UNIT- I

LESSON 1 MANAGERIAL ECONOMICS

STRUCTURE
1.1 INTRODUCTION

1.2 OBJECTIVES

1.3 NATURE OF MANAGERIAL ECONOMICS

1.3.1 Managerial Economics is a Science

1.3.2 Managerial Economics requires Art

1.3.3 Managerial Economics for administration of organisation

1.3.4 Managerial economics is helpful in optimum resource allocation

1.3.5 Managerial Economics has components of micro economics

1.3.6 Economics has components of macro economics

1.3.7 Managerial Economics is dynamic in nature

1.4 IMPORTANCE

1.5 SCOPE OF MANAGERIAL ECONOMICS

1.6 ROLE OF MANAGERIAL ECONOMICS

1.7 SUMMARY

1.8 SELF ASSESSMENT QUESTIONS

1.9 SUGGESTED READINGS

1.1 INTRODUCTION

The science of Managerial Economics has emerged only recently. With the growing

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variabilityand unpredictabilityof the business environment, business managers have
become increasingly concerned with finding rational and ways of adjusting to an
exploiting environmental change. The problems of the business world attracted the
attentions of the academicians from 1950 onwards. Managerial economics as a subject
gained popularity in the USA after the publication of the book “Managerial
Economics” by Joel Dean in 1951.

Managerial Economics can be defined as amalgamation of economic theory with

business practices so as to ease decisionmaking and future planning by management.
Managerial Economics assists the managers of a firm in a rational solution of obstacles
faced in the firm’s activities. It makes use of economic theory and concepts. It helps
in formulating logical managerial decisions. The key of Managerial Economics is the
microeconomic theory of the firm. It lessens the gap between economics in theory
and economics in practice. Managerial Economics is a science dealing with effective
use of scarce resources. It guides the managers in taking decisions relating to the firm’s
customers, competitors, suppliers as well as relating to the internal functioning of a
firm. It makes use of statistical and analytical tools to assess economic theories in
solving practical business problems. Studyof Managerial Economics helps in
enhancement of analytical skills, assists in rational configuration as wellas solution of
problems. While microeconomics is thestudyof decisions made regarding the allocation
of resources and prices of goods and services, macroeconomics is the field of
economics that studies the behaviour of the economy as a whole (i.e. entire industries
and economies).

The following figure tells the primary ways in which Managerial Economics correlates
to managerial decisionmaking.

1.1.2 DEFINITION:

Managerial economists have defined managerial economics in a variety of ways:

According to E.F. Brigham and J. L. Pappar, Managerial Economics is “The

application of economic theory and methodology to business administration
practice.”

Christopher Savage and John R. Small: “Managerial Economics is concerned with

business efficiency”.
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Milton H. Spencer and Lonis Siegelman define Managerial Economics as “The integration

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of economic theory with business practice for the purpose of facilitating decision
making and forward planning by management.”

In the words of Me Nair and Meriam, “Managerial Economics consists of the use
of economic modes of thought to analyse business situations.”

D.C. Hague describes Managerial Economics as “A fundamental academic subject

which seeks to understand and analyse the problems of business decision making.”

In the opinion of W.W. Haynes “Managerial Economics is the study of the allocation
of resources available to a firm of other unit of management among the activities of
that unit.”
According to Floyd E. Gillis, “Managerial Economics deals almost exclusively with
those business situations that can be quantified and dealt with in a model or at least
approximated quantitatively.”

1.2 OBJECTIVES

The objectives of this lesson is:

 To understand the concept of managerial economics.
 To know the scope and importance of managerial economics.

1.3 NATURE OF MANAGERIAL ECONOMICS

Managers studymanagerial economics because it gives them insight to reign the

functioning of the organisation. If manager uses the principles applicable to
economic behaviour reasonably, then it will result in smooth functioning of the
organisation.

1.3.1 Managerial Economics is a Science

Managerial Economics is an essential scholastic field. It can be compared to science in

a sense that it fulfills the criteria of being a science in following sense:

▪ Science is a Systematic body of Knowledge. It is based on the methodical

observation. Managerial economics is also a science of making decisions with regard
to scarce resources with alternative applications. It is a body of knowledge that
determines or observes the internal and external environment for decision making.
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▪ In science any conclusion is arrived at after continuous experimentation. In

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Managerial economics also policies are made after persistent testing and trailing.
Though economic environment consists of human variable, which is unpredictable, thus
the policies made are not rigid. Managerial economist takes decisions by utilising his
valuable past experience and observations.

▪ Science principles are universally applicable. Similarly policies of

Managerial economics are also universally applicable partially if not fully. The
policies need to be changed from time to time depending on the situation and attitude
of individuals to those particular situations. Policies are applicable universally but
modifications are required periodically.

1.3.2 Managerial Economics requires Art

Managerial economist is required to have an art of utilising his capability,

knowledge and understanding to achieve the organizational objective. Managerial
economist should have an art to put in practice his theoretical knowledge regarding
elements of economic environment.

1.3.3 Managerial Economics for administration of organisation

Managerial economics helps the management in decision making. These

decisions are based on the economic rationale and are valid in the existing economic
environment.

1.3.4 Managerial economics is helpful in optimum resource allocation

The resources are scarce with alternative uses. Managers need to use these
limited resources optimally. Each resource has several uses. It is manager who decides
with his knowledge of economics that which one is the preeminent use of the
resource.

1.3.5 Managerial Economics has components of micro economics

Managers studyand manage the internal environment of the organization and

work for the profitable and longterm functioning of the organisation. This aspect
refers to the micro economics study. The managerial economics deals with the
problems faced by the individual organization such as main objective of the
organisation, demand for its product, price and output determination of the organisation,

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available substitute and complimentary goods, supply of inputs and raw material, target
or prospective consumers of its products etc.

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1.3.6 Economics has components of macro economics

None of the organisation works in isolation. They are affected by the

external environment of the economy in which it operates such as government
policies, general price level, income and employment levels in the economy, stage of
business cycle in which economy is operating, exchange rate, balance of payment,
general expenditure, saving and investment patterns of the consumers, market
conditions etc. These aspects are related to macro economics.

1.3.7 Managerial Economics is dynamic in nature

Managerial Economics deals with humanbeings (i.e. human resource,

consumers, producers etc.). The nature and attitude differs from person to person.
Thus to cope up with dynamism and vitality managerial economics also changes itself
over a period of time.

1.4 IMPORTANCE OF MANAGERIAL ECONOMICS

The significance or importance of business/managerial economics can be

discussed
as:

1. Business economics is concerned with those aspects of traditional economics

which are relevant for business decision making in real life. These are adapted or
modified with a view to enable the manager take better decisions. Thus, business
economic accomplishes the objective of building a suitable tool kit from
traditional economics.

2. It also incorporates useful ideas from other disciplines such as psychology,

sociology, etc. If they are found relevant to decision making. In fact, business
economics takes the help of other disciplines having a bearing on the business
decisions in relation various explicit and implicit constraints subject to which
resource allocation is to be optimised.

3. Business economics helps in reaching a variety of business decisions in a

complicated environment. Certain examples are:

(i) What products and services should be produced?

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(ii) What input and production technique should be used?

(iii) How much output should be produced and at what prices it should be sold?

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 (iv) What are the best sizes and locations of new plants?

(v) When should equipment be replaced?

(vi) How should the available capital be allocated?

4. Business economics makes a manager a more competent model builder. It helps

him appreciate the essential relationship Characterising a given situation.

5. At the level of the firm. Where its operations are conducted though known
focus functional areas, such as finance, marketing, personnel and production,
business economics serves as an integrating agent by coordinating the activities in
these different areas.

6. Business economics takes cognizance of the interaction between the firm and
society, and accomplishes the key role of an agent in achieving the its social and
economic welfare goals. It has come to be realised that a business, apart from its
obligations to shareholders, has certain social obligations. Business economics
focuses attention on these social obligations as constraints subject to which business
decisions are taken. It serves as an instrument in furthering the economic welfare of
the societythrough socially oriented business decisions.

1.5 SCOPE OF MANAGERIAL ECONOMICS

Managerial Economics is a developing subject. The scope of managerial

economics refers to its area of study. Managerial economics has its roots in economic
theory. The empirical nature of managerial economics makes its scope wider.
Managerial economics provides management with strategic planning tools that can be
used to get a clear perspective of the way the business world works and what can be
done to maintain profitability in an ever changing environment. Managerial economics
refers to those aspects of economic theory and application which are directly relevant
to the practice of management and the decision making process within the
enterprise. Its scope does not extend to macro economic theory and the economics
of public policy which will also be of interest to the manager.

While considering the scope of managerial economics we have to

understand whether it is positive economics or normative economics.

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1.5.1 Positive versus Normative Economics:

Most of the managerial economists are of the opinion that managerial

economics is fundamentally normative and prescriptive in nature. It is concerned with
what decisions ought to be made. The application of managerial economics is
inseparable from consideration of values or norms, for it is always concerned with
the achievement of objectives or the optimisation of goals. In managerial
economics, we are interested in what should happen rather than what does happen.
Instead of explaining what a firm is doing, we explain what it should do to make its
decision effective.

I. Positive Economics:

A positive science is concerned with ‘what is’. Robbins regards economics as

a pure science of what is, which is not concerned with moral or ethical questions.
Economics is neutral between ends. The economist has no right to pass judgment on
the wisdom or folly of the ends itself. He is simply concerned with the problem of
resources in relation to the ends desired. The manufacture and sale of cigarettes and
wine may be injurious to health and therefore morally unjustifiable, but the economist
has no right to pass judgment on these since both satisfy human wants and involve
economic activity.

II. Normative Economics:

Normative economics is concerned with describing what should be the things.

It is, therefore, also called prescriptive economics. What price for a product
should be fixed, what wage should be paid, how income should be distributed and so
on, fall within the purview of normative economics?

It should be noted that normative economics involves value judgments.Almost

all the leading managerial economists are of the opinion that managerial
economics is fundamentally normative and prescriptive in nature. It refers mostly to
what ought to be and cannot be neutral about the ends. The application of
managerial economics is inseparable from consideration of values, or norms for it is
always concerned with the achievement of objectives or the optimisation of goals.

Further, in managerial economics, we are interested in what should happen

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rather than what does happen. Instead of explaining what a firm is doing, we
explain what it should do to make its decision effective. Managerial economists are
generally preoccupied

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with the optimum allocation of scarce resources among competing ends with a view
to obtaining the maximum benefit according to predetermined criteria.

To achieve these objectives they do not assume ceteris paribus, but try to
introduce policies. The very important aspect of managerial economics is that it tries to
find out the cause and effect relationship byfactual studyand logical reasoning. The scope
of managerial economics is so wide that it embraces almost all the problems and areas
of the manager and the firm.

1.5.2 Subject Matter of Marginal Economics

1. Demand Analysis and Forecasting

A firm is an economic organisation which transforms inputs into output that is to

be sold in a market. Accurate estimation of demand, by analysing the forces acting on
demand of the product produced by the firm, forms the vital issue in taking effective
decision at the firm level. Amajor part of managerial decision making depends on
accurate estimates of demand. When demand is estimated, the manager does not stop
at the stage of assessing the current demand but estimates future demand as well. This
is what is meant by demand forecasting. This forecast can also serve as a guide to
management for maintaining or strengthening market position and enlarging profit.
Demand analysis helps in identifying the various factors influencing the demand for a
firm’s product and thus provides guidelines to manipulate demand. The main topics
covered are: Demand Determinants, Demand Distinctions and Demand
Forecasting.

2. Cost and Production Analysis

Cost analysis is yet another function of managerial economics. In decision

making, cost estimates are very essential. The factors causing variation in costs must be
recognised and allowed for if management is to arrive at cost estimates which are
significant for planning purposes.

The determinants of estimating costs, the relationship between cost and output,
the forecast of cost and profit are very vital to a firm. An element of cost uncertainty
exists because all the factors determining costs are not always known or controllable.
Managerial economics touches these aspects of cost analysis as an effective
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knowledge and the application of which is corner stone for the success of a firm.

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 Production analysis frequently proceeds in physical terms. Inputs play a vital
role in the economics of production. The factors of production otherwise called inputs,
may be combined in a particular way to yield the maximum output.

Alternatively, when the price of inputs shoots up, a firm is forced to work
out a combination of inputs so as to ensure that this combination becomes the
least cost combination. The main topics covered under cost and production analysis
are production function, least cost combination of factor inputs, factor productiveness,
returns to scale, cost concepts and classification, costoutput relationship and linear
programming.

3. Inventory Management

An inventory refers to a stock of raw materials which a firm keeps. Now

the problem is how much of the inventoryis the ideal stock. If it is high, capital is
unproductively tied up. If the level of inventory is low, production will be affected.

Therefore, managerial economics will use such methods as Economic

Order Quantity (EOQ) approach, ABC analysis with a view to minimising the
inventory cost. It also goes deeper into such aspects as motives of holding inventory, cost
of holding inventory, inventory control, and main methods of inventory control and
management.

4. Advertising

To produce a commodity is one thing and to market it is another. Yet the

message about the product should reach the consumer before he thinks of buying it.
Therefore, advertising forms an integral part of decision making and forward planning.
Expenditure on advertising andrelated types of promotional activities is called selling
costs byeconomists.

There are different methods for setting advertising budget: Percentage of Sales
Approach, All You can Afford Approach, Competitive ParityApproach, Objective and
Task Approach and Return on Investment Approach.

5. Pricing Decision, Policies and Practices

Pricing is very important area of managerial economics. The control functions

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of an enterprise are not only productions but pricing as well. When pricing a
commodity, the cost of production has to be taken into account. Business decisions are
greatly influenced by pervading market structure and the structure of markets that
has been evolved by the

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nature of competition existing in the market.

Pricing is actually guided by consideration of cost plan pricing and the policies
of public enterprises. The knowledge of the pricing of a product under conditions of
oligopoly is also essential. The price system guides the manager to take valid and
profitable decision.

6. Profit Management

A business firm is an organisation designed to make profits. Profits are acid test
of the individual firm’s performance. In appraising a company, we must first understand
how profit arises. The concept of profit maximisation is very useful in selecting the
alternatives in making a decision at the firm level.

Profit forecasting is an essential function of anymanagement. It relates to

projection of future earnings and involves the analysis of actual and expected behaviour
of firms, the sales volume, prices and competitor’s strategies, etc. The main aspects
covered under this area are the nature and measurement of profit, and profit policies of
special significance to managerial decision making.

Managerial economics tries to find out the cause and effect relationship by
factual study and logical reasoning. For example, the statement that profits are at a
maximum when marginal revenue is equal to marginal cost, a substantial part of
economic analysis of this deductive proposition attempts to reach specific conclusions
about what should be done.

The logic of linear programming is deduction of mathematical form. In

fine, managerial economics is a branch of normative economics that draws from
descriptive economics and from well established deductive patterns of logic.

7. Capital Management

Planning and control of capital expenditures is the basic executive function.

The managerial problem of planning and control of capital is examined from an
economic stand point. The capital budgeting process takes different forms in different
industries.

It involves the equimarginal principle. The objective is to assure the most

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profitable use of funds, which means that funds must not be applied when the
managerial returns are less than in other uses. The main topics dealt with are: Cost of
Capital, Rate of Return and

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Selection of Projects.

Thus we see that a firm has uncertainties to rock on with. Therefore, we

can conclude that the subject matter of managerial economics consists of applying
economic principles and concepts towards adjusting with these uncertainties of the
firm.

In recent years, there is a trend towards integration of managerial economics

and Operation Research. Hence, techniques such as linear Programming, Inventory
Models, Waiting Line Models, Bidding Models, Theory of Games, etc. have also
come to be regarded as part of managerial economics.

1.5.3 Relation to Other Branches of Knowledge

A useful method of throwing light on the nature and scope of managerial

economics is to examine its relationship with other disciplines. To classify the scope of a
field of study is to discuss its relation to other subjects. If we take the subject in
isolation, our study would not be useful. Managerial economics has a close linkage
with other disciplines and fields of study.

The subject has gained bythe interaction with economics, mathematics and
statistics and has drawn upon management theory and accounting concepts. The
managerial economics integrates concepts and methods from these disciplines and
bringing them to bear on managerial problems.

(i) Managerial Economics and Economics:

Managerial Economics has been described as economics applied to

decision making. It may be studied as a special branch of economics, bridging the
gap between pure economic theory and managerial practice. Economics has two main
branches micro economics and macroeconomics.

Micro-economics:

‘Micro’ means small. It studies the behaviour of the individual units and
small groups of such units. It is a study of particular firms, particular households,
individual prices, wages, incomes, individual industries and particular commodities.
Thus micro economics gives a microscopic view of the economy.

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The micro-economic analysis may be undertaken at three levels:

(i) The equalisation of individual consumers and produces;

(ii) The equalisation of the single market;

(iii) The simultaneous equilibrium of all markets. The problems of scarcity and
optimal or ideal allocation of resources are the central problem in microeconomics.

The roots of managerial economics spring from microeconomic theory. In

price theory, demand concepts, elasticity of demand, marginal cost marginal revenue,
the short and long runs and theories of market structure are sources of the elements
of micro economics which managerial economics draws upon. It also makes use of
well known models in price theory such as the model for monopoly price, the kinked
demand theory and the model of price discrimination.

Macro-economics:

‘Macro’ means large. It deals with the behaviour of the large aggregates in
the economy. The large aggregates are total saving, total consumption, total income,
total employment, general price level, wage level, cost structure, etc. Thus macro-
economics is aggregative economics.

It examines the interrelations among the various aggregates, and causes of

fluctuations in them. Problems of determination of total income, total employment and
general price level are the central problems in macroeconomics.

Macroeconomies is also related to managerial economics. The environment,

in which a business operates, fluctuations in national income, changes in fiscal and
monetary measures and variations in the level of business activityhave relevance to
business decisions. The understanding of the overall operation of the economic system
is very useful to the managerial economist in the formulation of his policies.

The chief contribution of macroeconomics is in the area of forecasting. The

post Keynesian aggregative theory has direct implications for forecasting general
business conditions. Since the prospects of an individual firm often depend greatly on
business in general, forcasts of an individual firm depend on general business forecasts,
which make use of models derived from theory. The most widely used model in

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modern forecasting is

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the gross national product model.

(ii) Managerial Economics and Theory of Decision Making:

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

Economist are interested in the efficient use of scarce resources hence they
are naturally interested in business decision problems and theyapplyeconomics in
management of business problems. Hence managerial economics is economics
applied in decision making. According to M.H. Spencer and L. Siegelman,
“Managerial economics is the integration of economic theorywith business practice for
the purpose of facilitating decision making up and forward planning bymanagement”.
Managerial economics is a fundamental academic subject which seeks to understand
and to analyse the problems of business decision making.

The theory of decision making recognises the multiplicity of goals and the
pervasiveness of uncertainty in the real world of management. The theory of decision
making replaces the notion of a single optimum solution with the view that the objective
is to find solution that ‘satisfies’ rather than maximise. It probes into an analysis of
motivation of the relation of rewards and aspiration levels, and of pattern of influence
and authority.

Economic theory and theory of decision making appear to be in conflict,

each based on different set of assumptions. Much of the economic theory is based
on the assumption of single goalmaximisation of utility for the individual or maximisation
of profit for the firm.

(iii) Managerial Economics and Operations Research:

Mathematicians, statisticians, engineers and others teamed up together and

developed models and analytical tools which have since grown into a specialised
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subject, known as operation research. The basic purpose of the approach is to develop
a scientific model of the system which may be utilised for policy making.

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 Much of the development of techniques and concepts such as Linear
Programming, Dynamic Programming, Inputoutput Analysis, Inventory Theory,
Information Theory, Probability Theory, Queueing Theory, Game Theory, Decision
Theoryand Symbolic Logic.

Linear programming dealswith those programming problems where the

relationship among the variables is linear. It is a useful tool for the managerial
economist for reducing transportation costs and allocating purchase amongst different
supplies and site depots. It is employed when the objective function is to maximise
profit, output or efficiency.

Dynamic programminghelpsin solvingcertain types ofsequential decision

problems. A sequential decision problem is one in which a sequence of decision must
be made with each decision affecting future decision. It has been applied in cases of
maintenance and repair, financial portfolio balancing, inventory and production
control, equipment replacement and directed marketing.

Inputoutput analysis is a technique for analysing interindustryrelation. Prof. W.W.

Leontief tries to establish inter industry relationships by dividing the economyinto
different sectors. In this model, the final demand is treated as exogenously
determined and the inputoutput technique is used to find out the levels of activity in
the various sectors of the economic system. It can be used by firms for planning, co-
ordination and mobilisation of resources.

Queueing is a particular application of the statistical decision theory. It is

employed to get the optimum solution. The theory may be applied to such problems as
how to meet a given demand most economically or how to minimise the waiting period
or idle time. The theory of games holds out the hope of solving certain problems
concerning oligopolistic interminacy.

When we apply the game theory, we have to consider the following:

(i) The players are the two firms;

(ii) They play the game in the market place;

(iii) Their strategies are their price or output decision; and

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(iv) The payoffs or rewards are their profits. The numerical figures are what is
called payoff matrix. This matrix is the most important tool of game theory.

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(iv) Managerial Economics and Statistics:
Statistics is important to managerial economics. It provides the basis for the
empirical testing of theory. Statistics is important in providing the individual firm with
measures of the appropriate functional relationship involved in decision making.
Statistics is a very useful science for business executives because a business runs on
estimates and probabilities.
Statistics supplies many tools to managerial economics. Suppose forecasting
has to be done. For this purpose, trend projections are used. Similarly, multiple
regression technique is used. In managerial economics, measures of central tendency
like the mean, median, mode, and measures of dispersion, correlation, regression, least
square, estimators are widely used. The managerial economics is constantly faced with
the choice between models ignoring uncertainty and those that explicitly incorporate
probability theory.
Statistical tools are widelyused in the solution of managerial problems. For
example, sampling is very useful in data collection. Managerial economics makes use of
correlation and multiple regression in business problems involving some kind of
cause and effect relationship.
(v) Managerial Economics and Accounting:
Managerial economics is closely related to accounting. It is concerned
with recording the financial operation of a business firm. Abusiness is started with the
main aim of earning profit. Capital is invested it is employed for purchasing properties
such as building, furniture, etc and for meeting the current expenses of the business.
Goods are bought and sold for cash as well as credit. Cash is paid to credit
sellers. It is received from credit buyers. Expenses are met and incomes derived.
This goes on the daily routine work of the business. The buying of goods, sale of goods,
payment of cash, receipt of cash and similar dealings are called business
transactions.
The business transactions are varied and multifarious. They are too numerous
to be kept in one’s memory. This has given rise to the necessity of recording
business transaction in books. They are written in a set of books in a systematic
manner so as to facilitate proper study of their results.
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There are three classes of accounts:
(i) Personal account,

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(ii) Property accounts, and

(iii) Nominal accounts.

Management accounting provides the accounting data for taking business

decisions.
The accounting techniques are very essential for the success of the firm because profit
maximisation is the major objective of the firm.

(vi) Managerial Economics and Mathematics:

Mathematics is yet another important subject closely related to managerial

economics. For the derivation and exposition of economic analysis, we require a set
of mathematical tools. Mathematics has helped in the development of economic theories
and now mathematical economics has become a very important branch of the
science of economics.

Mathematical approach to economic theories makes them more precise and

logical. For the estimation and prediction of economic factors for decision making and
forward planning, the mathematical method is veryhelpful. The important branches of
mathematics generally used by a managerial economist are geometry, algebra and
calculus.

The mathematical concepts used by the managerial economists are the

logarithms and exponential, vectors and determinants, inputoutput tables. Operations
research which is closely related to managerial economics is mathematical in
character.

1.6 ROLE OF MANAGERIAL ECONOMICS IN BUSINESS DECISION

Decision making is an integral part of today’s business management. Making a

decision is one of the most difficult tasks faced by a professional manager. Amanager
has to take several decisions in the management of business. The life of a manager is
filled with making decisions alter decisions.

Decision making is a process and a decision is the product of such a

process. Managerial decisions are based on the flow of information. Decision
making is both a managerial function and an organisational process. Managerial function
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is exercised through decision making.

The purpose of decision making as well as planning is to direct human behaviour

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and effort towards a future goal or objective. It is organisational in that many
decisions transcend the individual manager and become the product of groups, teams,
committees, etc.

Once the decision is taken it is implemented within the minimum time and cost.
A study of the principles of business decisions will enable managers to understand
business problems in a better perspective and increase their ability to solve business
problems facing them in the management of business.

Executives make many types of decisions connected with the business such
as production, inventory, cost, marketing, pricing, investment and personnel. In the long-
run, application of principles of business decisions will result in successful outcomes.
Agood decision is one that is based on logic, considers all available data and possible
alternatives and applies the quantitative approach.

Organisational decisions are those which the executive makes in his personal
capacity as a manager. They include the adoption of the strategies, the framing of
objectives and the approval of plans. These decisions can be delegated to the
organisational members so that decisions could be implemented with their support. These
decisions aim at achieving the best interests of the organisation. The basic decisions are
those which are more important, they involve longrange commitment and
heavyexpenditure of funds.

Ahigh degree of importance is attached to them. Aserious mistake will

endanger the company s existence. The selection of a location, selection of a
product line, and decision relating to manage the business are all basic decisions. They
are considered basic because they affect the whole organisation.

1.6.1 IMPORTANT TYPES OF BUSINESS DECISIONS

(i) Production Decisions:

Production is an economic activity which supplies goods and services for sale in
a market to satisfyconsumer wants therebyprofit maximisation is made possible. The
business executive has to make the rational allocation of available resources at his
disposal. He may face problems relating to best combination of the factors to gain
maximum profit or how to use different machine hours for maximum production
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advantage, etc.

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(ii) Inventory Decision:

Inventory refers to the quantity of goods, raw material or other resources that
are idle at any given point of time held by the firm. The decision to hold inventories
to meet demand is quite important for a firm and in certain situation the level of
inventories serves as a guide to plan production and is therefore, a strategic
management variable. Large inventory of raw materials, intermediate goods and
finished goods means blocking of capital.

(iii) Cost Decisions:

The competitive abilityof the firm dependsupon the abilityto produce

thecommodity at the minimum cost. Hence, cost structure, reduction of cost and cost
control has come to occupy important places in business decisions. In the absence of
cost control, profits would come down due to increasing cost.

Business decisions about the future require the businessmen to choose among
alternatives, and to do this, it is necessary to know the costs involved. Cost information
about the resources is very essential for business decision making.

(iv) Marketing Decisions:

Within market planning, the marketing executive must make decisions on

target market, market positioning, product development, pricing channels of distribution,
physical distribution, communication and promotion.Abusinessman has to take mainlytwo
different but interrelated decisions in marketing.

They are the sales decision and purchase decision. Sales decision is
concerned with how muchto produce and sell for maximising profit. The purchase
decision is concerned with the objective of acquiring these resources at the lowest
possible prices so as to maximise profit. Here the executive’s basic skill lies in
influencing the level, timing, and composition of demand for a product, service,
organisation, place, person or idea.

(v) Investment Decision:

The problems of risks and imperfect foresight are very crucial for the
investment decision. In real business situation, there is seldom an investment which

29
does not involve uncertainties. Investment decision covers issues like the decisions
regarding the amount of

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money for capital investment, the source of financing this investment, allocation of
this investment amongdifferent projects over time. These decisions are of immense
significance for ensuring the growth of an enterprise on sound lines. Hence, decisions
on investment are to be taken with utmost caution and care by the executive.

(vi) Personnel Decision:

An organisation requires the services of a large number of personnel.

These personnel occupy various positions. Each position of the organisation has
certain specific contributions to achieve organisational objectives. Personnel decisions
cover the areas of manpower planning, recruitment, selection, training and
development, performance appraisal, promotion, transfer, etc. Business executives
should take personnel decisions as an essential element.

1.7 SUMMARY

Managerial economics generally refers to the integration of economic theory

with business practice. Economics provides tools and managerial economics applies
these tools to the management of business. In simple terms, managerial economics means
the application of economic theory to the problem of management. Managerial economics
may be viewed as economics applied to problem solving at the level of the firm.

It enables the business executive to assume and analyse things. Every firm tries
to get satisfactory profit even though economics emphasises maximising of profit.
Hence, it becomes necessary to redesign economic ideas to the practical world. This
function is being done by managerial economics.

The scope of managerial economics is not yet clearly laid out because it is
a developing science. Even then the following fields may be said to generally fall
under Managerial Economics:

1. Demand Analysis and Forecasting

2. Cost and Production Analysis

3. Pricing Decisions, Policies and Practices

4. Profit Management

31
 5. Capital Management

The usefulness of business economics lies in borrowing and adopting the

toolkit from economic theory, incorporating relevant ideas from other disciplines to
take better business decisions, serving as a catalytic agent in the process of decision
making bydifferent functional departments at the firm’s level, and finally accomplishing
a social purpose by orienting business decisions towards social obligations.

1.8 SELF ASSESSMENT QUESTIONS

1. Discuss the principles of managerial decision analysis?

2. State the relationship between micro economics, macro economics and

managerial economics.

3. Throw light on goals and scope of economics.

1.9 SUGGESTED READINGS

• Managerial economics, Dwivedi D.N., Vikas publishing house, New Delhi.

• Managerial Economics, Mehta, P.L., S. Chand, Delhi.

• Mithani, D.M., Managerial EconomicsTheory& application, Himalaya

Publishing House Pvt. Ltd., New Delhi.

3
2
• Gupta, G.S., Macro EconomicTheory&Application, Tata Mcgraw Hill
Publishing House, New Delhi.

• Vaish, M.C., Macro Economic Theory, Vikas Publishing House Pvt. Ltd.,
New Delhi.

• Mishra, S.k., and Puri, V.K., Modern Macro Economic Theory,

Himalayan Publishing House.

• Edward Shapiro, Macro Economic Analysis, Tata McGraw Hill, New Delhi.

• Jhingam, M.L. & Stephen, J.K, Managerial Econbomics, Vrinda Publications

Pvt. Ltd. Delhi.

• Dingra, I.C Managerial Economics, Sultan Chand, New Delhi.

33
 UNIT-I
LESSON 2 MANAGERIAL DECISION

ANALYSIS STRUCTURE

2.1 INTRODUCTION

2.2 OBJECTIVE

2.3 ECONOMIC THEORYAND MANAGERIAL THEORY

2.4 WHY DO MANAGERS NEED TO KNOW ECONOMICS?

2.5 DECISION MAKING

2.5.1 Contribution of Managerial Economics in Business Decision Making

2.6 MANAGERIAL DECISION ANALYSIS

2.6.1 Principles in Managerial Economics

2.6.2 Application of Economics to Business decisions Example

2.6.3 Other Economic Principles Relevant to Managerial Decisions

2.7 SUMMARY

2.8 SELF ASSESSMENT QUESTIONS

2.9 SUGGESTED READING

2.1 INTRODUCTION

Business Economics, also called Managerial Economics, is the application

of economic theoryandmethodologyto business. Business involves decisionmaking.
Decision making means the process of selecting one out of two or more alternative
courses of action. The question of choice arises because the basic resources such as
capital, land, labour and management are limited and can be employed in alternative
uses. The decision
3
4
making function thus becomes one of making choice and taking decisions that will
provide the most efficient means of attaining a desired end, say, profit maximisation.
Managerial Economics applies microeconomic tools to make business decisions. It deals
with a firm. The use of Managerial Economics is not limited to profitmaking firms and
organisations. But it can also be used to help in decisionmaking process of nonprofit
organisations (hospitals, educational institutions, etc). It enables optimum utilisation of
scarce resources in such organizations as well as helps in achieving the goals in most
efficient manner. Managerial Economics is of great help in price analysis,
production analysis, capital budgeting, risk analysis and determination of demand.
Managerial economics uses both Economic theory as well as Econometrics for
rational managerial decision making. Econometrics is defined as use of statistical
tools for assessing economic theories by empirically measuring relationship between
economic variables. It uses factual data for solution of economic problems.
Managerial Economics is associated with the economic theory which constitutes
“Theory of Firm”. Theory of firm states that the primary aim of the firm is to maximise
wealth. Decision making in managerial economics generallyinvolves establishment of
firm’s objectives, identification of problems involved in achievement of those
objectives, development of various alternative solutions, selection of best alternative and
finally implementation of the decision.

2.2 OBJECTIVES

The objectives of this lesson are:

 To provide knowledge of economic and managerial theory.
 To explain the concept of managerial decision making.
 To explain principles of managerial decision.

2.3 ECONOMIC THEORYAND MANAGERIAL THEORY

Economic Theory is a system of interrelationships. Among the social

sciences, economics is the most advanced in terms of theoretical orientations. There are
well defined theoretical structures in economics. One of the most widely discussed
structures is the postulational or axiomatic method of theory formulation. It insists that
there is a logical core of theory consisting of postulates and their predictions which

35
forms the basis of economic reasoning and analysis. This logical core of theory
cannot easily be detached

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from the empirical part of the theory. Economics has a logically consistent system
of reasoning. The theory of competitive equilibrium is entirely based on axiomatic
method. Both in deductive inferences and inductive generalisations, the underlying
principle is the interrelationships.

Managerial theory refers to those aspects of economic theory and

application which are directly relevant to the practice of management and the decision
making process. Managerial theory is pragmatic. It is concerned with those analytical
tools which are useful in improving decision making. Managerial theory provides
necessary conceptional tools which can be of considerable help to the manager in
taking scientific decisions. The managerial theoryprovides the maximum help to a
business manager in his decision making and business planning. The managerial
theoretical concepts and techniques are basic to the entire gamut of managerial
theory.

Economic theory deals with the body of principles. But managerial theory
deals with the application of certain principles to solve the problem of a firm.
Economic theory has the characteristics of both micro and macro economics. But
managerial theory has only micro characteristics. Economic theory deals with a study of
individual firm as well as individual consumer. But managerial theory studies only about
individual firm. Economic theory deals with a study of distribution theories of rent,
wages, interest and profits. But managerial theory deals with a study of only profit
theories. Economic theory is based on certain assumptions. But in managerial theory
these assumptions disappear due to practical situations. Economic theory is both
positive and normative in character but managerial theory is essentially normative in
nature. Economic theory studies onlyeconomic aspect of the problem whereas
managerial theory studies both economic and noneconomic aspects.

2.4 WHY DO MANAGERS NEED TO KNOW ECONOMICS?

Economics contributes a great deal towards the performance of managerial

duties and responsibilities. Just as biology contributes to the medical profession and
physics to engineering, economics contributes to the managerial profession. All other
professional qualifications being the same, managers with a working knowledge of
economics can perform their functions more efficiently than those without it. The

37
basic function of the managers of a business firm is to achieve the objective of the firm
to the maximum possible extent with the limited resources placed at their disposal.
The emphasis here is on the

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maximisation of the objective and limitedness of resources. Had the resources
been unlimited, the problem of recognising on the resources or resource management
would have never arisen. But resources at the disposal of a firm, be it finance, men, or
material, are by all means limited. Therefore, the basic task of the management is to
optimise their use.

As mentioned, economics, though variously defined, is essentially the study

of logic, tools and techniques of making optimum use of the available resources to
achieve the given ends. Economics thus provide analytical tools and techniques that
managers need to achieve the goals of the organisation they manage. Therefore, a
working knowledge of economics, not necessarily a formal degree, is essential for
managers. In other words, managers are essentially practicing economists.

In performing their functions, managers have to take a number of decisions

in conformitywith the goals of the firm. Manybusiness decisions are taken under the
conditions of uncertainty and risk. These arise mainlydue to uncertain behaviour of the
market forces, changing business environment, emergence of competitors with
highlycompetitive products, government policy, international factors impacting the
domestic market due to increasing globalisation as well as social and political changes
in the country. The complexity of the modern business world adds complexity to
business decision making. However, the degree of uncertainity and risk can be greatly
reduced if market conditions are predicted with a high degree of reliability.
Economics offers models, tolls and techniques to predict the future course of market
conditions and business prospects.

The prediction of the future course of business environment alone is not

sufficient. What is equally important is to take appropriate business decisions and to
formulate a business strategy in conformitywith the goals of the firm. Taking a rational
business requires a clear understanding of the technical and environmental conditions
related to the business issues for which decisions are taken. Application of economic
theories to explain and analyse the technical conditions and the business environment
contributes a good deal to rational decisionmaking. Economic theories have,
therefore, gained a wide range of application in the analysis of practical problems of the
business. With the growing complexity of business environment, the usefulness of
economic theory as a tool of analysis and its contribution to the process of decision
39
making has been widely recognised.

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2.5 DECISION MAKING

Managerial economics is supposed to enrich the conceptual and technical skill

of a manager. It is concerned with economic behaviour of the firm. It concentrates
on the decision process, decision model and decision variables at the firm level. It is the
application of economic analysis to evaluate business decisions. The primary function of
a manager in business organisation is decision making and forward planning under
uncertain business conditions. Some of the important management decisions are
production decision, inventory decision, cost decision, marketing decision, financial
decision, personnel decision and miscellaneous decisions. One of the hallmarks of a
good executive is the ability to take quick decision. He must have the clarity of goals,
use all the information he can get, weigh pros and cons and make fast decisions.

The decisions are taken to achieve certain objectives. Objectives are the
motivating factors in taking decision. Several acts are performed to attain the objectives
quantitative techniques are also used in decision making. But it may be noted that acts
and quantitative techniques alone will not produce desirable results. It is important to
remember that other variables such as human and behavioural considerations,
technological forces and environmental factors influence the choices and decisions
made by managers.

2.5.1 Contribution of Managerial Economics in Business Decision Making

Mathematical Economics and Econometrics are utilized to construct and

estimate decision models useful in determining the optimal behaviour of a firm. The
former helps to express economic theoryin the form of equations while the latter applies
statistical techniques and real world data to economic problems. Like, regression is
applied for forecasting and probability theory is used in risk analysis. In addition to
this, economists use various optimization techniques, such as linear programming, in
the study of behavior of a firm. They have also found it most efficient to express
their models of behavior of firms and consumers in terms of the symbols and logic of
calculus. Thus, Managerial Economics deals with the economic principles and
concepts, which constitute “Theory of the Firm”. The subject is a synthesis of economic
theoryand quantitative techniques to solve managerial decision problems. It is micro-
economic in character. Further, it is normative since it makes value judgments, that is, it

41
states what goals a firm should pursue. Fig. below summarises our discussion of the
principal ways in which Economics relates to managerial decision

4
2
making. Managerial Economics plays an equally important role in the management of
non business organizations such as government agencies, hospitals and educational
institutions. Regardless of whether one manages the ABC hospital, Eastman Kodak
or College of Fine Arts, logical managerial decisions can be taken by a mind trained
in economic logic.

2.6 MANAGERIAL DECISION ANALYSIS

Managerial Economics deals with allocating the scarce resources in a manner

that minimizes the cost. As we have already discussed, Managerial Economics is
different from microeconomics and macroeconomics. Managerial Economics has a more
narrow scope it is actually solving managerial issues using microeconomics. Wherever
there are scarce resources, managerial economics ensures that managers make
effective and efficient decisions concerning customers, suppliers, competitors as well
as within an organization. The fact of scarcity of resources gives rise to three
fundamental questions

a. What to produce?

b. How to produce?

c. For whom to produce?

To answer these questions, a firm makes use of managerial economics

principles.

The first question relates to what goods and services should be produced and
in what amount/quantities. The managers use demand theory for deciding this. The
demand theory examines consumer behaviour with respect to the kind of purchases
they would like to make currently and in future; the factors influencing purchase and
consumption of a specific good or service; the impact of change in these factors on
the demand of that specific good or service; and the goods or services which
consumers might not purchase and consume in future. In order to decide the amount of
goods and services to be produced, the managers use methods of demand
forecasting.

The second question relates to how to produce goods and services. The firm
has now to choose among different alternative techniques of production. It has to make
43
decision regarding purchase of raw materials, capital equipments, manpower, etc. The
managers can use various managerial economics tools such as production and cost
analysis (for hiring andacquiringof inputs), project appraisal methods (for longterm
investment decisions),

4
4
etc for making these crucial decisions.

The third question is regarding who should consume and claim the goods
and services produced bythe firm. The firm, for instance, must decide which is it’s niche
market domestic or foreign? It must segment the market. It must conduct a thorough
analysis of market structure and thus take price and output decisions depending
upon the type of market.

Managerial economics helps in decisionmaking as it involves logical thinking.

Moreover, bystudying simple models, managers can deal with more complex and
practical situations. Also, a general approach is implemented. Managerial Economics
take a wider picture of firm, i.e., it deals with questions such as what is a firm, what
are the firm’s objectives, and what forces push the firm towards profit and away from
profit. In short, managerial economics emphasises upon the firm, the decisions relating
to individual firms and the environment in which the firm operates. It deals with key
issues such as what conditions favour entry and exit of firms in market, why are people
paid well in some jobs and not so well in other jobs, etc. Managerial Economics is a
great rational and analytical tool.

Managerial Economics is not only applicable to profitmaking business

organizations, but also to non profit organisations such as hospitals, schools, government
agencies, etc.

2.6.1 Principles in Managerial Economics

Economic principles assist in rational reasoning and defined thinking.

Theydevelop logical abilityand strength of amanager. Some important principles of
managerial economics are:

1. Marginal and Incremental Principle: This principle states that a decision

is said to be rational and sound if given the firm’s objective of profit maximisation, it
leads to increase in profit, which is in either of two scenarios
 If total revenue increases more than total cost.
 If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable

45
on the

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other. Marginal generallyrefers to small changes. Marginal revenue is change in total
revenue per unit change in output sold. Marginal cost refers to change in total costs per
unit change in output produced (While incremental cost refers to change in total costs
due to change in total output). The decision of a firm to change the price would depend
upon the resulting impact/change in marginal revenue and marginal cost. If the
marginal revenue is greater than the marginal cost, then the firm should bring about
the change in price.
Incremental analysis differs from marginal analysis onlyin that it analysis the
change in the firm’s performance for a given managerial decision, whereas marginal
analysis often is generated by a change in outputs or inputs. Incremental analysis is
generalisation of marginal concept. It refers to changes in cost and revenue due to a
policy change. For example adding a new business, buying new inputs, processing
products, etc. Change in output due to change in process, product or investment is
considered as incremental change. Incremental principle states that a decision is
profitable if revenue increases more than costs; if costs reduce more than revenues;
if increase in some revenues is more than decrease in others; and if decrease in
some costs is greater than increase in others.
2. Equi-marginal Principle: Marginal Utility is the utility derived from the
additional unit of a commodity consumed. The laws of equimarginal utility states that
a consumer will reach the stage of equilibrium when the marginal utilities of various
commodities he consumes are equal.According to the modern economists, this law has
been formulated in form of law of proportional marginal utility. It states that the
consumer will spend his moneyincome on different goods in such a way that the
marginal utility of each good is proportional to its price, i.e.,
MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.
Similarly, a producer who wants to maximize profit (or reach equilibrium) will
use the technique of production which satisfies the following condition:
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
Where, MRP is marginal revenue product of inputs and MC represents
marginal
47
cost.
Thus, a manger can make rational decision by allocating/hiring resources in a

4
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manner which equalizes the ratio of marginal returns and marginal costs of various use
of resources in a specific use.

3. Opportunity Cost Principle: By opportunity cost of a decision is meant

the sacrifice of alternatives required by that decision. If there are no sacrifices, there is
no cost. According to Opportunity cost principle, a firm can hire a factor of production
if and only if that factor earns a reward in that occupation/job equal or greater than it’s
opportunity cost. Opportunity cost is the minimum price that would be necessary to
retain a factor service in it’s given use. It is also defined as the cost of sacrificed
alternatives. For instance, a person chooses to forgo his present lucrative job which
offers him Rs.50000 per month, and organizes his own business. The opportunity
lost (earning Rs. 50,000) will be the opportunity cost of running his own business.

4. Time Perspective Principle: According to this principle, a manger/decision

maker should give due emphasis, both to shortterm and longterm impact of his decisions,
giving apt significance to the different time periods before reaching any decision. Short-
run refers to a time period in which some factors are fixed while others are variable.
The production can be increased by increasing the quantity of variable factors. While
longrun is a time period in which all factors of production can become variable. Entry
and exit of seller firms can take place easily. From consumers point of view, shortrun
refers to a period in which they respond to the changes in price, given the taste and
preferences of the consumers, while longrun is a time period in which the consumers
have enough time to respond to price changes by varying their tastes and
preferences.

5. Discounting Principle: According to this principle, if a decision affects costs

and revenues in longrun, all those costs and revenues must be discounted to present
values before valid comparison of alternatives is possible. This is essential because a
rupee worth of money at a future date is not worth a rupee today. Money actually
has time value. Discounting can be defined as a process used to transform future
dollars into an equivalent number of present dollars. For instance, $1 invested today at
10% interest is equivalent to
$1.10 next year.
t
FV = PV*(1+r)

49
 Where, FV is the future value (time at some future time), PV is the present
value (value at t0, r is the discount (interest) rate, and t is the time between the future
value and

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present value.

2.6.2 Application of Economics to Business decisions- Example

We have discussed above how economics can contribute to business

decision making. Business decision making is essentially a process of selecting the
best out of alternative opportunities open to the firm. The process of decision making
comprises four main phases:

a) Determining and defining the objective to be achieves;

b) Collections and analysis of business related data and other information

regarding economic, social, political and technological environment and
foreseeing the necessity and occasion for decision making;

c) Inventing, developing and analysing possible courses of action; and

d) Selecting a particular course of action, from the available alternatives.

This process of decision making is, however, not as simple as it appears to

be. Step (ii) and (iii) are crucial inbusiness decision making. These stepsput managers’
analytical ability to test and determine the appropriateness and validity of decisions in
the modern business world. Modern business conditions are changing so fast and
becoming so competitive and complex that personal sense, intuition and experience
alone may not prove sufficient to make appropriate business decisions.

2.6.3 Other Economic Principles Relevant to Managerial Decisions

Some other key economic principles that are relevant to managerial decisions
are:

1) Division of Labour

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

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
51
division of labor is one cause (arguably the main cause) of increasing returns to
scale.

5
2
 Virtuous Circles in Economic Growth: For Smith, a major consequence of
division of labour and resulting increasing productivitywas a “virtuous circle” of
continuing growth. Modern “virtuous circle” theories have more dimensions, but
division of labour and increasing returns to scale are among them.
2) Market Equilibrium
The market equilibrium model could be broken down into several principlesthe
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:
Elasticity and Revenue: These ideas are a key to understanding how market
changes transform society.
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.
Cobweb Adjustment: This might give the explanations when the market does
not move smoothly to equilibrium, but overshoots.
Competition vs. Monopoly: Why economists tend to think highly of
competition, and lowly of monopoly.
3) Diminishing Returns
Perhaps the bestknown of major economic principles, the Principle of
Diminishing Returns is much more reliable in shortrun than in longrun 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.
4) Game Equilibrium
Game theory allows strategy to be part of the story. One result is that we have to allow for

53
several kinds of equilibriums.

Non-cooperative equilibrium

(a) Prisoners’ Dilemma (dominant strategy) equilibrium

(b) Nash (best response) equilibrium, (but notall Nash equilibrium are dominant
strategy equilibrium),

Cooperative equilibrium

Oligopoly
5) Measurement Principles

Economics is multidimensional, and that creates some difficulties in

measuringthings like production, incomes, and price levels. Some of the problems can
be solved more or less fully.

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.

“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.

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.

6) 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.

7) Income-Expenditure Equilibrium

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4
Like the market equilibrium principle, but even more so, this model pulls
together

55
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 incomeconsumption 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

8) 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 “IncomeExpenditure
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 same way very often. This can lead to:

(a) Policy ineffectiveness

(b) Permanence

(c) Path Dependence.

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2.7 SUMMARY

Managerial economics is a science applied to decision making. It bridges the

gap between abstract theory and managerial practice. It concentrates more on the
method of reasoning. In short, managerial economics is “Economics applied in
decision making”. The primary function of management executive in a business
organisation is decision making and forward planning. Decision making and forward
planning go hand in hand with each other. Decision making means the process of
selecting one action from two or more alternative courses of action. Forward
planning means establishing plans for the future to carry out the decision so taken.
The problem of choice arises because resources at the disposal of a business unit
(Land, Labour, capital, and managerial capacity) are limited and the firm has to
make the most profitable use of these resources. The decision making function is that
of the business executive, he takes the decision which will ensure the most efficient
means of attaining a desired objective, say profit maximisation. After taking the
decision about the particular output, pricing, capital, rawmaterials and power etc., are
prepared. Forward planning and decisionmaking thus go on at the same time. A
business manager’s task is made difficult by the uncertainty which surrounds
business decisionmaking. Nobodycan predict the future course of business conditions.
He prepares the best possible plans for the future depending on past experience and
future outlook and yet he has to go on revising his plans in the light of new experience
to minimise the failure. Managers are thus engaged in a continuous process of decision-
making through an uncertain future and the overall problem confronting them is one
of adjusting to uncertainty.

2.8 SELFASSESSMENT QUESTIONS

1. What is economic theory? How it is different from managerial theory?

2. Explain the concept of managerial decision analysis?

57
5
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3. Discuss the principles followed in decision making.

4. Give the importance of managerial economics in business decision making.

2.8 SUGGESTED READINGS

 Dwivedi D.N., Managerial Economics, Vikas Publishing House, New Delhi.
 Mithani, D.M., Managerial EconomicsTheory&Application, Himalaya
Publishing House Pvt. Ltd., New Delhi.
 Shapiro Edward, Macro Economic Analysis, Tata McGraw Hill, New Delhi.
 Dingra, I.C., Managerial Economics, Sultan Chand, New Delhi.

59
 UNIT I

LESSON 3 MANAGERIAL ECONOMICS-A

POSITIVE OR NORMATIVE SCIENCE

STRUCTURE

3.1 INTRODUCTION

3.2 OBJECTIVE

3.3 METHODOLOGY OF ECONOMICS

3.4 GOALS OF ECONOMICS

3.5 MANAGERIAL ECONOMICS- POSITIVE OR NORMATIVE SCIENCE

3.6 IMPORTANCE OF ECONOMICS IN OUR LIFE

3.7 CENTRAL PROBLEMS OF AN ECONOMY

3.8 SUMMARY

3.9 SELF ASSESSMENT QUESTIONS

3.10 SUGGESTED READINGS

3.1 INTRODUCTION

We observe that there are different types of people or stakeholders who

use economics in different ways. For example, a practising economist or a policy
practitioner uses economic tools and information to make any suggestion or critical
analysis. Generally, such people use economic theories and tools for proper
understanding and specific forecasting of economic variables. It is because use of
economic sciences is generally for proper decision making and accuracy in economic
forecasting. Thus, positive statements are about facts. They state what the reality is. To
be specific, economics is strictly positive in character and is concerned with merely
positive statements. Since positive statements are about facts, any disagreement over
such statement or analysis can be handled properly only by use of facts and their
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0
analysis. Thus, positive economics is one that deals with the

61
real life situations or the facts or evidences. Any inferences are derived and
disputed based upon such facts and analysis only. Normative economics is based on
the normative statements. Normative statements are concerned with what are to
be? In this case, economics is not concerned with real life experiences rather, it is
concerned with, how things should operate. As against the positive economics, the
normative economics cannot be challenged based upon any fact. For example, if a
political leader projects his party’s vision in election that the unemployment rate should
be brought down to 2.0 per cent, this statement is not based upon any analysis or fact,
rather it is desire or the wish or the norm applied by the particular political party. Now,
if the political party comes to the power the policy maker must tune the system to
realise this target. Despite there being differences between positive economics and
normative economics, economics is a science having both positive and normative
aspects. It is more so because economics is a social science.
According to Ross D. Eckert and Richard H. Leftwich, (1988), “Economic
policy- making-conscious intervention in economic activity with the intent of altering
the course that it will take-is essentially normative in character. But if economic policy-
making is to be effective in improving economic well-being, it must obviously be rooted
in sound positive economic analysis. Policy-makers should be cognised of the full range
of consequences of the policies they recommend.” (“The Price System and Resource
Allocation”, New York, 10th edition, p. 10) According to Samuelson and Nordhaus,
(2000), positive and normative economics may be interpreted as under. “Positive
economics deals with questions such as: why do doctors earn more than janitors?
Does free trade raise or lower wages for most Americans? …Although these are
difficult questions to answer, they can all be resolved by reference to analysis and
empirical evidence. That puts them in the realm of positive economics.” “Normative
economics involves ethical precepts and norms of fairness. Should poor people be
required to work if they are to get government assistance? Should unemployment
be raised to ensure that price inflation does not become too rapid? … There are no
right or wrong answers to these questions because they involve ethics and values rather
than facts. They can be resolved only by political debate and decisions, not by
economic analysis alone.”
3.2 OBJECTIVES
The objectives of this lesson are to explain the:
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 Positive and Normative science of economics.

