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Engineering Economics
 9789350432471, 9789350243442

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Engineering Economics Dr. E. Dharmaraj, M.A., M.Phll., Ph.D. Member, Board of Studies, University of Madras, Chennai, Tamil Nadu.

Hal GJiimalayaGJlublishingCflouse MUMBAI • DELHI • NAGPUR • BANGALORE • HYDERABAD

©

No part of this book shall be reproduced, reprinted or translated for any purpose whatsoever without prior permission of the athor and Publisher in writing.

ISBN

: 978-93-5024-344-2

Revised Edition :2010

Published by

Branch Offices Delhi

Nagpur Bangalore Hyderabad

Printed by

Mrs. Meena Pandey for HIMALAYA PUBLISHING HOUSE, "Ramdoot", Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004. Phones: 386 01 70/386 38 63, Fax:'022-387 71 78 Email: [email protected] ' Website: www.himpub.com "Pooja Apartments", 4-B, Murari Lal Street, Ansari Road, Darya Ganj, New Delhi - 110002. Phone: 327 03 92, Fax: 011-325 62 86 Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 018. Phone: 72 12 16, Telefax: 0712-72 12 15 No. 12, 6th Cross, Opp. Hotel Annapoorna, Gandhinagar, Bangalore - 560 009. Phone: 2281541, Fax: 080-228 6611 No. 2-2-1167/2H, 1st Floor, Near Railway Bridge, Tilak Nagar, Main Road, Hyderabad - 500 044. Phone: 650 1745, Fax: 040-7560041 Bhave Pvt. Ltd., 242, Belasis Road, N agpada, Mumbai - 400 008. .

.Contents 1

SIGNIFICANCE OF ECONOMICS

1-12

Introduction - Definitions of Economics - Wealth Definition - Welfare Definition - Scarcity Definition - Modem Definition. Main Divisions of Economics - Micro Economics - Macro Economics - Consumption - Production - Exchange - Distribution - Public Finance - Major Issues in Economics Engineering Economics - Characteristics - Engineering Economics and other subjects.

2

DEMAND ANALYSIS

13-49

Meaning - Demand Schedule - Shape of the Demand Curve '- Law of Demand - Elasticity of Demand - Types of Elasticity of Demand - Measurement - Elasticity of Substitution - Law of diminishing marginal utility - Law of equi marginal utility - consumers surplus - With graphical and Tabular illustrations

3

DEMAND FORECASTING

50-59

Meaning - Types of Demand Forecasting - Forecasting Methods 4

PRODUCTION FACTORS

Meaning of production - Factors of production Land - Features - Labour - Features -Division of labour - Efficiency of labour - Capital - Features - Capital formations - Low growth of capital formation Organizations - Features - Individual Enterprises - Partnership - Joint Stock Companies - Co-operative Organisation - Public Enterprises - Advantages - Disadvantages.

60-78

5

SUPPLY ANALYSIS AND PRODUCTION THEORIES

79-100

Factors Determining Supply - Law. of Supply - Supply Curve - Elasticity of supply - Kinds of Elasticity of Supply - Law of variable proportions -'Return to scale -' Production function- Linear function - cobb Douglas function - CES function - with Graphical and-Tabular Illustrations.

6

COST AND OUTPUT RELATIONSHIP

101-118

Costs Concepts - Kinds of Costs - Relationship lJetween Marginal Costs, Average ~osts - engineering cost - short run and long run costs - Tot.al Costs with Graphical Illustrations.

7

MARKET STRUCTURE

119-149

Meaning of the Markets - Classifications of Markets - Monopoly - Perfect Competition - Imperfect Competition - Oligopoly - Duopoly and other Market Structures. Price Output Determination -with graphical and Tabular illustrations.

8

BREAK EVEN ANALYSIS

150-159

Meaning - Usefulness - Break Even Point - Break Even Chart - Assumptions - Limitations - Popularity - Advantages - Applications ....: Graphical and Tabular Illustrations

9

PRICING METHODS AND PRICE POLICY Importance - Objectives ~ Pricing Methods - Price Fixation - Regulation of Prices - Legal Restrictions -. MRTP Act. 1969 - Essential Commodities Act, 1955 - Drug (Price control) Order, 1970 - Problems in Pricing - Pricing Policies - Internal Factors- External Factors - Basing Point Pricing.

160-173

10

NATIONAL INCOME

174-179

Measurement of National Income - Output Method - Income Method ~ Expenditure Method -. GNP - NNP at Factor Cost - Personal Income - Disposable Income.

11

INFLATION AND DEFLATION

180-191

Meaning - Types ofinflation,- Measures to Control Inflation - Deflation -. stagflation - Inflation and Economic development - wholesale price index .:... consumer price index.

12

PRODUCTION AND PRODUCTIVITY ANALYSIS

192-202

Production. Management - Type of Production - Productivity - Difference - Application of Productivity Techniques - Significance - Factors Affecting National Productivity -' Industrial Productivity - Human Factor for Low Productivity.

13

CAPITAL BUDGETING

203-216

Meaning of Capital - Fixed Capital - Working Capital- Factors Affecting Working Capital- Source of Finance - D~mand for . Capital - Capita.! Productivity - Supply of Capital - Credit Rationing - Objectives - Necessity - Process of Capital Budgeting - Methods of Preparing Capital Budget, - Method of Appraising Profitability - Evaluation of Appraisal Methods with Graphical and Tabular lliustrations

14

DECISION MAKING PROCESS AND PRINCIPLES OF MOTION ANALYSIS Economic Decision Making - Technical Decision Making - Technical Efficiency and Economic Efficiency - Principles - Sub Divisions - Rules Relating to Design of Tools and Equipment - Motion analysis - use of human body - use of w9rk place.

217-223

"This page is Intentionally Left Blank"

1 Significance of Economics

INTRODUCTION The origin of the term 'Economics' lies in the Greek words oikan and nomos. It means laws of households signifies household economics. The subject now been defined as a social science which covers the actions of individuals and groups of individuals in the process of producing, exchanging and consuming of goods and services. Economics is the oldest of the arts, the newest of the sciences, and it is indeed, the queen of the social sciences. It is growing fast and . hence its scope is continually changing and expanding as defined and discussed at different times by different economists. DEFINITIONS OF ECONOMICS Adam Smith, the father of Economics in his book (published ·in 1774) An Inquiry into the Nature and Causes of Wealth of Nations emphasized Economics as Science of Wealth. French economist, J.B Say, opines that Economics is the science which treats of wealth. Prof. Walkar, an American economist says that economics is that body of knowledge which relates to wealth. Professor Smith defines economics

-

-

-

---- -

---

En,glneerlng Economics : 2

as the study of ho-..y in a civilized society one obtains the share of~hat other people have produced and how the total product-of the society changes and is determined. By civilized society, it ,means legal institution as well d,S rights of property and other things in the society. This definition contains (1) the problem of distribution of income among ~arious members of the society (2) how to~al ~nc,ome and employment are determined.lt incorporates the theory of ecenomic growth since it explicitly states that economics inquires into how the ,total product of society changes. It means that economists should explain the factors which determine economic growth of the .country which implies the increase in the natural product over a long period of time. But' this definition , has neglected the problems of aIlocation of resources and pricing of pn)ducts which has been the concern of econoniics. 1. Wealth Definition

Adam Smith, the father of Economics, in his bdOk An inquiry into the Nature and Causes of the Wealth of Nations, analy~es the factors that determine. the growth in the volume of production.' .~is emphasis is on the wealth of a nation. The great object of political economy of every countryis to increase the riches of that country. Adam Smith · emphasizes the production and expansion of wealth as a subject matter of economics and the factors that determine'the growth of the volume of production. , Ac~ordingto Adam' Smith, Economics is the study of the nature and causes of wealth of nations. Acquisition of 'wealth is the main objective of human activity, how wealth is produced and consumed. In short, Sm~th views eco~omics as science of wealth. Criticism of Wealth Definition

Economics is a social science which deals with human behaviour. But there is no mention of man in wealth definition. Another drawback of the wealth definition is undue emphasis on wealth producing ' activities 'but neglected other area's of human effort. Marshall pointed out that for economics, wealth is. not an end in itself but only a means to an end; the end being the promotion of human welfare. According to Marshall, wealth is only a secondary thing, it is man and his Qrdinary business of life which is the primary object of the economic study.

