Module 1

NATURE & SCOPE OF MANAGERIAL ECONOMICS

The terms Managerial Economics and Business Economics are often used interchangeably. However, the

terms Managerial Economics has become more popular and seems to displace Business Economics.

DECISION-MAKING AND FORWARD PLANNINGThe chief function of a management executive in a business firm is decision-making and forward planning.

Decision-making refers to the process of selecting one action from two or more alternative courses of action.

Forward planning on the other hand is arranging plans for the future. In the functioning of a firm the question

of choice arises because the available resources such as capital, land, labour and management, are limited

and can be employed in alternative uses. The decision-making function thus involves making choices or

decisions that will provide the most efficient means of attaining an organisational objectives, for example

profit maximization. Once a decision is made about the particular goal to be achieved, plans for the future

regarding production, pricing, capital, raw materials and labour are prepared. Forward planning thus goes

hand in hand with decision-making. The conditions in which firms work and take decisions, is characterised

with uncertainty. And this uncertainty not only makes the function of decision-making and forward planning

complicated but also adds a different dimension to it. If the knowledge of the future were perfect, plans could

be formulated without error and hence without any need for subsequent revision. In the real world, however,

the business manager rarely has complete information about the future sales, costs, profits, capital

conditions. etc. Hence, decisions are made and plans are formulated on the basis of past data, current

information and the estimates about future that are predicted as accurately as possible. While the plans are

implemented over time, more facts come into the knowledge of the businessman. In accordance with these

facts the plans may have to be revised, and a different course of action needs to be adopted. Managers are

thus engaged n a continuous process of decision-making through an uncertain future and the overall

problem that they deal with is adjusting to uncertainty.

To execute the function of ‘decision-making in an uncertain frame-work’, economic theory can be

applied with considerable advantage. Economic theory deals with a number of concepts and principles

relating to profit, demand, cost, pricing, production, competition, business cycles and national income, which

are aided by allied disciplines like accounting. Statistics and Mathematics also can be used to solve or at

least throw some light upon the problems of business management. The way economic analysis can be

used towards solving business problems constitutes the subject matter of Managerial Economics.

DEFINITIONAccording to McNair the Merriam, Managerial Economics consists of the use of economic modes of thought

to analyse business situations.

Spencer and Siegelman have defined Managerial Economics as “the integration of economic

theory with business practice for the purpose of facilitating decision-making and forward planning by

management.”

The above definitions suggest that Managerial economics is the discipline, which deals with the

application of economic theory to business management. Managerial Economics thus lies on the margin

between economics and business management and serves as the bridge between the two disciplines. The

following Figure 1.1 shows the relationship between economics, business management and managerial

economics.

APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENTThe application of economics to business management or the integration of economic theory with business

practice, as Spencer and Siegelman have put it, has the following aspects :

Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions: In economic theory, the technique of analysis is that of model building.

This involves making some assumptions and, drawing conclusions on the basis of the assumptions

about the behavior of the firms. The assumptions, however, make the theory of the firm unrealistic

since it fails to provide a satisfactory explanation of what the firms actually do. Hence, there is need

to reconcile the theoretical principles based on simplified assumptions with actual business practice

and develop appropriate extensions and reformulation of economic theory. For example, it is

usually assumed that firms aim at maximising profits. Based on this, the theory of the firm suggests

how much the firm will produce and at what price it would sell. In practice, however, firms do not

always aim at maximum profits (as they may think of diversifying or introducing new product etc.)

To that extent, the theory of the firm fails to provide a satisfactory explanation of the firm’s actual

behavior. Moreover, in actual business language, certain terms like profits and costs have

accounting concepts as distinguished from economic concepts. In managerial economics, an

attempt is made to merge the accounting concepts with the economics, an attempt is made to

merge the accounting concepts with the economic concepts. This helps in a more effective use of

financial data related to profits and costs to suit the needs of decision-making and forward

planning.

Estimating economic relationships: This involves the measurement of various types of

elasticities of demand such as price elasticity, income elasticity, cross-elasticity, promotional

elasticity and cost-output relationships. The estimates of these economic relationships are to be

used for the purpose of forecasting.

Predicting relevant economic quantities: Economic quantities such as profit, demand,

production, costs, pricing and capital are predicated in numerical terms together with their

probabilities. As the business manager has to work in an environment of uncertainty, the future

needs to be foreseen so that in the light of the predicted estimates, decision-making and forward

planning may be possible.

Using economic quantities in decision-making and forward planning: This involves

formulating business policies for establishing future business plans. This nature of economic

forecasting indicates the degree of probability of various possible outcomes, i.e., losses or gains

that will occur as a result of following each one of the available strategies. Thus, a quantified

picture gets set up, that indicates the number of courses open, their possible outcomes and the

quantified probability of each outcome. Keeping this picture in view, the business manager is able

to decide about which strategy should be chosen.

Understanding significant external forces: Applying economic theory to business management

also involves understanding the important external forces that constitute the business environment

and with which a business must adjust. Business cycles, fluctuations in national income and

government policies pertaining to taxation, foreign trade, labour relations, antimonopoly measures,

industrial licensing and price controls are typical examples. The business manager has to appraise

the relevance and impact of these external forces in relation to the particular business unit and its

business policies.

CHARACTERISTICS OF MANAGERIAL ECONOMICSThere are certain chief characteristics of managerial economics, which can help to understand the nature of

the subject matter and help in a clear understanding of the following terms:

Managerial economics is micro-economic in character. This is because the unit of study is a firm

and its problems. Managerial economics does not deal with the entire economy as a unit of study.

Managerial economics largely uses that body of economic concepts and principles, which is known

as Theory of the Firm or Economics of the Firm. In addition, it also seeks to apply profit theory,

which forms part of distribution theories in economics.

Managerial economics is concrete and realistic. I avoids difficult abstract issues of economic

theory. But it also involves complications ignored in economic theory in order to face the overall

situation in which decisions are made. Economic theory ignores the variety of backgrounds and

training found in individual firms. Conversely, managerial economics is concerned more with the

particular environment that influences decision-making.

Managerial economics belongs to normative economics rather than positive economics. Normative

economy is the branch of economics in which judgments about the desirability of various policies

are made. Positive economics describes how the economy behaves and predicts how it might

change. In other words, managerial economics is prescriptive rather than descriptive. It remains

confined to descriptive hypothesis.

Managerial economics also simplifies the relations among different variables without judging what

is desirable or undesirable. For instance, the law of demand states that as price increases, demand

goes down or vice-versa but this statement does not imply if the result is desirable or not.

Managerial economics, however, is concerned with what decisions ought to be made and hence

involves value judgments. This further has two aspects: first, it tells what aims and objectives a firm

should pursue; and secondly, how best to achieve these aims in particular situations. Managerial

economics, therefore, has been described as normative microeconomics of the firm.

Macroeconomics is also useful to managerial economics since it provides an intelligent

understanding of the business environment. This understanding enables a business executive to

adjust with the external forces that are beyond the management’s control but which play a crucial

role in the well being of the firm. The important forces are: business cycles, national income

accounting, and economic policies of the government like those relating to taxation foreign trade,

anti-monopoly measures and labour relations.

DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICSThe difference between managerial economics and economics can be understood with the help of the

following points:

Managerial economics involves application of economic principles to the problems of a business

firm whereas; economics deals with the study of these principles only. Economics ignores the

application of economic principles to the problems of a business firm.

Managerial economics is micro-economic in character, however, Economics is both macro-

economic and micro-economic.

Managerial economics, though micro in character, deals only with a firm and has nothing to do with

an individual’s economic problems. But microeconomics as a branch of economics deals with both

economics of the individual as well as economics of a firm.

Under microeconomics, the distribution theories, viz., wages, interest and profit, are also dealt with.

Managerial economics on the contrary is mainly concerned with profit theory and does not consider

other distribution theories. Thus, the scope of economics is wider than that of managerial

economics.

Economic theory assumes economic relationships and builds economic models. Managerial

economics adopts, modifies and reformulates the economic models to suit the specific conditions

and serves the specific problem solving process. Thus, economics gives the simplified model,

whereas managerial economics modifies and enlarges it.

Economics involves the study of certain assumptions like in the law of proportion where it is

assumed that “The variable input as applied, unit by unit is homogeneous or identical in amount

and quality”. Managerial economics on the other hand, introduces certain feedbacks. These

feedbacks are in the form of objectives of the firm, multi-product nature of manufacture, behavioral

constraints, environmental aspects, legal constraints, constraints on resource availability, etc. Thus

managerial economics, attempts to solve the complexities in real life, which are assumed in

economics. this is done with the help of mathematics, statistics, econometrics, accounting,

operations research, etc.

OTHER TERMS FOR MANAGERIAL ECONOMICSCertain other expressions like economic analysis for business decisions and economics of business

management have also been used instead of managerial economics but they are not so popular. Sometimes

expressions like ‘Economics of the Enterprise’, ‘Theory of the Firm’ or ‘Economics of the Firm’ have also

been used for managerial economics. It is, however, not appropriate t use theses terms because managerial

economics, though primarily related to the economics of the firm, differs from it in the following respects:

First, ‘Economics of the Firm’ deals with the theory of the firm, which is a body of economic

principles relating to the firm alone. Managerial economics on the other hand deals with the,

application of the same principles to business.

Secondly, the term ‘Economics of the firm’ is too simple in its assumptions whereas managerial

economics has to reckon with actual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICSAs regards the scope of managerial economics, there is no general uniform pattern. However, the following

aspects may be said to be inclusive under managerial economics:

Demand analysis and forecasting.

Cost and production analysis.

Pricing decisions, policies and practices.

Profit management.

Capital management.

These aspects may also be defined as the ‘Subject-Matter of Managerial Economics’. In recent

years, there is a trend towards integrations of managerial economics and operations research. Hence,

techniques such as linear programming, inventory models and theory of games have also been regarded as

a part of managerial economics.

Demand Analysis and ForecastingA business firm is an economic Organisation, which transforms productive resources into goods that are to

be sold in a market. A major part of managerial decision-making depends on accurate estimates of demand.

This is because before production schedules can be prepared and resources are employed, a forecast of

future sales is essential. This forecast can also guide the management in maintaining or strengthening the

market position and enlarging profits. The demand analysis helps to identify the various factors influencing

demand for a firm’s product and thus provides guidelines to manipulate demand. Demand analysis and

forecasting, thus, is essential for business planning and occupies a strategic place in managerial economics.

It comprises of discovering the forces determining sales and their measurement. The chief topics covered in

this are:

Demand determinants

Demand distinctions

Demand forecasting.

Cost and Production AnalysisA study of economic costs, combined with the data drawn from the firm’s accounting records, can yield

significant cost estimates. These estimates are useful for management decisions. The factors causing

variations in costs must be recognised and thereby should be used for taking management decisions. This

facilitates the management to arrive at cost estimates, which are significant for planning purposes. An

element of cost uncertainty exists in this because all the factors determining costs are not always known or

controllable. Therefore, it is essential to discover economic costs and measure them for effective profit

planning, cost control and sound pricing practices. Production analysis is narrower in scope than cost

analysis. The chief topics covered under cost and production analysis are:

Cost concepts and classifications

Cost-output relationships

Economics of scale

Production functions

Cost control.

Pricing Decisions, Policies and Practices Pricing is a very important area of managerial economics. In fact price is the origin of the revenue of a firm.

As such the success of a usiness firm largely depends on the accuracy of price decisions of that firm. The

important aspects dealt under area, are as follows:

Price determination in various market forms

Pricing methods

Differential pricing product-line pricing and price forecasting.

Profit ManagementBusiness firms are generally organised with the purpose of making profits. In the long run, profits provide the

chief measure of success. In this connection, an important point worth considering is the element of

uncertainty existing about profits. This uncertainty occurs because of variations in costs and revenues.

These are caused by factors such as internal and external. If knowledge about the future were perfect, profit

analysis would have been a very easy task. However, in a world of uncertainty, expectations are not always

realised. Thus profit planning and measurement make up the difficult area of managerial economics. The

important aspects covered under this area are:

Nature and measurement of profit.

Profit policies and techniques of profit planning.

Capital ManagementAmong the various types and classes of business problems, the most complex and troublesome for the

business manager are those relating to the firm’s capital investments. Capital management implies planning

and control and capital expenditure. In this procedure, relatively large sums are involved and the problems

are so complex that their disposal not only requires considerable time and labour but also top-level

decisions. The main elements dealt with cost management are:

Cost of capital

Rate of return and selection of projects.

The various aspects outlined above represent the major uncertainties, which a business firm has to

consider viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty and capital

uncertainty. We can, therefore, conclude that managerial economics is mainly concerned with applying

economic principles and concepts to adjust with the various uncertainties faced by a business firm.

MANAGERIAL ECONOMICS AND OTHER SUBJECTS

Yet another useful method of explaining the nature and scope of managerial economics is to examine its

relationship with other subjects. The following discussion helps to understand relationship between

managerial economics and economics, statistics, mathematics, accounting and operations research.

Managerial Economics and EconomicsManagerial economics is defined as a subdivision of economics that deals with decision-making. It may be

viewed as a special branch of economics bridging the gulf between pure economic theory and managerial

practice. Economics has two main divisions-microeconomics and Macroeconomics. Microeconomics has

been defined as that branch where the unit of study is an individual or a firm. It is also called “price theory”

(or Marshallian economics) and is the main source of concepts and analytical tools for managerial

economics. To illustrate, various micro-economic concepts such as elasticity of demand, marginal cost, the

short and the long runs, various market forms, etc., are all of great significance to managerial economics.

Macroeconomics, on the other hand, is aggregative in character and has the entire economy as a

unit of study. The chief contribution of macroeconomics to managerial economics is in the area of

forecasting. The modern theory of income and employment has direct implications for forecasting general

business conditions. As the prospects of an individual firm often depend greatly on general business

conditions, individual firm forecasts rely on general business forecasts.

A survey in the U.K. has shown that business economists have found the following economic

concepts quite useful and of frequent application:

Price elasticity of demand

Income elasticity of demand

Opportunity cost

Multiplier

Propensity to consume

Marginal revenue product

Speculative motive

Production function

Liquidity preference

Business economists have also found the following main areas of economics as useful in their

work. Demand theory

Theory of firms – price, output and investment decisions

Business financing

Public finance and fiscal policy

Money and banking

National income and social accounting

Theory of international trade

Economies of developing countries.

Thus, it is obvious that Managerial Economics is very closely related to Economics.

Managerial Economics and StatisticsStatistics is important to managerial economics in several ways. Managerial economics calls for the

organising quantitative data and deriving a useful measure of appropriate functional relationships involved in

decision-making. For instance, in order to base its pricing decisions on demand and cost considerations, a

firm should have statistically derived or calculated demand and cost functions. Managerial economics also

employs statistical methods for experimental testing of economic generalisations. The generalisations can

be accepted in practice only when they are checked against the data from the world of reality and are found

valid. Managers do not have exact information about the variables affecting decisions and have to deal with

the uncertainty of future events. The theory of probability, upon which statistics is based, provides logic for

dealing with such uncertainties.

Managerial Economics and MathematicsMathematics is yet another important subject closely related to managerial economics. This is because

managerial economics is mathematical in character, as it involves estimating various economic

relationships, predicting relevant economic quantities and using them in decision-making and forward

planning. Knowledge of geometry, trigonometry ad algebra is not only essential but also certain

mathematical tools and concepts such as logarithms and exponential, vectors, determinants, matrix,

algebra, calculus, differential as well as integral, are the most commonly used devices. Further, operations

research, which is closely related to managerial economics, is mathematical in character. It provides and

analyses data ad develops models, benefiting from the experiences of experts drawn from different

disciplines, viz., psychology, sociology, statistics and engineering.