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  Inductive and deductive methods of economics.

3.3 METHODOLOGY OF ECONOMICS

Economics is also like a science but it is a social science. It deals mainly with
the human behaviour. Therefore, many economists argue that economics can not be as
precise a science as the natural sciences like physics, chemistry etc. The latter can be
studied in the laboratory conditions where variables can be easily controlled during
experiments. However, social sciences like economics cannot be easily controlled. Still
over a period of time economic sciences have gained maturity to develop its
methodologywhich is proving now to be quite efficient and such methodologies can be
used for efficient analysis of the economic relationships and predictions can be made
with sufficient accuracythat generate a sense of confidence and faith. There are two
broad methods used in the economic sciences.

1. The deductive method

2. The inductive method

1. The deductive method: This method involves going from general to particular.
Certain hypotheses or postulates regarding human behaviour are taken to be true and
then with the help of logical reasoning and examination, Nature and Scope of
Economics.

Here in this lesson we try to figure out the cause and effect relationship between
the factors under consideration. The following steps are involved in the deductive
method.

I. Firstly, a problem needs to be identified and then it should be properly

specified for the study.

II.The assumptions required in the study should be clear.Appropriate

assumptions are crucial in economic analysis.

III. After specifying the assumptions, hypotheses should be clearly framed.

The hypothesis formulation requires likely relationship among the different economic
variables.

IV. In the last phase, hypotheses should be tested through different tools
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like mathematical economics and econometrics.

V.Based on the above analysis proper inference needs to be derived for

specific

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economic decision making.

2. The inductive method: Although deductive method has strong points of merit to
depend upon, this methodology seems to suffer from certain weaknesses. Therefore,
economists belonging to the historical school and many other economists have favoured
the inductive or empirical method.

The method of induction involves going from particular to general. Here the appeal is
to facts, rather than reasoning and an attempt is made to arrive at conclusions
from the known facts of actual life. The inductive method required the following
steps:

I. The first step, as under the deductive method, is selecting and specifying
the problem that is to be studied.

II. The second step involves collection of data pertaining to the problem
selected for study.

III. The stage of collection is followed by classification and then analysis of

the data by appropriate statistical techniques.

IV. The fourth stage is that of ‘inference’, i.e. drawing conclusions from
the statistical analysis conducted. The conclusions are presented in the form of
economic generalisation.

3.4 ECONOMIC GOALS

Any science moves with certain goals to be achieved. Economics has

become now a crucial branch of knowledge. Being a social science it keeps on
revising its goals from time to time. The list might be quite large, but we would like to
focus only on certain major goals of economics as given under:

1. A low rate of unemployment: People willing to work should be able to find

jobs reasonably quickly. Widespread unemployment is demoralising and it
represents an economic waste. Society forgoes the goods and services that the
unemployed could have produced.

2. Price stability: It is desirable to avoid rapid increases-or decreases- in the

average level of price.
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3. Efficiency: When we work, we want to get as much as we reasonably can take out of

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 our productive efforts. For this, efficient technology becomes quite useful.

4. An equitable distribution of income: When many live in affluence, no group of

citizens should suffer stark poverty. Given this, developing countries are strategising
goals like participatory growth and inclusive growth.

5. Growth: Continuing growth, which would make possible an even higher standard
of living in the future, is generally considered an important objective.

6. Economic freedom and choice: Any economy should grow and develop in such
a manner that people should get more choices and there should not be any
outside pressure on their choices.

7. Economic welfare: Economic policies should be pursued in such a manner that

welfare of the people or the social benefits get maximised.

8. Sustainable development: It has become a major challenge for economists to

carry on the process of economic growth in such a manner that the resources are
optimally utilized not only for intergenerational equity but also for sustainable
development in quite long run.

3.5 MANAGERIAL ECONOMICS- A POSITIVE OR NORMATIVE

SCIENCE
Most of the managerial economists are of the opinion that managerial
economics is fundamentally normative and prescriptive in nature. It is concerned with
what decisions ought to be made. The application of managerial economics is
inseparable from consideration of values or norms, for it is always concerned with
the achievement of objectives or the optimisation of goals. In managerial
economics, we are interested in what should happen rather than what does happen.
Instead of explaining what a firm is doing, we explain what it should do to make its
decision effective.
Positive Economics:
A positive science is concerned with ‘what is’. Robbins regards economics as
a pure science of what is, which is not concerned with moral or ethical questions.
Economics is neutral between ends. The economist has no right to pass judgment on

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the wisdom or folly of the ends itself.

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 He is simply concerned with the problem of resources in relation to the
ends desired. The manufacture and sale of cigarettes and wine may be injurious to
health and therefore morally unjustifiable, but the economist has no right to pass
judgment on these since both satisfy human wants and involve economic activity.

Normative Economics:

Normative economics is concerned with describing what should be the things.

It is, therefore, also called prescriptive economics. What price for a product
should be fixed, what wage should be paid, how income should be distributed and so
on, fall within the purview of normative economics?

It should be noted that normative economics involves value judgments.Almost

all the leading managerial economists are of the opinion that managerial
economics is fundamentally normative and prescriptive in nature.

It refers mostly to what ought to be and cannot be neutral about the ends.
The application of managerial economics is inseparable from consideration of values, or
norms for it is always concerned with the achievement of objectives or the
optimisation of goals.

Managerial economists are generally preoccupied with the optimum allocation

of scarce resources among competing ends with a view to obtaining the maximum
benefit according to predetermined criteria.

To achieve these objectives they do not assume ceteris paribus, but try to
introduce policies. The very important aspect of managerial economics is that it tries to
find out the cause and effect relationship byfactual studyand logical reasoning. The scope
of managerial economics is so wide that it embraces almost all the problems and areas
of the manager and the firm.

3.6 IMPORTANCE OF ECONOMICS IN OUR LIFE

Economics is the study of how finite resources are consumed bydemand,

according to the costs imposed by their supply in relation to that demand. In other
words, economics tells us that a freeze in Florida that damages the orange crop will
cause the price of orange juice to change and how the price will modify demand
over time.
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Modern economic theory is said to have originated in “The Wealth of Nations,” a

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book written by Scottish scholar Adam Smith in 1776. The theory holds that rational
self interest pursued by individuals and businesses in a free market society leads to
optimal economic conditions.

The studyof economics helps formulate an understanding of the effects of

financial actions and reactions byindividuals and institutions. This understandingallows the
projection of future economic conditions based on current indications.

An understanding of economics assists governments in managing

macroeconomic conditions such as limiting a recession by inducing recovery. However,
economic theory is not foolproof because it is a social science based on the interplay
between culture and money. Economic effects change as cultural customs change.

3.7 CENTRAL PROBLEMS OF AN ECONOMY

Every economy faces some problems. These problems are associated with
growth, business cycles, unemployment and inflation. The macroeconomic theory is
designed to explain how supply and demand in the aggregate interact to concern
with these four problems. Economists these veryimportant national problems as
macroeconomic problems
- that is, as problems that could not be understood or solved without an understanding
of the workings of the economic system as a whole. The four distinctively
macroeconomic problems are:

1. Recession

2. Unemployment

3. Inflation

4. Economic Growth or Stagnation

A. Recessions, Depressions and Economic Fluctuations

The event that created modern macroeconomics was called “the Great
Depression,” but the general term for decreasing national production, in modern
economics, is a recession.

But why do economists regard a recession as a problem?

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 It is not self-evident that a drop in production is a bad thing. For example, it
might be that people want to enjoy more leisure, and spend less time producing
goods and

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services. If production dropped for that reason, we would have no reason to think of it
as an economic problem. But, in some periods of recession, we have evidence that this
was not what happened. In many recession periods, businesses that announced they
were hiring had long lines of people who wanted to apply, with many more people
than they could hire. This suggests that the people standing in line for a job had more
leisure than they wanted, and would have preferred jobs and income to buy more
goods and services. In the 1930’s, some people sold apples or pencils in the street
to get a little income, typically much less than they would have had in their old jobs.
Again, this suggests that people had too much leisure and would have preferred more
work and income. If this is so, then it seems that something was going wrong. In
different terms, it seemed that the recession had caused unemployment. Another
possibility is that production might drop because a war or disaster had destroyed
factories and other capital goods. But, in 1933, it seems very unlikely that the
productive capacity of the economy could have dropped by 30%. There had been no
war. And in fact, factories had been closed that could have been reopened and put to
work, at the same time as many people were looking for work. Perhaps these
circumstances show why the recession is regarded as a major economic problem.
B. Unemployment
Our second macroeconomic problem is unemployment. This problem is highly
correlated with recession, but is distinct, and we need to look at it in its own
terms. Unemployment occurs when a person is available to work and currently
seeking work, but the person is without work. The prevalence of unemployment is
usually measured using the unemployment rate, which is defined as the percentage
of those in the labour force who are unemployed.
Economists distinguish between various types of unemployment. For example,
cyclical, frictional, structural and classical, seasonal, hardcore and hidden. Real-
world unemployment may combine different types. The magnitude of each of these is
difficult to measure, partly because they overlap.
Unemployment is a status in which individuals are without job and are seeking
a job. It is one of the most pressing problems of any economy especially the
underdeveloped ones. This has macroeconomic implications too some of which are
discussed below:
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 Reduction in the Output: The unemployed workforce could be utilised for
the production of goods and services. Since they are not doing so, the economy is
losing out on its output.

Reduction in Tax Revenue: Since income tax is an important part of the

revenue for the government. The unemployed are unable to earn, the government loses
out on the income tax revenue.

Rise in the Government Expenditure: The government has to give

unemployment insurance benefits to the claimants. Hence the government will lose
from both sides in terms of unemployment benefits and loss of tax revenue.

C. Inflation

In economics, inflation is a rise in the general level of prices of goods and

services in an economy over a period of time. A rising price level – inflation- has the
following disadvantages:

1. It creates uncertainty, in that people do not know what the money they earn today
will buy tomorrow.

2. Uncertainty, in turn, discourages productive activity, saving and investing.

3. Inflation reduces the competitiveness of the country in international trade. If this is

not offset by a devaluation of the national currency against other currencies, it
makes the country’s exports less attractive, and makes imports into the country
more attractive, which in turn tends to create unbalance in trade.

4. Inflation is a hidden tax on “nominal balances.” That is, people who hold bonds
and bank accounts in dollars lose the value of those accounts when the price level
rises, just as if their money had been taxed away.

5. The inflation tax is capricious-some lose by it and some do not without any
good economic reason.

6. As the purchasing power of the monetary unit becomes less predictable, people
resort to other means to carry out their business, means which use up resources
and are inefficient.

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D. Economic Growth or Stagnation

Stagnation is a period of many years of slow growth of gross domestic product,

in which the growth is, on the average, slower than the potential growth in the
economy.

Causes of Stagnation

1. Population growth might high.

2. Fewer people might choose to work.

3. The growth of labour productivity might slow.

Stagnation is economic growth that, while positive, is less than the potential
growth of the economy. Some economists believe that stagnation is a serious problem
and a cause of other problems, but since identification of stagnation depends on
one’s idea of the potential, it remains controversial whether the slowing we see is
stagnation or a reduction of the potential.

3.8 SUMMARY

Traditional economic theory has developed along two lines; viz., normative
and positive. Normative focuses on prescriptive statements, and help establish rules
aimed at attaining the specified goals of business. Positive, on the other hand, focuses on
description it aims at describing the manner in which the economic system operates
without staffing how they should operate. The emphasis in business economics also
known as managerial economics is on normative theory. Business economics seeks to
establish rules which help business firms attain their goals, which indeed is also the
essence of the word normative. However, if the firms are to establish valid decision
rules, theymust thoroughly understand their environment. This requires the studyof
positive or descriptive theory. Thus, managerial economics combines the essentials of
the normative and positive economic theory, the emphasis being more on the
former than the latter.

3.9 SELFASSESSMENT QUESTIONS

1. What is meant by business environment? What branch of economics is

related to the environment issues of private business?
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2. What are basic functions of business managers? How does economics help
business managers in performing their functions?

3. Differentiate between positive economics and normative economics.

3.10 SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas Publishing house, New Delhi.
 Mishra, S.K., and Puri, V.K., Modern Macro Economic Theory,
Himalayan Publishing house.
 Edward Shapiro, Macro Economic Analysis, Tata McGraw Hill, New Delhi.
 Jhingam, M.L. & Stephen, J.K, Managerial Economics, Vrinda Publications
Pvt. Ltd. Delhi.
 Dingra, I.C., Managerial economics, Sultan Chand, New Delhi.

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 Unit-I
LESSON 4 APPROACHES TO MANAGERIAL

DECISIONS STRUCTURE
4.1 INTRODUCTION

4.2 OBJECTIVES

4.3 ROLE OF A MANAGERIAL ECONOMIST

4.4 RESPONSIBILITIES OF A MANAGERIAL ECONOMIST

4.5 TECHNIQUES OR APPROACHES TO MANAGERIAL DECISION

MAKING

4.5.1 Scientific Method

4.5.2 The Statistical Method

4.5.3 Method of Intellectual Experiment

4.5.4 Method of Simulation

4.5.5 Historical Method

4.5.6 DESCRIPTIVE METHOD

4.6 SUMMARY

4.7 SELF ASSESSMENT QUESTIONS

4.8 SUGGESTED READINGS

4.1 INTRODUCTION

Decision making is an essential part of planning. Decision making and

problem solving are used in all management functions, although usually they are
considered a part of the planning phase. Adiscussion of the origins of management
science leads into one on modeling, the five-step process of management science, and

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the process of engineering

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problem solving. Managerial decision making is the process of making a conscious
choice between two or more rational alternatives in order to select the one that will
produce the most desirable consequences (benefits) relative to unwanted
consequences (costs). If there is only one alternative, there is nothing to decide. In
this lesson, we consider the process of developing and evaluating alternatives and
selecting from among them the best alternative, and we review briefly some of the
tools of management science available to help us in this evaluation and selection. If
planning is truly “deciding in advance what to do, how to do it, when to do it, and who
is to do it” (as proposed by Amos and Sarchet1), then decision making is an
essential part of planning. Decision making is also required in designing and staffing
an organisation, developing methods of motivating subordinates, and identifying
corrective actions in the control process. However, it is conventionally studied as
part of the planning function, and it is discussed here.

4.2 OBJECTIVES

After reading this Lesson, you will be able:

• To discuss how decision making relates to planning.
• To explain the process of problem solving.
• To discuss the differences between decision making under certainty, risk,
and uncertainty.
• To describe decision-making techniques.

4.3 ROLE OFA MANAGERIAL ECONOMIST

With the advent of managerial revolution and transition from the owner-
manager to the professional executive, the managerial economists have occupied an
important place in modern business. In real practice, firms do not behave in a
deterministic world.

They strive to attain a multiplicity of objectives. Economic theory makes a

fundamental assumption of maximising profits as the basic objective of every firm.
The application of pure economic theory seldom leads us to direct executive
decisions.

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 Present business problems are either too obvious in their solution or
purely speculative and theyneed a special form of insight. Amanagerial economist with
his sound knowledge of theoryand analytical tools can find out solution to the
business problems. In

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advanced countries, big firms employ managerial economists to assist the management.

Organisationally, a managerial economist is placed nearer to the policy

maker simple because his main role is to improve the quality of policy making as it
affects short term operation and long range planning. He has a significant role to play
in assisting the management of a firm in decision making and forward planning byusing
specialised skills and techniques.

The factors which influence the business over a period are:

(i) External and (ii) Internal.

The external factors lie outside the control of the firm and these factors
constitute ‘Business Environment’. The internal factors lie within the scope and
operation of a firm and they are known as ‘Business Operations’.

1. External Factors

The prime dutyof a managerial economist is to make extensive studyof the

business environment and external factors affecting the firm’s interest, viz., the level and
growth of national income, influence of global economy on domestic economy, trade
cycle, volume of trade and nature of financial markets, etc. They are of great
significance since every business firm is affected by them.

These factors have to be thoroughly analysed by the managerial economist

and answers to the following questions have also to be found out:

(i) What are the current trends in the local, regional, national and international
economies? What phase of trade cycle is going to occur in the near future?

(ii) What about the change in the size of population and the resultant change in
regional purchasing power?

(iii) Is competition likely to increase or decrease with reference to the products

produced by the firm?

(iv) Are fashions, tastes and preferences undergoing any change and have they
affected the demand for the product?

(v) What about the availability of credit in the money and capital markets?
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(vi) Is there any change in the credit policy of the government?

(vii) What are the strategies of five year plan? Is there any special emphasis for
industrial promotion?

(viii) What will be the outlook of the government regarding its commercial and
economic policies?

(ix) Will the international market expand or contract and what are the provisions
given by the trade organisations?

(x) What are the regulatory and promotional policies of the central bank of a country?

Answer to these and similar questions will throw more light on the
perspective business and these questions present some of the areas where a managerial
economist can make effective contributions through scientific decision making. He
infuses objectivity, broad perspective and concept of alternatives into decision
making process.

His focus on long term trends helps maximise profits and ensures the
ultimate success of the firm. The role of the managerial economist is not to take
decisions but to analyse, conclude and recommend. His basic role is to provide
quantitative base for decision making. He should concentrate on the economic aspects
of problems. He should have a rare intuitive ability of perception.

2. Internal Factors

The managerial economist can help the management in making decision

regarding the internal operations of a firm in respect of such problems as cost structure,
forecasting of demand, price, investment, etc.

Some of the important relevant questions in this connection are as follows:

(i) What should be the production schedule for the coming year?

(ii) What should be the profit budget for the coming year?

(iii) What type of technology should be adopted in the specific process and specify it?

(iv) What strategies have to be adopted for sales promotion, inventory control
and utilisation of manpower?
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(v) What are the factors influencing the input cost?

(vi) How different input components can be combined to minimise the cost of production?

Apart from the above studies, the managerial economist has to perform
certain specific functions. He helps to co-ordinate practices relating to production,
investment, price, sales and inventory schedules of the firm. Forecasting is the
fundamental activity which consumes most of the time of the managerial
economist.

The sales forecast acts as a link between the external uncontrollable factors
and the internal controllable factors and are intimately related to general economic
activity. The managerial economist is usually assigned the task of preparing short term
general economic and specific market forecasts to provide a framework for the
development of sales and profit. He has to help the firm to plan product
improvement, new product policy, and pricing and sales promotion strategy.

The managerial economist often needs focused studies of specific problems

and opportunities. He should indulge in market survey, a product preference test, an
advertising effectiveness studyand marketing research. Marketing research is undertaken to
understand a marketing problem better.

The managerial economist has to undertake an economic analysis of

competing firms. He should also under-take investment appraisal, project evaluation
and feasibility study. It is the duty of the managerial economist to provide
necessary intelligence.

To conclude, a managerial economist has a very important role to play. He

should be held in the confidence of the management. A managerial economist can
serve the management best only if he always keeps in mind the main objective of his
firm, which is to make a profit.

4.4 RESPONSIBILITIES OFA MANAGERIAL ECONOMIST

The managerial economist can play a very important role byassisting

management in using the increasingly specialised skills and sophisticated techniques
which are required to solve the different problems of successful decision making and
forward planning.
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 The functions of a managerial economist can be broadly defined as the study
and interpretation of economic data in the light of the problems of the
management. The

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managerial economist should be in a position to spare more time and thought on
problems of an economic nature than the firm’s administration. His job may involve a
number of routine duties closely tied in with the firm’s day to day activities.

The managerial economist is employed primarilyas a general adviser. The

advisory service refers to the opportunities open to the managerial economist because of
the growing role of government in business life. He is responsible for the working of the
whole business concern. The most important obligations of a managerial economist is
that his objective must coincide with that of the business. Traditionally, the basic
objective of business has been defined in terms of profit maximisation.

As a managerial economist, he must do something more than routine

management to earn profit. He cannot expect to succeed in serving management unless
he has a strong conviction which helps him in enhancing the ability of the firm. The
other most important responsibility of a managerial economist is to try to make as
accurate forecast as possible. The managerial economist has to forecast not only the
various components of the external business picture, but he has also to forecast the
various phases of company’s activity, that is the internal picture of the company.

The managerial economist should recognise his responsibilities to make

successful forecast. By making the best possible forecasts, the management can follow a
more closely course of business planning. Yet another responsibility of the managerial
economist is to bring about a synthesis of policies pertaining to production, investment,
inventories, price and cost. Production is an organised activity of transforming inputs into
output. The process of production adds to the values or creation of utilities. The money
expenses incurred in the process of production constitute the cost of production. Cost
of production provides the floor, to pricing. It provides a basis for managerial
decision.

There are several areas which have attracted the attention of the
managerial economist, such as maximising profit, reducing stocks, forecasting sales, etc.
If the inventory level is very low, it hampers production. A managerial economist’s
first responsibility, therefore, is to reduce his stocks, for a great deal of capital is
unprofitably tied up in the inventory. The managerial economist’s contribution will be
adequate only when he is a member of full status in the business team. The managerial

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economist should make use of his experience and facts in deciding the nature of
action.

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 He should be ready to undertake special assignments with full seriousness. The
managerial economist can put even the most sophisticated ideas in simple language
and avoid hard technical terms. It is also the managerial economist’s responsibility to
alert the management at the earliest possible moment in case he discovers an error in
his forecast. By this way, he can assist the management in adopting appropriate
adjustment in policies and programmes. He must be alert to new developments both
economic and political in order to appraise their possible effects on business. The
managerial economist should establish and maintain many contacts and data sources
which would not be immedi-ately available to the other members of management. For
this purpose, he should join professional and trade associations and take an active part
in them.

To conclude, a managerial economist should enlarge the area of certainty.

To discharge his role successfully, he must recognise his responsibilities and
obligations. No one can denythat the managerial economist contributes significantly to
the profitable growth of the firm through his realistic attitude.

4.5 TECHNIQUES OR APPROACHES TO MANAGERIAL DECISION

MAKING

Six most important methods used by managerial economics to explain and

solve business problems of a firm are:

4.5.1 SCIENTIFIC METHOD

Scientific method is a branch of study which is concerned with observed

facts systematically classified and which includes trustworthymethod for the discoveryof
truths. It refers to a procedure or mode of investigation by which scientific and
systematic knowledge is acquired.

The method of enquiry is a very important aspect of science, perhaps this is

the most significant feature. Scientific method alone can bring about confidence in the
validity of conclusions. It concentrates on controlled experiments and investigates the
behaviour of preconceived elements in a highly simplified environment.

The experimental method may be usefully applied to those aspects of

managerial behaviour which call for accurate and logical thinking. The experimental

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methods are of limited use to managerial economics. Amanagerial economist cannot
apply experimental

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methods to the same extent and in the same way as a physicist can in physical
sciences.

We usually adopt an inductive as well as deductive approach in any analysis

of managerial behaviour. The deductive method begins with postulates and hypotheses
which are arbitrary. For the rationalists, there stands at the head of the system, a
set of self- evident propositions and it is from these that other propositions (theorems)
are derived by the process of reasoning.

At the other end are inductionist (empiricists) who believe that science
must construct its axioms from the same data and particularly by ascending
continually and gradually till it finally arrives at the most general axioms.

It is often asked what the method of science is, whether induction or

deduction? The proper answer to this is, both. Both the methods are
interdependent and hold an equally important place in any scientific analysis.

4.5.2 THE STATISTICAL METHOD

Statistical methods are a mechanical process especially designed to facilitate

the condensation and analysis of the large body of quantitative data. The aim of
statistical method is to facilitate comparison, studyrelationships between the two
phenomena and to interpret the complicated data for the purpose of analysis.

Many a time comparison has to be made between the changes and results
which are due to changes in time, frequency of occurrence, and many other factors.
Statistical methods are used for such comparison among past, present and future
estimates.

For example, such methods as extrapolation can be applied for the purpose
of making future forecast about the trends of say, demand and supplyof a particular
commodity. The statistical method of drawing inference is mathematical in nature. It not
onlyestablishes causal connection between two variables but also tries to establish a
mathematical relation-ship between them.

Statistical approach is a quantitative micro-approach. Certain important

correlation and association of attributes can be found with the help of statistics. It is
useful for the study of manage-ment, economics, etc. and it is very helpful to bankers,
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state, planners, speculators, researchers, etc.

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 Though statistical methods are the handmaid of managerial economics,
theyshould be used with care. The most significant peculiarity of the statistical method
is that it helps us to seek regularities or patterns in economic data and permits us to arrive
at generalisations that cannot be reached by any other method.
4.5.3 METHOD OF INTELLECTUAL EXPERIMENT
The fundamental problem in managerial economics is to find out the nature of
any relationship between different variables such as cost, price and output. The real
world is also invariably complex. It is influenced by many factors such as
physical, social, temperamental and psychological. It is difficult to locate any order,
sequence or law in such a confused and complex structure. In this context, it is
essential for the managerial economist to engage in model building.
At times, to analyse behaviour we use models. A model is an abstraction
from reality. A model may be in the form of diagram, a verbal description or a
mathematical description. It can be classified into three categories such as iconic,
analogue and symbolic.
Managerial economics may be viewed as economics applied to problem
solving at the level of the firm. The problems relate to choices and allocation of
resources is faced by managers all the time. Managerial economics is more concrete
and situational and mainly concerned with purposefully managed process of
allocation. For this purpose the managerial economist can and does use an abstract
model of the enterprise.
Models are approximate representations of reality. They help us in
understanding the underlyingforces of the complex world of reality through
approximation. Model building is more useful in mana-gerial economics, as it helps us to
know the actual socio-economic relationship prevailing in a firm.
Firms have onlylimited resources at their disposal which they must utilise to
make profit. The managers of these firms must make judgements about the disposition
of their resources and decide which priorities among the various competing claims they
have upon them. Models can guide business executives to predict the future
consequences.

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4.5.4 METHOD OF SIMULATION
It is an extension of the intellectual experiment. This method has gained
popularity with the development of electronic computers, calculators and other
similar equipment

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and internet services. We can programme a complex system of relationship with the
help of this method. Computer is not only used for scientific or mathematical
applications, it may also be used for some business applications, document
generations and graphical solutions. Computer is a fast electronic calculating
machine capable of absorbing, processing, integrating, relating and producing the
resultant output information within a short span of time.

A manager has to take numerous decisions in the management of business

which may be minor or major, simple or complex. They have to ensure that once the
decision is taken, it is to be implemented within the minimum time and cost. The
electronic gadgets will enable the manager to understand business problems in a better
perspective and increase his ability to solve the business problems facing him in the
management of business.

4.5.5 HISTORICAL METHOD

Past knowledge is considered to be a pre-requisite for present knowledge. This

is the main argument for the adoption of historical method in the present day
managerial economics. In order to discover some basis for business activity, the
method becomes generic in character.

The main objective of this method is to applymind in the matter of various

business problems by discovering the past trend regarding facts, events and
attitudes and by demarcating the lines of development of thought and action. If we
have an idea of the past events, we can understand the current economic problems
much better. The wisdom of a particular economic policy is an inevitable product of
its past.

The historical method requires experience not only in collecting data but also
in finding out their relations and significance in the particular context. The managerial
economist must take up the analytical view in order to get perfect control over facts and
the synthetic view of facts.

He should be able to find out the relations between events and events and
between events and environment. It is necessary to make an objective approach both in
discovering facts and interpreting them. But in order to be objective, the approach
must be based on relevant, adequate and reliable data.
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For applying historical method, the managerial economist should be familiar
with

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the general field of his topic and be clear with regard to his own objective. Agood deal of
imagination is required to apply the historical method.
4.5.6 DESCRIPTIVE METHOD
The descriptive method is simple and easilyapplicable to various business
problems, particularly in developing countries. It is a fact finding approach related
mainly to the present and abstract generalisations through the cross sectional studyof
the present situation.
This method is mainly concerned with the collection of data. To some extent,
the descriptive method is also concerned with the interpretation of data. In order to
apply the descriptive method, the data should be accurate and objective and if possible
quantifiable.
Since the descriptive method wants to relate causality of the collected facts, it
is necessary for it to make comparisons between one situation with the other and
among different aspects of the same situation. Thus, situational comparability is an
essential element of this method.
This method is used to describe the organisation and functioning of institutions
and the policies which have economic significance. To analyse the impact of the
organisational structure in the working of business enterprises, it is widely used by
the managerial economist.
The best descriptive studies are observational in nature. This method provides
the empirical and logical basis for drawing conclusions and gaining knowledge. Thus it
enables the managerial economists to describe or present the picture of a phenomenon or
phenomena under investigation.
4.6 SUMMARY
Managerial Economics is a discipline that combines economic theory with
managerial practice. Managerial Economics bridge the gap between the problems of
logic that intrigue economic theorist and problems of policy that plague practical
managers. Managerial economics enriches the analytical skill, helps in logical
structuring of problems and provides adequate solutions to the economic problems.
The study of it helps in all direction of managerial decision making process to
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execute business efficiently and effectively.

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 Managerial economics leverages economic concepts and decision science
techniques to solve managerial problems. It provides optimal solutions tomanagerial
decision making issues. Business firms are a combination of manpower, financial,
and physical resources which help in making managerial decisions. Societies can be
classified into two main categories - production and consumption. Firms are the
economic entities and are on the production side, whereas consumers are on the
consumption side.

The performances of firms get analysed in the framework of an economic

model. The economic model of a firm is called the theory of the firm. Business
decisions include many vital decisions like whether a firm should undertake
research and development program, should a company launch a new product, etc.
Business decisions made by the managers are veryimportant for the success and failure
of a firm. Complexityin the business world continuously grows making the role of a
manager or a decision maker of an organisation more challenging. The impact of
goods production, marketing, and technological changes highly contribute to the
complexity of the business environment.

4.7 SELFASSESSMENT QUESTIONS

1. Critically evaluate micro economics. How micro economics is helpful in

taking business decisions?

2. Determine strategies a manager can use to create a more effective decision

making environment ?

3. Identify the factors that influence decision-making?

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4.8 SUGGESTED READINGS
 Managerial economics, Dwivedi D.N., Vikas Publishing House, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Mithani, D.M., Managerial Economics-Theory&Application, Himalaya
Publishing House Pvt. Ltd., New Delhi.

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 UNIT- II
LESSON 5 DEMAND ANALYSIS

STRUCTURE

5.1 INTRODUCTION

5.2 OBJECTIVES

5.3 MEANING OF DEMAND

5.3.1 Types of Demand

5.4 FEATURES OF A DEMAND

5.5 DETERMINANTS OF DEMAND

5.6 EXCEPTIONS TO THE LAW OF DEMAND

5.7 ELASTICITY OF DEMAND

5.8 SUMMARY

5.9 SELF ASSESSMENT QUESTIONS

5.10 SUGGESTED READINGS

5.1 INTRODUCTION

The concepts of demand and supply are useful for explaining what is happening
in the market place. Every market transaction involves an exchange and many
exchanges are undertaken in a single day. Amarket is a place where we buy and sell
goods and services. A buyer demands goods and services from the market and the
sellers supply the goods in the market. This chapter describes demand which is the
driving force behind a market economy. In Economics, use of the word ‘demand’
is made to show the relationship between the prices of a commodity and the amounts
of the commodity which consumers want to purchase at those prices. Demand is one
of the forces determining price. The theory of demand is related to the economic

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activities of a consumer, called consumption.

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The process through which a consumer obtains the goods and services he wants to
consume is known as demand. Demand is one of the most important managerial
factors because it assists the managers in predicting changes in production and input
prices. The manager can take better decisions regarding the kind of product to be
produced, the quantity, the cost of the product and its selling price. Let us understand
the concept of demand and its importance in decision making.

5.2 OBJECTIVES

The objectives of this chapter is:

 To understand the general theory of demand.
 To know about the various types of demand.
 To know about the factors affecting demand of a product.

5.3 DEFINITION OF DEMAND

An economic principle that describes a consumer’s desire and willingness to

pay a price for a specific good or service. Holding all other factors constant, the
price of a good or service increases as its demand increases and vice versa.
Demand means the ability and willingness to buy a specific quantity of a commodity at
the prevailing price in a given period of time. Therefore, demand for a commodity
implies the desire to acquire it, willingness and the ability to pay for it.

According to Prof. Hibdon, “Demand means the various quantities of goods

that would be purchased per time period at different prices in a given market.” Thus,
three things are necessary for demand to exist; (1) the price of a commodity (2) the
amount of the commodity the consumer or consumers are prepared to buy per unit
of time; (3) a given time. Similarly, Benham wrote down, “The demand for anything
at a given price is the amount of it which will be bought per unit of time at that
price.”

5.3.1 Types of Demand

There are eight demand states and their details given below:

1. Negative Demand: Product is disliked in general. The product might be

beneficial but the customer does not want it.
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 For example: for dental care, and others have a negative demand for air travel.

2. No demand: Target consumers may be unaware and uninterested about

the product. For examples: Farmers may be not interested in new farming
method. College students may not be interested in foreign language course.

3. Latent demand: Consumers may share a strong need that cannot be satisfied
by any existing product. For examples: Harmless cigarette, safer neighborhood,
more fuel efficient car.

4. Declining demand: When the demand of the product or service becomes

lower. For examples private colleges have seen application falls.

5. Irregular demand: Demand varies on a seasonal, daily and hourly basis.

For examples: Museums are under visited in week days and overcrowded on
week days.

6. Full demand: When the organisation is pleased with their volume of

business. For example, Ideal Situation where supply is equal to demand.

7. Overfull demand: Demand level is higher that the organisation can and want
to handle. For example, national park is terribly overcrowded in the
summer.

8. Unwholesome demand: Those kinds of demands, not acceptable by the

society. For example Cigarettes, hard drinks, alcohol.

5.4 FEATURES OF DEMAND

a) Difference between desire and demand. Demand is the amount of a

commodity for which a consumer has the willingness and the ability to buy.
There is difference between need and demand. Demand is not only the need, it
also implies that the consumer has the money to purchase it.

b) Relationship between demand and price. Demand is always at a price.

Unless price is stated, the amount demanded has no meaning. The consumer
must know both the price and the commodity and he will tell his amount
demanded.

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c) Demand at a point of time. The amount demanded must refer to some
period of time such as 10 quintals of wheat per year or six shirts per year or
five kilos of

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 sugar per month. Not only this, the amount demanded and the price must
refer to a particular date.

5.5 DETERMINANTS OF DEMAND

The demand for a product is determined by a large number of factors. It would

be impossible to include all possible determinants of demand in any study. Therefore, a
few factors which underlie the demand for most of the products can be easily spotted.
These factors are price of the commodity, incomes of the buyers’ of the commodity,
prices of related goods, advertising and sales promotion. These factors are found to have
a substantial influence on the sales of a commodity. These are expressed and
measured in various ways. In demand studies, these constitute the controlling
variables. The importance of each determinant varies from product to product. As
such the demand for a particular product has to be analysed only after the
importance of each determinant is specified. Some of these factors are within a
firm’s control, others may not be so. For example, a firm can change the price of the
commodity, its promotional expenditure, quality of the product and sales conditions.
Let us discuss all these determinants in brief:

i. Price of the Commodity- The most important factor affecting amount

demanded is the price of the commodity. The amount of a commoditydemanded
at a particular price is more properly called price demand. The relation between
price and demand is called the Law of Demand. It is not only the existing price
but also the expected changes in price which affect demand.

ii. Income of the Consumer- The second most important factor influencing
demand is consumer income. In fact, we can establish a relation between the
consumer income and the demand at different levels of income, price andother
things remaining the same. The demand for a normal commodity goes up when
income rises and falls down when income falls. But in case of Giffen goods
the relationship is the opposite.

iii. Prices of related goods. The demand for a commodity is also affected by
the changes in prices of the related goods also. Related goods can be of two
types:
(1) Substitutes which can replace each other in use; for example, tea and coffee
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are substitutes. The change in price of a substitute has effect on a
commodity’s demand in the same direction in which price changes. The rise
in price of coffee

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 shall raise the demand for tea; (2) Complementary goods are those which
are jointly demanded, such as pen and ink. In such cases complementary
goods have opposite relationship between price of one commodity and the
amount demanded for the other. If the price of pens goes up, their demand is
less as a result of which the demand for ink is also less. The price and the
demand go in opposite direction. The effect of changes in price of a
commodity on amounts demanded of related commodities is called Cross
Demand.

iv. Tastes of the Consumers- The amount demanded also depends on

consumer’s taste. Tastes include fashion, habit, customs, etc. Aconsumer’” taste
is also affected by advertisement. If the taste for a commodity goes up” its
amount demanded is more even at the same price. This is called increase in
demand. The opposite is called decrease in demand.

v. Wealth- The amount demanded of a commodity is also affected by the amount

of wealth as well as its distribution. The wealthier are the people higher is the
demand for normal commodities. If wealth is more equally distributed, the
demand for necessaries and comforts is more. On the other hand, if some
people are rich, while the majorities are poor, the demand for luxuries is
generally higher.

vi. Population- Increase in population increases demand for necessaries of life.

The composition of population also affects demand. Composition of population
means the proportion of young and old and children as well as the ratio of men
to women. A change in composition of population has an effect on the nature
of demand for different commodities.

vii. Government Policy- Government policy affects the demands for

commodities through taxation. Taxing a commodity increases its price and
the demand goes down. Similarly, financial help from the government
increases the demand for a commodity while lowering its price.

5.6 EXCEPTIONAL DEMAND CURVE

The demand curve slopes from left to right upward if despite the increase in
price of the commodity, people tend to buy more due to reasons like fear of shortages
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or it may be an absolutely essential good. The law of demand does not apply in
every case and

109
situation. The circumstances when the law of demand becomes ineffective are known as
exceptions of the law. Some of these important exceptions are as under.
1. Giffen Goods:
Some special varieties of inferior goods are termed as Giffen goods.
Cheaper varieties millets like bajra, cheaper vegetables like potato etc come under this
category. Sir Robert Giffen of Ireland first observed that people used to spend more of
their income on inferior goods like potato and less of their income on meat. After
purchasing potato the staple food, they did not have staple food potato surplus to buy
meat. So the rise in price of potato compelled people to buy more potato and thus
raised the demand for potato. This is against the law of demand. This is also known
as Giffen paradox.
2. Conspicuous Consumption / Veblen Effect:
This exception to the law of demand is associated with the doctrine
propounded by Thorsten Veblen. Afew goods like diamonds etc are purchased by the
rich and wealthy sections of society. The prices of these goods are so high that they are
beyond the reach of the common man. The higher the price of the diamond, the higher
its prestige value. So when price of these goods falls, the consumers think that the
prestige value of these goods comes down. So quantity demanded of these goods falls
with fall in their price. So the law of demand does not hold good here.
3. Conspicuous Necessities:
Certain things become the necessities of modern life. So we have to
purchase them despite their high price. The demand for T.V. sets, automobiles and
refrigerators etc. has not gone down in spite of the increase in their price. These
things have become the symbol of status. So they are purchased despite their rising
price.
4. Ignorance:
A consumer’s ignorance is another factor that at times induces him to
purchase more of the commodityat a higher price. This is especially true, when the
consumer believes that a high-priced and branded commodity is better in quality than
a low-priced one.
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5. Emergencies:
During emergencies like war, famine etc, households behave in an abnormal way.

111
Households accentuate scarcities and induce further price rise by making increased
purchases even at higher prices because of the apprehension that they maynot be
available.
. On the other hand during depression, , fall in prices is not a sufficient condition
for consumers to demand more if they are needed.

6. Future Changes in Prices:

Households also act as speculators. When the prices are rising households tend
to purchase large quantities of the commodity out of the apprehension that prices may
still go up. When prices are expected to fall further, they wait to buy goods in future at
still lower prices. So quantity demanded falls when prices are falling.

7. Change In Fashion:

Achange in fashion and tastes affects the market for a commodity. When a
digital camera replaces a normal manual camera, no amount of reduction in the price of
the latter is sufficient to clear the stocks. Digital cameras on the other hand, will have
more customers even though its price may be going up. The law of demand
becomes ineffective.

8. Demonstration Effect:

It refers to a tendency of low income groups to imitate the consumption pattern

of high income groups. They will buy a commodity to imitate the consumption of
their neighbours even if they do not have the purchasing power.

9. Snob Effect:

Some buyers have a desire to own unusual or unique products to show that
they are different from others. In this situation even when the price rises the demand
for the commodity will be more.

10. Speculative Goods/ Outdated Goods/ Seasonal Goods:

Speculative goods such as shares do not follow the law of demand. Whenever
the prices rise, the traders expect the prices to rise further so they buy more. Goods
that go out of use due to advancement in the underlying technology are called
outdated goods. The demand for such goods does not rise even with fall in prices
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11. Seasonal Goods:

Goods which are not used during the off-season (seasonal goods) will also
be subject to similar demand behaviour.

12. Goods in Short Supply:

Goods that are available in limited quantity or whose future availability is

uncertain also violate the law of demand.

5.7 ELASTICITY OF DEMAND

In economics, the term elasticity means a proportionate (percentage) change

in one variable relative to a proportionate (percentage) change in another variable. The
quantity demanded of a good is affected by changes in the price of the good, changes
in price of other goods, changes in income and changes in other factors. Elasticity is a
measure of just how much of the quantity demanded will be affected due to a change
in price or income. Elasticity of Demand is a technical term used by economists to
describe the degree of responsiveness of the demand for a commodity due to a fall in
its price. Afall in price leads to an increase in quantity demanded and vice versa.

5.7 SUMMARY

Demand is one of the forces determining price. The theory of demand is related
to the economic activities of a consumer, called consumption. The process through
which a consumer obtains the goods and services he wants to consume is known as
demand. In Economics, use of the word ‘demand’ is made to show the
relationship between the prices of a commodity and the amounts of the
commodity which consumers want to purchase at those prices.

The demand for a product is determined by a large number of factors, viz.,

price, income, prices of related goods, tastes, preferences, population etc. There is an
inverse relationship between the price of a commodity and the amount demanded.

In Economics, this relationship is known as the Law of Demand. The

demand curve is negatively sloped just because of law of diminishing marginal utility,
substitution effect, different uses of the commodity, and because of income effect.

As we know that the demand curve is negatively sloped form left to right, but in
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some cases it is positively sloped like in case of inferior or giffen goods, expecting rise
or fall in the prices of goods in future, due to ignorance of consumers etc.

Law of demand is important to determine price of a product, budget fixing

by finance minister, How far a good shall or bad crop affect the economic condition of
the farmer can be known from the Law of Demand and also in planning for
individual commodities and industries.

5.8 SELFASSESSMENT QUESTIONS

1. Explain the general theory of Demand?

2. What are various factors an individual should consider while making a

demand of a product?

3. Explain features/characteristics of demand?

5.9 SUGGESTED READINGS

 Business Economics, Chopra P.N., Kalyani Publishers, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.

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 UNIT-II
LESSON 6 MARKET DEMAND

ANALYSIS STRUCTURE
6.1 INTRODUCTION

6.2 OBJECTIVE

6.3 MEANING OF MARKET DEMAND

6.3.1 Definition

6.3.2 Market demand Curve

6.3.3 Difference between Demand and Desire

6.4 DETERMINANTS OF MARKET DEMAND

6.5 FACTORS AFFECTING MARKET DEMAND

6.6 DIFFERENCE BETWEEN INDIVIDUAL DEMAND AND MARKET

DEMAND

6.7 SUMMARY

6.8 SELF ASSESSMENT QUESTIONS

6.9 SUGGESTED READING

6.1 INTRODUCTION

Demand for a good is defined as the quantity of the good purchased at a

given price at given time.

Thus the definition of demand includes three components

(a) Price of the commodity

(b) Quantity of the commodity bought

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 (c) Time period.

Note that time period may vary. This can be week, month, year etc.

6.2 OBJECTIVES

The objectives of this lesson are:

 To explain the concept of market demand

 To explain the factors and determinants affecting market demand

6.3 MEANING OF MARKET DEMAND

The aggregate of the demands of all potential customers (market participants)

for a specific product over a specific period in a specific market is called as market
demand of a particular good.

6.3.1 Definition

The total demand for a product or service in the market as a whole.

Market demand is calculated to determine at what level to set production output for
a good or service, and to help to determine optimal pricing levels to maximise sales
revenues.

6.3.2 Market Demand Curve

A graph that shows the amount of a good or service that consumers purchase
on the X axis at a range of pricing levels that are plotted on the Y axis. The market
demand curve for a good or service provided by a business can be combined with
its market supply curve to determine the product’s equilibrium price that is located
where the two curves cross.

6.3.3 Difference between Demand and Desire

On many occasions people confuse between desire and demand and use
them interchangeably. In fact these are two different terms. Demand is desire backed
by ability to purchase. This means that if somebody desires to have a good, he/she can
demand it if he/she has the money to purchase it by paying its price. Anyone can
desire any good or service. But just by desiring something, one cannot have it without
paying the price. Once the price is paid by the person who has desired it, only then it
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becomes the demand for the

117
good by that person. Take the example given above once again- “Varsha purchased 2
kg of mangoes at Rs. 50 per kg last week.” This is the demand for mangoes by
Varsha. Had Varsha desired to have mangoes but could not pay the price to buy,
then it would have been said as Varsha’s desire but not demand for mangoes.

6.4 DETERMINANTS OF MARKET DEMAND

Demand schedule and law of demand state the relationship between price
and quantity demanded byassuming “other things remaining the same “. When there is a
change in these other things, the whole demand sched-ule or demand curve undergoes
a change. In other words, these other things determine the position and level of the
demand curve. If these other things or the determinants of demand change, the whole
demand schedule or the demand curve will change. As a result of the changes in these
determinants, a demand curve will shift above or below as the case may be.

The following are the determinants of market demand for goods:

1. Tastes and Preferences of the Consumers:

An important factor which determines demand for a good is the tastes and
preferences of the consumers for it. Agood for which consumers’ tastes and
preferences are greater, its demand would be large and its demand curve will lie at
a higher level.

People’s tastes and preferences for various goods often change and as a
result there is change in demand for them. The changes in demand for various goods
occur due to the changes in fashion and also due to the pressure of advertisements bythe
manufacturers and sellers of different prod-ucts.

For example, a few years back when Coca Cola plant was established in
New Delhi demand for it was very small. But now people’s taste for Coca Cola has
undergone a change and become favour-able to it because of large advertisement and
publicity done for it. The result of this is that the demand for Coca-Cola has
increased very much. In economics we would say that the demand curve For Coca
Cola has shifted upward. On the contrary when any good goes out of fashion or
people’s tastes and preferences no longer remain favourable to it the demand for it
decreases. In economics we say that the demand curve for these goods will shift
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downward.

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2. Changes in the Prices of the Related Goods:

The demand for a good is also affected by the prices of other goods,
especially those which are related to it as substitutes or complements. When we
draw a demand schedule or a demand curve for a good we take the prices of the related
goods as remaining constant. Therefore, when the prices of the related goods,
substitutes or complements, change the whole demand curve would change its position;
it will shift upward or downward as the case may be. When price of a substitute for a
good falls, the demand for that good will decline and when the price of the substitute
rises, the demand for that good will increase.

For example, when price of the tea as well as the incomes of the people
remains the same but price of the coffee falls, the consumers would demand less of tea
than before. Tea and coffee are very close substitutes, therefore when coffee
becomes cheaper, the consumers substitute coffee for tea and as a result the demand
for tea declines. The goods which are complementary with each other, the change in
the price of any of them would affect the demand of the other. For instance, if price of
the milk falls, the demand for sugar would also be affected. When people would
take more milk or would prepare more khoya, burfi, rasgullas with milk; the demand
for sugar will also increase. Likewise, when price of cars falls, the demand for them will
increase which in turn will increase the demand for petrol Cars and petrol are
complementary with each other.

3. The Number of Consumers in the Market:

We have already explained that the market demand for a good is obtained
by adding up the individual demands of the present as well as pro-spective
consumers or buyers of a good at various possible prices. The greater the number
of consumers of a good, the greater the market demand for it. Now, the question
arises on what factors the number of consumers of a good depends. If the consumers
substitute one good for another, then the number of consumers of that good which has
been substituted by the other will decline and for the good which has been used in its
place, the number of consumers will increase.

Besides, when the seller of a good succeeds in finding out new markets for
his good and as a result the market for his good expands the number of consumers
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of that good will increase. Another Important cause for the increase in the number of
consumers is the growth in population. For instance, in India the demand for many
essential goods,

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especially food-grains, has increased because of the increase in the popu-lation of the
country and the resultant increase in the number of consumers for them.

4. Changes in Propensity to Consume:

People’s propensity to consume also affects the de-mand for them. The income
of the people remaining constant, if their propensity to consume rises, then out of the
given income they would spend a greater part of it with the result that the demand for
goods will increase.

On the other hand, if propensityto save of the people increases, that is, if
propensity to consume declines, then the consumers would spend a smaller part of
their income on goods with the result that the demand for goods will decrease. It is
thus clear that with income remaining constant, change in propensity to consume of the
people will bring about a change in the demand for goods. Similarly, when the
consumers hope that in the future they will have good income, then in the present
theywill spend greater part of their incomes with the result that their present demand
for goods will increase.

5. Income Distribution:

Distribution of income in a society also affects the demand for goods. If

distribution of income is more equal, then the propensity to consume of the society as a
whole will be relatively high which means greater demand for goods. On the other hand,
if distribution of income is more unequal, then propensity to consume of the society
will be relatively less, for the propensity to consume of the rich people is less than
that of the poor people.

Consequentlywith more unequal distribution of income, the demand for

consumer goods will be comparatively less. This is the effect of the income
distribution on the propensity to consume and demand for goods. But the change in the
distribution of income in the society would affect the demand for various goods
differently. If progressive taxes are levied on the rich people and the money so collected
is spent on providing employment to the poor people, the distribution of income
would become more equal and with this there would be a transfer of purchasing
power from the rich to the poor.

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 As a result of this, the demand for those goods will increase which are
generally purchased by the poor because the purchasing power of the poor people
has increased and, on the other hand, the demand for those goods will decline which
are usually consumed

123
by the rich on whom progressive taxes have been levied.