SignifIcance of Economics : 3

2. Welfare Definition(Marshall's Definition) Marshall gives his definition of economics in his book Principles of Economics published in·1890. The welfare definition in economics is the study of mankind in the ordinary business of life; it examines that part of individual and s@cial action which is most closely connected with the attainment and with the use of the material requisites qf wellbeing. It is a study of a man as such not of wealth. It studies man' II action regarding how he earns .wealth and how he spends it. Economics is the study of wealth ·and study of man. Welfare definition implies that economics is concerned with a particular aspects of man's life. There are many aspects like social, religious and political etc. Economics is the study of man's action in the ordinary business of life. It enquires how he gets his income and how he uses it. Marshall takes into account only the material things that are capable of promoting welfare. Hence, Marshall's definition is known. as the material welfare definition. of economics. Ml;lny other economics like Pigou and Cannan h;lve defined economics in welfare terms. According to Edwin Cannan, the aim of political economy is the explanation of the general causes on which the material welfare of human beings depends. According to Pigou, Economic sciebce, economic welfare being that part of social welfare that can be brought directly or indirectly into relation with the measuring rod of money. Marshall gave a respectable place to economics among the social sciences, he laid emphasis on man and his welfare as the primary object in the promotion of material welfare. Economists are concerned with only one aspect of human welfare which is concerned with the achievement and the use of the material means of welfare. Criticism of Welfare Definition

According to Lionel Robins, it is incorrect to say that economics is concerned with material things alone. He points out that how the prices of non-material services such as professional skills of doctors, engineers al1d singers etc. are determined and they are also the important topics of price theory. It is difficult to separate material welfare from other types of welfare. The concept of welfare is not fixed and definite one, but differs. Welfare is a subjective thing and it varies from person to person.

Engineering Economics : 4

According to Robins, economi~s is concerned with many goods and activities which are thought to be harmful to human welfare. For example, the production of alcoholic drinks and opium are certainly economic activities, but they are not conducive to human welfare. According to him, economics studies the problems due to the scarcity of resources. Goods and services are scarce in relation to demand, it would carry price in the market. Nature has not provided to mankind sufficient resources to satisfy all their wants. 3. Scarcity Definition Lionel Robbins introduced a new defiqition which is known as Scarcity definition. His book The Nature and Significance of Economic Science was published in 1932. Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. This definition is based upon the following three facts. (i) Unlimited Wants: Human wants are unlimited, the fundamental

facts of economic life of the peopl~. In reality, when one want is satisfied another want arises and so ~m with unequal intensity. People are able to allocate their resources to satisfy some of their wants due to different intensities.

(ii) Scarce Means: The second element is that the resources are scarce in relation to wants. All wants cannot be satisfied. In actual life, we cannot obtain goods freely, we have to pay the price for them and choose between the wants and allocating the resources to satisfy the most urgent wants. (iii) Alternative Uses of Means: Resources can be put into several uses.. For example, coal can be used as fuel for industries, running trains, domestic cooking and many other uses. Man has to choose the uses various alternative uses of resources to decide the best allocation of resources. So the economic problem essentially is the problem of ~hoice. Robins did not distinguish between material and non-materials, between welfare and non-welfare. It deals with how resources would be allocated to satisfy different wants. The question of choice arise~ whenever the wants are many and resources are scarce.

Significance of Economics : 5

Criti'::ism of Scarcity Definition 1. The question of allocation of scarce resources does not arise without the satisfaction or welfare. 2. Economists should have to tell what is good or bad for welfare and progress. The role of the economist is not only to explain but also to educate and condemn .. 3. It has reduced economics to (I. mere value theory. In macro economics, we study how national income of a country and total employment are determined. Price fluctuations and polices for removing fluctuations in the levels of income, output and employment. All these things are absent in Robbins's theory. 4. It does not cover the theory of economic growth and development 5. It is the duty of the economist to study the causes of the problem of unemployment and surplus labour and to suggest means to solve it. 6. Economics is a social science and it should study the problems of choice when it has social aspect and concerned with the administration of scarce resources.

RECENT DEFINITIONS OF ECONOMICS Scarcity definition does not cover the theory of income and employment determination as well as the theory of economic growth. Prof. Henry Smith defines as the study of how in a civilized society and obtain the share of what other people have produced and of how the total products of society changes and is determined. This definition contains three main subjects and problems of economics. Firstly, it contains the problem of distribution of income among various sections of the society. Secondly, how to determine economic growth of the country which implies the increase in the national product over a long period.

Samuelson's Definition Prof.Samuelson's growth oriented definition recognizes the dynamic changes taking place in the economy. It is termed as the growth oriented definition of economics. Samuelson gives his definition in his book. Economics. Economics is the study of how men and society choose

Engineering Economics: 6

with or without the use of money, to employ scarce productive resources which could have alterative uses to produce various commodities overtime and distribute them for consumption now and in the future among various people and groups of society. For example suppose a society wishes to produce goods like paddy, cotton, textiles, aeroplanes and musical instruments. To produce these goods they have inputs like land, machinery, equipment, technology etc.are scarce in relation to demand. So there is competition between producers to obtain the inputs. The available inputs have to be allocated among the competing lines of production. This forces the community to choose between various wants and the uses of available resources. Economic studies how a society makes these decisions or choices. Implication of the Definition 1. Samuelson has stressed the problem of scarcity of means in relation to unlimited ends. 2. Samuelson includes the element of time, within its purview the problem of growth has wide in scope. 3. It deals with the problems of choice in its dynamic setting. Human wants are dynamic In character it not only changes but also multiplies. 4. Economics is therefore the study of the allocation of scarce resources in relation to unlimited ends and of the determination of income, output, employment, and economic growth. 5. Economics may be defined as a social concerned with the proper use and allocation of resources for the achievement and maintenance of growth and stability. Superiority of Samuelson's Definition Samuelson's growth oriented definition appears to be most satisfactory in the sense that it is applicable to capitalist, communist and mixed economic system. Criticism of the Definition Some economists strongly oppose the attempt of defining economics, Prof. Jacob Viner says Economics is what economists do. It is very difficult to define the boundaries of a social science. As times passes, there are new topics that might be included. Any definition

Significance of Economics : 7

which is given today may not be accurate tomorrow. The problem of studying and dealing with definition in economics, assumes greater importance in the context of multiplicity of definitions. The latest developments in social sciences need to be assimilated for a proper understanding of economic problems. MAJOR DIVISIONS OF ECONOMICS

Economics is a subject, and has been divided broadly into two parts: Micro Economics and Macro Economics. These terms were first used by Ragnar Frisch and latter many economists adopted world wide. The term Micro Economics derived from the Greek word, Mikros which means small. The term Macro derives from the word Makros which means large. Micro Economics deals with the analysis of small or individual unit of the economy such as individual consumption, savings and individual units. According to K.E. Boulding, Micro Economics is the study of particular firm, particular household, prices, wages, income of individual industries and particular commodities. Macro Economics concerns with the analysis of the aggregate economy such as national output, income, employment, consumption and investment etc. Micro Economics