MANAGERIAL ECONOMICS AND ACCOUNTINGManagerial economics is also closely related to accounting, which is concerned with recording the financial

operations of a business firm. In fact, a managerial economist depends chiefly on the accounting information

as an important source of data required for his decision-making purpose. for instance, the profit and loss

statement of a firm shows how well the firm has done and whether the information it contains can be used

by managerial economist to throw significant light on the future course of action that is whether the firm

should improve its productivity or close down. Therefore, accounting data require careful interpretation,

reconstruction and adjustments before they can be used safely and effectively. It is in this context that the

link between management accounting and managerial economics deserves special mention. The main task

of management accounting is to provide the sort of data, which managers need if they are to apply the ideas

of managerial economics to solve business problems correctly. The accounting data should be provided in

such a form that they fit easily into the concepts and analysis of managerial economics.

Managerial Economics and Operations ResearchOperations research is a subject field that emerged during the Second World War and the years thereafter.

A good deal of interdisciplinary research was done in the USA. as well as other western countries to solve

the complex operational problems of planning and resource allocation in defence and basic industries.

Several experts like mathematicians, statisticians, engineers and others teamed up together and developed

models and analytical tools leading to the emergence of this specialised subject. Much of the development

of techniques and concepts, such as linear programming, inventory models, game theory, etc., emerged

from the working of the operation researchers. Several problems of managerial economics are solved by the

operation research techniques. These highlight the significant relationship between managerial economics

and operations research. The problems solved by operation research are as follows:

Allocation problems: An allocation problem confronts with the issue that men, machines and

other resources are scarce, related to the number sand size of the jobs that need to be completed.

The examples are production programming and transportation problems.

Competitive problems: competitive problems deal with situations where managerial decision-

making is to be made in the face of competitive action. That is, one of the factors to be considered

is: “What will competitors do if certain steps are taken?” Price reduction, for example, will not lead

to increased market share if rivals follow suit.

Waiting line problems : Waiting line problems arise when a firm wants to know how many

machines it should install in order to ensure that the amount of ‘work-in-progress’ waiting to be

machined is neither too small nor too large. Such situations arise when for example, a post office,

or a bank wants to know how many cash desks or counter clerks it should employ in order to

balance the business lost through long guesses against the cost of installing more equipment or

hiring more labour.

Inventory problems: Inventory problems deal with the principal question: “What is the optimum

level of stocks of raw-materials, components or finished goods for the firm to hold?”

The above discussion explains that the managerial economics is closely related to certain subjects such

as economics, statistics, mathematics and accounting. A trained managerial economist combines concepts

and methods from all these subjects by bringing them together to solve business problems. In particular,

operations research and management accounting are getting very close to managerial economics.

USES OF MANAGERIAL ECONOMICSManagerial economics achieves several objectives. The principal objectives are as follows:

It presents those aspects of traditional economics, which are relevant for business decision-making

in real life. For this purpose, it picks from economic theory those concepts, principles and

techniques of analysis, which are concerned with the decision-making process. These are adapted

or modified in such a way that it enables the manager to take better decisions. Thus, managerial

economics attains the objective of building a suitable tool kit from traditional economics.

Managerial economics also incorporates useful ideas from other disciplines such as psychology,

sociology, etc. If they are found relevant for decision-making. In fact, managerial economics takes

the aid of other academic disciplines that are concerned with the business decisions of a manager

in view of the various explicit and implicit constraints subject to which resource allocation is to be

optimised.

It helps in reaching a variety of business decisions even in a complicated environment. Certain

examples of such decisions are those decisions concerned with:

o The products and services to be produced

o The inputs and production techniques to be used

o The quantity of output to be produced and the selling prices to be subscribed

o The best sizes and locations of new plants

o Time of replacing the equipment

o Allocation of the available capital

Managerial economics helps a manager to become a more competent model builder. Thus, he can

pick out the essential relationships, which characterise a situation and leave out the other

unwanted details and minor relationships.

At the level of the firm, functional specialists or functional departments exist, e.g., finance,

marketing, personnel, production etc. For these various functional areas, managerial economics

serves as an integrating agent by co-ordinating the different areas. It then applies the decisions of

each department or specialist, those implications, which are pertaining to other functional areas.

Thus managerial economics enables business decision-making to operate not with an inflexible

and rigid but with an integrated perspective. This integration is important because the functional

departments or specialists often enjoy considerable autonomy and achieve conflicting

goals.Managerial economics keeps in mind the interaction between the firm and society and

accomplishes the key role of business as an agent in attaining social economic welfare. There is a

growing awareness that besides its obligations to shareholders, business enterprise has certain

social obligations as well. Managerial economics focuses on these social obligations while taking

business decisions. By doing so, it serves as an instrument of furthering the economic welfare of

the society through socially oriented business decisions.

Thus, it is evident that the applicability and usefulness of managerial economics is obtained by

performing the following activates:

Borrowing and adopting the tool-kit from economic theory.

Incorporating relevant ideas from other disciplines to achieve better business decisions.

Serving as a catalytic agent in the course of decision-making by different functional

departments/specialists at the firm’s level.

Accomplishing a social purpose by adjusting business decisions to social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICSEconomic theory offers a variety of concepts and analytical tools that can assist the manager in the

decision-making practices. Problem solving in business has, however, found that there exists a wide

disparity between the economic theory of a firm and actual observed practice, thus necessitating the use of

many skills and be quite useful to examine two aspects in this regard:

The basic tools of managerial economics which it has borrowed from economics, and

The nature and extent of gap between the economic theory of the firm and the managerial theory of

the firm.

Basic Economic Tools in Managerial EconomicsThe most significant contribution of economics to managerial economics lies in certain principles, which are

basic to the entire range of managerial economics. The basic principles may be identified as follows:

1. Opportunity Cost PrincipleThe opportunity cost of a decision means the sacrifice of alternatives required by that decision. This can be

best understood with the help of a few illustrations, which are as follows:

The opportunity cost of the funds employed in one’s own business is equal to the interest that could

be earned on those funds if they were employed in other ventures.

The opportunity cost of the time as an entrepreneur devotes to his own business is equal to the

salary he could earn by seeking employment.

The opportunity cost of using a machine to produce one product is equal to the earnings forgone

which would have been possible from other products.

The opportunity cost of using a machine that is useless for any other purpose is zero since its use

requires no sacrifice of other opportunities.

If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is

equal to the quantity of Y, which it would have produced. If that machine can produce 10 units of X

or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y.

If no information is provided about quantities produced, except about their prices then the

opportunity cost can be computed in terms of the ratio of their respective prices, say Px/Py.

The opportunity cost of holding Rs. 500 as cash in hand for one year is equal to the 10% rate of

interest, which would have been earned had the money been kept as fixed deposit in a bank. Thus,

it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no

sacrifice, its opportunity cost is nil.

For decision-making, opportunity costs are the only relevant costs. The opportunity cost principle

may be stated as under:

“The cost involved in any decision consists of the sacrifices of alternatives required by that

decision. If there are no sacrifices, there is no cost.”

Thus in macro sense, the opportunity cost of more guns in an economy is less butter. That is the

expenditure to national fund for buying armour has cost the nation of losing an opportunity of buying more

butter. Similarly, a continued diversion of funds towards defence spending, amounts to a heavy tax on

alternative spending required for growth and development.

2. Incremental PrincipleThe incremental concept is closely related to the marginal costs and marginal revenues of economic theory.

Incremental concept involves two important activities which are as follows:

Estimating the impact of decision alternatives on costs and revenues.

Emphasising the changes in total cost and total cost and total revenue resulting from changes in

prices, products, procedures, investments or whatever may be at stake in the decision.

The two basic components of incremental reasoning are as follows:

Incremental cost: Incremental cost may be defined as the change in total cost resulting from a

particular decision.

Incremental revenue: Incremental revenue means the change in total revenue resulting from a

particular decision.

The incremental principle may be stated as under:

A decision is obviously a profitable one if:

o It increases revenue more than costs

o It decreases some costs to a greater extent than it increases other costs

o It increases some revenues more than it decreases other revenues

o It reduces costs more that revenues.

Some businessmen hold the view that to make an overall profit, they must make a profit on every

job. Consequently, they refuse orders that do not cover full cost (labour, materials and overhead) plus a

provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit

maximisation in the short run. A refusal to accept business below full cost may mean rejection of a possibility

of adding more to revenue than cost. The relevant cost is not the full cost but rather the incremental cost. A

simple problem will illustrate this point.

IIIustration

Suppose a new order is estimated to bring in additional revenue of Rs. 5,000. The costs are estimated as

under:

Labour Rs. 1,500

Material Rs. 2,000

Overhead (Allocated at 120% of labour cost) Rs. 1,800

Selling administrative expenses

(Allocated at 20% of labour and material cost) Rs. 700

Total Cost Rs. 6,000

The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can

be, utilised to execute this order then the order can be accepted. If the order adds only Rs. 500 of overhead

(that is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of

supervision, and so on), Rs. 1,000 by way of labour cost because some of the idle workers already on the

payroll will be deployed without added pay and no extra selling and administrative cost then the incremental

cost of accepting the order will be as follows.

Labour Rs. 1,500

Material Rs. 2,000

Overhead Rs. 500

Total Incremental Cost Rs. 3,500

While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears

that it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does not

mean that the firm should accept all orders at prices, which cover merely their incremental costs. The

acceptance of the Rs. 5,000 order depends upon the existence of idle capacity and labour that would go

unutilised in the absence of more profitable opportunities. Earley’s study of “excellently managed” large firms

suggests that progressive corporations do make formal use of incremental analysis. It is, however,

impossible to generalise on the use of incremental principle, since the observed behaviour is variable.

3. Principle of Time Perspective The economic concepts of the long run and the short run have become part of everyday language.

Managerial economists are also concerned with the short-run and long-run effects of decisions on revenues

as well as on costs. The actual problem in decision-making is to maintain the right balance between the

long-run and short-run considerations. A decision may be made on the basis of short-run considerations, but

may in the course of time offer long-run repercussions, which make it more or less profitable than it

appeared at first. An illustration will make this point clear.

IIIustrationSuppose there is a firm with temporary idle capacity. An order for 5,000 units comes to management’s

attention. The customer is willing to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more. The

short-run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead

and profit is Re. 1.00 per unit (Rs. 5,000 for the lot. However, the long-run repercussions of the order ought

to be taken into account are as follows:

If the management commits itself with too much of business at lower prices or with a small

contribution, it may not have sufficient capacity to take up business with higher contributions when

the opportunity arises. The management may be compelled to consider the question of expansion

of capacity and in such cases; even the so-called fixed costs may become variable.

If any particular set of customers come to know about this low price, they may demand a similar

low price. Such customers may complain of being treated unfairly and feel discriminated. In

response, they may opt to patronise manufacturers with more decent views on pricing. The

reduction or prices under conditions of excess capacity may adversely affect the image of the

company in the minds of its clientele, which will in turn affect its sales.

It is, therefore, important to give due consideration to the time perspective. The principle of time

perspective may be stated as under: ‘A decision should take into account both the short-run and long-run

effects on revenues and costs and maintain the right balance between the long-run and short-run

perspectives.”

Haynes, Mote and Paul have cited the case of a printing company. This company pursued the

policy of never quoting prices below full cost though it often experienced idle capacity and the management

was fully aware that the incremental cost was far below full cost. This was because the management

realised that the long-run repercussions of pricing below full cost would make up for any short-run gain. The

management felt that the reduction in rates for some customers might have an undesirable effect on

customer goodwill particularly among regular customers not benefiting from price reductions. It wanted to

avoid crating such an “image” of the firm that it exploited the market when demand was favorable but which

was willing to negotiate prices downward when demand was unfavorable.

4. Discounting Principle One of the fundamental ideas in economics is that a rupee tomorrow is worth less than a rupee today. This

seems similar to the saying that a bird in hand is worth two in the bush. A simple example would make this

point clear. Suppose a person is offered a choice to make between a gift of Rs. 100 today or Rs. 100 next

year. Naturally he will choose the Rs. 100 today.

This is true for two reasons. First, the future is uncertain and there may be uncertainty in getting

Rs. 100 if the present opportunity is not availed of. Secondly, even if he is sure to receive the gift in future,

today’s Rs. 100 can be invested so as to earn interest, say, at 8 percent so that. one year after the Rs. 100

of today will become Rs. 108 whereas if he does not accept Rs. 100 today, he will get Rs. 100 only in the

next year. Naturally, he would prefer the first alternative because he is likely to gain by Rs. 8 in future.

Another way of saying the same thing is that the value of Rs. 100 after one year is not equal to the value of

Rs. 100 of today but less than that. To find out how much money today is equal to Rs. 100 would earn if one

decides to invest the money. Suppose the rate of interest is 8 percent. Then we shall have to discount Rs.

100 at 8 per cent in order to ascertain how much money today will become Rs. 100 one year after. The

formula is:

V =

Rs. 100

1 + i

where,

V = present value

i = rate of interest.

Now, applying the formula, we get

V =

Rs. 100

1 + i

=

100

1.08

If we multiply Rs. 92.59 by 1.08, we shall get the amount of money, which will accumulate at 8 per cent

after one year.

92.59 x 1.08 = 99.0072

= 1.00

The same reasoning applies to longer periods. A sum of Rs. 100 two years from now is worth:

V =

Rs. 100

=

Rs. 100

=

Rs. 100

(1+i)2 (1.08)2 1.1664

Similarly, we can also check by computing how much the cumulative interest will be after two

years. The principle involved in the above discussion is called the discounting principle and is stated as

follows: “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and

revenues to present values before a valid comparison of alternatives is possible.”

5. Equi-marginal PrincipleThis principle deals with the allocation of the available resource among the alternative activities. According

to this principle, an input should be allocated in such a way that the value added by the last unit is the same

in all cases. This generalisation is called the equi-marginal principle.

Suppose a firm has 100 units of labour at its disposal. The firm is engaged in four activities, which

need labour services, viz., A, B, C and D. It can enhance any one of these activities by adding more labour

but sacrificing in return the cost of other activities. If the value of the marginal product is higher in one activity

than another, then it should be assumed that an optimum allocation has not been attained. Hence it would,

be profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing

the total value of all products taken together. For example, if the values of certain two activities are as

follows:

Value of Marginal Product of labour

Activity A = Rs. 20

Activity B = Rs. 30

In this case it will be profitable to shift labour from A to activity B thereby expanding activity B and

reducing activity A. The optimum will be reach when the value of the marginal product is equal in all the four

activities or, when in symbolic terms:

VMPLA = VMPLB = VMPLC = VMPLD

Where the subscripts indicate labour in respective activities.

Certain aspects of the equi-marginal principle need clarifications, which are as follows:

First, the values of marginal products are net of incremental costs. In activity B, we may add one

unit of labour with an increase in physical output of 100 units. Each unit is worth 50 paise so that

the 100 units will sell for Rs. 50. But the increased output consumes raw materials, fuel and other

inputs so that variable costs in activity B (not counting the labour cost) are higher. Let us say that

the incremental costs are Rs. 30 leaving a net addition of Rs. 20. The value of the marginal product

relevant for our purpose is thus Rs. 20.

Secondly, if the revenues resulting from the addition of labour are to occur in future, these

revenues should be discounted before comparisons in the alternative activities are possible.

Activity A may produce revenue immediately but activities B, C and D may take 2, 3 and 5 years

respectively. Here the discounting of these revenues will make them equivalent.