6. Advertisement Expenditure:

Advertisement expenditure made by a firm to promote the sales of its product

is an important factor determining demand for a product, especially of the product of
the firm which gives advertisements. The purpose of advertisement is to influence the
consumers in favour of a product. Advertisements are given in various media such as
newspapers, radio, and television. Advertisements for goods are repeated several
times so that consumers are convinced about their superior quality. When advertisements
prove successful they cause an increase in the demand for the product.

6.5 FACTORS AFFECTING MARKET DEMAND

When examining demand factors, especially for businesses, it is important to

realize that there is a relationship between Individual and Market Demand. These
two, though slightly different, share the same causes and are impacted by macro and
micro economic variables in the same way, but not the same magnitude.

The demand changes as a result of changes in price, other factors determining

it being held constant. These other factors determine the position or level of demand
curve of a commodity. It may be noted that when there is a change in these non-price
factors, the whole curve shifts rightward or leftward as the case maybe. The following
factors determine market demand for a commodity.

6.5.1 PRICE OF GOOD

Individual and market demand are affected by the price of the good or
service being offered. The law of demand shows that there is an inverse
relationship between price and demand. An increase in one will cause a decrease in
the other. This holds true at both the individual and market level.

6.5.2 PRICE OF COMPLIMENTARY GOODS

A complimentary good is one that is used with another good. For example,
when you buy a cooker, you have to buy cooking gas or electricity. Another example
would be a car and gas. By buying one good, you have to buy the other in order to use
it. When the price a complimentary good increases all other factors remaining

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constant and the demand

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for the others good decreases with it. With an increase in the price of cars, less
people will buy gas.

6.5.3 PRICE OF SUBSTITUTE GOODS

Substitute goods are goods that compete for consumption. When you take
one, you substitute it for the other. You consume either one or the other. This is as
long as the substitute is seen as matching or being better in terms of quality. For both
individual and market demand, when the price of substitute goods change, there is
an effect on the demand.

6.5.4 INCOME

Income is a major factor influencing individual and market demand. When

there is an increase in income, demand for goods increase. This is because there is
more money to be spent on the good. A good or service that experiences this is
called a “normal” good. However, some goods experience a decrease in demand with
an increase in income. These are classified as “inferior goods”. People purchase these
goods because they are cheap and that is what they can afford. However, as their
income increase, they go for better quality goods and services. For example, some
people view public transport as an inferior good.

6.5.5 FUTURE EXPECTATIONS

People aim to place themselves at an advantage when theyhave information

about the future. If they expect, for example, to have a shortage of a vital good, they
will increase their demand drastically today to beat the shortage. Every year you know
winter is coming, so you buy winter clothing before it happens.

6.5.6 TASTES AND PREFERENCE

Beyond the rational reasons, people purchase simply because they like it.
Sometimes they are influenced by fashion trends. Other times it is because a
celebrity endorsed a product, or they simply have a taste for it. Out of all the factors
influencing individual and market demand, this is probably the hardest to predict. This
is because it is influenced by psychological factors, which are difficult to categorise
and tabulate.

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6.6 DIFFERENCE BETWEEN INDIVIDUAL DEMAND AND
MARKET DEMAND

The quantity of a commodity an individual is willing and able to purchase at

a particular price, during a specific time period, given his/her money income, his/her
taste, and prices of other commodities, such as substitutes and complements, is referred
to as the individual demand for the commodity whereas,

The total quantity which all the consumers of the commodity are willing and
able to purchase at a given price per time unit, given their money incomes, their
tastes, and prices of other commodities, is referred to as the market demand for the
commodity.

6.7 SUMMARY

The analysis of total demand for a firm’s product plays a crucial role in
business decision making. The market demand or the size of the market at a point in
time at different prices gives the overall scope of business; it gives prospects for
expanding business; and it plays a crucial role in planning for future production,
inventories of raw materials, advertisements, and setting up sales outlets.
Therefore, the information regarding the magnitude of the current and future
demand for the product is indispensable. Theory of demand provides an insight into
these problems. Form the analysis of market demand, business executives can
know:
 The factors that determine the size of the demand
 Elasticities of demand, i.e., how responsive or sensitive is the demand to
the changes in its determinants,
 Possibility of sales promotion through manipulation of prices,
 Responsiveness of demand to advertisement expenditures, and
 Optimum levels of sales, inventories and advertisement cost, etc.

The law of demand plays a crucial role in decision-making and forward

planning of a business unit. The production planning in a firm mainly rests on
accurate demand analysis. The law of demand has theoretical as well as practical
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advantages. These are as
; Price determination: With the help of law of demand a monopolist fixes the price of
his

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product. He is able to decide the most profitable quantity of output for him. Useful
to government: The finance minister takes the help of this law to know the effects of
his tax reforms and policies. Onlythose commodities which have relatively inelastic
demand should be taxed. Useful to farmers: From the law of demand, the farmer knows
how far a good or bad crop will affect the economic condition of the fanner. If
there is a good crop and demand for it remains the same, price will definitely go
down. The farmer will not have much benefit from a good crop, but the rest of the
society will be benefited. In the field of planning: The demand schedule has great
importance in planning for individual commodities and industries. In such cases it is
necessary to know whether a given change in the price of the commoditywill have the
desired effect on the demand for commoditywithin the country or abroad. This is known
from a study of the nature of demand schedule for the commodity.

6.8 SELFASSESSMENT QUESTIONS

1. Explain the factors influencing market demand?

2. How individual demand schedule and market demand schedule is different

form market demand schedule?

3. Briefly illustrates the various types of market demand?

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6.9 SUGGESTED READINGS

 Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012,

S. Chand and Company Ltd, New Delhi.

 Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing

House, New Delhi.

 Economic Theory, Chopra, P.N., 2005, Kalyani Publishers New Delhi.

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 UNIT II
LESSON 7 MARKET DEMAND

SCHEDULE STRUCTURE
7.1 INTRODUCTION

7.2 OBJECTIVE

7.3 DEMAND SCHEDULE

7.3.1 Types of Demand Schedule

7.4 TYPES OF MARKET DEMAND

7.5 MARKET DEMAND CURVE

7.6 SUMMARY

7.7 SELF ASSESSMENT QUESTIONS

7.8 SUGGESTED READINGS

7.1 INTRODUCTION

The individual demand curve- sometimes also called the household demand
curve- that is based on an individual’s choice among different goods. In this lesson we
show how to build the market demand curve from these individual demand curves.
When demand changes due to the factors other than price, there is a shift in the
whole demand curve. Apart from price, demand for a commodity is determined by
incomes of the consumers, his tastes and preferences, prices of related goods. Thus,
when there is any change in these factors, it will cause a shift in demand curve. For
example, if incomes of the consumers increase, say due to the hike in their wages and
salaries or due to the grant of dearness allowance, they will demand more of a
good, say cloth, at each price. This will cause a shift in the demand curve to the right.
Similarly, if preferences of the people for a commodity, say colour TV, become greater,

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their demand for colour TV will increase, that is, the

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demand curve will shift to the right and, therefore, at each price they will demand
more colour TV. The other important factor which can cause an increase in
demand for a commodity is the expectations about future prices. If people expect
that price of a commodity is likely to go up in future, they will try to purchase the
commodity, especially a durable one, in the current period which will boost the current
demand for the goods and cause a shift in the demand curve to the right. As seen
above, the prices of related commodities such as substitutes and complements can
also change the demand for a commodity. For example, if the price of coffee rises
other factors remaining the constant, this will cause the demand for tea, a substitute for
coffee, to increase and its demand curve to shift to the right.

If there are adverse changes in the factors influencing demand, it will lead to
the decrease in demand causing a shift in the demand curve. For example, if due to
inadequate rainfall agricultural production in a year declines this will cause a fall in the
incomes of the farmers. This fall incomes of the farmers will cause a decrease in the
demand for industrial products, say cloth, and will result in a shift in the demand
curve to the left. Similarly, change in preferences for commodities can also affect the
demand. For example, when colour TVs came to India people’s greater preference for
them led to the increase in their demand. But this brought about decrease in demand
for black and white TVs causing leftward shift in demand curve for these black and
white TVs. The decrease in demand does not occur due to the rise in price but due to
the changes in other determinants of demand. Decrease in demand for a commodity
may occur due to the fall in the prices of its substitutes, rise in the prices of
complements of that commodity and if the people expect that price of a good will fall
in future.

7.2 OBJECTIVES

The objectives of this lesson is to:

 Explain the concept of demand curves
 Describe the relationship between individual demand curve and market
demand curve.
 Demand schedule and types of demand schedule.

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 Types of demand.

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7.3 DEMAND SCHEDULE

The relationship between the price of a commodity and the amount demanded
is dependent on a large, number of factors, the most important being the nature of a
commodity. The response of amount demanded to changes in price of a commodity is
known as the demand schedule. It summarises the information on prices and quantities
demanded. The table 7.1 showing the prices per unit of the commodity and the
amount demanded per period of time.

Table: 7.1
Price per Amount Amount Total
Quintal (Rs.) Demanded by Demand by Market by
buyer A buyer B buyer B
50 5 10 15
40 15 20 35
30 25 30 55
7.3.1 Types of Demand Schedule
The Demand Schedule may be the Individual Demand Schedule which refers
to the prices and amount demanded of the commodity by an individual.
In Price Theory we are mainly interested in the Market Demand Schedule.
A market consists of all those individuals who want to purchase a given commodity.
Therefore, “Market Demand Schedule is defined as the quantities of a given
commodity which all consumers will buyat all possible prices at a given moment of
time.” It should be clear that the Individual Demand Schedules when added give us
the Market Demand Schedule.
The following table 7.1 shows the Individual Demand Schedules of buyers
Aand B and the Market Demand Schedule where there are only two buyers.
7.4 TYPES OF MARKET DEMAND
There are mainly three types of demand. They
are
1. Price Demand
2. Income Demand and
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3. Cross Demand

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Price Demand
It refers to the various quantities of the good which consumers will purchase at
a given time and at certain hypothetical prices assuming that other conditions remain
the same. We are generally concerned with price demand only. In the explanation of
the law of demand given above, we dealt in detail with price demand only.
Income demand
Income demand refers to the various quantities of a commodity that a
consumer would buyat a given time at various levels of income. Generally, when the
income increases, demand increases and vice versa.
Cross Demand
When the demand of one commodity is related with the price of other
commodity is called cross demand. The commodity may be substitute or
complementary. Substitute goods are those goods which can be used in case of each
other. For example, tea and coffee, Coca-cola and Pepsi. In such case demand and
price are positively related. This means if the price of one increased then the
demand for other also increases and visa versa. Complementary goods are those
goods which are jointly used to satisfy a want. In other words, complementary goods
are those which are incomplete without each other. These are things that go together,
often used simultaneously. For example, pen and ink. Tennis rackets and tennis balls,
cameras and film, etc. In such goods the price and demand are negatively related. This
means when the price of one commodityincreases the demand for the other falls. Tennis
rackets and tennis balls, cameras and film, etc. In such goods the price and demand are
negatively related. This means when the price of one commodity increases the
demand for the other falls.
Other Types of Demand
Joint demand
When several commodities are demanded for a joint purpose or to satisfy
a particular want. It is a case of a joint demand. Milk , sugar and tea dust are jointly
demanded to make tea. Similarly, we may demand paper, pen and ink for writing.
Demand for such commodities in bunch is known as joint demand. Demand for
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land, labour, capital and organisation for producing commodity is also a case of
joint demand.

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Composite demand
The demand for a commodity which can be put to several uses is a
composite demand. In this case a single product is wanted for a number of uses.
For example, electricity is used for lighting, heating, for running the engine, for the fans
etc. Similarly coal is used in industries, for cooking etc.
Direct and Derived demand
The demand for a commodity which is for direct consumption, i.e.. Demand
for ultimate object, is called direct demand, e.g food, cloth, etc. Direct demand is
called autonomous demand. Here the demand is not linked with the purchase of
some main products. When the commodity is demanded as a result of the demand
for another commodity or service, it is known as the derived demand or induced
demand. For example, demand for cement is derived from the demand for building
construction; demand for tires is derived from the demand for cars or scooters, etc.
7.5 MARKET DEMAND CURVE
The relationship between the demand curves of individual buyers and the
market demand curve is shown in Figure 1. In that figure we suppose, for the sake of
argument, that there are only two buyers in the market—Individual Aand Individual B.
Each of these individuals will choose to purchase a particular quantity at each possible
price. To find the total market demand at each price we simply add together the
quantities demanded by the two individuals at that price.

For example, the quantity demanded by Individual Aat price P in the Figure
0
is Q and the quantity demanded by Individual B is Q . The quantity demanded
1 2
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in the

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market as a whole is therefore Q + Q . The market demand curve is simplythe
horizontal sum of the individual 1buyers’
2 demand curves.

As can be seen from the above Figure, an important reason whythe market
demand curve is negatively sloped (that is, why the quantity demanded in the market
increases as the price falls) is the entry of new consumers as the price falls. Individual
B chooses not to
consume any of the product at prices above P . As the price falls below that level
1 buyers will enter the market as the
she enters the market. In general, more and more
price
falls, adding their demands to the market demand.
There are also important reasons why the individual consumers’ demand
curves are negativelysloped. Individuals consume in order to satisfy certain wants—
food, shelter, entertainment, self-image, etc. Different commodities are substitutes for
each other in supplying these wants. One can eat chicken, fish or goat instead of beef,
or abandon all of these for a vegetarian diet. What one does will depend on the
relative prices of these meats. If the price of beef rises substantially, with all other
prices remaining the same, many consumers will choose to consume less beef and
more fish, goat or chicken.
Broad categories of consumption are also substitutes for each other. For
example, a substantial rise in rents relative to the costs of dining out, frequenting bars
and going to the cinema may lead some consumers to maintain smaller and cheaper
apartments and spend more leisure time on outside entertainment. This tendency to
substitute cheaper goods and services for ones whose prices have risen is called the
substitution effect. The substitution effect of a price change is always negative—a rise
in a good’s price reduces the quantity of it demanded.
It should be obvious from the above that the quantity of a good demanded
depends not only on its own price but on the prices of substitute goods. For example,
consider the demand curve for chicken, plotted in Figure 2.

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 A fall in the price of chicken, holding all other prices constant, will bring about
an increase in the quantity of chicken demanded—the price-quantity combination
moves downward to the right along the demand curve. At the same time, a rise in the
price of beef (or fish, or goat) will also increase the quantity of chicken demanded
at every price of chicken. Thiswill shift the demandcurve in Figure 2 to the right.
Achange in the commodity’s own price leads to a movement along the demand curve,
while changes in the prices of substitute commodities cause the demand curve to
shift. In general, the increase in the price of a substitute good shifts the demand curve
for a commodity to the right—more of the commodity is demanded at each price.

Increases in the prices of other goods do not always cause the quantity
demanded of a commodity to increase. Consider, for example, the market for shoelaces.
A rise in the price of shoes will cause the quantity demanded of shoes to fall as people
repair old shoes and wear them longer. Since there will be a smaller demand for shoes,
there will also be a smaller demand for shoelaces. A rise in the price of shoes thus
leads to a decline in the demand for shoelaces—the demand curve for shoelaces shifts
to the left. People substitute other goods for both shoes and shoelaces. In this case,
shoes and shoelaces are said to be complementary goods or complements. The
effect of an increase in the price of a complementary good on the quantity of a
good demanded is shown in Figure 3.

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The quantities demanded of commodities are also affected by the level of income.

143
People’s entire income must be spent on something (saving is treated here as an
expenditure on future goods). When that income rises and more is therefore available
to spend it is necessarily the case that consumers’ expenditure on goods will, on
average, rise. If a good is a normal good, people’s expenditure on it will increase as
their income increases. The quantity demanded of the good will increase at each price
of that good. This is shown in the left panel of Figure 4.

Not all goods are normal. Consider, for example, rice consumption in
mainland China. As the country’s income rose with the influx of capital from the rest
of the world and the development of new enterprises, people were likely to decide
that they can now afford to add a bit more meat to their diet and rely less heavily
on rice.

One’s primary goal is to survive. To survive at low levels of income it may

be necessary to spend all available funds on rice, meat being too expensive.At higher
incomes, one can purchase much more rice than would be necessary for
sustenance. It is then worthwhile to substitute a bit of meat for some of that rice and
have a more enjoyable diet. For this reason, the demand curve for rice might well shift
to the left with an increase in income. Rice is in this instance an inferior good. This is
shown in the right panel of Figure 4 above. When income rises, the demand curves for
normal goods shift to the right and the demand curves for inferior goods shift to the
left.

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 Up to this point we have argued that the demand curve is negativelysloped
because of the substitution effect-when the price of a good rises consumers substitute
other goods

145
whose prices have not risen. But an increase in the price of a good also has an
income effect on the quantity of it demanded.

Suppose that you earn $1000 per month and spend $500 of it on rent.
Assume that your rent goes up to $600—that is, by 20 percent. The cost of your original
consumption bundle is now $1100, so you have to cut your consumption of something
—either housing or other goods or both—by $100. Your real income has thus
declined by 10 percent. If housing is a normal good, you will allocate some of this
cut in overall consumption to it. So there will be a decline in the quantityof housing
demanded additional to anysubstitution of other goods for housing you make on account
of the substitution effect. This will make the demand curve for housing flatter than it
would otherwise have been, as is shown in the left panel of Figure 5.

There is, of course, the possibility that the commodity whose price has risen
may be an inferior good. In this case the income effect will make the demand curve
steeper. The adverse effect on real income of an increase in the price of rice, for
example, may make it necessary for people to consume less meat and more rice.
This is shown in the right panel of Figure 5.

In the case of normal goods, the income and substitution effects work in the
same direction; in the case of inferior goods they work in opposite directions.

It turns out that the income effect is unlikely to be of much importance in

practice. People spend tiny fractions of their income on most goods so that the effects
on their real incomes of changes in the prices of those goods is likely to be trivial.

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7.5 SUMMARY

The market demand reflects the total quantity purchased by all consumers
at alternative hypothetical prices. It is the sum-total of all individual demands. It is
derived by adding the quantities demanded by each consumer for the product in
the market at a particular price. The table presenting the series of quantities
demanded of all consumers for a product in the market at alternative hypothetical
prices is known as the Market Demand Schedule. If the data are represented on a
two dimensional graph, the resulting curve will be the Market Demand Curve.
From the point of view of the seller of the product, the market demand curve shows
the various quantities that he can sell at different prices. Since the demand curve of an
individual is downward sloping, the lateral addition of such curves to get market
demand curve will also result in downward sloping curve.

7.7 SELFASSESSMENT QUESTIONS

1. Distinguish between individual demand and market schedule?

2. List the major purposes of demand analysis from the management point of
view?

3. What is meant by the elasticity of demand?

7.8 SUGGESTED READINGS

147
 Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012, S.

1
4
 Chand and Company Ltd, New Delhi.
 Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing
House, New Delhi.
 Edward Shapiro, Macro Economic Analysis, Tata McGraw Hill, New Delhi.
 Jhingam, M.L. & Stephen, J.K, Managerial Econbomics, Vrinda Publications
Pvt. Ltd. Delhi.
 Dingra, I.C Managerial Economics, Sultan Chand, New Delhi.

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 Unit-II
LESSON-8 ECONOMIC SLOWDOWN

STRUCTURE
8.1 INTRODUCTION

8.2 OBJECTIVES

8.3 ECONOMIC SLOWDOWN

8.3.1 Measuring changes in GDP

8.3.2 Business cycle

8.4 REASONS FOR ECONOMIC SLOWDOWN

8.5 IMPACT OF ECONOMIC SLOWDOWN

8.6 SUMMARY

8.7 SELF ASSESSMENT QUESTIONS

8.8 SUGGESTED READINGS

8.1 INTRODUCTION

The emerging market economies have experienced impressive growth over the
past 20 years, substantially boosting their share of global economic output and
worldwide trade. Recently, however, economic momentum has tailed off considerably in a
large number of emerging market economies, and the growth lead they once enjoyed
over the industrial countries has narrowed. At first, many thought this was due to
cyclical strains, notably the short- lived lull in demand in the industrial countries. The
fact that the slowdown is so persistent suggests, however, that it is rather the
underlying path of expansion that has flattened. Given the advanced stage of the
convergence process, it could be said that this is a “natural” easing of the rate of
expansion. Nevertheless, such is the scale of the slowdown that a number of additional
factors are also likely to be at play in several emerging market economies. In China,
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the weaker pace of growth can probably be partly explained by the

151
decreasing structural change at the sectoral level and the lessening impact of growth
impulses stemming from earlier market reforms. For the emerging market economies
specialising in the export of raw materials, the end of the commodities boom appears
to be a relevant factor. In the emerging market economies of eastern Europe, the
reduced pace of growth reflects a return to more normal circumstances, now that the
high rates of growth seen immediately prior to the financial crisis have proven to be
unsustainable. More moderate investment levels and neglect of the economic policy
reform course are also holding back economic growth.

The predominantly structural nature of the slowdown would suggest that

the aggregate pace of growth in the group of emerging market economies will remain
muted in the years ahead. Growth could diminish further still if things take a turn for the
worse. For the advanced economies, this outlook means that the underlying pace of
their exports to the emerging market economies is likely to be lower in the foreseeable
future. If the Chinese economy were to undergo a sharp downturn, the ripple effects
would also be felt in Germany. The slowdown in the pace of aggregate growth in the
emerging market economies shows that a speedy and buoyant catch- up process
cannot be taken for granted. The emerging market economies need new reform stimuli
to put growth back on a higher trend path over the medium term.

8.2 OBJECTIVES

The objective of this lesson is:

 To understand the concept of economic slowdown
 To explain the effect of economic slowdown on market demand

8.3 ECONOMIC SLOWDOWN

An economic slowdown occurs when the rate of economic growth slows in

an economy. Countries usually measure economic growth in terms of GDP (Gross
Domestic Product), which is the total value of goods and services produced in an
economy during a specific period of time.

8.3.1 Measuring changes in GDP

The rate of economic growth or decline is calculated bydetermining the percentage

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change in GDP form one period to another. For example, the value of a country’s GDP
in the second quarter of this year may have increased 2% from the value from the
first quarter GDP. On the other hand, if GDP rose only 1.5% between the second
quarter and the third quarter, we can that the economy is slowing down because it is
not growing as fast.

8.3.2 Business cycle

Economic fluctuations are explained by the business cycle. The cycle starts at
an economic peak where growth has reached its highest point in the cycle, which is
then followed by a decline in growth-the economic slowdown.

When growth becomes negative for a specific period of time, the economy
has entered a recession. If the negative growth lasts long enough or is severe
enough, the economy may enter a depression. Eventually, the economy will bounce
off the bottom, and it will enter a recovery period characterised by economic growth
until it reaches a new peak and cycle starts over again.

8.4 REASONS FOR THE DECLINE IN TREND GROWTH

The slowdown in trend growth in the emerging market economies suggests that
a “natural” easing of the rate of expansion has occurred, after the rapid convergence
process had moved many countries closer to the very limits of their technological
capabilities. However, a very wide gap still remains. There are calculations, for instance,
which indicate that labour productivity in China and in other major emerging market
economies had each reached less than one- tenth of the corresponding level in the
United States in 2011. Similarly, total factor productivity, a measure which also
incorporates capital input, continues to show that China and other countries trail a long
way behind the United States.12From this perspective, it seems reasonable to assume
that a number of additional factors were behind the relatively sharp downturn in trend
growth witnessed in recent years. Trend growth has slackened since 2006-07 in
roughly two- thirds of the 135 economies observed overall. One of these is economic
heavyweight China, where trend growth plummeted from around 12% to 7.%.
Other countries which have seen a marked downturn in the underlying pace of
economic activity include a remarkably large number of economies specialising in the
export of commodities.
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1. Breaking down trend growth to single out the contributions made by
labour input and labour: productivity sheds greater light on China’s
macroeconomic slowdown. It reveals that labour input, as measured in
terms of the number of persons working in the overall economy, has only
ever contributed minimally to the increase in economic output due to its weak
upward tendency. The main driver here is the rise in labour productivity, which
has experienced marked decline in recent years and is behind the slowdown in
trend growth, whereas the low positive contributions attributable to labour input
have remained more or less unchanged.

2. Increasing productivity in economy as a whole curbed by flagging

structural Change: The flagging pace of structural change appears to be
partly to blame for the lower rise in labour productivity. One major factor
driving overall productivity growth in China is the migration of rural
agricultural labour to urban areas, where theytake up employment in the
significantlymore productive industrial or services sector.

3. Positive effects of past structural reforms petering out: Probably of even

greater significance than the waning pace of sectoral structural change is
the slowdown in productivity gains at the sectoral level, with the dwindling
positive effects of previous structural reforms likely to have played a major
role in this.

4. Evidence of lower investment efficiency: Another factor that contributed

to the sharp rise in intra sectoral productivity was exceptionally dynamic
investment activity on the back of high levels of domestic saving. Growth in
gross fixed capital formation gained even more traction during the global financial
and economic crisis, sending its share of GDP higher still from 38% in 2007 to
44% in 2009. This ratio of capital formation, which is decidedly high by
international standards, raises

8.5 IMPACT OF ECONOMIC SLOWDOWN

Recession or economic slowdown reduced industrial output, job opportunities,

liquidity in the Indian economy. It also brings GDP down and brought change in
consumer behaviors and their purchasing power.
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8.5.1 Impact of Recession on Indian Industrial output: During Recession
industrial growth faltering India’s industrial sector which are suffering from the
depressed demand

155
condition in its export market as well as from suppressed domestic demand due to
the slow generation of employments. The domestic demand due to the India’s
economic downturn leaves middle classes fearing the worst. After the 2008 world
economic crisis India recorded 9% GDP growth for at least two years but in recent the
rupee was tumbled, losing a sixth of its value against the dollar. Share prices were
fallen, commodity prices were on rise, investment was stalled and growth was slow.
Few experts termed as “It is a crisis” while some experts trace the problem to the failure
of Manmohan Singh’s government to push through structural reforms that could boost
growth. Notably, India imports much more than it exports, and so the current
account deficit is at an unsustainable 4.8% of GDP. Until it is brought down, there
can be very little hope of reviving investor confidence in the economy. Gold has played
an important role in skewing the trade deficit. A century ago, the economist John
Maynard Keynes wrote that India’s irrational love for gold was “ruinous to her
economic development”, and the obsession still runs deep. India’s annual production
of gold is barely 10 tonnes, so last year it imported 860 tonnes, which were made
into jewellery or stored as coins and bars in family safes.

8.5.2 Impact of Global Meltdown on the Indian Economy: The Indian

economy has shown negative impact of the recent global financial meltdown. Though
the Public sector in India, including nationalized banks could somehow insulate the
injurious effects of globalization as we are also part of the globalisation strategy of neo
liberalisation, there is a limit of our ability to resist global recession, which may change
into a great depression. The impact of the crisis was significantly different for the
Indian economy as opposed to the western developed nations.

· The most immediate effect of this global financial crisis on India is an out flow
of foreign institutional investment (FII) from the equity market. This withdrawal by the
FIIs led to a steep depreciation of the rupee. The banking and non-banking financial
institutions have been suffering losses. The recession generated the financial crisis in
USA and other developed economies have adversely affected India’s exports of
software and IT services. India’s exports are adversely affected by the slowdown in
global markets. This is already evident in certain industries like the garments industries
where there have been significant job losses with the onset of the crisis. This along with
a squeeze in the high-income service sectors like financial services, hospitality and

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tourism etc. led to a reduction in consumption spending and overall demand with the
domestic economy. A direct consequence of this

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was a simultaneous loss of informal employment and lower generation of new non-
farm employment in the economy. The depreciation of rupee could not positively
affect the exports bill of India.
 This declining trend has affected adversely the industrial activity, especially, in
the manufacturing, infrastructure and in service sectors mainly in the
construction, transport and communication, trade, hotels etc. Service export
growth was also likely to slow as the recession deepens and financial services
firms, traditionally large users of out-sourcing services were restructured.
 A financial crisis could cause workers’ earnings to fall as jobs were lost in
formal sector demand for services provided by the informal sector declined and
working hours and real wages were cut. When formal sector workers who
have lost their jobs entered the informal sector, theyput additional pressure on
informal LABOUR markets.
 During recession industrial growth was also faltering. India’s industrial sector
has suffered from the depressed demand conditions in its export markets, as
well as from suppressed domestic demand due to the slow generation of
employment.
 The most immediate effect of that crisis on India has been an outflow of
foreign institutional investment from the equity market. Foreign Institutional
Investment (FIIs), which need to retrench assets in order to cover losses in their
home countries and were seeking havens of safety in an uncertain
environment, have become major sellers in Indian markets. As FIIs pull out
their money from the stock market, the large corporate no doubt have affected,
the worst affected was likely to be the exports and small and marginal
enterprises that contribute significantly to employment generation.
 The currency depreciation may also affect consumer prices and the higher cost
of imported food hurt poor individuals and households that spend much of their
income on food.
 Faster than expected reduction in inflation. The decline inflation should
support consumption demand and reduce input costs for corporate.
 The foreign exchange market came under pressure because of reversal of capital
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 flows as part of the global decelerating process. Foreign exchange reserves
were depleting.
 The shrinking of aggregate in the world market as a consequence of the crisis
has hurt the exporting manufacturing industries in the country.
 On the demand side, much higher investments replaced government
stimulus. Wholesale price inflation has been around 10 percent between
February and May 2010 after remaining in negative during much of 2009.
Food inflation, however, declined from 18 percent to 12 percent over the same
period. Global commodity prices have rebounded after the financial crisis but
price pressures are remained under control.
8.5.3 Change in consumer behaviours due to recession: Not only in India but
recession has affected all over the world now-a-day. Economic slowdown resulted
many companies loses their contract, probably it influence the employees and fails to get
enough money and losing jobs. So inour daily activities it affects different problems in
life and our lifestyle turns very worse. But if people have a mentality to overcome
this situation he himselfdecreases his expenses and should follow the tables. Easilyhis
life will gohappiness. The fact that recession is changing the consumer behaviours as
well as the attitudes in the current retail market .The customer has become more loyal &
they stick to the supermarket which gives them value for money. I am not sure how the
income tracker of an average middle class family this year, but average family has
seen less spending per month. Even during an economic downturn, consumer
spending continues. However, buyer attitudes and behaviour patterns alter
substantially in recession as consumers delay replacing serviceable products and
focus on achieving value for money, seeking out deals and eliminating indulgences.
This insight explores how consumers prioritise spending during a recession and
provides implications and recommendations for action.

8.5.4 Impact of The Slowdown On India’s Exports: Global demand plays an

important role in determining the export growth of a product. With a rise in global
incomes, demand for normal and luxury products rises while for inferior products it
may decline. Income elasticity of demand for luxury products is expected to be
greater than one, while for normal goods it is expected to be between 0 and 1. The
kind of products a country exports, i.e., the income elasticity of demand of the
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product, is an important factor which

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determines the impact of a slowdown on the country’s exports.Alongwith income
elasiticity, price competitiveness may also determine the impact of a slowdown on
exports. If the products exported are less price sensitive, then in the case of a
slowdown the option of lowering prices to maintain market shares may not be
feasible. The empirical evidence of low price elasticity and high income elasticity of
export demand in general has important implications for exports of developing countries.
Firstly, this suggests that the export growth of developing countries is highly dependent
on the economic performance of developed countries. Secondly, it implies that the
developing countries may have limited feasibility of using price competition to
maintain or increase exports.

8.6 SUMMARY

A recession is slowdown or a massive contraction in economic activities. Its’

a period of temporaryeconomic decline during which trade and industrial activity are
reduced; generally identified by a fall in GDP (gross domestic product) in two or more
successive quarters. Arecession normally takes place when consumers lose confidence
in the growth of the economy and spend less. This leads to a decreased demand for
goods and services, which in turn leads to a decrease in production, lay-offs and a sharp
rise in unemployment. Investors spend less as they fear stocks values will fall and
thus stock markets fall on negative sentiment. The economy of India is the tenth-largest
in the world by nominal GDP and the third-largest by purchasing power parity (PPP).
The country is one of the G-20 major economies and a member of BRICS. IMF
(International Monetary Fund) report reveals “on a per-capita-income basis, India
ranked 141 by nominal GDP and 130 by GDP (PPP) in 2012”. India is the 19th-
largest exporter and the 10th-largest importer in the world. The economy slowed to
around 5.0% for the 2012–13 fiscal year compared with 6.2% from past fiscal. Due
to India’s rapid and growing integration into the global economy India has been hit by
the global meltdown. To combat these effects of the global crisis on the Indian
economy and to prevent future collapse, an effective departure from the dominant
economic philosophy of the neo-liberalism is required.

8.7 SELFASSESSMENT QUESTIONS

1. Explain the effects of economic slowdown on market demand?

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2. Explain the factors influencing market demand?

3. What is economic slowdown? Explain the impact of economic slowdown on

Indian economy.

8.8 SUGGESTED READINGS

 Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012,
S. Chand and Company Ltd, New Delhi.
 Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing
House, New Delhi.
 Economic Theory, Chopra, P.N., 2005, Kalyani Publishers New Delhi.

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 UNIT- III
LESSON 9 PRICING POLICY

STRUCTURE

9.1 INTRODUCTION

9.2 OBJECTIVES

9.3 PRICE DEFINED

9.3.1 The Customer’s View of Price

9.3.2 Price from a Societal Perspective

9.3.3 The Marketer’s View of Price

9.4 PRICING OBJECTIVES

9.5 FACTORS DETERMINING PRICING POLICY

9.6 PRACTICAL ASPECT OF PRICING DECISION

9.7 SUMMARY

9.8 SELF ASSESSMENT QUESTIONS

9.8 SUGGESTED READINGS

9.1 INTRODUCTION

Pricing is a crucial managerial decision. Most companies do not encounter it in

a major way on a day-to-day basis. But there is need to follow certain additional
guidelines in the pricing of the new product. The marketing of a ‘new product’ poses a
problem for any firm because new products have no past information. Here the firm
is also not in a position to determine consumer reaction. The question is, what do
we mean by a new product? New products for our purposes will include original
products, improved products, modified products and new brands that the firm develops
through its own R&D efforts. When fixing the first price, the decision is obviously a

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major one. When the company

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introduces its product for the first time, the whole future depends heavily on the
soundness of initial pricing decision. Top management is accountable for the new
product’s success record and therefore establish specific criteria for acceptance of new
product ideas especially in a large multidivisional company where all kinds of projects
bubble up as favourites of various managers. There are always competitors who would
also like to produce it at the earliest opportunity. Pricing decision assumes special
importance when one or more competitors change their prices or products or both.
Sometimes, the competitors may introduce a new brand without altering the price of
an existing brand. If the new brand is perceived to compete with a given brand more
effectively, then the firm in question may have to think on its pricing policy once
again.

From a customer’s point of view, value is the sole justification for price,
Many times customers lack an understanding of the cost of materials and other costs
that go into the making of a product. But those customers can understand what that
product does for them in the way of providing value. It is on this basis that customers
make decisions about the purchase of a product. Effective pricing meets the needs of
consumers and facilitates the exchange process. It requires that marketers understand
that not all buyers want to pay the same price for products, just as they do not all
want the same product, the 3ame distribution outlets, or the same promotional
messages. Therefore, in order to effectively price products, markets must distinguish
among various market segments. The key to effective pricing is the same as the key
to effective product, distribution, and promotion strategies. Marketers must understand
buyers and price their products according to buyer needs if exchanges are to occur.
However, one cannot overlook the fact that the price must be sufficient to support the
plans of the organisation, including satisfying stockholders. Price charged remains the
primary source of revenue for most businesses,

9.2 OBJECTIVES

The objectives of this lesson is:

 To understand the concept of pricing.
 To know about the factors affecting pricing decisions.

9.3 PRICE DEFINED

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Although making the pricing decision is usually a marketing decision, making
it

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correctly requires an understanding of both the customer and society’s view of price as
well. In some respects, price setting is the most important decision made by a business.
A price set too low may result in a deficiency in revenues and the demise of the
business. A price set too high may result in poor response from customers and,
unsurprisingly, the demise of the business. The consequences of a poor pricing
decision, therefore, can be dire.

9.3.1 The Customer’s View of Price

As discussed in an earlier chapter, a customer can be either the ultimate user of

the finished product or a business that purchases components of the finished product. It
is the customer that seeks to satisfy a need or set of needs through the purchase of a
particular product or set of products. Consequently, the customer uses several criteria
to determine how much they are willing to expend in order to satisfy these needs.
Ideally, the customer would like to pay as little as possible to satisfy these needs.
Therefore, for the business to increase value (i.e., create the competitive advantage), it
can either increase the perceived benefits or reduce the perceived costs, Both of
these elements should be considered elements of price,

9.3.2 Price from a Societal Perspective

Price, at least in dollars and cents, has been the historical view of value.
Derived from a bartering system-i.e., exchanging goods of equal value-the monetary
system of each society provides a more convenient way to purchase goods and
accumulate wealth. Price has also become a variable society employs to control its
economic health. Price can be inclusive or exclusive. In many countries, such as Russia,
China, and South Africa, high prices for products such as food, health care, housing,
and automobiles, means that most of the population is excluded from purchase. In
contrast, countries such as Denmark, Germany, and Great Britain charge little for
health care and consequentlymake it available to all . There are two different ways to
look at the role price plays in a society: rational man and irrational man. The former is
the primary assumption underlying economic theory, and suggests that the results of
price manipulation are predictable.

9.3.3 The Marketer’s View of Price

Price is important to marketers, because it represents marketers’ assessment of

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the value customers see in the product or service and are willing to pay for a product
or service. A number of factors have changed the way marketers undertake the
pricing of their products and services.

1. Foreign competition has put considerable pressure on U.S. firms ‘ pricing

strategies. Many foreign-made products are high in quality and compete in U.S.
markets on the basis of lower price for good value.

2. Competitors often try to gain market share by reducing their prices. The
price reduction is intended to increase demand from customers who are
judged to be sensitive to changes in price.

3. New products are far more prevalent today than in the past. Pricing a new
product can represent a challenge, as there is often no historical basis for
pricing new products. If a new product is priced incorrectly, the
marketplace will react unfavourably and the “wrong” price can do long-
term damage to a product’s chances for marketplace success.

4. Technology has led to existing products having shorter marketplace lives. New
products are introduced to the market more frequently, reducing the “shelf life”
of existing products.As a result, marketers face pressures to price products to
recover costs more quickly. Prices must be set for early successes including
fast sales growth, quick market penetration, and fast recovery of research and
development costs.

9.4 PRICING OBJECTIVES

Firms rely on price to cover the cost of production, to pay expenses, and to
provide the profit incentive necessary to continue to operate the business. We might
think of these factors as helping organisations to: (1) survive, (2) earn a profit, (3)
generate sales, (4) secure an adequate share of the market, and (5) gain an
appropriate image.

1. Survival: It is apparent that most managers wish to pursue strategies that

enable their organisations to continue in operation for the long term. So
survival is one major objective pursued by most executives. For a
commercial firm, the price paid by the buyer generates the firn1’s revenue. If

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revenue falls below cost for a long period of time, the firm cannot survive.

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2. Profit: Survival is closely linked to profitability. Making a $500,000 profit
during the next year might be a pricing objective for a firm. Anything less
will ensure failure. All business enterprises must earn a long-term profit. For
many businesses, long-term profitability also allows the business to satisfy
their most important constituents-stockholders. Lower-than-expected or no
profits will drive down stock prices and may prove disastrous for the
company.

3. Sales: Just as survival requires a long-term profit for a business enterprise,

profit requires sales. As you will recall from earlier in the text, the task of
marketing management relates to managing demand. Demand must be
managed in order to regulate exchanges or sales. Thus marketing
management’s aim is to alter sales patterns in some desirable way.

4. Market Share: If the sales of Safeway Supermarkets in the Dallas-Fort

Worth metropolitan area account for 30% of all food sales in that area, we
say that Safeway has a 30% market share. Management of all firms, large
and small, are concerned with maintaining an adequate share of the market
so that their sales volume will enable the firm to survive and prosper. Again,
pricing strategy is one of the tools that is significant in creating and sustaining
market share. Prices must be set to attract the appropriate market segment in
significant numbers.

5. Image: Price policies play an important role in affecting a firm’s position of

respect and esteem in its community. Price is a highlyvisible communicator. It
must convey the message to the community that the firm offers good value,
that it is fair in its dealings with the public, that it is a reliable place to
patronise, and that it stands behind its products and services.

9.5 FACTORS DETERMINING PRICING POLICY

The pricing decisions for a product are affected by internal and external factors.

A. Internal Factors:

1. Cost

While fixing the prices of a product, the firm should consider the cost involved in
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producing the product. This cost includes both the variable and fixed costs. Thus,

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 while fixing the prices, the firm must be able to recover both the variable and
fixed costs.

2. The predetermined objectives

While fixing the prices of the product, the marketer should con-sider the
objectives of the firm. For instance, if the objective of a firm is to increase return
on investment, then it may charge a higher price, and if the objective is to
capture a large market share, then it may charge a lower price.

3. Image of the firm

The price of the product may also be determined on the basis of the image of
the firm in the market. For instance, HUL and Procter & Gamble can
demand a higher price for their brands, as they enjoy goodwill in the
market.

4. Product life cycle

The stage at which the product is in its product life cycle also affects its price.
For instance, during the introductory stage the firm may charge lower price to
attract the customers, and during the growth stage, a firm may increase the
price.

5. Credit period offered

The pricing of the product is also affected by the credit period offered by
the company. Longer the credit period, higher may be the price, and shorter the
credit period, lower may be the price of the product.

6. Promotional activity

The promotional activity undertaken by the firm also determines the price. If
the firm incurs heavy advertising and sales promotion costs, then the pricing of
the product shall be kept high in order to recover the cost.

B. External Factors:

1. Competition

While fixing the price of the product, the firm needs to study the degree of
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competi-tion in the market. If there is high competition, the prices may be
kept

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 low to effectively face the competition, and if competition is low, the prices
may be kept high.

2. Consumers

The marketer should consider various consumer factors while fixing the
prices. The consumer factors that must be considered includes the price
sensitivity of the buyer, purchasing power, and so on.

3. Government control

Government rules and regulation must be considered while fixing the prices.
In certain products, government may announce administered prices, and
therefore the mar-keter has to consider such regulation while fixing the
prices.

4. Economic conditions

The marketer may also have to consider the economic condition prevail-ing in
the market while fixing the prices. At the time of recession, the consumer
may have less money to spend, so the marketer may reduce the prices in order
to influence the buying decision of the consumers.

5. Channel intermediaries

The marketer must consider a number of channel intermediaries and their

expectations. The longer the chain of intermediaries, the higher would be the
prices of the goods.

Some other factors need to be consider while fixing price for a product are:
 Determine primary and secondary market segments. This helps you
better understand the offering’s value to consumers. Segments are important for
positioning and merchandising the offering to ensure maximized sales at the
established price point.
 Assess the product’s availability and near substitutes. Underpricing
hurts your product as much as overpricing does. If the price is too low,
potential customers will think it can’t be that good. This is particularly true for
high-end, prestige brands. One client underpriced its subscription product,
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yielding depressed

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 response and lower sales. The firm underestimated the uniqueness of its
offering, the number of close substitutes, and the strength of the consumer’s
bond with the product. As a result, the client could increase the price with only
limited risk to its customer base. In fact, the initial increase resulted in more
subscribers as the new price was more in line with its consumer-perceived
value.
 Survey the market for competitive and similar products. Consider
whether new products, new uses for existing products or new technologies
can compete with or, worse, leapfrog your offering. Examine all possible
ways consumers can acquire your product. I’ve worked with companies that
only take into account direct competitors selling through identical channels.
Don’t limit your analysis to online distribution channels.
Competitors may define your price range. In this case, you can price higher
if consumers perceive your product and/or brand is significantly better; price
on parity if your product has better features; or price lower if your product has
relatively similar features to existing products. An information client faced this
situation with a premium product. Its direct competitors established the price for a
similar offering. As the third player in this segment, its choices were price parity
with an enhanced offering or a lower price with similar features.
 Examine market pricing and economics. A paid, ad-free site should
generate more revenue than a free ad-supported one, for example. In considering
this option, remember to incorporate the cost of forgone revenue, especially
as advertisers find paying customers more attractive.
To gain additional insight from this analysis, observe consumers interacting
with your product to better understand their connection to it. This can yield
insights into how to package and promote the offering that can affect on
pricing, features, and incentives.
 Calculate the internal cost structure and understand how pricing
interacts with the offering. A content client promote its advertising-
supported free e- zines to incent readers to register. The client believed the e-
zines had no value as the content was repurposed from another product, so it

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didn’t advertise them. Yet the repurposed content was exactly what readers
viewed as a benefit. By

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 undervaluing its offering, the client missed an opportunity to increase
registrations and, hence, advertising revenues with a product that effectively had
no development costs.
 Test different price points if possible. This is important if you enter a new
or untapped market, or enhance an offering with consumer-oriented benefits.
To determine price, MarketingExperiments.com tested three different price
points for a book. It found the highest price yielded the greatest product revenue.
Interestingly, the middle price yielded greater revenue over time, as it generated
more customers to whom other related products could be marketed.
 Monitor the market and your competition continually to reassess
pricing. Market dynamics and new products can influence and change
consumer needs. Determine price based on a number of factors. Most
important is what potential customers are willing to pay and their value to
your company over time.
9.6 PRACTICALASPECT OF PRICING DECISION

Practical aspect of pricing decision explained here with the help of a case study.

CASE STUDY: PRICING IN THE PACKAGE HOLIDAY MARKET

UK holidaymakers take some 36 million overseas holidays each year. Of

these, almost half are “packaged holidays” - where the consumer buys a complete
package of accommodation, flight and other extras - all bundled into one price.
This is a highly competitive market with a small number of large tour operators
(including Thomson Holidays, Air tours, First Choice, JMC) battling hard for market
share. Package holidays were devised partly as a way of achieving high sales volumes
and reducing unit costs by allowing tour operators to purchase the different elements
(flight, catering, accommodation, etc.) in bulk, passing some of the savings on to
consumers.

Low margins require high asset utilisation

Estimates of tour operating margins vary, but fairly low average figures - of
the order of 5% (or around £22 on the typical holiday price of around £450) are
widely assumed in the mainstream segment of the market. It should however be noted
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that vertically integrated holiday operators (where the tour operator also owns an
airline and a travel

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agency) will normally also generate profit from consumers. Accordingly, the gross
margins on the total operations of the integrated operators may be larger than those on
their tour operation activities alone. Tour operators need to operate at high levels of
capacity utilisation (figures of the order of 95% or more in terms of holidays sold) in
order to maintain profitability. Matching capacity and demand is therefore critical to
profitability, especially since package holidays are perishable goods - a given package
loses all its value unless it is sold before its departure date. Perishable goods markets
require highlyflexible production and distribution systems so that supply and demand
can be closely matched and ‘waste’ production minimised. But suppliers of package
holidays are severelyhampered in precisely aligning capacity and demand. They need
to ‘produce’ (i.e. contract for the necessary flights, accommodation, etc.) virtually
the whole of what they expect to sell a long time before it is ‘consumed’ (i.e. when
the consumer departs for the holiday destination, or at the earliest, when the consumer
pays the bulk of the price - usually around 8 weeks before departure).

Long-term management of capacity

Tour operators’ capacity plans, and the associated contracts with hoteliers
and airlines, are typically fixed 12-18 months ahead of the holiday season. Some
adjustments are possible after this date. However, within about 12 months of departure
date, once the booking season has begun (i.e. from about the summer of 2002 for
departures in summer 2003) the scope for changes is severely limited. This is due to
the inflexibility of many commitments with suppliers and the problems associated with
changing dates, flights, hotels, etc., of customers who have already booked. Only by
contracting for their expected needs well ahead of time, enabling suppliers to plan
ahead, can tour operators obtain a sufficiently low price to attract an adequate
volume of profitable sales. Tour operators therefore need to encourage early
bookings. These improve cash flow - a substantial deposit (usually around £100
per person, equivalent to around 25% of a typical short- haul holiday price) is paid
byconsumers on booking; the balance is payable two months in advance of departure
(except, naturally, for ‘late’ bookings). Tour operators also reduce the risk of unsold
holidays, and the consequent need for discounting, later on. Adding capacity is easier
than reducing it during a season, although in some instances, e.g. where a particular
resort is proving especially popular, all suitable accommodation (and/or flights to the

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relevant airport) will already have been reserved, at least for the peak period. But it

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is generally difficult for tour operators to ‘unwind’ their contracts, especially those for
air transport, without substantial penalties. The tour operator, accordingly, bears almost
all of the risk of any contracted capacity remaining unsold.
The price mechanism
Faced with this limited ability to reduce output in the short term (i.e. once
the brochures are published and the selling season has started), tour operators can,
for the most part, only try to match supply and demand via the price mechanism - in
other words, by discounting once it becomes clear that sales of their holidays appear
unlikely to match the supply that they have contracted.
The fixed costs of tour operation (mainly, the cost of the airline seat and most
of the accommodation and catering costs) make up a high proportion of total costs, so
that relativelyhigh levels of discount can be applied if necessary to clear unsold stock.
Reductions of up to 25% off the initial brochure price are available on some ‘late’
sales - although consumers will often in such cases be required to accept the
operator’s choice of hotel, or even the resort, according to availability. Discounting of
holidays during this ‘late’ part of the selling season is a similar phenomenon to that of
‘end of season stock clearance’ sales in other retail sectors (e.g. clothing). However,
the impact of discounting on ‘late’ in a normal season should be seen in the context
of the operator’s turnover for the season; it is effectively reduced by only about 5%
(25% off 25% of holidays sold). Discounts (or equivalent incentives such as ‘free
child’ places or ‘free insurance’) for early purchase are also offered, but they are much
less significant both as to the amount of the reduction (5- 10% appears typical) and its
impact on costs and turnover. About three-quarters of all package holidays typically
are sold at or close to the brochure price. The fundamental rigidities in the market
have important consequences for competition. Theymake suppliers closely dependent
on each other from a strategic, as well as a short-term, viewpoint. In particular, any
decision by a tour operator to try to increase market share by increasing capacity (i.e.
offering more holidays for sale) will lead to a fall in prices unless competitors reduce
their share by an equivalent amount by cutting capacity.
9.7 SUMMARY
This chapter begins by defining price from the perspective of the consumer,

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society, and the business. Each contributes to our understanding of price and
positions it as a

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competitive advantage. The objectives of price are fivefold: (1) survival, (2) profit,
(3) sales, (4) market share, and (5) image. In addition, a pricing strategy can target to:
meet competition, price above competition, and price below competition. Several pricing
tactics were discussed. They include new product pricing, price lining, price
flexibility, price bundling, and the psychological aspects of pricing. The most important
pricing objective is revealed to be maintenance of existing customers, followed by
the attraction of new customers and the satisfaction of customers’ needs. Other
important objectives are cost coverage, the creation of a prestige image for the
company, its long-term survival, and service quality leadership. Objectives related to
profit, sales and market share are less important, perhaps because of the difficulties
associated with maximising profits or sales in reality. The least important objective is
discouraging new competitors from entering the market, perhaps because of the high
barriers to market entry that exist among some of the sectors examined in the study.
Also the companies regard quantitative objectives (those related to, for example, the
firm’s profits, sales, market share and cost coverage) as less significant than qualitative
objectives, which are associated with less quantifiable goals such as the relationship
with customers, competitors and distributors, plus the long-term survival of the firm
and the achievement of social goals. Moreover, companies seem to pursue more than
one objective, perhaps because of the complexity of pricing decisions.

