in the market with the
objective of obtaining revenue to reduce budget deficits. During the period 1991-92 to
2011-12, the government could raise a sum of Rs. 60,000 crore by way of disinvestment. On
an average, disinvestment receipts have managed to cover 7 per cent of the revenue deficit
and 4 percent of the fiscal deficit over the period 1992-2012.
Government announced a new policy on November 5, 2009 which has two components: One
dealing with listed profit-making units and another extending to all other government-owned
companies. While the former will have to off load minimum 10 per cent equity stake, unlisted ones
(meeting 3 criteria – a positive net worth, no accumulated reserves and a net profit for three
consecutive years) will have to opt for listing on the stock exchanges by divesting similar amounts.

Globalisation
Globalisation is the process of integrating the various economies of the world without creating any
barriers in the flow of goods and services, technology, capital and labour/human capital. It
involves four components:

1. Reduction of trade barriers in the form of custom duties/quotas/quantitative restrictions

so as to permit free flow of goods and services in different economies.
2. Creation of an environment in which free flow of capital (or investment) can take place
between nation states.
3. Creation of an enabling environment for the free flow of technology; and
4. From the viewpoint of developing countries, creation of an environment in which free
flow of labour or human resources can take place among different countries of the world.
Essentially, globalisation is an extension of the process of liberalisation in the international domain.
It therefore signifies internationalisation plus liberalisation.
In India, the process of globalisation began with the adoption of LPG model during economic
reforms since 1990s. Some of the key features in this context are:

i. Its key impact was seen in India’s service sector particularly in fast-paced growth of
industries like information technology (IT), information technology enabled services
(ITES), outsourcing, telecommunications, tourism, real estate, transport, banking,
insurance, entertainment, etc.

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ii. Inducement to foreign investment flows (FDIs and FIIs) has brought about efficiency,
competition, profitability and global standards in productivity and quality of
economic goods. Mergers, joint-ventures, PPPs, and contracting to foreign players
have accelerated the development process in the Indian economy.
iii. The two decades of economic-reforms have seen an increase in the rate of exports,
migration (domestic and international), etc.

Public Private Partnership (PPP)

India is setting out a successful example of PPP projects and encouraging private participation
in key development projects. The main advantages of public-private partnerships are efficient
and speedy delivery of projects, alleviation of capacity constraints and bottlenecks in the
economy, innovation and diversity in provision of world-class facilities, value for money of the
tax-payer through optimal risk transfer and risk management, etc. There are various models of
PPP and the ones primarily followed in India are:

- build-operate transfer (BOT), example – Mumbai Metro rail undertaken by Anil

Ambani group
- build-own-operate-transfer
- build-own-operate (BOOT), example – Rajiv Gandhi International airport,
Hyderabad.
- concession
- design-build-finance operate
- management contract
- asset sale
These models are being developed as per the needs of the projects for highways (expressways,
flyovers, sub-ways and foot-over-bridges), railways (IRCTC), metro rail as well as airports. As
of now 450 PPP projects are under implementation

12.4 Banking Sector Reforms

In continuation to NEP and to bring structural reforms in the working of the economy, a series of
measures were introduced in the financial sector especially in the banking sector. In the following
section, you will study about these reforms. In 1991, the Government of India set up the
Narasimham Committee to examine all aspects relating to the structure, functioning, organization
and procedure of the financial system to remodel these institutions for raising the overall efficiency.

Narasimham Committee, 1991

Narasimham Committee was set up in 1991 to analyse the falling efficiency of the India banking
sector and then recommended certain reforms to revive the banking sector.
Major recommendations of the Narasimham Committee, 1991 are:

1. The committee felt that the present structure was too rigid and inflexible so it proposed
the deregulation of the interest rate structure and said that the interest rate should be
determined by market forces.
2. Re-examination of direct credit programme and to include small and marginal farmers,
tiny industrial sector and weaker sections. The aggregate credit to the redefined priority
sector to be fixed at 10%.
3. Reduction of Statutory liquidity ratio (SLR) to 25% over a period of 5 years from 38.5% in
1991. Further, the cash reserve ratio (CRR) to be reduced in a phased manner from the
existing rate of 15%.
4. Establishment of 4 tier hierarchy for the banking structure which should be as follows:
i. 3-4 banks (including SBI) at the top of the banking structure and they could become
international in character.

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ii. 8-10 banks engaged in general or universal banking and they would have a network
of branches throughout the country.
iii. Local banks whose operation would be confined to a specific region.
iv. Regional banks including Reginal Rural Banks (RRBs) would be confined to rural
areas and they would be engaged in financing agriculture and allied activities.
5. Introduction of prudential norms and regulation:
i. Definition of Non-Performing Assets: An asset would be considered nonperforming if
the interest on such assets remains past due for a period exceeding 180 days at the
balance sheet date. Banks and financial institutions to be given a period of 3 years to
move towards these norms.
ii. For the purpose of provisioning, the committee recommended classifying assets into 4
categories, namely, standard, sub-standard, doubtful and loss assets. Regarding the
substandard, a general provision should be created equal to 10 percent of the total
outstanding under this category. In case of doubtful assets provision should be created to
the extent of 100 percent of security shortfall. In respect of the secured portion of some
doubtful debts, further provision should be created ranging from 20 percent, 50 percent
depending on the period for which such assets remain in the doubtful category. With
respect to loss assets, it is suggested that either fully they be written off or provision be
created to the extent of 100 percent. The committee also suggested that a period of 4 years
should be given to the banks and financial institutions to conform to those provision
requirements.
iii. Banks and financial institutions should achieve a minimum of 4 % capital adequacy ratio
by March 1993 of which Tier-1 capital should not be less than 2%.
6. An Asset Reconstruction Fund (ARF) to be established for the recovery of loans. This fund
would take a portion of the bad and doubtful debts of the banks at a discount.
7. End to the duality of control and RBI should be the primary agency for the regulation of
the banking system.
8. To provide autonomy to the banks the chief executive of the bank should be appointed
based on professionalism and integrity and not on political consideration.
9. Banks can access the capital market and issue of fresh capital to the public through the
capital market.The Banking Companies (Acquisition and Transfer of Undertaking) Act
was amended so that banks can raise capital through public issues but to the condition
that the holding of Central Government would not fall below 51% of paid-up capital.
10. Setting up of new private sector banks if they conform to the requirement of minimum
start-up capital and other requirements. Further, there should not be any differential
treatment between public and private sector banks.
11. Opening of foreign banks to open offices in India either as branches or as subsidiaries.

Narasimham Committee II -1998

This committee was given the mandate to review the progress of banking sector reforms and design
a programme to further strengthen the financial structure, technological upgradation, human
resource development, capital adequacy norms and bank mergers. The major recommendations
include:

1. A stronger banking system in the context of Current Account Convertibility (CAC). Indian
banks must be made capable of handling problems pertaining to domestic liquidity and
exchange rate management. So strong banks need to be merged which will have a
multiplier effect on the industry.
2. Revival of Narrow Banking Concept whereby weak banks should place their funds only in
short term and risk-free assets like government securities.
3. Setting up of small, local banks which would cater to needs of states or cluster of the
district to serve local trade, small industry and agriculture.
4. Banks should aim to reduce gross NPAs to 3 % by 2002.

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5. To improve the strength of the Indian banking system the government should raise capital
adequacy norms of 9 % by 2000, 10 % by 2002.
6. Banks to give more autonomy and freedom in the recruitment of skilled, specialized
manpower from the market.
7. Rapid introduction of computerization and technology.
8. Amendments in the Banking Regulation Act, Nationalisation Act and State Bank of India
Act, RBI Act, Bank Nationalisation Act, etc. to allow greater autonomy, higher private-
sector shareholdings, and so on.

Financial Sector Reforms

The Government of India from time to time have been making certain reforms to strengthen and
stabilize the financial sector.
I. Financial Stability and Development Council (FSDC)
The government of India, in 2010 created an apex body (non-statutory) to promote financial sector
development and strengthen the mechanism for maintaining financial stability. The regulator is
entrusted with the responsibility to maintain macro-prudential supervision in the country, inter-
regulatory coordination and financial development issues. The Union Finance Minister is the
chairperson of the FSDC and other members include the governor of RBI, chairman of SEBI, IRDA
and others.
II. Merger of Forward Markets Commission (FMC) with the Securities and Exchange Board of India
(SEBI)
As you must be familiar with forward trading in the context of shares in which buyers and sellers
agree to trade a financial asset at a future date at a specified price. Similarly, forward contracts are
agreements in the commodity market concerning the future delivery of a commodity at the pre-
negotiated prices. The Forward Market Commission (FMC) established in 1953 acted as the
regulatory body for the commodity futures market in India.
However, as part of Financial Sectors Reforms, FMC was merged with the Securities and
Exchange Board of India (SEBI) in 2015. The merger aimed at realising the benefits of
economies of scope and scale for exchange and to harmonize the regulation of commodity
derivatives and the securities market.
III. Insolvency and Bankruptcy Code, 2016
Before the Insolvency and Bankruptcy Code, 2016, there were several laws and procedures mostly
overlapping and adjudicating forums that dealt with insolvency and financial failure of individuals
and companies in India. The institutional and legal framework imposed a heavy strain on the
Indian credit system as there was no time limit on the effective and time recovery or restructuring
of defaulted assets. Reforms in the bankruptcy and insolvency regime were critical not only for
credit markets which were under a lot of stress but for the ease of doing business in the country.
The new code aims at consolidating and amending laws relating to reorganization and resolution of
corporate persons, individuals and partnership firms in a time-bound manner i.e. 180 days in case
of companies. However, a subsequent amendment in this code in 2019 (The Insolvency and
Bankruptcy Code (Amendment) Act, 2019) has enhanced the mandatory upper time limit to 330
days which includes time spent in the various legal processes to complete the resolution process.
To promote entrepreneurship and availability of credit and balance the interests of all the
stakeholders, under the new Code, the National Company Law Tribunal (NCLT) will now
adjudicate insolvency resolution for companies and the Debt Recovery Tribunal (DRT) will
adjudicate insolvency resolution for individuals. Establishment of the Insolvency and Bankruptcy
Board of India will oversee the insolvency proceedings in the country and regulation of all entities
registered under it. To speed up the implementation of this Code, Government of India established
the Tribunals, National Company Law Tribunal (NCLT) and National Company Appellate
Tribunal (NCLAT) and Insolvency and Bankruptcy Board of India (IBBI) in 2016.
Banking Regulation (Amendment) Ordinance, 2017

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One of the biggest problems in the Indian banking system pertains to Non-Performing Assets
(NPA). Over the years they have accumulated and have reached trillion of crore rupees. To deal
with the problem of stressed assets, Banking Regulation (Amendment) Ordinance, 2017 was
promulgated in 2017. The bill has amended the Banking Regulation Act, 1949 and has inserted two
new sections namely 35AA and 35AB after Section 35A. Accordingly, RBI is now authorized to
direct banking companies to resolve specific stressed assets by initiating an insolvency resolution
process wherever required. The RBI is also empowered to issue other directions for the resolution
of the stressed assets. RBI can also form committees to advise banks on the resolution of stressed
assets and the members of such committees will be appointed by the RBI. The Ordinance enabled
RBI to deal with NPAs quickly. Accordingly, now the Oversight Committee can bypass three major
factors/hurdles which slowed the resolution process. These are: 1) stop ‘free riding’ by lenders who
did not participate in the resolution process. 2) compliance after an agreement has been sealed. 3)
certify the process to alleviate fears of future investigations.
V. The Banking Regulation (Amendment) Act, 2020
To find a solution to the deteriorating condition of cooperative banks in the country, the
government amended the Banking Regulation Act, 1949 and promulgated Banking Regulation
Amendment Bill, 2020. The major objective is to bring cooperative banks under the supervision of
the RBI.
RBI, after placing the bank under a moratorium can prepare a scheme for reconstruction or
amalgamation of the bank. This is done once the RBI is satisfied that such an order is necessary to
protect the interest of the depositors, public of the banking system. However, the act also allows
RBI to initiate such a scheme without imposing a moratorium.
The Cooperative bank can now issue equity shares, preference shares or special shares to its
members or to any other person residing within its area of operation, They can also issue unsecured
debentures or bonds with a maturity of 10 years or more to such person with the prior approval of
RBI. No person can demand payment towards the surrender of shares that are issued by a
cooperative bank.
The RBI may exempt a cooperative bank or a class of cooperative banks from a certain provision of
the Act through notification. The cooperative banks cannot employ someone who is insolvent or
has been convicted of a crime. The RBI has the power to remove the chairman if he/she is not fit for
the position and can appoint another person as chairman. Cooperative banks cannot make loans or
advances on the security of their own shares. They cannot grant unsecured loans or advances to
their directors or to private companies where the bank’s director or chairman is an interested party.
The Act has specified certain conditions under which unsecured loans or advances may be granted
and it specifies how these loans may be reported to RBI.
The cooperative banks without prior approval of RBI, cannot open a new place of business or
change their location outside the city, town or village in which it is currently located. This Act does
not apply to Primary Agricultural Credit Societies (PACS) and cooperative land mortgage banks.