Thirdly, the measurement of value of the marginal product may have to be corrected if the

expansion of an activity requires an alternative reduction in the prices of the output. If activity B

represents the production of radios and it is not possible to sell more radios without a reduction in

price, it is necessary to make adjustment for the fall in price.

Fourthly, the equi-marginal principle may break under sociological pressures. For instance, du to

inertia, activities are continued simply because they exist. Similarly, due to their empire building

ambitions, managers may keep on expanding activities to fulfil their desire for power. Department,

which are already over-budgeted often, use some of their excess resources to build up propaganda

machines (public relations offices) to win additional support. Governmental agencies are more

prone to bureaucratic self-perpetuation and inertia.

Gaps between Theory of the Firm and managerial EconomicsThe theory of the firm is a body of theory, which contains certain assumptions, theorems and conclusions.

These theorems deal with the way in which businessmen make decisions about pricing, and production

under prescribed market conditions. It is concerned with the study of the optimisation process.

For optimality to exist profit must be maximised and this can occur only when marginal cost equals

marginal revenue. Thus, the optimum position of the firm is that which maximises net revenue. Managerial

economics, on the other hand, aims at developing a managerial theory of the firm and for the purpose it

takes the help of economic theory of the firm. However, there are certain difficulties in using economic

theory as an aid to the study of decision-making at the level of the firm. This is because for the purposes of

business decision-making it fails to provide sufficient analytical tools that are useful to managers. Some of

the reasons are as follows:

Underlying all economic theory is the assumption that the decision-maker is omniscient and rational

or simply that he is an economic man. Thus being omniscient means that he knows the alternatives

that are available to him as well as the outcome of any action he chooses. The model of “economic

man” however as an omniscient person who is confronted with a compete set of known or

probabilistic outcomes is a distorted representation of reality. The typical business decision-maker

usually has limited information at his disposal, limited computing ability and a limited number of

feasible alternatives involving varying degrees of risk. Further, the net revenue function, which he is

expected to maximise, and the marginal cost and marginal revenue functions, which he is expected

to equate, require excessive knowledge of information, which is not known and cannot be obtained

even by the most careful analysis. Hence, it is absurd to expect a manager to maximise and

equalise certain critical functional relationships, which he does not know and cannot find out.

In micro-economic theory, the most profitable output is where marginal cost (MC) and marginal

revenue (MR) are equal. In Figure 1.2, the most profitable output will be at ON where MR=MC. This

is the point at which the slope of the profit function or marginal profit is zero. This is highlighted in

Figure 1.3 where the most profitable output will be again at ON. In economic theory, the decision-

maker has to identify this unique output level, which maximises profit.

In real world, however, a complexity often arises, viz., certain resource limitations exist. As a result, it is

not possible to attain the maximum output level (ON). In practical terms the maximum output possible as a

result of resource limitations is, say, OM. Now the problem before the decision-maker is to find out whether

the output, which maximises profit, is OM or some other level of output to the left of OM. It is obvious that

economic theory is of no help for ON level of output because it is not relevant in view of the resource

limitations. A managerial economist here has to take the aid of linear programming, which enables the

manager to optimise or search for the best values within the limits set by inequality conditions.

Another central assumption in the economic theory of the firm is that the entrepreneur strives

to maximise his residual share, or profit. Several criticisms of this assumption have been

made:

o The theory is ambiguous, as it doesn’t clarify. Whether it is short or long run profit that

is to be maximised. For example, in the short run, profits could be maximised by firing

all research and development personnel and thereby eliminating considerable

immediate expenses. This decision would, however, have a substantial impact on

long-run profitability.

o Certain questions create some confusion around the concept of profit maximisation.

Should the firm seek to maximise the amount of profit or the rate of profit? What is the

rate of profit? Is it profit in relation to total capital or profit in relation to shareholders’

equity?

o There is no allowance for the existence of “psychic income” (Income other than

monetary, power, prestige, or fame), which the entrepreneur might obtain from the

firm, quite apart from his monetary income.

o The theory does not recognise that under modern conditions, owners and managers

are separate and distinct groups of people and the latter may not be motivated to

maximise profits.

o Under imperfect competition, maximisation is an ambiguous goal, because actions

that are optimal for one will depend on the actions of the other firms.

o The entrepreneur may not care to receive maximum profits but may simply want to

earn “satisfactory profits”. This last point is particularly relevant from the behavioural

science standpoint because it introduces a concept of satiation. The notion of

satiation plays no role in classical economic theory. To explain business behaviour in

terms of this theory, it is necessary to assume that the firm’s goals are not concerned

with maximising profit, but with attaining a certain level or rate of profit, holding a

certain share of the market or a certain level of sales. Firms would try to satisfy rather

than maximise. But according to Simon the satisfying model damages all the

conclusions that can be derived concerning resource allocation under perfect

competition. It focuses on the fact that the classical theory of the firm is empirically

incorrect as a description of the decision-making process. Based on this notion of

satiation, it appears that one of the main strengths of classical economic theory has

been seriously weakened.

Most corporate undertakings involve the investment of funds, which are expect to produce

revenues over a number of years. The profit maximisation criterion provides no basis for

comparing alternatives that can promise varying flows of revenue and expenditure over time.

The practical application of profit maximisation concept also has another limitation. It provides

no explicit way of considering the risk associated with alternative decisions. Two projects

generating similar expected revenues in the future and requiring similar outlays might differ

vastly as regarding the degree of uncertainty with which the benefits to be generated. The

greater the uncertainty associated with the benefits, the greater the risk associated with the

project.

Baumol on the other hand is of the view that firms do not devote all their energies to

maximising profit. Rather a company will seek to maximise its sales revenue as long as a

satisfactory level of profit is maintained. Thus Baumol has substituted “Total sales revenue” for

profits. Also, two decision criteria or objectives have been advanced viz., a satisfactory level of

profit and the highest sales possible. In other words, the firm is no longer viewed as working

towards one objective alone. Instead, it is portrayed as aiming at balancing two competing and

non-consistent goals. Baumol’s model is based on the view that managers’ salaries, their

status and other rewards often appear as closely related to the companies’ size in which they

work and is measured by sales revenue rather than their profitability. As such, managers may

be more concerned to increased size than profits. And the firm’s objective thus becomes sales

maximisation rather than profits maximisation.

Empirical studies of pricing behaviour also give results that differ from those of the economic

theory of firm as can be seen from the following examples:

o Several studies of the pricing practices of business firms have indicated that

managers tend to set prices by applying some sort of a standard mark-up on costs.

They do not attempt to estimate marginal costs, marginal revenues or demand

elasticities, even if these could be accurately measured.

o For many firms, prices are more often set to attain, a particular target return on

investment, say, 10 per cent, than to maximise short or long-run profits.

o There is some evidence that firms experiencing

declining market shares in their industry strive more vigorously to increase their

sales than do competing firms, which are experiencing steady or increasing market

shares.

An alternative model to profit maximisation is the concept of

wealth maximisation, which assumes that firms seek to maximise the present value of

expected net revenues over all periods within the forecasted future.

As pointed out by Haynes and Henry, a study of the

behaviour of actual firms shows that their decisions are not completely determined by the

market. These firms have some freedom to develop decisions, strategies or rules, which

become part of the decision-making system within the firm. This gap in economic theory has

led to what has come to be known as ‘Behavioural Theory of the Firm’. This theory, however,

does not replace the former but rather powerfully supplements it. The behavioural theory

represents the firm as an adoptive institution. It learns from experience and has a memory.

Organisational behaviour, is embodies into decision rules and standard operating procedures.

These may be altered over long run as the firm reacts to “feedback” from experience.

However, in the short run, decisions of the organisation are dominated by its rules of thumb

and standard methods.

CONCLUSIONThe various gaps between the economic theory of the firm and the actual decision-making process at the

firm level are many in number. They do, however, stress that economic theory seriously needs major fixing

up and substantial changes are in progress for creating better and different models. Thus the classical

economic concepts like those of rational man is undergoing important changes; the notion of satisfying is

pushing aside the aim of maximisation and newer lines and patterns of thoughts are being developed for

finding improved applications to managerial decision-making. A strong emphasis is laid on quantitative

model building, experimentation and empirical investigation and newer techniques and concepts, such as

linear programming, game theory, statistical decision-making, etc., are being applied to revolutionise the

approaches to problem solving in business and economics.

Module 2

Demand analysis

In economic terminology the term demand conveys a wider and definite meaning than in the ordinary usage. Ordinarily demand means a desire, whereas in economic sense it is something more than a mere desire. It is interpreted as a want backed up by the - purchasing power. Further demand is per unit of time such as per day, per week etc. moreover it is meaningless to mention demand without reference to price. Considering all these aspects the term demand can be defined in the following words,

“Demand for anything means the quantity of that commodity, which is bought, at a given price, per unit of time.”

Demand = Desire + willingness to buy + ability to pay

Law Of Demand - Demand Price Relationship

This law explains the functional relationship between price of a commodity and the quantity demanded of the same. It is observed that the price and the demand are inversely related which means that the two move in the opposite direction. An increase in the price leads to a fall in the demand and vice versa. This relationship can be stated as

“Other things being equal, the demand for a commodity varies inversely as the price”

or

“The demand for a commodity at a given price is more than what it would be at a higher price and less than what it would be at a lower price”

Demand Schedule or Demand Table

These are the two devices to present the law. The demand schedule is a schedule or a table which contains various possible prices of a commodity and different quantities demanded at them. It can be an individual demand schedule representing the demand of an individual consumer or can be the market demand schedule showing the total demand of all the consumers taken together, this is indicated in the following table.

It can be observed that with a fall in price every individual consumer buys a larger quantity than before as a result of which the total market demand also rises. In case of an increase in price the situation will be reserved. Thus the demand schedule reveals the inverse price-demand relationship, i.e. the Law of Demand.

Demand Curve DD

It is a geometrical device to express the inverse price-demand relationship, i.e. the law of demand. A demand curve can be obtained by plotting a demand schedule on a graph and joining the points so obtained, like the demand schedule we can derive an individual demand curve as well as a market demand curve. The former shows the demand curve of an individual buyer while the latter shows the sum total of all the individual curves i.e. a market or a total demand curve. The following diagram shows the two types of demand curves.

 

In the above diagram, figure (A) shows an individual demand curve of any individual consumer while figure (B) indicates the total market demand. It can be noticed that both the curves are negatively sloping or downwards sloping from left to right. Such a curve shows the inverse relationship between the two variables. In this case the two variable are price on Y axis and the quantity demanded on X axis. It may be noted that at a higher price OP the quantity demanded is OM while at a lower price say OP1, the quantity demanded rises to OM1 thus a demand curve diagrammatically explains the law of demand.

Assumptions of the 'Law of Demand'

The law of demand in order to establish the price-demand relationship makes a number of assumptions as follows:

1. Income of the consumer is given and constant.2. No change in tastes, preference, habits etc.3. Constancy of the price of other goods.4. No change in the size and composition of population.

These Assumptions are expressed in the phrase “other things remaining equal”.

Exceptions of the 'Law of Demand'

In case of major bulk of the commodities the validity of the law is experienced. However there are certain situations and commodities which do not follow the law. These are termed as the exceptions to the law; these can be expressed as follows:

1. Continuous changes in the price lead to the exceptional behavior. If the price shows a rising trend a buyer is likely to buy more at a high price for protecting himself against a further rise. As against it when the price starts falling continuously, a consumer buys less at a low price and awaits a further in price.

2. Giffens’s Paradox describes a peculiar experience in case of inferior goods. When the price of an inferior commodity declines, the consumer, instead of purchasing more, buys less of that commodity and switches on to a superior commodity. Hence the exception.

3. Conspicuous Consumption refers to the consumption of those commodities which are bought as a matter of prestige. Naturally with a fall in the price of such goods, there is no distinction in buying the same. As a result the demand declines with a fall in the price of such prestige goods.

4. Ignorance Effect implies a situation in which a consumer buys more of a commodity at a higher price only due to ignorance.

In the exceptional situations quoted above, the demand curve becomes an upwards rising one as shown in the alongside diagram. In the alongside figure, the demand curve is positively sloping one due to which more is demanded at a high price and less at a low price.

Determinants (Factors Affecting) of Demand

The law of demand, while explaining the price-demand relationship assumes other factors to be constant. In reality however, these factors such as income, population, tastes, habits, preferences etc., do not remain constant and keep on affecting the demand. As a result the demand changes i.e. rises or falls, without any change in price.

1. Income: The relationship between income and the demand is a direct one. It means the demand changes in the same direction as the income. An increase in income leads to rise in demand and vice versa.

2. Population: The size of population also affects the demand. The relationship is a direct one. The higher the size of population, the higher is the demand and vice versa.

3. Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc. of the consumer have a profound effect on the demand for a commodity. If a consumers dislikes a

commodity, he will not buy it despite a fall in price. On the other hand a very high price also may not stop him from buying a good if he likes it very much.

4. Other Prices: This is another important determinant of demand for a commodity. The effects depends upon the relationship between the commodities in question. If the price of a complimentary commodity rises, the demand for the commodity in reference falls. E.g. the demand for petrol will decline due to rise in the price of cars and the consequent decline in their demand. Opposite effect will be experienced incase of substitutes.

5. Advertisement: This factor has gained tremendous importance in the modern days. When a product is aggressively advertised through all the possible media, the consumers buy the advertised commodity even at a high price and many times even if they don’t need it.

6. Fashions: Hardly anyone has the courage and the desire to go against the prevailing fashions as well as social customs and the traditions. This factor has a great impact on the demand.

7. Imitation: This tendency is commonly experienced everywhere. This is known as the demonstration effects, due to which the low income groups imitate the consumption patterns of the rich ones. This operates even at international levels when the poor countries try to copy the consumption patterns of rich countries.

Variation & Changes In Demand

The law of demand explains the effect of only-one factor viz., price, on the demand for a commodity, under the assumption of constancy of other determinants. In practice, other factors such as, income, population etc. cause the rise or fall in demand without any change in the price. These effects are different from the law of demand. They are termed as changes in demand in contrast to variations in demand which occur due to changes in the price of a commodity. In economic theory a distinction is made between (a) Variations i.e. extension and contraction in demand due to price and (b) Changes i.e. increase and decrease in demand due to other factors.

(a) Variations in demand refer to those which occur due to changes in the price of a commodity.

These are two types.

1. Extension of Demand: This refers to rise in demand due to a fall in price of the commodity. It is shown by a downwards movement on a given demand curve.

2. Contraction of Demand: This means fall in demand due to increase in price and can be shown by an upwards movement on a given demand curve.

(b) Changes in demand imply the rise and fall due to factors other than price.

It means they occur without any change in price. They are of two types.

1. Increase in Demand: This refers to higher demand at the same price and results from rise in income, population etc., this is shown on a new demand curve lying above the original one.

2. Decrease in demand: It means less quantity demanded at the same price. This is the result of factors like fall in income, population etc. this is shown on a new demand lying below the original one.

 

 

Fig (A) Extension/Contraction of Demand

Fig (B) Increase/Decrease in Demand

In figure A, the original price is OP and the Quantity demanded is OQ. With a rise in price from OP to OP1 the demand contracts from OQ to OQ1 and as a result of fall in price from OP to OP2, the demand extends from OQ to OQ2.

In figure, B an increase in demand is shown by a new demand curve, D1 while the decrease in demand is expressed by the new demand curve D2, lying above and below the original demand curve D respectively. On D1 more is demand (OQ1) at the same price while on D2 less is demanded (OQ2) at the same price OP.

Elasticity of Demand

The law of demand explains the functional relationship between price and demand. In fact, the demand for a commodity depends not only on the price of a commodity but also on other factors such as income, population, tastes and preferences of the consumer. The law of demand assumes these factors to be constant and states the inverse price-demand relationship. Barring certain exceptions, the inverse price- demand relationship holds good in case of the goods that are bought and sold in the market.