9.8 SELFASSESSMENT QUESTIONS

1. Discuss the objectives which pricing policies can be established to accomplish?

2. Why is price an important pal1 of the marketing mix?

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3. Who typically has responsibility for setting prices in most organisations? Why?

9.9 SUGGESTED READINGS

 Mishra, S.k., and Puri, V.K., modern macro economic theory, Himalayan
Publishing house.
 Edward Shapiro, Macro Economic Analysis, Tata McGraw Hill, New Delhi.
 Jhingam, M.L. & Stephen, J.K, Managerial Economics, Vrinda Publications
Pvt. Ltd. Delhi.
 Dingra, I.C Managerial Economics, Sultan Chand, New Delhi.

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 UNIT-III
LESSON 10 PRICING METHODS

STRUCTURE

10.1 INTRODUCTION

10.2 OBJECTIVE

10.3 METHODS OF PRICING

10.3.1 Pricing a New Product

10.3.2 Pricing of Multiple Products

10.3.3 Product-Line Pricing

10.3.4 Pricing over the Life Cycle of a Product

10.3.5 Cyclical Pricing

10.3.6 Transfer Pricing

10.3.7 Differential Pricing

10.3.8 Cost-Plus or Full-Cost Pricing

10.4 SUMMARY

10.5 SELF ASSESSMENT QUESTIONS

10.6 SUGGESTED READING

10.1 INTRODUCTION

Pricing is the most neglected element of the marketing mix. The pricing
objectives of service firms provide directions for action. They range from, for example,
maximising profits, or sales, or market share, to avoiding price wars or achieving social
goals. Pricing methods, meanwhile, are explicit steps or procedures by which firms
arrive at marketing decisions. They can be cost based (such as adding a profit margin
187
to the average cost of

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the service), competition based (such as pricing similar to competitors or according to
the market’s average prices) or demand based (such as setting the price so as to
satisfy the customer’s needs).

10.2 OBJECTIVES

The objectives of this lesson are:

 To explain various pricing strategies
 To know the practical aspect of pricing decision

10.3 METHODS OF PRICING

10.3.1 Pricing a New Product

Pricing is a crucial managerial decision. Most companies do not encounter it in

a major way on a day-to-day basis. But there is need to follow certain additional
guidelines in the pricing of the new product. The marketing of a new,’ product poses
a problem for any firm because new products have no past information.

Here the firm is also not in a position to determine consumer reaction. The
question is, what do we mean by a new product? New products for our purposes
will include original products, improved products, modified products and new
brands that the firm develops through its own R&D efforts.

When fixing the first price, the decision is obviouslya major one. When the
company introduces its product for the first time, the whole future depends heavily on
the soundness of initial pricing decision. Top management is accountable for the new
product’s success record.

Top management must establish specific criteria for acceptance of new

product ideas especially in a large multidivisional company where all kinds of projects
bubble up as favourites of various managers. There are always competitors who
would also like to produce it at the earliest opportunity. Pricing decision assumes
special importance when one or more competitors change their prices or products
or both.

Sometimes, the competitors may introduce a new brand without altering the
price of an existing brand. If the new brand is perceived to compete with a given
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brand more effectively, then the firm in question may have to think on its pricing
policy once again.

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 The price fixed for the new product must:

(i) Earn good profits for the firm over the life of the product;

(ii) Provide better quality at a cheaper price and at a faster speed than
competitors;

(iii) Face rising R & D, manufacturing and marketing costs and

(iv) Satisfy public criteria such as consumer safety and ecological compatibility.

The firm can select two types of strategy:

(A) Skimming Pricing

(B) Penetration Pricing

(A) Skimming Pricing:

Skimming pricing is known as charging high price in initial stages. This can be
followed by a firm by charging skimming price for a new product in pio-neering
stage. When demand is either unknown or more inelastic at this stage, market is
divided into segments on the basis of different degree of elasticity of demand of
different consumers.

This is a short period device for pricing. The demand for new products is likely to
be less price elastic in the early stages, that is, the initial high price helps to
“Skim the Cream” of the market which is relatively insensitive to price.

This policy is shown in Fig. 1, where the manu-facturer of new product

initially determines OP price and sells OQ quantity. Thus he receives KPMN
abnor-mal profit. Under this policy, consumers are distin-guished by the producers
on the basis of their intensity of desire for a commodity.

For example, in the beginning the prices of computers, T.Vs, electronic

calculators, etc., were very high but now they are declining every year. Ahigh initial
price together with heavy promotional expenditure may be used to launch a new
product if conditions are appropriate.

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These conditions are listed below:

(i) Demand is likely to be less price elastic in the early stages than later. The
cross elasticity demand should be very low.

(ii) Launching a new product with a high price is an efficient device for breaking
the market into segments that differ in price elasticity of demand.

(iii) When the demand elasticity is unknown, high introductory price serves as a
refusal price during the stage of exploration.

(iv) High initial prices help to finance the floatation of the product. In the early
stages, the cost of production and organisation of distribution are high. In
addition, research and promotional investments have to be made.

(B) Penetration Pricing:

Penetration price is known as charging lowest price for the new product. This is
aimed to quick in sales, capture market share, utilise full capacity and economies
of scale in productive process and keep the competitors away from the market.

Penetration price policy can be adopted in the following circumstances:

(i) There is very high price elasticity of demand.

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(ii) There are substantial cost savings due to enhanced production process.

(iii) By nature the product is acceptable to the mass of consumers.

(iv) There is no strong patent protection.

(v) There is imminent threat of potential competition so that a big share of the
market must be captured quickly.

Penetration price is a long term pricing strategy and should be adopted with
great caution. Penetration pricing is successful also when there is no elite market.
When a firm adopts a penetrating pricing policy, adjustments to price throughout
the product life cycle are minimal. Since this policy prevents competition, it is also
referred to as ‘Stay-out’ price policy.

Penetration price is explained in Fig. 2, where market price is OP , and

quantity demanded is OQ . Now the producer of a new product fixes theo price
o
less than the market price i.e., OP and sells OQ more quantity. Obvi-ously, it has
1 1
a wide potential market.

The comparison between skimming pricing and pen-etration pricing is that

high skimming price policy needs vigorous and costly promotional effort to back it
but low penetration price would require low promotional expenditures.

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But the policy is inappropriate where

(i) The total market is expected to stay small, and

(ii) The new product calls for capital recovery over a long period.

10.3.2 Pricing of Multiple Products

The traditional theory of price determination is based on the assumption that

the firm produces a single homogeneous product. But firms usually produce more
than one product. When firms produce several products, managers must consider
the interrelationships between those products.

Such prod-ucts may be joint products or multi-products. Joint products are

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

For evolving price policy for multi-product firm, certain basic considerations
involved in decision making are:

(i) Price and cost relationship in product line,

(ii) Demand relationship in product line, and

(iii) Competitive differences.

They are explained as follows:

(I) Price and Cost Relationship:

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

Proper pricing does require, however, that prices at least cover the
incremental cost of producing each good. Incre-mental costs are additional costs that
would not be incurred if the product were not produced. As long as the price of a
product exceeds its incremental costs, the firm can increase total profit by
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supplying that product.

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 Hence decisions should be based on an evaluation of incremental costs. A
price that offers maximum contribution over costs is generally acceptable but in multi-
product cases, incremental cost becomes more essential to make such decisions.

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

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

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

(c) Prices of multi-products maybe assessed with reference to their contribution

margin as proportional to conversion cost.
(d) Prices of multi-product may be fixed differently keeping into consideration
market segments.
(e) Prices for multi-products maybe fixed as per the product life cycle of each
product.
(II) Inter-relation of Demand for Multi-product:
Demand inter-relationships arise because of competition in which case
theybecome substitutes or they may be complementary goods. Sale of one product may
affect the sale of another product. Different demand elasticity of different consumers
may allow the firm to follow policies of price discrimination in different market
segments. Two products of the same price may be substitutes to each other with cross
elasticity of demand due to high degree of competitiveness.
In such a situation, pricing of the multi-products will have to be done in such a
long waythat maximum return could be obtainedfrom each market segmentsbyselling
maximum products. Demand inter-relationships in the case of multiple products make
it clear that we should take into account a thorough analysis of the total effect of the
decision on the firm s revenues.
(III) Competitive Differences:
Yet another important point should be considered for making price decisions,
for a product line is the assessment of degree of competitiveness. Such an assessment
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will set

197
up market share for each product. A product having large market share can stand a
high makeup and can contribute to bear the losses.
There is competition among a few sellers of a relatively homogeneous
product that has enough cross elasticity of demand so that each seller must in his
pricing decisions take account of rivals’ reaction. Each producer is actually aware of
the disastrous effects that an announced reduction of his own price would have on
the prices charged by competitors. The firm should also analyse whether the
competitors have free entry to the market or not.
IV Marginal Technique for Pricing of Multi-products:
Marginal technique for pricing multi-products is based on the logic that when
the firm has spare capacity, unutilised technical resources, managerial and organisational
abilities and capabilities, the firm enters into production of various other products with most
profitable uses of alternatives.
The product is technically independent in the production process. For selecting
these alternatives, the firm considers marginal costs of each such alternative and
adopts those which offer higher margin on cost through sales.
Since each additional unit produced entails an additional cost as well as
generates additional rev-enue, the logic of profit maximisation stresses that production
should be stabilised at a point where MR just covers MC. ‘Marginal cost more
accurately reflects those changes in costs which result from a decision. Marginal pricing
is more useful because of the prevalence of multi-product firms.
A firm shall produce the multi-product to the level where MR from sales of
all these products equals the MC. If MC is more than MR then the firm shall stop
producing and selling one of the products which offer less MR than MC.
V Pricing of Joint Products:
Products can be related in production as well as demand. One type of
production interdependency exists when goods are jointly produced in fixed proportions.
The process of producing mutton and hides in a slaughter house is a good example of
fixed proportion in production. Each carcass provides a certain amount of mutton
and hide.

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 There is little that the slaughter house can do to alter the proportion of the
two products. When goods are produced in fixed proportion they should be thought
of as a ‘product package’. Because there is no way to produce one part of this
package without also producing the other part, there is no conceptual basis for
allocating total production costs between the two goods.
VI Pricing of joint products can be explained under two different
circumstances:
(i) When there is fixed proportion of products.
(ii) When there is variable proportion of products.
(i) Joint Products with Fixed Proportion:
In joint product case with fixed proportion of quantity, there is no possibilityof
increasing one at the expense of another. In this situation, the costs are joint and
cannot be increased at the expense of another. In this situation, the costs are joint
and cannot be allocated to each product on any sound basis. Although the two
goods are produced together, their demands are independent.
However, there is a single marginal cost curve for both products. This reflects
the fixed proportion of production, i.e., the marginal cost is the cost of
supplying one more unit of the product package. Where goods are jointly
produced as in the case of mutton and hides, pricing decision should take this
interdependency into account.

Figure 3 indicates how profit maximising prices and quantities are determined. P
and P repre-sent the most profitable prices for the joint products. The figure M
H
carries the assumption that each product is produced in fixed proportion
because the output
point for both is one and the same whereas their demand and marginal revenue
curves
are separate for different markets existing for them. MR and MR are the
marginal revenue curves for mutton and hides respectively. M But Hwhen an
additional animal is
processed at a slaughter house both mutton and hide become available for sale.
Hence the marginal revenue associated with sale of a unit of the product package is
the sum of the marginal revenues.
199
 This sum is represented by the line MR . MR is determined by adding MR
T
and MR , for each rate of output. Graphically, itTis the vertical sum of the marginal
M
T
revenue curves of the two products. The profit maximising output Q is de-
O
termined by the intersection of MR and MC curve at point E with price of mutton
T
OP and of hides OP .
M H
(ii) Joint Products with Variable Proportions:
Pricing of joint products which can be produced with variable proportions presents
interesting analysis of price, cost and output. When it is possible for a firm to
produce joint products in different proportions, the total cost has to be divided
among different products because there cannot be a being e marginal cost
curve.

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Figure 4 Illustrates the pricing method of multiple products with variable
proportions wherein three main things are to be observed:

(i) The production possibilitycurve is concave to the origin indicating imperfect

adaptability of productive resources in producing products A and B. In other
words, it indicates the quantity of A and B which can be produced with the
same total cost. It is the isocost curve labelled as TC in the figure.
(ii) The iso-revenue lines define the prices which the firm receives for the two
products irrespec-tive of any combination of their output. They are shown as TR
in the figure.
(iii) The best combinations are the points of tangency of isocost curves and iso-revenue
lines tor optimum production and maximisation of sales revenues or profits.
Thus the optimal output combination is at a point where an iso-revenue line
is tangent to an isocost curve. We can find the optimal combination by comparing the
profit level at each tangency point and choosing the point with the highest profit level,
given fixed product prices.
Suppose a firm produces and sells two products A and B, given their prices.

201
Each isocost curve, TC, shows the quantities of these products that can be
produced at the

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same cost. Each iso-revenue line shows the combinations of outputs of Aand B that
yield the same revenue.
The problem facing the firm is to determine the outputs of joint products Aand
B. To solve it, let us start with an output combination where an iso-revenue line is not
tangent to the iso-cost curve. Let us take such a point as P in the figure. This cannot be
the optimal output combination because it is possible to increase revenue without
changing cost by moving to point R on the same isocost curve where the iso-revenue
line is tangent to the isocost curve.
Besides, the firm has to take into consideration the profit maximisation optimal
output of combina-tion A and  products. For this, it compares the level of profit at
each tangency point and chooses that point where the profit level is the highest. In the
figure, there are four tangency points K , R ,S and T corresponding to the profit
levels = Rs 2 crore, = Rs, 4 crore, = Rs 6 crore and = Rs 4 crore respectively.
It is clear from the above that the firm will choose the optimal output
combination at point S where it produces and sells OA units of product Aand
3
OB units of product Â
3
and earns the highest profit Rs. 6 crore. It cannot produce at the higher output
combination point T as compared to S because its profit level will fall to Rs 4
crore.
10.3.3 Product-Line Pricing

Product line pricing is an important practical problem for most modern

industrial enterprises. Since almost every firm makes several related products, product
line pricing is an important phase of price policy. Product line pricing refers to the
determination of prices of the individual products which form units of an output package.
From the viewpoint of management a typical modem firm produces multiple models,
styles or sizes of output each of which can be considered a separate product. Although
product line pricing requires same economic concepts used for single product pricing, the
analysis becomes complicated, however, by demand and production externalities which
arise because of substi-tutability or complementary between the products on the
demand or the production side.
203
 The problem of product line pricing is to find the proper relationship among
the prices of mem-bers of a product group. Product line pricing can include use-
differentials (e.g., fluid milk vs. cheese milk), seasonal differentials (e.g., morning
movie specials) and

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style cycle differentials. These are all phases of product line pricing. Our analysis of
product line pricing is divided into two parts, the first sets forth a general approach, to
–
the problem
, and the second applies this approach to some specific cases.

General Approach:

We discuss, in this section, problems of exploring demand relationships

and competitive differ-ences and of making and using cost estimates for pricing related
products.

Alternative Policies of Price Relationship:

A logical approach to product line pricing is to start with a picture of the

alternative kinds of policy regarding the relationships among prices of members of a
product line.

Let us examine some systematic patterns below:

(i) Prices that are Proportional to Full Cost:

Prices that are proportional to full cost, i.e., that produce the same percentage
net profit margin for all products. Here cost plus pricing is followed.

(ii) Prices that are Proportional to Incremental Costs:

Prices that are proportional to incre-mental costs i.e., that produce the
same percentage contribution margin over incremental costs for all products.
Incremental cost is the additional cost of added units.

(iii) Prices with Profit Margins that are Proportional to Conversion Cost:

Prices with profit margins that are proportional to conversion cost, i.e., that
take no account of purchased materials cost. Conversion costs refer to costs incurred to
convert the raw materials into finished products.

(iv) Prices that produce Contribution Margins that depend upon the
Elasticity of Demand:

Buyers with high incomes are usually less sensitive to price than those that
make up the mass market and it is often profitable to put higher profit margins as
205
products for the plushy class markets than for the rough and tumble mass markets.

(v) Prices that are systematically related to the Stage of Market and

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 Competitive Development of Individual Members of the Product Line:

Manyproducts pass through life cycles.Aproduct line pricing policythat

specifically recognises that a company’s various products is at different stages in their
life cycles and hence face different market acceptance and competitive intensity has
much to command it. This method emphasises that the firm should charge high price
for those products in the line which are in their pioneering stage and prices are kept low
for products in the maturity stage.
VI Competitive Differences:
An analysis of competition is frequentlya vital phase of product line pricing
because differences of competitive selling among products call for differences in profit
margins or distribution margins. Even though it is not possible to measure the
relevant aspect of competitive differences amongproducts. Differences in competitive
condition depend upon the firm’s share of each product in the market. Here two aspects
of competition, existing and potential, have to be considered.
Existing competition can be measured indirectly by several of its symptoms:
(i) The number of competitors,
(ii) The market share, and
(iii) The degree of similarity of the competitive products.
In general, the fewer the competing sellers, the higher the margins, aside
from other dimensions of competition. A product with a dominant market share can
stand a higher mark-up since the presump-tion is that it has competitive superiority. The
degree of similarity of the competitive product indicates that differentiated or unique
products can have higher prices.
Potential competition can use indices like:
(i) Incentives for competitive entry,
(ii) Patent barriers,
(iii) Financial barriers, and
(iv) Technological barriers.
207
 Existing profits of the firm are the index to the entry of other firms. Higher
profits will attract other firms. Patent barriers to future competition depend upon the
ability to initiate the production process. Financial barriers can be quantified by guessing
how much money it would require to develop a competitive product and sell it.
Technical barriers are similar to patent barriers.

VII Cost Estimates:

The cost should be the dominant if not the sole consideration in determining
the relationship of prices within a product line. Cost estimates are indispensable for
accurate analysis of almost every kind of pricing problems. Cost estimates are needed
in product line pricing to project roughly the effects upon profits of different price
structures.

Specific Problems:

Other dimensions that have to be considered in the philosophy of

products line pricing are:

(i) Pricing products that differ in size

(ii) Pricing products that differ in quality

(iii) Charm prices

(iv) Pricing special designs

(v) Load factor price differentials

(vi) Pricing repair path

(vii) Pricing leases and licenses

They are explained as under:

(i) Pricing Product that differs in Size:

The intensity of competition often varies with size. The logical role for size as
a pricing criterion is as a measure of value of the buyer. In selecting the pattern of
relationship of price to size, much depends upon whether the typical buyer has
freedom to substitute one size of product for another. The best example of size-
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differential pricing problems is given with reference to fractional page advertising
rate in newspapers.

209
(ii) Pricing Products that differ in Quality:

The pricing decision here depends primarilyupon the strategic objectives of

having products that differ in quality. Sometimes the purpose of high quality items is
to bring prestige to the entire line. The firm may also produce products of lower quality
to compete with the low priced product in the market. The low quality products are
introduced at low prices to face competition.

(iii) Charm Prices:

Charm price theory is based upon consumer psychology that prices ending in
odd figures e.g. Rs. 4.95 and Rs. 9.95 have greater effect than odd or even prices such
as Rs. 5 and Rs.10. This is a point of controversy and empirical research, yet it does
not permit a conclusive answer. Newspaper advertisements are dominated by prices
ending in odd numbers.Another explanation is that odd figures conveythe notion of a
discount or bargain.

(vi) Pricing Special Designs:

Pricing special designs is a common practice to estimate normal full cost, then
add to cost a fixed percentage to represent a fair or desirable profit. The price
decision as special order is really a decision as to whether or not to produce the
product at all. Here cost plays a peculiar role in special order pricing. An important
base for special order pricing is good judge men estimating accurately the future
cost of unfamiliar products.

(v) Load Factor Price Differentials:

Here firms charging different prices at different times the same product or
service in order to improve the sellers’ load factor have important profit potentiates
for many producers. Such load factor price differentials are part of peak load
pricing theory.

Examples of load factor price differentials are off peak rates for electric
energy, morning movies, summer discounts on winter clothing, etc. It need not be
for the same product at different period. Analysis of demand, cost and competition
should enter into this consideration.

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(vi) Pricing Repair Parts:

All producers of durable goods face the problems of pricing the repair parts or

211
spare parts. Some firms even experience higher sales receipts from repair parts
production than from new equipment. Spare parts pricing has an element of monopoly.
This monopoly power is how-ever always restricted by competition of various
forms.

Pricing of spare parts should not be related to relative average cost or to

relative weight. Parts that are readily available should be sold at relatively low prices.
Parts that the buyer can himself rebuild or get it made, for them prices should be
low.
(vii) Pricing Leases and Licenses:
Royalty licensing and leasing of capital goods and patents reflect application
of market segmentation pricing. Uniform price cannot be charged. The price charged
on these is closely related to the benefits the firm receives. This pricing practice reaps
for the seller-a share of the gains of the most advantageous users.
Benefits are determined by the purpose for which the equipment is obtained,
the rate of utilisation, the efficiency of alternatives and so forth. As far as royalty
price is concerned, it need not consider the development costs that were incurred in
creating the equip-ment.
10.3.4 Pricing over the Life Cycle of a Product
The cycle begins with the invention of the new product. The innovation of a
new product and its degeneration to a common product is termed as the life cycle of a
product. It is an important concept m marketing that provides insights into a product’s
competitive dynamics. The life cycle of a product portrays distinct stages in the
sales history of a product.
Corresponding to these stages are distinct opportunities and problems with
respect to market strategy and profit potential. By identifying the stag that a product is
in, or may be headed toward, companies can formulate better marketing plans. Figure
5 depicts the life cycle of a product.

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 Every product moves through a life cycle having five phases as shown
in the figure and they are:
(i) Introduction:
This is the first stage in the life cycle of a product. This is an in-fant stage.
The product is a new one. The product is put on the market, awareness and
acceptance are minimal. There are high pro-motional costs. Therefore, the profit may be
low. The firm can use two types of pric-ing policy, i.e., skimming price policy or
centralising price policy in this stage.

(ii) Growth:

In this stage, a product gains acceptance on the part of consumers and

businessmen. The product begins to make rapid sales gains because of the
cumulative effects of introductory promo-tion, distribution work or mouth influence.
The product satisfies the market. For the purpose of pricing, there is not much
difference between growth and maturity stages.’

(iii) Maturity:

At this stage, keen competition increases. Sales growth continues, but at a

dimin-ishing rate, because of the declining number of potential customers.

213
Competitors go

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for mark-down price. Additional expenses are involved in the product’s modification
and improvement, thus profit margin slips. This period is useful because it gives out
signals for taking precaution in pricing policy.

(iv) Saturation:

In this stage, the sales are at the peak and further increase is not possible.
The demand for the product is stable. The rise and fall of sale depend upon supply and
demand. There is little additional demand to be stimulated, it happens to be its
replacement demand. Therefore, the product pricing in the saturation stage is full
cost plus normal mark-up.

(v) Decline:

Sales begin to diminish absolutely as the customers begin to tire of a product.

The competitors have entered the market with substitutes and imitations. Price
becomes the competitive weapon. The product should be reformulated to suit the
consumers preferences, it is possible in the case of few commodities.

Throughout the cycle, changes take place in price and promotional elasticity of
demand as also in the production and distribution costs of the product. Therefore,
pricing policy must be adjusted over the various phases of the cycle.

10.3.5 Cyclical Pricing

Cyclical pricing refers to the pricing decisions of the firm which are taken to
suit the fluctuations in the business conditions. To simplify decision making in response
to the alterations in the entire economic system, it is necessary for the firm to have some
kind of policy based on cyclical price behaviour. It is more apparent to say that prices
are slashed during recession and pegged up during a demand-pull or a demand-
push.

In formulating a policy of cyclical pricing, various factors such as

demand, competition, cost- push, price rigidity, price fluctuations, fluctuations due to
substitutes, purchasing power, market share and demand fluctuation should be
taken into account.

They are explained as under:

215
(i) Demand:

The commodities are divided into durable and non-durable goods. The
necessaries

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fall under non-durable goods and demand for them is constant and inelastic. The
purchase of necessary goods cannot be postponed but the purchase of durable goods
can, however, be postponed. Under imperfect market conditions, demand plays an
important role.
(ii) Competition:
If the market is imperfect, firms compete against each other and there is an
element of interdependence. Apolicy change on the part of one firm will have
immediate effects on competitors. Price cuts lead to price war. Therefore,
adjustments have to be made.
(iii) Cost-push:
Producers tend to pass on increase in cost of production to consumers in the
form of higher prices.
This may happen due to:
(a) Wage increases higher than output;
(b) Inadequate investment in plant may reduce output;
(c) Shortages of factors of production; and
(d) Increase in price of basic raw materials.
In these conditions costs are bound to rise. Under this situation, what kind
of pricing policy should be followed by the firms? It is difficult to answer this
question.
Joel Dean suggests that in formulating a policy of cyclical prices, the following
factors may be considered:
(a) Price Rigidity:
Firms do not believe that prices change because of business cycles. The
cyclical fluctuations are caused by economic factors like income, profit and
psychological factors like expectations of the consumers. They have control over these
factors. They are also of the opinion that it is not healthy to change prices in
response to cyclical fluctuations.
217
(b) Price Fluctuation:
Price fluctuations conform to cost changes at current full cost, standard full
cost, and incremental cost. Confirming cyclical changes in prices to changes in
company costs is

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another popular cyclical policy. It amounts to stabilising some sort of unit profit
margin.
(c) Fluctuation due to Substitutes:
The use of substitute product as a cyclical pricing guide is an appropriate
price policy in many situations. It may also stabilise the industry’s share of the vast
substi-tute market.
(d) Purchasing Power:
If prices can be reduced because of a fall in the purchasing power of the
people during a depression, then we have what is known as the blanket index of the
purchasing power. Purchasing power index is onlyan average that covers up great
disparities. Therefore component prices are more important.
(e) Market Share:
Market share is determined by many factors and price is an important deter-
minant. Price policyhas a profound effect upon the larger share of the substitute
market.Areduction in price would increase the market share. Market share can be a
useful pricing guide for cyclical pricing.
(f) Demand Fluctuations:
If there are shifts in demand, they should be taken into account in setting
prices. They are more important than the elasticity of demand. One recession pricing
policy is to change prices in relationship to some appropriate index of shifts in
demand for the product.
This pricing method assumes:
(i) That flexible rather than rigid prices are appropriate,
(ii) That changes in prices in the past have adjusted for changes in demand
correctly,
(iii) That these past pricing objectives are today’s objectives, and
(iv) That cost behaviour and competitive reactions will be the same as in similar
periods in the past.

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10.3.6 Transfer Pricing

Transfer pricing is one of the most complex problems in pricing. The growth
of

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2
large scalemulti- divisional organisations has givenrise to the problemof
pricingcommodities that are transferred inter-nally from one division to another.

The divisional organisations are preferred due to the following reasons:

(i) It provides a systematic way of delegation and decision making

(ii) For proper evaluation of contribution, and

(iii) For the precise evaluation of manager’s performance.

This involves the problem of sub-optimisation. The transfer price

must satisfy the following two criteria:

(i) It should help establish the profitability of each division or department.

(i It should permit and encourage maximisation of the profits of the company as a

whole.

For determining the transfer price there are three alternative methods. They
are explained as follows:

(i) Market Price Basis:

The suitable system of transfer of goods from one division to another under the
same management to another company is the market price basis. The market price
should be the transfer price. Wherever a market price exists for a product, the inter-
divisional transfer price should equal the market price to avoid sub-optimization. This
method definitely avoids the possibilityof passing the inefficiencies of one department to
the other departments.

(ii) Cost Basis:

In case the product produced by a division of the firm can be sold only to
another division of the firm, the inter-divisional transfer should be priced at the level of
the actual cost of production. Here transfer prices will be useful to achieve the best
joint level of output. It will maximise profits.

(iii) Cost plus Basis:

Under this method the goods and services of each department are charged on
221
the basis of actual cost plus a margin by way of profit. The major defect of this
method is that

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the transferring department may add a high margin so as to raise the profit of the
department. It may result in setting the ultimate price unduly high thereby affecting
sales.

Transfer Price Determination:

Objectives:

Firms have the following objectives while determining the transfer price:

1. The aim of the firm is to ensure that its goal coincides with that of the
related divisions.

2. The price of the transferred product should be so determined that the

profitability of each division could be ensured.

3. The price should be such that it could induce profit-maximisation of the

company as a whole rather than of a particular division.

Large firms often divide their operations into various divisions or departments.
One division uses the product of the other division. In such a situation, firms are faced
with the problem of determining an appropriate price for the product transferred
from one division or sub-division to the other.

In other words, transfer pricing refers to the price determination of goods

and services transferred among interdependent units or divisions within the
organisation. This operates as a measure of the economic achievements of profit
making divisions in the organisation. It is necessary to consider various situa-tions
while determining transfer price.

1. Transfer Pricing: Absence of an External Market:

If an intermediate product has no external market, transfer pricing will be

according to the mar-ginal cost of the producer. Suppose that a firm has two
independent divisions: production division and marketing division. The Production
division produces one product that is sold to the marketing division of the same firm.

The price at which it sells is called transfer price. Further, the marketing
division presents that product as a final product by packaging it and sells it to the

223
public. We also assume that the product manufac-tured by the production division has
no market outside the firm.

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2
In other words, the marketing division completely depends upon the production
division for the supplyof the product and the production division depends on the
marketing division for its demand. Therefore, the total quantityof the product
manufactured by the production division must be equal to the amount sold by the
marketing division.

In Fig. 6 MC and MC are the cost curves of production division and

P
marketing division respectively M MC is the firm’s cost curve. This curve is the
and
sum-mation of
MC and MC curve D is the firm’s demand curve and MR is the marginal
p curve for
revenue M the finalFproduct. The firm will be in equilibrium at point E where
its MC curve
cuts its MR curve. The firm will be selling OQ quantity of the product at OP price.

Now, the question is how much price the produc-tion division should charge
for its product from the mar-keting division? The transfer price is equal to the mar-ginal
revenue of the production division. The transfer price once determined is always stable
because the de-mand curve of production division is horizontal on which the marginal
revenue of
production division is equal to the transfer price, i.e., D=MR —P . The production
p at1 that point where
division will earn the maximum profit for its intermediate product
Price (P ) which is also its marginal revenue (MR ), is equal to its marginal cost
1 p
(MC ), i e P = MR =MC . This situation is at point where the MC curve cuts the.
p 1 p p p

225
D=MR =P curve from below.
p 1
2. Transfer Pricing: Presence of an External Market:
If there is an external market for the intermediate product, the production division

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2
may produce more product than the marketing division needs and may sell the
surplus product in the external mare. On the other hand, it may produce less than the
needs of the marketing division and the market division can obtain the rest of its
requirements from the external market. Thus, it is more free for maximising its
profit.

(1) Transfer pricing: In a Perfectly Competitive External Market:

In the case of a perfectly competitive external market, where the

intermediate product can be sold or bought from the perfectly competitive outside
market by the firm, the quan-tity produced by the production division may not be equal
to the required quantity for the mar-keting division.

In such a situation transfer price of intermediate product is the market price of

that product. The firm can be in the maximum profit situation onlywhen all its divisions
oper-ate at their related MR — MC points. In these conditions, we explain transfer
pricing in terms of Figure 7.

In the figure, D is the demand curve of intermediate product which is a

horizontal line. This curve shows marginal revenue (MR ), average revenue (AR )
p p
and price (P) of
the pro-duction division. According to the figure, the production division will receive
the
maximum profit at OQ output level because at this level marginal cost of
2 to its marginal revenue (MR ) which determines OP
production (MC ) is equal
p p 1
227
price. Here the equilibrium is at point E where the MC curve cuts die D=AR =
MR curve from below. p p
p
To maximise total profit of the firm in the perfectly competitive market, it will
be

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2
appropriate to keep transfer price at OP level. It is at this price that the production
1 the marketing division or to outside customers,
division will sell its intermediate product to
and the marketing division will also give only OP price for the intermediate product to
the production division. 1

The marginal cost curve of the marketing division is MC which is the

M
summation of marginal marketing cost and transfer price P . To maximise its profit,
1
marketing division will have to purchase OQ quantity where its marginal cost MC is
1 M
equal to its marginal revenue MR at point In the figure, the maximum profitable
M
quantity for the production division will be OQ and that for the’ marketing division
2
OQ Hence, the production division will sell OQ – OQ = Q Q portion of its
1 2 1 2 1
output in the external market.
(2) Transfer Pricing:

In Imperfectly Competitive External Market, Here we discuss trans-fer pricing

in that market situation where the production division sells its product in
imperfectly com-petitive external market as well as to the marketing division. In
such a situation, an important problem of price differentiation arises in different
markets.

The production division will get the maximum profit, when the marginal revenue
in each market is equal to marginal revenue for the total market, and total market
marginal revenue is equal to marginal cost. In other words, transfer price for the
marketing division should be equal to the marginal cost of production division. Transfer
price determination in the case of imperfectly competitive external market is shown
is Fig. 8.

229
Panel (A) of the figure is related to an imperfectly competitive external market in

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3
which D is its demand curve and MR is its marginal revenue curve. Panel (B) is
E MR is the net marginal revenue curve
related to the marketing division in which
M
of the marketing division. In other words, MR = (P =MC ). Here, transfer price
M T p
(P ) is equal to the marginal cost of the production division (MC ) Panel (C) is
T p
related to the production division.

Its marginal revenue curve MR is the summation of marginal revenue of

p
the marketing division within the firm (MR ) and marginal revenue of the external
M
market (MR ). The optimum production level of the production division is OQ when
E
MR curve is equal to MC curve at point Å and the transfer price is OP . The
p T
marketing division wall buy OQ quantity of output at OP transfer price from the
M T
production division and the production division can sell OQ units of its produc-tion
E
at OP price in the external market.
10.3.7 Differential Pricing

Differential pricing is a method that is used by some sellers to tailor their prices
to the specific situation of buyers. The firm may charge the same or different prices
for the same product. It is a practical device available to management to enlarge profits.
It exploits the difference in demand elasticities.

The most common ones include quantitydifferentials, location differentials,

product use differentials and time differentials. To achieve differential pricing, it is
necessary to segment markets. The common techniques utilised for market segmentation
are differences in product design, quality, choice of chan-nel, time of sale, patents,
packaging and advertising.

The important reasons for the price differentials are the following:

(i) The location of purchase,

(ii) The amount of purchase,

(iii) The time of purchase,

(iv) The status of the buyer,

(v) The promptness of payment, and

(vi) The personal situation.

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The major goals of price differentials are the following:
(i) Implementation of different market strategy,
(ii) To achieve profitable market segmentation,
(iii) To attract new customers,
(iv) To face competition, and
(v) To solve production problem.
(A) Distributor Discounts:
The differential prices often take the form of price discount. Modern
business extends over a very wide area. The whole market may be divided into
different areas or regions, thereby trade channel is formed. The manufacturer puts his
product in the trade channel through various intermediaries or distributors. He allows
certain rate of discount to the distributors. Such discounts are called distributor
discounts. They refer to discounts or price deductions allowed to various distributors
in the channel.
Factors Determining Distributor’s Discounts:
Discounts given to distributors will depend on the following:
(i) Services of the Distributor:
The role played by the distributor is different for each product. In general,
the merchandise business distributor himself will have to decide the
investment and there is any sort of help from the manufacturer. On the other
hand, the people who run specialised business like electronic gadgets have
todevote themselves exclusively to the products of only one firm. The distribu-tor
discount is generally at a low and fixed level and for the specialised
distributors, the discounts are normally high.
(ii) Operating Cost of the Distributor:
The aim of allowing discounts to the distributor is to cover the operating costs
and normal profits of distributors. The operating costs depend upon the
vari-ous functions they perform. The producer himself may take up the
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3
function of a distributor and thus assess the cost. This may provide a basis
for assessing the operating cost.

233
 (iii) Discount Structure of Competitors:
Many close substitutes are available in a competitive market. Different
manufacturers will be providing different discount rates. The discounts given
by rival sellers are very practical guide.
(iv) Effect of Discounts on Ultimate Buyers.
A producer must take into account the effect of discount allowed to a
distributor on the ultimate buyers. He should watch whether the distributor at-
tempts to expand sales or not. Some distributors may forego a part of their
discounts by disposing of the product below the list price.
(v) Effect of Distributor Population:
The manufacturers must adopt an attractive discount policyexpand the
distributor population quickly. Amanufacturer must also take into account
whether he wants to have a wide network of small distributors or only a few
big distributors
(vi) Cost of Selling to Different Channels:
The cost of distributing the commodity to different channels of distribution is
yet another criterion. In certain cases, the distributor will receive the orders and
pass on to the manufacturer. In mail order channels, the rate of discount is low.
Apart from this the distance, local taxes, and mode of transport engaged may
also cause variations in the cost of distribution.
(vii) Opportunities for Market Segmentation:
In some cases, the market is sub-divided into several sub-markets. The
sub- market may have its own demand and competitive characteristics. These
markets are characterised by variation in the elasticity of aggregate demand
and cross demand.
(B) Quantity Discounts:
Quantity discounts relate to the quantity purchased. These are important
pricing tools for most modem firms.
There are two main considerations involved in this:

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(i) The type of discount system to be chosen, and

235
 (ii) The size of quantity discount to be allowed.

For the type of discount system to be chosen, certain guidelines have to be

adopted. The important guidelines have to be based on:

(i) The way the size is measured

(ii) On the measurement of the quantity of individual product

(iii) The form of calculation

(iv) The number of transaction.

The size of quantity discount to be allowed involves two considerations:

(i) Specific market objec-tives; and

(ii) Legality of the discount.

(i) Under specific market objectives, quantity discounts can help to induce
the customers to give t e seller bigger lots. They can stimulate the same
customers to give the seller a larger share of their total business. It is to
overcome competition through hidden price reduction.

(ii) Under legality of the quantity discount, all quantity discounts are
discriminatory and applied to suppress competition. The question of legality
arises when quantity discount tends to suppress competition.

(C) Cash Discounts:

Cash discounts are reduction in the price which depend upon promptness
of payment. It relates to cash sales. Cash discounts are allowed by the producers to
dealers and dealers to customers. The cash discount is a convenient way to identify
bad credit risks. If a buyer wants to buy on credit, he may have to forego discount. By
discouraging customers from credit buying, the producer is able to reduce the
working capital.

(D) Geographical Price Differentials:

It is another commonly practised differential pricing. This is based on

buyer’s location. It revolves round the nature of transportation cost and certain legal
2
3
considerations.

237
They take a variety of forms:
(i) F O.B. Factory Pricing:
Under FOB pricing, the buyer is required to bear the entire cost of transport
and is responsible for the risks occurring during transport except those are
assumed by the carrier. Since the product is priced at the seller’s plant, the
buyers can choose the method often transportation. It assures uniform net price
on all shipments regardless of where they go. The seller responsible for delay
in carriage and no risk is assured by the seller.
(ii) Postage Stamp Pricing:
Postage stamp pricing means charging the same delivered price or all
destinations irrespective of buyer’s location. The price naturally includes the
estimated average transport cost. It is most commonly employed for goods of
popular brands and having nationwide distribution. This pricing gives a
manufacturer access to all markets regard- less of his location.
(iii) Zone Pricing:
Under zone pricing, the seller divides the countryinto zones and regions and
charges the same delivered price within each zone, but different prices between
different zones. I is preferred where transport cost on goods is too high to
permit, the sale, though cost on goods is too high
(iv) Basic Point Pricing:
A basic point price consists of a factory price plus transportation charges
calculated with reference to a particular basic point! Under the system, the
delivered price may be computed by using either single basic point or multiple
basic points. If the delivered price is computed by using a single basic point it
is called single basic point pricing. If more than one basic points are selected
for pricing, it becomes multiple basic pricing.
10.3.8 Cost-Plus or Full-Cost Pricing
Cost-plus is a short cut method in pricing a product. It means the addition of
a certain percentage of the costs as profits to the cost of production to arrive at the

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3
price.

239
This is known as à this is precisely cost-plus pricing. This method suggests that the price
of a product should cover f cost and generate the returns as investments at a fixed
mark-up percentage.

Full cost is full average cost which includes average direct costs (AVC) plus
average overhead costs (AFC) plus a normal margin for profit:

p = AVC + AFC + profit margin or mark-up.

Thus, of the two elements of cost-plus price, one is the cost and the other one
is mark-up. These two components are separately analysed.

Cost is an important factor in determining price. The cost is the base on which
is grounded the percentage of profit. Costs carry main influence on price and are long-
term price determinants are different methods of computing the cost.

Broadly speaking, there are three methods of computing the cost:

(i) The actual cost,

(ii) The expected cost, and

(iii) The standard method of costing.

The actual costs are those which are actually incurred on the production of
an item. It includes the wage rate, material cost and overhead expenses.

The expected cost is a forecast of the actual expenses for the pricing
period. Suppose a product is planned to be introduced in the market, say three
months from today, the firm first arrives at the cost of producing one unit at current
prices. Then the prices of various components are projected for the next three
months to arrive at the expected cost.

Under the standard method of costing, the capacity of the plant is taken
into account. For exam-ple, the plant may be present by running at 70 per cent
capacity. It may be that when it runs at 90 per cent, the cost may be normal or
optimum. This is a factor that will have to be taken into account.

The second aspect is the percentage mark-up. In determining appropriate

mark- up, the firm should carefully evaluate cost, demand elasticity and degree of
2
4
competition

241
faced by the product. The firm should also take into account the brand image and long
run strategy in fixing mark-up. Once the mark-up is fixed, it should be added to the
cost of a product.

Cost-plus pricing can be classified into two categories on the basis of mark-
up and they are (i) rigid cost-plus, and (ii) flexible cost-plus.

Rigid Cost-Plus Price:

In rigid cost-plus pricing, it is customary to add a fixed percentage to the cost

to get price. Only variable costs are taken and a fixed mark-up percentage is added
to it. This method is simple to calculate and is consistent with profit motive.

Flexible Cost-Plus Pricing:

In flexible cost-plus pricing, mark-up is not rigidly fixed as cost but it is

allocated on different heads of variable and fixed costs. It considers all aspects of costs,
viz., labour, material, machine hours and all overheads.

Hall and Hitch suggest the following reasons for the firm to observe full cost-
pricing:

(i) Consideration of fairness,

(ii) Ignorance of demand,

(iii) Ignorance of potential reaction of competitors,

(iv) The belief that the short-run elasticity of market demand is low,

(v) The belief that increased prices would encourage new entrants, and

(vi) Administrative difficulties of a more flexible price policy.

Mark-up and Turn over:

Mark-up may have direct link with turnover. High turnover items may
carry low mark-up. This is due to the following reasons:

(i) Customers are aware of the prices of such items and would shift to other
source of supply, and

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 (ii) For high turnover goods, storing space is a big problem and opportunity cost
of space utilisa-tion and inventory buildup should be taken into account.

Mark-up and Rate of Return:

There is another way of arriving at the price which is known as the rate of
return pricing. In cost- plus pricing the question of mark-up poses a problem. To by
pass this problem, the rate of return pricing method may be followed. Under this
method, the price is determined by the planned rate of return on the investment
which is expected to be converted into a percentage of mark-up.

For fixing rate of return mark-up on cost, three steps are necessary:

(i) To estimate the normal rate of production and the total cost of a year’s
normal production over a cycle,

(ii) To calculate the ratio of invested capital to a year’s standard cost, and

(iii) To modify the capital turn over by rate of return. This gives us on the
mark-up percentage.

Determination of Cost-Plus Price:

The determination of cost-plus price is explained below in terms of

Prof.Andrews’s version. Prof. Andrews in his study, Manufacturing Business,
1949, explains how a manufacturing firm actually fixes the selling price of its product
on the basis of the full-cost or average cost.

The firm finds out the average direct costs (AVC) by dividing the current
total costs by current total output. These are the average variable costs which are
assumed to be constant over a wide range of output. In other words, the AVC curve
is a straight line parallel to the output axis over a part of its length if the prices of
direct cost factors are given.

The price which a firm will normally quote for a particular product will equal
the estimated aver-age direct costs of production plus a costing-margin or mark-up.
The costing-margin will normally tend to cover the costs of the indirect factors of
production (inputs) and provide a normal level of net profit, looking at the industry
as a whole.
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The usual formula for costing-margin (or mark-up)

is, M = P-AVC/AVC ….(1)

where M is mark-up, P is price and AVC is the average variable cost and the
numerator P-AVC is the profit margin.
If the cost of a book is Rs 100 and its price is Rs

125, M = 125-100/100 = 0.25 or 25%

If we solve equation (1) for price, the result is

P=AVC (1+M) ….(2)

The firm would set the price,

P=Rs 100 (1+0.25) =Rs125.

Once this price is chosen by the firm, the costing-margin will remain
constant, given its organisa-tion, whatever the level of its output. But it will tend to
change with any general permanent changes in the prices of the indirect factors of
production.

Depending upon the firm’s capacity and given the prices of the direct factors
of production (i.e., wages and raw materials), price will tend to remain unchanged,
whatever the level of output. At that price, the firm will have a more or less clearly
defined market and will sell the amount which its customers demand from it.

But how is the level of output determined? It is determined in either of the

three ways:

(a) As a percentage of capacity output; or (b) as the output sold in the preceding
production period; or (c) as the minimum or average output that the firm expects
to sell in the future. If the firm is a new one, or if it is an existing firm introducing a
new product, then only the first and third of these interpretations will be relevant. In
these circumstances, indeed, it is likely that the first will coincide roughly with the
third, for the capacity of the plant will depend on the expected future sales.

The Andrews version of full-cost pricing is illustrated in Figure 9 where AC is

the average variable or direct costs curve which is shown as a horizontal straight
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4
line over

245
 a wide range of output. MC is its corresponding marginal cost curve. Suppose
the firm chooses OQ level of output.

At this level of output, QC is the full-cost of the firm made up of average

direct cost QV plus the costing-margin VC. Its selling price OP will, therefore, equal
QC. The firm will continue to charge the same price OP but it might sell more
depending upon the demand for its product, as represented by the curve DD. In this
situation, it will sell OQ output.
1
“This price will not be altered in response to changes in demand, but only
in response to changes in the prices of the direct and indirect factors.”

Advantages:

The main advantages of cost-plus pricing are:

1. When costs are sufficiently stable for long periods, there is price stability which
is both cheaper administratively and less irritating to retailers and customers.

2. The cost-plus formula is simple and easy to calculate.

3. The cost-plus method offers a guarantee against loss-making by a firm. If it

finds that costs are rising, it can take appropriate steps by variations in
output and price.

4. When the firm is unable to forecast the demand for its product, the cost-
plus method can be used.
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 5. When it is not possible to gather market information for the product or it is
expensive, cost-plus pricing is an appropriate method.

6. Cost-plus pricing is suitable in such cases where the nature and extent of
competition is unpre-dictable.

Criticisms:

The cost-plus pricing theory has been criticised on the following grounds:

1. This method is based on costs and ignores the demand of the product which
is an important variable in pricing.
2. It is not possible to accurately ascertain total costs in all cases.

3. This pricing method seems naive because it does not explicitly take into
account the elasticity of demand. In fact, where the price elasticity of demand of
a product is low, the cost plus price may be too low, and vice versa.

4. If fixed costs of a firm form a large proportion of its total cost, a circular
relationship may arise in which the price would rise in a falling market and fall in
an expanding market. This happens because average fixed cost per unit of
output is low when output is large and when output is small, average fixed
cost per unit of output is low.

5. Cost-plus pricing method is based on accounting data for total cost and not
the opportunity cost that the sale of product incurs.

6. This method cannot be used for price determination of perishable goods

because it relates to long period.

7. The full-cost pricing theory is criticised for its adherence to a rigid price.
Finns often lower the price to clear their stocks during a recession. They also
raise the price when costs rise during a boom. Therefore, firms often follow an
independent price policy rather than a rigid price policy.

8. Moreover, the term ‘profit margin’ or ‘costing margin’ is vague. The theory
does not clarify how this costing margin is determined and charged in the full
cost by a firm. The firm may charge more or less as the just profit margin

247
depending on its

2
4
 cost and demand conditions.As pointed out by Hawkins, “The bulk of the
evidence suggests that the size of the ‘plus’ margin varies it grows in boom
times and it varies with elasticity of demand and barriers to entry.”

9. Empirical studies in England and the U.S. on the pricing process of

industries reveal that the exact methods followed by firms do not adhere
strictly to the full- cost principle. The calculation of both the average cost and
the margin is a much less mechanical process than is usually thought. As a
matter of fact, businessmen are reluctant to tell economists how they
calculated prices and to discuss their relations with rival firms so as not to
endanger their long-run profits or to avoid government intervention and
maintain good public image.

10. Prof. Earley’s study of the 110 ‘excellently managed companies’ in the U.S.
does not support the principle of full-cost pricing. Earley found a widespread
distrust of full-cost principle among these firms. He reported that the firms
followed marginal accounting and costing principles, and the majority of
them followed pricing, marketing and new product policies.

10.4 SUMMARY

Pricing is the process of determining what a company will receive in exchange

for its product or service. A business can use a variety of pricing strategies when
selling a product or service. The price can be set to maximize profitability for each unit
sold or from the market overall. It can be used to defend an existing market from
new entrants, to increase market share within a market or to enter a new market.
The two most popular pricing methods used by service companies in the study are
cost-plus, where a profit margin is added to the average cost of the service, and
pricing according to the market’s average prices. This may be because both methods
are easy to implement. The limited emphasis given to customer-based methods –
such as pricing according to customers’ needs or customers’ perceptions of value, or
setting a fairly low price for a high quality service – is surprising given that customer-
based objectives are the most popular among the companies surveyed. One reason
may be the difficulty of determining customers’ demands and needs. Another may
be that the cost plus method enables firms to cover their costs and levy competitive

249
prices, and thus both satisfy existing customers and attract new ones.

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10.5 SELFASSESSMENT QUESTIONS
1. Explain differential pricing?

2. Explain pricing policy of a new product?

3. Discuss transfer pricing?

4. Critically evaluate various pricing strategies.

10.6 SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas Publishing House, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Mithani, D.M., Managerial Economics-Theory&Application, Himalaya
publishing House Pvt. Ltd., New Delhi.
 Gupta, G.S., Macro Economic- theory &Application, Tata McGraw Hill
Publishing house, New Delhi.
 Vaish, M.C., Macro Economic theory, Vikas publishing house pvt. Ltd.,
New Delhi.

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 UNIT III

LESSON 11 PROFIT POLICY

STRUCTURE

11.1 INTRODUCTION

11.2 OBJECTIVE

11.3 CONCEPT OF PROFIT IN BUSINESS

11.4 PROFIT POLICY

11.4.1 Objectives of Profit Policy

11.4.2 The Measurement of Profit

11.5 SUMMARY

11.6 SELF ASSESSMENT QUESTIONS

11.7 SUGGESTED READINGS

11.1 INTRODUCTION

Profit may implymonopoly profit. It is earned by a firm through extortion,

because of its monopoly power in the market. It is not related to any useful specific
function. Thus monopoly profit is not a functional reward. Profit may sometimes be
in the nature of a windfall. It is an unexpected reward earned by a firm just by mere
chance, an inflationary boom.