12.5 Economic reforms and Agriculture

Economic reforms include a number of issues. They try to correct the basic shortcomings of the
economy that hinder its growth and welfare of its people. Purpose of economic reforms is to
generate output and employment and maximize economic growth. In an agriculture dependent
economy, no effort in this direction can be successful without making agriculture conducive for
growth. Therefore, economic reforms have relevance for agriculture as well.
The principal thrusts of reforms in agricultural sector are the following:
a) Encourage private investments: This can be achieved by providing credit facilities, irrigation,
transportation, marketing, warehousing facilities, information and export opportunities to the
farmers. Land Reforms: In India about 75% of the cultivators own 25% of the total land under
cultivation. If these poor farmers could be provided with more land by redistributing the land it
will boost agricultural production and investments. This is because land owned by the existing big
landlords are often leased out to poor tenants. These tenants do not possess enough money to
invest. There is also a large section of landless labourers and tenant farmers who need to be
allocated land. Such redistribution of land would ensure a regular source of income to agricultural
labourers and tenants besides increasing production. For this measure to be successful

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supplementary supports in the form of cheap seeds, fertilizers, irrigation and credits have to be
provided.
c) Taxing the Agricultural Rich: On the ground that majority of the Indian farmers are poor, the
government does not impose taxes on agricultural income. But the benefits of such a policy accrue
to the rich landlords and farmers who only get richer by this exemption. Moreover, this concession
has become a means of tax evasion. People often show their non-agricultural income as agricultural
income and claim tax exemptions. To generate sufficient resources for development purposes, the
possibility of taxing rich landlords and farmers needs to be explored.
d) Managing the Terms of Trade: The price relation between the agricultural and industrial sectors
is a matter of great importance. It determines the level of real income for the entire population. In a
poor country like India, high food prices (which means a high terms of trade for agriculture) mean
a low living standard for a large segment of the population. It means high poverty level and low
demand for industrial goods. As a result, industrial output and employment may suffer. High
procurement prices offered by the government mainly benefit rich farmers with marketable
surplus.
e) Promoting Exports of Agricultural Goods: India has the potential of growing a variety of crops
because of its differing climatic conditions. Thus this potential should be properly utilized in order
to capture the foreign market for these goods. At the same time, however, it should be remembered
that in many cases higher global prices often leads to outflow of foodgrains and food products
which could lead to shortages in the country.
f) Rationalizing Subsidies: Subsidies have been the subject of much debate in India. In the post-
independence period Indian farmers have been given huge amount of subsidies under a number of
heads. Be it building of public infrastructure such as dams and irrigation projects, or provision of
cheap power, HYV seeds and fertilizer, or even regular procurement of crops at remunerative
prices. However, critics question whether the subsidies are reaching the target groups. Many are of
the view that only the rich farmers in select northern states get most of these subsidies. Thus a
proper scheme for the provision of subsidies, which benefits majority of farmers, needs to be
designed.
g) Free Trade in Agri-Products: As we have seen in the previous unit India is facing a problem of
over-supply in food grains and many other agricultural commodities. However, for many years
there was restriction on movement Ofari-products across states. These restrictions were imposed in
the form of licensing of dealers, placing limits on stocks, and control on movement of commodities
under the Essential Commodities Act, 1955. The government has now withdrawn licensing
requirement of dealers and restrictions on storage and movement of food grains (wheat, paddy,
rice, coarse grains), sugar, oilseeds and edible oils. Free movement of agricultural products has
another benefit – we don’t need self-sufficiency in all agricultural commodities at the regional level.
Once self-sufficiency is attained at the national level, free trade will help in movement of food
grains from surplus to deficit regions. Moreover, free trade will create an integrated national
market in agricultural produce.

Areas of Reforms in Indian Agriculture

Based on the discussion in the previous section we attempt to identity areas in which reforms need
to be carried out. We enlist them below.

Prices
The prices which the cultivators get for their crops and the prices at which consumers buy from the
market need to be rationalized. We saw in Unit 19 that high remunerative price induces agricultural
investments and growth. But it may lead to impoverishment of lower income groups and
decelerate industrial growth. The price charged at the public distribution system (PDS) shops also
needs to be reformulated. The hike in issue prices in recent years has resulted in low off-take from
the PDS outlets. This is because the price levels for the ‘Above Poverty Line’ (APL) target group
exceeded the market price whereas the products on offer were of sub-standard quality. For the
‘Below Poverty Line’ (BPL) group the prices were somewhat lower but the rich and the influential
got themselves registered as BPL and reaped the benefits. The result has been fall in cereal
consumption by the poor and rising inequality. There is a need for a well thought out policy in this
area which protects the interests of both producers and consumers.

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Subsidies
Subsidies are related to the issue of prices. Lower price that the consumers pay at PDS fair price
shops is due to the subsidies granted by the government. However, as mentioned above, in many
cases subsidies do not reach the target groups. In the case of ‘production subsidies’ provision of
subsidised fertilizers, seeds, pump sets and other equipment’s have helped the rich farmers,
particularly in agriculturally developed states. On the whole, we can say that agricultural subsidies
need to be streamlined or reformed. It does not mean that they have to be done away with; rather
they have to be properly focussed.

Exports
Exports by a farmer result in higher income for the farmer. It also earns foreign exchange for the
country which makes its economic position stronger. Therefore, the government should look at the
issue of export promotion of agricultural products and provide necessary support. It should
minimize the legal and bureaucratic hassles in the way of setting up of a production unit and
exporting abroad. But the considerations which we have talked about earlier, such as not fuelling
the domestic food price or not contributing to poverty, should also be kept in mind. Not
contributing to poverty, should also be kept in mind have some commodity which it can produce at
the minimum relative cost. And it will be beneficial for all the countries if they specialize in
production and export of commodities where they have comparative advantage. The aggregate
welfare and output will be maximized in this way.
It follows from the above theory that measures which restrict trade or encourage production of
commodities in which a country does not have comparative advantage lead to a fall in domestic
and global welfare. It then follows that all tariffs and quota son imports should be scrapped.
Subsidies that are given to production of exports goods should be withdrawn because they distort
the free market price. Free market price ensures that resources are efficiently allocated between
alternative uses. Extending this logic to agricultural goods, it is recommended that all quantitative
restrictions (QRs) on the imports of agricultural products should be abolished. The restrictions
India had earlier on import of agricultural goods were based on a different understanding.
The import quotas sought to guarantee that Indian farmers were protected against foreign
competition and dumping. It was argued that dependence of food imports might mean poverty and
famine in years when global food shortage occurs.
Another set of measures suggested by the WTO is related to patent laws and their implementation.
WTO believes that a company inventing a particular product should have the exclusive rights to
benefit from it. This will ensure that people do get necessary incentive and money to invent and
research on a new product. Result of this policy is that anybody using a patented product or
producing it has to pay a royalty to the original inventor. This is called TRIPS (trade related
intellectual property rights). It has the implication that in order to use high yielding patented
varieties of seeds, fertilizers and pesticides, the users have to pay a fee to the respective
patentholders. Anyone who wants to do research on a patented seed is being forbidden to do so
without permission and payment of royalty to the patent holder. The impact of such patents is an
increase in the cost of production for the farmers.
Other broad WTO recommendations which also affect Indian agriculture are as
follows:
i) Reduction in subsidies to farmers: The WTO believes that subsidies have two adverse effects.
First, it distorts free market prices leading to misallocation of resources. Second, it raises
government fiscal deficit. High fiscal deficit may lead to balance of payment difficulties and
inflation.
ii) Reduction in government spending: The international organizations such as IMF have been
suggesting that the government should cut down on expenditure so as to reduce fiscal deficit. An
outcome of such efforts by many governments including India has been a reduction in the outlay
on public infrastructure such as roads, electricity, transportation and rural banking. Investments on
public irrigation facilities have also declined.
iii) Privatization of the public sector units: The WTO believes that government should have no
economic interventions in production and resource allocation. It should play the role of a facilitator
in realization of higher growth and maintain economic stability. An implication of such a
prescription has been the selling off of public sector undertakings.

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iv) Dismantling the PDS: The PDS implies two kinds of subsidies to be paid by the government.
First to the farmers in terms of procurement price higher than market price. Second to the
consumers by selling food grains at lower than market price. Such operations raise fiscal deficit and
promotes inefficiency.

12.6 Economic Reforms and Industry

By the late 1970s and early 1980s, it was obvious to many that the pervasive regulation and controls
over private economic activity by the Government had inhibited economic efficiency and growth.
The industrial sector in India fared quite impressively in the 1980s in terms of growth of
output/value added compared to the earlier period 1966-79. Overall, the Government of India
maintained a reasonably good growth rate during the late 1980s but it was achieved only by
increasing fiscal deficits. Indeed, when Rajiv Gandhi became the Prime Minister in 1984, he
declared that his primary objective was to “rationalise” controls. The intent was clearly to reduce
the number of overlapping and sometimes even inconsistent regulations. In fact, the process of
industrial policy reform started in 1970s. Automatic capacity expansions were permitted during the
1970s and 1980s and a few industries were delicensed in 1975 but this liberalisation was trivial.
Systematic deregulation began in earnest in the mid-1980s. Taxation reform – mainly the
conversion of multi-point excise duties into a modified value added tax (MODVAT) in all sectors
except petroleum products, textiles and tobacco by 1990 – also impacted industrial performance by
reducing the taxation of inputs and the associated distortion. The New Industrial Policy (NIP)
statement of 1991 introduced reforms in regulations governing licensing, monopoly, foreign
investment and small-scale sector industries and in the role of public sector enterprises. It may be
mentioned that the series of economic reforms that India initiated in July 1991 were unprecedented
in their scope and magnitude.
In 1985 a system of “broad-banding” was introduced that allowed existing license-holders to
diversify into a number of related industries without obtaining prior permission. By 1988, the
number of broad product groups that required capacity licensing by the Government had been
reduced to 27 from 77 previously. Further, deregulation in 1993 brought this down to 18 items that
were important for strategic, environmental or social reasons or were producers of luxury items
and finally to only six in 1999. All other industries were permitted to expand according to their
market needs, without obtaining prior expansion or capacity clearance from the Indian
Government. In particular, industries included in the negative list for producing ‘elitist’ products
such as motor cars and consumer durables were delicensed in 1993, the entertainment electronics
industry in 1996 and sugar, petroleum products and coal and lignite industries in 1998.
Liberalisation of industrial licensing and opening industry to foreign investment was an important
part of the NIP statement of 1991. This element has progressed well as far as Central Government
controls are concerned. Investors still face many problems in implementing projects, but these are
largely at the State level, which is a second-generation area. However, there are some areas of
industrial deregulation where further action is needed. The sugar industry is one such area. Sugar
is an extremely important agro-based industry and the second largest industrial employer in the
country after cotton textiles. If liberalisation is beneficial to industry, it should be beneficial to sugar
also. Yet this industry remains subject to extensive control associated with the existing dual price
system. In the sugar industry, State advised prices to be paid to farmers are often unconnected with
market conditions and a portion of the production must be surrendered as levy sugar at an
unremunerative price. Even the so-called fee market sugar is also subject to release control. The
industry complains of a non-level playing field against imports, which do not suffer from the levy.
There is a strong case for decontrolling sugar and opening this industry to market competition.
Another important aspect of the reform process of the 1990s was the amendment to the Monopolies
and Restrictive Trade Practices (MRTP) Act which eliminated the need for prior Government
approval for new investment, capacity expansion and mergers by large firms. The amended MRTP
Act gave more emphasis to prevention and control of monopolistic, restrictive, and unfair trade
practices, to provide adequate protection to consumers.
There had been little change in the list of state-dominated industries between 1956 and 1991. As we
have learned in unit 7, the reforms of 1991 reduced the role of the public sector by abolishing
Schedule B (It included 12 industries, sea transport, drugs, dyestuffs and plastics, fertiliser,
synthetic rubber, chemical pulp, aluminium, etc., in which private sector firms would be accepted,
although the public sector would play an increasing role in the future expansion of these
industries.) and reducing the number of items reserved for the public sector alone (i.e. the Schedule