The law of demand explains the direction of a change as it states that with a rise in price the demand contracts and with a fall in price it expands. However, it fails to explain the extent or magnitude of a change in demand with a given change in price. In other words, the law of demand merely shows the direction in which the demand changes as a result of a change in price, but does not throw any light on the amount by which the demand will change in response to a given change in price. Thus, the law of demand explains the qualitative but not the quantitative aspect of price- demand relationship.

Although it is true that demand responds to change in price of a commodity, such response varies from commodity to commodity. Some commodities are more responsive or sensitive to change in price while some others are less. The concept of the elasticity of demand has great significance as it explains the degree of responsiveness of demand to a change in price. It thus elaborates the price-demand relationship. The elasticity of demand thus means the sensitiveness or responsiveness of demand to a change in price.

According to Marshall, “the elasticity (or responsiveness) of demand in a market is great or small accordingly as the demand changes (rises or falls) much or little for a given change (rise or fall) in price.”

From the above discussion, it will be clear that thought different commodities react to a change in price in the same direction; the degree of their response differs. Demand for some commodities is more sensitive or responsive to a change in price, while it is less responsive for some others. Elasticity of demand is a measure of relative changes in the amount demanded in response to a small change in price. Certain goods are said to have an elastic demand while others have an inelastic demand. The demand is said to be elastic when a small change in price brings about considerable change in demand. On the other hand, the demand for a good is said to be inelastic when a change in price fails to bring about significant change in demand.

The concept of elasticity can be expressed in the form of an equation as:

Ep = [Percentage change in quantity demanded / Percentage change in the price]

Types of Price Elasticity

The concept of price elasticity reveals that the degree of responsiveness of demand to the change in price differs from commodity to commodity. Demand for some commodities is more elastic while that for certain others is less elastic. Using the formula of elasticity, it possible to mention following different types of price elasticity:

1. Perfectly inelastic demand (ep = 0)2. Inelastic (less elastic) demand (e < 1)3. Unitary elasticity (e = 1)4. Elastic (more elastic) demand (e > 1)5. Perfectly elastic demand (e = ∞)

1. Perfectly inelastic demand (ep = 0)

This describes a situation in which demand shows no response to a change in price. In other words, whatever be the price the quantity demanded remains the same. It can be depicted by means of the alongside diagram.

The vertical straight line demand curve as shown alongside reveals that with a change in price (from OP to Op1) the demand remains same at OQ. Thus, demand does not at all respond to a change in price. Thus ep = O. Hence, perfectly inelastic demand. Fig a

2. Inelastic (less elastic) demand (e < 1)

In this case the proportionate change in demand is smaller than in price. The alongside figure shows this type.

In the alongside figure percentage change in demand is smaller than that in price. It means the demand is relatively c less responsive to the change in price. This is referred to as an inelastic demand. Fig e

3. Unitary elasticity demand (e = 1)

When the percentage change in price produces equivalent percentage change in demand, we have a case of unit elasticity. The rectangular hyperbola as shown in the figure demonstrates this type of elasticity. In this case percentage change in demand is equal to percentage change in price, hence e = 1. Fig c

4. Elastic (more elastic) demand (e > 1)

In case of certain commodities the demand is relatively more responsive to the change in price. It means a small change in price induces a significant change in, demand. This can be understood by means of the alongside figure.

It can be noticed that in the above example the percentage change in demand is greater than that in price. Hence, the elastic demand (e>1) Fig d

5. Perfectly elastic demand (e = ∞)

This is experienced when the demand is extremely sensitive to the changes in price. In this case an insignificant change in price produces tremendous change in demand. The demand curve showing perfectly elastic demand is a horizontal straight line. Fig b

It can be noticed that at a given price an infinite quantity is demanded. A small change in price produces infinite change in demand. A perfectly competitive firm faces this type of demand.

From the above analysis it can be concluded that theoretically five different types of price elasticity can be mentioned. In practice, however two extreme cases i.e. perfectly elastic and perfectly inelastic demand, are rarely experienced. What we really have is more elastic (e > 1) or less elastic (e < 1 ) demand. The unitary elasticity is a dividing line between these two cases.

Determinants of Elasticity

1. Nature of the Commodity: Humans wants, i.e. the commodities satisfying them can be classified broadly into necessaries on the one hand and comforts and luxuries on the other hand. The nature of demand for a commodity depends upon this classification. The demand for necessities is inelastic and for comforts and luxuries it is elastic.

2. Number of Substitutes Available: The availability of substitutes is a major determinant of the elasticity of demand. The large the number of substitutes, the higher is the elastic. It means if a commodity has many substitutes, the demand will be elastic. As against this in the absence of substitutes, the demand becomes relatively inelastic because the consumers have no other alternative but to buy the same product irrespective of whether the price rises or falls.

3. Number Of Uses: If a commodity can be put to a variety of uses, the demand will be more elastic. When the price of such commodity rises, its consumption will be restricted only to more important uses and when the price falls the consumption may be extended to less urgent uses, e.g. coal electricity, water etc.

4. Possibility of Postponement of Consumption: This factor also greatly influences the nature of demand for a commodity. If the consumption of a commodity can be postponed, the demand will be elastic.

5. Range of prices: The demand for very low-priced as well as very high-price commodity is generally inelastic. When the price is very high, the commodity is consumed only by the rich people. A rise or fall in the price will not have significant effect in the demand. Similarly, when the price is so low that the commodity can be brought by all those who wish to buy, a change, i.e., a rise or fall in the price, will hardly have any effect on the demand.

6. Proportion of Income Spent: Income of the consumer significantly influences the nature of demand. If only a small fraction of income is being spent on a particular commodity, say newspaper, the demand will tend to be inelastic.

7. According to Taussig, unequal distribution of income and wealth makes the demand in general, elastic.

8. In addition, it is observed that demand for durable goods, is usually elastic.9. The nature of demand for a commodity is also influenced by the complementarities of goods.

From the above analysis of the determinants of elasticity of demand, it is clear that no precise conclusion about the nature of demand for any specific commodity can be drawn. It depends upon the range of price, and the psychology of the consumers. The conclusion regarding the nature of demand should, therefore be restricted to small changes in prices during short period. By doing so, the influence of changes in habits, tastes, likes customs etc., can be ignored.

Measurement of Elasticity

For practical purposes, it is essential to measure the exact elasticity of demand. By measuring the elasticity we can know the extent to which the demand is elastic or inelastic. Different methods are used for measuring the elasticity of demand.

1. Percentage Method: In this method, the percentage change in demand and percentage change in price are compared.

ep = [Percentage change in demand / Percentage change in price]

In this method, three values of ‘ep’ can be obtained. Viz., ep = 1, ep > 1, ep > 1.

o If 5% change in price leads to exactly 5% change in demand, i.e. percentage change in demand is equal to percentage change in price , e = 1, it is a case of unit elasticity.

o If percentage change in demand is greater than percentage change in price, e > 1, it means the demand is elastic.

o If percentage change in demand is less than that in price, e > 1, meaning thereby the demand is inelastic.

2. Total Outlay Method: The elasticity of demand can be measured by considering the changes in price and the consequent changes in demand causing changes in the total amount spent on the goods. The change in price changes the demand for a commodity which in turn changes the total expenditure of the consumer or total revenue of the seller.

o If a given change in price fails to bring about any change in the total outlay, it is the case of unit elasticity. It means if the total revenue (price x Quantity bought) remains the same in spite of a change in price, ‘ep’ is said to be equal to 1

o If price and total revenue are inversely related, i.e., if total revenue falls with rise in price or rises with fall in price, demand is said to be elastic or e > 1.

o When price and total revenue are directly related, i.e. if total revenue rises with a rise in price and falls with a fall in price, the demand is said to be inelastic pr e < 1.

3. Another suggested by Marshall is to measure elasticity at a point on a straight line is called Point Method

Income Elasticity of Demand

The discussion of price elasticity of demand reveals that extent of change in demand as a result of change in price. However, as already explained, price is not the only determinant of demand. Demand for a commodity changes in response to a change in income of the consumer. In fact, income effect is a constituent of the price effect. The income effect suggests the effect of change in income on demand. The income elasticity of demand explains the extent of change in demand as a result of change in income. In other words, income elasticity of demand means the responsiveness of demand to changes in income. Thus, income elasticity of demand can be expressed as:

EY = [Percentage change in demand / Percentage change in income]

The following types of income elasticity can be observed:

1. Income Elasticity of Demand Greater than One: When the percentage change in demand is greater than the percentage change in income, a greater portion of income is being spent on a commodity with an increase in income- income elasticity is said to be greater than one.

2. Income Elasticity is unitary: When the proportion of income spent on a commodity remains the same or when the percentage change in income is equal to the percentage change in demand, EY = 1 or the income elasticity is unitary.

3. Income Elasticity Less Than One (EY< 1): This occurs when the percentage change in demand is less than the percentage change in income.

4. Zero Income Elasticity of Demand (EY=o): This is the case when change in income of the consumer does not bring about any change in the demand for a commodity.

5. Negative Income Elasticity of Demand (EY< o): It is well known that income effect for most of the commodities is positive. But in case of inferior goods, the income effect beyond a certain level of income becomes negative. This implies that as the income increases the consumer, instead of buying more of a commodity, buys less and switches on to a superior commodity. The income elasticity of demand in such cases will be negative.

Cross Elasticity of Demand

While discussing the determinants of demand for a commodity, we have observed that demand for a commodity depends not only on the price of that commodity but also on the prices of other related goods. Thus, the demand for a commodity X depends not only on the price of X but also on the prices of other commodities Y, Z….N etc. The concept of cross elasticity explains the degree of change in demand for X as, a result of change in price of Y. This can be expressed as:

EC = [Percentage Change in demand for X / Percentage change in price of Y]

The relationship between any two goods is of two types. The goods X and Y can be complementary goods (such as pen and ink) or substitutes (such as pen and ball pen). In case of complementary commodities, the cross elasticity will be negative. This means that fall in price of X (pen) leads to rise in its demand so also rise in t) demand for Y (ink) On the other hand, the cross elasticity for substitutes is positive which means a fall in price of X (pen) results in rise in demand for X and fall in demand for Y (ball pen). If two commodities, say X and Y, are unrelated there will be no change i. Demand for X as a result of change in price of Y. Cross elasticity in cad of such unrelated goods will then be zero.

In short, cross elasticity will be of three types:

1. Negative cross elasticity – Complementary commodities. 2. Positive cross elasticity – Substitutes.3. Zero cross elasticity – Unrelated goods.

Importance of Elasticity

The concept of elasticity is of great importance both in economic theory and in practice.

1. Theoretically, its importance lies in the fact that it deeply analyses the price-demand relationship. The law of demand merely explains the qualitative relationship while the concept of elasticity of demand analyses the quantitative price-demand relationship.

2. The Pricing policy of the producer is greatly influenced by the nature of demand for his product. If the demand is inelastic, he will be benefited by charging a high price. If on the other hand, the demand is elastic, low price will be advantageous to the producer. The concept of elasticity helps the monopolist while practicing the price discrimination.

3. The price of joint products can be fixed on the basis of elasticity of demand. In case of such joint products, such as wool and mutton, cotton and cotton seeds, separate costs of production are not known. High price is charged for a product having inelastic demand (say cotton) and low price for its joint product having elastic demand (say cotton seeds).

4. The concept of elasticity of demand is helpful to the Government in fixing the prices of public utilities.

5. The Elasticity of demand is important not only in pricing the commodities but also in fixing the price of labour viz., wages.

6. The concept of elasticity of demand is useful to Government in formulation of economic policy in various fields such as taxation, international trade etc. (a) The concept of elasticity of demand guides the finance minister in imposing the commodity taxes. He should tax such commodities which have inelastic demand so that the Government can raise handsome revenue.(b) The concept of elasticity of demand helps the Government in formulating commercial policy. Protection and subsidy is granted to the industries which face an elastic demand.

7. The concept of elasticity of demand is very important in the field international trade. It helps in solving some of the problems of international trade such as gains from trade, balance of payments etc. policy of tariff also depends upon the nature of demand for a commodity.

In nutshell, it can be concluded that the concept of elasticity of demand has great significance in economic analysis. Its usefulness in branches of economic such as production, distribution, public finance, international trade etc., has been widely accepted.

Demand forecasting

COST CONCEPTS

Business decisions are generally taken on the basis of money values of the inputs and outputs. The cost

production expressed in monetary terms is an important factor in almost all business decisions, specially

those pertaining to (a) locating the weak points in production management; (b), minimising the cost; (c)

finding out the optjmum level of output; and (d) estimating or projecting the cost of business operations.

Besides, the term 'cost' has different meanings under different settings and is subject to varying

interpretations. It is therefore essential that only relevant concept of costs is used in the business decisions.

CONCEPT OF COST

The concepts of cost, which are relevant to business operations and decisions, can be grouped, on the

basis of their purpose, under two overlapping categories such as concepts used for accounting purposes

and concepts used in economic analysis of business activities.

SOME ACCOUNTING CONCEPTS OF COST

Opportunity Cost and Actual Cost

Opportunity cost is the loss incurred due to the unavoidable situations such as scarcity of resources. If

resources were unlimited, there would be no need to forego any income yielding opportunity and, therefore,

there would be no opportunity cost. Resources are scarce but have alternative uses with different returns,

Resource owners who aim at maximising of income put their scarce resources to their most productive use

and forego the income expected from the second best use of the resources. Thus, the opportunity cost may

be defined as the expected returns from the second best use of the resources foregone due to the scarcity

of resources. The opportunity cost is also called the alternative cost.

For example, suppose that a person has a sum of Rs. lOO,OOO for which he has only two alternative

uses. He can buy either a printing machine or, alternatively, a lathe machine. From printing machine, he

expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000. If he is a profit maximising

investor, he would invest his tnoney in printing machine and forego the expected income from the lathe.

The opportunity cost of his income from printing machine is,· the expected income from the lathe machine,

i.e., Rs. l5,000. The opportunity cost arises because of the foregone opportunities. Thus, the opportunity

cost of using resources in the'Printing business is the best opportunity ahdthe expected return from the

lathe machine is the second best alternative. In assessing the alternative cost, both explicit and implicit

costs are taken into account.

Associated with the concept of opportunity cost is the concept of economic rent or economic profit. In

our example, economic rent of the printing machine is the excess of its earning over the income expected

from the lathe machine (i.e., Rs. 20,000 - Rs. 15,000 = Rs. 5,000). The implication of this concept for a

businessman is that investing in printing machine is preferable as long as its economic rent is greater than

zero. Also, if firms have knowledge of the economic rent of the various alternative uses of their resources,

it will be helpful for them to choose the best Investment A venue. In contrast to opportunity cost, actual

costs are those which are actually incurred by the firm in the payment for labour, material, plant, building,

machinery, equipments, travelling and transport, advertisement, etc. The total money expenditures,

recorded in the' books of accounts are, the actual costs, Therefore, the actual cost comes under the

accounting concept.

Business Costs and Full Costs

Business.costs include all the expenses, which are incurred to carry out a business. The concept of

business costs is similar to the actual or the real costs. Business costs include all the payments and'

contractual obligations made by the firm together with the book cost of depreciation on plant and

equipment. These cost concepts are used for calculating business profits and losses, for filing returns for

income tax and for other legal purposes. The concept of full costs, include business costs, opportunity cost

and. normal profit. As stated earlier the opportunity cost includes the expected earning from the second

best use of the resources, or the market rate of interest on the total money capital and the value of

entrepreneur's own services, which are not charged for'in the current business. Normal profit is a

necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its

present occupation.