11.2 OBJECTIVES

The objective of this lesson is to provide information about:

 The concept of profit
 Meaning of profit policy
 Objectives of profit policy

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11.3 CONCEPT OF PROFIT IN BUSINESS

The concept of profit entails several different meanings. Profit may mean
the compensation received bya firm for its managerial function. It is called normal profit
which is a minimum sum essential to induce the firm to remain in business. Profit may
be looked upon as a reward for true entrepreneurial function. It is the reward
earned by the entrepreneur for bearing the risk. It is termed as supernormal profit
analysis.

Profit is the earning of entrepreneur. To the economist, the most significant

point about profit is that it is a residual income. However, the term profit has different
connotations.

In short, the following are the distinctive features of profit as a factor reward:

(i) It is not a predetermined contractual payment.

(ii) It is not a fixed remuneration.

(iii) It is a residual surplus.

(iv) It is uncertain.

(v) It may even be negative. Other factor rewards are always positive.

Gross Profit and Net Profit:

In ordinary parlance, profit actually means gross profit.

Gross profit is a term in which the following items are included in addition to
the net profit due to the entrepreneur:

(i) Remuneration for factors of production contributed by entrepreneur himself.

(ii) Depreciation and maintenance charges.

(iii) Extra personal profits.

(iv) Net profit.

Net profit is the exclusive reward for the entrepreneur for the following
functions performed by him:

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(i) Reward for co-ordination

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 (ii) Reward for risk taking

(iii) Reward for uncertainty bearing, and

(iv) Reward for

innovation. In short,

Gross Profit = Net profit + implicit rent + implicit wages + implicit interest +
normal profit + depreciation and maintenance charges + non-entrepreneurial profit.
Net Profit = Gross profit – (implicit rent + implicit wages + implicit interest +
normal profit + depreciation and maintenance charges + non-entrepreneurial profit)
In fact, Net Profit = economic profit or pure business profit. It is the net profit
which may be positive or negative. A negative profit means a loss.

Accounting Profit and Economic Profit:

An accountant looks at profit as a surplus of revenues over costs, as recorded

in the books of accounts. An accountant is interested in accounting, auditing, planning
and budgeting profit. The accountant does not take care of implicit or opportunity
cost. Accounting profit is also called residual profit.

For the business firm, accounting profit is very important. Accounting profit
is defined as the revenue realised in a given period after providing for expenses
incurred during the production of a commodity. A firm while making accounting
profits may be incurring economic losses. Such a firm would have to withdraw from
business in the long run. In the balance sheet of a firm, accounting profit occupies
an important place.

The economist, however, does not agree with the accountant’s approach to
profit. The account-ant would only deduct the explicit or actual costs from the
revenues to determine profit. The economist points out that in addition to the
deduction of explicit cost, imputed cost, i.e., the cost that would have been
incurred in the absence of the employment of self owned factors, should also be
deducted.

Their examples are:

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(i) Entrepreneur’s wages that he could earn by working for someone else,

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 (ii) Rental income on self-owned land and building employed in the business, and
(iii) Interest on self owned capital that could have been earned byinvesting it
elsewhere.
Thus the profit arrived at after deducting both explicit and imputed costs may
be called economic profit. From the managerial point of view, economic profit is
veryimportant because this alone shows the viability of a firm.
Normal Profits and Supernormal Profits:
Normal profits refer to the imputed returns to capital and risk-taking just
necessary to prevent the owners from withdrawing from the industry. The normal profits
are usually defined as the supply price or opportunity cost of entrepreneurship. Such
cost must be covered if the firm is to stay in business in the long run.
When competition among entrepreneurs is perfect, the market price of the
product is equal to average cost which itself includes ‘normal profit’. Normal profit is the
minimum to induce the entrepreneur to remain in the business in the long run.
It is possible that the entrepreneur may not get normal profit in the short run
and may have to sell his product at a loss, but in the long run every entrepreneur must
get at least the normal profits. It is assumed to be part of the price. In the words of
Mrs. Joan Robinson, “Normal profit is that profit which neither attracts a new firm to
enter into the industry nor obligates the existing firm to go out of the industry.”
Supernormal profit is defined as the surplus over the normal profit. It is
obtained by the super -marginal firms. The marginal firm gets only the normal profit, but
determines the supernormal profit of the intra marginal firm.
Profit as Functional Reward:
Some economists consider profit as a functional reward. According to them,
profit is a reward for the entrepreneur for his entrepreneurial functions. Some have
said that organising and coordinating other factors of production are the main
functions of the entrepreneur. Some others have said that risk- taking and decision
making are the important functions of the entrepreneur.
They say that since the entrepreneur takes risks in business, he earns

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profit. Schumpeter said that the entrepreneur is performing the role of an innovator
and therefore

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profit is a reward for his innovation. Prof. Knight opined that profit is due to his risk
taking and uncertainty bearing.
Monopoly Profit:
When a firm possesses monopoly power, it can restrict output and obtain a
higher profit than it could under competitive conditions. Profit is the result of continued
scarcity. It can exist only in an imperfect market where output is for various reasons
restricted and the consumers are deprived of the opportunity of alternative sources
of supply.
Sources of such powers are usually found in legal restric-tions, sole ownership
of raw materials or access of sale to particular markets. Even some degree of
uniqueness in a firm’s product confers some monopoly power. Summarising, it can be
said that profits may come to exist as a result of monopoly.
Windfall Profit:
Some consider profit as a windfall gain. According to them, profit is not a
reward for any entrepreneurial function or monopoly power. It is merely a windfall
gain. It arises due to changes in the general price level in the market. If the producer
or trader buys his inputs and raw materials when the prices are low and sells the output
when the prices have abruptly gone up due to some unforeseen external factors, we
call the profit as windfall profit. This is also included under net profit.
Earning of Management:
The entrepreneur having good bargaining power, purchases raw materials
at reasonable prices. He makes suitable arrangements to store the raw materials
properly. By proper inventory building, he maintains the supply of raw materials
regularly.
He hires labour at normal wages and borrows working capital at reasonable
rates of interest. Thus he manages and controls explicit costs. Ensuring of supply of
capital is the most important function of profit. A certain percentage of net profit is set
apart for better management of business.
11.4 PROFIT POLICY

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 It is generallyheld that the main motive of a firm is to make profits. The volume
of profit made by it is regarded as a primary measure of its success. Economic
theory

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advocates profit maximisation as the chief policy of a firm. Modem business
enterprises do not accept this view and relegate the profit maximisation theory to the
back ground. This does not mean that modem firms do not aim at profits. They do
aim at maximum profits but aim at other goals as well. All these constitute the
profit policy.

(i) Industry Leadership

Industry leadership may involve either the achievement of the maxi-mum

sales volume or the manufacture of the maximum product lines. For the attainment of
leadership in the industry, there has to be a satisfactory level of profit consistent with
capital invested, labour force employed and volume of output produced.

(ii) Restricting the Entry

If a firm follows a policy of restricting its profit, no competitors are likely to

enter the market. Reasonable profits which guarantee its survival and growth are
essential. According to Joel Dean, “Competitors can invade the market as soon as they
discover its profitability and find ways to shift the patents and make necessary
changes in design, technique, and production plant and market penetration.”

(iii) Political Impact

High profits are considered to be suicidal for a firm. If the government comes
to know that the firms are earning huge returns, it may resort to high taxation or to
nationalisation. High profits are often considered as an index of monopoly power and
to prevent the govern-ment may introduce price control and profit regulation
policies.

(iv) Consumer Goodwill

Consumer is the foundation of any business. For maintaining consumer

goodwill, firms have to restrict the profit. By maintaining low profit, the firms may seek
the goodwill of the consumers. Consumer goodwill is valued so much these days that
firms often make organised efforts through advertisements.

(v) Wage Consideration

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 Higher profits may be taken as an evidence of the ability to pay higher
wages. If the labour associations come to know that the firms are declaring higher
dividends to the

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shareholders, naturally they demand higher wages, bonus, etc. Under these
circumstances in the interest of harmonious relations with employees, firms keep the
profit margin at a reasonable level.

(vi) Liquidity Preference

Many concerns give greater importance to capital soundness of a firm and

hence prefer liquidity to profit maximisation. Liquidity preference means the preference
to hold cash to meet the day to day transactions. The first item that attracts one’s
attention in the balance sheet is the ratio of current assets to current liabilities. In
order to give capital soundness, the business concerns keep less profit and maintain
high cash.

(vii) Avoid Risk

Avoiding risk is another objective of the modem business for which the firms
have to restrict the profit. Risk element is high under profit maximisation. Managerial
decision involving the setting up of a new venture has to face a number of uncertainties.
Very often experienced managements avoid the possibility of such risks. When there is
oligopolistic uncertainty, firms mayfocus attention at minimising losses. The
guidingprinciple of business economics is not maximisation of profit but the
avoidance of loss.

Alternative Profit Policies

Economists have suggested different profit policies which business firms

mayadopt as an alternative to profit maximisation.

These alternative profit policies are listed below

Prof. K. Rothschild observes, “Profit maximisation has until now served as

the wonderful market key that opened all doors leading to an understanding of the
behaviour of the entrepreneur. It was always realised that familypride, moral and ethical
considerations, poor intelligences and similar factors may modify the results built on the
maximum profit assumption, but it was right by assuming that these disturbing
phenomena are sufficiently exceptional to justify their exclusion from the main body
of price theory. But there is another motive which cannot be so lightly dismissed and
which is probably a similar order of magnitude as the desire for maximum profits,
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namely the desire for secure profits”. He has suggested that the primary motive of an
enterprise is long run survival.

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 According to him, the assumption of profit maximisation is no doubt valid to
the situation of perfect competition or monopolistic competition. Under monopolistic
condition, the aim of the firm is to secure monopoly profits. In the case of oligopoly, he
says that the assumption of profit maximisation is not sufficient.
W.J. Baumol puts forth the maximisation of sales as the ultimate aim of the
firm. He says while maximising sales the producer will not regard costs incurred as
output and profits to be made. If the sales of the company increase, it means that the
producer is not only covering costs but also making a usual rate of return on
investment. Baumol’s theory of sales maximisation as a rational behaviour of the
producer is considered as an alternative to the theory of profit maximisation.
Benjamin Higgins, Mekin Reder and Tibor Scitovsky have developed
another alternative to the theory of profit maximisation, that of utility maximisation, if
the producer is supposed to maximise his satisfaction. In this approach, they have
introduced leisure as a variable. Leisure is an essential ingredient of an individual
welfare. If more work is put in by the producer, the less leisure he will be able to enjoy.
It is said that the producer would get maximum satisfaction where his net profit is
optimum.
Donaldson and Lorsch are of the opinion that career managers prefer policies
that favour long term stability and growth of their firms which are possible only when
they get maximum current profits. For the survival, self sufficiency and success, the
top managers strive hard and augment corporate wealth. The more the wealth, the
greater the assurance of the means of survival.
11.4.1 Objectives of Profit Policy
The firm seeks to achieve many objectives and profit making is the main
objective but it is not the only objective. Profit making is no doubt necessary. In addition
to adequate profit, the firm often pursues multiple and even contradictory objectives. If
a firm makes sufficient profits, it can give good dividends and attractive salaries, etc.
The firm can fix a target rate for profits as its investment. There is a problem in
determining the target rate of profits.
They are:

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(i) Competitive rate of profit

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 (ii) Historical profit rate
(iii) Rate of profit sufficient enough to protect the equity, and
(iv) Plough back of profit rate.
Competitive rate of profit is the rate earned by other companies in the same
industry or of selected companies in other industries working under similar conditions.
It may be slightly different from the rate of profit of other companies.
Historical rate of profit is the rate of profit determined as the basis of past
earnings in the normal times. The rates should be sufficient enough to attract equity
capital, have provided adequate dividend to share holders and have not encouraged
much competition.
Rate of profit sufficient enough to protect the equity is the rate sufficient enough
to attract equity capital and the rate of return on investment should protect the
interest of present shareholders. Plough back of profit late is that late of profit which
should be such that there is a surplus after paying the dividends to finance further
growth of the industry. Cyert and March have focused on five objectives which
represent main operative organisational goals.
They are:
(i) Production goal
(ii) Inventory goal
(iii)Sales goal
(iv)Marketing share goal and
(v) Profit goal
Production Goal
The firms want to maintain the production of the product at a stable level to
ensure stable employment and growth. The basic requirement is that the production
does not fluctuate.
Inventory Goal

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To ensure a complete and convenient stock of inventory throughout the production,

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a minimum level of inventory has to be maintained so that the firm can prevent
fluctuations in prices.

Sales Goal

It is considered as very important from the point of view of stability and survival
of the firm. Increasing sales mean progress of the firm. Sales strengthen the organisation.
The more are the sales, the more is the profit.

Market Share Goal

Companysales do not reveal how well the company is performing. If the

company’s market share goes up, the companyis gaining as a competitor, if it goes down
the company is losing relative to competitors.

Profit Goal

Profits are a function of the chosen price, advertising and sales promotion
budgets. Normal profit is essential not only to pay dividends but also to ensure
additional resources for reinvestment.

11.4.2 The Measurement of Profit

The problem of profit measurement has always been a difficult affair. In the
present business world, the tendency is to discard the word ‘profit’ and use a neutral
expression as “business income”. In the accounting sense, profit is an ex-post concept.
Accountants follow conventions and define their terms by enumeration.

Conventional accounting is largely concerned with historical profits rather

than anticipated profits. Economists disagree with conventional techniques and
theydefine their terms functionally. For an economist, profit is an ex-ante concept.

It is a surplus in excess of all opportunity costs or the difference between the

cash value of an enterprise at the beginning and end of a period. From the management
point of view, economic profits are a better reflection of profitability of business. The
economist is basically interested in the theoretical analysis of profit.

The most important points of difference between the economist’s and

accountant’s approaches centre around:

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(i) Inclusiveness of Costs
To determine profits, economists include in costs, wages, rent and interest for
all the services employed in the business, including both those actually paid for in the
market and virtual wage or interest or rent for services rendered by the owner
himself.
To determine profits, accountants only deduct explicit or paid out costs from
the income. The non-cost items as the entrepreneurial wages, rental income on land
and the interest that the capital could earn elsewhere do not appear in the books of
accounts.
The economist s costs of production are a payment which is necessary to
keep resources out of the next best alternative employment. The economist does not
agree with the accountant’s approach. The accountant would only deduct actual
costs from the revenues, the economist points out that in addition to the deduction of
actual cost imputed cost should also be deducted.
(ii) Depreciation
The treatment of depreciation has an important bearing on the measurement
of profit. To the economist, depreciation is capital consumption cost. The cost of
capital consumption is the replacement cost of the equipment. It has various
meanings. In the accounting sense, it refers to the writing off the unamortised cost over
the useful life of an asset. In the value sense, it may be defined as the lessening in the
value of a physical asset caused by deterioration.
Economists recognise only two kinds of depreciation charges and they are:
(a) The opportunity cost of the equipment, and
(b) The exhaustion of a year’s worth of limited valuable life.
The former includes the most profitable alternative use of it that is forgone
by putting it into its present use, while the latter aims at preserving enough capital so
that the equipment may be replaced without causing any loss. Both these concepts are
useful to the management.
Causes of Depreciation

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The major causes of depreciation may be classified as follows:
(i) Physical depreciation,

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 (ii) Functional depreciation, and

(iii) Accidental depreciation.

Physical depreciation resulting in the decline of the physical usefulness of an

asset due to normal use is frequently known as physical depreciation. The deterioration
may be due to abrasion, shock, vibration, impact and so on.

Functional depreciation arises due to economic factors such as

suppression, obsolescence and inadequacy. Here nothing happens to the ability of
the asset but the demand for an asset may be sup-pressed or it becomes so obsolete
or it is not adequate enough to accommodate the demand placed upon it.

Accidental depreciation may be the physical damages caused by fire,

explosion, collision and wind storm are generally insured and there are some normal
risks or business such as minor damages due to natural calamities. All these are,
therefore, accounted and treated as depreciation.

Methods of Depreciation

In the economics of an enterprise, the methods of depreciation occupy a

very important role. Depreciation is an important internal source of funds and the
method of depreciation becomes important as a tool of capital accumulation. Different
methods are used to offset depreciation. The main aim of depreciation policy is to
reduce the gap between the present depreciated value of the asset and its present
book value.

There are many accepted methods of depreciation and they are:

(i) The straight line method

(ii) The unit of production method

(iii) The sinking fund method

(iv) The declining balance method

(v) The double declining balance method

(vi) The sum of the years digits method

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(vii)The revaluation method

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 (viii) The repair provision method

(ix) The retirement accounting method

(x) The insurance policy method, and

(xi) The mileage method

(i) The Straight Line Method

It is the simplest and the most commonly used method of deprecia-tion. It

is otherwise known as proportional or equal instalments method. This method is based
on the assumption that the value of an asset declines at a constant rate. The amount of
annual depreciation is calculated by dividing the initial costs of the assets by the
estimated life in years, assuming that there is no scrap value. If the asset has scrap
value then the amount should be deducted from the initial cost.

(ii) The Unit of Production Method

This method is also known as machine hour rate method. This method of
depreciation is more or less a depletion method. Under this method, instead of
counting the life of the assets in years, it is estimated in terms of working hours. The
speciality of this method is that it utilises production instead of time as the unit of
measurement. According to this method, capital expenses of the equipment are recovered
on the basis of the expected production. This method is best suited for providing
depreciation on costly machine.

(iii) The Sinking Fund Method

Under this method of depreciation, the amount written off as depreciation

is calculated by means of fixed periodic charges and is deposited in readily saleable
securi-ties at compound interest which accumulates to provide a sum equal to the
original cost of the asset. The securities are then sold and the new asset is purchased
with the sale proceeds. This method is useful if the asset has to be replaced when it
becomes a scrap. It is best suited for the replacement of machinery and plant.

(iv) The Declining Balance Method

It is differently known as “fixed percentage method or Mathesan method

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of depreciation.” Under this method, a constant percentage of depreciation is charged
each

275
year as the value of the asset as it stands in the books at the beginning of the year.
The basic idea behind the use of this method is to provide for a more or less uniform
total cost of production of the asset over different years of its life. Under this method,
depreciation is high in the early part of the asset’s life but it declines in the later
years.

(v) The Double Declining Balance Method

Under this method, depreciation is provided at a uni-form rate on the book

value of the asset as it stands at the beginning of the year. The book value is the
balance of the unamortised cost of the asset as well as depreciation expenses and both
go on declining at a constant rate. Any method of calculating depreciation that allows
huge amounts in the initial years is preferred by management, as it helps in the quick
recovery of the major part of the original investment.

(vi) The Sum of the Years Digit Method

Previously, this method was known as Cole method. Under this method,
annual depreciation charge also declines each year. The economic advantage of this
method is that it allows one to write off investment very rapidly. The very idea of
this method is similar to that of the declining balance method.

The amount of depreciation in the beginning of the life of the asset is higher
and it declines with the span of time. This method is realistic. It takes into account the
immediate drop in the value of the asset and makes the decision to sell and replace the
asset earlier before die expiry of its estimated life.

(vii) The Revaluation Method

This method is frequently used in the case of small items such as loose
tools, laboratory glassware, livestock, jigs, packages, patterns, etc. where it is not
possible to provide for depreciation on mathematical basis. The method of providing
depreciation by means of periodic deductions each of which is equal to the difference
between the value of such assets and their revalued value at the close of the financial
year is considered as the amount of depreciation.

(viii) The Repair Provision Method

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According to this method, the cost of repairs is added to the cost of the
equipment.

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This method provides for the aggregate of depreciation and maintenance cost by means
of periodic charges each of which is a constant proportion of the aggregate of the cost
of the asset depreciated and the expected maintenance cost during its life. Thismethod is
commonly used by the public works contractors while hiring their own plants to
other contractors. This method not only deals with depreciation but with repairs and
maintenance too.

(ix) The Retirement Accounting Method

This method stresses that we shall charge the cost of capital less salvage value
as depreciation only when the asset is worn out. This method is considered one of the
most objective methods. The validity of the method is that the total cost of the capital is
charged as depreciation once and for all.

(x) Insurance Policy Method

This method is similar to sinking fund method. According to this method,

an endowment policy is taken as the life of the asset so that at the end of a definite
period the insurance company will pay the assured money and with the help of that
money a new asset can be purchased. This method is suitable for leases where the
life of the asset is definitely known.

(xi) The Mileage Method

This method is otherwise known as ‘use method’. This method appears to be

fair as the depreciation charged will be according to the use to which the asset is
put. This technique is followed in the case of those assets the use of which can be
measured in terms of miles, e.g. automobiles.

So far we have discussed the different methods of depreciation but not about
the methods used in actual practice. The suitability of methods of depreciation depends
on the nature of assets concerned and their owner’s discretion. But a liberal
depreciation policy is helpful to stimulate capital formation and encourages risky
investments.

(iii) Treatment of Capital Gains and Losses

All the assets of a firm are subject to windfalls due to inflation or natural

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calamities or legal judgements. It plays an important role in the economics of a firm.
These changes generallyresult in larger losses than gains. Conservative concerns never
record such changes.

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The gains accruing from revaluation of assets are usually transferred to capital reserves.
Certain concerns add capital gains to the profit of the year in which such
gains occur. Capital losses are charged either to current profits or to retained earnings.
Economists are least interested in recording these windfalls. They are concerned
about the future. Economists are of the view that most of these gains or losses can be
foreseen before they are realised.
11.5 SUMMARY
Profit estimates play a pivotal role in business decision. For measuring
profits, accountants rely on historical costs rather than current prices. Economists are
concerned with income, assets and net worth in the future. Gross profits for the
economist come much closer to the accountant’s net profits.
11.6 SELFASSESSMENT QUESTIONS
1. Explain the concept of profit?

2. What strategies the management has to follow while fixing pricing policy?

3. How accounting profit is different from economic profit?

11.6 SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas House, New Delhi.

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 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Mithani, D.M., Managerial Economics-Theory and Application, Himalaya
publishing house Pvt. Ltd., New Delhi.
 Gupta, G.S., Macro Economic- theory and Application, Tata McGraw Hill
Publishing House, New Delhi.
 Vaish, M.C., Macro Economic theory, Vikas Publishing House Pvt. Ltd.,
New Delhi.
 Mishra, S.K., and Puri, V.K., Modern Macro Economic theory,
Himalayan Publishing House.

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 Unit-III
LESSON 12 PROFIT PLANNING AND

CONTROL STRUCTURE

12.1 INTRODUCTION

12.2 OBJECTIVES

12.3 PROFIT PLANNING

12.3.1 Essential Elements in Profit Planning

12.3.2 Steps in Profit Planning

12.3.3 Need for Profit Planning

12.3.4 Aids to Profit Planning

12.4 CONTROL OF PROFIT

12.5 PROFIT POLICY AND FORECASTING

12.5.1 Profit Forecast

12.5.2 Approaches to Profit Forecasting

12.6 PROBLEMS IN SETTING A PROFIT POLICY

12.7 SUMMARY

12.8 SELF ASSESSMENT QUESTIONS

12.9 SUGGESTED READINGS

12.1 INTRODUCTION

As we know that objectives of business firms can be various. There is no

unanimity among the economists and researchers on the objective of business firms.
One thing is, however, certain that the survival of a firm depends on the profit it can

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make. So whatever

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the goal of the firm-sales maximisation, maximisation of firms, growth, maximisation
of managers’ utility function, long- run survival, market share, or entry-prevention-it
has to be a profitable organisation. Maximisation of profit in technical sense of the term
may not be practicable, but profit has to be there in the objective function of the
firms. The firms may differ on ‘how much profit’ but they set a profit target for
themselves. Some firms set their objective at a ‘standard profit’, some at a ‘target
profit’ and some at a ‘reasonable profit’. ‘A reasonable profit’ is the most common
objective.

12.2 OBJECTIVES

After reading this Lesson, you will be able:

 To understand the concept of profit planning
 To know about the measurement of profit

12.3 PROFIT PLANNING

Profit planning is a disciplined method whereby the environments encroaching

on an organisation are analysed, the available resources and internal competence
identified, agreed objectives established and plans made to achieve them. Profit
planning is largely routine and covers a definite time span.

Strategy is a word often used in conjunction with profit planning. Profit

planning and strategyformula-tion are complementary. Profit planning is often a
reasonable substitute for the fair and imagination need of the entrepreneurs.

12.3.1 Essential Elements in Profit Planning

The following are the essential elements in profit planning:

1. Objectives and results are established and measured at all management levels.

2. The role of the chief executive is often vital in ensuring success.

3. The system should become the major framework in guiding and

controlling management performance.

4. The system should be totally pervasive, especially in framing objectives.

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5. The system is recognised as the key method of management in the organisation.

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 6. Planners have been trained in economics or associated disciplines.

7. Budgeting, cost control, and contribution analyses are the keyelementsin

controlling a profit plan.

12.3.2 Steps in Profit Planning

Some rudimentary form of planning may already be in existence in most

organisations. Many of the techniques used in profit planning may be in use. The
following activities will need to be introduced or improved or enhanced if they are
undertaken at present.

1. Establish Suitable Objectives

Objectives can cover many factors of the business survival, profits or increase
in net worth. The way in which objectives are determined is nearly as
important as the types that are pursued. It will be essential to take account of
past performance, resource availability, management competence, environment
changes, competitors’ activities and so on. Objectives should not be
imposed.

2. Establish Suitable Control System

Profit planning and control may have grown out of budgetary control systems. It
is necessary to have some form of budgetary cost control, plan monitor-ing
and management information systems which will serve to enable profit planning
to be effective.

3. Establishing Job Responsibilities

Often job responsibilities are too imprecise to provide the information on

which performance standards can be established and then judged. It is
necessary to have job breakdowns in such detail that the need for resources
can be identified.

4. Carry Out a Situation Audit

It entails an audit of all the factors both internal and external that will have
an influence on companyaffairs. It should include establishing the skills of

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competition, the economic situation which will impinge on company
performance and the potential and actual social, technological and cultural
changes to be accommodated.

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 5. Gap Analysis

This is an activity where the desired company objectives are compared with
the probable results of continuing current trends.Agap will almost certainly be
obvious between the two. Profit planning is largely concerned with how the
gap can be closed.

6. Establishing Base Data

Often the base data essential for profit planning is either nonexistent or set out
in a way that is inappropriate for planning purposes. The data include
product and operational costs, production speeds, material utilisation, labour
efficiency, etc.

7. Establish Appropriate Plans and Strategies

The management should ensure that there is plan integration. Strategies are
the results of choosing between alternatives in the use of the companyresources
through which it is hoped that the corporate objectives will be achieved.
They can be highly complex and appropriate alternatives need to be set out.

12.3.3 Need for Profit Planning

The need for profit planning arises:

(i) To improve management performance.

(ii) To ensure that the organisation as a whole pulls in the right direction.

(iii) To ensure that objectives should be set which will stretch but not
overwhelm managers.

(iv) To encourage strict evaluation of manager’s performance in monetary terms.

(v) To run a company in a more demanding way.

12.3.4 Aids to Profit Planning

The following are the aids to profit planning in an organisation:

1. Organisation

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Profit planningorganisation must ensure that it is sensitive to environmental changes

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 and that such changes are speedily reflected in profit plans. To carry profit
planning, the organisation must be designed accordingly.A high state of expertise
is required and this should be reflected in the profit planning organisation.

Involvement and participation are more important. Wherever possible,

decentralisation should be established. It is essential that the organisation
should be dynamic. The or-ganisation must help goal identification and problem
resolution.

2. Information System

Management information systems are an essential factor in profit plan-ning

and control. This system must help to provide the means for allocation of
resources and the measurement of results. It should help to identify the
various strategy alternatives and help for the integration of various main
plans and sub-plans.

3. The Computer

A computer can be applied in profit planning modelling. Information of all

kinds can be obtained much faster than when normal files are used. The
computer should be able to help management to make profit planning
decisions. The interactive nature of many planning decisions can be generated
more cheaply. Application programme changes are simplified and
amendments to output requirements take less time and cost.

4. Use of Modelling

A model is a representation of a real life situation. A model is fabricating

and integrating the relationships. Models have been used to aid decision
making and forecasting. Amodel provides an opportunity to manipulate a
situation. It is the only way in which a solution to the problem can
reasonably be obtained.

5. Planning Techniques

Profit planning should be a management activity that guides the use of

company resources at all management levels. Profit planning can itself be

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regarded as a technique. Most techniques used by management services
like forecasting, investment appraisal, risk analysis, decision theory, and
organisational development might be applied in profit planning.

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12.4 CONTROL OF PROFIT
The main goal of the business firm is to produce and market the goods and
services which satisfy the buyers and thereby earn a profit sufficient for the survival and
growth of business. Profit making is no doubt an essential function of a business
firm.
Profit as such is not at all a defective objective. The future growth of the
economy depends upon generation and reinvestment of profit. Profit should serve as a
motivation for expansion, diversification and innovation. Therefore, we need some
control over it.
Profit control may be achieved by controlling the internal and external
factors which have an influence on profits. Some planning at a particular level has to
be done to achieve this control. For this, we have to find out the chief factors which
influence the volume of profit. In reality, sales revenue and the total cost of
production are the chief factors which influence the volume of profit.
Profit is usually interpreted as the difference between the total expenses
involved in making or buying of a commodity and the total revenue accruing from its
sales. However, sales revenue, the price per unit of output sold, the total cost of
production, the volume of inputs and the price per unit of input are all interrelated.
Similarly, provision of depreciation and taxes create measurement problems in
profit analysis, as they are likely to vary from firm to firm depending on the method
of estimation and taxation laws respectively. A large firm may follow different
method of depreciation accounting than a smaller one.
Let us go back to the profit accounting system. For that the relationship
between various factors mentioned above are to be understood and established. If
profit (P) is the difference between the sales revenue (R) and the total cost of production
(C), the relationship is:
P = R-C
P is gross or net profit which depends on what is included in C. We may
express Ñ =r. K+D where Ñ is the total cost of production, r is a rate of return
covering depreciation, interest rate and risk premium appropriate to the industry and Ê
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is capital. D is direct cost such as labour cost, material cost, cost of fuel and
power, selling cost, managerial remuneration, etc.

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 Now the sales revenue (R) is the result of the volume of sale (S), and the price
per unit of output sold is (U),

Therefore, the relationship is:

R = S.U

The total cost of production (C) is the result of the price per unit of input (I)
and the volume of inputs (V).

Hence the relationship is:

Ñ =I.V

Let us re-write the three equations:

P = R-

C R =

S.U Ñ

– I.V

P – (S. U) – (I. V)

To control profits, the volume of sales (S) or the volume of inputs (I) can
be manipulated. Therefore, if a firm wants to increase its profits, it may either increase
the volume of sales or reduce the volume of inputs.

12.5 PROFIT POLICYAND FORECASTING

A project plays two primary roles in the functioning of the economic system.
First, the project acts as a signal to producers to change the rate of output or to enter or
leave an industry. Second, profit is a reward that encourages entrepreneurs to organise
factors of production and take risk. High profits in an industry usually are a signal that
buyers want more output from that industry.

Those profits provide the incentive for firms to increase output and for new
firms to enter the market. Conversely, low profits are a signal that less output is being
demanded by consumers or that production methods are not efficient. Firms maynot
maximise profit, but they do have a profit policy. Profit policy and profit planning
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must go together. The profit policy is more strategy-oriented and the profit planning
is more technique-oriented.

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 The firm has to consider a lot of short run and long run factors in designing
its profit policy. The main motive of the businessman is to make profits. The profit that
a firm makes should not be at the point of exploitation of consumers. The firm while
making profits should also satisfy the requirements of the consumers.

At present, the concept of social obligations has been thrust upon the
businessman. The business community is required to safeguard the health and
wellbeing of the society. The business people should have concern for the public. They
should give priority to the goals set by the government for the betterment of the
people. They are expected to solve many social and ecological problems.

There are two issues involved in profit policy decisions and they are:

(i) Setting Profit Standards:

Profit standards involve a choice of a particular measure and concept of

profit with reference to which achievements and aspirations may be compared.
In profit policy decision, the task is to decide 011 an acceptable rate of profit.
The firm has to consider rate of profit earned by other firms in the same
industry, historical profit rate earned by the firm itself in the past, rate of
profit sufficient to attract equitycapital and rate of profit necessary to generate
internal finance for replacement and expansion.

(ii) Limiting the Target Profit:

Apart from setting profit standards, the firm should also con-sider a set of
environmental factors to limit its rate of target profit. The profit target should
be limited which means the shareholders do not ask for higher dividends, the
wage earners do not ask for higher wages, the government does not impose
high taxes, the consumers do not ask for lower prices, the suppliers do not
ask for higher rates, and the goodwill of the business is not affected.

Profit policyis programmed through profit planning. Profit planning gives a

concrete shape to the profit policy of the firm.

12.5.1 Profit Forecast

It is usual to calculate a profit forecast for each major product group or service

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which an organisation offers. It presupposes that it is possible to assume what rates
of inflation will occur, the market share the company will obtain and the degree of
overall economic activity which the company will enjoy. Profit forecasting means
projection of future earnings taking into consideration all the factors affecting the size of
business profits. It is an essential part of operation planning. The major factors are the
turnover and costs.

1. Turnover

Turnover is the major factor and its element is the product. It must, however,
be emphasised at the outset that the product is the starting point for all planning
activities. To a manufac-turer, the special aspect of a product is most relevant which
earns good profit. A higher turnover indicates a healthier performance.

2. Costs

It is the costs that form the basis for many managerial decisions. It is the level
of costs relative to revenue that determines the firm’s overall profitability. In order to
maximise profits, a firm tries to increase its revenue and lower its costs.

The costs can be brought down either by producing the optimum level of
output, using the least cost combinations of inputs or increasing factor productivities, or
byimproving the organisational efficiency. The elements of costs are sales cost, product
develop-ment, distribution, inventories, production, general administration,
depreciation and reserves.

(i) Sales Costs

Sales costs consist of salesmen’s compensation, sales promotion, market

research and adminis-tration. The salesman is the key figure in the economy. Salesmen
have to be recruited, trained, directed, motivated and supervised.

There is particular significance in devising a good compensation plan in the case

of salesmen because the functions of selling are such that its results can be judged in
concrete terms. The level of comparison refers to the overall remuneration paid to
salesmen.

Of these, the more com-mon forms of payments are:

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(i) Salary,

(ii) Commission,

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 (iii) A combination of salary and commission, and

(iv) Bonus.

Sales promotion is designed to supplement and co-ordinate personal selling

and advertisement effort. Sales promotion techniques include trading stamps, mail
refunds, trade shows, free demonstra-tions and sales and displays at retail centres. It is
expensive but at the same times a controllable variable. It does not involve mass
media.

Marketing research has grown into importance very rapidly. It is mainly

concerned with market identification, market size, market share, market segmentation
and market trends. It is a systematic search for information. It involves data collection,
analysis and interpretation. Research cannot drown decisions, but it helps the
marketers in the task of decision making. It is also expensive and time consuming.

Administration is the policymaking function and a top level

activity.Administration handles the current problems arising out of the policies laid
down by the management. It requires the services of a large number of personnel.
These personnel occupy the various positions created through the process of
organising.

Top management is chiefly concerned with performing administrative

activities. There are many decisions which the marketing manager takes which have a
significant impact on the profitabil-ity of the firm. The production manager controls a
major part of the investment in the form of equipments, materials and men.

The top management which is interested to ensure that the firm’s long term
goals are met, finds it convenient to use the financial statements as a means for keeping
itself informed of the overall effectiveness of the organisation.Administration expenseswill
include all accounting, personnel and legal expenses and office expenses.

(ii) Product Development

In many organisations, this activity is part of R&D’s responsibility. However,

the need for sales to start in the market place suggests that marketing involvement with
product development should have a good impact on sales revenue and profit. Product
development involves R&D and production engi-neering.
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(a) R&D implies a function that will promote and defend profitability by maintaining

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 and improv-ing the company’s position in product design, quality and cost
and developing new products, materials and production methods where the
improvement of current products is not economic. R&D must be used to help
to close the gap between the required or desired profit and that anticipated,
after all cost reduction and marketing plans have been made.

(b) Production engineering co-ordinates search for knowledge in rational manner

cutting across the entire spectrum of integrated management and processing
activities to attain optimal economic objectives of sufficiency. It lays down a
disciplined use of strategies for increased productivity with ensured quality
and quantity.

Production engineering is the thread of the garland of flowers of agricul-tural,

civil and architecture; mechanical, electrical and electronics; metallurgy and
mining; chemical and environment; textile; computer and telecommunications;
marine and such others.

(iii) Distribution

When a product has been developed and made ready and its price also
determined, the next task is distribution, to bring it to the market and reach it to the
consumer. Distribution is a key external resource and is much important as the internal
operations of research, engineering and production.

It involves two operations and they are:

(i) Selection of the channel of distribution, and

(ii) Physical distribution. It involves warehousing, packaging and transport.

The place where the goods are stored is known as warehouse. It implies a
house for wares. Warehouse is a building for the accommodation of goods, possessing
facilities to perform other market-ing functions. It is meant for final products. It holds
the goods as a distribution centre. In the ware-house, allied marketing functions
such as grading, standardisation, blending, mixing and packing are performed. It
facilitates the user to sell the goods at the best possible price and thus derive better
profit.

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 Packaging is an activitywhich is concerned with protection, economy,
convenience and promo-tional consideration. The packaging of a consumer product
is an important

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part of the marketing. It prevents breakage, contamination, pilferage, chemical
change and insect attack.

Attractiveness is a major consideration in modem packaging. A good

package stimulates sales. Packaging is the sub-division of the packing function of
marketing. Innovative packaging can bring large benefits to consum-ers and profits
to producers.

Transportation means the physical movement of persons and goods from

one place to another. It is the blood stream of a country’s economy. It is described as
physical marketing. It is the key link between the production and other marketing
functions. It develops trade and commerce. It encourages specialisation, division of
labour, large scale production and the extent of market. It increases the mobility and
widens the market. Both consumers and producers benefit by the extension of the
market.

(iv) Inventories

In today’s competitive and ever changing environment, it is essential to

hold adequate stocks to minimise production holdups and win customer satisfaction.
Material constitutes a recurring investment and modem management has recognised that
a constant review of inventory can reduce this capital tied up without limbering the
production and customer goodwill.

Holding large stocks will mean high inven-torycarrying charges and possible
losses caused by price declines. Similarly, shortages in inventories interrupt production,
making machines and men idle and causing sales loss. Hence there is need for inventory
control or what is sometimes termed as inventory planning.

It would be appropriate to men-tion that an effective inventory control

system secures various benefits to the concerned business unit. The purpose of holding
inventories is to allow the firm to separate the process of purchasing, manufac-turing and
marketing of its primary products.

Inventoryplanning involves a forecast of unit requirement during the future

period. Both a sales forecast and an estimate of the safety level of support in
unexpected sales opportunities are required. The marketing department should

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also provide pricing information so that higher profit items receive more attention.

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 (v) Production

Production reflects the ability of the organisation to produce whatever is

demanded by the envi-ronment. The measures of production include profits, sales,
market share, students graduated, clients served and the like. It is concerned with the
supply side of the market.

The basic function of a firm is that of readying and presenting a product for
sale, presumably at profit. While the broader measurement of profit and return as
investment will indicate to some extent the efficiency of the manufacturing units, more
appropriate and directly applicable measurements such as added value and resource
utilisation of various kinds are needed.

Managers will usually have a major proportion of the company’s resources

under their control. How they delay these resources, could have a fundamental
effect as the profit plan is being made. It involves labour, materials, manufacturing,
overheads and maintenance.

(vi) General Administration

Making policies is the function of administration. In all kinds ofbusiness, the

function of admin-istration is the same. Administration personnel are normally
engaged in two activities. First, routine- covering sales order, processing accounting,
secretarial duties, filing, etc. Second, development-activities that can be used to give
positive help to other major functions such as the use of the computer, management
accounting development, management services, various personnel services, etc.

The two activities need to be planned but with a different emphasis in each
case. In amanufacturingorganisation, the administration plan should show the relationship
between the cost and numbers of administration staff and those in other functions
and activities.

(vii) Depreciation

There are two measures of working capital and they are gross working
capital and net working capital. Gross working capital is the total of current assets. Net
working capital is the difference between the total of current assets and the total of
current liabilities.
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The working capital of a concern is normally replaced by income from sales and
is

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available to the owners for the payment of salaries, the purchase of raw materials and
the acquisition of productive services. But the originally invested capital wears out or
becomes obsolete with the passage of time.

It cannot be recovered when the usefulness of these assets is exhausted.

Businessmen, therefore, have realised that in order to state business income
properly, some provision should be made to recover that part of the original asset
which eventually becomes worthless because of depreciation. Depreciation means a
fall in the quality or value of an asset.

An accountant is interested in accounting, auditing, planning and budgeting

profit. The account-ant does not take care of opportunity costs. On the other hand, the
economist is very much concerned with the opportunity cost. The opportunity cost
includes the most profitable alternative use of it that is foregone by putting it into its
present use. This concept is useful to the management since it is needed for operating
problems of profit making.

(viii) Reserves

Reserve is an amount set aside out of profits and other surpluses. It is not
designed to meet anyexisting liability, contingency or diminution of value of assets.
Reserves maybe divided into two main classes. Reserves arising from normal profits are
known as Revenue Reserves. They are available for distribution through the profit
and loss account.

Reserves arising out of unusual profit such as sale of fixed assets at a profit
on revaluation of assets and liabilities are known as Capital Reserves. There are not
generally available for distribution. These are used to write off capital loss such as loss
on sale of a fixed asset, discount allowed on shares or debentures, etc.

A Revenue Reserve maybe created out of profits in order to strengthen the

financial position of the business. This is called a ‘General Reserve’. It is a free reserve
available for any purpose whatso-ever. It may be used for covering unforeseen losses.
It may be even distributed among the proprietors, or it may be used as an additional
working capital.

A Revenue Reserve may also be created for a specific purpose. It is called

307
Specific Reserve. It is generally created for such purposes as repayment of a long
term loan, replacement of an asset, creation of fund for acquiring assets in future,
etc. A Specific Reserve is not available for any purpose other than the purpose for
which it is created. It

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is not available for distribution.

Secret Reserve

Where the existence of a reserve is not disclosed by Balance Sheet, it is

called Secret Reserve. It means that the net asset position is stronger than that
disclosed by the balance sheet.

Secret Reserves are created by various ways:

(i) By exclusive depreciation of assets,

(ii) By under valuation or omission of assets,

(iii) By making accessing provision for bad debts, and

(iv) By charging a capital expenditure to revenue.

Reserve Fund

When a reserve is created out of profits and a corresponding amount of cost

is withdrawn from the business and invested outside in securities, the reserve is called
Reserve Fund. This depends upon the nature of the business and the purpose of the
reserve.

Thus reserve is an appropriation of profits. A reserve can be created only

when there are profits. The object of a reserve is to strengthen the financial
position of the business. Areserve is available for distribution.

12.5.2 Approaches to Profit Forecasting

Profit forecasting is indispensable for profit planning. Profit forecasting

means projecting the future profits assuming the factors like growth of the size of the
business, the pricing policies of the firm, the cost control policies, depreciation and
so on. It is also necessary from the point of view of economic health and stability of
the firm to project for certain years the growth of sales increase in costs and
consequently the profits also.

According to Joel Dean, there are three approaches to profit forecast-ing:

(i) Spot projection

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(ii) Environmental analysis, and

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 (iii) Break-Even analysis

Spot Projection

It relates to projecting the entire profit and loss for a specified period, say
five years or seven years or ten years. The projection of profit and loss statements
for this period depends on the projection of sales, costs and prices of the same
period.

Since profits are surpluses resulting from the forces that shape demand for
the company’s products and govern the behaviour of costs, their predictions are
subject to wide margins of error, from culmination of errors in forecasting revenues
and costs, and from the interrelation of the income statement.

Environmental Analysis

It relates the company’s profit to key variables in the economic de-

velopment during the relevant period. The key variables are general business activity
and general price level. These are external to the company. These factors are beyond
the control of the firm and force the firm to abandon the profit maximising goal. In
reality, factors that control profit have a tendency to move in regular and related
patterns.

The controlling factors of profit are the rate of output, prices, wages,
material costs and efficiency. These are all inter-connected in aggregate business
activity. The environmental analysis might show areas where the company has superior
competence or advantage of some kind.

Break-Even Analysis

The break-even analysis is a powerful tool for profit planning and man-
agement control. Of the three techniques, the break-even analysis is the most
important tool of profit forecasting. The break-even analysis involves the study of
revenues and costs of a firm in relation to its volume of sales and particularly the
determination of that volume at which the firm’s costs and revenues will be equal.

The break-even point may be defined as the level of sales at which total
revenues equal total costs and the net income is equal to zero. This is also known as

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no-profit no- loss point. The main objective of the break-even analysis is not simply to
spot the BEP, but to develop an understanding of the relationship of costs, price
and volume within a

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company’s practical range.
12.6 PROBLEMS IN SETTINGA PROFIT POLICY
The objectives and aims of a business may be different. In fact, most
business concerns like to earn a target rate of return on their investment.
There are four criteria to judge the target rate of return and these are:
(i) Rate adequate enough to attract equity capital
(ii) Rate earned by other companies in the same industry
(iii) Normal or historical profits rate of return
(iv) Rate sufficient to finance growth from internal sources
12.7 SUMMARY
As we know that objectives of business firms can be various. There is no
unanimity among the economists and researchers on the objective of business firms.
One thing is, however, certain that the survival of a firm depends on the profit it can
make. So whatever the goal of the firm-sales maximization, maximisation of firms,
growth, maximisation of managers’ utility function, long- run survival, market share, or
entry-prevention-it has to be a profitable organisation. Maximisation of profit in
technical sense of the term may not be practicable, but profit has to be there in the
objective function of the firms. The firms may differ on ‘how much profit’ but they set
a profit target for themselves. Some firms set their objective at a ‘standard profit’,
some at a ‘target profit’ and some at a ‘reasonable profit’. ‘A reasonable profit’ is
the most common objective.
12.8 SELFASSESSMENT QUESTIONS
1. Why do modem corporations aim at a “reasonable profit” rather than to
profits?

2. What are the criteria for setting standard for a reasonable profit?
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3. How should “reasonable profits” be determined?

12.9 SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas publishing house, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Mithani, D.M., managerial economics-theory & application, Himalaya
publishing house Pvt. Ltd., New Delhi.
 Gupta, G.S., Macro economic- theory & application, Tata Mcgraw hill
publishing house, new delhi.
 Vaish, M.C., Macro Economic theory, Vikas publishing house pvt. Ltd.,
new delhi.
 Mishra, S.k., and Puri, V.K., modern macro economic theory, Himalayan
Publishing house.

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 UNIT- IV
LESSON 13 KNOWLEDGE BASED ECONOMY

STRUCTURE
13.1 INTRODUCTION

13.2 OBJECTIVES

13.3 MEANING OF KNOWLEDGE BASED ECONOMY

13.4 FEATURES OF KNOWLEDGE ECONOMY

13.5 FRAMEWORK OF KNOWLEDGE ECONOMY

13.6 K-PROFIT ANALYSIS

13.8 SELF ASSESSMENT QUESTIONS

13.9 SUGGESTED READINGS

13.1 INTRODUCTION

The knowledge economy is also seen as the latest stage of development in

global economic restructuring. Thus far, the developed world has transitioned from
an agricultural economy (pre-Industrial Age, largely the agrarian sector) to
industrial economy (with the IndustrialAge, largely the manufacturing sector) to post-
industrial/mass production economy (mid-1900s, largely the service sector) to
knowledge economy (late 1900s – 2000s, largely the technology/human capital
sector). This latest stage has been marked by the upheavals in technological
innovations and the globally competitive need for innovation with new products and
processes that develop from the research community (i.e., R&D factors, universities,
labs, educational institutes). In the knowledge economy, the specialised labour force is
characterised as computer literate and well-trained in handling data, developing
algorithms and simulated models, and innovating on processes and systems.
Harvard Business School Professor, Michael Porter asserts that today’s economy is far

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more dynamic and that comparative advantage is less relevant than competitive

317
advantage which rests on “making more productive use of inputs, which requires
continual innovation”.
Consequently, the technical, STEM careers including computer scientists,
engineers, chemists, biologists, mathematicians, and scientific inventors will see
continuous demand in years to come. Additionally, well-situated clusters, which Michael
Porter argues is vital in global economies, connect locallywith linked industries,
manufacturers, and other entities that are related by skills, technologies, and other
common inputs. Hence, knowledge is the catalyst and connective tissue in modern
economies.
13.2 OBJECTIVES
The objectives of this chapter is:
 To understand the concept of k-economy
 To know about k-profit analysis
13.3 MEANING OF KNOWLEDGE BASED ECONOMY
The knowledge economy is the use of knowledge to generate tangible and
intangible values. Technology and in particular knowledge technology help to transform
a part of human knowledge to machines. This knowledge can be used by decision
support systems in various fields and generate economic values. Knowledge economyis
also possible without technology.
The term was popularised by Peter Drucker as the title of Chapter 12 in
his book The Age of Discontinuity (1969), that Drucker attributed to economist
Fritz Machlup, originating in the idea of “scientific management” developed by
Frederick Winslow Taylor.
Other than the agricultural-intensive economies and labour-intensive
economies, the global economy is in transition to a “knowledge economy”, as an
extension of an “information society” in the Information Age led by innovation. The
transition requires that the rules and practices that determined success in the industrial
economyneed rewriting in an interconnected, globalised economy where knowledge
resources such as trade secrets and expertise are as critical as other economic
resources.
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In other words, the knowledge economyis a system of consumption and production

319
that is based on intellectual capital. The knowledge economy commonly makes up a
large share of all economic activity in developed countries. In a knowledge economy, a
significant part of a company’s value may consist of intangible assets, such as the value
of its workers’ knowledge (intellectual capital), but generally accepted accounting
principles do not allow companies to include these assets on balance sheets.

13.3.1 Concepts of knowledge economy

A key concept of the knowledge economy is that knowledge and education

(often referred to as “human capital”) can be treated as one of the following two:
 A business product, as educational and innovative intellectual products and
services can be exported for a high value return.
 A productive asset
It can be defined as:

Production and services based on knowledge-intensive activities that

contribute to an accelerated pace of technical and scientific advance, as well as rapid
obsolescence. The key component of a knowledge economyis a greater reliance on
intellectual capabilities than on physical inputs or natural resources.

The initial foundation for the knowledge economy was introduced in 1966 in
the book The Effective Executive by Peter Drucker. In this book, Drucker
described the difference between the manual worker and the knowledge worker. The
manual worker, according to him, works with his or her hands and produces goods or
services. In contrast, a knowledge worker works with his or her head, not hands, and
produces ideas, knowledge, and information. The keyproblem in the formalisation and
modelling of knowledge economy is a vague definition of knowledge, which is a
rather relative concept.

For example, it is not proper to consider information society as

interchangeable with knowledge society. Information is usually not equivalent to
knowledge. Their use, as well, depends on individual and group preferences which
are “economy-dependent”.