In Micro Economics, we see a microscopic study of the economy. Prof. Lerner says Micro economics consists of looking at the economy through a microscope, as it were, to see how the millions of cells in the body, economic the individuals or households as consumers and the individuals or firms as producer pay their part in the working of the whole economic organism. For instance, in Micro economic analysis, we study the demand of an individual consumer for a good and from there go on to derive the market demand for the good (i.e. demand for a group of individuals consuming a particular group). Micro economics theory studies the behaviour of the individual firms in regard to the fixation of price, output, their reactions on the demand and supply conditions. It seeks to determine the mechanism in which the different economic units attain the position of eqUilibrium, proceeding from the individual units to a narrowly defined group. It also explains how they are allocated to the production of particular good. It is the allocation of resources that determine what goods shall

Engineering Economics : 8

be produced and how they shall be produced. The theory of product pricing and factor pricing fall within the domain of micro economics. Economists are concerned about the four basic questions: (1) what goods shall be produced and in what quantities, (2) how they shall be produced, (3) how the goods and services shall be distributed and (4)whether the production of goods and their distribution for consumption is efficient within the domain of micro economics. Micro economics occupies a significant role in the study of economic theory which has both theoretical and practical points of view. It explains the functioning of a free enterprise economy and tells how millions of consumers and producers take part in decision making about the proper allocation of productive resources. It explains how goods and services produced in the community are distributed through market mechanism. It also explains the determination of the relative prices of the various products and productive services. It explains the conditions of efficiency both in consumption and production and departure from the optimum. Micro economics analysis can be applied to Public finance and International economics. It is used to explain the factors that determine the distribution of the incidence or burden of commodity tax between producers or sellers and consumers. It shows economic efficiency by the imposition of a tax. Micro economics helps in the formulation of economic policies to promote efficiency in production and for the welfare of masses. However, micro economic analysis suffers from certain limitations. (a) It cannot give an idea of the functioning of the economy as a whole. An individual industry may be flourishing, whereas the economy as a whole may be languishing. It assumes full employment which is a rare phenomenon in the capitalistic world.

Macro Economics Macro economics analyses the behaviour of the whole economic system in totality. It studies the behaviour of the aggregates such as total employment, national product or income, the general price level of the economy. Prof. Boulding says that Macro economics deals not with individual's quantities as such but with the aggregates of these quantities; not with individual income but with the national income; not with individual prices but with the price levels, not with individual output but with the national output. Prof. Gardner Ackley says Macro economics concerns itself with such variables as the aggregate volume of the output of an economy,

Significance of Economics : 9

with the extent to which its resources are employed, with the size of the national income, with the general price level. The subject matter of macro economics is to explain what determines the level of national income and employment and what causes the fluctuations in the macro variables like level of income, output and employment. The classical theories of Adam Smith, David Ricardo, Malthus and 1.S. Mill mainly discussed the determination of growth of national income and wealth, the division of national income among the broad social classes o~ general price level, effect of technology and population increase on the growth of economy. Recently, the theory of economic growth (Growth economics) is a long run phenomenon of the economy. Macro economic models of Harod and Domar have revealed the rate of growth of income that must take place if the steady growth of the economY,is to be achieved. The growth theories have been further extended which applies to both the developed and underdeveloped economics explain the causes of underdevelopment and poverty in underdeveloped countries for initiating and accelerating growth generally known as Economic development. In 1936, 1.M Keynes published a book A General Theory of Income, Employment, Interest and Money. It is a macro economic model revealed how consumption function, investment function, liquidity preference function conceived in aggregate terms, interact to determine income, employment, interest and the general price level. The reason for the separate study of macro economics is the generalization of micro approach about the behaviour of the economic system as a whole may give misleading conclusions. In fact. the micro economics and macro economics are complementary to each other.' Samuelson rightly says there is really no opposition between micro and macro economics, both are absolutely vital.

Engineering Economics Engineering Economics deals with the application of economic principles in engineering. It is the study of efficient utilization of the factors of production considering profit, demand, cost, pricing, production, and competition. It fulfills the functions of decision making and solve the problems of business management. The tools of economic analysis have most relevance in decision making process for engineers.

Engineering Economics : 10

Features 1. Engineering economics is basically micro economics in discipline and does not deal with the entire economy. 2. It is a pragmatic approach, It avoids complication in economics theory and face the situation in which decisions are made. 3. It considers the particular decision making environment.

Scope of Engineering Economics Engineering economics is closely related to certain important subjects, viz., Economics, Statistics, Mathematics and Accounting. An innovative engineer can integrate all the subjects; concept and methods to restructure the engineering problems in the industrial way. In precise, Operation research, Management accounting and Econometrics have close networking link with engineering economics. Engineering economics can be regarded as a discipline which integrates economics theory with engineering practice. It is not only drawing upon the logic of economics but also enriches itself from the analytical tools of mathematics and statistics. It can be analyzed and understand the engineering problems. The relevant topics of engineering economics are Business cycles, National Income Accounting, Industrial Policies, Taxation, Foreign trade, Anti monopoly policies and Industrial relations. Main Divisions in Economics

1. Consumption Consumption means destruction of utilities. It is the satisfaction of human wants through goods and services. Many important economic laws governing consumption are Law of demand, Law of diminishing marginal utility, Law of substitution, the Engel's law of family expenditure and the Concept of consumer surplus. 2. Production In economics, Production means creations of utilities. All productive operations are the result of the four factors of production, viz., land. labour, capital and organisation. 3. Exchange In exchange, we study market conditions. The system of valuation and exchange of goods by using money, banking and financial institutions. In value determination, commodity demand and supply

Significance of Economics : 11

becomes equally important. The value of a commodity is determined by the interactive forces of demand and supply in all types of market conditions.

4. Distribution It deals with how national income is shared among the four factors of production as rent, wages, interest and profit. In distribution branch of economics, we deal with theories of rent, wages, interest and profit. Distribution is interrelated and interdependent because there can be no consumption without production. Moreover, the link between production and consumption have to be analyzed in distribution. S. Public Finance In public finance, we study the finance of governments. It deals with how government raises resources to meet the increasing expenditure. Dalton says it is concerned with the income and expenditure of public authorities and with the adjustment of one to the other. Public finance has a vital role in the developed countries, to ensure stability at full employment and steady rate of economic growth. For the developing countries, how to generate a higher rate of economic growth so as to tackle the problems of price stability, besides maintaining price stability. Public finance has not only to augment resources for development and to achieve optimum allocation of resources, but also to promote fair distribution of income and ~xpansion in employment opportunities. There are two important branches of public finance, viz., public expenditure and public revenue. There are other divisions of which, general economist deals with specialized branches. They are International Economics, Monetary Economics, Economics of Growth, Economics of Planning, Agriculture, Industry, and Labour Welfare. Managerial Economics Managerial economics is an application of economics in decision making. It is one of the branches of economics, provides a link between economic theory and practice based on economic analysis for identifying problems and evaluating alternatives. To have a clear understanding, a few definitions of managerial economics are important which are given below. Managerial economics is the economic modes of thought to analyze business situations. Siegelman defines that the integration of economic theory with business practice for the purpose of facilitating, decision

Engineering Economics: 12

making and forward planning by management. Watson defines as price theory in the services of business executives. It is the application of economic theory and methodology to business management practices. Hague defines it as a fundamental subject which seeks to understand and analyse the problems of business decisions making. Features 1. Managerial economics is concerned with decision making economics by nature. It implies that identification of economic choices and allocation of scarce resources. 2. It deals with how decisions should be made by managers to achieve the organisational goals. 3. It is pragmatic and concerns with those analytical tools useful for decision making. 4. Managerial economics provides a link between traditional economics and the decision science for managerial decision making. S. It estimates and predicts the economic quantities, economic forecasting and suggests various outcomes of probabilities for managers to choose the firm. 6. The managers must understand and adjust the external factors like Government intervention, Taxation, and Business cycle fluctuations etc. 7. Managerial Economics is micro economics in character and concentrates only on the study of firm. 8. It is normative rather than positive in approach. It is perspective rather than descriptive. It concerns with the decisions involve value judgements not the behaviour of the firm. REVIEW QUESTIONS 1. What are the major divisions in Economics? 2. An inquiry into the nature and causes of wealth of nations - Discuss? 3. Explain the salient features of welfare definition of economics? 4. State the significance of Engineering Economics? 5. State Lionel Robbins's definition of Economics?