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A industries) from 17 in 1983 to six in 1993 and finally to four in 1999 – arms and ammunition,
atomic energy, minerals used in atomic energy production and rail transport. The scope of Public
Sector Units (PSUs) was restricted to the provision of infrastructure services. PSU reform was
essential, as the inefficiencies in this sector would multiply into downstream inefficiencies due to its
dominant presence in infrastructure and the provision of critical inputs (Srinivasan and Bhagwati,
1993). Under the amended Sick Industrial Companies Act, poorly performing PSUs could be
referred to the Board for Industrial and Financial
Reconstruction (BIFR) for rehabilitation and were given prioritised allocation from the National
Renewal Fund for displaced workers. In the early 1990s, greater autonomy was given to more
efficient PSUs and some divestment of Government equity was carried out. Complete privatisation,
finally introduced in the late 1990s, made slow progress with the first major successful privatisation
taking place in 2001. Reforms were also undertaken to encourage foreign investment and
technology. The Government had established a more liberalised foreign investment policy.
Consequent to the above changes, a separate set of policy measures were introduced for the
promotion and strengthening of Small-Scale Industries (SSIs) in August 1991. This new policy
statement was a clear re-affirmation of the commitment of the Government towards the importance
of this sector in economic growth objectives. The policy proposed to impart more vitality and
growth impetus to the sector to enable it to contribute its mite fully to the economy, particularly in
terms of growth of output, employment and exports.
In due course, the sector was substantially delicensed and investment limits in plant and machinery
were increased. Further, efforts were made to deregulate and de-bureaucratise the sector and the
Government proposed to review and modify, wherever necessary, all statutes, regulations and
procedures to ensure that their operations did not militate against the interests of the small and
village enterprises.
To summarise, firms operating in the Indian market in the pre-reform period (i.e., before 1991)
faced barriers to entry due to Government control over private investment through the licensing
regulations, reservation of production for the public sector and lengthy and opaque procedures for
approving foreign direct investment (FDI) that were further subject to a maximum limit of 40 per
cent equity share. These restrictions on entry were gradually eased during the 1990s. With the
industrial policy reforms of 1990s, India has moved into an era of a more competitive industrial
environment in which entrepreneurs respond to market signals rather than try to skirt around
bureaucratic controls.

Industrial Growth and its Structural Transformation in the 1990s

The industry sector in India has undergone a significant transformation in the 1990s. The process of
organisational restructuring and the concomitant supportive changes in industrial policy aimed at
creating a more competitive and challenging industrial environment are under way. The need for
industrial restructuring has raised several issues associated with mergers and acquisitions in the
private corporate sector, reforms in the public sector enterprises and so on and so forth. The
structural changes have influenced the industrial performance. In the 1990s, the overall industrial
growth based on the Index of Industrial Production (IIP) recorded a much wider variation (ranging
between 0.6 per cent to 12.7 per cent) as compared to the relatively low order of variation (ranging
between 3.2 per cent to 9.3 per cent) observed in the 1980s. Over the past three decades, the
industrial sector has not shown any definitive trend either in its growth rate or in its contribution to
Gross Domestic Production (GDP). The share of industry in GDP rose from 18.6 per cent in 1970 to
27 per cent in 1995-96. However, it fell to 22 per cent in 1996-97 where it remained in the
subsequent two years.
Generally, industrial growth is portrayed through growth in IIP. The IIP is a standard measure of
the trends of industrial production and is being published as a monthly series since 1950 by the
Ministry of Industry, Government of India. Revisions of IIP are carried out from time to time by
shifting the comparison base to a more recent period and by reviewing coverage of
items/industries for reflecting changes in the structure of the Indian industry sector. The
Department of Statistics set up a Technical Advisory Committee (TAC) in June 1995 to examine all
technical issues relating to comparable state level IIPs and make recommendations thereon.

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12.7 Economic Reforms and Service Sector

To appreciate the nature of service-sector reforms initiated during the last two decades, we prepare
two catalogues: (1) Pre-reforms strategies, and (2) Post reforms strategies as follows in Table 12.1. It
may be observed that all these reform measures are comprehensive in their range and sweep as
they cover all the sectors of the economy. But they have specific implications for the service sector,
as the service sector conditions and is conditioned by production processes both in the primary and
secondary sectors of the economy.

Table 12.1 Service Sector Strategies

Within the contours of this model of service sector reforms, we can enumerate the various reform-
measures as follows:

Exchange Rate Policy

After a steep devaluation of about 22 per cent vis-à-vis dollar in July 1991, the rupee was floated in
phased manner. In March 1992, rupee was partially floated. This was followed by shift to market-
determined rate of rupee in March 1993.

Fiscal Policy
Tax reforms aim at reducing the dependence on indirect taxes for revenue, reduction in tax rates
(excise, customs, corporation tax and personal income tax), and rationalisation (slabs for tax rates
have been reduced to few levels from several levels), widening of tax base, reduction in the fiscal
deficits, and curtailing monetisation of budget deficits. Falling interest rates have ensured that the
cost of servicing huge public debt is more manageable than before. Debt management is more
sophisticated — the government raises more long-term debt today, while its dependence on short-
term debt has fallen. Buoyant capital flows have helped fund the fiscal deficit with some ease.
While the government has been on a huge internal borrowing, external debt is well under control.

Monetary and Financial Sector Policy

Objective has been to control inflation and stabilise the value of rupee in market system. Broad
money growth brought down to reasonable levels from previously high levels. Reserve ratios for
banks progressively reduced. Banks selectively allowed to access the capital market. New banks
allowed to function parallel with the public sector banks. Interest rates have been progressively
deregulated.

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Trade Policy and FDI Policy

Tariffs progressively brought down (currently the average tariff rate is close to 10per cent and
maximum rate at 30 per cent). All quantitative restrictions on imports have been removed.
Automatic approval is granted for foreign investment up to certain equity in selected sectors, 100
per cent equity is also allowed in these and all other sectors but requires case-by-case approval by
the Foreign Investment Promotion Board.

Short-term Foreign Investment Policy

Some restrictions exist on both inward and outward flows of short-term capital for loans, purchase
of bonds and shares. Since September 1992, foreign institutional investors are allowed to invest in
Indian capital market, but there are restrictions on acquisition of shares of companies by these
investors. Selected companies allowed to raise equity in the international markets. Domestic
residents and firms permitted to buy stocks and bonds, subject to ceilings from international
markets. Most of these steps were undertaken in the initial phase of the reforms programme. But
we could not complete the whole menu. A large part of the programme remained unaccomplished.
With the onset of the new millennium, a fresh phase of reforms has begun. This has come to be
known as the phase of second-generation reforms.

Features of Reforms
Some of the important features of the reforms process have been as follows:

i. The approach towards reforms has been cautious, with an appropriate

sequencing of measures, complementary reforms across sectors (for example, the
monetary, fiscal and external sectors) and the development of financial
institutions and markets.
ii. The pace and sequencing of liberalisation has been responsive to domestic
developments, especially in the monetary and financial sectors, and the evolving
international financial architecture.
iii. The approach to reform was ‘gradual but steady’, rather than a ‘big bang
‘approach.
iv. The major thrust driving the reform process was the quest for higher growth and
efficiency, along with macro-economic stability. At the same time, the reforms
had to be ‘inclusive’, in the sense that the benefits of reforms were to be shared by
all sections, in particular the vulnerable ones.

Second Generation Service Sector Policy Reforms

As we are in the second decade of the twenty-first century, it is necessary now to launch the new
wave of reforms or what may also be called Operation 2-G.
One set of reforms becomes outdated after its implementation and with passage of time. Second
generation reforms is about getting into the details. By definition, it is tedious and more difficult.
The first phase of reforms was relatively easy as the required changes in trade, finance and fiscal
areas were known. In the second phase, issues of equity, regional and sectoral allocation, good
governance, institutional changes, etc. will become more prominent. Hard decisions on competition
policy, labour policy, disinvestment and privatisation will have to be taken.
The nature of the needed measures are well known but efforts to implement them are stalled by
fierce opposition from the well-to-do and the middle classes (which benefit most from huge implicit
subsidies on public services as well as the opportunities arising from globalisation), middle and
large peasants (who benefit from subsidised inputs and artificially high support prices), from
employees of the public sector (who are loath to give up their sinecures) and from State and Central
level politicians (whose control over public resources gives them immense scope for political and
personal patronage).

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Table 12.2 Stages of Service Sector Reforms

The first-generation reforms were essentially crisis-driven. This time round we can have consensus-
driven reforms so that we can act in anticipation of a crisis which would definitely visit upon us if
present trends were allowed to continue.
We will need to improve the quality of reforms, per se. This requires good analysis to identify the
critical bottlenecks to higher growth and poverty reduction, innovative design of policy, taking
account of socio-political constraints and supportive institutional changes. These steps improve the
efficiency and sustainability of reforms.

Evaluation of the Policy Reforms

Of the three sectors of the economy the biggest benefactor of the reform measures has been the
services sector. As already discussed in Unit 10, the service sector has recorded phenomenal growth
during the last two decades, much higher than what has been recorded in the primary and the
secondary sectors. As a result, the share of the service sector in India’s GDP has been continuously
rising. The service sector has become the dominant sector of the economy. The growth of service
sector, however, has not been smooth. It has, from time to time, come against strong barriers and
boulevards; these have involved legislative amendments, bureaucratic interventions and judicial
reviews. These have involved policy changes and reforms. We will have a brief review of the major
policy issues facing the service sector

Summary
The economic reforms undertaken in the country in the nineties of the last century brought about
an absolute turn in the Indian economy. From a socialist, pro public sector, welfare-oriented

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economy it became a market oriented, profit earning economy. The formation of WTO in 1994 led
to further changes in the economy in its light. The reforms were triggered by the balance of
payment crisis that emerged in the late eighties and 1990-1991 but there were economic churnings
at the international level which saw a shift in the economic power. As a result, the world over the
economies became more market oriented. Indian financial sector is dominated by the banking
sector which went changes as result of the Narsimhan Committee Report I and II. Similarly,
agriculture and industrial sector also underwent reforms which made them more competitive and
open. The base of the industrial sector reforms was laid down in the eighties when liberalisation of
policies was undertaken.

Keywords
Fiscal Year: It is one year period that is used for financial reporting and budgeting by companies
and governments.
Non-Performing Assets (NPAs): It is a loan or advance that are in default or arrears. The principal
or interest payment is due for 90 days.
Subsidies: can be considered as grants given by the government to people. Agricultural subsidies,
for example, are given to farmers in the form of cheap fertilizer, equipment, seeds and higher
procurement price.
World Trade Organization: (WTO) was founded in 1995 replacing General Agreement on Tariffs
and Trade (GATT). Its purpose is to promote multilateral global trade and welfare.
Structural Reforms: Microeconomic reforms are termed as structural reforms.
Stabilisation Programme: During an economic crisis, the undertaking of a series of measures by
the Government to address short-term issues is referred to as stabilisation programme.