13.3.2 Driving forces

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Commentators suggest that there are various interlocking driving forces, which

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are changing the rules of business and national competitiveness. These driving forces are:
 Globalisation - markets and products are more global.
 Information technology, which is related to next three:
 Information/Knowledge Intensity — efficient production relies on information
and know-how; many factory workers use their heads more than their
hands.
 New Media – New media increases the production and distribution of
knowledge which in turn, results in collective intelligence. Existing knowledge
becomes much easier to access as a result of networked data-bases which
promote online interaction between users and producers.
 Computer networking and Connectivity – developments such as the Internet
bring the “global village” ever nearer.
As a result, goods and services can be developed, bought, sold, and in
many cases even delivered over electronic networks.

As regards the applications of any new technology, this depends on how it

meets economic demand. It can remain dormant or make a commercial
breakthrough.

13.4 FEATURES OF KNOWLEDGE ECONOMY

It can be argued that the knowledge economy differs from the traditional
economy in several key respects:

1. The economics are not of scarcity, but rather of abundance. Unlike most
resources that are depleted when used, information and knowledge can be shared,
and actually grow through application.

2. The effect of location is either:

 Diminished, in someeconomic activities: usingappropriatetechnologyand methods,
virtual marketplaces and virtual organisations that offer benefits of speed,
agility, round the clock operation and global reach can be created.
 or, on the contrary, reinforced in some other economic fields, by the
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creation of business clusters around centres of knowledge, such as universities
and research

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 centres. However, clusters already existed in pre-knowledge economy times.

3. Laws, barriers, taxes and ways to measure are difficult to apply solely on a
national basis. Knowledge and information “leak” to where demand is highest and
the barriers are lowest.

4. Knowledge enhanced products or services can command price premiums over

comparable products with low embedded knowledge or knowledge intensity.
5. Pricing and value depends heavilyon context. Thus, the same information or
knowledge can have vastlydifferent value to different people or even to the same
person at different times.

6. Knowledge when locked into systems or processes has higher inherent value
than when it can “walk out of the door” in people’s heads.
7. Human capital competencies are a key component of value in a knowledge-
based company, yet few companies report competency levels in annual reports. In
contrast, downsizing is often seen as a positive “cost cutting” measure.

8. Communication is increasinglybeing seen as fundamental to knowledge flows.

Social structures, cultural context and other factors influencing social relations are
therefore of fundamental importance to knowledge economies.

These characteristics require new ideas and approaches from policy

makers, managers and knowledge workers.

The knowledge economy has manifold forms in which it may appear but there
are predictions that the new economy will extend radically, creating a pattern in
which even ideas will be recognised and identified as a commodity. Considering the
very nature of ‘knowledge’ itself, added to the fact that it is the thrust of this new form
of economy, there is a clear way forward for this notion, though the particulars (i.e.
the quantum of the revolutionaryapproach and its applicabilityand commercial value),
remain in the speculative realm, as of now.

13.5 FRAMEWORK OF KNOWLEDGE ECONOMY

The knowledge revolution and the technological and economic changes it

implies
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clearly entail the need to rethink countries’ overall development strategies.
Knowledge- and innovation-related policies should be at the core of those strategies,
which should be built on four pillars: the country’s education and training base, its
information and telecommunications infrastructure, the innovation system, and the
overall business and governance framework..
A Four-Pillar Framework of knowledge economy
I. Rationales
A knowledge economy (KE) relies on knowledge as the key engine of
economic growth. It is an economy in which knowledge is acquired, created,
disseminated, and applied to enhance economic development. Intuitively,
conditions for a knowledge based development process would seem to include an
educated and skilled labour force, a dense and modern information infrastructure,
an effective innovation system, and an institutional regime that offers incentives for
the efficient creation, dissemination, and use of existing knowledge.
 The labour force should be composed of educated and skilled workers who
are able to continuously upgrade and adapt their skills to create and use
knowledge efficiently. Education and training systems encompass primary
and secondary education, vocational training, higher education, and lifelong
learning. The weight placed on the different segments will differ somewhat
depending on a country’s level of development. For example, basic education
will receive more attention at low levels of development, as basic literacy and
numeracyare necessaryfoundations on which more advanced skills are built.
Similarly, lifelong learning has increasing importance in the current context of
the knowledge revolution, which requires constant adaptation of knowledge
and know-how. It also grows in importance as the population ages.
Globalisation, meanwhile, is bridging the distance between basic skill needs
and advanced skills, forcing countries to cover a wide educational band even at
low levels of development to catch up with advanced economies and then
remain competitive.
 A modern and adequate information infrastructure will facilitate the
effective communication, dissemination, and processing of information and

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knowledge. Information and communication technologies (ICTs)—
including telephone,

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 television, and radio networks—are the essential infrastructure of the
global, information-based economies of our time, as railways, roads, and
utilities were in the industrial era. They can considerably reduce transaction
costs by providing ready access to information. ICT-related policies cover
telecommunications regulation as well as the investments needed to build and
exploit ICTs throughout the economy and society through various “e-
applications”—e-government, e- business, e-learning, etc. Low-income
countries should focus first on the basic ICT infrastructure before promoting
advanced technologies and applications.
 An effective innovation system is composed of firms, research centres,
universities, consultants, and other organizations that keep up with new
knowledge and technology, tap into the growing stock of global knowledge,
and assimilate and adapt it to local needs. Public support for innovation,
science, and technology covers a wide range of infrastructure and institutional
functions, from the diffusion of basic technologies to advanced research
activities. The former should receive a great deal of attention in developing
countries. For most developing countries much of the knowledge and
technologythat nurtures innovation will originate from foreign sources, entering
the country through foreign direct investment (FDI), imports of equipment
and other goods, and licensing agreements. Foreign sources are important when
the economy is less developed, though imports must not be allowed to obscure
or marginalize the country’s unique indigenous knowledge assets, such as
traditional knowledge. Diffusion of basic technologies should receive a great deal
of attention in developing countries.
 The country’s institutional regime, and the set of economic incentives it
creates, should allow for the efficient mobilisation and allocation of resources,
stimulate entrepreneurship, and induce the creation, dissemination, and
efficient use of knowledge. The notion covers a vast array of issues and
policy areas, ranging from aspects of the macroeconomic framework, to trade
regulations, finance and banking, labour markets, and governance. The latter
includes the rule of law and its applications (judicial systems), the quality of
the bureaucracy as reflected in measures of government effectiveness, and

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the level of corruption. Mediocre governance resulting in a poor business
climate is the single greatest hindrance to economic and social development in
general, and to knowledge-based development

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 in particular.

II. Interactions among the Pillars and Virtuous Development Circles

We have seen that each of the four pillars in the KE framework must function
efficiently in order to spur knowledge-driven growth. But more is needed:
investments in the four pillars must be balanced and coordinated so that the
pillars interact to produce benefits greater than those obtainable from their
independent operation.

The purpose of the World Bank’s Knowledge Economy framework is to

evaluate the quality, adaptation, and use of knowledge in an economy, with the
goal of creating effective knowledge economies capable of competing in the
global economy.

A Knowledge Economy is one that utilises knowledge to develop and sustain

long- term economic growth, thus the Knowledge Economy framework focuses
on four pillars which it suggests are needed to support a successful knowledge
economy.

The first pillar of the frameworkis an economic and institutional regime that is
conducive to the creation, diffusion, and utilisation of knowledge.Aregime that
provides incentives that encourage the use and allocation of existing and new
knowledge efficiently will help to foster policy change. The economic environment
must have good policies and be favourable to market transactions, such as being
open to free trade and foreign direct investment. The government should
protect property rights to encourage entrepreneurship and knowledge
investment.

The second pillar is a well-educated and skilled population that creates, shares,
and uses knowledge efficiently. Education, especiallyin the scientific and engineering
fields, is necessary to achieve technological growth. A more educated society
tends to be more technologically sophisticated, generating higher demand for
knowledge.

The third pillar is a dynamic information infrastructure that facilitates the

communication, dissemination, and processing of information and technology. The

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increased flow of information and knowledge worldwide reduces transactions
costs, leading to greater communication, productivityand output.

The final pillar is an efficient innovation system of firms, research centres,

universities, think tanks, consultants, and other organisations that applies and
adapts global

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 knowledge to local needs to create new technology.
The generation of technical knowledge leads to productivity growth. With these
pillars in place, countries can develop a knowledge economy and sustain long-term
economic growth.
Example of the framework in use: South Korea after 1997
The Knowledge Economy framework can be applied to the development
strategy used by South Korea after its financial crisis in 1997. The World Bank,
Organisation for Economic Co-operation and Development, and several think tanks
worked together to develop a strategy to develop a knowledge economy. The
organisations found that South Korea needed to improve its productivity since it
was not getting the returns it expected from massive capital and investment inputs.
They determined that updating Korea’s economic incentive and institutional regime,
including the role the government played, would improve productivity.
A more favourable climate was needed for innovation since universities conducted
little research. The specialisation and knowledge exchange among universities,
local government, firms, and research institutes would reduce transaction costs and
lead to greater productivity. Contrary to expectations, information and
communication technology was growing at a fast rate. Thus, no major
improvements to the information infrastructure were needed.
However, education was determined to be a huge roadblock in the wayof a
knowledge economy. The country was only investing 13 percent of its GDP in
education, which was deemed inefficient and inappropriate. Reforms included:
deregulating the control bythe Ministryof Education; implementing outcome-oriented
governance; reallocating public and private resources; integrating learning systems;
and strengthening links to the global education system.
By implementing good economic policies, adopting a high-growth
development programme, and increasing social capital and improving the
labour force through enhanced education, Korea was able to transform itself
into a knowledge economy.
What sorts of policy advice does the framework deliver?

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The Knowledge Economy framework suggests that to be effective knowledge

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 economies in which knowledge is created, disseminated and used well,
economies have to have four pillars in place. Policy advice would focus attention
on which of the pillars is in particular need, in terms of appropriate policies,
institutions, investments and coordination. The World Bank has produced a guide
the Knowledge Assessment Methodology, which can be used to assess what a
country needs if it is to become a knowledge economy

III. BREAKING DOWN ‘Knowledge Economy’

Lesser-developed countries tend to have agriculture and manufacturing-based

economies, while developing countries tend to have manufacturing and service-
based economies, and developed countries tend to have service-based
economies. Most countries’ economies consist of each of these three major
categories of economic activity but in differing proportions relative to the wealth
of that country. Examples of knowledge economy activities include research,
technical support and consulting.

In the Information Age, the global economy moved towards the knowledge
economy. This transition to the InformationAge includes the best practices taken from
the service- intensive, manufacture-intensive and labor-intensive types of
economies and added knowledge-based factors to create an interconnected and
globalized economy where sources of knowledge like human expertise and trade
secrets are crucial players in economic growth and are considered as important
as other economic resources.

The knowledge economyaddresses how education and knowledge — generally

called “human capital — can serve as a productive asset or a business product since
innovative and intellectual services and products can be sold and exported and can
yield profits for the individual, the business and the economy. This component
of the economy relies greatly on intellectual capabilities instead of natural
resources or physical contributions. In the knowledge economy, the production
of services and products that are knowledge-based provides rapid acceleration in
the technical and scientific fields, making way for more innovation in the
economy as a whole.

IV. Knowledge Workers vs. Manual Workers

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The concept of the knowledge economy was first used by Peter Drucker in his
1966 book “The Effective Executive.” In this book, the difference between a
knowledge

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 worker and a manual worker was discussed. According to Drucker, the manual
worker uses his hands and other physical capabilities to produce and provide
services and other goods. On the other hand, a knowledge worker uses his
head and produces knowledge, information and ideas that may be beneficial for
the overall system of the business or that may be the key source in building the
business in the first place.

V. Technology

The technology requirements for an Innovative System as described by the World

Bank Institute must be able to disseminate a unified process bywhich a working
method may converge scientific and technology solutions, and
organizational
[16]
solutions. According to the World Bank Institute‘s definition, such innovation
would
further enabletheWorld Bank Institute‘s vision outlined in their Millennium
Development Goals.

VI. Challenges for Developing Economy

The United Nations Commission on Science and Technology for Development

report (UNCSTD, 1997) concluded that for developing countries to
successfully integrate ICTs and sustainable development in order to participate in
the knowledge economy they need to intervene collectively and strategically.
Such collective intervention suggested would be in the development of effective
national ICT policies that support the new regulatory framework, promote the
selected knowledge production, and use of ICTs and harness their organizational
changes to be in line with the Millennium Development Goals. The report
further suggests that developing countries to develop the required ICT
strategies and policies for institutions and regulations taking into account the
need to be responsive to the issues of convergence.

13.6 K-PROFIT ANALYSIS

Some might argue that the knowledge economy is so clearly self-evident that a
more precise definition is unnecessary and that knowledge is such a difficult concept to
pin down that any measures are bound to be unsatisfactory or even misleading.
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However, without measurable definitions, the knowledge economy will remain a vague
concept. The impact of the knowledge economy on industrial organisation,
institutional structures, employment and society would remain more a matter of
assertion and intuition rather than

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demonstrable proof based on hard facts. It would not be possible to answer basic
questions about how big the knowledge economy really is, how many people work in it
whether it is growing and at what rate, and how the UK compares with similar OECD
economies. And it would be hard if not impossible to off era set of practical
evidence based policy recommendations to policy makers in both the corporate
and public sector. However, developing better definitions of the knowledge
economy will be challenging.

If the term knowledge economy is to be useful we need to identify

distinctive features that we would not expect to find- or at least not in such abundance
- in the rest of the economy. A clear distinctive feature is the central role of the use of
new information and technologies in allowing knowledge and information to be used in
ways that underpin the knowledge economy concept. The rapid fall in price and vast
increase in computing power has been a key underlying driver in creating
networked systems able to store, analyse and handle knowledge and information
flows. Knowledge economy might be defined more precisely in ways that are
measurable and therefore, in principle, testable against hard data: Industry sector
definitions of knowledge intensive industries and services Occupational based definitions
of knowledge workers Innovation related definitions of the share of innovating fi rms.
The knowledge economy is often thought of and sometimes defined in terms of
knowledge intensive industries based ICT production or usage and/or high sharesof
highlyeducated labour. Industrial definitions initiallyfocused on manufacturing and often
used R&D intensity as an indicator to distinguish between high, medium and low-tech
sectors. The definition has steadily expanded to include service industries that invest
little in R&D but are intensive users of ICT technologies and/or have a highly skilled
workforce using the benefits from technological innovation. Defining the
knowledge economy in terms of knowledge workers has the advantage of being
cross-sectoral, so avoids the shortcomings of industrial definitions. It has the
disadvantage that there is no agreed or straightforward definition of who is a
knowledge worker. There are (at least) three ways we can work towards a definition
of knowledge workers: All those who work in the top three standard occupational
classifications (managers, professionals, associate professionals).All those with high
levels skills, indicated bydegreeor equivalent qualifications (NVQ level 4) All those who
perform tasks that require expert thinking and complex communication skills with
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the assistance of computers.

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13.7 SUMMARY

Numerous social scientists have documented the transition underway in

advanced industrial nations from an economy based on natural resources and physical
inputs to one based on intellectual assets. We document this transition with patent data
that show marked growth in the stocks of knowledge, and show that this expansion is
tied to the development of new industries, such as information and computer
technology and biotechnology. The literature on the knowledge economy focuses
heavily on knowledge production, however, and attends less to knowledge dissemination
and impact. This neglect is unfortunate because a key insight of the productivity debate is
that significant gains in productivity are achieved only when new technologies are
married to complementary organisational practices.

Information technology that facilitates the broad distribution of knowledge is

not successfully tethered to a hierarchical system of control. Thus one cannot assume
that there is a natural link between knowledge production and flexible work, as new
information technologies open up novel possibilities for both discretion and control.

A focus onknowledge dissemination might alsoaid the analysis ofthe skills

mismatch thesis. The argument that some classes of workers are highly disadvantaged
by technical change is too simple, although clearly older, less-skilled, and minority
workers have borne the brunt of the transition to an economy based on intellectual
skills. But fine-grained studies of how some less-skilled workers acquired the
necessary technical skills to work in new settings are rare, and would be valuable.

The debate over skills also reveals the relative lack of standard metrics in this
area of research. Patents have become an appropriate measure of stocks of
knowledge, but we lack anycomparable indicators of skills, and too often researchers
rely on occupational labels or categories.

13.8 SELFASSESSMENT QUESTIONS

1. Explain the concept of knowledge based economy?

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2. Discuss the framework of k- economy?

3. Outline the constraints in the growth & development of K- economy?

13.9 SUGGESTED READINGS

 Mithani, D.M., Managerial Economics-theory&Application, Himalaya
publishing House Pvt. Ltd., New Delhi.
 Gupta, G.S., Macro Economic- theory & application, Tata Mcgraw hill
publishing house, New Delhi.
 Vaish, M.C., Macro Economic theory, Vikas publishing house Pvt. Ltd.,
New Delhi.
 Mishra, S.K., and Puri, V.K., Modern Macro economic theory, Himalayan
Publishing house.

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 UNIT-IV
LESSON 14 GROWTH OF KNOWLEDGE

ECONOMY STRUCTURE
14.1 INTRODUCTION
14.2 OBJECTIVE
14.3 STEPS FOR DEVELOPING KNOWLEDGE ECONOMY
14.3.1 Learning from Others
14.3.2 Adopting Conducive Attitudes
14.3.3 Adapting PolicyActions to Development Levels
14.3.4 Managing Reform Processes
14.3.5 Sequencing Reforms
14.3.6 Exploiting Entry Points: Driving Sectors and Cities
14.3.7 Dealing with a Country’s Context
14.3.8 Socio-cultural Issues
14.4 CONSTRAINTS TO THE GROWTH OF KNOWLEDGE ECONOMY
14.4.1 Challenges and Opportunities
14.4.2 Future challenges for a knowledge-based economy
14.4.3 Policies for a knowledge-based economy
14.5 SUMMARY
14.6 SELF ASSESSMENT QUESTIONS
14.7 SUGGESTED READING

14.1 INTRODUCTION

The knowledge economyand the growth of knowledge management, as an

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essential

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competency of organisations, provides new opportunities for librarians and
information specialists to expand existing roles and utilise the skills they have honed to
meet corporate objectives. The keyinformation management role of both internal and
external information, alongside the contribution to information competence and the
ability to contextualise information, contributes to organisational excellence,
customer benefit and competitive advantage which can be achieved more effectively
through collaboration and partnership.

The new Knowledge Economy is a period of rapid change – a paradigm

shift – for librarians and libraries. It can be viewed as either the beginning of a new
“golden age” for the profession, or the point when librarians and information
professionals became marginalized, and perhaps made irrelevant, by the rapid
advances in digital computer and telecommunication technologies and the networking
power of the Internet, intranets, and extra Librarians and information professionals are
in a position to transform themselves into value-adding knowledge professionals.
However, this will require a radical change in how they view their roles and jobs within
knowledge-based organizations. It will require them to visualize a world of rapid
change, instantaneous communications, and the transformation of organizations
from those based on identifiable boundaries to networks of business relationships.
This is the challenge facing the profession.

The term “knowledge-based economy” results from a fuller recognition of

the role of knowledge and technologyin economic growth. Knowledge, as embodied in
human beings (as “human capital”) and in technology, has always been central to
economic development. But only over the last few years has its relative importance
been recognised, just as that importance is growing. The OECD economies are more
strongly dependent on the production, distribution and use of knowledge than ever
before. Output and employment are expanding fastest in high-technology
industries, such as computers, electronics and aerospace.

14.2 OBJECTIVES

The objectives of this lesson are:

 To understand the steps for developing knowledge economy
 To explain the constraints to the growth of K-economy
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14.3 STEPS FOR DEVELOPING KNOWLEDGE ECONOMY

14.3.1 Learning from Others

To understand how to build knowledge-based economies, it is useful to look

at countries that have succeeded in setting their growth processes on a knowledge
and innovation-based track-even if the relevant policyactions were part of broader
development strategies and an explicit knowledge economy (KE) approach was
onlyrecently identified and named. Several cases throughout the world deserve
particular attention. Finland is considered by many to be the world’s most
competitive country. Canada and Australia also enjoy competitive economies. The
Republic of Korea and Ireland initiated explicit KE strategies in the past few decades,
starting from a low-income base to achieve leading positions in the world economy.

i. Middle-income economies- A few decades ago, the nations of Chile and

Costa Rica in Latin America, Malaysia in East Asia, Tunisia in the Middle
East, and Mauritius and Botswana in Africa, instituted multi sector reforms to
attract foreign investment and create a KE-oriented environment. Transitional
economies. The Baltic countries, notably Estonia, have instituted KE reforms
over the past decades that are now paying off. Low-income economies. Vietnam
has developed rapidly by taking advantage of globalization. The African
countries of Mauritania, Mozambique, Uganda, and Rwanda are also active in
instituting KE reforms (if in a fragmented way) and have enjoyed some
economic success. China and India. Finally, there are the examples of China
and India. These are the two emerging giants of our time, and their
ascendance has benefited from the selective use of the KE approach. The
experiences of these countries offer answers to the questions of what to do to
build a knowledge economy and how to do it. The examples of the Republic of
Korea, Ireland, and Finland are examined in detail in this chapter. Although their
economies are now fairly advanced, they offer useful and generally applicable
lessons. To resolve the crisis and put the economy back on solid footing,
the government enacted remedial financial and economic measures, while at the
same time launching a nationwide, multi sector KE plan (box 3.5) promoted
through an awareness campaign in the nation’s main business newspaper.
Coordinated bythe Ministry of Finance, the plan included reforms across all
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levels

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 of the education system, incentives to stimulate R&D (to compensate for
the business sector slowdown), the promotion of venture businesses, and the
building of a dynamic information society. This last phase, the most successful
of the plan, resulted in the creation of an advanced information infrastructure (as
measured by Internet access, e-applications, and so on) supported bya
verydynamic information technology (IT) industry.

Inspired by these examples, the following sections set out principles for
implementing KE (knowledge economy) strategies, including:

 the change of mindset needed for KE strategies

 the general attitudes that should inspire KE strategies
 the adaptation of policy measures to development levels
 the management of reform
 the exploitation of entry points such as driving sectors and cities
 the need to deal with contextual specifics of various types.

14.3.2 Adopting Conducive Attitudes

i. A New Mindset for Government Action- The KE development calls for

government action beyond the familiar programs of market liberalisation
and selective, modernizing interventions. The new approach complements,
rather than replaces, the liberalisation and modernisation views.

ii. Key Attitudes- The general attitudes that should guide knowledge-based
strategies: determination, vision, openness, and pragmatism. The same attitudes
underpin the successful efforts of other countries as well: Determination-
A KE-based approach requires determination. Adherence to the so-called
Washington Consensus on policy reform-which calls for macroeconomic
stability, deregulation, trade liberalization, and privatisation-is not sufficient in
itself. Policies need to address all intangible assets and sources of growth-
education, research, information, communication, and entrepreneurship-in
order to foster and apply knowledge throughout the economy. Determination
requires thinkingbig. Successful knowledge-based strategies require determined

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action across sectors and fields.

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 Restricting efforts to a specific policyplank is thinking small. Determination
involves the ways and means used to accomplish the basic policy actions
needed at a nation’s stage of development. While it is difficult to make the
transition to a stage of higher development, it is possible to apply modern
means to achieve the objectives applicable within a stage. For instance,
the use of advanced communication tools and distance learning can facilitate
the meeting of education objectives even in the poorest countries. Similarly, the
use of basic telephone and Internet facilities in countries at a higher stage of
development can rapidly and radically transform the conditions within which
entrepreneurs-including farmers and fishermen-do business. The application
of these means can be effectively supported by government efforts.
Determination is demonstrated by clearly structured industrial policies set
to facilitate the development of a strong manufacturing sector. These
measures improve the overall environment in which businesses evolve. Vision-
Countries that advance have started with a vision that, in one way or another,
points to a goal and gives a sense of identity. Aclear vision gives expression to
determination.Avision generally takes the long view, sometimes with the fruition
of goals 20 years out. Vision arises from small groups of people, from
community or regional leaders, and sometimes even from the head of state.
Visionaries need to look for resources in various sectors of society, such as
business and education. This is necessary to anchor the vision in reality and to
obtain the commitment of the populace. It is crucial to realize a vision in
concrete terms quickly-in tangible projects, even if of modest size. The
vision thus becomes credible and reinforces national investment and self-
confidence. Openness.Another lesson from the Korean, Irish, and Finnish
experiences-and from other successful transitions to a KE approach-is the
need for openness to the outside world. Globalization offers considerable
opportunities; chief among them is the opportunity to attract FDI and
employit appropriately. Each countrymust organise instruments and channels to
systematically monitor technologies and knowledge abroad that might be
relevant to its activities and goals.

A successful knowledge economy relies on policy exposure, which can be

gained through international exchange, study tours, and pilot programs based on policy
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measures that have proven successful abroad. Pragmatism, Determination, vision,
and openness

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must be grounded in reality.
Policymakers need to clearly understand the needs and constraints of their
economy and temper their ambitions and goals, adapting their efforts to their country’s
capacities and resources. They must make the best use of their country’ s
competitive advantage, whether in agriculture, tourism, or natural resources, and to
direct their attention first to the areas with the highest leverage to position the country
on a successful KE track. As the experiences of the Republic of Korea, Finland,
and Ireland demonstrate, building a knowledge economy is a gradual process in
which efforts, investments, and policy actions are adapted at each stage of development,
accompanied byan understanding of the country’s specific needs, capabilities, and
comparative advantages.
14.3.3 Adapting Policy Actions to Development Levels
The three examples of the Republic of Korea, Ireland, and Finland suggest
policy actions appropriate for various stages of development. Progress toward a
knowledge economy is measured in relation to the stages of development as defined
by the World Bank, and by respective levels of advancement. Low-income countries
are at an early KE stage and need to build foundations; lower-middle-income
countries are at an upgrading KE stage and need to raise their KE assets before
they can embark on a broad KE strategy for growth; upper-middle-income countries
are at an emerging KE stage; and high-income countries are ready for a full-fledged
KE strategy.
Low-Income Countries
Low-income countries at an early KE stage need to establish solid foundations
in governance and the business environment. Governments may choose to establish
special economic zones (SEZs) with few bureaucratic entanglements and transaction
costs. This attracts foreign investment, which introduces new technology and
management and creates jobs. Large but vital tasks are (a) the reduction of illiteracy
through basic education and
(b) the strengthening of a few technical and tertiary institutions to build core competency
in advanced technology, engineering, and science. For ICT advancement, low-
income countries should first build a minimal telephone infrastructure that takes advantage

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of mobile technology and then establish fixed-line connections for the Internet (at least
10 percent of the population must be connected in order for the knowledge economy
to take off). For educational and cultural advancement, they should also make good
use of TV and radio

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networks, notably to reach rural areas. In terms of innovation, they should make the
best possible use of national and global knowledge to serve the basic needs of the
population (for food, healthcare, and housing), and develop basic infrastructure for
quality control, metrology, and other services essential for supporting technology
diffusion and adaptation throughout the nation, particularly in rural areas. Investments
may be directed to selected IT niches if it is possible to take advantage of a literate
labour force and entrepreneurial individuals well connected to international markets.

Lower-Middle-Income Countries

Lower-middle-income countries that are upgrading toward a knowledge

economy should further improve their business environment by focusing on financial
and labour markets and by facilitating the reallocation of both financial and human
resources toward an emerging formal private sector. Bureaucratic and regulatory
obstacles that prevent expansion should be removed. SEZs should be developed across
the economy, and more FDI attracted through targeted strategies and incentives. To
achieve full literacy and expand the higher education base by joining networks of
advanced institutions worldwide, there must be full access to primary education and
increased standards of quality as well as access to secondary and vocational
education. Internet access should be expanded to improve governance, logistics,
business services, and the delivery of social services. Innovation requires an
increased awareness of global developments to identify and import relevant
technologies. Extension services designed to increase productivity in agriculture and
manufacturingshould be increased. While private R&D maybe encouraged, the existing
public R&D infrastructure should be strengthened. Both must be supported by
measures to increase technological and managerial competence. University-
industryinteraction should be encouraged on a selective basis through appropriate
support and incentives.

Upper-Middle-Income Countries

As they move closer to a solid knowledge economy, upper-middle-income

countries should further strengthen their business environment. In particular, they must
focus on financial and equity markets by facilitating the mobilisation of development
and venture capital. The efficiency of government tax collection and expenditure should

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improve with an educated labour force and improved governance. Access to higher
education should continue to widen and the qualityof education to improve. Lifelong
learning systems

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characterised by multiple pathways and providers should be developed. The
application and use of Internet-based technology should be further developed, increased,
and diversified to further reduce transaction costs and improve economic efficiency.
Domestic innovative capacity should be encouraged through appropriate incentives
(reimbursable subsidies, tax incentives, and so on), particularly for developing private
sector R&D, with a goal of increasing R&D expenditure to 2 percent of GDP.
Protection for intellectual property rights (IPR) should also be expanded, although
this is less important for low-income countries.
Advanced Countries
For advanced economies, development and maintenance of a true
knowledge economy require an immediately responsive and flexible environment.
Incentives should be directed toward intangibles such as R&D, education, software,
and marketing and should be adapted for a service-based economy. In the
education sector, the priority should be to increase access to and quality of the higher
education sector. This, in return, becomes part of a larger, seamless, lifelong learning
system with a large number of tertiary students, including adults. ICT becomes the
basic infrastructure of the economy with a broad development of special applications,
including dedicated software and multimedia. Innovation becomes the key engine of
growth. International strategic alliances for R&D, production, and marketing are
encouraged by government support.
14.3.4 Managing Reform Processes
Timeline and Impact of Reforms
Knowledge Economy reforms can have a very significant impact in a
relatively short time, even though their full effect requires sustained action across the four
pillars. The effect of measures that improve the business environment may be felt in one
or two years- sometimes in only a few month-in areas such as enterprise development
and the attraction of FDI. Similarly, investments or actions relating to ICT may show
tangible effects in only a few years- witness the rapid spread of cell phones. By contrast,
innovation policy requires a minimum of five years to generate significant improvements
in technology diffusion, job creation, enterprise growth, and international
competitiveness.And education policyreforms will not take full effect until the passing of

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one to two decades at best. However, measures to retrain workers-and more generally
to establish lifelong learning venues-should improve

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employment opportunity for much of the population far more rapidly. KE
development processes are nonlinear. Unexpected events-such as a crisis that
demands immediate decisions or the restructuring of a sector or firm that leads to
immediate and unanticipated industrial growth-can effect a major change in
direction.
Knowledge Dynamics: Incremental Change
Determination and vision are necessary to build confidence that a new and
better era in national development is at hand. However, the conditions for substantial
change throughout the institutional system are often not fulfilled even in countries that
have been affected bya deep crisis. When effective market mechanisms and government
organisations are in their infancy, policy makers may face both market failure and
government failure. Under such conditions, pragmatism-adopting and adapting what
works-should inform knowledge strategies. The design of institutional solutions for
knowledge-based growth does not require full-scale public sector reform. If resources are
few and time is constrained, policies that establish institutional shortcuts maybe
appropriate. Imperfect and idiosyncratic institutions may ensure a functional fit between a
country’s conditions and the challenges of reform.
For example, many observers have been puzzled by the remarkable success
of town and village enterprises in China. These enterprises were owned and controlled
by local governments. Standard theory cannot account for their comparative advantage
over private enterprises. It seems that the public structure accommodates the particular
features of the Chinese economy and society at this point in time. China is not the only
country to employ incremental reform. Modest reforms appeared to account for
economic growth in India, allowing the nation to exceed its traditional growth rate of 3
percent. In the 1980s, under Rajiv Gandhi, the government relaxed industrial
regulations, encouraged imports of capital goods, and rationalised the tax system.
Though the reforms were modest, they tipped the balance by encouraging rather
than discouraging entrepreneurial pursuits. Entrepreneurship is both a principal
route into global knowledge flows and a principal actor in transforming knowledge
into wealth. The recent surge of growth in these emerging giants can be traced to their
strategy of gaining knowledge that can then be transformed into wealth. The reforms in
China and India illustrate incremental changes from the bottom up, offering a favourable
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balance of risks and returns by encouraging first steps at many and diverse entry
points. This incremental process increases the chances of setting the

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cycle of institutional reform and knowledge-based development into motion.

Sustaining Knowledge Dynamics: Bottom-Up and Top-Down Initiatives

Since most developing countries need to implement major reforms if they are
to move ahead. Developing a consensus for reform agendas can be as challenging as
removing the institutional impediments to reform. Finland and the Republic of
Korea are good examples of concerted consensus building efforts to engineer
successful transitions to knowledge-based economies. In both cases, a national
economic crisis compelled the affected actors to define and implement a new agenda
through explicit or implicit national consensus on goals and mechanisms for moving
forward. Policy makers and private sector leaders extended the time horizon for
results from the adopted policies. In both cases, mechanisms already in place
anticipated change and the need to undertake or adjust appropriate reforms. These
cases show that to overcome institutional rigidities and bottlenecks, a combination
of top-down and bottom-up policies is necessary.

14.3.5 Sequencing Reforms

Transitions are required to facilitate the concerted efforts that are crucial
to successful reforms. Inspired by successful processes, one may propose a three-
stage scheme:

 Immediate agenda. Through a top-down initiative, create awareness,

develop rational indicators to monitor progress toward a knowledge economy,
and evaluate ongoing pilot initiatives.

 Short- and medium-term agendas. Through top-down and bottom-up

cooperation, institute a shared vision led by the private sector, institute a
national monitoring system linked to budgetarypriorities, and consolidate micro
level “rapid results” projects and/or pilot projects in visible initiatives across
regions and sectors. The priorities of a national monitoring system can be expected
to result in significant changes in budgetary priorities.

 Longer-term agenda. Set a full-fl edged reform agenda that will eliminate
or transform major vested interests and will introduce a new incentive
structure for major agents.
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14.3.6 Exploiting Entry Points: Driving Sectors and Cities
Innovation and growth often arise in specific sectors or locations following
the accumulation of a critical mass of talent, resources, and entrepreneurship. There
must be an adequate and functioning infrastructure (power, transportation) in
place, and a permissive-if not supportive-environment for entrepreneurial
initiatives. When these conditions coalesce, competitive industries emerge or clusters
develop. There are many examples of this process in advanced countries; the Irish
Shannon-Limerick area and Finnish cities are cases in point. There are many
examples to be found in lower-income countries as well. The role of government is to
facilitate innovation and growth by bringing together the elements and personnel that can
make a difference. In its pragmatic approach, China intentionally created enclaves for
growth known as export processing zones (EPZs) and technology parks within SEZs
that offer financial and regulatory incentives to local and foreign enterprises willing to
relocate, along with training facilities. Well-equipped government laboratories or state
schools led by visionary leaders and accompanied by an active private sector provide
an efficient nucleus for clustering processes.
The city of Bangalore in India offers an example. It began as an active IT
service center, drawing on local IT schools and a few private enterprises that had
contracts with
U.S. firms located in Silicon Valley. With a well-trained and cheap labour force, it
grew rapidly. Bangalore now seems to be reachingcertain limits, but its success has been
emulated by other Indian cities. More generally, IT communities and sectors are
plausible entry points throughout the world. They are led by entrepreneurs using new
technologies and offering attractive opportunities for employment, for profit, and for
exports within a relatively short time. In today’s world, ICTs appeal to the public at
large and offer an opening into the knowledge and information age.
14.3.7 Dealing with a Country’s Context
Development Trajectories and Policy Agendas
The World Bank has recognised the need to adapt development strategies
and policy measures to each country’s specific context. When considering the
development trajectory that is most appropriate for a country, it is crucial to consider

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different approaches in industrial strategies. Korea developed its industries with
technologyfrom abroad, through its licensing policy and systematic OEM agreements.
The core chaebol industry groups

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were family owned. For example, Korea should now expand its indigenous
innovative capability and concurrently address the trends toward polarization of its
economy and society. Ireland should build a larger research base and diversify its
innovation clusters. Finland should maintain its position of technological pioneer and
world competition leader by finding new niches. In recognition of the significant
differences between countries, the World Bank recently tested a growth diagnostics
methodology based on the identification of bindingconstraints.Agovernment must focus
its policyactions on removingthese systemic obstacles rather than employing the usual
laundry list of measures that touch all areas (trade, investment, finance, governance,
labour, and so on). The growth process in Brazil is affected in the first instance by
constraints on entrepreneurs-particularly the lack of development capital. The
situations thus require very different policy approaches.
14.3.8 Socio-cultural Issues
Sociocultural considerations are of paramount importance in the
development process. Whatever the policy actions and strategies for change, slowly
changing socio cultural specificities will shape efforts, investments, and growth
trajectories. Cultural influences on and implications for countries’ economic systems
and policies, particularly their knowledge and innovation dimensions, can be
approached at the different levels of a “culture tree”. There are striking differences
between Eastern and Western civilizations. These can be imputed in part to different
cognitive processes, with implications for relationships to the world, as well as
societal organisation. Two different postures can be identified: in the West
muchthinkinginvolvesadistancingfromreality, in the Eastanimmersion in it. These different
ways of thinking implydifferences in various domains of human activity including
medicine, law, science, human rights, and international relations. In science and
technology, the Western approach to reality favours a scientific search for causality
in understanding natural phenomena, while the Eastern mind favours holistic
combinations of existing elements as the basis for technological development. With
regard to the legal and institutional environment, Western societies are concerned
with the establishment and observance of the rule of law as the basic means of
protecting the individual, while Eastern societies tend to emphasize informal
relationships regulating collective groupings, such as the Chinese guanxi. This leads to
two clearly different economic systems with some contrasting features.
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The historical experience of nations, and their geographic location, also plays a

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vital role in shaping collective mindsets and behaviours. At the level of nations,
behaviour and thinking are strongly influenced by history. For the developing world,
the impact of colonisation is particularly important. The situation is better when trauma
has been limited or the contact has been well integrated. Japan, for example, has
maintained its integrity throughout its history, and has thus been able to integrate modern
features into its traditions. Botswana is another instance in more recent times, and on a
particularly troubled continent. As far as geography is concerned, an island-in
geographic and cultural terms-seems to possess a special sense of identity that helps
to mobilise the available resources, provided that the countryis open enough to external
pressures and opportunities.All value judgments should be eliminated. What matters is
to understand how deeply rooted factors that have shaped mindsets and behaviours over
time and created the true wealth of mankind in all its extraordinary diversity-influence
development processes positively or negatively. Cultures and related mindsets and
behaviours are very slow to change, and it may be that the globalisation process,
instead of leading to uniformity, pushes civilisations and nations to intensify their
specificities, thereby contributing to a healthy diversity. Cultural features present both
strengths and weaknesses, and the policy implications are clear: build on one’s
natural strengths while being conscious of one’s weaknesses.

14.4 CONSTRAINTS TO THE GROWTH OF KNOWLEDGE ECONOMY

14.4.1 Challenges and Opportunities

It is for all these reasons that the term knowledge economy (KE) has been
coined. Its meaning is broader than that of high technology or the new economy,
which are closely linked to the Internet, and even broader than the often-used
information society. Its foundations are the creation, dissemination, and use of
knowledge. A knowledge economy is one in which knowledge assets are
deliberately accorded more importance than capital and labour assets, and where the
quantity and sophistication of the knowledge pervading economic and societal
activities reaches very high levels.

1. Coping with Knowledge-Based Economic Competition

Industrialised countries, for which the term KE was initially forged (OECD
1996), are coping unevenly with the new realities. The nations of North America
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seem to have benefited quickly from the new opportunities offered, with a higher
growth rate and higher productivity performances over the last 15 years or so. Gaps
in income per inhabitant

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between North America and Europe have increased. In Europe, small, dynamic
economies such as Finland and Ireland have become models of knowledge-based
growth and competitiveness, while larger continental economies such as France and
Germany-which led the technological and industrial race in past decades-have, had
difficulty adjusting. Meanwhile, Japan has experienced a difficult decade, with slow
growth caused bya variety of factors, but has continued to build KE assets (by
increasing spending on basic research. There is a strong correlation between innovation
performance, total factor productivity, and economic growth in OECD countries.
Nordic and English-speaking countries have, as a whole, performed better than
others. The transition economies of Eastern Europe have had difficulty coping with
the new knowledge-based competition, although they benefited from considerable past
investments in education and science. Smaller economies such as Hungary, Slovenia,
and Estonia have coped well and taken advantage of European enlargement. Estonia, in
particular, has adopted an aggressive KE approach. However, a number of other new
EU members and candidates are undergoing a more painful adjustment process. The
Russian Federation and other countries of the former Soviet Union have yet to
demonstrate their capacity to make use of a knowledge potential that was considerable
at the time when the Berlin wall fell but eroded rapidly owing to the emigration of
highly educated people. Among medium- and low-income countries, Chile, Malaysia,
and Tunisia have clearly taken a knowledge-based approach to increasing
competitiveness and growth. According to a recent World Bank study on economic
growth, countries with successful growth-defined as those that both caught up with
advanced countries and sustained growth over time-did so by combining three
important factors: capital accumulation, efficient resource allocation, and
technological catch-up. The 18 successful countries were China, Vietnam, Republic
of Korea, Chile, Mauritius, Malaysia, Lao People’s Democratic Republic, India,
Thailand, Bhutan, Sri Lanka, Bangladesh, Tunisia, Botswana, Indonesia, Arab
Republic of Egypt, Nepal, and Lesotho. The report underscores the importance of
technological catch-up and its translation into economic growth through increases in
total factor productivity, which accounted for between one-half and three-quarters of
economic growth in all countries listed.
The report also confirms that productivity gains should be considered in a
wide Sense-not onlyin terms of technological change, but also including institutional
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innovations, which are just as important for productivity as breakthroughs in science
and technology. Such gains are also stimulated by internal competition, openness to
external markets, and

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the role of foreign direct investment (FDI) in particular. Each government among the
18 countries listed played a unique role in the growth process. China embarked on
a knowledge-based growth track by attracting massive FDI and then building an
indigenous knowledge base through huge investments in education and research. India
has succeeded by making the best use of its elite institutions and exploiting
international IT-related opportunities, in part through the deft use of knowledge
assets. There is a distinct KE model and process for countries at all levels of
development.
Globalisation and the knowledge revolution present both challenges and
opportunities to developing countries. On the one hand, there is the threat of a widening
in the existing knowledge gap with industrialised countries. Indeed, research and
innovation capabilities-measured by the usual indicators of R&D investments
(expenditures, researchers) and outputs (scientific articles, patents) tend to be more
concentrated in industrialised countries.
On the other hand, the digital gap-differences in telephone and Internet use-
is being gradually reduced, although this does not reflect the considerable
inequalities in Internet access among the poor and the rich in developing countries,
or the mediocre quality of Internet infrastructures (in terms of bandwidth and
soon).
For developing countries, easy access to global knowledge and technology
is crucial. Relevantknowledge and modern technologycan be decisive in helping such
countries reach several of the Millennium Development Goals 8 at a very low cost.
Nonetheless, much is needed to become a vibrant knowledge economy-often more
than what was needed to succeed among traditional economies. Then, competition was
a matter of capital investments in natural resources or low-cost, unskilled labour.
Now, facing world competition means climbing up the value chain.And success in the
climb means upgrading the labor force and ensuring efficient telecommunications and
logistics. A knowledge economy requires a significant segment of highly educated
people, not simply a population with a basic education. While low labour costs alone
can attract FDI and boost economic growth, on their own they also present the risk of
trapping economies in the manufacturing part of the production process.
2. Global Issues
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The number of major challenges facing the world’s economies is mounting, in
part

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because of globalisation and the recent technological revolution. Among these
challenges are growing fragility in the world community, widening global economic
imbalances (all the more difficult to reduce as China and India become major economic
players), unsustainable urbanisation, and increasinglyevident environmental and resource
constraints on economic growth. Knowledge and innovation can help nations face
these challenges, several of which are outlined below.
Fragility. Various factors make the world community more fragile, with greater risks
of systemic propagation effects and paralysis. These include uncontrolled epidemics
such as bird flu, global financial speculation in interconnected markets, terrorist attacks on
sensitive points (such as major trade or oil routes), proliferation of weapons of mass
destruction, and so on. Such risks result, in part, from the increased integration of
economies and societies, which ICTs have accelerated. At the same time, however,
these technologies help monitor and control potential dangers.
Imbalances. Economic globalisation has been accompanied by a redistribution of
production through off shoring and outsourcing. FDI has tended to concentrate in a
few regions, primarily China and Eastern Europe (following the fall of the Berlin
wall). For lower-skill industries, this has led to drastic and permanent employment shifts
worldwide. High-income countries have lost jobs, and low- to medium income
countries have lost export and employment opportunities. This trend will likely
increase in the coming years and continue to affect service industries, spurred bythe rapid
growth of India. Consequences are considerable for regions in great need of
employment, such as the Middle East, where it is estimated that some 90 million jobs
will have to be created in the next 20 years in order to prevent a further increase in
unemployment. At present, 15 percent of the total population-and more than 30
percent of the youth population-is unemployed.
Unsustainable urbanisation. The rapid and anarchic urbanisation that accompanies
industrialisation affects developing countries in particular. In 2003, 48 percent of the
world’s population lived in urban areas- a 33 percent increase from 1990. It is
projected that, by 2020, 4.1 billion people (55 percent of the world’s population) will
live in urban areas. Almost 94 percent of this increase will occur in developing
countries. By 2015, there will be 22 megacities (cities or agglomerations with a
population of more than 8 million) and 475 cities with populations exceeding 1
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million. While urbanisation helps renew cultures and brings innovations into people’s
lives, it is accompanied by a loss of autonomy and by

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violence, human trafficking, and so on. Coping with urbanization and its side effects is
a serious challenge. It requires the capacityto conceive, produce, and disseminate
technologies that favour autonomous local development processes. This can help prevent
the excessive concentration of populations that can lead to dangerous fragmentation.
Environmental and resource constraints. Finally, it is important to recognise that
the rapid emergence of China and India, coupled with global warming, means that the
world economycannot continue to use energy and natural resources at the current rate.
Production and consumption systems in both developingand industrialised countries will
have to change profoundly. Global innovation is challenged-perhaps to a degree never
before experienced- as caps on growth are approached.
To conclude Knowledge has always played a determining role in the development
of societies. In the last two decades, however, a distinct Knowledge Economy model
and process have been observable in successful economies worldwide, and among
both industrialised and developing countries. Globalisation and the fast-moving digital
age open new opportunities to developing countries to the extent that those countries
follow successful economic models. It is urgent that developing countries proceed with
the investments and reforms required to build knowledge-based economies. Chief
among those requirements are creating jobs, facing competition from China and India,
and meeting environmental challenges.
14.4.2 Future challenges for a knowledge-based economy
Not only has there been a general lack of progress towards reaching the Lisbon
goals of Europe becoming a more dynamic and competitive knowledge-based
economy, but challenges are actually increasing over time, due to demographic
changes, increasing competition from China in high value-added goods and from
India in services, and the continuing dominance of the United States in KBE sectors
such as ICT and biotechnology. There are a number of major structural changes
occurring on a global level that are relevant to knowledge-based economies and that
will alter the environment for innovation and competition over the next few decades,
and consequently, influence the types of indicators that European policy makers and
academics will need to be able to effectively evaluate and respond to future
challenges. These major structural changes include:

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1. Increasingly global production chains for goods and services, leading to
changes

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 in the location of comparative advantages.