(April, 2002)

6. Distinguish between Micro and Macro Economics?(Oct, 2001& April, 2002) 7. What is Economic Analysis?

(April, 2002)

2 Demand Analysis

MEANING Demand is desire with the ability to buy a commbdity. It is a multi-variate relationship which is determined by many factors. The demand for a commodity depends on its price, prices of other commodities, income and tastes of consumers. In common parlance, several other factors which affect the demand are invention of new products, changes in policies of commerce and industry, changes in income distribution, urbanization, population, credit availability, past level of income and demand. We can express the economic relationship of demand in mathematical terms by demand equation as givenbelow:

Q = bo+b/+b/o+b/ +bi Where

= Quantity of commodity demanded P = Price of the commodity PO = Prices of other commodities Y = Income of consumers Q

T

= Tastes

bO' b J,b2 , b3, b4. are coefficients

Engineering Economics: 14

Demand is a function of price, it varies inversely wit~ price and it can be expressed as D =f (p) where D is demand and P is price. More precisely, the functional relationships of demand can be explained wJth an example. If the price falls by 10 percent, it does not mean that the demand will increase exactly by 10 percent. We can say that the demand will expand when price falls, but we cannot say how much this will depend on the elasticity of demand.

Types of Demand Importantly, there are three types of demand which are briefly discussed as follows.

1. Price Demand In general, demand refers to price demand alone. Price demand refers to various quantities of a commodity or service that a consumer would purchase at a given time in a market at various hypothetical prices. The demand for an individual consumer is called Individual demand. The total demand of all the consumers combined for the commodity or service is called Industry demand.

2. Income Demand Income demand refers to various quantities of goods and services purchased by the consumer at different levels of income. Income demand shows the relationship between income and quantity demanded of goods and services~

3. Cross Demand The cross demand means the quantities of a good or service which will be purchased with reference to changes in price of inter-related goods. These goods are either substitutes or complementary in nature.

Shape of the Demand Curve It is graphical presentation of quotations of good which will be demanded by the consumer at different prices in a given period a time. It is very important to know the relationship of price and demand. It depends upon the tastes and preferences of the consumer, his income, the prices of substitutes and complementary goods. The demand curve or demand schedule may change" if any changes occur and both new demand schedule and new demand curve may exist. Generally, the demand curve slopes downward from left to right. But in some occasions

Demand Analysis: 15

instead of sloping downward, it will rise upwards. When people buy more at the price rises, it can be represented by a rising demand curve, such cases are very rare. It was first investigated by Sir Robert Giffen. The Giffen paradox holds that the demand is strengthened with a rise in price or weakened with a fall in price. Benham has mentioned it from such situation, when a serious shortage is feared, people get panic and buy more at high price. In case of the use of commodity, wealthy people buy more when price rises. They may cut their purchases, if they believe the commodity is inferior one. People buy more at a higher price in sheer ignorance also. If the price of necessary goods goes up, the consumers will readjust their whole expenditure and cut down expenditure on food items and spend on the particular good. By doing this, more goods will be purchased at high price. The demand curve simply shows how the quantity purchased varies with the variations in price. It is depicted in figure 2.1. On the X axis, represents various levels of quantity demand and on the Y axis, the prices of the commodity at various levels. It will be seen at price OP, OQ level quantity of commodity is purchased, at OPt' the quantity purchased is OQI and at OP2 price OQr The demand curve is also known as average revenue curve because the price paid by the consumer is revenue per unit for the seller. Let us assume that there are three consumers in a market demanding bananas. When the price of bananas is Rs. 10, the consumer A buys one dozen banana and B buys 2 dozens. When the price falls to Rs. 8, A buys 2, B buys 3, and C buys one. When price falls to Rs. 6, A buys 3, B buys 4 and C buys 2 and so on. By adding up the quantity demanded by all the three consumers at various prices, we get the market demand curve. Market demand schedule is presented in Table 2.1. In the market demand schedule, difficulties arose due to the tentative assumptions. In practice, there are numerous consumers with different scale 'of income and expectations of price at varying degrees. As mentioned earlier, suppose, there are three individual buyers (A), (B) and (C) of good in the market. Fig 2.2 shows the demand curve of the three independent buyers. The market demand curve is obtained by adding the amounts of the goods purchased by each individual consumer. We can plot the quantities of good that is demanded by all the three individual consumers at different prices. When all points show

Engineering Economics: 16

the quantity demanded for the good at various prices which slopes downward to right.

Table 2.1: Market Demand Schedule Price ofa dozen banana (Rs.)

Demand by consumers A B C

Market demand by all three consumers

10

1

2

0

3

8

2

3

1

6

6

3

4

2

9

4

4

5

3

12

2

5

6

4

15

y

~---------r~

p

,

p1

-------------------r--- -------

GI

:

Q.

:

.2

'

,,, ,

,,

o

Q

2

Q

Q

1

x

Quantity demanded

Fig. 2.1: Shape of Demand Curve.

Reasons for the Downward Slope of Demand Curve (1) The law of demand is based on the law of diminishing marginal

utility which explains marginal utility of additional unit of the commodity decrease, as the consumer uses more and more quantity of the particular commodity. The consumer will pay low price for additional units of the commodity. (2) The operation of the principle of Equi-marginal utility in which the consumers may arrange their purchase in such a way that marginal utility is equal in all the quantities purchased.

Demand Analysis: 17 y

.. . c c

10

D

.c

'0 8

'"

.!!

;;. 6 4 2 0

D

5

10 15 20 Quantity Demanded

25

X

Fig. 2.2: Market Demand Curve.

(3) The law of demand that operates on account of the commodities have several end uses. If the price of the commodity is high, the end uses will be restricted to very important purpose and if the price falls, the commodity purchased will be used for several purposes. (4) Nature and tendencies of people to buy more commodities when price falls. The downward slope of demand curve can be best explained by the help of marginal utility analysis and indifference curve analysis. The increase in real income of the consumer induces to buy more of a commodity whose price falls. The other reason is substitution effect. Marshal explained the downward sloping demand curve with the help of substitution effect. Hicks and Allen put forward indifference curve with both the income effect and substitution effect. The Law of Demand The law of demand expresses the relationship between quantity demanded of commodity and its price. The law states that demand varies inversely with price, not necessarily proportionately. If price falls, demand will rise and vice versa. The law states that a rise in the price of a commodity or service is followed by a decrease in demand and a fall in price is followed by an increase in demand, if conditions of d>'Jmand remain constant. According to Marshall the greater the

Engineering Economics: 18

quantity to be sold, the smaller must be the price. In other words, the quantity demanded increases with afall in price and-diminishes with a rise in price. Obviously, the law demand is based on law of diminishing marginal utility. Assumptions of the Law of Demand

The law of demand is based on the following assumptions: 1. Income of the consumer is constant 2. Prices of other goods remain the same 3. Tastes and preferences of the consumers are unchanged 4. Expectation of future price change is not applicable 5. Existence of continuous demand for a commodity 6. No perfect substitutes of a commodity. Influencing Factors of Demand

1. Changes in Demographic Structure A change in the population growth will-bear direct relationship between the price and quantity of certain commodities. If birth rate increases more instant baby foods will be demanded and vice versa.