Self Assessment
1. The immediate cause for the New Economic Policy of 1991 was
A. Shortage of foreign exchange
B. Change in government
C. Oil crisis
D. Gulf war

2. The first oil crisis was a result of

A. Embargo by OPEC countries on America
B. USA removing dollar from the gold standard
C. Both the above
D. None of the above

3. What was the amount of loan taken by India in 1981?

A. 4.8 billion SDR
B. 5.8 billion SDR
C. 5.8 million SDR
D. 58 billion SDR

4. The level of indebtedness of India because of the IMF loan of 1981 was
A. 11%
B. 15%
C. 26%
D. 4%

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5. Which is the bank not nationalized in 1969?

A. Allahabad Bank
B. Bank of India
C. Bank of Baroda
D. Vijaya Bank

6. Which bank not nationalized in 1980?

A. Punjab and Sind Bank
B. Oriental Bank of India
C. Corporation Bank
D. Canara Bank

7. In which year were the banks allowed to privatize?

A. 1991
B. 1992
C. 1994
D. 1996

8. Has India adopted the Basel 3 norms?

A. Yes
B. No

9. Which of the following was included as part of the land reforms initiated in India?
A. Abolition of intermediaries
B. Tenancy reforms
C. Reorganization of agriculture
D. All the above

10. How much public investment is required to enable the doubling of farmer’s real income in
India by 2022-23?
A. INR 78424 cr
B. INR 46298 cr
C. INR 100000cr
D. None of the above

11. Is inter-state and inter-district exchange of agricultural commodities allowed?

A. Yes
B. No

12. How many food processing projects been approved by the state government in 2020?
A. 132
B. 134
C. 142
D. 144

13. When was FIPB abolished?

A. 1993

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B. 1997
C. 2017
D. 2020

14. If processed food is produced in India, is it allowed to get 100% FDI under the automatic
route.
A. True
B. False

15. Is FDI allowed in retail sector?

A. True
B. False

Answers for Self Assessment

1. A 2. C 3 B 4. B 5. D

6. D 7. C 8. B 9. D 10. A

11. A 12. B 13. C 14. A 15. A

Review Questions
1. What is the relevance of Economic Reforms in India?
2. “The economic reforms in India were prompted by external events”. Evaluate
3. “The industrial reforms in the nineties had their genesis in the liberalisation policy of the
eighties.” Comment
4. Explain the service sector reforms and their impact on the Indian economy.
5. Explain the reforms in the agriculture sector and its impact on Indian Agriculture.

Further Readings
Pursell, Garry, 1992, “Trade Policy in India,” in Dominick Salvatore, ed., National Trade
Policies, New York: Greenwood Press, 423–458.
Rodrik, Dani, 2002, “Institutions, Integration, and Geography: In Search of the Deep
determinants of Economic Growth,” in Dani Rodrik, ed., Modern Economic Growth:
Analytical Country Studies (forthcoming).
Ishwar C. Dhingra, (2012): The Indian Economy, Environment and Policy, Sultan Chand
and Suns, New Delhi.
Kaushik Basu (ed), (2010): The Oxford Companion to Economics in India. Oxford
University Press, New Delhi

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Tanima Dutta, Lovely Professional University Unit 13: Monetary Policy

Unit13 : Monetary Policy

CONTENTS
Objectives
Introduction
13.1 Evolution of Monetary Policy
13.2 Objectives of Monetary Policy
13.3 Instruments of Monetary Policy
13.4 Monetary Policy after Reforms
13.5 Monetary Policy and Inflation
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
Discuss the concept of Monetary Policy

• evaluate the development of monetary policy as an important economic policy

• list and analyse the objectives of monetary policy
• discuss the tools of monetary policy
• evaluate the tools in light of current pandemic
• analyse monetary policy during reforms
• discuss the monetary policy for inflation

Introduction
Demand for and supply of money are regulated by certain monetary authority, usually the Central
Bank of the country. The Central Bank of a country, as you know by now, has several functions to
perform. Traditional functions of a central bank such as the ‘bankers’ bank’ (i.e., the apex bank of a
country) and ‘lender of last resort’ still applies. However, many more functions pertaining to
stabilization of the economy and overall development of the country have come up. In India, the
Reserve Bank of India (RBI) is the apex bank of the country to monitor and regulate the supply of
money and demand for credit. In doing so, the RBI like other central banks takes into account
factors such as economic growth, price stability, easy access to credit, and smooth functioning of the
economy.
Along with structural changes of the economy over time, monetary management of the economy
has become very important. The RBI designs and implements the regulatory policy framework for
banking and non-banking financial institutions with the aim of providing people access to the
banking system, protecting depositors’ interest, and maintaining the overall health of the financial
system. Along with these, management of public debt, management of foreign exchange rate and
foreign exchange reserve, determination of interest rate, maintenance of inflation rate, and
facilitation of high economic growth have become quite complex.

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13.1 Evolution of Monetary Policy

India
1935 to 1949: Initial Phase
The Reserve Bank came into being in the backdrop of the great depression facing the world
economy. Given the unsettled international monetary systems, the Preamble to the RBI Act, 1934
provided the edifice for the evolution of monetary policy framework. Until independence, the focus
was on maintaining the sterling parity by regulating liquidity through open market operations
(OMOs), with additional monetary tools of bank rate and cash reserve ratio (CRR). In other words,
exchange rate was the nominal anchor for monetary policy. In view of the agrarian nature of the
economy, inflation often emerged as a concern due to frequent supply side shocks. While the price
control measures and rationing of essential commodities was undertaken by the Government, the
Reserve Bank also used selective credit control and moral suasion to restrain banks from extending
credit for speculative purposes.

1949 to 1969: Monetary Policy in sync with the Five-Year Plans

India’s independence in 1947 was a turning point in the economic history of the country. What
followed was a policy of planned economic development. These two decades were characterised
not only by a predominant role of the state but also by a marked shift in the conduct of monetary
policy. The broad objective was to ensure a socialistic pattern of society through economic growth
with a focus on self-reliance. This was intended to be achieved by building up of indigenous
capacity, encouraging small as well as large-scale industries, reducing income inequalities, ensuring
balanced regional development, and preventing concentration of economic power. Accordingly, the
government also assumed entrepreneurial role to develop the industrial sector by establishing
public sector undertakings.
As planned expenditure was accorded pivotal role in the process of development, there was
emphasis on credit allocation to productive sectors. The role of monetary policy, therefore, during
this phase of planned economic development revolved around the requirements of five-year plans.
Even if there was no formal framework, monetary policy was relied upon for administering the
supply of and demand for credit in the economy. The policy instruments used in regulating the
credit availability were bank rate, reserve requirements and open market operations (OMOs). With
the enactment of the Banking Regulation Act in 1949, statutory liquidity ratio (SLR) requirement
prescribed for banks emerged as a secured source for government borrowings and also served as an
additional instrument of monetary and liquidity management. Inflation remained moderate in the
post-independence period but emerged as a concern during 1964-68.

1969 to 1985: Credit Planning

Nationalisation of major banks in 1969 marked another phase in the evolution of monetary policy.
The main objective of nationalisation of banks was to ensure credit availability to a wider range of
people and activities. As banks got power to expand credit, the Reserve Bank faced the challenge of
maintaining a balance between financing economic growth and ensuring price stability in the wake
of the sharp rise in money supply emanating from credit expansion. Besides, Indo-Pak war in 1971,
drought in 1973, global oil price shocks in 1973 and 1979, and collapse of the Bretton-woods system
in 1973 also had inflationary consequences. Therefore, concerns of high inflation caused by deficit
financing during 1960s gathered momentum during the 1970s. Incidentally, the high inflation in the
domestic economy coincided with stagflation – high inflation and slow growth – in advanced
economies. In such a milieu, traditional monetary policy instruments, viz., the Bank Rate and
OMOs were found inadequate to address the implications of money supply for price stability. As
banks were flushed with deposits under the impact of deficit financing, they did not need to
approach RBI for funds. This undermined the efficacy of Bank Rate as a monetary policy
instrument. Similarly, due to underdeveloped government securities market, OMOs had limited
scope to be used as monetary policy instrument. During this phase, the average growth rate
hovered around 4.0 per cent, while wholesale price index (WPI) based inflation was around 8.8 per
cent.

13.2 Objectives of Monetary Policy

Monetary policy is a mechanism through which the supply of and demand for money in an
economy are regulated. Such regulations on supply of and demand for money are expected to ful

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fill the objectives of monetary policy. We will discuss about the objectives or goals of monetary
policy in this Unit.
You should note that there is a difference between objectives and targets of monetary policy.
Objectives of monetary policy indicate the direction in which the policy variables should be aimed
at, viz., reducing inflation, achieving full employment, realizing higher economic growth. On the
other hand, targets of monetary policy are the variables targeted such as money supply, bank
credit, and short term interest rates through the instruments of monetary policy. A central bank
could have a single objective or multiple objectives to follow. The primary objective of most central
banks today is price stability. Price stability does not mean that there should not be any price rise in
an economy. Rather the objective is to have moderate inflation. Very often, many countries, have
come up with monetary policy that targets inflation rate Inflation targeting was introduced for the
first time in 1990 in New Zealand. Subsequently many countries such as Canada, United Kingdom,
Sweden, Australia, Chile, Poland, etc. adopted inflation targeting as the objective of monetary
policy during the 1990s. India formally changed the RBI Act and adopted inflation targeting in
2016. Accordingly, the target variable for monetary policy in India is an inflation rate of 4 per cent.
The RBI formulates monetary policy in such a manner that inflation rate remains in the range of 2
per cent to 4 per cent per annum.
Prior to 2016, since 1998, India pursued multiple indicators as objectives of monetary policy. Under
this approach the RBI considered a number of target variables such as money, credit, output, trade,
capital flows, fiscal deficit, inflation rate and exchange rate. We elaborate on some of the major
goals of monetary policy in an economy, so that you get an idea of their importance.

1. Higher Economic Growth

An important objective of the monetary policy is to realize high economic growth. Economic
growth leads to higher per capita income and higher standard of living for people. As pointed out
earlier, higher investment is crucial for accelerating economic growth. An expansionary monetary
policy decreases the rate of interest and increases investment and output, thus increasing the rate of
growth of the economy.

2. Full Employment Level

Another important objective of an economy is provision of employment to people. We observe that
unemployment of resources, including human resources exists in an economy. Further, during
recessionary periods, the level of Monetary Policy unemployment increases. Thus, there is a need to
formulate policies that generates employment and takes the country towards full employment. At
full employment level of output or potential output, all the factors of production (including labor)
are fully employed. However, this does not imply that there is no unemployment. Essentially, full
employment is associated with a positive rate of unemployment due to people switching jobs. Such
an output is also called full-capacity output. Monetary policy can help in realization of full-capacity
output by influencing aggregate demand.

3. Price Stability
Price stability, as mentioned earlier, does not mean that prices should remain constant; it means
that the price increase should be moderate. The objective of price stability may be in conflict with
other objectives such as economic growth and full employment. Any increase in aggregate demand
via an expansionary monetary policy is typically inflationary. If there is shortfall in aggregate
demand, there could be a tendency towards deflation in the economy. Monetary policy should aim
to avoid both inflationary and deflationary situations.

4. Exchange Rate Stability

Monetary policy could affect the balance of payments of an economy via the interest rate channel.
Interest rate plays an important role in foreign investment in the economy. If there is a decline in
the rate of interest, it may result in capital outflows. Consequently, the demand for foreign currency
increases and this results in the depreciation of domestic currency. Depreciation of currency may
have several consequences – value of domestic currency declines in terms of foreign currency;
foreign goods become more expensive; and import of essential commodities such as raw materials
and inputs may decline which results in decrease in GDP. As domestic goods and services become
cheaper in terms of foreign currency (due to depreciation), exports of the country may increase
which improves the balance of payments position. The final outcome however depends on several
factors such as elasticity of imports and exports, and global economic environment (recession, wars,
global price levels, etc.).