Explicit and Implicit or Imputed Costs

Explicit costs are those, which fall under actual or business costs entered in the books of accounts. For

example, the payments for wages and salaries, materials, licence fee, insurance premium and depreciation

charges etc. These costs involve cash payment and, are recorded in normal accounting practices. In

contrast with these costs, there are other costs, which neither take the form of cash outlays, nor do they

appear in the accounting system. Such costs are known as implicit or imputed costs. Implicit costs may be

defined as the earning expected froin thesecond best alternative use of resources. For example, suppose an

entrepreneur does not utilise his services in his own business and works as a manager in ·some other firm

on a salary basis. If he starts his own business, he foregoes his salary as a manager. This loss of salary is

the opportunity cost of income from his business. This is an implicit cost of his business. The cost is implicit,

because the entrepreneur suffers the loss, but does not charge it as the explicit cost of his own business.

Implicit costs are not taken into account while calculating the loss or gains of the business, but they form an

important consideration in whether or not a factor would remain in its present occupation. The explicit and

implicit costs together make the economic cost.

Out-of-Pocket and Book Costs

The items of expenditure, which involve cash payments or cash transfers recurring and non-recurring are

known as out-of-pocket costs. All the explicit costs such as wage, rent, interest and transport expenditure.

On the contrary, there are actual business costs, which do not involve cash payments, but a provision is

made for them in the books of account. Thes costs are taken into account while finalising the profit and loss

accounts. Such expenses are known as book costs. In a way, these are payments that the firm needs to

pay itself such as depreciation allowances and unpaid interest on the businessman's own fund.

Fixed and Variable Costs

Fixed costs are those, which are fixed in volume for a given output. Fixed cost does not vary with variation

in the output between zero and any certain level of output. The costs that do not vary for a certain level of

output are known as fixed cost. The fixed costs include cost of managerial and administrative staff,

depreciation of machinery, building and other fixed assets and maintenance of land, etc.

Variable costs are those, which vary with the variation in the total output. They are a function of output.

Variable costs inclue cost of raw materials, running cost on fixed capital, such as fuel, repairs, routine

maintenance expenditure, direct labour charges associated with the level of output and the costs of all other

inputs that vary with the output.

Total, Average and Marginal Costs

Total cost represents the value of the total resource requirement for the production of goods and services. It

refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce

a given level of output. It includes both fixed and variable costs. The total cost for a given output is given by

the cost function.

The Average Cost (AC) of a firm is of statistical nature and is not the actual cost. It is obtained by

dividing the total cost (TC) by the total output (Q), i.e.,

AC =

TC

= average cost Q

Marginal cost is the addition to the total cost on account of producing an additional unit of the product.

Or marginal cost is the cost of marginal unit produced. Given the cost function, it may be

defined as

These cost concepts are discussed in further detail in the following section. Total, average and

marginal cost concepts are used in economic analysis of firm's producti on activities.

Short-run and Long-run Costs

Short-run and long-run cost concepts are related to variable and fixed costs, respectively, and often appear

in economic analysi.s interchangeably. Short-run costs are those costs, which change with the variation in

output, the size of the firm remaining the same. In other words, short-run costs are the same as variable

costs. Long-run costs, on the other hand, are the costs, which are incurred on the fixed assets like plant,

building, machinery, etc. Such costs have long-run implication in the sense that these are not used up in the

single batch of production.

Long-run costs are, by implication, same as fixed costs. In the long-run, however, even the fixed

costs become variable costs as the size of the firm or scale of production increases. Broadly speaking, the

short-run costs are those associated with variables in the utilisation of fixed plant or other facilities whereas

long-run costs are associated with the changes in the size and type of plant.

Incremental Costs and Sunk Costs

Conceptually, increment natal costs are closely related to the concept of marginal sot. Whereas marginal

cost refers to the cost of the macgmalunit of output, incremental cost refers to the total additional cost

associated with the marginal batch of output. The concept of incremental cost is based on a specific and

factual principle. In the real world, it is not practicable for lack of perfect divisibility of inputs to employ factors

for each unit of output separately. Besides, in the long run, firms expand their production; hire more men,

AC=

aTC

aQ

materials, machinery, and equipments. The expenditures of this nature are the incremental costs, anq not

the marginal cost. Incremental· costs also arise owing to the change in product lines, addition or introduction

of a new product, replacement of worn out plan and machinery, replacement of old technique of production

with a new one, etc.

The sunk costs are those, which cannot be altered, increased or decreased, by varying the rate of

output. For example, once it is decided to make incremental investment expenditure and the funds are

allocated and spent, all the preceding costs are considered to be the sunk· costs since they accord to the

prior commitment and cannot be revised or reversed when there is change in market conditions orchange

in business decisions.

Historical and Replacement Costs

Historical cost refers to the cost of an asset acquired· in the past whereas replacement cost refers to the

outlay, which has to be made for replacing an old asset. These concepts own their sigtlificance to unstable

nature of price behaviour. Stable prices over a period of time, other things given, keep historical and

replacement costs on par with each other. Instability in asset prices, however, makes the two costs differ

from each other.

Historical cost of assets is used for accounting purposes, in the assessment of net worth of the

firm.

Private and Social Costs

We have so far discussed the cost concepts that are related to the working of the firm and those which are

used in the cost-benefit analysis of the business decision process. There are, however, certain other

costs, which arise due to functioning of the firm but do not normally appear in business decisions. Such

costs are neither explicitly borne by the firms. The costs of this category are borne by-the society. Thus,

the total cost generated by a firm's working may be divided into two categories:

• Those paid out or provided for by the firms,

• Those not paid or borne by the firm.

The costs that are not borne by the firm include use of resouces freely available and the disutility

created in the process of production. The costs of the former category are known as private costs and of the

latter category are known as external or social costs. A few examples of social cost are: Mathura Oil

Refinery discharging its wastage in the Yamuna River causes water pollution. Mills and factories located in

city cause air pollution by emitting smoke. Similarly, plying cars, buses, trucks, etc., cause both air and noise

pollution; Such pollutions cause tremendous health hazards, which involve health cost to the society as it

whole Thes'e costs are termed external costs from the firm's point of view and social cost from the society's

point of view. The relevance of the social costs lies in understandipg the overall impact of firm's working on

the society as a whole and in working out the social cost of private gains. A further distinction between

private cost and social cost therefore, requires discussion.

Private costs are those, which are actually incurred or provided by an individual or a firm on the

purchase of goods and services from the market. For a firm, all the actual costs both explicit and implicit are

private costs. Private costs are the internalised cost that is incorporated in the firm's total cost of production.

Social costs, on thehand refer to the total cost for the society on account of production ofa

commodity. Social cost can be the private cost or the external cost. It includes the cost of resources for

which the firm is not compelled to pay a price such as rivers and lakes, the public, utility services like

roadways and drainage system, the cost in the form of disutility created in through air, water and noise

pollution. This category is generally assumed to be equal to total private and public expenditures. The

private and public expenditures, however, serve only as an indicator of public disutility. They do not give

exact measure of the public disutility or the social costs.

COST-OUTPUT RELATIONS

The previous section discussed the variou cost concepts, which help in the business decisions. The

following section contains the discussion of the behaviour of costs in relation to the change in output. This

is, in fact, the theory of production cost.

Cost-output relations play an importai)t role in business decisions relating to cost

minirnisalioil"Of'profiHnaximisation and optimisation of output. Cost-output relations are specified through a

cost function expressed as

T(C) = f(Q) (1)

where,

TC = total cost

Q = quantity produced

Cost functions depend on production function and market-supply function of inputs. Production

function specifies the technical relationship between the input, and the output. Production function of a firm

combined with the supply function of inputs or prices of inputs determines the cost function of the firm.

Precisely, cost function is a function derived from the production function and the market supply function.

'Depending on whether short or long-run is considered for the production, there are two kinds of cost

functions: such as short-run cost-function and long-run cost function. Cost-output relations in relation to the

changing level of output will be discussed here u.nder both kinds of cost-functions.

Short-run Cost Output Relations

The basic analytical cost concepts used in the analysis of cost behaviour are total average and marginal

costs. The totalcost (TC) is defined as the actual cost that must be incurred to produce a given quantity of

output. The short-run TC is composed of two major elements: total fixed cost (TFC) and total variable cost

(TVC). That is, in the short-run,

TC = TFC + TVC (2)

As mentioned earlier, TFC (i.e" the ·cost·of plant, building, equipment, etc.) remains fixed in the

short-run, where as TVC varies with the variation in the output.

For a given quantity of output (Q), the average total cost, (AC), average fixed cost (AFC) and,

average var!able cost (AVC) can 'be defined as follows:

AC =

TC

=

TFC + TVC

Q Q

AFC =

TFC

Q

AVC =

TVC

Q

and AC = AFC +AVC (3)

Marginal cost (MC) is defined as the change in the total cost divided by the change in the

total output, i.e.,

MC =

∆TC

or

aTC

∆Q aQ

(4)

Since ∆TC = ∆TFC + ∆TVC and, in the short-run, ∆TFC = 0, therefore, ∆TC=∆TVC

Furthermore, under marginality concept, where ∆Q = 1,MC = ∆TVC.

Cost Function and Cost-output Relations

The concepts AC, AFC and AVC give only a static relationship between cost and output in the sense that

they are related to a given output. These cost concepts do not tell us anything about cost behaviour, i.e.,

how AC, A VC and AFC behave when output changes. This can be understood better with a cost function of

empirical nature.

Suppose the cost function (I) is specified as

TC = a + bQ - CQ2 + dQ3 (5)

(where a = TFC and b, c and d are variable-cost parameters)

And also the cost function is empirically estimated as

TC = 10 + 6Q - 0.9Q2 + 0.05Q3 (6)

and TVC = 6Q - 0.9Q2 + 0.05Q3 (7)

The TC and TVC, based on equations (6) and (7), respectively, have been calculated for Q = I to 16

and is presented in Table 3.1. The TFC, TVC and TC have been graphically presented in Figure 3.1. As the

figure shows, TFC remains fixed for the whole range of output, and hghce, takes the form of a horizontal

line, i.e., TFC. The TVCcurve shows that the total variable cost first increases ata'i decreasing rate and then

at an increasing rate with the increase it the total output. The rate of increase can be obtained from the

slope of TVC curve. The pattemof change in the TVC stems directly from the law of increasing and

diminishing returns to the variable inputs. As output increases, larger quantities of variable inputs are

required to produce the same quantity of output due to diminishing returns. This causes a subsequent

increase in the variable cost for producing the same output. The following Table 3.1 shows the cost output

relationship.

Table 3.1: Cost Output Relations

Q FC TVC TC AFC AVC AC MC

(I) (2) (3) (4) (5) (6) (7) (8)

0 10 0.0 10.00 - - - -I 10 5.15 15.15 10.00 5.15 15.15 5.152 10 8.80 18.80 5:00 4.40 9.40 3.653 10 11.25 21.25 3.33 3.75 7.08 2.45

4 10 12.80 22.80 2.50 3.20 5.70 1.555 10 13.75 23.75 2.00 2.75 4.75 0.956 10 14.40 24.40 1.67 2.40 4.07 0.65

7 10 15.05 25.05 1.43 2.15 3.58 0.65

8 10 16.00 26.00 1.25 2.00 3.25 0.959 10 17.55 27.55 1.11 1.95 3.06 1.55

10 10 20.00 30.00 1.00 2.00 3.00 2.4511 10 23.65 33.65 0.90 2.15 3.05 3.65

12 10 28,80 38.80 0.83 2.40 3.23 5.1513 10 35.75 45.75 0.77 2.75 3.52 6.9514 10 44.80 54.80 0.71 3.20 3.91 9.0515 10 56.25 66.25 0.67 3.75 4.42 11.45

16 10 70.40 80.40 0.62 4.40 5.02 14.15

From equations (6) and (7), we may derive the behavioural equations for AFC, AVC and AC. Let us

first consider AFC.

Average Fixed Cost (AFC) As already mentioned, the costs that remain fixed for a certain level of output make the total fixed cost in the

short-run. The fixed cost is represented by the constant term 'a' in equation (6). We know that

AFC =

TFC (8)

Q

Substituting 10 for TFC in equation (8), we get

AFC =

10 (9)

Q

Equation (9) expresses the behaviour of AFC in relation to change in Q. The behaviour of AFC for

Q from 1 to 16 is given in Table 3.1 (col. 5) and is presented graphically by the AFC curve in the Figure

3.1. The AFC curve is a rectangular hyperbola.

Average Variable Cost (AVC)

As defined above,

AVC =

TVC

Q

Given the TVC function in equation 7, we may express AVC as follows:

AVC =

6Q-0.9Q2+0.05Q3

= 6- 0.9Q+0.05Q3 (10)Q

Having derived the A VC function (equation 10), we may easily obtain the behaviour of A VC in

response to change in Q. The behaviour of A VC for Q from I to 16 is given in Table 3.1 (co 1. 6), and is

graphically presented in Figure 3.2 by the A VC curve.

Critical Value of A VC

From equation (10), we may compute the critical value or Q in respect of A Vc. The

critical value of Q (in respect of A VC) is that value of Q at which A VCis minimum.

The Ave will be minimum when its decreasing rate of change is equal to zero. This can

be accomplished by differentiating equation (10) and setting it equal to zero. Thus,

critical value of Q can be obtained as

Q=

aAVC

= 0.9+0.10Q=0 (11)aQ

Q= 9

Thus, the critical value of Q=9. This can be verified from Table 3.1Average Cost (AC)

The average cost in defined as

AC =

TC

Q

Substituting equation (6) for TC in above equation, we get

AC =

10+6Q-09Q2+0.05Q3 (12a)

Q

=

10

+ 6-0.9Q+0.05Q2

Q

The equation (l2a) gives the behaviour of AC in response to change in Q. The behaviour of AC for

Q from I to 16 is given in Table 3.1 and graphically presented in Figure 3.2 by the AC-curve. Note that AC-

curve is U-shaped.

From equation (12a), we may easily obtain the critical value of Q in respect of AC. Here, the critical valuepf

Q in respect of AC is one at which AC is minimum. This can be obtained by differentiating equation (l2a) and

setting it equal to zero. This, critical vallie of Q in respect of AC is given by

aAC

=

10

- 0.9 + 0.1Q = 0 (12b)aQ Q2

This equation takes the form of a quadratic equation as

-10 – 0.9Q2 + 0.1Q3 = 0

or, Q3 – 9Q2 = 100 = 0

By solving equation (12b), we get

Q = 10

Thus, the critical value of output in respect of AC is 10. That is, AC reaches its minimum at Q = 10.

This can be verified from Table. 3.1 shows short-run cost curves.

Marginal Cost (MC)The concept of marginal cost (MC) is particularly useful in economic analysis. MC is technically the first

derivative of TC function. That is,

MC =

aTC

aQ

Given the TC function as in equation (6), the MC function can be obtained asaTC

= 6-1.8Q+0.15Q2 (13)aQ

Equation (13) represents the behaviour of MC. The behaviour of MC for Q from 1 to 16 computed as

MC = TCn - TCn- i is given in Table 3.1 (col. 8) and graphically presented by MC-curve in Figure 3'.2. The

critical 'value of Q in respect of MC is 6 or 7. It can be seen from Table 3.1.

One method of solving quadratic equation is to factorise it and find the solution.

Thus, Q3 – 9Q2 – 100 = 0

(Q – 10) (Q2 + Q + 10) = 0

For this to hold, one of the terms must be equal to zero,

Suppose (Q2 + Q + 10) = 0

Then, Q – 10 = 0 and Q = 10.