2. Change in Taste and Fashion According to the law of demand, when price falls, demand is expected to increase. But in the meantime consumer's tastes have made greater change in fashion and as a consequence demand may be low even with the price falls. For example, readymade shirts. 3. Changes in Real Income When prices fall real income increases, which help people to demand certain goods in major quantities. When goods become cheaper, the purchasing power of money increases. In other words, when real income increases it enables a buyer to buy more quantities of certain goods. 4. Changes in the Distribution of Income The demand for goods changes with changes in distribution of wealth in the community. By progressive tax, wealth tax of rich in the demand for essential goods by the poor increases, while the demand for luxuries will fall.

Demand Analysis: 19

5. Technical Progress Inventions and discoveries brought new goods in the market as a result old goods are no longer demanded. The best example in this case is colour television sets replacing black and white television. 6. Advertisement Effect and Media Effect Advertisement campaign in various media create growing demand for many consumer durable goods and health products. The best examples are toilet products and medicines. The law of demand can be illustrated by a demand schedule and by a demand curve. The demand schedule is presented in Table 2.2. It will be seen from the demand schedule that the price of a commodity is Rs. 14 per unit, consumer purchases 5 units of the commodity. When the price of the commodity falls to Rs.I0 he purchases 15 units of the commodity. Similarly, when the price further falls, qu~ntity demanded by him goes on rising until at price Rs. 4 the quantity demanded by him rises to 30 units. V

0 15 C

10 B

• .2

ir. A 5

o

0

Q

R

s

x

Units of commodity

Fig. 2.3: Law of Demand.

We can draw demand curve from the demand schedule by graphically plotting various price quantity combinations. Figure 2.3 illustrates the quantity demanded and the price levels of the commodity.. On the X axis, quantity demanded is measured and along the Y axis, the price of the commodity is measured. By plotting 5 units of the commodity at price Rs.14, we get point Q in the figure. Likewise by

I

~.

Engineering Economics : 20

plotting 15 units of commodity demanded at price Rs.I0 we plot point K in the figure. Similarly points J, K and M are plotted representing other combinations of price and quantity demanded by joining various points, we get a demand curve DD.

Table 2.2: Demand Schedule Price (rupees)

Quantity Demanded(units)

14

5

12

10

10

15

8

20

6

25

4

30

Exceptions to the Law of Demand Law of demand is believed to have some exceptions. Veblen, an economist argues that some consumers measure utility of a commodity by its price i.e., greater the price of a commodity, the greater is it's utility. Another exception is Giffin good. Sir Robert Giffin postulated the direct price and quantity of demand relationship of goods in which the rise in the price of a commodity, the quantity demanded of a . commodity increases and vice versa. In this case, the demand curve will slope upward to the right. Future expectation of price changes due to natural calamities. Therefore even if the price of food grains is high, the consumers demand more quantities, as contrary to the law of demand. The demand for many commodities may increase during prosperity periods due to the rise in the income of the people and the demand for many commodities may decrease during the time of depression period due to fall in the income of the people. Some people demand high priced commodities more than the low priced commodities. It is because the consumers who buy more of the high priced commodities may have the view that the high priced commodities are superior than the low priced commodities.

Limitation of the Law of Demand In some cases, the demand does not contract when price rises and vice versa. Such cases are indicated by exceptional demand (upward

Demand Analysis: 21

rising of demand curve). The law will hold good if the following conditions of demand remains unchanged. These conditions relate to the consumer's tastes, income, price of other goods, substitutability of goods and expected price changes etc. The traditional static theory of demand explains only a few determinants of demand. An important implicit assumption of the theory of demand is that firms sell their products directly to the final consumers but in the modern prices. Another defects of the theory is that it does not deal with the demand for investment goods and intermediate goods but only deals with the consumers demand. The total demand includes both the final demand and the intermediate demand for goods. ELASTICITY OF DEMAND Elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to a change in its price, income and prices of related goods. There are three types of elasticity of demand: (1) Price elasticity of demand, (2) Income elasticity of demand and (3) Cross elasticity of demand. Let us discuss briefly each of them as follows:

I.

Price Elasticity of Demand

Price elasticity of demand expresses the response of quantity demanded of a good to change in its price, the income of the consumer, his tastes and preferences and price of all other goods. Therefore, price elasticity means the degree of responsiveness or sensitiveness of quantity demanded of a good to change in its prices. More precisely, it is defined as the proportionate change in quantity demanded in response to a small change in price divided by the proportionate change in price. Therefore, Price Elasticity =

Proportionate change in quantity demanded

Change in quantity demanded Quantity demanded Change in price Price

Proportionate change in price

Engineering Economics: 22

L\q Q L\q x In symbols ep = = L\P L\P P

P q

Where ep stands for price elasticity q stands for quantity P stands for price L\ stands for infinitesimal change.

Price elasticity of demand (ep) is negative, since the change in quantity demanded is in the opposite direction to the change in price. When price falls, quantity demanded rises and vice versa. For instance, if 2 percent change in price leads to 4 percent change in quantity demanded of good A and 8 percent change in that of B, then the above formula of elasticity will give the value of price elasticity of good A is equal to 2 and of good B is equal to 4. It indicates that the quantity demanded of good B changes much more than that of good A in response to a given change in price. It is a matter of understanding that there is a considerable variations between different goods with regard to the magnitude of response of demand to changes in price. The demand for some goods is more responsive to change in price than those of others. In economic terminology, the demand for some goods is more elastic or price elasticity of demand for some goods is greater than those of the others. Elasticity is a matter of degree only. There is no commodity for which the demand is completely inelastic and no good whose demand is perfectly elastic. Demand for a good is said to be elastic, if the elasticity of demand for the good is greater than one. The demand for a good is inelastic, if the elasticity of demand is less than one. Unitary elasticity of demand represents the dividing line between elastic and inelastic demand. Some goods show great changes in respect of elasticity of demand, i.e. their responsiveness to change in price. But goods like salt, wheat and rice are very irresponsive to change in their prices. The demand for salt remains the same for a small rise or fall in price. Hence, the demand for salt is said to be inelastic. Demand for goods like radios and refrigerators is elastic because the price of these goods bring to a large change in the quantity demanded.

Demand Analysis: 23

Types of Elasticity of Demand

1. Perfectly Elastic Demand When a small change in price leads to an infinitely large change in quantity demanded. It is said to be perfectly elastic demand. Figure 2.4 shows an infinitely elastic demand curve DD, which is a horizontal straight line parallel to the X axis. It shows that even an infinitesimally small reduction in price leads to an unlimited extension of demand. y

Pl-----------

D

o Quantity Demano

x

Fig. 2.4: Perfectly Elastic Demand.

2. Perfectly Inelastic Demand Perfectly inelastic demand refers to a large change in price causes no change in quantity demanded. Figure 2.5 shows perfectly inelastic demand or zero elasticity. The demand curve DD is a vertical straight line perpendicular to X axis and parallel to Y axis. It shows that the price may fall or rise, the amount demanded remains the same. In this figure, the quantity demanded is OD both at price OP and at price OP I. In actual life, elasticity of demand for a good is somewhere between more than zero but less than infinity.

3. Relatively Elastic Demand A small change in price leads to a big change in quantity demanded. It is said to be relatively elastic demand. Figure 2.6 illustrates that, as price increases from OP to OP I the quantity demanded for the commodity decreases from OQI to OQ2 which is more than the price.