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13.3 Instruments of Monetary Policy

The instruments of monetary policy to control credit are divided into two categories, viz.,
Quantitative and Qualitative. Quantitative measures are non-discriminatory in nature, say for
example, when a certain interest rate is set by the central bank of a country, that rate applies to the
banking system of the country as a whole. In contrast, Qualitative / Selective measures vary from
one section of society to the other.

Quantitative Instruments
The important quantitative credit control instruments of the monetary policy are
as follows:

1. Repo Rate
2. Reverse Repo Rate
3. Bank Rate
4. Liquidity Adjustment Facility
5. Marginal Standing Facility
6. Open Market Operations
7. Cash Reserve Ratio
8. Change in Liquidity Ratio

Repo Rate
The most noticed and significant instrument of monetary policy is the repo rate. It is the rate at
which commercial banks borrow money from the RBI on submission of collateral such as securities.
Similarly, commercial banks can deposit their excess
reserves in the central bank for which the ‘reverse
The (fixed) interest rate at which the repo rate’ is applicable. The repo rate is periodically
Reserve Bank provides overnight decided by the RBI. Other rates, such as reverse repo
liquidity to banks against the rate, bank rate, and marginal standing facility (MSF)
collateral of government and other rate get automatically adjusted as a fixed percentage
approved securities under the above repo rate. The RBI uses repo rate to manage
liquidity adjustment facility (LAF). inflation, economic growth and balance of payments.
When inflation rate is high, the RBI can increase repo
rate so that interest rates increase, leading to decline
in aggregate demand. On the other hand, the RBI can decrease repo rate when economic growth is
sluggish.
The banks are allowed to borrow from RBI at repo rate under the Liquidity Monetary Policy
Adjustment Facility (LAF). Deposit of excess liquidity with RBI is also made under the LAF. This
arrangement helps the bank to manage liquidity pressure and resolve short term cash shortages. In
addition to the LAF, the RBI has ‘Marginal Standing Facility’ (MSF), which facilitates provision of
overnight loans to commercial banks. The objective is to meet unanticipated shocks such as
largescale withdrawal of cash by customers. The MSF thus receives a penal interest rate above the
repo rate.

Reverse Repo Rate

The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from
banks against the collateral of eligible government securities under the LAF.

Bank Rate
Bank rate is the rate of interest at which the central
bank provides loans to commercial banks and other
It is the rate at which the Reserve
financial institutions. Increase in bank rate has the
Bank is ready to buy or rediscount
effect of increasing the rate of interest in the economy.
bills of exchange or other
Similarly, decrease in bank rate lowers the rate of
commercial papers.
interest in the economy. Higher bank rate lowers the
extent of credit creation in the economy which leads to

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a decline in aggregate demand and hence lower prices. On the other hand, in a recessionary phase a
lower bank rate is proposed. It is difficult to predict the impact on change in bank rate on bank
borrowings. This is because bank rate itself is not the key lending rate, though is does form the
basis for the multiplicity of RBI’s lending rates charged for different types of advances. The impact
of change in bank rate on bank’s borrowings depends on various factors such as (a) the degree of
bank’s dependence on borrowed reserves, (b) the sensitivity of the banks’ demand for borrowed
reserves to the differential between their lending rates and borrowing rates (c) the extent to which
other rates of interest have already changed or change subsequently (d) the state of the demand for
loans and the supply of funds from other sources, etc.
Banks are not discouraged from borrowing in the face of higher bank rates if the market interest
rates are high such that banks expect higher returns from borrowed funds. There is a subtle
difference between repo rate and bank rate. Financial institutions can borrow from the RBI at the
bank rate without submission of any collateral. On the other hand, repo rate is charged for re-
purchase of securities issued by the RBI. Further, bank rate is higher than repo rate.

Liquidity Adjustment Facility (LAF)

The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has
increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range
of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn
can set market-based benchmarks for pricing of loans and deposits, and hence improve
transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo
auctions, as necessitated under the market conditions.

Marginal Standing Facility (MSF)

A facility under which scheduled commercial banks can borrow additional amount of overnight
money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to
a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks
to the banking system.

Open Market Operations

The central bank exercises control over the money supply through sale and purchase of
government securities. The term ‘open market
operations’ (OMO) refers to the sale/purchase of These include both, outright
government securities by the central bank to/from purchase and sale of government
the public and banks. While purchase of government securities, for injection and
securities in open market increases the high- absorption of durable liquidity,
powered money (H), an open market sale of respectively.
government securities decreases H by an equal
amount.
Following the change in ‘H’, the usual money multiplier (mm) process leads to change in money
supply (M). In order to follow a contractionary monetary policy to check inflation, the central bank
decreases money supply by selling securities. In a situation of falling prices, the central bank buys
securities for increasing the money supply in the economy. Such an expansionary monetary policy
helps in boosting aggregate demand and reviving the economy from recession.
Open market operations are flexible and reversible in time. Hence, it is considered to be an efficient
instrument of monetary control. Moreover, unlike bank rate and reserve requirements, it is free
from ‘announcement effects’ as no prior public announcement has to be made to conduct these
operations. The direct effect on ‘H’ is immediate and the amount of H created or destroyed is
precisely determinable. There are indirect effects also such as interest rate changes. Purchase and
sale of securities in the open market by the central bank or the monetary authority is popularly
known as open market operations. In order to
The average daily balance that a bank is contract the credit in the economy, the central
required to maintain with the Reserve Bank bank sells securities in the open market. This
as a share of such per cent of its Net leads to fall in aggregate demand and
demand and time liabilities (NDTL) that the reduction in price level. Whereas, when credit
Reserve Bank may notify from time to time is to be expanded, there is purchase of
in the Gazette of India. securities by the central bank in the open
market. This leads to increase in aggregate
demand and production levels in the economy.

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Cash Reserve Ratio

A certain fraction of total assets is always kept by banks as cash partially to comply with the
statutory reserve requirements and partially for meeting day-today cash payments. Cash is held as
‘cash on hand’ and as cash balances with the central bank. These are known as cash reserves of
banks which are classified as ‘required reserves’ and ‘excess reserves’. Banks are statutorily
required to hold cash balances with the central bank. In India, the RBI has the power to impose
statutorily ‘cash reserve ratio’ (CRR) on banks anywhere between 3-15 per cent of the net demand
and time liabilities. A higher CRR implies lower liquidity in the system. Thus, when the central
bank plans to increase liquidity in the economy, it decreases the CRR and vice versa.
Cash Reserve Ratio varies across countries. For example, in 2019, it is as high as45 per cent in Brazil
and as low as 1 per cent in the European Union. In India, as on April 2019, the CRR was 4 per cent.
Further, CRR varies over time for the same country, depending upon the economic environment.
Banks also hold excess reserves, apart from required reserves. These are held more than required
reserves. These excess reserves are used to meet the currency drains, i.e., the net withdrawal of
currency by depositors, and clearing drains which is the net loss of cash due to cross clearing of
cheques among banks. Large part of excess reserves is held as cash on hand, remaining small part is
held as Monetary Policy excess balances with the RBI.
By varying the reserve requirements, the RBI uses the CRR as a tool of controlling money supply.
When CRR is raised, banks hold larger cash balances with the RBI. Since reserves are a part of ‘H’
or high-powered money, this essentially means that a part of H is withdrawn from the public
equalling the amount of additional reserves impounded. On the other hand, lowering of CRR
amounts to a virtual increase in H, which results in an increase in money supply’s’. In this manner,
the CRR serves as an instrument of monetary control. In case of inflation, CRR is increased, thus
decreasing the lending ability of banks. Alternately, by lowering the CRR, credit expansion by
banks increases.

Statutory Liquidity Ratio

Besides CRR, banks are also required to meet the statutory liquidity ratio (SLR) requirements. The
RBI Act stipulates that banks are required to hold a certain fraction of their demand and time
liabilities in the form of “liquid assets in their own
vault”.
The share of NDTL that a bank is
This is called the “Statutory Liquidity Ratio”. Liquid required to maintain in safe and
assets include cash, gold and approved securities, liquid assets, such as, unencumbered
mainly the government securities. Banks prefer government securities, cash and gold.
government securities as they earn interest income.
The central bank uses SLR to check the money supply in the economy. Increasing SLR decreases
liquidity in the economy and vice-versa. As on July2019, the SLR rate in India is 18.75 percent.
However, CRR is more actively used by the RBI to manage liquidity in the economy.

Qualitative Instruments
Qualitative instruments may not lead to changes in volume of money in the economy. These policy
instruments are used for discriminating between different uses of credit. Thus these instruments
are used for regulating credit for specific purposes. Some of the instruments are as follows:

Selective Credit Control

Selective Credit Control relates to qualitative method of credit control by the central banks. The
central bank can take steps to channelize credit to priority sectors. Similarly, it can impose
restrictive measures on credit to certain sectors. In India, such controls have been used to check
speculative hoarding of essential commodities such as food grains to check their price rise. When
credit flow for purchasing and holding such stocks is restricted, traders increase the market supply
of these commodities and their prices do not increase as much. Hence, selective credit controls help
in moderation of inflation. You will find several examples of selective credit control in the Indian
case. Credit extended to agricultural sector and small scale industries are instances of selective
credit control.

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Margin Requirements
The margin refers to that part of the loan amount which the bank does not finance. For example, if
you approach a bank for financing a loan towards purchase of a house, the bank will not provide
loan for the full amount – it may provide loan for about 80 to 85 per cent of the purchase value. An
implication of the above is that 15 to 20 per cent of the purchase value should be financed from own
funds. A higher margin on loan discourages borrowing. By changing the margin requirements, the
central bank can encourage credit flow to certain sectors while restricting it to others. For instance,
in order to encourage priority lending to certain sectors, the government may reduce margin
requirements.

Credit Rationing
In order to restrict credit to certain sectors, the central bank may ration credit by putting certain
limit on the amount the bank can lend to particular sector or section of society. Through rationing
of credit, the central bank can perform the following tasks:

• It can decline loan to a particular commercial bank

• It can ask commercial banks to extend certain percentage of credit to priority areas such as
agriculture or small-scale enterprises.

Moral Suasion
Central bank persuades other banks to comply with its policy stance through discussions, letters
and speeches. This is known as moral suasion. Moral suasion can be employed for both qualitative
and quantitative credit control. RBI can urge banks to keep a large fraction of their assets in the
form of government securities. It can also discourage banks from borrowing excessively during
inflationary periods. These measures help control money supply. Moral suasion is also used for
controlling the distribution of bank credit.

Direct Action
Sometimes, the RBI can directly take action against a bank which is not following its directives and
conforming to the broad monetary policy goals. For example, the RBI may refuse rediscount
facilities to such banks or it may charge a penal rate over and above the bank rate. Central banks
use a mix of different tools for monetary control. Bank rate, reserve requirements, open market
operations and selective credit controls measures should be adopted simultaneously.

13.4 Monetary Policy after Reforms

1985 to 1998: Monetary Targeting
In the 1980s, fiscal dominance accentuated as reflected in automatic monetisation of budget deficit
through ad hoc treasury bills and progressive increase in SLR by 1985. Concomitantly, inflationary
impact of deficit financing warranted tightening of monetary policy – both the CRR and Bank Rate
were raised significantly. The experience of monetary policy in dealing with the objectives of
containing inflation and promoting growth eventually led to adoption of monetary targeting as a
formal monetary policy framework in 1985 on the recommendations of the Chakravarty
Committee. In this framework, with the objective of controlling inflation through limiting monetary
expansion, reserve money was used as operating target and broad money as intermediate target.
The targeted growth in money supply was based on expected real GDP growth and a tolerable
level of inflation. This approach was flexible as it allowed for feedback effects. CRR was used as the
primary instrument for monetary control. Nonetheless, due to continued fiscal dominance, both
SLR and CRR reached their peak levels by 1990.
The worsening of fiscal situation in late 1980s was manifested in deterioration of external balance
position and collapse in domestic growth in 1991-92, in the backdrop of adverse global shocks – the
gulf war and disintegration of the Soviet Union. The resultant balance of payments crisis triggered
large scale structural reforms, financial sector liberalization and opening up of the economy to
achieve sustainable growth with price stability. Concurrently, there was a shift from fixed exchange
rate regime to a market determined exchange rate system in 1993. In the wake of trade and financial
sector reforms and the consequent rise in foreign capital flows and financial innovations, the
assumption of stability in money demand function as well as efficacy of broad money as

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intermediate target came under question. At the same time, there was a notable shift towards
market-based financing for both the government and the private sector. In fact, automatic
monetisation through ad hoc treasury bills was abolished in 1997 and replaced with a system of
ways and means advances (WMAs). During this period, average domestic growth rate was 5.6 per
cent and average WPI-based inflation was 8.1 per cent.