2. The development of new centres of knowledge and innovative activities.

3. Demographic changes including increases in the average life span.

4. Changes in stocks and flows of skilled workers.

5. Technological shifts driven by new technologyor environmental requirements.

This section examines these five challenges and the types of indicators that will
be required to track structural changes over time. We also briefly discuss three related
scenarios on demand for innovation, supply of skilled human resources and
environmental. The goal of these scenarios is to assess the relevance of existing
indicators and to suggest new indicators where necessary.

a. Global production chains: The first structural change consists of major shifts in
the location of comparative advantage for the production of both manufactured
goods and services. While China accounts for a growing share of manufactures,
India is developing strengths in services such as software development, clinical
trials, and call centres. Over the short to medium term of up to 20 years, firms in
developed countries are likely to respond to cost competition from India and
China by increased delocalisation of production, including the production of high
technology products, such as ICT or aerospace equipment. Such shifts in the
location of production have been made possible by ICT, innovation in
organizational forms and logistics and low transportation costs. Innovative firms
rely on cross-national production networks and create value from the efficient use
of global supply chains, thanks to globalization and the increasing modularisation
of standard components. New types of indicators to inform policy options and
private investment decisions are needed. Although MNEs are important actors in
the innovation process, their role needs to be better understood. Statistics related to
MNEs are usually limited to the national level and country to country
comparisons, creating incomplete data and unclear profiles on their activities,
including the location of their innovation investments around the world. Due to a
lack of official statistics, little is known about the extent and real impact of
delocalisation of production. Further work is required to identify employment
effects, including types of employment affected (e.g. knowledge creation vs.
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application); occupations most

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 affected (e.g. different skill levels and fields of specialisation), and wage
differentials for the same occupation between the source country and the off-shored
location, plus rates of salary growth abroad. Acrucial point about current changes
in the location of comparative advantage is that it won’t last. Sooner or later,
increasing productivity and wealth in India, China and other developing
countries will result in currency realignments that will reduce the disparities in
wages and incomes that drive off-shoring strategies based on seeking lower wage
costs in manufacturing and the provision of services. An often forgotten point is
that the advantages of distant, low-cost production are slim. Even a 10% increase
in shipping costs can reduce the cost advantage of producing some goods in
China to zero. The rapid increase in the cost of petroleum products after 2006, if
sustained, could lead to a shift in some manufacturing in China to locations closer
to major markets.

b. The changing environment for innovation strategies: Outsourcing and

delocalisation of production are not new phenomena. However, data suggest
that countries such as India and China are likely to increasingly compete not only
on the basis of low wages, but also on their innovation capabilities, including in
knowledge intensive sectors, such as software, capital goods and ICT
manufacturing. American FDI or suppliers toAmerican firms in these two countries
also appear to be increasingly responsible for developing patentable innovations for
their parent firm, suggesting that both China and India are capable of turning FDI
into a mechanism for developing innovative capabilities. One consequence is
that it could be increasingly difficult for high-wage countries to compete on the
basis of “continualinnovation”. Thedevelopment of innovative capabilities in China
and India could drive firms to increasingly develop R&D centres in these two
countries. First, firms can take advantage of local pools of inexpensive but highly
skilled labour; second, they can seek specialised expertise that is not available in
their home countries and third, they can establish R&D labs in foreign markets
to adapt current products to local tastes or develop new products that meet local
demand. The OECD estimate that about 20% of total jobs in the EU could be off-
shored, including many of the ‘knowledge jobs’ of the future gives pause for
thought. This is already occurring in some sectors, such as software development
in India, and the establishment of research centres in China by telecommunication
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and biotechnology firms. To date, we lack reliable statistics on both the extent to
which

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innovation activities such as R&D are being globalised, and more importantly,
the innovation capabilities of the research centres that have beenestablished
bymultinational firms in developing countries. We do not know if these centres are
performing leading- edge research or largely adapting products to local markets.
Competitive advantages provided by innovation could decline as an increasing
share of firms base their competitive strategies on innovation, driven both by
an increasing awareness of innovation by firms based in developed countries
and by an increase in the use of innovation by firms based in developing
countries. Greater competition could reduce the ability of innovative activities to
provide the excess rents that drive profits and investment. This could produce a
paradox whereby policy efforts to encourage more creative innovation, as with the
3% R&D intensity goal for Europe, result in declines to the private returns from
innovation. However, three factors could mitigate the reduction in profits from
increasing competitionover innovation. Thefirst factor concerns the location and costs
of innovation activities. With R&D becoming more of a commodity, it can be
purchased from universities, start ups and spin-offs, or from cheaper R&D
centres in developing countries.29 The second factor is that firms can more
aggressively manage intellectual property to profit from their investments in
innovation, for example through patenting. The organisation of innovation itself
is changing and these changes can improve the productivity of innovation. IT has
driven down the costs of experimentation, and globalisation has reduced the cost of
research collaboration and the cost of outsourcing. Firms have decreased the role of
standalone central labs and increased their use of linkages such as networks,
alliances and formal and informal relations. Such linkages could be producing basic
structural changes that improve research productivity and allow innovation systems to
adapt to new conditions, as well as reduce uncertainty, share costs and knowledge,
and bring innovative products and services more quickly to the market. Indicators
to track and understand these dynamics are important for policies that support this
experimentation while retaining a competitive environment. The efficacy of these
three counter strategies to improve the profitability of innovation depends on
favourable technological opportunities, or the R&D and engineering costs
ofdeveloping new innovations versus the expected earnings from these innovations.
There are no reliable data for technological opportunity, but the opportunities are

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believed to be highest during the early years of a new technology,

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 lowest during its mid life, and to increase as the technology matures.

c. Demographic change and demand: The third major structural change is a

demographic increase in the average age in many developed countries. This
change has two impacts on a KBE: first, on the market demand for innovative
products, and second, on the supply of highlyskilled individuals. Services is
inverselyproportional to age and positivelycorrelated with income. Demographic
change leading to large increase in the population share of older age cohorts could
reduce aggregate domestic demand for innovative goods and services. Assuming
that a sophisticated domestic market plays a role in national innovative
capabilities, an aging population with low levels of interest in innovation could
reduce the innovative capabilities of the home market. These factors could lead
firms based in countries with aging populations to seek both markets and research
facilities in more youthful countries. Another development that could be affected
by changing demographics is user-centred innovation. The actual economic
importance of user-centred demand in either lowering innovation costs for firms or
influencing the direction of innovation is unknown, but insofar as user-centred
innovation occurs through the internet, the low internet access rates among older
age cohorts could be a concern. Conversely, the internet permits firms to get global
feedback for their products and services. Because consumer demand can constitute
an important incentive or constraint in shaping the innovative activity carried out
by private firms, data on the value that innovation generates for customers is
needed. Moreover, with a possible increase in user-centred innovation, the location
where innovation takes place changes. This requires integrating customer
requirements and ideas through organisational innovation (customer-related
processes are integrated with sales, delivery, inventorymanagement and so forth).
Attention needs to be given to the role of suppliers, customers and interactions among
them. This means developingindicators of innovation processes that look at those
interactions by using new technologies.

d. Scenario on innovation demand: In the KBE, productivity and economic

growth are largely related to innovation. Not onlydoes competition drives
innovation, enabling firms to reduce production costs, but there are other more
complex factors driving product innovation, including both technology push and

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market demand factors. Firms invest in product innovation based on current or
expected demand for innovative goods and services. Without a current or
potential market, innovation activity may be

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 compromised. The market can be other firms (business to business),
individual consumers, governments, or export markets. Demand is one of the two
main drivers of innovation (the other is the supply of technological opportunities).
Consequently, several policyactions, apart from the creation of a single European
market, can influence innovation. The innovation demand scenario identifies
indicators that could be used to evaluate national differences in demand factors and
find out how policy could influence demand in a way that would stimulate
innovative activity.

e. New technologies: Major technological shifts are difficult to predict. They

could occur through the development of new generic technologies such as
biotechnology or nanotechnology, in response to rapidly increasing demand for food,
mineral, fibre, and energy resources, or from environmental imperatives to
counteract unsustainable exploitation of the world’s resources. Regardless of the
cause, technological shifts can increase demand for investment in research and the
skills to use new technology. For example, science and technology will need to
move forward in several energy related fronts (mainly to counter climate change
and growing demand for oil from countries such as China and India), which will
require innovation in the resource sectors and in how energy is used across all
sectors. Biotechnology is widely viewed as an emerging generic technology,
although its economic impact is likely to be far less than that of ICT.
Nevertheless, the application of biotechnology to agriculture and industry could
have major economic effects, in addition to social and environmental benefits.
Obtaining these benefits will require a long-term research strategy, which may
increasingly take place in major developing countries, rather than in the original
biotechnology leaders of the US and Europe. Shifts in technology can also result
from changes in public support for research, such as the change occurring in the
US through an increase in public support for life sciences, including
biotechnology, and a decline in support for technology fields (engineering, physical
sciences, maths and computer science). This shift in priorities is controversial,
partly due to the long lag times before life sciences R&D results in commercial
products.

The future growth of all types of economic activity will require materials and

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energy. Whereas developed countries are investing heavily in innovation, China
has realised the importance of resources and is currently investing large amounts of
money in the exploitation and purchase of natural resources worldwide. Growing
resource scarcity

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 is likely to produce significant rents in the future for the owners of commodities.

14.4.3 Policies for a knowledge-based economy

For policymakers in industrialised economies, the development of a KBE is

viewed as essential for economic growth in the face of increased competition from
lower cost countries inboth basic manufacturing andin higher skilled services and
production. European countries not only face the challenge posed by competition from
these emerging countries (e.g. China and India), but also continue to face pressure
from countries such as the United States and Japan, two countries identified as the
major competitors in European policy documents since 1995.

In addition to existing policies to promote ICT use, R&D, and education, a

broad range of policies are relevant to the goal of supporting a KBE. These include
policies to promote organizational and “presentational” innovation and “soft”
parameters such as human creativity and human resource management. The goal is to
develop policy based on concrete evidence. The challenges include a lack of
empirical evidence for present developments in the KBE, as well as the need to
address future trends and uncertainty. Good policy making must also incorporate
political, economic, and cultural contexts. A few challenges for policy development
need to be taken into account.

1. First, policy tends to focus on goals and outcomes – such as the 3% R&D
intensity goal agreed in Lisbon and Barcelona - that are easy to measure
because adequate data and indicators are readily available. This contrasts with a lack
of data and indicators for other KBE goals. This disparitybetween data and indicator
availability could distract the policycommunity from pursuing other important
policies for encouraging growth in a KBE.

2. Second challenge for evidence-based policy is to measure the effect of

government programmes on policy goals when large number of factors can
influence outcomes. Identifying the effect of factors requires a variety of indicators,
many of which may be unavailable, except as one-off indicators collected in a single
survey at a single point in time. Such problems can occur for measuring a number
of policies relevant to a KBE, such as promotingthe use of patents and other IPR,
383
public sector innovation or improved quality of human capital.

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3. A third challenge is that policyformulation must address the waywe want our
economies and society to look in the future. Consequently, policy making requires
indicators of relevance to medium- and long-term goals. A key limitation with
any discussion of policy is the time-lag inherent in policy formulation and
implementation and in the timeliness of data and indicators to measure policy
outcomes.

In many cases, policy is learning from the past to plan for the future. In order
to address the policy challenges of a KBE, we need to consider policy from
two dimensions. First, what policies are currently in place, and are theycapable of
meeting current challenges? Second, can policies be designed with sufficient
flexibility to adapt to possible future challenges?

14.5 SUMMARY

The design of successful policies to encourage a KBE requires data and

indicators for new challenges, such as the impact of an ageing workforce, globalisation,
rising imports and rising job insecurity. The rapid integration into the world trading
system of China and India, with their huge pools of low-wage labour, and the recent
enlargement of the European Union have fuelled fears of further job losses, as global
competitive pressures increase. There are many possible responses to competition,
including developing new products, product differentiation, branding, improved design,
and efficiency gains from technological and organisational change. All of these
methods entail some degree of innovation. The ability to innovate relies upon the
health of the economic environment (availability of skilled labour, R&D funding, tools
for commercialisation that is nurtured and facilitated by the policy environment, which
in turn is informed and guided by indicators. Certain aspects of the KBE are already
covered by a rich set of indicators from established surveys. These include indicators
of business performance, R&D activities, and patents. These and other indicators are
used to evaluate causal relationships between investment and economic performance
and growth. Other aspects of indicator development for a KBE are in their infancy,
such as composite indicators based on summarising several component indices.
Composite indices can be used to generate a ‘constellation’of events. Agroup of
indicators can ‘collectively’ give early warning signals, while also reducing complex

385
data sets in a way that can help users to better understand the relationships among
the factors in the KBE.The KBE characteristics and drivers points to the need to
revisit existing composite

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indicators as well as the need to develop new composite indices. If we go back to
the notion of a ‘constellation’ of indicators, we can consider the ‘night sky’ of a KBE.
Some ‘stars’ (indicators) are constant in illuminating a picture, others flare up and
gain more attention while yet others burn out and no longer play an important role.
In the KBE, different segments of the economy grow or decline, different players
gain or lose their importance, emerge or disappear. Ways of learning, producing and
exchanging knowledge are different than in previous economies and continue to change.
While the role of ICT in the KBE is undeniable, it is the reconfiguration of economic,
social and political relationships that needs indicator development. The interviews with
policy analysts show that indicators are often seen more as a bunch of dots that remain
unconnected on a drawing board - or to continue with our previous analogy, the actual
constellation patterns in the night sky are not yet visible. The challenges include
understanding the process and interactions of the system of innovation, and developing
indicators and measures that can connect the individual dots or stars.

14.6 SELFASSESSMENT QUESTIONS

1. Explain the steps in developing K-economy?

2. Discuss the various challenges faced by k-economy?

3. Explain the future challenges being faced by knowledge economy?

387
4. Discuss various policies to be followed for a successful knowledge economy?

14.7 SUGGESTED READINGS

 Mithani, D.M., Managerial Economics-Theory&Application, Himalaya

Publishing House Pvt. Ltd., New Delhi.

 Gupta, G.S., Macro Economic- Theory &Application, Tata Mcgraw hill

Publishing House, New Delhi.

 Vaish, M.C., Macro Economic theory, Vikas Publishing House Pvt. Ltd.,
New Delhi.

 Mishra, S.k., and Puri, V.K., Modern Macro Economic Theory,

Himalayan Publishing House.

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 UNIT IV
LESSON 15 NATIONAL INCOME

STRUCTURE

15.1 INTRODUCTION
15.2 OBJECTIVE
15.3 DEFINITIONS
15.4 COMPONENTS OF NATIONAL INCOME
15.5 SIGNIFICANCE
15.6 SUMMARY
15.7 SELF ASSESSMENT QUESTIONS
15.8 SUGGESTED READINGS

15.1 INTRODUCTION

National income is an uncertain term which is used interchangeably with

national dividend, national output and national expenditure. On this basis, national
income has been defined in a number of ways. In common parlance, national income
means the total value of goods and services produced annually in a country.

In other words, the total amount of income accruing to a country from

economic activities in a year’s time is known as national income. It includes
payments made to all resources in the form of wages, interest, rent and profits.

15.2 OBJECTIVES

The objectives of this lesson are:

 To understand the concept of national income.
 To know about various components of national income.
 To discuss its importance.

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15.3 DEFINITIONS
The definitions of national income can be grouped into two classes: One,
the traditional definitions advanced by Marshall, Pigou and Fisher; and two, modern
definitions.
The Marshallian Definition:
According to Marshall: “The labour and capital of a country acting on its
natural resources produce annuallya certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or revenue
of the country or national dividend.” In this definition, the word ‘net’ refers to
deductions from the gross national income in respect of depreciation and wearing out of
machines. And to this, must be added income from abroad.
Limitations of this definition: Though the definition advanced by Marshall
is simple and comprehensive, yet it suffers from a number of limitations. First, in the
present world, so varied and numerous are the goods and services produced that it is
very difficult to have a correct estimation of them. Consequently, the national income
cannot be calculated correctly. Second, there always exists the fear of the mistake of
double counting, and hence the national income cannot be correctly estimated.
Double counting means that a particular commodity or service like raw material or
labour, etc. might get included in the national income twice or more than twice.
For example, a peasant sells wheat worth Rs.2000 to a flour mill which
sells wheat flour to the wholesaler and the wholesaler sells it to the retailer who, in
turn, sells it to the customers. If each time, this wheat or its flour is taken into
consideration, it will work out to Rs.8000, whereas, in reality, there is only an
increase of Rs.2000 in the national income. Third, it is again not possible to have a
correct estimation of national income because many of the commodities produced are
not marketed and the producer either keeps the produce for self-consumption or
exchanges it for other commodities. It generallyhappens in an agriculture- oriented
countrylike India. Thus, the volume of national income is underestimated.
The Pigou Definition:
A.C. Pigou has in his definition of national income included that income which

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can be measured in terms of money. In the words of Pigou, “National income is that
part of

391
objective income of the community, including of course income derived from abroad
which can be measured in money.”
This definition is better than the Marshallian definition. It has proved to be
more practical also. While calculating the national income now-a-days, estimates are
prepared in accordance with the two criteria laid down in this definition.
First, avoiding double counting, the goods and services which can be measured
in money are included in national income. Second, income received on account of
investment in foreign countries is included in national income.
It’s Defects:
The Pigouvian definition is precise, simple and practical but it is not free
from criticism. First, in the light of the definition put forth by Pigou, we have to
unnecessarily differentiate between commodities which can and which cannot be
exchanged for money. But, in actuality, there is no difference in the fundamental forms
of such commodities, no matter they can be exchanged for money. Second, according
to this definition when only such commodities as can be exchanged for money are
included in estimation of national income, the national income cannot be correctly
measured.
According to Pigou, a woman’s services as a nurse would be included in
national income but excluded when she worked in the home to look after her children
because she did not receive any salary for it. Similarly, Pigou is of the view that if a man
marries his lady secretary, the national income diminishes as he has no longer to pay for
her services. Thus, the Pigovian definition gives rise to a number of paradoxes. Third,
the Pigovian definition is applicable only to the developed countries where goods and
services are exchanged for money in the market.
According to this definition, in the backward and underdeveloped countries of
the world, where a major portion of the produce is simply bartered, correct estimate of
national income will not be possible, because it will always work out less than the
real level of income. Thus the definition advanced by Pigou has a limited scope.
Fisher’s Definition:
Fisher adopted ‘consumption’ as the criterion of national income whereas
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Marshall and Pigou regarded it to be production. According to Fisher, “The National
dividend or

393
income consists solely of services as received by ultimate consumers, whether from
their material or from the human environments. Thus, a piano, or an overcoat made for
me this year is not a part of this year’s income, but an addition to the capital. Only
the services rendered to me during this year bythese things are income.” Fisher’s
definition is considered to be better than that of Marshall or Pigou, because Fisher’s
definition provides an adequate concept of economic welfare which is dependent on
consumption and consumption represents our standard of living.

It’s Defects:

But from the practical point of view, this definition is less useful, because there
are certain difficulties in measuring the goods and services in terms of money. First, it is
more difficult to estimate the money value of net consumption than that of net
production.

In one country there are several individuals who consume a particular good
and that too at different places and, therefore, it is verydifficult to estimate their total
consumption in terms of money. Second, certain consumption goods are durable and
last for many years.

If we consider the example of piano or overcoat, as given by Fisher, only

the services rendered for use during one year by them will be included in income. If an
overcoat costs Rs. 100 and lasts for ten years, Fisher will take into account only Rs. 100
as national income during one year, whereas Marshall and Pigou will include Rs. 100
in the national income for the year, when it is made.

Besides, it cannot be said with certainty that the overcoat will last only for
ten years. It may last longer or for a shorter period. Third, the durable goods generally
keep changing hands leading to a change in their ownership and value too. It therefore,
becomes difficult to measure in money the service-value of these goods from the
point of view of consumption. For instance, the owner of a Maruti car sells it at a price
higher than its real price and the purchaser after using it for a number of years further
sells it at its actual price.

Now the question is as to which of its price, whether actual or black market
one, should we take into account, and afterwards when it is transferred from one
person to another, which of its value according to its average age should be included
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in national income?

395
 But the definitions advanced by Marshall, Pigou and Fisher are not
altogether flawless. However, the Marshallian and Pigovian definitions tell us of the
reasons influencing economic welfare, whereas Fisher’s definition helps us compare
economic welfare in different years.

Modern Definitions:

From the modern point of view, Simon Kuznets has defined national income
as “the net output of commodities and services flowing during the year from the
country’s productive system in the hands of the ultimate consumers.”

On the other hand, in one of the reports of United Nations, national income has
been defined on the basis of the systems of estimating national income, as net
national product, as addition to the shares of different factors, and as net national
expenditure in a country in a year’s time. In practice, while estimating national income,
any of these three definitions may be adopted, because the same national income would
be derived, if different items were correctly included in the estimate.

15.4 CONCEPTS AND COMPONENTS OF NATIONAL INCOME

The total net value of all goods and services produced

within a nation over a specified period of time, representing the
sum of wages, profits, rents, interest, and pension payments to
residents of the nation.

There are a number of concepts pertaining to national income and methods

of measurement relating to them.
A. Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within the country
during a year. This is calculated at market prices and is known as GDP at market prices.
Dernberg defines GDP at market price as “the market value of the output of final goods
and services produced in the domestic territory of a country during an accounting
year.”

There are three different ways to measure GDP, these are:

Product Method, Income Method and Expenditure Method.

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These three methods of calculating GDP yield the same result because National

397
Product = National Income = National Expenditure.

1. The Product Method:

In this method, the value of all goods and services produced in different
industries during the year is added up. This is also known as the value added
method to GDP or GDP at factor cost by industry of origin. The following items are
included in India in this: agriculture and allied services; mining; manufacturing,
construction, electricity, gas and water supply; transport, communication and trade;
banking and insurance, real estates and ownership of dwellings and business services;
and public administration and defense and other services (or government services). In
other words, it is the sum of gross value added.

2. The Income Method:

The people of a country who produce GDP during a year receive incomes
from their work. Thus GDP by income method is the sum of all factor incomes:
Wages and Salaries (compensation of employees) + Rent + Interest + Profit.

3. Expenditure Method:

This method focuses on goods and services produced within the country
during one year.

GDP by expenditure method includes:

(1) Consumer expenditure on services and durable and non-durable goods (C),

(2) Investment in fixed capital such as residential and non-residential

building, machinery, and inventories (I),

(3) Government expenditure on final goods and services (G),

(4) Export of goods and services produced by the people of country (X),

(5) Less imports (M). That part of consumption, investment and government
expenditure which is spent on imports is subtracted from GDP. Similarly,
any imported component, such as raw materials, which is used in the
manufacture of export goods, is also excluded.

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Thus GDP by expenditure method at market prices = C+ I + G + (X – M), where
(X-M) is net export which can be positive or negative.

B. GDP at Factor Cost

GDP at factor cost is the sum of net value added by all producers within
the country. Since the net value added gets distributed as income to the owners of
factors of production, GDP is the sum of domestic factor incomes and fixed capital
consumption (or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

GDP at factor cost includes:

(i) Compensation of employees i.e., wages, salaries, etc.

(ii) Operating surplus which is the business profit of both incorporated and
unincorporated firms. [Operating Surplus = Gross Value Added at Factor Cost
— Compensation of Employees—Depreciation]

(iii) Mixed Income of Self- employed.

Conceptually, GDP at factor cost and GDP at market price must be

identical/This is because the factor cost (payments to factors) of producing goods must
equal the final value of goods and services at market prices. However, the market
value of goods and services is different from the earnings of the factors of
production.

In GDP at market price are included indirect taxes and are excluded subsidies
by the government. Therefore, in order to arrive at GDP at factor cost, indirect
taxes are subtracted and subsidies are added to GDP at market price.

Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes +

Subsidies.

C. Net Domestic Product (NDP)

NDP is the value of net output of the economy during the year. Some of
the country’s capital equipment wears out or becomes obsolete each year during the
production process. The value of this capital consumption is some percentage of
399
gross investment which is deducted from GDP. Thus Net Domestic Product =
GDP at Factor Cost – Depreciation.

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D. Nominal and Real GDP
When GDP is measured on the basis of current price, it is called GDP at
current prices or nominal GDP. On the other hand, when GDP is calculated on the
basis of fixed prices in some year, it is called GDP at constant prices or real GDP.
Nominal GDP is the value of goods and services produced in a year and
measured in terms of rupees (money) at current (market) prices. In comparing one year
with another, we are faced with the problem that the rupee is not a stable measure of
purchasing power. GDP may rise a great deal in a year, not because the economy has
been growing rapidly but because of rise in prices (or inflation).
On the contrary, GDP may increase as a result of fall in prices in a year but
actually it may be less as compared to the last year. In both 5 cases, GDP does not
show the real state of the economy. To rectify the underestimation and overestimation
of GDP, we need a measure that adjusts for rising and falling prices.
This can be done by measuring GDP at constant prices which is called real
GDP. To find out the real GDP, a base year is chosen when the general price level is
normal, i.e., it is neither too high nor too low. The prices are set to 100 (or 1) in the
base year.
Now the general price level of the year for which real GDP is to be
calculated is related to the base year on the basis of the following formula which is
called the deflator index:

GDP for the Base Year

Real GDP =
Current Year (=100) Current
×
Year Index
Suppose 1990-91 is the base year and GDP for 1999-2000 is Rs. 6, 00,000
crores and the price index for this year is 300.
Thus, Real GDP for 1999-2000 = Rs. 6, 00,000 x 100/300 = Rs. 2, 00,000
crores
E. GDP Deflator

401
 GDP deflator is an index of price changes of goods and services included in
GDP. It is a price index which is calculated by dividing the nominal GDP in a given
year by the real GDP for the same year and multiplying it by 100. Thus,

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 It shows that at constant prices (1993-94), GDP in 1997-98 increased by
135.9% due to inflation (or rise in prices) from Rs. 1049.2 thousand crores in
1993-94 to Rs. 1426.7 thousand crores in 1997-98.

F. Gross National Product (GNP)

GNP is the total measure of the flow of goods and services at market value
resulting from current production during a year in a country, including net income
from abroad.

GNP includes four types of final goods and services:

(1) Consumers’ goods and services to satisfy the immediate wants of the people;

(2) Gross private domestic investment in capital goods consisting of fixed capital
formation, residential construction and inventories of finished and unfinished
goods;

(3) Goods and services produced by the government; and

(4) Net exports of goods and services, i.e., the difference between value of
exports and imports of goods and services, known as net income from
abroad.

In this concept of GNP, there are certain factors that have to be taken into
consideration: First, GNP is the measure of money, in which all kinds of goods and
services produced in a country during one year are measured in terms of money at
current prices and then added together.

But in this manner, due to an increase or decrease in the prices, the GNP
shows a rise or decline, which may not be real. To guard against erring on this account,
a particular year (say for instance 1990-91) when prices be normal, is taken as the
base year and the GNP is adjusted in accordance with the index number for that year.
403
This will be known as GNP at 1990-91 prices or at constant prices.

Second, in estimating GNP of the economy, the market price of only the
final

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products should be taken into account. Many of the products pass through a number
of stages before they are ultimately purchased by consumers.

If those products were counted at every stage, they would be included

many a time in the national product. Consequently, the GNP would increase too much.
To avoid double counting, therefore, only the final products and not the intermediary
goods should be taken into account.

Third, goods and services rendered free of charge are not included in the
GNP, because it is not possible to have a correct estimate of their market price. For
example, the bringing up of a child by the mother, imparting instructions to his son
by a teacher, recitals to his friends by a musician, etc.

Fourth, the transactions which do not arise from the produce of current year
or which do not contribute in any way to production are not included in the GNP.
The sale and purchase of old goods, and of shares, bonds and assets of existing
companies are not included in GNP because these do not make any addition to the
national product, and the goods are simply transferred.

Fifth, the payments received under social security, e.g., unemployment

insurance allowance, old age pension, and interest on public loans are also not
included in GNP, because the recipients do not provide any service in lieu of them.
But the depreciation of machines, plants and other capital goods is not deducted
from GNP.

Sixth, the profits earned or losses incurred on account of changes in capital

assets as a result of fluctuations in market prices are not included in the GNP if
they are not responsible for current production or economic activity.

For example, if the price of a house or a piece of land increases due to

inflation, the profit earned by selling it will not be a part of GNP. But if, during the
current year, a portion of a house is constructed anew, the increase in the value of the
house (after subtracting the cost of the newly constructed portion) will be included in the
GNP. Similarly, variations in the value of assets, that can be ascertained beforehand and
are insured against flood or fire, are not included in the GNP.

Last, the income earned through illegal activities is not included in the

405
GNP.Although the goods sold in the black market are priced and fulfill the needs of
the people, but as

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they are not useful from the social point of view, the income received from their sale
and purchase is always excluded from the GNP. There are two main reasons for this.
One, it is not known whether these things were produced during the current year or
the preceding years. Two, many of these goods are foreign made and smuggled and
hence not included in the GNP.

Three Approaches to GNP

After having studied the fundamental constituents of GNP, it is essential to

know how it is estimated. Three approaches are employed for this purpose. One, the
income method to GNP; two, the expenditure method to GNP and three, the value
added method to GNP. Since gross income equals gross expenditure, GNP estimated by
all these methods would be the same with appropriate adjustments.

1. Income Method to GNP:

The income method to GNP consists of the remuneration paid in terms of

money to the factors of production annually in a country.

Thus GNP is the sum total of the following items:

(i) Wages and salaries:

Under this head are included all forms of wages and salaries earned
through productive activities by workers and entrepreneurs. It includes all sums
received or deposited during a year by way of all types of contributions like overtime,
commission, provident fund, insurance, etc.
(ii) Rents:

Total rent includes the rents of land, shop, house, factory, etc. and the
estimated rents of all such assets as are used by the owners themselves.

(iii) Interest:

Under interest comes the income by way of interest received by the individual
of a country from different sources. To this is added, the estimated interest on that
private capital which is invested and not borrowed by the businessman in his personal
business. But the interest received on governmental loans has to be excluded,

407
because it is a mere

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transfer of national income.

(iv) Dividends:

Dividends earned by the shareholders from companies are included in the GNP.

(v) Undistributed corporate profits:

Profits which are not distributed bycompanies and are retained bythem are
included in the GNP.

(vi) Mixed incomes:

These include profits of unincorporated business, self-employed persons and

partnerships. They form part of GNP.

(vii) Direct taxes:

Taxes levied on individuals, corporations and other businesses are included in the
GNP.

(viii) Indirect taxes:

The government levies a number of indirect taxes, like excise duties and sales tax.

These taxes are included in the price of commodities. But revenue from
these goes to the government treasury and not to the factors of production.
Therefore, the income due to such taxes is added to the GNP.

(ix) Depreciation:

Every corporation makes allowance for expenditure on wearing out and

depreciation of machines, plants and other capital equipment. Since this sum also is not
a part of the income received by the factors of production, it is, therefore, also
included in the GNP.

(x) Net income earned from abroad:

This is the difference between the value of exports of goods and services and
the value of imports of goods and services. If this difference is positive, it is added to
the GNP and if it is negative, it is deducted from the GNP.

409
 Thus GNP according to the Income Method = Wages and Salaries + Rents
+ Interest + Dividends + Undistributed Corporate Profits + Mixed Income + Direct
Taxes
+ Indirect Taxes + Depreciation + Net Income from abroad.

2. Expenditure Method to GNP:

From the expenditure view point, GNP is the sum total of expenditure incurred
on goods and services during one year in a country.

It includes the following items:

(i) Private consumption expenditure:

It includes all types of expenditure on personal consumption by the individuals

of a country. It comprises expenses on durable goods like watch, bicycle, radio,
etc., expenditure on single-used consumers’ goods like milk, bread, ghee, clothes, etc.,
as also the expenditure incurred on services of all kinds like fees for school, doctor,
lawyer and transport. All these are taken as final goods.

(ii) Gross domestic private investment:

Under this comes the expenditure incurred byprivate enterprise on new

investment and on replacement of old capital. It includes expenditure on house
construction, factory- buildings, and all types of machinery, plants and capital
equipment.

In particular, the increase or decrease in inventory is added to or subtracted from it.

The inventory includes produced but unsold manufactured and semi-manufactured goods
during the year and the stocks of raw materials, which have to be accounted for in
GNP. It does not take into account the financial exchange of shares and stocks because
their sale and purchase is not real investment. But depreciation is added.

(iii) Net foreign investment:

It means the difference between exports and imports or export surplus.

Every country exports to or imports from certain foreign countries. The imported
goods are not produced within the country and hence cannot be included in national
income, but the exported goods are manufactured within the country. Therefore, the
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difference of value between exports (X) and imports (M), whether positive or
negative, is included in the

411
GNP.

(iv) Government expenditure on goods and services:

The expenditure incurred by the government on goods and services is a part of

the GNP. Central, state or local governments spend a lot on their employees, police and
army. To run the offices, the governments have also to spend on contingencies which
include paper, pen, pencil and various types of stationery, cloth, furniture, cars, etc.

It also includes the expenditure on government enterprises. But expenditure on

transfer payments is not added, because these payments are not made in exchange
for goods and services produced during the current year.

Thus GNP according to the Expenditure Method=Private Consumption

Expenditure (C) + Gross Domestic Private Investment (I) + Net Foreign Investment
(X- M) + Government Expenditure on Goods and Services (G) = C+ I + (X-M) +
G.

As already pointed out above, GNP estimated by either the income or the
expenditure method would work out to be the same, if all the items are correctly
calculated.

3. Value Added Method to GNP

Another method of measuring GNP is by value added. In calculating GNP,

the money value of final goods and services produced at current prices during a year is
taken into account. This is one of the ways to avoid double counting. But it is difficult to
distinguish properly between a final product and an intermediate product.

For instance, raw materials, semi-finished products, fuels and services, etc.
are sold as inputs by one industry to the other. They may be final goods for one
industry and intermediate for others. So, to avoid duplication, the value of intermediate
products used in manufacturing final products must be subtracted from the value of
total output of each industry in the economy.

Thus, the difference between the value of material outputs and inputs at each
stage of production is called the value added. If all such differences are added up for all
industries in the economy, we arrive at the GNP by value added. GNP by value

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added = Gross value added + net income from abroad. Its calculation is shown in
Tables 1, 2 and 3.

Table 1 is constructed on the supposition that the entire economy for purposes of

413
total production consists of three sectors. They are agriculture, manufacturing, and
others, consisting of the tertiary sector.

Out of the value of total output of each sector is deducted the value of its
intermediate purchases (or primary inputs) to arrive at the value added for the
entire economy. Thus the value of total output of the entire economy as per Table 1, is
Rs. 155 crores and the value of its primary inputs comes to Rs. 80 crores. Thus the
GDP by value added is Rs. 75 crores (Rs. 155 minus Rs. 80 crores).

`The total value added equals the value of gross domestic product of the
economy. Out of this value added, the major portion goes in the form wages and
salaries, rent, interest and profits, a small portion goes to the government as indirect taxes
and the remaining amount is meant for depreciation. This is shown in Table 3.

Thus we find that the total gross value added of an economy equals the value of
its gross domestic product. If depreciation is deducted from the gross value added, we
have net value added which comes to Rs. 67 crores (Rs. 75 minus Rs. 8 crores).

This is nothing but net domestic product at market prices. Again, if indirect
taxes (Rs. 7 crores) are deducted from the net domestic product of Rs. 67 crores,
we get Rs. 60 crores as the net value added at factor cost which is equivalent to net
domestic product at factor cost. This is illustrated in Table 2.
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 Net value added at factor cost is equal to the net domestic product at factor
cost, as given by the total of items 1 to 4 of Table 2 (Rs. 45+3+4+8 crores=Rs. 60
crores). By adding indirect taxes (Rs 7 crores) and depreciation (Rs 8 crores), we
get gross value added or GDP which comes to Rs 75 crores.

If we add net income received from abroad to the gross value added, this
gives - us, gross national income. Suppose net income from abroad is Rs. 5 crores.
Then the gross national income is Rs. 80 crores (Rs. 75 crores + Rs. 5 crores) as
shown in Table 3.

It’s Importance:

The value added method for measuring national income is more realistic than

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the product and income methods because it avoids the problem of double counting by
excluding

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the value of intermediate products. Thus this method establishes the importance
of intermediate products in the national economy. Second, by studying the national
income accounts relating to value added, the contribution of each production sector to
the value of the GNP can be found out.

For instance, it can tell us whether agriculture is contributing more or the share
of manufacturing is falling, or of the tertiary sector is increasing in the current year as
compared to some previous years. Third, this method is highly useful because “it provides
a means of checking the GNP estimates obtained by summing the various types of
commodity purchases.”

It’s Difficulties:

However, difficulties arise in the calculation of value added in the case of

certain public services like police, military, health, education, etc. which cannot be
estimated accurately in money terms. Similarly, it is difficult to estimate the
contribution made to value added by profits earned on irrigation and power
projects.

G. GNP at Market Prices:

When we multiply the total output produced in one year by their market
prices prevalent during that year in a country, we get the Gross National Product
at market prices. Thus GNP at market prices means the gross value of final goods
and services produced annually in a country plus net income from abroad. It includes
the gross value of output of all items from (1) to (4) mentioned under GNP. GNP at
Market Prices = GDP at Market Prices + Net Income from Abroad.

H. GNP at Factor Cost

GNP at factor cost is the sum of the money value of the income produced by
and accruing to the various factors of production in one year in a country. It includes
all items mentioned above under income method to GNP less indirect taxes.

GNP at market prices always includes indirect taxes levied by the government
on goods which raise their prices. But GNP at factor cost is the income which the
factors of production receive in return for their services alone. It is the cost of
production.
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Thus GNP at market prices is always higher than GNP at factor cost.
Therefore,

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in order to arrive at GNP at factor cost, we deduct indirect taxes from GNP at
market prices. Again, it often happens that the cost of production of a commodity to the
producer is higher than a price of a similar commodity in the market.
In order to protect such producers, the government helps them bygranting
monetary help in the form of a subsidy equal to the difference between the market price
and the cost of production of the commodity. As a result, the price of the commodity to
the producer is reduced and equals the market price of similar commodity.
For example if the market price of rice is Rs. 3 per kg but it costs the producers
in certain areas Rs. 3.50. The government gives a subsidy of 50 paisa per kg to
them in order to meet their cost of production. Thus in order to arrive at GNP at
factor cost, subsidies are added to GNP at market prices.
GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.
I. Net National Product (NNP)
NNP includes the value of total output of consumption goods and
investment goods. But the process of production uses up a certain amount of fixed
capital. Some fixed equipment wears out, its other components are damaged or
destroyed, and still others are rendered obsolete through technological changes.
All this process is termed depreciation or capital consumption allowance. In
order to arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to the
exclusion of that part of total output which represents depreciation. So NNP = GNP—
Depreciation.
J. NNP at Market Prices
Net National Product at market prices is the net value of final goods and
services evaluated at market prices in the course of one year in a country. If we deduct
depreciation from GNP at market prices, we get NNP at market prices. So NNP at
Market Prices = GNP at Market Prices—Depreciation.
K. NNP at Factor Cost
Net National Product at factor cost is the net output evaluated at factor prices.
It includes income earned by factors of production through participation in the

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production process such as wages and salaries, rents, profits, etc. It is also called
National Income.

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This measure differs from NNP at market prices in that indirect taxes are deducted
and subsidies are added to NNP at market prices in order to arrive at NNP at
factor cost. Thus

NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies

= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.

= National Income.

Normally, NNP at market prices is higher than NNP at factor cost because
indirect taxes exceed government subsidies. However, NNP at market prices can be
less than NNP at factor cost when government subsidies exceed indirect taxes.

L. Domestic Income

Income generated (or earned) by factors of production within the country from
its own resources is called domestic income or domestic product.

Domestic income includes:

(i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest,
(iv) dividends, (v) undistributed corporate profits, including surpluses of public
undertakings,
(vi) mixed incomes consisting of profits of unincorporated firms, self- employed
persons, partnerships, etc., and (vii) direct taxes.

Since domestic income does not include income earned from abroad, it can
also be shown as: Domestic Income = National Income-Net income earned from
abroad. Thus the difference between domestic income f and national income is the
net income earned from abroad. If we add net income from abroad to domestic
income, we get national income, i.e., National Income = Domestic Income + Net
income earned from abroad.

But the net national income earned from abroad may be positive or negative. If
exports exceed import, net income earned from abroad is positive. In this case,
national income is greater than domestic income. On the other hand, when imports
exceed exports, net income earned from abroad is negative and domestic income is
greater than national income.
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M. Private Income
Private income is income obtained by private individuals from any source,
productive or otherwise, and the retained income of corporations. It can be arrived
at from NNP at Factor Cost by making certain additions and deductions.
The additions include transfer payments such as pensions, unemployment
allowances, sickness and other social security benefits, gifts and remittances from
abroad, windfall gains from lotteries or from horse racing, and interest on public debt. The
deductions include income from government departments as well as surpluses from public
undertakings, and employees’ contribution to social securityschemes like provident funds,
life insurance, etc.
Thus Private Income = National Income (or NNP at Factor Cost) +
Transfer Payments + Interest on Public Debt — Social Security — Profits and
Surpluses of Public Undertakings.
N. Personal Income
Personal income is the total income received by the individuals of a country
from all sources before payment of direct taxes in one year. Personal income is never
equal to the national income, because the former includes the transfer payments
whereas they are not included in national income.
Personal income is derived from national income by deducting
undistributed corporate profits, profit taxes, and employees’ contributions to social
security schemes. These three components are excluded from national income
because they do reach individuals.
But business and government transfer payments, and transfer payments from
abroad in the form of gifts and remittances, windfall gains, and interest on public debt
which are a source of income for individuals are added to national income. Thus
Personal Income = National Income – Undistributed Corporate Profits – Profit
Taxes – Social Security Contribution + Transfer Payments + Interest on Public
Debt.
Personal income differs from private income in that it is less than the latter
because it excludes undistributed corporate profits.

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Thus Personal Income = Private Income – Undistributed Corporate Profits – Profit Taxes.

423
O. Disposable Income
Disposable income or personal disposable income means the actual income
which can be spent on consumption byindividuals and families. The whole of the
personal income cannot be spent on consumption, because it is the income that accrues
before direct taxes have actually been paid. Therefore, in order to obtain disposable
income, direct taxes are deducted from personal income. Thus Disposable
Income=Personal Income – Direct Taxes.
But the whole of disposable income is not spent on consumption and a part of it
is saved. Therefore, disposable income is divided into consumption expenditure and
savings. Thus Disposable Income = Consumption Expenditure + Savings.
If disposable income is to be deduced from national income, we deduct
indirect taxes plus subsidies, direct taxes on personal and on business, social security
payments, undistributed corporate profits or business savings from it and add transfer
payments and net income from abroad to it.
Thus Disposable Income = National Income – Business Savings – Indirect
Taxes
+ Subsidies – Direct Taxes on Persons – Direct Taxes on Business – Social
Security Payments + Transfer Payments + Net Income from abroad.
P. Real Income
Real income is national income expressed in terms of a general level of prices
of a particular year taken as base. National income is the value of goods and services
produced as expressed in terms of money at current prices. But it does not indicate the
real state of the economy.
It is possible that the net national product of goods and services this year
might have been less than that of the last year, but owing to an increase in prices, NNP
might be higher this year. On the contrary, it is also possible that NNP might have
increased but the price level might have fallen, as a result national income would appear
to be less than that of the last year. In both the situations, the national income does not
depict the real state of the country. To rectify such a mistake, the concept of real
income has been evolved.

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 In order to find out the real income of a country, a particular year is taken as
the base year when the general price level is neither too high nor too low and the
price level for

425
that year is assumed to be 100. Now the general level of prices of the given year for
which the national income (real) is to be determined is assessed in accordance with the
prices of the base year. For this purpose the following formula is employed.
Real NNP = NNP for the Current Year x Base Year Index (=100) / Current Year
Index
Suppose 1990-91 is the base year and the national income for 1999-2000 is Rs.
20,000 crores and the index number for this year is 250. Hence, Real National Income
for 1999-2000 will be = 20000 x 100/250 = Rs. 8000 crores. This is also known as
national income at constant prices.
Q. Per Capita Income
The average income of the people of a country in a particular year is called
Per Capita Income for that year. This concept also refers to the measurement of
income at current prices and at constant prices. For instance, in order to find out
the per capita income for 2001, at current prices, the national income of a country
is divided by the population of the country in that year.
National income for 2001
Per Capita Income for 2001 =
Population in 2001

Similarly, for the purpose of arriving at the Real Per Capita Income, this
very formula is used.
Real national income for
Real Per Capita Income for 2001 =
2001
Population in 2001

This concept enables us to know the average income and the standard of living
of the people. But it is not very reliable, because in every country due to unequal
distribution of national income, a major portion of it goes to the richer sections of the
society and thus income received by the common man is lower than the per capita
income.
15.5 SIGNIFICANCE OF NATIONAL INCOME ANALYSIS
The national income data have the following importance:
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1. For the Economy- National income data are of great importance for the economy

427
of a country. These days the national income data are regarded as accounts of the
economy, which are known as social accounts. These refer to net national income and
net national expenditure, which ultimately equal each other. Social accounts tell us how
the aggregates of a nation’s income, output and product result from the income of
different individuals, products of industries and transactions of international trade.
Their main constituents are inter-related and each particular account can be used to
verify the correctness of any other account.

2. National Policies- National income data form the basis of national policies
such as employment policy, because these figures enable us to know the direction in
which the industrial output, investment and savings, etc. change, and proper measures can
be adopted to bring the economy to the right path.

3. Economic Planning-In the present age of planning, the national data are of
great importance. For economic planning, it is essential that the data pertaining to a
country’s gross income, output, saving and consumption from different sources should
be available. Without these, planning is not possible.

4. Economic Models- The economists propound short-run as well as long-

run economic models or long-run investment models in which the national income
data are very widely used.

5. Research- The national income data are also made use of by the research
scholars of economics. They make use of the various data of the country’s input,
output, income, saving, consumption, investment, employment, etc., which are
obtained from social accounts.

6. Per Capita Income- National income data are significant for a country’s
per capita income which reflects the economic welfare of the country. The higher
the per capita income, the higher the economic welfare of the country.

7. Distribution of Income- National income statistics enable us to know about

the distribution of income in the country. From the data pertaining to wages, rent,
interest and profits, we learn of the disparities in the incomes of different sections of the
society. Similarly, the regional distribution of income is revealed.

It is only on the basis of these that the government can adopt measures to

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remove

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the inequalities in income distribution and to restore regional equilibrium. With a view
to removing these personal and regional disequibria, the decisions to levy more
taxes and increase public expenditure also rest on national income statistics.

15.6 SUMMARY

National Income is the moneyvalue of all goods and services produced in a

country during a year. Gross Domestic Product (GDP) and Gross National Income
(GNI) are core statistics in National Accounts. They are both important economic
indicators and useful for analysingthe overall economic situation of an economy, withthe
former particularly useful for reflecting the level of production, and the latter for aggregate
income of residents. Statistics on GDP are compiled as from the reference year of 1961
while those on GNI as from the reference year of 1993.GDP is a measure of the total
value of production of all resident producing units of an economy in a specific period
(typically a year or a quarter), before deducting the consumption of fixed capital. Per
capita GDP of an economy is obtained by dividing the total GDP in a year by the
population of that economy in the same year. National Income helps us to know the
economic progress achieved and to make comparative study. Product method,
Income method and Expenditure method are the three methods used for national
income calculation. In India national income is calculated and published by the Central
Statistical Organisation (CSO). Net National Product, Per Capita Income etc., are
some of the important concepts related to National Income.

15.7 SELFASSESSMENT QUESTIONS

1. Explain the concept of national income?

2. Discuss various components of national income?

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3. Discuss the importance of national income?

15.8 SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas publishing house, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Mithani, D.M., managerial economics-theory & application, Himalaya
Publishing House Pvt. Ltd., New Delhi.
 Gupta, G.S., Macro Economic- theory and application, Tata McGraw Hill
Publishing House, New Delhi.

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 Unit-IV
LESSON 16 MEASURING NATIONAL INCOME

STRUCTURE
16.1 INTRODUCTION

16.2 OBJECTIVES

16.3 MEASUREMENT OF NATIONAL INCOME

16.3.1 Value Added Method

16.3.2 Income Method

16.3.3 Final Expenditure Method

16.3.4 Product Method

16.4 PROBLEMS IN THE MEASUREMENT OF NATIONAL INCOME

16.4.1 Problems in Income method

16.4.2 Problems in Product method

16.4.3 Problems in Expenditure method

16.5 USES OF NATIONAL INCOME

16.6 LIMITATIONS OF NATIONAL INCOME

16.7 SUMMARY

16.8 SELF ASSESSMENT QUESTIONS

16.9 SUGGESTED READINGS

16.1 INTRODUCTION

For the purpose of measurement and analysis, national income can be

viewed as an aggregate of various component flows. The most comprehensive

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measure of aggregate

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income which is widely known is Gross National Product at market prices. Gross
emphasises that no allowance for capital consumption has been made or that
depreciation has yet to be deducted. Net indicates that provision for capital
consumption has already been made or that depreciation has already been deducted.
The term national denotes that the aggregate under consideration represents the total
income which accrues to the normal residents of a country due to their participation
in world production during the current year. It is also possible to measure the value of
the total output or income originating within the specified geographical boundary of a
country known as domestic territory. The resulting measure is called “domestic
product”. The valuation of the national product at market prices indicates the total
amount actuallypaid by the final buyers while the valuation of national product at factor
cost is a measure of the total amount earned by the factors of production for their
contribution to the final output.
GNP at market price = GNP at factor cost + indirect taxes -
Subsidies. NNP at market price = NNP at factor cost + indirect
taxes - Subsidies
For some purposes we need to find the total income generated from production
within the territorial boundaries of an economy irrespective of whether it belongs to
the inhabitants of that nation or not. Such an income is known as Gross Domestic
Product (GDP) and found as “
GDP = GNP - Net Factor Income from Abroad
Net Factor Income from Abroad = Factor Income Received From Abroad
- Factor Income Paid Abroad
The NNP is an alternative and closely related measure of the national income.
It differs from GNP in only one respect. GNP is the sum of final products. It
includes consumption of goods, gross investment, government expenditures on goods
and services, and net exports.
GNP = NNP “ Depreciation
NNP includes net private investment while GNP includes gross private
domestic investment. Personal income is calculated bysubtracting from national income
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those types of incomes which are earned but not received and adding those types
which are received but not currently earned.

435
 Personal Income = NNP at Factor Cost “ Undistributed Profits “ Corporate Taxes
+ Transfer Payments

Disposable income is the total income that actually remains with individuals to
dispose off as they wish. It differs from personal income by the amount of direct taxes
paid byindividuals.

Disposable Income = Personal Income “ Personal taxes

The concept of value added is a useful device to find out the exact amount that
is added at each stage of production to the value of the final product. Value added
can be defined as the difference between the value of output produced by that firm and
the total expenditure incurred by it on the materials and intermediate products
purchased from other business firms.

16.2 OBJECTIVES

After reading this Lesson, you will be able:

 To understand the concept of national income.

 To explain various methods used for the measurement of national income.

 To know the problems in the measurement of national income.

16.3 METHODS OF MEASURING NATIONAL INCOME

National income is the total money value of goods and services produced by a
country in a particular period of time. The duration of this period is usually one year.

National income can be defined by taking three viewpoints, namely production

viewpoint, income viewpoint, and expenditure viewpoint.

Based on these viewpoints, there are three different methods of estimating national
income, which are shown in Figure-1:

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For calculating national income, an economy is looked upon from three
different angles, which are as follows:

1. Production units in an economy are classified into primary, secondary, and

tertiary sectors. On the basis of this classification, value-added method is used to
measure national income.

2. Economy is also viewed as a combination of individuals and households

owing different kinds of factors of production. On the basis of this
combination, income method is used for estimating national income.

3. Economy is viewed as a collection of units used for consumption, saving,

and investment. On the basis of this collection, final expenditure method is
used for calculating national income.

Let us discuss the different methods of measuring national income (as shown in Figure-
1).

16.3.1 Value-added Method:

Value added method, also called net output method, is used to measure the
contribution of an economy’s production units to the GDPmp. In other words,
value- added method measures value added by each industry in an economy. For
calculating national income through value-added method, it is necessary to first
calculate gross value added at market price (GVAmp), net value added at market

437
price (NVAmp), and net value added at factor cost (NVAfc).

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These can be calculated as follows:

(i) GVAmp:

Refers to the value of output at market prices minus intermediate

consumption. The value of output can be calculated by multiplying quantity of
output produced by a production unit during a given time period with price per
unit. For instance, if output produced by a production unit in a year is 10000 units
at price Rs. 10 per unit, then the total value of output would be 100000.

The value of output is also calculated as:

Value of output = Total Sales + Closing Stock – Opening

Stock Where
Net change in stock = Closing Stock – Opening Stock

Glossing stock includes the value of unsold output in the previous year and
forms the opening stock of the current year. Thus, by deducting the opening stock
from the closing stock, unsold output of the current year can be calculated.

On the other hand, intermediate consumption refers to the value of non-

durable goods and services purchased bya production unit from another production unit
in particular period of time. These goods and services used up or resold during that
particular period of time.

So, GVAmp can be calculated using the following formula:

GVAmp = Value of Output Intermediate Consumption

The word gross in GVAmp indicates the inclusion of depreciation.

(ii) NVAmp:

Excludes depreciation from GVAmp. In other words, NVAmp is GVAmp

minus depreciation.

(iii) NVAfc:

Refers to another measure of value added.

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It is calculated as:
NVAfc = NVAmp Indirect Taxes +
Subsidies Or
NVAfc = GVAmp Depreciation Indirect Taxes + Subsidies
Now, using the value-added method, we aim to calculate national income
(NNPfc).
The following are the steps to calculate national income using the value-
added method:
1. Classifying the production units into primary, secondary, and tertiary sectors.
2. Estimating Net Value Added (NVAfc) of each sector.
3. Taking the sum of NVAfc of all the industrial sectors of the economy. This
will give NDPfc.
ΣNVA fc = NDPfc
4. Estimating NFIA and adding it to NDPfc, which gives NNPfc (national
income). NDPfc + NFIA = National Income (NNPfc)
The following are the precautions that should be taken into consideration while
calculating national income using the value-added method:
i. Avoiding double counting of output as it leads to the overestimation of
national income. For example, a farmer produces 5 kilograms of wheat worth Rs.
10000. He sells this wheat to a baker who uses it for making breads. The baker
further sells these breads lo a grocer for Rs. 20000. Finally, the grocer sells these
breads to consumers for Rs. 25000.
Thus, the total output of the farmer, baker, and grocer would be Rs.
55000. However, this cannot be taken as the value of actual physical output. This is
because it includes the value of wheal three times and value of bread two times. The
double counting can be avoided by two measures. First is by taking the total value
added instead of taking the total output.