Engineering Economics: 24

4. Relatively Inelastic Demand Relatively inelastic demand exists when a large change in price leads to a small change in amount demanded. The demand curve is steeper and the elasticity is less than one. Consider figure 2.7. When price falls from OP to OP I, the quantity increased from OQ to OQI which is smaller than the change in price. 5. Unit Elasticity of Demand Elasticity is said to be unitary, the change in demand is exactly equal to the change in price. In other words, unit elasticity of demand represents the dividing line between elastic and inelastic demand. Consider figure 2.8. In figure 2.8, the two areas on the X axis and Y axis are equal, i.e. the total amount spent on the purchase of the commodity at different prices and the quantity demanded is the same. Therefore, elasticity of demand in this case is unity. Such a curve is called as equilateral or rectangular hyperbola. y

CD

D

II

c,

P

c

.2

Ii.

o

D

x

Quantity Demanded

Fig. 2.5: Perfectly Inelastic Demand.

II. Income Elasticity of Demand Income elasticity is a measure of responsiveness of potential buyers to a change in income. It shows that how quantity demanded will change when the income of the purchaser changes the price of the commodity remains unchanged. It may be defined as the ratio of the percentage change in the amount spent on the commodity to a percentage change in the consumer's income, price of commodity remains constant.

Demand Analysis : 25 y

.

.~ P I------+------'~N Q.

o

o

o

01

x

Quantity

Fig. 2.6: Relatively Elastic Demand. y

o I-----\E

.~ 1\ '.

..

.~ P,

...

I

i '.-

I

:

i

o

Q

'---------. 0

I

x

Q,

Quantity

Fig. 2.7: Relatively Inelastic Demand. y

o

p CD

.~

0-

~ 1-------+------~C1 ---0

o

Q

Q1

Quantity Demanded

Fig. 2.8: Unit Elastic Demand.

x

Engineering Economics : 26

' . Proportionate change in quantity purchased Income Elastlclty = Proportionate change in income It is equal to unity when the proportion of income spent on a good remains the same even though income has increased. It is said to be greater than unity, when the proportion of income spent on a good increases as income increases. It is said to be less than unity, when the proportion of income spent on a good decreases as income increases. It is said to be zero, when a change in income makes no change in demand and it is said to be negative when with an increase in income, the consumer purchases less in case of inferior goods. Both the price elasticity and the income elasticity are valuable in the measureme~ of demand for different commodities. It is also helpful in measuring the incidence of taxation. Let Y stands for an initial income, ~ Y for a small change in income, q for the initial quantity purchased, ~q for a change in quantity purchased as a result of a change in income and ei for Income elasticity of demand. ~q

ei

q ~q y ~qY = -~y =-x-=-xq ~Y ~Y q Y

For, instance, a consumer's income rises from Rs. 100 to Rs.102, his purchase of good X increases from 25 units per week to 30 units, then his income elasticity of demand for X is

ei

=

5 25 1 1 1 50 --=-x-=-x-=10 2 5 50 5 1 100

Measurement of Income Elasticity of Demand Income demand curve shows .the quantity demanded for the good at different levels of income. Normally with the increase in income, more quantity of the good will be demanded. Income demand curve slopes upward from left to right. We shall explain the measurement of income elasticity at a point on the income demand curve. In figure 2.9,

Demand Analysis: 27

DK is the income demand curve. It is required to measure income elasticity at point R on it. At point A, OS quantity of the good is demanded at income equal to SA. Suppose the income increases from SA to RB and as a result quantity demanded increases by SR or AC.

Using income elasticity formula ei = ~q

xy

~y

q

at point A, ei =

AC CB

SA OS

-x-

Now, take triangles ACB and ASK LBAC = LAKS LACB = LASK (right angles) Third LSAK = third LCBA Therefore the triangles ACB and ASK are similar Hence

AC 'CB

KS SA

-x-

b · . subsntutmg -KS",lor -AC.m (.) 1 a ove we get SA CB

. KS SA KS atpomtR= - x - = SA OS OS Therefore, income elasticity at point A can be obtained by measuring KS and OS and dividing the former by the latter. Since in the figure KS is smaller than OS, income elasticity at point A is less than one. Therefore, if income demand curve on its being extended downward meets the X axis to the right of the point of origin, income elasticity will be less than one. III. Cross Elasticity of De~and The change in the demand for one good in response to the change in price of the other good represents cross elasticity of demand for one good to another good. Sometimes the demand for two goods are so related to each other, that if the price of anyone of them changes, the demand for other good also changes while price remains the same.

Engineering Economics : 28 y

D

GI

E

o

c

A

(,)

c

o

S R K Quantity dem anded

x

Fig. 2.9: Income Elasticity of Demand. y

D \

\\ P,

.....

"-

---~

~ ~l----LI ~'~

~P

j

o

M2 (A)

M,

Quantity of good X

x

,

D

I

o

G, (8)

G2

x

Quantity of good Y

Fig. 2.10: Cross Elasticity of Demand.

It is illustrated by Fig 2.10, where the demand curve of two goods X and Yare given. Initially, the price of good Y is OP 1 at which OG 1 quantity of it is demanded and the price of good X is OP at which OM 1 quantity of it is demanded. Suppose the price of good Y falls from OP 1 to OP 2 , while the price of good X remains constant at OP. As a consequence of the fall in price of good Y from OP 1 to OP2 , its quantity demanded rises from OG 1 to OG 2 by drawing demand curve DD for

Demand Analysis : 29

good .?C, it is assumed that the prices of other goods (including Y) remains the same. Now the price of good Y has fallen and as a result, the quantity demanded has increased, it will have an effect on the demand for good X. If good Y is a substitute for good X, then as a result of the fall in price of good Y from OPt' to OP 2 the demand curve for good X will shift to the left, i.e. the demand for good X will decrease. This is because, as the quantity of a good increases, the marginal utility of its substitute good declines and therefore the marginal utility curve of the substitute good shifts to the left. As we have seen from Fig 2.10 as a result of the fall in price of good Y, the demand curve of good X shifts from DD to the dotted position of DPI so that at price OP now less quantity OM 2 of X is demanded, M I, M2 of good X has been substituted by G I,G 2 of good Y. When the quantity demanded of good X rises as a result of the fall in the price of good Y the co-efficient of cross elasticity of demand of X for Y will be equal to the relative change in the quantity demanded for good X in response to a given relative change in the price of good Y. Proportionate change in the Co-efficient of Cross Elasticity of Demand of X for Y

=

quantity demanded of X Proportionate change in the price of good Y

i\qX orec

qX i\qX i\PY i\PY = QX - PY

=

PY

=

i\QX x PY QX i\PY

i\QX PY =--MYQX Where ec

stands for cross elasticity of demand of X for Y

Q x stands for the original quantity demanded of X

i\Qx PY

stands for change in quantity demanded of good X

i\P y

stands for a small change in the price Y

stands for the original price of good Y

Engineering Economics: 3U

Elasticity of Substitution Elasticity of substitution is one of the important concepts of demand elasticity. Elasticity of substitution between two goods is a measure with which one can be substituted for the other. When substitution between two goods is easy, then a small change in the proportion of two goods possessed by the consumer, the change in the marginal rate of the substitution between the two goods will not be much. When substitution is difficult between one good for another, then the small change in the proportion of the goods will bring about a large change in the marginal rate of substitution between goods. Therefore, from the change in the proportion of two goods and the resultant change in the marginal rate of substitution, we know clearly the elasticity of substitution. The elasticity of substitution can be expressed as follows: Proportionate increase in the .. S b· . EI astIclty u stItutlon

amount of X with respect to Y =-----------=------Proportionate decrease in the marginal rate of substitution of X for Y

Where es stands for elasticity of substitution

qx q y stands for the original proportions between the quantities of good X and Y.

a(:: )

stands for the small change in the proportion of good X and Y.