1998 to 2015: Multiple Indicators Approach

As liberalisation of the economy since the early 1990s and financial innovations began to
undermine the efficacy of the prevalent monetary targeting framework, a need was felt to review
the monetary policy framework and recast its operating procedures. As a result, the Reserve Bank
of India adopted multiple indicators approach in April 1998. Under this approach, besides
monetary aggregates, a host of forward looking indicators such as credit, output, inflation, trade,
capital flows, exchange rate, returns in different markets and fiscal performance constituted the
basis of information set used for monetary policy formulation. The enactment of the Fiscal
Responsibility and Budget Management (FRBM) Act in 2003, by introducing fiscal discipline,
provided flexibility to monetary policy. Increased market orientation of the domestic economy and
deregulation of interest rates introduced since the early 1990s also enabled a shift from direct to
indirect instruments of monetary policy. There was, therefore, greater emphasis on rate channels
relative to quantity instruments for monetary policy formulation. Accordingly, short-term interest
rates became instruments to signal monetary policy stance of RBI.
In order to stabilise short-term interest rates, the Reserve Bank placed greater emphasis on the
integration of money market with other market segments. It modulated market liquidity to steer
monetary conditions to the desired trajectory by using a mix of policy instruments. Some of these
instruments including changes in reserve requirements, standing facilities and OMOs were meant
to affect the quantum of marginal liquidity, while changes in policy rates, such as the Bank Rate
and reverse repo/repo rates were the instruments for changing the price of liquidity.
An assessment of macroeconomic outcomes suggests that the multiple indicator approach served
fairly well from 1998-99 to 2008-09. During this period, average domestic growth rate improved to
6.4 per cent and WPI based inflation moderated to 5.4 per cent.

2013-2016: Preconditions Set for Inflation Targeting

In the post-global financial crisis period (i.e., post-2008), however, the credibility of this framework
came into question as persistently high inflation and weakening growth began to co-exist. In the
face of double-digit inflation of 2012-13, the US Fed’s taper talk in May/June 2013 posed significant
challenges to domestic monetary policy for maintaining the delicate balance between sustaining
growth, containing inflation and securing financial stability. The extant multiple indicators
approach was criticised on the ground that a large set of indicators do not provide a clearly defined
nominal anchor for monetary policy. An Expert Committee was set up by RBI to revise and
strengthen the monetary policy framework and suggest ways to make it more transparent and
predictable. In its Report of 2014, the Committee reviewed the multiple indicators approach and
recommended that inflation should be the nominal anchor for the monetary policy framework in
India. Against this backdrop, the Reserve Bank imposed on itself a glide path for bringing down
inflation in a sequential manner – from its peak of 11.5 per cent in November 2013 to 8 per cent by
January 2015; 6 per cent by January 2016 and 5 per cent by Q4 of 2016-17.

2016 onwards: Flexible Inflation Targeting

Amid this, a Monetary Policy Framework Agreement (MPFA) was signed between the Government
of India and the Reserve Bank on February 20, 2015. Subsequently, flexible inflation targeting (FIT)
was formally adopted with the amendment of the RBI Act in May 2016. The role of the Reserve
Bank in the area of monetary policy has been restated in the amended Act as follows: “the primary
objective of monetary policy is to maintain price stability while keeping in mind the objective of
growth”.
Empowered by this mandate, the RBI adopted a flexible inflation targeting (FIT) framework under
which primacy is accorded to the objective of price stability, defined numerically by a target of 4
per cent for consumer price headline inflation with a tolerance band of +/- 2 per cent around it,
while simultaneously focusing on growth when inflation is under control. The relative emphasis on
inflation and growth depends on the macroeconomic scenario, inflation and growth outlook, and
signals emerging from incoming data. Since then, RBI has been conducting monetary policy in a
forward-looking manner and effectively communicating its decisions to maintain inflation around
its target and thereby to support growth. At the same time, RBI is also fine-tuning its operating

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procedures of monetary policy for effective policy transmission across the financial markets and
thereby onto the real economy. As an outcome, inflation has fallen successively and has averaged
below 4 per cent since 2017-18, notwithstanding recent up-tick in inflation driven by food prices,
especially the sharp increase in vegetable prices reflecting the adverse impact of unseasonal rains
and cyclone.

13.5 Monetary Policy and Inflation

Inflation is pre-dominantly considered to be a monetary problem which can be targeted with the
use of monetary policy. There are various tools of monetary policy which have been discussed
earlier are used to target inflation. In recent years, many central banks, the makers of monetary
policy, have adopted a technique called inflation targeting to control the general rise in the price
level. In this framework, a central bank estimates and makes public a projected, or “target,”
inflation rate and then attempts to steer actual inflation toward that target, using such tools as
interest rate changes. Because interest rates and inflation rates tend to move in opposite directions,
the likely actions a central bank will take to raise or lower interest rates become more transparent
under an inflation targeting policy. Advocates of inflation targeting think this leads to increased
economic stability.

Why inflation targeting?

In general, a monetary policy framework provides a nominal anchor to the economy. A nominal
anchor is a variable policymakers can use to tie down the price level. One nominal anchor central
banks used in the past was a currency peg—which linked the value of the domestic currency to the
value of the currency of a low-inflation country. But this approach meant that the country’s
monetary policy was essentially that of the country to which it pegged, and it constrained the
central bank’s ability to respond to such shocks as changes in the terms of trade (the value of a
country’s exports relative to that of its imports) or changes in the real interest rate. As a result,
many countries began to adopt flexible exchange rates, which forced them to find a new anchor.
Many central banks then began targeting the growth of money supply to control inflation. This
approach works if the central bank can control the money supply reasonably well and if money
growth is stably related to inflation over time. Ultimately, monetary targeting had limited success
because the demand for money became unstable—often because of innovations in the financial
markets. As a result, many countries with flexible exchange rates began to target inflation more
directly, based on their understanding of the links or “transmission mechanism” from the central
bank’s policy instruments (such as interest rates) to inflation.

How does inflation targeting work?

Inflation targeting is straightforward, at least in theory. The central bank forecasts the future path of
inflation and compares it with the target inflation rate (the rate the government believes is
appropriate for the economy). The difference between the forecast and the target determines how
much monetary policy has to be adjusted. Some countries have chosen inflation targets with
symmetrical ranges around a midpoint, while others have identified only a target rate or an upper
limit to inflation. Most countries have set their inflation targets in the low single digits. A major
advantage of inflation targeting is that it combines elements of both “rules” and “discretion” in
monetary policy. This “constrained discretion” framework combines two distinct elements: a
precise numerical target for inflation in the medium term and a response to economic shocks in the
short term.
Rather than focusing on achieving the target at all times, the approach has emphasized achieving
the target over the medium term—typically over a two- to three-year horizon. This allows policy to
address other objectives—such as smoothing output—over the short term. Thus, inflation targeting
provides a rule-like framework within which the central bank has the discretion to react to shocks.
Because of inflation targeting’s medium-term focus, policymakers need not feel compelled to do
whatever it takes to meet targets on a period-by-period basis.

What is required?
Inflation targeting requires two things. The first is a central bank able to conduct monetary policy
with some degree of independence. No central bank can be entirely independent of government
influence, but it must be free in choosing the instruments to achieve the rate of inflation that the
government deems appropriate. Fiscal policy considerations cannot dictate monetary policy. The

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second requirement is the willingness and ability of the monetary authorities not to target other
indicators, such as wages, the level of employment, or the exchange rate.
Having satisfied these two basic requirements, a country can, in theory, conduct a monetary policy
centred on inflation targeting. In practice, the authorities may also take certain preliminary steps:

i. Establish explicit quantitative targets for inflation for a specific number of periods ahead.
ii. Indicate clearly and unambiguously to the public that hitting the inflation target takes
precedence over all other objectives of monetary policy.
iii. Set up a model or methodology for inflation forecasting that uses a number of indicators
containing information about future inflation.
iv. Devise a forward-looking operating procedure through which monetary policy
instruments are adjusted (in line with the assessment of future inflation) to hit the chosen
target.

Target practitioners?
Central banks from advanced, emerging market, and developing economies and from every
continent have adopted inflation targeting (see table). Full-fledged inflation targets are countries
that make an explicit commitment to meet a specified inflation rate or range within a specified time
frame, regularly announce their targets to the public, and have institutional arrangements to ensure
that the central bank is accountable for meeting the target.
The first country to adopt inflation targeting was New Zealand. The only central banks to have
stopped inflation targeting once they started it are Finland, Spain, and the Slovak Republic—in
each case after they adopted the euro as their domestic currency. Armenia, the Czech Republic,
Hungary, and Poland adopted inflation targeting while they were making the transition from
centrally planned to market economies. Several emerging market economies adopted inflation
targeting after the 1997 crisis, which forced a number of countries to abandon fixed exchange rate
pegs.

On target?
It is difficult to distinguish between the specific impact of inflation targeting and the general impact
of more far-reaching concurrent economic reforms. Nonetheless empirical evidence on the
performance of inflation targeting is broadly, though not totally, supportive of the effectiveness of
the framework in delivering low inflation, anchoring inflation expectations, and lowering inflation
volatility. Moreover, these gains in inflation performance were achieved with no adverse effects on
output and interest volatility.
Inflation targeters also seem to have been more resilient in turbulent environments. Recent studies
have found that in emerging market economies, inflation targeting seems to have been more
effective than alternative monetary policy frameworks in anchoring public inflation expectations. In
some countries, notably in Latin America, the adoption of inflation targeting was accompanied by
better fiscal policies. Often, it has also been accompanied by the enhancement of technical capacity
in the central bank and improvement of macroeconomic data. Because inflation targeting also
depends to a large extent on the interest rate channel to transmit monetary policy, some emerging
market economies also took steps to strengthen and develop the financial sector. Thus, the
monetary policy outcomes after the adoption of inflation targeting may reflect improved broader
economic, not just monetary, policymaking.

Indian Monetary Policy and Inflation Targeting

In India, like other developing and emerging countries, the central bank of the country that is
Reserve Bank of India has made inflation targeting as the main objective of monetary policy. The
Monetary Policy Committee formed in 2016 adopted the flexible inflation targeting. Prior to the
amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by
an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of
India of February 20, 2015.The MPC determines the policy interest rate required to achieve the
inflation target. The first meeting of the MPC was held on October 3 and 4, 2016 in the run up to the
Fourth Bi-monthly Monetary Policy Statement, 2016-17.

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The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the
monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve
Bank contribute to the process for arriving at the decision on the policy repo rate.
The Financial Markets Operations Department (FMOD) operationalises the monetary policy,
mainly through day-to-day liquidity management operations. The Financial Markets Committee
(FMC) meets daily to review the liquidity conditions so as to ensure that the operating target of the
weighted average call money rate (WACR) is aligned with the repo rate.
Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy
with experts from monetary economics, central banking, financial markets and public finance
advised the Reserve Bank on the stance of monetary policy. However, its role was only advisory in
nature. With the formation of MPC, the TAC on Monetary Policy ceased to exist.

Summary
Monetary policy pertains to management of the supply of money and demand for credits. The
objective of such controls is to achieve certain goals set for the economy. The objectives of monetary
policy are attained through certain policy instruments. The policy instruments could be
quantitative or qualitative in nature. The quantitative tools are repo rate, bank rate, open market
operations, reserve requirements, etc. The qualitative tools are selective credit controls, moral
suasion, etc. In a liquidity trap like situation, however, the usual instruments do not work. Hence,
central banks can adopt quantitative easing which injects liquidity in the banking system and
lowers the lending rates of banks.