COST CURVES AND THE LAWS OF DIMINISHING RETURNS

We now return to the laws of variable proportions and explain it through the .cost curves. Figures 3.1 and

3.2 clearly bring out the short-term laws of production, i.e., the laws of diminishing returns. Let us recall the

law: it states that when more and more units of a variable input are applied to those inputs which are held

constant, the returns from the marginal units of the variable input may initially increase but will eventually

decrease. The same law can also be interpreted in term's of decreasing and increasing costs. The law can

then be stated as, if more and more units of a variable inputs are applied to the given amount of a fixed

input, the' marginal cost initially decreases, but eventually increases. Both interpretations of the law yield the

same information: one in terms of marginal productivity of the variable input, and the other, in terms of the

marginal cost. The former is expressed through production function and the latter through a cost function.

Figure 3.2 represents the short-run laws of returns in terms of cost of production. As the figure

shows, in the initial stage of production, both AFC and AVC are declining because of internal economies.

Since AC = AFC + AVC, AC is also declining, this shows the operation of the law of increasing returns. But

beyond a certain level of output (i.e., 9 units in out example), while AFC continues to fall, AVC starts

increasing because of a faster increase in the TVC. Consequently, the rate of fall in AC decreases. The AC

reaches its minimum when output increases to 10 units. Beyond this level of output, AC starts increasing

which shows that the law of diminishing returns comes in operation. The MC, curve represents the pattern of

change in both the TVC and TC curves due to change in output. A downward trend in the MC shows

increasing marginal productivity of the variable input mainly due to internal economy resulting from increase

in production. Similarly, an upward trend in the MC shows increase in TVC, on the one hand, and

decreasing marginal productivity of the variable input, on the other.

SOME IMPORTANT COST RELATIONSHIPS

Some important relationships between costs used in analysing the short-run cost behaviour may now be

summed up as follows:

As long as AFC and AVC fall, AC also falls because AC = AFC +AVC.

When AFC falls but A VC increases, change in AC depends on the rate of change in AFC and

AVC then any of the following happens:

ifthereisdecrease in AFC and increase in A VC, AC falls,

if the decrease on AFC is equal to increase in Ave, AC remains constant, and

if the d~crease in AFC is less than increase in A VC, AC increases.

The relationship between AC and MC is of varied nature. It may be described as follows:

When MC falls, AC follows, over a certain range of initial output. When MCis failing, the rate of

fall in MC is greater than that of AC This is because in case of MC the decreasing marginal cost

is attributed, : to a single marginal unit while; in case of AC, the decreasing marginal cost is

distributed overall the entire output. Therefore, AC decreases at a lower rate than MC.

Similarly, when MC increase, AC also increases but at a lower rate fbr the reason given in'the

above point. There is however a range of output over which this relationship does not exist. For

example, compare the behaviour of MC and AC over the range of output frbm 6 units to 10 units

(see Figure 3.2). Over this range of ~utput, MC begins to increase while AC continues to

decrease. The reason for this can be seen in Table. 3.1. When MC starts increasing, it

increases at a relatively lower rate, which is sufficient only to reduce the rate of decrease in AC,

i.e., not sufficient to push the AC up. That is why AC continues to fall over some range of output

even, if MC falls.

MC iJ1tetsects AC at its minimum point. This is simply a mathematical relationship between MC

and AC curves when both of them are obtained from the same TC function. In simple words,

when AC is at its minimum, then it is neither increasing nor decreasing it is constant. When AC

is constant, AC = MC.

Optimum Output in Short-run

An optimum level of output is the one, which can be produced at a minimum or least average cost, given the

required technology is available. Here, the least'tcost' combination of inputs can be understood with the help

of isoquants and isocosts. The least-cost combination of inputs also indicates the optimum level of output at

given investment and factor prices. The AC and MC cost Curves can also be used to find the optimum level

of output, given the size of the plant in the short-run. The point of intersection between AC and MC curves

deterinines the minimum level of AC. At this level of output AC = MC. Production beloW or beyond

thislevelwill be in optimal. If production is less than 10 units (Figure 3.2) it will leave some scope for reducing

AC by producing more, because MC < AC. Similarly, if production is greater than 10 units, reducing output

can reduce AC. Thus, the cost curves can be useful in finding the optimum level of output. It may be noted

here that optimum level of output is not necessarily the maximum profit output. Profits cannot be known

unless the revenue curves of firms are known.

Long-run Cost-output Relations

By definition, in the long-run, all the inputs become variable. The variability of inputs is based on the

assumption that, in the long run, supply of all the inputs, including those held constant in the short-run,

becomes elastic. The firms are, therefore, in a position to expand the scale of their production by hiring a

larger quantity of all the inputs. The long-run cost-output relations, therefore, imply the relationship between

the changing scale of the firm and the total output; conversely in the short-run this relationship is essentially

one between the total output and, the variable cost (labour). To understand the long-run costoutput

relations (lnd to derive long-run cost curves it will be helpful to imagine that a long run is composed of a

series of short-run production decisions. As a' corollary of this, long-run cost curves are composed of a

series of short-run cost curves. We may now derive the long-run cost curves and study their' relationship

with output.

Long-run Total Cost Curve (LTC)

In order to draw the long-run total cost curve, let us begin with a short-run situation. Suppose that a firm

having only one-plant has its short-mn total cost curve as given-by STCl in panel (a) of Figure 3.3. In this

example if the firm decides to add two more plants to its size over time, one after the other then in

accordance two more short-run total cost curves are added to STCl in the manner shown by STC2 and STC3

in Figure 3.3 (a):. The LTC can now be drawn through the minimum points of STC l, STC2 and STC3 as

shown by the LTC curve

corresponding to each STC.

Long-run Average Cost Curve (LAC)

Combining the short-run average cost curves (SACs) derives the long-run average cost curve (LAC). Note

that there is one SAC associated with each STC. Given the STC1 STC2, and STC3 curves in panel (a) of

Figure 3.3, there are three corresponding SAC curves as given by SAC1 SAC2 arid SAC3 curves in panel (b)

of Figure 3.3. Thus, the firm has a series of SAC curves, each having a bottom point showing the minimum

SAC. For instance, C1Q1 is the minimum AC when the firm has only one plant. The AC decreases to C2Q2

when the second plant is added and then rises to C3Q3after the inclusion of the third plant. The LAC carl be

drawn through the bottom of SAC1 SAC2 and SAC3 as shown in Figure·3.3 (b) The LAC curve is also known

as ‘Envelope Curve' or 'Planning Curve' as it serves as a guide to the entrepreneur in his planning to

expand production.

The SAC curves can be derived from the data given in the STC schedule, from STC function or

straightaway from the LTC-curve. Similarly, LAC can be derived from LTC-schedule, LTC function or from

LTC-curve. The relationship between LTC and output, and between LAC and output can now be easily

derived. It is obvious. from the LTC that the long-run cost-output relationship is similar to the short-run cost-

output relationship. With the subsequent increase in the output, LTC first increases at a decreasing rate,

and then at an increasing rate. As a result, LAC initially decreases until the optimum utilisation of the

second plant and then it begins to increase. From these relations are drawn the 'laws of returns to scale'.

When the scale of the firm expands, unit cost of production initially decreases, but it ultimately increases as

shown in Figure 3.3 (b).

Long-run Marginal Cost Curve

The long-run marginal, cost curve (LMC) is derived from the short-run marginal cost curves (SMCs). The

derivation of LMC is illustrated in Figure 3.4 in which SAC3'and LAC arethe same as'in Figure 3.3(b). To

derive the LMC3, consider the points of tangency between SAC3 and the LAC, i.e., points A, Band C. In the

long-run production planning, these points determine the output levels at the different levels of production.

For example, if we draw perpendiculars from points A, Band C to the X-axis, the corresponding output levels

will be OQ1 OQ2 and OQ3 The perpendicular AQ1 intersects the SMC1 at point M. It means that at output

BQ2, LMC, is MQ1. If output increases to OQ2, LMC rises to BQ2. Similarly, CQ3 measures the LMC at output

OQ3. A curve drawn through points M3B and N, as shown by the LMC, represents the behaviour of the

marginal cost in the long run. This curve is known as the long-run marginal cost curve, LMC. It shows the

trends in the marginal cost in response to the change in the scale of production.

Some important inferences may be drawn from Figure 3.4. The LMC must be equal to SMC for the

output at which the corresponding SAC is tangent to the LAC. At the point of tangency, LAC = SAC. For all

other levels of output (considering each SAC separately), SAC > LAC. Similarly, for all levels of outout

corresponding to LAC = SAC, the LMC = SMC. For all other levels output, i:he LMC is either greater or less

than the SMC. Another important point to notice is that the LMC intersects LAC when the latter is at its

minimum, i.e., point B. There, is one and only one short-run plant size whose minimum SAC coincides with

the minimum LAC. This point is B where, SAC2 = SMC2 = LAC = LMC.

Optimum Plant Size and Long-run Cost Curves

The short-run cost curves are helpful in showing how a firm can decide on the optimum utilisation of the

plant-which is the fixed factor; or how it can determine the least-cost output level. Long-run cost curves, on

the other hand, can be used to show how the management can decide on the optimum size of the firm. An

Optimum size of a firm is the one, which ensures the most efficient utilisation of resources. Given the state:

of technology overtime, there is technically a unique size of the firm and lever of output associated with the

least cost Concept. This uriique size of the firm can be obtained with the help of LAC and LMCIn Figur 3.4

the optimum size consists of two plants, which produce OQ2 units of a produd, at minimum long-run average

cost (LAC) of BQ2.

The downtrend in the LAC ihdicates that until output reaches the level of OQ2, the firm is of non-

optimal size. Similarly, expansion of the firm beyond production capacity OQ2 causes a rise in SMC as well

as LAC. It follows that given the technology, a firm trying to mini mise its average cost over time must

choose a plant which gives minimum LAC where SAC = SMC = LAC = LMC. This size of plant assures most

efficient utilisation of the resource. Any change in output level, i.e., increase or decrease, will make the firm

enter the area of in optimality.

ECONOMIES AND DISECONOMIES OF SCALE

Scale of enterprise or size of plant means the amount of investment in relatively fixed factors of production

(plant and fixed equipment). Costs of production are generally lower in larger plants than in the smaller

ones. This is so because there are a number of economies of large-scale production.

Economies of Scale Marshall classified the economies of large-scale production into two types:

1. ExternalEconomies

2. Internal Economies

External Economies are those, which are available to all the firms in an industry, for example, the

construction of a railway line in a certain region, which would reduce transport cost for all the firms, the

discovery of a new machine, which can be purchased by all the firms, the emergence of repair industries,

rise of industries utilising by-products, and the establishment of special technical schools for training skilled

labour and research institutes, etc. These economies arise from the expansion in the size of an industry

involving an increase in the number and size of the firms engaged in it.

Internal Ecnomies are the economies, which are available to a particular firm and give it an

advantage over other firms engaged in the industry. Internal economies arise from the expansion of the size

of a particular firm. From the managerial point of view, internal economies are more important as they can

be affected by managerial decisions of an individual firm to change its size or scale.

Types of Internal Economies

There are various types of internal economies such as labour, technical, managerial, marketing and so on.

We will discuss the types of internal economies in detail in the following section:

Labour Economies: If an firm decides to expand its scale of output, it will be possible for it to

reduce the labour costs per unit by practising division of labour. Economies of division of labour

arise due to increase in the skill of workers, and the saving of time involved in changing from one

operation to the other. Again, in many cases, a large firm may find it economical to have a number

of operations performed mechanically rather than manuaily. These economies will be of great use

in firms where the product is complex and the manufacturing processes can be sub-divided.

Technical Economies: These are economies derived from the use of subsize machines and such

scientific processes like those which can be carried out in large production units. A small

establishment cannot afford to use such machines and processes, because their use would bring a

saving only when they are used intensively. On the other hand, their use will be quite uneconomical

if they were to lie idle over a considerable part of the time. For example, a large electroplating plant

costs a great deal to keep it in operation. Therefore, the cost per unit will be low only if the output is

large. Similarly, a machine that facilitates the pressing out a side of a motorcar will take a week or

more to be put ready for operation to produce a particular design. The greater the output of cars of

this particular designs the lower the cost per unit of getting the machine ready for operation.

Similarly, if a dye is made to produce a particular model of cars, the cost of dye per unit of cars will

depend upon the output of the cars. Very often large firms may find it economical to produce or

manufacture parts and components for their products rather than buy them from outside sources.

For example, Hind Cycles, unlike small mariufacturers, produced parts and components

themselves. Moreover, large firms may find it profitable to utilise their by-products and waste

products. For example, Tata use the smoke from their furnaces to manufacture coal tar,

naphthalene, etc. A small firm's output of smoke would not be large enough to justifY setting up the

.equipment necessary to do so.

Managerial Economies: When the size of the fern increases, the efficiency of the management

usually increases because there can be greater specialisationin managerial staff. In a large firm,

experts can be appointed to look after the various sections or divisions of the business, such as

purchasing, sales, production, financing, personnel, etc. But a small firm cannot provide full-time

employm·entto these experts naturally, the various aspects of the business have to be looked after

by few people only who may not necessarily be experts. Moreover, a large firm can afford to set up

data processing and mechanised accounting, etc., whereas small firms cannot afford to do so.

Marketing Economies: A large firm can secure economies in its purchasing and sales. It can

purchase its requirements in bulk and thereby get better terms. It usually receives prompt deliveries,

careful attention and special facilities from its suppliers. This is sometimes due to the fact that a

large buyer can exert more pressure·, at times compulsive in nature, for specially favoured

treatment. It can also get concessions from transport agencies. Moreover, it can appoint expert

buyers and expert salesmen. Finally, a large firm can spread its advertising cost over bigger output

because advertising costs do not rise in proportion to a rise in sales.

Economies of Vertical integration: A large firm may decide to have vertical integration by combining

a number of stages of production. Thisintegration has the advantage that the flow of goods through

various stages in production processes is more readily controlled. Steady supplies of raw materials,

on the one hand, and steady outlets for these raw materials, on the other, make production planning

more certain and less subject to erratic and unpredictable changes. Vertical integration may also

facilitate cost control, as most of the costs become controllable costs for the enterprise. Transport'

costs may also be reduced by planning transportation in such a way that cross hauling is reduced to

the minimum.

Financial Economies: A large firm can offer better security and is, therefore, in a position to secure

better and easier credit facilities both from its suppliers and its bankers. Due to a better image, it enjoys

easier access to the capital market.

Economies of Risk-spreading: The larger the size of the business, the greater is the scope for

spreading of risks through diversification. Diversification is possible.on two lines as follows:

o Diversification of Output: If there are many products, the loss in the sale of one product

may be covered by the profits from others. By diversification, the firm avoids what may be

called putting all eggs in the same basket. For example, Vickers Ltd., make aircrafts,

ships, armaments, food-processing plant, rubber, plastics, paints, instruments arid a wide

range of other products. Many of the larger firms have taken to diversification. ITC

diversified to include marine products and hotel business in its operations.

o Diversification of Markets: The larger producer is glenerally in a position to sell his

goods in many different and even far-off places. By depending upon one market, he runs

the risk of heavy loss if sales in that market decline for one reason or the other.

Sargant Floren'ce and Economies of Scale Sargant Florence has attributed the economies of scale the three principles, which are in operation in a

large-sized business, namely, the principle of bulk transactions, the principle of massed reserves, and the

principle of multiples.

Principle of Bulk Transactions: This principle implies that the cost of dealing with a large batch is

often no greater than the cost of dealing with a small batch, for example,' the cost of placing an

order, large or small; availability of discounts on bulk orders, or annual purchase contracts;

economies in the use or'large containers such as tanks or trucks of special design, for a container

holding, say, twice as much as the other one, does not cost double the amount.