L\ L\ y stands for the original marginal rate of substitution of good X x

for Y.

Demand Analysis : 31

A(

~: ) stands for the change in the marginal rate of substitution

of good X for Y. The concept of substitution elasticity of demand can be easily understood with the aid of an indifference curve. In Figure 2.11, the Indifference curve between two close substitutes has been drawn. Being close substitutes, the indifference curve is nearer to a straight line. On the other hand, in Fig 2.12 the indifference curve between two complementary goods has been Crawn. Since the substitution between the two complementary goods is difficult, the convexity of the indifference curve between the two goods is very large. y

y

C

C;

E

>

>

~

~

'C

'C

o

0

E E

E E

0

o

IC

o

0

F Commodity X

Fig 2.11: Elasticity of Substitution (Close Substitutes).

X

D

F

X

Commodity X

Fig 2.12: Marginal Rate of Substitution (Complementary goods).

In both the indifference curves the point from L to M there is same change in the marginal rate of substitution whereas in both the indifference curves, the fall in the marginal rate of substitution of X for Y between L to M is the same. The increase in the quantity of X in the indifference curve in Fig 2.11 is much greater than the increase in quantity of X in indifference curve in Fig 2.12. These two figures will show that the distance of the point M, and M2 in Fig 2.11 is greater than the distance of the points M, and M2 in Fig 2.12.

Engineering Economics : 32

When the two goods X and Yare perfect substitutes of each other, then the proportion between them (i.e. qX ) can be increased infinitely without any change in the marginal rate of substitution between them i.e. elasticity of substitution between q Y the perfect substitute is infinite and that is why the indifference curve of the two perfectly substitute goods is a straight line. Goods are perfect complements in nature if th~y are used in a fixed proportion and no substitution is possible between them. Therefore, for those complement goods, the marginal rate of substitution between them is zero.

THEORY OF CONSUMER'S BEHAVIOUR The demand for a commodity depends on the utility that commodity to a consumer if a consumer gets more utility from a commodity, he would be willing to pay a higher price and vice-versa. Utility is the want satisfying power of a commodity. It is a subjective entity and varies from person to person. It should be noted that utility is not the same thing as usefuln~ss. In economics, the concept of utility is ethically neutral. Therefore, utility hypothesis forms the basis for the theory of consumer's behaviour. Three important theories that explain consumer's behaviour are (i) Marginal utility analysis, (ii) Equi marginal utility and (iii) Indifference curve analysis

I.

Marginal Utility Analysis

The Marginal utility analysis is the oldest theory of demand which provides an explanation of consumers demand for a product and it derives from the law of demand which shows inverse relationship between price and quantity demanded of a product. However, marginal utility approach to the theory of demand has been subjected to bitter criticisms. There are two laws, which occupy a significant place in utility theory. They are: (I) The law of Diminishing Marginal Utility and (2) The law of Equi Marginal Utility. Marshall was the famous exponent of the Marginal utility analysis. He stated the law of diminishing marginal utility as the additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has. This law is based upon two important facts. Firstly, while total wants of man are unlimited. Each want is satiable. Individual consumer

Demand Analysis : 33

demands more and more units of good beyond certain point, he needs no more units of the good when saturation point is reached, when marginal utility of a good becomes zero. It implies that the individual has all that he wants of the good in question. The second fact is that the law of diminishing marginal utility is based on different goods which are not perfect substitutes for each other in the satisfaction of particular wants. This law describes a very fundamental tendency of human nature. In simple words, it says that as a consumer takes more unit of a good, the extra satisfaction that he derives from an extra unit of good goes on falling. It is to be noted that it is the marginal utility and not the total utility which declines with the increase in the consumption of a good. This theory is formulated by Alfred Marshall. It seeks to explain how a consumer spends his Income on different goods and services so as to maximize satisfaction. This theory is based on certain assumptions.

Basic Premises of Marginal Utility Analysis Marginal utility analysis of demand is based upon certain important assumptions, which are as follows: 1.

Cardinal Measurability of Utility

According to the exponents of marginal utility analysis, Utility is a cardinal concept. ie. It is measurable and quantifiable entity. A person can express the utility or satisfaction which he derives from a good in quantitative terms. Moreover, the cardinal measurement of utility involves that a person can compare in respect of size how much one level of utility is greater than another. Utility may be regarded as measurable only in principle. According to Marshall, marginal utility measurable in principle, is also measurable in terms of money. Some economists (Cardinalist school) measure utility is imaginary units called Utils. They feel that a consumer is capable of saying that one apple provides him utility equal to 4 utils. Further, he can say that he gets twice as much utility from an apple as from an orange.

2. Hypothesis of Independent Utilities The second tenant of cardinal utility analysis is the hypothesis of independent utilities. The utility which a consumer obtains from a good does not depend upon the quantity consumed of other goods. The Cardinalist school views that utility as additive, i.e. separate utilities of

Engineering Economics : 34

different goods can be added to obtain the total utilities of all goods consumed.

3. Constancy of Marginal Utility of Money Marginal utility analysis assumes that marginal utility of commodities diminishes as more of them are consumed, but the marginal utility of money remains constant. Marshall measured marginal utilities in terms of money. When the price of a good falls, the real income of the consumer rises, the marginal utility of money to him will fall and vice versa. 4. Introspective Method Another important assumption of Marginal utility analysis is the use of introspecti ve method in judging the behaviour of marginal utility. It is the ability of the observer to reconstruct events which go on with the help of observation by another person. 5. Rationality . Every consumer is rational. He seeks to maximize satisfaction by the maximization of his total utility subject to the constraint imposed by his given income. How a consumer attains equilibrium position i.e. how he spends his money income on different commodities so as to derive maximum satisfaction. Table 2.3: Total and Marginal Utility Schedules Quantity of Coffee Consumed (cups per day)

Total Utility ( Utils)

Marginal Utility( Utils)

1 2

20 35 45 54 62 68

0 15

3

4 5 6 7 8

72

75

9

77

10

78 76

11

10

9

8 6 4 3 2 1 -2

Demand Analysis: 35

Let us illustrate the law with the help of an example. Consider Table 2.3. The total utility and marginal utility derived by a person from cups of coffee consumed per day. When one cup of coffee is taken per day, the total utility derived by the person is 30 utils and marginal utility derived is also 30 utils with the consumption of 2nd CUp per day the total utility rises to 50 but marginal utility falls to 20. As seen that consumption of coffee increases to 10 cups per day, margi~l,ll utility from the additional cups goes on diminishing. When the cups of coffee consumed per day increases to 11, then instead of giving positive marginal utility, the eleventh cup of coffee gives negative marginal utility.

Marginal utility curve

10

10

11

Quantity of coffee

Fig. 2.13: Marginal Utility Curve.

As seen in Figure 2.13, the marginal utility curve goes on declining throughout and it applies almost to all commodities. However, a few exceptions have been pointed out by some economists. limitations of the Law

The important limitations of the law are as follows: 1. The law of diminishing marginal utility operates under certain assumptions only. 2. Different units consumed should be identical in all respects such as income of the consumer remain unchanged. It is not practicable.

Engineering Economics : 36

3. The different units consumed should consist of standard units. 4. There should be no time gap or interval between the consumption of one unit and another unit. 5. The law may not apply to articles like gold, diamond and cash in which greater quantity may be preferred. 6.

The shape of the utility curve may be affected by the substitutes or complements. For example, the utility obtained from coffee may be affected if no sugar is available. Since coffee and sugar are complementary goods.