Keywords
Central Bank: A central bank is a financial institution given privileged control over the production
and distribution of money and credit for a nation or a group of nations
Inflation: The rate of increase in the general price level over a period of time. It is measured usually
in terms of the growth in a price index such as the Consumer Price Index.
Inflation Targeting: The objective of the monetary policy in many countries is inflation targeting,
where the central bank targets to achieve certain inflation rate.
Monetary Policy: Monetary policy refers to the policy of the central bank with regard to the use of
monetary instruments under its control to achieve the goals specified by the central bank.
Monetary Policy Committee: The Monetary Policy Committee is a statutory and institutionalized
framework under the Central bank of a country, for maintaining price stability, while keeping in
mind the objective of growth.
Repo Rate: Rate at which the central bank lends funds to the commercial banks against submission
of collateral such as securities by the banks

Self Assessment
1. Which is the first country to delink itself from the fixed exchange rate system of Bretton
Woods?
A. United Kingdom
B. Germany
C. United States of America
D. France

2. In which year did Bretton Woods dismantle the gold standard system?
A. 1971
B. 1972
C. 1973
D. 1974

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3. If there is an expansionary monetary policy, then the rate of interest will…

A. Increase
B. Decrease
C. Remain constant
D. May increase or decrease

4. At the potential level of output, all the factors of production are

A. Fully employed
B. Unemployed
C. Depends on the situation
D. None of the above

5. Which of them is not a quantitative tool?

A. Moral suasion
B. REPO rate
C. CRR
D. SLR

6. Which of the following reserve is to be maintained with the RBI?

A. SLR
B. CRR
C. Bank rate
D. None of the above

7. Which of the following reserve is to be maintained with the bank itself?

A. SLR
B. CRR
C. Bank rate
D. None of the above

8. Which is the facility under which a bank can borrow additional capital by dipping into its
statutory liquidity reserve?
A. Liquidity adjustment facility
B. Marginal standing facility
C. Corridor
D. None of the above

9. When was SLR introduced in the Indian banking sector?

A. Before 1947
B. 1947
C. 1949
D. 1969

10. When did India move to market determined exchange rate system?

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A. 1969
B. 1973
C. 1979
D. 1993

11. Ways and Means advances was introduced in …….

A. 1985
B. 1997
C. 2000
D. 2014

12. When did RBI adopt multiple indicators approach?

A. 1985
B. 1997
C. 1998
D. 2014

13. How many types of inflation are there?

A. One
B. Two
C. Three
D. Depends on the situation of the country

14. If there is inflation in the economy, the RBI will

A. Increase the CRR
B. Decrease the CRR
C. Decrease SLR
D. Increase both CRR and SLR

15. What is the inflation target set by the Central government?

A. 2%
B. 4%
C. 6%
D. 8%

Answers for Self Assessment

1. B 2. C 3 B 4. A 5. A

6. B 7. A 8. B 9. C 10. D

11. B 12. C 13. B 14. D 15. B

Review Questions
1. How did Monetary Policy evolve in economic theory?
2. How did Monetary Policy evolve in India?

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3. Is monetary policy the right instrument to target inflation in developing countries?

4. What are the best measures/tools to control money flow during a crisis like COVID?
5. What are the major functions of monetary policy in India?

Further Readings
Ashima Goyal 2014 “History of Monetary Policy in India SinceIndependence”, Springer
Briefs in Economics
Reserve Bank of India Act, 1934 (As amended by the Finance (No. 2) Act,2019

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Tanima Dutta, Lovely Professional University Unit 14: Fiscal Policy

Unit14: Fiscal Policy

CONTENTS
Objectives
Introduction
14.1 Concept of fiscal policy
14.2 Objectives of fiscal policy
14.3 Types of Fiscal Policy
14.4 Instruments of Fiscal Policy
14.5 Fiscal Reforms in India: Policy Measures and Developments
Summary
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further readings

Objectives
• Understand the concept of fiscal policy
• Discuss the objectives of fiscal policy
• Analyse the tools of fiscal policy
• Evaluate the use of fiscal policy as a measure of inflation control

Introduction
The actual working of the economy needs Regulation and policies which clearly outline the track
which an economy will take. in the modern world, the government uses its tools to achieve higher
growth rate as it is argued that with higher GDP growth rate, the per capita income of the common
masses would go up intern would improve the standard of living. Here, let us be clear that there is
an ongoing debate about the obsession with growth rates and how does not always lead to
equitable development. I will not get into this debate, rather, we will discuss fiscal policy which is
used by the government to promote stability and growth. concept of fiscal policy, evolution and
objectives in the first part of the chapter. we will then take up the tools of fiscal policy and how
they are used to regulate the economy. inflation is an issue which is controlled by the use of
various fiscal policy tools and this will become the point of discussion in the next part. we will then
take the case of India and see how fiscal policy has evolved over time and especially after the
reforms, how has developed and impacted the economy.

14.1 Concept of fiscal policy

In layman’s words, a fiscal Policy which deals with government revenue expenditure which has
some component of welfare embedded in it. Basically, it is the income and expenditure of the
government which is used to regulate the economy and to focus on economic growth. the fiscal
policy is used to target poverty and it is seen as an effective tool for inclusive growth. In developing
countries, the fiscal policy is treated as an effective policy measure than the monetary policy for
egalitarian growth. this policy is also looked upon as a crisis management tool. In the post World
War 1 scenario, the role of the state government magnified, and public spending was seen as an

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initiative which was bound to give positive results. since then, most emerging economies have
used this policy effectively for combating the crisis of capitalism.
The major tools of fiscal policy are taxes, expenditure, and borrowings of the government. these
tools are used for the allocation of resources to have balanced distribution of these resources and
also to promote growth. the impact of fiscal policy is widespread but its impact on employment,
economic stability, price stability, economic growth, saving and investment, balance of payments
etc. is considered as they are quantifiable and therefore, can be measured and evaluated.

14.2 Objectives of fiscal policy

classical economics started off with the premise of full employment and there was the assumption
of laissez-faire economic system where the market forces adjusted to fully employ all the resources.
during the Great Depression of 1930 it was felt that the state intervention was required to
restructure and regroup the economies. Here, we need to understand the entire Keynesian
economics is based on the role of the state and how it is used for stabilizing the economy. the
objectives of the fiscal policy developing economies are:

1. Full employment: This is one of the primary objectives of fiscal policy, especially for
developing countries where there is lack of optimal utilization of
resources. it does not that there is no voluntary unemployment.
Is Full Keynesian economics pointed out that full employment is
Employment a generally not attainable but the I am the state is to minimise
Reality? unemployment. the government therefore spends social and
economic overheads like roads, power, telecommunications,
education, health etc. these are not help in development but also generates employment
and pushes liquidity in the economy. Thus, public expenditure and investment gives a
specific direction to the economy.

2. Price Stability: There is a general agreement that economic growth and stability are joint
objectives for underdeveloped countries. In a developing country, economic instability is
manifested in the form of inflation. Prof. Nurkse believed that “inflationary pressures are
inherent in the process of investment but the way to stop them is not to stop investment.
They can be controlled by various other ways of which the chief is the powerful method of
fiscal policy. Therefore, in developing economies, inflation is a permanent phenomenon
where there is a tendency to the rise in prices due to expanding trend of public
expenditure. As a result of rise in income, aggregate demand exceeds aggregate supply.
Capital goods and consumer goods fail to keep pace with rising income.

Thus, these result in inflationary gap. The price rise generated by demand pull reinforced
by cost push inflation leads to further widening the gap. The rise in prices raises demand
for more wages. This further gives rise to repeated wage-price spirals. If this situation is
not effectively controlled, it may turn into hyperinflation.

In short, fiscal policy should try to remove the bottlenecks and structural rigidities which
cause imbalance in various sectors of the economy. Moreover, it should strengthen
physical controls of essential commodities, granting of concessions, subsidies, and
protection in the economy. In short, fiscal measures as well as monetary measures go side
by side to achieve the objectives of economic growth and stability.

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3. Increase rate of Economic Growth: Primarily, fiscal policy in a developing economy,

should aim at achieving an accelerated rate of economic growth. But a high rate of
economic growth cannot be achieved and maintained without stability in the economy.
Therefore, fiscal measures such as taxation, public borrowing and deficit financing etc.
should be used properly so that production, consumption, and distribution may not
adversely affect. It should promote the economy which in turn helps to raise national
income and per capita income.

In this connection it is significant to quote the views of Mrs. Hicks, who observed, “now
that fiscal policy has been developed as an established economic function of a
government, every country is anxious to gear its public finance in pursuit of the twin aims
of stability and growth, but their relative importance is very differently regarded from one
country to another… A steady rate of expansion will tend to reduce the violence of such
fluctuations as may occur; a successful full employment policy will provide an atmosphere
which is congenial for growth.”

4. Optimum Allocation of Resources: Fiscal measures like taxation and public expenditure
programmes, can greatly affect the allocation of resources in various occupations and
sectors. As it is true, the national income and per capita income of underdeveloped
countries is very low. In order to gear the economy, the government can push the growth
of social infrastructure through fiscal measures. Public expenditure, subsidies and
incentives can favorably influence the allocation of resources in the desired channels.

Tax exemptions and tax concessions may help a lot in attracting resources towards the
favored industries. On the contrary, high taxation may draw away resources in a specific
sector. Above all, direct curtailment of consumption and socially unproductive investment
may be helpful in mobilization of resources and the further check of the inflationary
trends in the economy. Sometimes, the policy of protection is a useful tool for the growth
of some socially desired industries in an under-developed country.

5. Allocation of Resources: It is needless to emphasize the significance of equitable

distribution of income and wealth in a growing economy. Generally, inequality in wealth
persists in such countries as in the early stages of growth, it concentrates in few hands. It is
also because private ownership dominates the entire structure of the economy. Besides,
extreme inequalities create political and social discontentment which further generate
economic instability. For this, suitable fiscal policy of the government can be devised to
bridge the gap between the incomes of the different sections of the society.

6. Reduce inequalities: To do distributive justice, the government should invest in those

productive channels which incur benefit to low-income groups and are helpful in raising
their productivity and technology. Therefore, redistributive expenditure should help
economic development and economic development should help redistribution.

Thus, well-planned fiscal programme, public expenditure can help development of human
capital which in turn possesses positive effects on income distribution. Regional
disparities can also be removed by providing incentives to backward regions. A
redistributive tax policy should be highly progressive and aim at imposing heavy taxation
on the richer and exempting poorer sections of the community. Similarly, luxurious items,
which are consumed by the higher section, may be subject to heavy taxation.

7. Economic Stability: Fiscal measures, to a larger extent, promote economic stability in

the face of short-run international cyclical fluctuations. These fluctuations cause variations
in terms of trade, making the most favorable to the developed and unfavorable to the
developing economies. So, for the purpose of bringing economic stability, fiscal methods
should incorporate built-in-flexibility in the budgetary system so that income and
expenditure of the government may automatically provide compensatory effect on the rise
or fall of the nation’s income. Therefore, fiscal policy plays a leading role in maintaining
economic stability in the face of internal and external forces. The instability caused by
external forces is corrected by a policy, popularly known as ‘tariff policy’ rather than
aggregative fiscal policy. In the period of boom, export and import duties should be
imposed to minimize the impact of international cyclical fluctuations. To curb the use of
additional purchasing power, heavy import duty on consumer goods and luxury import

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restrictions are essential. During the period of recession, government should undertake
public works programmes through deficit financing. In nutshell, fiscal policy should be
viewed from a larger perspective keeping in view the balanced growth of various sectors
of the economy.