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In the above example, the value added by farmer is nil, by the baker is Rs.
10000,

441
and by the grocer is Rs. 15000. Thus, the sum total of value added is Rs. 25000.
Second is by taking the value of final products only. Final products are those which are
purchased for consumption and investment. In the above example, the final product is
bread sold to the consumers for Rs. 25000. Thus, the final output is Rs. 25000.
i. Including output produced byproduction units for self-consumption in total
output. All the production should be included whether u is sold in the market or not.
In addition, the value of free services provided by government and non-profit
institutions should also be taken into account. Non-inclusion of these will lead to
underestimation of national income.
iii. Avoiding the inclusion of sales of pre-owned goods. This is because
these goods are already counted when sold for the first time. The output of only newly
produced goods is included in total output. However, the value of services provided
by agents in selling pre-owned goods is fresh output and should be included in the
total output.
16.3.2 Income Method
Income method, also known as factor income method, is used to calculate
all income accrued to the basic factors of production used in producing national
product. Traditionally, there are four factors of production, namely land, labor,
capital, and organization. Accordingly there are four factor payments, namely rent,
compensation of employees, interest, and profit. There is another category of factor
payment called mixed income.
These factor payments are explained as follows:
(a) Rent:
Refers to the amount payable in cash or in kind by a tenant to the landlord
for using land. In national income accounting, the term rent is restricted to land and
not to other goods, such as machinery.
In addition to rent, royalty is also included in national income which is defined
as the amount payable to landlord for granting the leasing rights of assets that can be
extracted from land, for example, coal and natural gas.
(b) Compensation of Employees:

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Refer to the remuneration paid to employees in exchange of services rendered by

443
them for producing goods and services.

Compensation of employees is divided into two parts, which are as follows:

(i) Wages and salaries:

Include remuneration given in the form of cash to employees on a daily, weekly,

or monthly basis. It includes allowances, such as conveyance allowance, bonuses,
commissions, rent-free accommodation, loans on low interest rates, and medical
and educational expenses.

(ii) Social security contribution:

Includes remuneration provided to employers in the form of social security

schemes such as insurance, pensions, and provident fund.

(c) Interest:

Refers to the amount payable bythe production unit for using the borrowed
money. Generally, production units borrow for making investment and households
borrow for meeting consumption expenditure.

In national income accounting, interest is restricted to the payment by

production units. If production units use their own savings, then the interest is payable
to them in the form of imputed interest.

(d) Profits:

Refers to the amount of money earned by the owner of a production unit for
his/ her entrepreneurial abilities. The profits are distributed by the production unit
under three heads. First is by paying income tax, called corporate profit tax.

Second is by paying dividend to shareholder. Third is the retained earnings

called undistributed profits. Thus, profit Is the sum total of corporate profit tax,
dividend, and retained earnings.

(e) Mixed Income:

Refers to earnings from farming enterprises, sole proprietorships, and

other professions, such as medical and legal practices. In these professions, owners
themselves
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assume the role of an entrepreneur, financier, worker and landlords. Mixed income
also takes into account the income of those individuals who earn from different
sources, such as wages rents on own property, and interests on own money.

Therefore,

National Income Rent + Wages + Interest + Profit + Mixed Income

Now, let us discuss steps involved in estimating national income using the

income
method.

These steps are as follows:

1. Classifying the production units into primary, secondary, and tertiary sectors.

2. Estimating Net Value Added (NVAfc) of each sector. The sum total of the
factor payments equals NVAfc.

3. Taking the sum of NVAfc of all the industrial sectors of the economy. This
will give NDPfc.

ΣNVAfc = NDPfc

4. Estimating NFIA and adding it to NDPfc, which gives NNPfc (national

income). NDPfc + NFIA = National Income (NNPfc)

The following are the precautions that should be taken into

consideration while calculating national income using the income method:
a. Including the imputed value of factor services rendered bythe owners of
production units themselves. For example, if production units use their own savings
for production, then the interest is payable to them in the form of imputed interest.
This imputed interest should be added in the calculation of national income.

b. Avoiding the inclusion of transfer payments, such as gifts, donations and taxes.

c. Excluding the gains that arise from the sales of pre-owned goods. These gains
are called capital gains.

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d. Excluding the income arising from sale of financial assets, such as shares and

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debentures. This is not related to the production of goods and services. However,
national income includes the value of services rendered by the agents in selling these
financial assets.
16.3.3 Final Expenditure Method:
Final expenditure method, also known as final product method, is used to
measure final expenditures incurred by production units for producing final goods
and services within an economic territory during a given time period.
These expenditures are incurred on consumption and investment. This method
is the opposite of the value-added method. This is because value-added method
estimates national income from the sales side, whereas the expenditure method
calculates national income from the purchase side.
Final expenditure of an economy is divided into consumption expenditure
and investment expenditure, which are explained as follows:
(a) Consumption
Expenditure: Includes the
following:
(i) Private Final Consumption Expenditure (PFCE):
Includes expenditure incurred by households and expenditure incurred by
private non-profit institutions serving households (PNPISH). Thus, PFCE is divided
into two parts, namely Household’s Final Consumption Expenditure (HFCE) and
PNPISH Final Consumption Expenditure (PNPISH-FCE).
HFCE is defined as expenditures, both actual and imputed, incurred by a
country’s households on final goods and services for satisfying their wants. In
addition to actual money expenditure, HFCE includes imputed value of goods and
services received without incurring money expenditure, for example, self-consumed
output and gifts received in kind.
Expenditure by non-residents of a country is not included in HFCE. However,
the expenditure incurred by the national residents in foreign countries is included in
HFCE. Thus, imports are the part of HFCE. In addition, HFCE excludes the receipts
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from the sale of pre-owned goods, wastes, and scraps.

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HFCE can be calculated with the help of the following formula:
HFCE = Money expenditure on consumption by residents + Imputed value
of consumer goods and services received in kind by residents – Sale of pre-owned
goods, wastes, and scraps
On the other hand, PNPISH includes expenditure incurred by private
charitable institutions, trade unions, and religious societies, which produce goods and
services to be supplied to consumers either free or at token prices.
PNPISH-FCE = Imputed value of goods and services produced
Commodity and non-commodity sales
Commodity sales imply the sale at a price that covers cost, while non-
commodity sales imply the sale at a price that does not cover cost.
(ii) Government Final Consumption Expenditure (GFCE):
Includes expenditure that is incurred by government for providing free goods
and services to citizens. GFCE is equal to value of output minus sales (GFCE =
Value of Output – Sales).
The value of output is calculated as:
Value of output generated by government = Compensation of government
employees + purchases of commodities and services + consumption of fixed
capital
Sales by government = Commodity Sales + Non- Commodity Sales
(b) Investment Expenditure:
Involves expenditure incurred on capital formation. This expenditure is known
as Gross Domestic Capital Formation (GDCF).
There are three components of GDCF, which are as follows:
(i) Acquisition of fixed capital assets:
Implies purchasing assets, such as building and machinery.
(ii) Change in stocks:

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Involves making addition to the stock of raw materials, semi-finished goods, and

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finished goods.

(iii) Net acquisition of valuables:

Involvesacquisition ofvaluablesminus disposal ofvaluables. These valuables

include precious stones, metals, and jewellery.

GDCF becomes net when it is diminished by

depreciation. Net GDCF = GDCF – depreciation

GDCF is subdivided into Gross Domestic Fixed Capital Formation (GDFCF)

and change in stocks.

Now, let us discuss steps involved in estimating national income using final
expenditure method.

These steps are as follows:

1. Classifying the production units into primary, secondary, and tertiary sectors.

2. Estimating the final expenditures on goods and services by industrial sectors.

These expenditures are PFCE, GFCE, and GDCF. The expenditure also includes net
exports, which are equal to exports minus imports.

3. Taking the sum of the final expenditures which gives

GDPmp. GDPmp = PFCE + GFCE + GDCF + Net

Exports

4. Estimating the consumption of fixed capital and net indirect taxes to

calculate NDPfc.
NDPfc = GDPmp – Consumption of Fixed Capital- Net Indirect Taxes

5. Adding NFIA to get national income

(NNPfc) NDPfc +NFIA = NNPfc

The following are the precautions that should be taken into consideration while
calculating national income using the final expenditure method:

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a. Excluding the intermediate expenditure as it is already a part of final
expenditure

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b. Including the imputed expenditure incurred for producing goods for self-
consumption
c. Excluding the expenditure incurred on transfer payments
d. Excluding expenditure incurred on financial assets, such as shares and debentures
e. Excluding the expenditure incurred on pre-owned goods
Table-1 shows the summarize calculation of national income by three methods:
Table-1 : Calculation of National Income by Three Methods

Value-added Method Income Method Final Ependiture Method

Sum Total of GVAmp by Sum Total of factor income paid PFGE + GFCE + GDCF + Net exports
all industrial sectors. out by industrial sectors = compensation Les : consumption of fixed capital
Les : consumption of fixed capital of employees + rent + interest + profit Less : net indirect taes
Less : net indirect taes = NDPfc
Add : NFIA Add : NFIA Add : NFIA
= NNPfc = NNPfc = NNPfc
= National Income = National Income = National Income

Which method is to be used depends on the availability of data in a country

and the purpose in hand.
16.3.4 Product Method
According to this method, the total value of final goods and services produced
in a country during a year is calculated at market prices. To find out the GNP, the data
of all productive activities, such as agricultural products, wood received from forests,
minerals received from mines, commodities produced by industries, the contributions to
production made by transport, communications, insurance companies, lawyers,
doctors, teachers, etc. are collected and assessed at market prices. Only the final
goods and services are included and the intermediary goods and services are left
out.
16.4 DIFFICULTIES OR PROBLEMS IN MEASURING NATIONAL
INCOME
There are many difficulties in measuring national income of a country accurately.
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The difficulties involved in national income accounting are both conceptual and
statistical in nature. The six major difficulties faced in the measurement of national
income are 1. problems of definition i.e. What should we include in the National
Income? Ideally we should include all goods and services produced in the course of
the year, but there are some services which are not calculated in terms of money,
e.g., services of housewives.
(2) Lack ofAdequate Data: The lack of adequate statistical data makes the task of
estimation of national income more acute and difficult. (3) Non-availability of Reliable
Information: The reason of illiteracy, most producers has no idea of the quantity
and value of their output and do not follow the practice of keeping regular accounts.
(4) Choice of Method: The selection of method while calculating National Income is
also an important task. The wrong method leads to poor results. (5) Lack of
Differentiation in Economic Functioning: In all the countries the occupational
specialisation is still incomplete so that there is a lack of differentiation in economic
functioning. An individual may receive income partly from farm ownership and partly
from manual work in industry in the slack season. (6) Double Counting: Double
counting is also an important problem while calculating national income. If the value of
all goods and services totalled, the total will overtake the national output, because
some goods are currently consumed being used in the making of others. The best way
to avoid this error is to calculate only the value of those goods and services that enter
into final consumption.

There are many more conceptual and statistical problems involved in

measuring national income by the income method, product method, and
expenditure method.

We discuss them separately in the light of the three methods:

16.4.1 Problems in Income Method

The following problems arise in the computation of National Income by

income method:

1. Owner-occupied Houses:

A person who rents a house to another earns rental income, but if he occupies
the house himself, will the services of the house-owner be included in national
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income. The services of the owner-occupied house are included in national income as if
the owner sells to himself as a tenant its services.

455
For the purpose of national income accounts, the amount of imputed rent is estimated
as the sum for which the owner-occupied house could have been rented. The
imputed net rent is calculated as that portion of the amount that would have
accrued to the house- owner after deducting all expenses.
2. Self-employed Persons:
` Another problem arises with regard to the income of self-employed persons. In
their case, it is very difficult to find out the different inputs provided by the owner
himself. He might be contributing his capital, land, labour and his abilities in the
business. But it is not possible to estimate the value of each factor input to production.
So he gets a mixed income consisting of interest, rent, wage and profits for his factor
services. This is included in national income.
3. Goods meant for Self-consumption:
In under-developed countries like India, farmers keep a large portion of food
and other goods produced on the farm for self-consumption. The problem is whether
that part of the produce which is not sold in the market can be included in national
income or not. If the farmer were to sell his entire produce in the market, he will have
to buy what he needs for self-consumption out of his money income. If, instead he
keeps some produce for his self-consumption, it has money value which must be
included in national income.
4. Wages and Salaries paid in Kind:
Another problem arises with regard to wages and salaries paid in kind to
the employees in the form of free food, lodging, dress and other amenities. Payments
in kind by employers are included in national income. This is because the employees
would have received money income equal to the value of free food, lodging, etc. from
the employer and spent the same in paying for food, lodging, etc.
16.4.2 Problems in Product Method
The following problems arise in the computation of national income by
product method:
1. Services of Housewives:

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The estimation of the unpaid services of the housewife in the national income

457
presents a serious difficulty.Ahousewife renders a number of useful services like
preparation of meals, serving, tailoring, mending, washing, cleaning, bringing up
children, etc.
She is not paid for them and her services are not including in national
income. Such services performed by paid servants are included in national income.
The national income is, therefore, underestimated by excluding the services of a
housewife.
The reason for the exclusion of her services from national income is that the
love and affection of a housewife in performing her domestic work cannot be
measured in monetary terms. That is why when the owner of a firm marries his
lady secretary, her services are not included in national income when she stops
working as a secretary and becomes a housewife.
When a teacher teaches his own children, his work is also not included in
national income. Similarly, there are a number of goods and services which are
difficult to be assessed in money terms for the reason stated above, such as painting,
singing, dancing, etc. as hobbies.
2. Intermediate and Final Goods:
The greatest difficulty in estimating national income byproduct method is the
failure to distinguish properly between intermediate and final goods. There is always the
possibility of including a good or service more than once, whereas only final goods
are included in national income estimates. This leads to the problem of double counting
which leads to the overestimation of national income.
3. Second-hand Goods and Assets:
Another problem arises with regard to the sale and purchase of second-
hand goods and assets. We find that old scooters, cars, houses, machinery, etc. are
transacted daily in the country. But theyare not included in national income because
theywere counted in the national product in the year they were manufactured.
If they are included every time they are bought and sold, national income
would increase many times. Similarly, the sale and purchase of old stocks, shares, and
bonds of companies are not included in national income because they were included
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in national income when the companies were started for the first time. Now they are
simply financial transactions and represent claims.

459
 But the commission or fees charged by the brokers in the repurchase and resale
of old shares, bonds, houses, cars or scooters, etc. are included in national income.
For these are the payments they receive for their productive services during the
year.

4. Illegal Activities:

Income earned through illegal activities like gambling, smuggling, illicit

extraction of wine, etc. is not included in national income. Such activities have value
and satisfy the wants of the people but they are not considered productive from the
point of view of society. But in countries like Nepal and Monaco where gambling is
legalised, it is included in national income. Similarly, horse-racing is a legal activity in
England and is included in national income.

5. Consumers’ Service:

There are a number of persons in society who render services to consumers but
they do not produce anything tangible. They are the actors, dancers, doctors,
singers, teachers, musicians, lawyers, barbers, etc. The problem arises about the
inclusion of their services in national income since they do not produce tangible
commodities. But as they satisfy human wants and receive payments for their services,
their services are included as final goods in estimating national income.

6. Capital Gains:

The problem also arises with regard to capital gains. Capital gains arise when a
capital asset such as a house, some other property, stocks or shares, etc. is sold at
higher price than was paid for it at the time of purchase. Capital gains are excluded
from national income because these do not arise from current economic activities.
Similarly, capital losses are not taken into account while estimating national
income.

7. Inventory Changes:

All inventory changes (or changes in stocks) whether positive or negative

are included in national income. The procedure is to take changes in physical units of
inventories for the year valued at average current prices paid for them.

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 The value of changes in inventories may be positive or negative which is added
or subtracted from the current production of the firm. Remember, it is the change in
inventories

461
and not total inventories for the year that are taken into account in national income
estimates.

8. Depreciation:

Depreciation is deducted from GNP in order to arrive at NNP. Thus

depreciation lowers the national income. But the problem is of estimating the current
depreciated value of, say, a machine, whose expected life is supposed to be thirty years.
Firms calculate the depreciation value on the original cost of machines for their
expected life. This does not solve the problem because the prices of machines
change almost every year.

9. Price Changes:

National income by product method is measured by the value of final goods

and services at current market prices. But prices do not remain stable. They rise or fall.
When the price level rises, the national income also rises, though the national
production might have fallen.

On the contrary, with the fall in the price level, the national income also
falls, though the national production might have increased. So price changes do not
adequately measure national income. To solve this problem, economists calculate the
real national income at a constant price level by the consumer price index.

16.4.3 Problems in Expenditure Method

The following problems arise in the calculation of national income by

expenditure method:

(1) Government Services:

In calculating national income by, expenditure method, the problem of

estimating government services arises. Government provides a number of services,
such as police and military services, administrative and legal services. Should
expenditure on government services be included in national income?

If they are final goods, then only they would be included in national income.
On the other hand, if they are used as intermediate goods, meant for further production,
they would not be included in national income. There are many divergent views on
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this issue.

One view is that if police, military, legal and administrative services protect
the

463
lives, property and liberty of the people, they are treated as final goods and hence
form part of national income. If they help in the smooth functioning of the production
process by maintaining peace and security, then they are like intermediate goods that do
not enter into national income.

In reality, it is not possible to make a clear demarcation as to which service

protects the people and which protects the productive process. Therefore, all such
services are regarded as final goods and are included in national income.

(2) Transfer Payments:

There arises the problem of including transfer payments in national

income. Government makes payments in the form of pensions, unemployment
allowance, subsidies, interest on national debt, etc. These are government expenditures
but they are not included in national income because they are paid without adding
anything to the production process during the current year.

For instance, pensions and unemployment allowances are paid to individuals

by the government without doing any productive work during the year. Subsidies
tend to lower the market price of the commodities. Interest on national or public
debt is also considered a transfer payment because it is paid by the government to
individuals and firms on their past savings without any productive work.

(3) Durable-use Consumers’ Goods:

Durable-use consumers’ goods also pose a problem. Such durable-use

consumers’ goods as scooters, cars, fans, TVs, furniture’s, etc. are bought in one
year but they are used for a number of years. Should they be included under
investment expenditure or consumption expenditure in national income estimates? The
expenditure on them is regarded as final consumption expenditure because it is not
possible to measure their used up value for the subsequent years.

But there is one exception. The expenditure on a new house is regarded as

investment expenditure and not consumption expenditure. This is because the rental
income or the imputed rent which the house-owner gets is for making investment
on the new house. However, expenditure on a car by a household is consumption
expenditure. But if he spends the amount for using it as a taxi, it is investment
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expenditure.

465
(4) Public Expenditure:

Government spends on police, military, administrative and legal services,

parks, street lighting, irrigation, museums, education, public health, roads, canals,
buildings, etc. The problem is to find out which expenditure is consumption
expenditure and which investment expenditure is.

Expenses on education, museums, public health, police, parks, street lighting,

civil and judicial administration are consumption expenditure. Expenses on roads,
canals, buildings, etc. are investment expenditure. But expenses on defence equipment
are treated as consumption expenditure because they are consumed during a war as they
are destroyed or become obsolete. However, all such expenses including the salaries of
armed personnel are included in national income.

16.5 USES OF NATIONAL INCOME DATA

Modern Governments take unusual pains in the collection of national income

data for a number of reasons. Raising national income is the important goal of all
economic activity. Economic welfare of a country depends upon what goods and
services are made available for the consumption of its people.

The following are the main uses of national income statistics:

(i) National income data are used to measure economic welfare of the
community. Other things being equal, economic welfare is greater if national
income is greater.

(ii) National income figures give us an idea as to the standard of living of a

community.

(iii) The national income figures are further useful in helping us to assess the pace
of economic development of a country. If they do not measure progress
precisely, at least they will show us the trends.

(iv) The study of national income statistics is also useful in diagnosing the
economic ills of a country and suggesting remedies.

(v) The national income data are used to assess the saving and investment potential
of the community. The rate of saving and investment is ultimately dependent
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on the national income.

467
(vi) We can make inter-temporal comparisons, i.e., comparisons between two
periods of time in the country in order to form an idea of the economic
conditions prevalent in the respective periods.

(vii) We can also make inter-country comparisons by taking the national income
data of two countries. This will help us to know where we stand among the
world economies.

(viii) National income data also enable us to assess inter-sectoral growth of an

economy. This information is useful in planning development of the various
sectors.

(ix) The national income data also offer a reasonable basis for forecasting
future economic events. This will enable a country to foresee the probable
results of a particular economic policy.

(x) Another use of the national income estimates is that they throw light on inter-
class distribution of national income. One can judge the standard of welfare of the
various sections of the community. All modern societies aim at reducing
inequalities of incomes and this is not possible without the aid of national
income data.

(xi) Above all, the national income data are used for planned economic
development of the country. In their absence all planning will be a leap in
the dark.

In. Samuelson’s words, “By means of statistics of national income, we can

chart the movements of a country from depression to prosperity, its steady long-term
rate of economic growth and development, and finally, its material standard of living in
comparison with other nations.”

16.6 Limitations of National Income Accounts

There is no doubt that the national income data are highlyuseful and even
necessary for a modern society. But we should take care not to attach to them
exaggerated importance. They cannot be taken as absolutely reliable nor can they be
taken as an infallible guide to economic policy.

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They suffer from certain limitations:

(i) Theyare onlyrough approximations with all the care taken and the expense
incurred in their preparation. We have, therefore, to be very careful in their
use.

469
(ii) The national income figures measure moneyincomes rather than real income.
Any attempt at inflating or deflating money incomes in order to ascertain real
income will create a host of other uncertainties.
(iii) Inter-temporal comparisons, i.e., comparisons between two differ-ent periods
in the country are not possible. This is due to the fact that a number of changes
must have occurred in the meantime to render the comparison meaningless.
(iv) Inter-country comparisons too are also not very fruitful. This is due to the fact
that economic conditions of the two countries as well as the nature of
goods and services that have entered into calculation may be widely
different.
(v) The national income estimates do not justify any forecasting owing to a
large measure of approximation in their calculation. On their basis we cannot
say that a certain policy will produce the desired results.
16.7 SUMMARY
The national income estimates serve a very useful purpose and improvement
both in the data and in the techniques no doubt has added to their validity.
The three alternative methods used for measuring national income are as
follows:
1. Value Added Method 2. Income Method 3. Expenditure Method.
Since factor incomes arise from the production of goods and services, and
since incomes are spent on goods and services produced, three alternative methods of
measuring national income are possible.
Value Added Method
This is also called output method or production method. In this method the
value added by each enterprise in the production goods and services is measured.
Value added by an enterprise is obtained by deducting expenditure incurred on
intermediate goods such as raw materials, unfinished goods (purchased from other
firms from the value of output produced by an enterprise.
Value of output produced by an enterprise is equal to physical output (Q)

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produced multiplied by the market price (P), that is, P.Q. From the value added by
each enterprise we subtract consumption of fixed capital (i.e., depreciation) to obtain
net value added at

471
market prices (NVA ).
MP
However, for estimating national income (that is, Net National Product at
factor cost (NNP ) we require to estimate net value added at factor cost (NVA )
FC FC
by each
enterprise in the economy. NVA can be found out by deducting net indirect taxes (i. e.
FC by the Government).
indirect taxes less subsidies provided

Under this method, the economy is divided into different industrial sectors such as
agriculture, fishing, mining, construction, manufacturing, trade and commerce, transport,
communication and other services. Then, the net value added at factor cost (NVA ) by
each productive enterprise as well as by each industry or sector is estimated. FC

It follows from above that in order to arrive at the net value added at factor
cost by an enterprise we have to subtract the following from the value of output of an
enterprise:

1. Intermediate consumption which is the value of goods such as raw materials,

fuels purchased from other firms

2. Consumption of fixed capital (i.e., depreciation)

3. Net indirect taxes.

Summing up the net values added at factor cost (NVA ) by all productive
enterprises of an industry or sector gives us the net value addedFC
at factor cost of each
industry or sector. We then add up net values added at factor cost by all industries or
sectors to get net domestic product at factor cost (NDP ). Lastly, to the net domestic
FC
product we add the net factor income from abroad to get net national product at
factor cost (NNP ) which is also called national income. Thus,
FC
NI or NNP = NDP + Net factor income from abroad
FC FC
This method of calculating national income can be used where there exists a
census
of production for the year. In many countries, the data of production of only important
industries are known. Hence this method is employed along with other methods to
arrive at the national income. The one great advantage of this method is that it reveals
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the relative importance of the different sectors of the economybyshowing their respective
contributions to the national income.

473
Income Method
This method approaches national income from distribution side. In other
words, this method measures national income at the phase of distribution and appears
as income paid and or received by individuals of the country. Thus, under this method,
national income is obtained by summing up of the incomes of all individuals of a
country. Individuals earn incomes by contributing their own services and the services of
their property such as land and capital to the national production.
Therefore, national income is calculated by adding up the rent of land, wages
and salaries of employees, interest on capital, profits of entrepreneurs (including
undistributed corporate profits) and incomes of self-employed people. This method of
estimating national income has the great advantage of indicating the distribution of
national income among different income groups such as landlords, owners of
capital, workers, entrepreneurs.
Expenditure method arrives at national income by adding up all
expenditures made on goods and services during a year. Income can be spent
either on consumer goods or capital goods. Again, expenditure can be made by
private individuals and households or by government and business enterprises.
Further, people of foreign countries spend on the goods and services which
a country exports to them. Similarly, people of a country spend on imports of goods
and services from other countries. We add up the following types of expenditure
byhouseholds, government and by productive enterprises to obtain national income.
1. Expenditure on consumer goods and services by individuals and households.
This is called final private consumption expenditure, and is denoted by C.
2. Government’s expenditure on goods and services to satisfy collective wants.
This is called government’s final consumption expenditure, and is denoted
by G.
3. The expenditure by productive enterprises on capital goods and inventories
or stocks. This is called gross domestic-capital formation, or gross
domestic investment and is denoted by I or GDCF.
A greatest difficulty in the measurement of national income in the developing
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countries is general lack of adequate statistical data. Inadequacy, non-availability and
unreliability of statistics is a great handicap in measuring national income in these
countries.

475
 Statistical information regarding agriculture and allied occupations, and
household enterprises is not available. Even the statistical information regarding the
enterprises in the organised sector is sketchy and unreliable. There is no accurate
information available regarding consumption, investment expenditure and savings
of either rural or urban population.

In under-developedcountries like India, weface some special difficulties in estimating

national income.

Some of these difficulties are:

(i) The first difficulty arises because of the prevalence of non-monetized

transactions in under-developed countries like India, so that a considerable
part of output does not come into the market at all.Agriculture still being in the
natureof subsistence farming in these countries, a major part of output is
consumed at the farm itself. The national income statistician, therefore, has to
face the problem of finding a suitable measure for this part of output.

(ii) Because of illiteracy, most producers have no idea of the quantity and value
of their output. They do not follow the practice of keeping regular accounts.
This makes the task of getting reliable information from a large number of
pettyproducers all the more difficult.

(iii) Because of under-development, occupational specialization is still incomplete

so that there is a lack of differentiation in economic functioning. An individual
may receive income partly from farm ownership, partly from manual work in
industry in the slack season, etc.

(iv) There is a general lack of adequate statistical data and this makes the task
of estimation all the more difficult.

(v) It is not easy to calculate the value of inventories, i.e., raw materials, semi-
finished and finished goods in the custody of the producers. Obviously, any
miscalculation on this score will vitiate the estimates of the output of
productive enterprises.

(vi) The calculation of depreciation on capital consumption presents another

formidable difficulty. There are no accepted standard rates of deprecia-tion
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applicable to the

477
 various categories of machines. Unless from the gross national income
correct deductions are made for depreciation, the estimate of net national
income is bound to go wrong.

(vii) Then there is the difficulty of avoiding double counting. If the value of the output
of sugar and sugarcane are counted separately, the value of the sugarcane
utilized in the manufacture of sugar will have been counted twice. This
must be avoided.

(viii) The application of the expenditure method too is full of difficulties. It is difficult
to estimate all personal as well as investment expenditure.

16.8 SELFASSESSMENT QUESTIONS

1. Explain the methods of measuring national income?

2. What are various difficulties faced while calculating national income?

3. Which method is used to find out the contribution of factors of production

to national income? Explain.

16.9 SUGGESTED READINGS

 Managerial economics, Dwivedi D.N., Vikas Publishing House, New Delhi.

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• Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Mithani, D.M., Managerial Economics-Theory and Application, Himalaya
Publishing House Pvt. Ltd., New Delhi.
 Gupta, G.S., Macro Economic- Theory and Application, Tata McGraw
Hill Publishing House, New Delhi.

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 SKILL DEVELOPMENT
OBJECTIVE: To make students acquainted with the specimen for the classroom
teaching pattern and internal assessment.

STRUCTURE:

5.1 Draw a chart for approaches to managerial decisions.

5.2 Chart out the factors influencing price policy.

5.3 Prepare a survey report on the demand forecasting of any product.

5.4 Discuss the process of business decision making with the help of case study.

5.5 Collect and present in tabular form the national income of five years.

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5.1 DRAW A CHART FOR APPROACHES TO MANAGERIAL DECISIONS.

Solution: The below mention chart showing the decision making process in management:

481
 A SYSTEMATIC APPROACH TO DECISSION MAKING :
 A logical and sytematic decision-makinf proce help you addre the citical
element that results in a good decision. By taking an organized approach,
you’re le likely to mis important factors and you can build on the approach to
make your decisions better and better.
There are six teps to making an effective deciion :
 Create a contructive environment.
 Generate good alternative.
 Explore these alternatives.
 Choose the best alternative.
 Check you decision.
 Communicate your decision and take action.

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 MANAGEMENT SCIENCE APPROACH
 Management science uses a scientific approach to solving
management problems.
 It is used in a variety of organizations to solve many different
types of problem.
 It encompasse a logical mathematical appraoch to problem solving.
 It is also referred to a : Decision Modeling
Quantitative
Analysis Operations
Reearch

483
4
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5.2 CHART OUT THE FACTORS INFLUENCING PRICE POLICY.

Solution: The factors influencing for a price decision can be divided into two groups:

(A) Internal Factors and (B) External Factors.

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(A) Internal Factors:

1. Organisational Factors:

Pricing decisions occur on two levels in the organisation. Over-all price strategy
is dealt with by top executives. They determine the basic ranges that the product falls
into in terms of market segments. The actual mechanics of pricing are dealt with at lower
levels in the firm and focus on individual product strategies. Usually, some combination of
production and marketing specialists are involved in choosing the price.

2. Marketing Mix:

Marketing experts view price as only one of the many important elements of
the marketing mix. A shift in any one of the elements has an immediate effect on the
other three- Production, Promotion and Distribution. In some industries, a firm may
use price reduction as a marketing technique.
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 Other firms mayraise prices as a deliberate strategy to build a high-prestige
product line. In either case, the effort will not succeed unless the price change is
combined with a total marketing strategy that supports it. A firm that raises its
prices may add a more impressive looking package and may begin a new
advertising campaign.
3. Product Differentiation:
The price of the product also depends upon the characteristics of the product.
In order to attract the customers, different characteristics are added to the product, such
as quality, size, colour, attractive package, alternative uses etc. Generally, customers
pay more prices for the product which is of the new style, fashion, better package
etc.
4. Cost of the Product:
Cost and price of a product are closely related. The most important factor is
the cost of production. In deciding to market a product, a firm may try to decide what
prices are realistic, considering current demand and competition in the market. The
product ultimately goes to the public and their capacity to pay will fix the cost,
otherwise product would be flapped in the market.
5. Objectives of the Firm:
A firm may have various objectives and pricing contributes its share in
achieving such goals. Firms may pursue a variety of value-oriented objectives, such as
maximizing sales revenue, maximizingmarketshare, maximizing customervolume,
minimizingcustomer volume, maintaining an image, maintaining stable price etc.
Pricing policy should be established only after proper considerations of the
objectives of the firm.
(B) External Factors:
1. Demand:
The market demand for a product or service obviously has a big impact on
pricing. Since demand is affected by factors like, number and size of competitors, the
prospective buyers, their capacity and willingness to pay, their preference etc. are
taken into account while fixing the price.
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 A firm can determine the expected price in a few test-markets by trying
different prices in different markets and comparing the results with a controlled
market in which

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price is not altered. If the demand of the product is inelastic, high prices may be fixed.
On the other hand, if demand is elastic, the firm should not fix high prices, rather it
should fix lower prices than that of the competitors.

2. Competition:

Competitive conditions affect the pricing decisions. Competition is a crucial

factor in price determination.Afirm can fix the price equal to or lower than that of the
competitors, provided the quality of product, in no case, be lower than that of the
competitors.

3. Suppliers:

Suppliers of raw materials and other goods can have a significant effect on
the price of a product. If the price of cotton goes up, the increase is passed on by
suppliers to manufacturers. Manufacturers, in turn, pass it on to consumers.

Sometimes, however, when a manufacturer appears to be making large profits

on a particular product, suppliers will attempt to make profits by charging more for
their supplies. In other words, the price of a finished product is intimately linked up
with the price of the raw materials. Scarcity or abundance of the raw materials also
determines pricing.

4. Economic Conditions:

The inflationary or deflationary tendency affects pricing. In recession period,

the prices are reduced to a sizeable extent to maintain the level of turnover. On the other
hand, the prices are increased in boom period to cover the increasing cost of
production and distribution. To meet the changes in demand, price etc.

Several pricing decisions are available:

(a) Prices can be boosted to protect profits against rising cost,

(b) Price protection systems can be developed to link the price on delivery to
current costs,

(c) Emphasis can be shifted from sales volume to profit margin and cost
reduction etc.

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5. Buyers:

The various consumers and businesses that buy a company’s products or

services may have an influence in the pricing decision. Their nature and behaviour for
the purchase of a particular product, brand or service etc. affect pricing when their
number is large.

6. Government:

Price discretion is also affected by the price-control by the government

through enactment of legislation, when it is thought proper to arrest the inflationary
trend in prices of certain products. The prices cannot be fixed higher, as government
keeps a close watch on pricing in the private sector. The marketers obviously can
exercise substantial control over the internal factors, while they have little, if any,
control over the external ones.

5.3 PREPARE A SURVEY REPORT ON THE DEMAND

FORECASTING OFANY PRODUCT.

Solution: Demand forecasting is the art and science of forecasting customer demand
to drive holistic execution of such demand by corporate supply chain and business
management. Demand forecasting involves techniques including both informal
methods, such as educated guesses, and quantitative methods, such as the use of
historical sales data and statistical techniques or current data from test markets.
Demand forecasting may be used in production planning, inventory management, and
at times in assessing future capacity requirements, or in making decisions on
whether to enter a new market.

Demand forecasting is predicting future demand for the product. In other

words, it refers to the prediction of probable demand for a product or a service on the
basis of the past events and prevailing trends in the present.

Demand forecasting of Maggie noodles

Nestle is the market leader with 58.3% market share in the overall
categoryandover 80% in the pure noodles category. Nestlé‘s

Maggi has been synonymous withnoodles.But over the last couple of years it

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has been losing market share on a monthly basisto new entrants like ITC’s Sunfeast
Yippee, GlaxoSmithKline’s (GSK) HorlicksFoodles, Hindustan Unilever’s (HUL)
Knorr Soupy noodles, Big Bazaar’s Tasty Treat,Top Ramen and several other smaller
players. Maggi‘s

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share of the noodle market on a pan India basis has slipped from over 90% to
around 85% in a matter of years.

Its instant noodles market share has dropped off across all parts of India at
thesame time Maggi has been market leader in the noodle‘s segment in India and has
recordedthe highest sales in this market. It took several years and lots of money
andresources for nestle to establish its noodles brand in India.

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493
4
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495
5.4 DISCUSS THE PROCESS OF BUSINESS DECISION MAKING
WITH THE HELPOF CASE STUDY.

CASE PROBLEM: Decisions about whether, when and how to downsize

(restructure). Company Southwest Airlines Southwest Airlines Co. (“Southwest”) is a
major domestic airline that provides primarily short haul, highfrequency, point to point,
low fare service. Founded in 1971 and headquartered in the US, Southwest is a
large low cost airline. Airlines rely on key inputs such as aircraft, fuel and labour in
order to operate. Like any airline it is sensitive to jet fuel prices and other operating
costs. FORTUNE has listed Southwest Airlines amongAmerica’s Top Ten most
admired corporations and previously ranked SouthwestAirlines in the top five of the
“Best Companies to Work For” in America. Today Southwest operates over 500 Boeing
737 aircraft in 66 cities. Southwest has among the lowest cost structures in the domestic
airline industry and consistently offers the lowest and simplest fares. Southwest also
has one of the best overall Customer Service records. The company is committed to
provide its employees with a stable work environment with equal opportunityfor
learning and personal growth; there are more than 35,000 employees throughout the
Southwest system. The airline is unionized (heavilyunionizedwhen compared with other
US airlines). In 1995, Southwest became one of the first airlines to have a web site. In
2006, 70 percent of flight bookings and 73 percent of revenue was generated from
bookings on southwest.com.
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 The best way to become acquainted with Managerial Economics is to come
face to face with real world decision problems. Many companies have applied
established principles of Managerial Economics to improve their profitability. In the
past decade, a number of known companies have experienced successful changes in
the economics of their business by using economic tools and techniques. Some cases
as discussed below.

CASE1: For P&G7, the 1990s was a decade of “value-oriented” consumer. The
company formulated policies in view of emergence of India as “value for money”
product market. This means that consumers are willing to pay premium price only
for quality goods. Customers are “becoming more price-sensitive and quality
conscious…more focused on self satisfaction…”7 It can, therefore, be said that
consumer preferences and tastes have come to play a vital role in the survival of
companies.

CASE2: Leading multinational players like Samsung, LG, Sony and Panasonic
cornered a large part of Indian consumer durables market in the late 1990s. This
was possible because of global manufacturing facilities and investment in technologies.
To maintain their market share, they resorted to product differentiation. These
companies introduced technologically advanced models with specific product
features and product styling.

CASE3: Apple, the companythat began the PC revolution, had always managed to
maintain its market share and profitability by differentiating its products from the
IBM PC compatibles. However, the introduction of Microsoft’s Windows operating
system gave the IBM and IBM compatible PCs the look feel, and ease of use of the
Apple Macintosh. This change in the competitive environment forced Apple to lower its
prices to levels much closer to IBM compatibles. The result has been an erosion of
profit margins. For example, between 1991 and 1993, Apple’s net profit margins
fell from 5 to 1 per cent.

CASE4: Reliance Industries has maintained top position in polymers by building a

world- scale plant and upgrading technology. This has resulted in low operating
costs due to economies of scale. Reliance Petroleum Ltd. registered a net profit of Rs.
726 crores on sales of Rs. 14,308 crores for the six months ended September30, 2000.

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Of these, exports amounted to Rs 2,138 crores, which make RPLIndia s largest
manufacturer and exporter. The overall economies of scale are in favor of
expansion. This expansion will further consolidate the position of RPL in the sector
and help in warding off rivals

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5.5 COLLECT AND PRESENT IN TABULAR FORM THE
NATIONAL INCOME OF FIVE YEARS.

Solution:

Recent Trends in Indian Economy

India has undergone a paradigm shift owing to its competitive stand in the
world. The Indian economy is on a robust growth trajectory and boasts of a stable
annual growth rate, rising foreign exchange reserves and booming capital markets
among others.

According to Ministry of Statistics and Programme Implementation

(MOSPI), Indian economy is estimated to grow at 5 percent in 2012-13 as compared
to the growth rate of 6.2 percent in 2011-12. These GDP figures are based at factor
cost at constant (2004-05) prices for the year 2012-13. As per the given data Gross
Domestic Product (GDP) at factor cost at constant (2004-05) prices in the year 2012-
13 is likely to attain a level of US$ 1013.63 billion, as against the GDP estimates for
the year 2011-12 of US$
966.56 billion.

The sectors which registered growth rate of over 5 percent are construction,
trade, hotels, transport and communication, financing, insurance, real estate and business
services, and community, social and personal services. There may be slow growth in
the sectors of agriculture, forestry and fishing (1.8 per cent), manufacturing (1.9 per
cent) and electricity, gas & water supply (4.9 per cent). The growth in the mining
and quarrying sector is estimated to be (0.4 per cent)

According to the Department of Agriculture and Cooperation (DAC), the

agriculture, forestry and fishing sector is likely to show a growth of 1.8 per cent in its
GDP during 2012-13, as against the previous year’s growth rate of 3.6 per cent.
Production of food grains is expected to decline by 2.8 per cent as compared to
growth of 5.2 per cent in the previous agriculture year. The production of cotton and
sugarcane is also expected to decline by 4.0 per cent and 6.5 per cent, respectively, in
2012-13.Among the horticultural crops, production of fruits and vegetables is expected
to increase by 3.5 per cent during the year 2012-13 as against 5.1 percent in the
previous year.
499
 The manufacturing sector is likely to show a growth of 1.9 per cent in GDP
during 2012-13. According to the latest estimates available on the Index of Industrial
Production

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(IIP), the index of manufacturing and electricity registered growth rates of 1.0 per
cent and 4.4 per cent, respectively during April-November, 2012-13, as compared
to the growth rates of 4.2 per cent and 9.5 per cent in these sectors during April-
November, 2011-12. The mining sector is likely to show a growth of 0.4 per cent
in 2012-13 as against negative growth of 0.6 per cent during 2011-12. The
construction sector is likely to show a growth rate of 5.9 per cent during 2012-13 as
against growth of 5.6 per cent in the previous year. The key indicators of construction
sector, namely, cement production and steel consumption have registered growth
rates of 6.1 per cent and 3.9 per cent, respectively during April-December, 2012-
13.

The estimated growth in GDP for the trade, hotels, and transport and
communication sectors during 2012-13 is placed at 5.2 per cent as against growth of
7.0 percent in the previous year. This is mainly on account of decline of 3.4 per
cent and 4.8 per cent respectively in passengers and cargo handled in civil aviation and
decline of 3.1 per cent in cargo handled at major sea ports during April-November,
2012-13. There has been an increase of 4.3 per cent in stock of telephone
connections as on November 2012. The sales of commercial vehicles witnessed an
increase of 0.74 per cent per cent in April- December 2012. The sector, financing,
insurance, real estate and business services, is expected to show a growth rate of 8.6
per cent during 2012-13, on account of 11.1 per cent growth in aggregate deposits and
15.2 per cent growth in bank credit as on December 2012 (against the respective
growth rates of 17.2 per cent and 16.0 per cent in the corresponding period of
previous year). The growth rate of community, social and personal services during
2012-13 is estimated to be 6.8 per cent.

The net national income (NNI) at factor cost, also known as national income,
at 2004-05 prices is likely to be US$ 877.38 billion during 2012-13, as against the
previous year’s estimate of US$ 842.42 billion. In terms of growth rates, the
national income registered a growth rate of 4.2 per cent in 2012-13 as against the
previous year’s growth rate of 6.1 per cent.

The per capita income in real terms (at 2004-05 prices) during 2012-13 is
likely to attain a level of US$ 721.06 as compared to the estimate for the year 2011-
12 of US$ 700.851. The growth rate in per capita income is estimated at 2.9 per cent
501
during 2012- 13, as against the previous year’s estimate of 4.7 per cent.

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Growth in Gross Domestic Product

Percentage change for economic activities are depicted in table below:

Percentage change over previous year

S. No. Industry at constant (2004-05 at current prices
prices)
2011-12 2012-13 2011-12 2012-13
1 Agriculture, forestry& fishing 3.6 1.8 12.2 12.1
2 Mining & quarrying -0.6 0.4 2.5 11.7
3 Manufacturing 2.7 1.9 11.2 7.7
4 Electricity, gas & water supply 6.5 4.9 10.5 18.3
5 Construction 5.6 5.9 15.1 13.9
6 Trade, hotels, transport & 7.0 5.2 18.5 12.8
communication
7 Financing, insurance, real 11.7 8.6 18.7 17.3
estate & business services
8 Community, social & personal 6.0 6.8 14.9 16.0
services
Total GDP 6.2 5.0 15.0 13.3

Real GDP growth or Gross Domestic

Product (GDP) growth of India at constant (2011-12) prices in the year 2015-16 is
estimated at
7.56 percent as compared to the growth rate of 7.24 percent in 2014-15. Quarterly
GDP growth rates are: Q1 (7.5%), Q2 (7.6%), Q3 (7.2%), Q4 (7.9%).

GVA growth rates of Agriculture & allied, Industry, and Services sector are
1.25%, 7.4%, and 8.92%, respectively. Manufacturing growth is at 9.3%. India has
registered highest growth of 10.3% in ‘Financial, real estate & professional
services’ sector and lowest 1.2% in ‘Agriculture, forestry & fishing’ sector.
503
 At current prices, GDP growth rates for year 2015-16 is 8.71%. Growth for
Q1, Q2, Q3 and Q4 are 8.8%, 6.4%, 9.1% and 10.4%, respectively.

At constant prices GVA (Gross Value Added), GNI (Gross National

Income), NNI (Net National Income) growth of India is estimated at 7.2%, 7.5%
and 7.6%, respectively. At curent prices these figures is 7.0%, 8.7% and 8.7%.

Data from 1950-51 to 2011-12 is from 2004-05 series and 2011-12 to 2014-
15 is from 2011-12 series.

According to IMF World Economic Outlook (April-2016), GDP growth rate

of India in 2015 is 7.336% and India is 9th fastest growing nation of the world. In
2014, India was 14th fastest growing nation of the world with GDP growth rate of
7.244%. Average growth rate from 1980 to 2014 stands at 6.27%, reaching an all
time high of 10.26% in 2010 and a record low of 1.06% in the 1991.

In previous methodology, Average growth rate from 1951 to 2014 stands

at 4.96%, reaching an all time high of 10.16% in 1988-89 and a record low of -5.2%
in the 1979-80. In 4 years, Growth was negative.

2011-12 Series
Year Growth at 2011-12 prices Growth at current prices
GDP GVA GNI NNI GDP GVA GNI NNI

2012-13 5.6 5.4 5.3 4.7 13.9 13.6 13.6 13.3

2013-14 6.6 6.3 6.6 6.2 13.3 12.7 13.2 13.2
2014-15 7.2 7.1 7.3 7.2 10.8 10.5 10.8 10.8
2015-16 7.6 7.2 7.5 7.6 8.7 7.0 8.7 8.7

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505
 Title: Economics for Managerial Decisions
Course No. : BC-203 Title: Economics for Managerial
Decisions Duration of Examination : 3 hours Total Marks :
100 Theory Examination : 80
Internal Assessment : 20
OBJECTIVE : This course aims to prepare the students to understand and analyse
over a remarkable range of business issues and phenomena of decision
making.
UNIT I : INTRODUCTION
Nature : importance, role of managerial economics, principles in
managerial decision analysis, Managerial economics- Apositive or
normative science; Approaches to managerial decision making..
UNIT II : MARKET DEMAND ANALYSIS
Meaning, determinants of demand, factos influencing market demand,
typesof demand schedule, types of demand, effect of economic slowdown
on market demand.
UNIT III : PRICING POLICYAND PROFIT POLICY
Introduction, objectives of price policy, factors determining price
policy, methods of pricing, practical aspects of pricing decision; Profit
policy- Reasons for controlling profits, problems in profit policy.
UNIT IV : KNOWLEDGE BASED ECONOMY
Meaning, features, frame work of knowledge economy, K- profit
analysis, steps for developing K- economy and constraints to the growth of
K- economy. Concepts, significance and components of national
income, Methods of calculating national income, problems in
measurements of national inome.

SKILL DEVELOPMENT (SPECIMEN FOR CLASS ROOM

TEACHING AND INTERNALASSESSMENT)
Draw a chart for approaches to managerial decisions.
Chart out the factors influencing price policy.
300
Prepare a surve report on the demand forecasting of any product.
Discuss the process of business decision making with the help of a case study.

507
 Collect and present in tabular form the national income of last five years.
BOOKS RECOMMENDED
1. MITHANI. D.M. : Managerial Economics-
Theory & Application,
Himalaya Publishing House
PVT. Ltd..
New Delhi
2. Diwedi, D.N. : Managerial Economs, Vikas Publisdhishing
House Pvt. Ltd, New Delhi
3. Gupta, G.S. : Macro-Economic- Theory & Application, Tata
McGraw Hill Publishing house Pvt. Ltd., New
Delhi.
4. Vaish, M.C. : Macro-Economic Theory, Vikas Pubishing
House Pvt. Ltd., New Delhi.
5. Mishra, S.K. & Puri,: Modern Macro Economic Theroy, Himalayan
V.K. Publishing House.
6. Edward Shapiro : Macro-Economic Analysis, Tata MGraw Hill,
New Delhi
7. Jhingam, M.L. & : Managerial Economics,Vrinda Publiations
Pvt. Stephen, J.K Ltd., Delhi.
8. Dingra, I.C : Managerial Economics, Sultan Chand,
New Delhi.

NOTE FOR PAPER SETTER

Equal weightage shalll be given to all the units of the syllabus. The external paper
shall be of the two sections viz, A & B
Section - A : This section will contain four short anwer quetions seleting one from
eah unit. Each question carries 5 marks. A candidate is required to
attempt all the four quetions. Total weightage to this section shall be 20
mark.
Section - B : This section will contain eight long answer question of 15 marks
each. Two questions with internal choice will be set from each unit. A
candidate has to attempt any four questions selecting one from each
unit. Total weightage to 300
this section shall be 60 marks.

301
 MODEL QUESTION PAPER

ECONOMICS FOR MANAGERIAL

DECISIONS
Section - A (20 Marks)

Attempt all the questions. Each question carries five marks.

1. State the role of managerial economics?

2. Briefly state the various types of demand?
3. What are the objetives of price policy?
4. State the framework of K-economy?
Section B

Attempt anyfour questions selecting one questionfrom each unit. Each question carries 15
marks.

1. Discuss the principles of managerial decision analysis?

OR
State the relationship between micro eonomics, macro economics and
managerial economics ?
2. Explain the effect of economic slowdown on market
demand ? OR
Explain the factor influencing market demand ?
3. Explain the methods of price determination ?
OR
Briefly state the criteria for acceptable rate of return on investment ?
4. Explain the steps in developing K-economy ?
OR
Outline the contraint in the growth & development of K-economy?
 MANAGERIAL ECONOMICS

CONTENTS

LESSON PAGE
NO. NO.

UNIT-I
1. Mangerial Economics 1-21
2. Managerial Decision Analysis 22-36
3. Managerial Economics-A Poitive or Normative Science 37-47
4. Approaches to Managerial Decisions 48-60
UNIT-II
5. DemandAnalysis 61-69
6. Market Demad Analysis 70-79
7. Market Demand Schedule 80-90
8. Economic Slowdown 91-99
UNIT-III
9. Pricing Policy 100-112
10. Pricing Methods 113-151
11. Profit Policy 152-168
12. Profit Planning and Control 169-186
UNIT-IV
13. Knowledge Based Economy 187-200
14. Growth of Knowledge Economy 201-226
15. National Income 227-251
16. Measuring National Income 252-278
17-20 Skill Development 279-298

302 303
 MANAGERIAL ECONOMICS

Course Contributors

• Ms. Ritika Samyal

© Directorate of Distance Education, University of Jammu, Jammu, 2017

• All rights reserved. No part of this work may be reproduced in any form, by
mimeograph or any other means, without permisison in writing from the
DDE, University of Jammu.

• The script writer shall be responsible for the lesson / script submitted to the
DDE and any plagiarism shall be his / her entire responsibility.

Printed at : Printech / 19 / 285

304
Directorate of Distance Education
UNIVERSITY OF JAMMU
JAMMU

http:/www.distanceeducationju.in
Printed and Published on behalf of the Directorate of Distance Education,
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305