• Principle of Massed Reserves: A large firm has a number of departments or sections and its overall

demand for services, say, transport services, is likely to be fairly large. But it is unlikely that all

departments will make heavy demands of the particular service at the saine time. Thus the firm can

afford to have its own transport fleet and fully utilise it and thereby ultimately reduce its costs. The

larger the firm, the greater are the advantages.

Principle of Multiples: This principle was first raised by Babbage in 1832 and has also been referred

to as 'Balancing of Processes'. The principle can be better explained through an example. Suppose a

manufacturing, operation involves three processes, first in which a machine (:an make 30 units a

week; second in which an automatic machine can make 1,000 units per week; and a third in which a

semi-automatic machine can make 400 units per week. Unles~ the output of the plant is some

common multiple of 30,1,000 anti 400, one or more of the processes will have unutilised capacity.

Their LCM is 6,000 and, therefore, to best utilise all the machines the plant size must be of at least

6,000 units or any of its multiples.

Economies of Scale and Empirical Evidence

According to the surveys conducted by the Pre-investment Survey Group (FAG) and later on by the

NCAER, it has been pf()Ved that in paper industry, profitability decreases with lower scaly of operations and

bigger plants beneht from economies of scale. The report of the Pre-investment Survey Group (FAG)

reveals that the manufacturing cost of writing and printing paper would fall from Rs. 1,489 in a 100-tonne

per day plant to Rs. 1,238 in a 200-tonne per day plant and further to Rs. 1,104 in a 300-tonne per day

plant. The following Table 3.2 further shows the capital cost of raw materials and operating cost per tonne of

paper according to the size of the unit, as estimated by the NCAER.

Table 3.2: Paper Industry: Investment and Other

Costs of Paper Mills according to Size

Size Tonnes Fixed Cost of raw Operatingper day) investment cost ma terials per cost per tonne

'. per tonne tonne of paper of paper100 • 4,473 324 1,307

200 4,070 263 1,116 250 3,945 258 1,056

Another study of cement industry by the Economic and Scientific Research undation-shows that the

per unit of capacity capital investment of a 3,000 tonne per' day (TPD) capacity cement plant islower than

the plants of 50 TPD size. Thus a single cement plant producing 3,200 TPD requires 46 per cent less capital

investment than 8 plants of 400 TPD productions would. As regards cost of production, a 800 TPD plant has

a 15 per cent cost advantage over a 400 TPD plant. The difference between the cost of production of a

tonne of cement by a 3,000 TPD plant and of a50 TPD plant is as high as Rs. 100 per tonne. In fact, there

has been a perceptible increase in the size of cement plants in India. For example, the 600 tonnes per day

capacity cement plants during the early 1960s gave way with their size going up to 1,200 tonnes per day.

The latest preference is for 3,200 tonnes per day capacity plants. A significant policy implication of

economics of scale is that in order to earn a reasonable return and at the same time ensure a fair deal to the

consumers, the industry should go in for larger plants and expand the existing plants to .the optimum level.

The 6/10 RuleA useful rule that seeks to measure economies of scale is the 6/1 0 rule. According to this rule, if we want to

double the volume of a container, the material needed to make it will have to be increased by 6/10, i.e., 60

per cent. A proofofthe'6/l0 rule is easy and can be given here with its advantage. Let us begin with the

volume of a container and the material required to make it. Suppose the container is of the shape of a Gube

with its side. The volume of the container then is:

Vo = ao x ao x ao = ao3

Now, to find out the area of material needed, we know that the container will have six equal square

faces, each of area an 2 so, the area of total material needed IS:

Mo = 6 x ao2 = 6ao2

Suppose now, that the container's dimension increases from an to all the volume of the container will

then increase to al3 and the area of t~e material needed will increase to 6a12.

Thus, for two containers of dimensions an and al the ratio of the areas of material needed will be:

M1

=

6a1/2

=

a1/2

M0 6a0/2 a0

The corresponding ratio of the volumes will be:

V1

=

a1/3

=

a1/3

V0 a0/3 a0

From the above, it follows that:

M1

=

a1/2

=

a1/3.2/3=

V 1 2/3

M0 a0/2 a0 V0

Now, if we double the volume, i.e., if

V1 = 2V0 or

V1

=2V0

Then,

M1

=

V1 2/3

= (20) 2/3 = 1.59M0 V0

M1 = 1.59 M0

In other words, doubling the volume requires 59 per cent increase in material. This is rouJded off

as 60 per cent, which is the same as 6/1O. It may be added that, if in place of a cubical container, we had

taken the example of a spherical or a rectangular or a cylindricai or for that matter a conical container, we

would have aijived at the same relationship, viz.,

M1

=

V12/3

M0 V0

The 6/10 rule is of great practical significance. Its significance can well be realised if we visualise, for

example, blast furnaces as boxes containing the ingredients needed to produce iron, or tankers as large

boxes containing oil.

Minimum Economic Capacity (MEC) Scheme Small size firms do not enjoy economies of scale. As such, in pursuance of government's policy to

encourage minimum efficient capacity in industrial und~i1akings, the Government of India has introduced'

MEC Scheme to petrochemical industries, for example, Naphtha / Gas Cracker (3 to 4 lakhs tonnes), Bopp

Film (56,000 tonnes), Polyster Film (5,000 tonnes), Polyster Filament Yam (25,000 tonnes), Acrylic Fibre

(20,000 tonnes), MEG (One lakh tonnes), PTA (2lakh tonnes), etc.

World Scale With recent trends towards globalisation of industries in India, the concept of "World Scale" has emerged.

The term 'World Scale' refers to that scale or size of the enterprise, which is large enough to enable the firm

to reap various large-scale economies so as to compete successfully on the world basis with global rivals.

Thus Reliance Industries Limited has recently announced to build a world scale polyester facility at Hnzira

and a cracker project with capacity expanding from earlier 40,000 tonnes·to the world scale of 7,50,000

tonnes per annum.

Diseconomies of Scale Economies of increasing size do not continue indefinitely. After a certain point, any further expansion of the

size leads to diseconomies of scale. For example, after the division of labour has reached its most efficient

point, further increase in the number of workers will lead to a duplication of workers. There will be too many

workers per machine for really efficient production. Moreover, the problem of co-ordination of different

processes may become difficult. There may be divergence of views concerning policy problems among

specialists in management

and reconciliation may be difficult to arrive. Decision-making process becomes slow resulting in missed

opportunities. There may be too much of formality, too many individuals between the managers and

workers, and supervision may' become difficult. The management problems thus get out of hand with

consequent adverse effects on managerial efficiency.

The limit of scale economics is also often explained in terms of the possible loss of control and

consequent inefficiency. With the growth in the size of the firm, the control by those at the top becomes

weaker. Adding one more hierarchical level removes the superior further away from the subordinates.

Again, as the firm expands, the incidence of wrong judgements increases and errors in judgement become

costly.

Last be not the least, is the limitation where the larger the plant, the larger is the attendant risks of

loss from technological changes as technologies are changing fast in modern times.

Diseconomies of Scale and Empirical Evidence

Large petro-chemical plants achieve economies in both full usage and in utilisation of a wider range ofby-

products, which would otherwise, be wasted. But above 5,00,000 tonnes, diseconomies of scale sets in

because of the following occurrences:

The plant becomes so large that on-site fabrication of some parts is required which is much more

expensive;

Starting up costs are much higher, more capital is tied up and delays in commissioning can be

extremely expensive; and

The technical limit to compressor size has been reached.

There is, however, no substantial evidence of diseconomies of large-scale production. In the final

analysis, however, a significant test of efficiency is survival. If small firms tend to disappear and large ones

survive, as in the automobile industry, we must conclude that small firms are relatively inefficient. If small

firms survive and large ones tend to disappear as in the textile industry, then large firms are relatively

inefficient. In reality, we find that in most industries, firms of very different sizes tend to survive. Hence, it

can be concluded that usually there is no significant advantage or disadvantage to size over a very wide

range of outputs. It may mean, of course, that the businessman in his planning decisions determines that

beyond a certain size, plants do have higher costs and, therefore, does not build them.

Somewhat surprisingly, some Indian entrepreneurs have been perceptive enough to attempt to derive

the advantages of both large and small-scale enterprises. In the late sixties, the Jay Engineering Co. Ltd.

evolved a strategy of blending large units with small enterprises to obtain the best of both worlds. It

manufactures its Usha fans in three different plants (Calcutta, Hyderabad and Agra), with each plant' manu

facturing the same or a similar range of products. Each unit is autonomous and is free to take operational

decisions except in highly strategic areas. Within each unit, the work-force is kept small to carry out vital

operations such as forgoing, blanking, notching and final assembly. The rest of the work is sub-contracted

to neighbouring small-scale units, which over a period or time have become almost integral parts of each

plant. Loans for the purchase of machinery are also advanced and technical know-how and sometimes-eve

training is provided to these ancillary units.

Payments are made promptly. The whole system operates like families within a larger family. Managers

in the US, who are always quick in innovating, have also begun adopting this blended system during the

past few years. General Motors encourages the creation ofa cluster of independent enterprises in an area,

with adequate autonomy granted to the company's area chief to encourage their growth and developm.ent.

Consequently, though a giant in the automobile industry, General Motors enjoys a large number of the

privileges that acerue to small units and also reaps the special benefits accruing to large business firms.

Economies of Scope

This concept is of recent development and is different from the concept of economies of scale. Here, the

cost efficiency in production process is brought out by variety rather than volume, that is, the cost

advantages follow from variety of output, for example, product diversification within the given scale of plant

as against increase in volume of production or scale 6f output. A firm can add new and newer products if

the size of plant and type of technology make it possible. Here, the firm will enjoy scope-economies instead

of scale economies.

COST CONTROL AND COST REDUCTION

Cost Control The long-run prosperity of a firm depends upon its ability to eam sustaid profits. Profit depends upon the

difference between the selling price and the cost of production. Very often, the selling price is not within the

control of a firm but many costs are under its control. The firm should therefore aim at doing whatever is

done at the minimum cost. In fact, cost control is ail essential element for the successful operation of a

business, Cost control by management means a search for better and more economical ways of completing

each operation. In effect, cost control would mean a reduction in the percentage of costs and, in turn, an

increase in the percentage of profits. Naturally, cost control is and will continue to be of perpetual concern to

the industry.

Cost control has two aspects' such as a reduction in specific expenses and a more efficient use of

every rupee spent. For example, if sales can be increased with the same amount of expenditure, say, on

advertising and saTesmen, the cost as a percentage of sales is cut down. In practice, cost control will

ultimately be achieved by looking into both these aspects and it is impossible to assess the contribution,

which each has made to the overall savings. Potential savings in individual businesses will, however, vary

between wide extremes depending upon the levels of efficiency already achieved before cost controls are

introduced.

It is useful to bear in mind the following rules covering cost control activities:

It is easier to keep costs down than it is to bring costs down.

The amount of effort put into cost control tends to increase when business is bad and decrease

when business is good.

There is more profit in cost control when business is. good than when I business is bad. Therefore,

one should not be slack when conditions are good.

Cost control helps a firm to improve its profitability and competitiveness. Profits may be drastically

reduced despite a large and increasing sales volume in the absence of cost control. A big sales volume

does not necessarily mean a big profit. On the other hand, it may create a false sense of prosperity while in

reality; increasing costs are eating up profits. Profit is in danger-when good merchantdising and cost control

do not go hand in hand. Cost control may also help a firm in reducing its costs and thus reduce its prices. A

reduction in prices of a firm would lead to an increase in its competitiveness. The aspect is of particular

relevance to Indian conditions because of high costs, India is being priced out of the world markets.

Tools of Cost Control Following ar.e the tools that are used for the cost control:

Standard Costs and Budgets: The technique of standard, costing has been developed to establish

standards of performance for producing gvuus and services. These standards serve "as a goal for the

attainment and as basis of comparison with actual costs in checking performance. The analysis of variance

between actual and standard costs will: (i) help fix the responsibility for non-standard performance and (ii)

focus attention on areas in which cost improvement should be sought by pinpointing the source of loss and

inefficiency. The principle here is that or controlling by exception. Instead of attempting to follow a mass of

cost data, the attention of those responsible for cost control is concentrated on significant variances from the

standard. If effective action is to be taken, the cause and responsibility of a variance, as well as its amount,

must be established.

The prime objective of standard costs is to generate greater cost consciousness and help in cost

control by directing attention to specific areas where action is needed. To those who are immediately

concerned, variances wou1d indicate whether any action is required on their part. It must be noted that

Costs are controlled at the points where they are incurred and at the time of occurrence of events,

and

At the same time they may be uncontrolled at some points.

It is, therefore, necessary to understand the difference between controllable and uncontrollable

costs. The variances may also be controllable and uncontrollable. For example, if the material cost variance

is due to rise in prices, it is not within the control of the production manager. But if the variance is due to

greater usage, control action is certainly possible on his part. The higher management can also deCide

whether or not they should intervene in the matter. Sometimes, variances may be so significant that a

complete reapRraisal of the standard costs themselves may be needed.

For example, if the variances are always favourable, it may point to the fact that the standards

have not been properly fixed. Standard costing can also provide the means for actual and standard cost

comparison by type of expense, by departments or cost centres. Yields and spoilage can be compared with

the standard allowance for loss. Labour operations and overheads also can be checked for efficiency.

Flexible budgets constitute yet another effective technique of cost control, especially control of factory

overheads. Flexible budgets, also known as variable budgets; provide a basis for determining costs that are

anticipated at various levels of activity. It provides a flexible standard for comparing the costs of an actual

volume of activity with the cost that should be or should have been. The variances can then be analysed

and necessary action can be taken in the matter. Table 3.3 gives a specimen flexible budget.

Table 3.3: Finishing Department, Modern Manufacturing Co.

Standard hours of direct labour

35,000 40,000 45,000 Labour cost hour at Rs. 3 per Rs. 1,05,000 Rs. 1,20,000 Rs. 1,35,000

Other variable costs 17500 20.000 22,500 Semi-variable costs 9,250 10,000 10,250 Fixed costs 50,000 50,000 50,000 Total Rs.l,81,75Q Rs. 2,00,000 Rs.2,17,750

The scientific establishment of standards of performance through standard costs and budgets has not

only provided better cost control but has led to cost reduction in a number of companies. This has been the

case especiilIIy in companies where standards were tied to wage-incentive plans and improyement in

control is part of a general programme of better management. The above table shows three budgets, one

each for 35,000, 40,000 and '45,000 standard hours of work. In practice, one may come across 50 or more

cost items in the budget and not just four as shown in the table.

Ratio Analysis RatIo is a statistical yardstick that provides a measure of the relationship betweeri two figures. This

relationship may be expressed as a rate (costs per rupee of sales), as a per cent (cost of sales as a

percentage of sales), or as a quotient (sales as a certain number of time the inventory). Ratios are

commonly used in the analysis of operations because the use of absolute figures might be misleading.

Ratios provide standards of comparison for appraising the performance of a business firm. They can be

used for cost control purposes in two ways:

A businessman may compare his firm's ratios for the period under scrutiny with similar ratios of the

previous periods. Such a comparison would help him identify areas that need his attention.

• The businessman can compare his ratios with the standard ratios in his jndustry. Standard ratios are

averages of the results achieved by thousands, of firms in the same line of business.

If these comparisons reveal any significant differences, thtYmanagement call analyse the reasons for these

differences and can take appropriate action to remove' the causeS responsible for increase in costs. Some

of the most commonly used ratios for cost corrtparisons are given below:

• Not profits/sales.

Gross profits/sales.