14.3 Types of Fiscal Policy

1. Neutral Fiscal Policy: This type of policy is usually undertaken when an economy is in
equilibrium. The consumers are not affected by taxation by the government or the welfare
spending of the state.
2. Expansionary Fiscal Policy: This policy is designed to boost the economy. It is mostly
used in times of high unemployment and recession. It leads to the government lowering
taxes and spending more, or one of the two. The aim is to stimulate the economy and ensure
consumers' purchasing power does not weaken. In developing countries, this is the type
which is followed extensively. This gives rise to deficit financing or revenue deficits for the
government. In India, till 1991 this was the main form of fiscal policy.

Fig. 14.1 Expansionary Fiscal Policy

3. Contractionary Fiscal Policy: As the term suggests, this policy is designed to slow
economic growth in case of high inflation. The contractionary fiscal policy raises taxes and
cuts spending.

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Fig. 14.2 Contractionary Fiscal Policy

14.4 Instruments of Fiscal Policy

To fulfil the twin objectives of low unemployment and price stability, the fiscal policy authority
adopts the following instruments:
Public Expenditure: This is used to stimulate or regulate an economy when it faces situations like
recession or boom. Any variation in public expenditure will have an important bearing on the level
of consumption, investment total income. Public expenditure constitutes an important share in total
expenditure of an economy and is mainly composed of expenditure on public works, relief
expenditures, subsidies, transfer payments, salaries, and social security benefits. Usually, an
expansionary fiscal policy action is used in case of recessionary situation. On the contrary, fiscal
constraints are employed during boom to avoid the consequences of hyper-inflationary tendencies.
Taxation Policy: The tax structure of an economy occupies an important place as a fiscal policy
tool. Taxes determine the size of disposable income in the hands of economic agents and thereby
the corresponding inflationary and deflationary gaps. Tax policy must be easy during depression
while during inflation or boom periods, it must curtail the spending ability of consumers and
investors.
Public Debt: A properly managed public borrowing programme and debt repayment serves as a
powerful instrument in combating the macroeconomic instabilities like inflation or deflation.
Government borrowing takes place through: (i) commercial banks, (ii) non-bank financial
intermediaries, (iii) the central bank or by the printing of new money. Borrowing from public
against the sale of bonds and securities help to reduce the consumption and private investment
spending and control inflation. If banks have excess reserves, borrowing from the banking system
enables the government to undertake investment projects stimulating the economy out of
depression. Withdrawals from the treasury add to easing depression, but account for a negligible
fraction of government borrowings. Debt monetization (in the form of printing money) adds
liquidity in the system but is inflationary in its effect. A proper mix of public debt alternatives is
therefore necessary to ensure desirable economic outcomes.
Budget: Budget document (financial plan of the government – usually for a year) serves as an
important policy tool to handle the economic fluctuations. Discretionary changes in expenditures
and/or tax rates through managed/balanced budget are used to stimulate the economy when in a
recession and to achieve price stability during the boom periods. A counter cyclical budgetary
policy may also be adopted by unbalanced budgeting. During the depression an unbalanced
budget implies deficit financing whereas during economic overheating episodes, it would be
surplus budget implying lower government expenditures and higher taxes.

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14.5 Fiscal Reforms in India: Policy Measures and Developments

While the move towards fiscal adjustment was discernible in the pronouncements made as a part of
long–term fiscal policy announced in the mid-1980s a comprehensive fiscal reform programme at
the Central Government level was initiated only at the beginning of the 1990s as part of the
economic adjustment programme initiated in 1991-92. On the other hand, in the case of States,
efforts towards fiscal adjustment began only in the late 1990s. Fiscal reforms in the States were,
inter alia, necessitated by:

1. Growing fiscal imbalances

2. Sluggishness in Central transfers resulting from falling tax to GDP ratio.
3. Introduction of reform –linked assistance as a part of Medium-Term Fiscal Reform
Progamme on the basis of the recommendation of the Eleventh Finance Commission and
4. Adjustment programme undertaken in some of the States, which was linked to
borrowings from multilateral agencies
Fiscal reforms at the Centre covered tax reforms, expenditure pruning, restructuring of PSUs and
better coordination between monetary and fiscal policies.

Tax Reforms
Restructuring of the tax system constituted a major component of fiscal reforms with the aim of
augmenting revenues and removing anomalies in the tax structure. The main focus of the reforms
was on simplification and rationalization of both direct and indirect taxes drawing mainly from the
recommendations of the Tax Reforms Committee, 1991 (Chairman: Raja J. Chelliah). Since the rates
were very high and the structure of indirect taxes highly complex, it was considered undesirable to
augment revenues merely by raising tax rates. The Committee had recommended adoption of a
small number of simple broad-based taxes with moderate and limited number of rates, and with
very few exemptions and deductions.
Accordingly, the tax rates were significantly rationalized and progressively brought down to the
levels comparable to some of the developed economies.
The key tax reforms have been:

1. Lowering of the maximum marginal personal income tax rate from 60 percent in 1980-81 to
the present level of 33 per cent (inclusive of 10 per cent surcharge on annual income of
above Rs.8.5 lakhs, announced in the Union Budget (2003-04).
2. Reducing the corporate tax rate on both domestic and foreign companies to the current level
of 35 per cent and 40 per cent, respectively, from a level of 65 per cent and 70 per cent in
1980-81.
3. Unification of tax rates on closely held as well as widely held domestic companies.
4. Rationalisation of capital gains tax and dividend tax: duty on non-agricultural products
from a level of more than 300 per cent during the period just prior to reforms to the level of
25 per cent as announced in the Union Budget 2003-04 ;
5. Reduction of 11 major ad-valorem excise duties to three viz. central rate of 16 per cent, merit
rate of 8 per cent and demerit rate of 24 per cent in year 1999-2000, introduction of a uniform
16 per cent CENVAT effective from 2000-01, while retaining special excise duties on
specified goods and in the Union Budget 2003–04 rationalization of excise rate structure by
proposing a 3 tier structure of 8 per cent, 16 per cent and 24 per cent which are, however, not
applicable to goods attracting specific duty rates

Fiscal policy and inflation

Generally, inflation is related to monetary policy as most of the economists and policy makers look
at the problem of inflation as a purely monetary problem and therefore the quantity of money
supplied is regulated. However, the fiscal policy is also used to counter the problem of inflation.
But before we look at the fiscal measures to combat inflation, let us understand what inflation is.

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Inflation: Inflation indicates the increase in the price of most of the goods and services. It is a
condition when the purchasing power of money decreases. It is measured in percentage and there
are indices to measure this increase in price. The currency devalues which reduces the purchasing
power of money. This is in turn induces people to spend, as money is already losing value. The
standard of living of the people goes down. Rate of unemployment goes down (this relationship is
explained by Philips Curve).
Fiscal policy adopts an indirect way to control inflation. Taxation and expenditure of the
government is used to regulate the money supply in the economy. Inflation refers to an increased
money supply in the economy and to curb this excess, the tax rate is increased by the government
and money is taken away from the hands of the spenders. It is much easier to increase the indirect
tax rather than the direct tax because it is done annually during the budget session in the country.
Indirect taxes are paid by all the consumers in the country and therefore the impact is on a wider
population. In developing countries like India where the rate of direct tax is still very high, the
government is not in favour of raising it. Similarly, government expenditure adds to this money
supply so at the time of inflation the government reduces its public spending so that the total
supply of money in the economy comes down both these measures have a long-term impact and
generally there is a lag of 9 to 12 months for it to it reflected in the economy. Therefore, most of the
analysts and policy makers rely on monetary policy for curbing inflation as it has a more direct and
immediate impact on regulating money supply.

Summary
Fiscal policy is a very important tool in the hands of the government specially in the developing
countries where the economy is not fully monetised or where the public is yet dependent on the
state for the necessities. The fiscal policy may be used to tax the private sector to fund the public
sector. In case of India, in the initial years after independence the government followed this policy
to fund the various welfare programs it undertook and to build the infrastructure of the country.
The objectives of the fiscal policy are meant for full employment, economic stability, improve the
rate of growth of the economy, optimum allocation, and utilisation of the resources and to provide
a strong base to the economy. Depending on the stage of development of the country and the
international economic environment, the fiscal policy can be neutral, expansionary, or
contractionary. The basic two instruments of fiscal policy are taxation and expenditure which are
used prudently by the state to provide stability to the economy.
In India, fiscal policy has been given more prominence as compared to the monetary policy by the
politicians and policy makers. Initially the rate of taxation was very high and taxes on the private
sector financed the public sector. The result of this was very high marginal rate of taxation and high
tax evasion. The new economic policy of 1991 brought about a massive change in policy making
and the role of the state in the economy was curbed which got reflected in the fiscal policy as well.
Inflation is targeted through fiscal policy though at times it appears to be too slow and insufficient.

Keywords
Contractionary Fiscal Policy: The contractionary fiscal policy raises taxes and cuts spending.
Expansionary Fiscal Policy: This policy is designed to boost the economy
Fiscal Policy—the changes in the level of taxation and spending—is designed to achieve
macroeconomic goals relating to output (gross domestic product) and employment.
Fiscal stabilization policy is the use of government spending and tax policies to affect the level of
economic activity.
Inflation is an increase in the general level of prices as measured by a price index.
Neutral Fiscal Policy: This type of policy is usually undertaken when an economy is in
equilibrium.

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Self Assessment
1. Fiscal policy in India is formulated by
A. Reserve Bank of India
B. Planning Commission
C. Finance Ministry
D. Securities and Exchange Board of India

2. Which economist gave the concept of fiscal policy?

A. J M Keynes
B. Adam Smith
C. A C Pigou
D. A Lewis

3. What are the tools of fiscal policy?

A. Taxation
B. Public expenditure
C. Private Expenditure
D. Both taxation and public expenditure

4. Can inflation be controlled by fiscal policy?

A. Yes
B. No

5. Which of them is not a type of Fiscal policy?

A. Neutral fiscal policy
B. Expansionary fiscal policy
C. Contractionary fiscal policy
D. Constant fiscal policy

6. Is there a quid-pro-quo clause in taxation?

A. True
B. False

7. Does fiscal policy redirect revenue from private sector to the public sector?
A. True
B. False

8. Income tax is a type of

A. Direct tax
B. Indirect tax
C. Depends on who levies the tax
D. None of the above

9. Which of the following is not a major economic problem of India?

A. Unemployment
B. Poverty

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C. Inequality
D. Maternal Health

10. Are the urban local bodies allowed to tax people in their jurisdiction?
A. True
B. False

11. When was the final report given by Chelliah committee?

A. 1991
B. 1992
C. 1993
D. 1994

12. When was the Vijay Kelkar committee formed?

A. 2002
B. 2004
C. 2006
D. 2008

13. If the rate of inflation is high, then the purchasing power will
A. Increase
B. Decrease
C. Remain constant
D. Depends on the product whose price is increasing

14. If there is inflation, then the rate of unemployment will

A. Increase
B. Decrease
C. Remain constant
D. Depends on the product whose price is increasing

15. The relationship between inflation and rate of unemployment is shown by

A. Philips curve
B. Laffer curve
C. Lorenze curve
D. None of the above

Answers for Self Assessment

1. C 2. A 3 D 4. A 5. D

6. B 7. A 8. A 9. D 10. A

11. C 12. A 13. B 14. B 15. A

188 LOVELY PROFESSIONAL UNIVERSITY

Notes

Managerial Economics

Review Questions
1. Write a note on fiscal policy.
2. Explain the evolution of Fiscal Policy in context of India.
3. If there is inflation in the country, especially food inflation, then what type of taxation
policy should be adopted and why?
4. What are the objectives of fiscal policy for a developing country?
5. Are the objectives of fiscal policy different for developed and developing countries?
6. Explain the various types of fiscal policy by citing examples from the economy.

Further readings
1. Managerial Economics- Principles and Worldwide Applications By Salvatore,
Dominick and Rastogi, Siddhartha K., Oxford University Press.
2. Managerial Economics- Economic Tools for Today’s Decision Makers by Keat Paul G,
Young Philip K. Y, Erfle Stephen and Banerjee Sreejata., Pearson Education, India
3. Managerial Economics by Geetika, Piyali Ghosh, and Purba Roy Choudhary,
McGraw Hill Education (India) Private Limited

LOVELY PROFESSIONAL UNIVERSITY 189

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