Net profits/total assets.

Sales/totaLassets.

• Production costs/costs of sales.

Selling Costs/costs of sales.

Admiriistration costs/costs of sales.

Sahes/iriventory or inventory turnover.

Material costs/prod1, Jction costs.

Labour costs/production costs.

Overhead/prqduction costs.

Value Analysis: Value analysis is an approach to cost saving that deals with product design. Here,

before making or buying any equipment or materials, a study is made of the purpose to which these things

serve. Would other lower-cost designs work as well? Could another less costly item fill the need? Will less

expensive material, do the job? Can scrap be reduced by changing the design or the type of raw materiaJ?

Are the seller's costs as low as they ought to be? Suppliers of alternative materIals can provide the ample

data to make the appropriate choice. Of course, absorbing and reviewing the data will need some time. Thus

the objective of value analysis is the identification of such costs in a product that do not in any manner

contribute to its specifications or functional value. Hence, value analysis is the process of reducing the cost

of the prescribed function without sacrificing the required standard of performance. The emphasis is, first, on

identificatiqn of the required function and, secondly, on determination of the best way to perform it at a lower

cost. This novel method of cost reduction is not yet seriously exploited, in our country. Value analysis is a

supplementary device in addition to the con~entional cost reduction methods.

Value analysis is closely related to value engineering, though they are not identical. Value analysis

refers to the work that purchasing department does in-this direction whereas value engineering usually

refers to what engineers are doing in this area. The purchasing department raises questions and consults

the engineering department and even the vendor company's department. Value analysis thus requires

wholehearted co-operation of not only the firm's expertise in design, purchase, production and costing but

also that of the vendor and other company expertise, if necessary. Some examples of savings through value

analysis are given below:

Discarding tailored products where standard components can do.

Dispensing with facilities not specified or not required by the customer, for example, doing away

with headphone in a radio set.

Use ofnewly-deyeloped, better and cheaper materials in place of traditional materials.

Taking the specific case of TV industry, there are various components of cost, which can be

questioned. The various items are as under:

Whether to have vertical holding chassis or the chassis should be tied down horizontally. In case,

chassis is held vertically, additional expenditure in terms of holding clamps is required.

Whether to have plastic cabinet or wooden cabinet.

Whether to have two speakers or one speaker.

Whether to have sliding switches or stationary switches.

Whether to have PVC back cover or wooden back cover.

Whether to have costly knobs or cheaper knobs.

Whether to have moulded mask or extruded plask.

Whether to have Electronic Tuner or Turret Tuner.

Whether to have digital operating unit or noble operating unit.

Cost control is applicable only to such costs, which can be altered by the management on their own

initiative. It may be noted in this context that, by and large, non-controllable costs exceed far more than

controllable ones thereby restricting the scope of profit impfoyement through cost, control. Of course,

attempts may be made to convert an uncontrollable cost into a controllable one. Vertical combinations to

secure control over sources of supply provide an example. So also instead of buying a component, a firm

may decide to make the conversion possible.

AREAS OF COST CONTROL Folloviing are the areas where the cost can be controlled:

1. Materials

There area number of ways that help in reducing the cost ofmatenals. Ifbuying is done properly, a firm avails

itself of quantity discounts. While buying from a particular source, in addition to the cost of materials,

consideration should be given to freight charges. In some cases, lower prices of materials may be offset by

higher freiight to the firm's godown. Whiie buying, one may attempt to buy from the cheapbt source by

inviting bids. At times, it may be possible to have more economical substitutes for raw materials that the firm

is using. Many a times, improvell1ent in product design may lead to reduction in material usage. It is

desirable to concentrate attention on the areas where saving potential is the highest.

Another area, which needs examination in this respect, is whether to make or buy components

from outside source. Very often firm may find it advantageous to manufacture certain parts and components

in one's own factory rather than buying them. Yet in many cases there are specific advantages in

purchasing spares and components from outside because suppliers may deliver goods at low cost with high

quality. For example, Ford and Chrysler of the US Auto Industry purchase their components from outside

source. But General Motors could not do so because the firm has its own departments for handling the

process of production. This type of firm is referred as vertically integrated firm where it owns the various

aspects of making seIling and delivering a product Hind Cycles, which has now been taken over by the

Government, manufactures all its components. But manufacturers of Hero and Avon Cycles purchased most

of their components from outside source and successfully competed with Hind Cycles.

Continuous Research and Development (R & D) may also lead to a reduction in raw material costs.

For example, Asian Paints made high savings in costs of raw materials by its phenomenal success on

Research and Development front, by manufacturing synthetic resins for captive consumption. Total

materials consumed as a ratio of value of production fell from 67.66 per cent in 1973 to 60-67 per cent in

1977. General Motors have reduced the weight of their cars to make them more fuel-efficient. Better

utilisation of materials' may also save the cost of materials by avoiding wastes in storing, handling and

processing. Some of the factors, responsible for excessive wastage of materials are: lack of laid down

requirements for raw materials, bad process planning, rejects due to faulty materials or poor workmanship,

lack of proper tools, jigs and fixtures, poor quality of materials, loose packing, careless and negligent

handling and careless storage.

Exploration of the possibilities of the use of standardised parts and components and the utilisation

of waste and by-products, may also lead to a significant reduction in the cost of materials.

Inventory control is yet another area for reducing materials cost. Thro inventory control, it is

possible to maintain the investment in inventories at lowest amount consistent with the production and

the sales requirements of firm. The cost of carrying inventories ranges from 15 to 20 per cent per annum

account of interest on capital, insurance, storage and handling charges, spilla breakage, physical

deterioration, pilferage and obsolescence. Again 50 per cent the gross working capital may be locked up

in inventories.

Some important ways of reducing inventories are:

Improved production planning.

Having dependable sources of supplies, which can ensure prompt deliver of materials at short

notice.

Elimination of slow-moving stocks and dropping of obsolete items.

Improved flow of part and materials leading to increased machine

utilisation and shorter manufacturing cycles.

Packaging constitutes a significant proportion of raw materials (9 to 24 per cent) and of the total

manufacturing expenses (7 to 22 per cent). Firm should mal attempts to reduce the packaging costs to the

minimum. For example, instead discarding containers that the materials come in it may be used for

shipping tl goods and thus, the packaging cost can be saved. The manufacturing firms such; cars and

motor bikes may request its customers to return the containers in whic are goods were sent so that they

could be used in future. This is because packin of such goods as well as the materials used for packing is

very expensive.

2. Labour Reduction in wages for reducing labour costs is out of question. On the other hand, wages might have to be

increased to provide incentives to workers. Yet there is good scope for reduction in the wage cost per unit. A

reduction in labour costs is possible by proper selection and training, improvement in productivity and by

automation, where possible. A study by cn (Confederation of Indian Industry) showed that Hero Cycles

improved their productivity per employee by 6.4 per cent. 'Purolators' were able to increase their productivity

by 100 per cent. Work· study might result in a lot of savings by reducing overtime and idle time and

providing better workloads. Labour productivity might increase if frequent change of tools is avoided.

Improvement in working conditions may reduce absenteeism and thus reduce costs per unit. Scrutiny of

overtime may reveal substantial scope for savings.

All efforts must be made to redllce wastage of human effort. Wastage of human effort may be due

to lack of co-ordination among various departments by having more workers than necessary, ·under-

utilisation of existing manpower, shortage of materials, improper scheduling, absenteeism, poor methods

and poor morale. For example, Metal Box adopted a Voluntary Severance Scheme in 197576 to reduce

their work force by 950 workers after they faced a huge operating loss ofRs. 2.4 crores. General Motors

eliminated 14,000 white-collar jobs through attrition to reduce cost. Japan's big 5 steel producers announced

substantial retrenchment programmes and workers co-operated with the management. Attempts must be

made to secure co-operation of employees in cost reduction by inviting suggestions from them. These

suggestions should be carefully examined and implemented if found satisfactory. Hindustan Lever has a

suggestion box scheme and employees who come out with good suggestions receive awards. These

suggestions may either lead to savings or improve safety and work convenJence. The basic idea is to

motivate workers and make them perceive working in the firm as a participative endeavour.

3. Overheads

Factory overheads may be reduced by proper selection of equipment, effective utilisation of space

and .equipment, proper maintenance of equipment and reduction in power cost, lighting cost, etc. For

example, fluorescent lighting can reduce lighting cost. Faulty designs may lead to excessive use of

materials or multiplicity of components, waste of steam, electricity, gas, lubricants, etc. A British team invited

by the Government of India to report on standards of fuel efficiency in Indian industry found that fuel

wastages might be as high as an average of 25 per cent. Keeping them in check even in the face of

increasing sales may reduce overhead costs per unit. For example, Metal Box maintained their fixed costs

in 1976-77 even when there was an increase in sales of over 18 per cent.

Taking advantage of truck or wagonloads may reduce transportation cost. Careful planning of

movements may also save transportation cost. Another point to be examined is whether it would be

economical to use one's own transport or hire a transport. For reasons of economy, many transport

companies hire trucks rather than owning them. This is because purchase and maintemince of trucks can be

more expensive. By chartering vehicles the problems of maintenance is left to the owner who in turn Cuts

cost for the firm. Thus by keeping a smaller work force on rolls and by introducing a contract rate linked to a

safe delivery schedule it is possible to ensure speedy point-to-point delivery of goods. Many firms now prefer

to use private taxis rather than have their own staff cars.

Reduction of wastes in general can also reduce manufacturing costs considerably. Of course, a

certain amount of waste and spoilage is unavoidable because employees do make mistakes, machines do

get out of order and sometimes raw materials are faulty. However, attempts can be made to reduce these

mistakes and faulty handling to the minimum. The normal figure for the waste and spoilage depends upon

the complexity of the product, the age of the manufacturing plant, and the skill and experience of the

workers. Once normal wastage is found out, production reports must be watched carefully to find out

whether the wastages are excessive. Wastes can be reduced considerably by educating operators in the

causes and cures of the wastes. Bad debt losses can be reduced considerably by selecting customers

carefully, and keeping an eye on the receivables. Concentrating on areas and media can reduce advertising

costs, which give the best results.

Selling costs can be controlled by improving the supervision and training of salesmen, rearrangement of

sales territories, replanting salesmen's routes and calls and redirecting of the sales efforts, to achieve a more

economic product mix. It may be possible to save selling costs by the use of warehouses, making bulk

shipments to the warehouses and giving faster deliveries to the customers. Centralisation, reduction, clerical

and accounting work may also lead to cost savings. A look at the telephone bills and the communication cost

in general may also reveal areas for substantial savings. For example a telegram may be sent in place of a

trunk call.

(a) Cost Reduction The Institute of Cost and Works Accounts of London has defined cost reduction as "the achievement of real

and permanent reductions in the unit costs of goods manufactured or services rendered without impairing

their suitability for the use intended". Thus, cost reduction is confined to savings in the cost of manufacture,

administration, distribution and selling by eliminating wasteful and unnecessary elements from the product

design and from the techniques and practices carried out in coilOection with cost reduction?

(b) Cost Contro/and Cost Reduction

According to the Institute of Cost and Works Accounts, London, "cost control, as generally practised, lacks

the dynamic approach to many factors affecting costs, which determine the need of cost reduction." For

example, under cost control, the tendency is to accept standards once they are fixed and leave them

unchallenged over a period. In cost reduction, on the other hand, standards must be constantly challenged

for improvement. And there is no phase of business, which is exempted from the cost reduction. Products,

processes, procedures and personnel are subjected to continuous scrutiny to see where and how they can

be reduced in cost.

To achieve success in cost reduction, the management must be convinced of the need for cost

reduction. The formulation of a detailed and co-ordinated plan of cost reduction demands a systematic

approach to the problem. The first step would be the institution of a Cost Reduction Committee consisting of

all the departmental heads to locate the areas of potential savings and to determine the priorities. The

Committee should review progress and assign responsibilities to appropriate personnel. Every business

operation should be approached in the belief that it is a potential source of economy and may benefit from a

completely new appraisal. Often, it may be possible to dispense entirely with routines, which, by tradition,

have come to be regarded as a permanent feature of concern. Cost reduction is just as much concerned

with the stoppage of unnecessary activity as with the curtailing of expenditure. It is imperative that the cost

of administering any scheme of cost reduction must be kept within reasonable limits. What is reasonable

must be determined in all cases from the relationship between the expenditure and the savings, which result

from it.

Essentials for the Success of a Cost Reduction Programme

Following are the some of the points that firms should take care in order to achieve success in the cost

reduction programme:

Every individual within the firm should recognise· his responsibility. The co-operation of every

individual requires a careful dissemination of the objectives and interest of the employees in the

achievement of the firm's goals.

Employee resistance to change should be minimised by disseminating complete information about the

proposed changes and convincing the emplcyees that the changes are concerned with the

problems faced by the firm and that they would ultimately benefit.

Efforts should be concentrated in the areas where the savings are likely to be the maximum.

Cost reduction efforts should be continuously maintained.

There should be periodic meetings with the employees to review the progress made towards cost

reduction.

(c) Factors Hampering Cost Control in India

The cost of raw material and other intermediate products is generally high. In many cases: the cost of raw

materials is substantially higher than their international prices, which makes it difficult for the Indian firms to

compete in foreign markets. The sharp rise in oil prices in recent years also gave a severe push to the cost

of raw materials with petrochemical base. Shortages of raw materials are a usual phenomenon. With a view

to insuring against these shortages, manufacturers keep larger inventories, which result in increase in their

costs. This occurs especially in case of imported raw materials. Wages are always being linked to cost of

living. There are wage boards for almost every industry and management has little control on wage rates.

Overheads are also higher in India due to the following reasons:

The size of the plant is very often uneconomic due to the Government's desire to prevent

concentration of economic power. However, there is now a marked change in the policy. In 1986,

the Government announced that 65 industries would be started with minimum economic capacity so

as to 'make India's products competitive. This process got a boost after the new Industrial Policy

was announced in July 1991.

There is under-utilisation of capacities due to lack of raw materials and power shortage. However a

manufacturer can exceed his capacity by improving the techniques of production process. Even

after making improvements, a manufacturer lacks the way to completely minimise the possibilities of

increase in the overheads.

Machinery and equipment obtained under tied credits usually cost 30 to 40 per cent more than what

it wouid cost if purchased in the open market.

There are delays in the issue of licences and by the time licences are issued, cost of equipment

goes up. The number of industries subject to licensing has now been drastically reduced.

Increase in administered prices for many items crucial to the industrial production by the

Government from time to time also pushes up costs.

Finally, there is what lis called by businessmen as 'unseen overheads' in the nature of demands for

illegitl gratification by various Government officials at different administrative levels.

There are indirect taxes, which also tend to raise the overall costs of production in India. Excise

duties and saies taxes also heighten the impact of indirect taxes on the cost of production. India is perhaps

the only country where basic raw materials carry heavy excise duties. According to an estimate by Mr. S.

Moolgaokar, Chairman, TELCO, as much as Rs. 25 crores of working capital is locked up in inventories and

work-in-progress with TELCO and its suppliers solely due to the present tax structure.

Until recent times the Indian industrialists operated in a sheltered domestic market. They were

protected against foreign competition by import controls and against domestic competition due to industrial

licensing. So long as this sellers' market prevailed competition among sellers was absent and there was no -

compelling reason for the industrialists to pay any attention to cost reduction. Cost consciousness was thus

by and large absent in India. The price fixation for products under price control ensured that the rise in costs

was fully reflected in the prices. This made it possible for the industrialists to pass on any increase in costs

to the consumers. However, now with the advent of recession tendencies, and liberalisation in licensing

policies, the Indian industrialist is compelled to pay greater attention to cost reduction and cost control.