II. The Law of Equi Marginal Utility Equi marginal utility principle is explained by the principle of consumers equilibrium. The law of Equi marginal utility states that the consumer will distribute his money income between the goods in such a way that the utility derived from the last rupee spent on each good is equal. Consumer is in equilibrium position when marginal utility of money expenditure on each good is the same. So the marginal utility of money expenditure on good is equal to the marginal utility of a good divided by the price of the good.

Assumptions of the Law 1. The consumer has a given fixed income in which he has to spend on various goods that he demanded. 2. The consumer is assumed to be rational i.e. he calculates and substitutes goods for one to another to maximize satisfaction. 3. The consumer behaviour will be governed by two factors,viz., Marginal utilities of a good and the prices of two goods. Symbolically MUe = MUx Px Where Mue is marginal utility of money expenditure, Mux is the marginal utility of x and Px is the price of x. The consumer is in equilibrium in respect of the purchases of two goods X and Y when Mux/px= Muy/py. If Mux/px and Muy/py are not equal and Mux/px is greater than Muy/py then the consumer will substitute good X for good Y. As a result, the marginal utility of good

Demand Analysis : 37

X will fall and marginal utility of good Y will rise. The consumer will continue to substitute good X for good Y till Mux/px becomes equal to Muy/py. When Mux/px becomes equal to Muy/py, the consumer will be in equilibrium. The consumer will go on purchasing goods till the marginal utility of expenditure on each good becomes equal to the marginal utility of money to him. Therefore, the consumer will be in equilibrium when Mux/px = ~uy/py =Mum. The law of equi marginal utility can be explained by Table 2.4.

Table 2.4. Marginal Utility of Two Goods (X and Y) Mux (utils)

Muy (utils)

4 5

20 18 16 14 12

24 21 18 15

6

10

3

Units

2 3

9

Let us assume that the price of goods X and Y be Rs. 2 and Rs. 3 respectively. Restructuring the above table by dividing marginal utilities of X (Mux) by Rs. 2 and marginal utilities ofY (Muy) by Rs. 3 and we get with Rs. 16 as income of the consumer, suppose his marginal utility of money is constant at Re. 1=6 utils. By looking at the table, it is clear that Mux/px is equal to 6 utils when the consumer purchases 5 units of good X; and Muy/py is equal to 6 utils when he buys 3 units of good Y. Therefore, the consumer is in equilibrium when he is buying 5 units of good X and 3 units of good Y and spend (Rs. 2 x 5 + Rs. 2 x 3) = Rs. 16 on them. Table 2.5: Marginal Utility of Expenditure Units

Mux/Px (Utils)

MuylPy (Utils)

10

8

2

9

7

3

8

4 5

7

6 5

6

3

6

5

Engineering Economics : 38 ·10

y

c MY. P,

D

o

Q

Quantity

x

Fig. 2.14: Consumber's Equilibrium (Equimarginal Utility).

Consumer's equilibrium is graphically portrayed in Fig. 2.14. Since the marginal utility curve slopes downward depicting Mux/px and Muy/ py will also slope downward. As the income of a consumer is given, let his marginal utility of money be constant at OM utils in Fig 2.14. Mux/px is equal to OM (the marginal utility of money) when ON amount of good X is purchased Muy/py is equal to OM when OQ quantity of good Y is purchased. Therefore, when the consumer is buying ON of X and OQ of Y, then Mux/px=Muy/py=Mum. The Equi marginal condition for the equilibrium of the consumer can be stated in three ways. Firstly, the consumer is in equilibrium, when he equates weighted marginal utilities of all goods. When Mux/ px = Muy/py = Mum/pm = Mum. Secondly, a consumer is in equilibrium, when he equalizes the ratios of marginal utilities of goods with the ratio of corresponding prices for each pair of goods consumed Le. when MuxlMuy = px/py and Muy/Muz = py/pz. Thirdly, since Mux/ px measures the marginal utility of a rupee's worth of each good consumed at the given price, consumer is said to be in equilibrium when the marginal utility of a rupee spent on each good consumed is equal.

Demand Analysis: 39

Limitations of the Law of Equi Marginal Utility The following are the important shortcomings of the law. (1) Consumers are generally governed by habits and customs on which they spent regardless their satisfaction. (2) Consumers behaviour is explained with the help of ordinal utility also. (3) The marginal utilities cannot be equated in case of indivisibility of certain goods. For example car and food grains. The marginal utility of a rupee obtained from a car cannot be equalized with that obtained from food grains.

III. Indifference Curve Analysis A very popular and more realistic method of explaining consumer's demand is the Indifference curve analysis based on consumers preferences. It believes that human satisfaction being a psychological phenomenon and cannot be measured quantitatively in monetary terms. It is much easier and scientifically sound to order preferences than to measure them in terms of money. The consumer preference approach, is, therefore an ordinal concept based on ordering of preferences.

Assumptions (1) The consumer is rational and possesses full information about all relevant aspects of economic environment in which he lives. (2) The consumer is capable of ranking all combinations of goods according to his satisfaction he derives. If he is given various combinations, say A, B,C,D,E he can rank them as first preference, second preference and so on. If a consumer happens to prefer A to B, but to not tell quantitatively how much he prefers A to B. (3) If the consumer prefers conimnation A to B, and B to C, then he must prefer combination A to C. (4) If the combination A has more commodities than combination B, then A must be preferred to B.

Indifference Curves Ordinal analysis of demand is based on indifference curves. An indifference curve represents all those combinations of goods which

Engineering Economics : 40

give same level of satisfaction to the consumer, the consumer is indifferent among them. In other words, since all the combinations provide same level of satisfaction, the consumer prefers them equally and does not mind which combination he derives. To understand the indifference curves, let us consider the example in Table 2.6 of a consumer who has one unit of food and 12 units of cloth. Now we ask the consumer how many units of cloth he is prepared to give up to get an additional unit of food, so that his level of satisfaction does not change. Suppose the consumer says that he is ready to give up 6 units of cloth to get an additional unit of food. We will have two combinations of food and cloth giving equal satisfaction to the consumer: The combination A has 1 unit of food and 12 units of cloth, the combination B has 2 units of food and 6 units of cloth. Similarly, by asking the consumer further, how much of cloth he will be prepared to forgo for successive increments in his stock of food so that his level of satisfaction remains unaltered.

Table 2.6: Indifference Schedule Combination

Food

Clothing

A

1

12

B

2

6

C

3

4

D

4

3

V

B

'" u c

5o

c o

o

2

3 Food

4

5

6

Fig. 2.15: Indifference Curves.

X

Demand Analysis: 41

In figure 2.15, an indifference curve IC is drawn by plotting the various combinations of the indifference schedule, the quantity of food is measured on the X axis and the quantity of cloth on the Y axis. As in indifference schedule, combinations lying on an indifference curve will give the consumer same level of satisfaction. Indifference Map A set of indifference curves is called indifference map. An indifference map depicts a complete picture of consumer's tastes and preferences. In figure 2.16, an indifference map of consumer is shown which consists of three indifference curves. y

>"C

o o

CJ

IC]

o

Good X

x

Fig. 2.16: Indifference Map.

We have taken good X on the X axis and good Y on the Y axis. It should be noted that while the consumer is indifferent among the combinations lying on the same indifference curve, he certainly prefers the combinations on the higher indifference curve than the combinations lying on a lower indifference curve because a t.igher indifference curve signifies a higher level of satisfaction. Thus, while all combinations of IC I give same satisfactions, all combinations lying on IC 2 give greater satisfaction than those lying on ICI.

Engineering Economics : 42

Properties of Indifference Curves The following are the important properties of indifference curves: 1. Indiffetence Curves Slope Downward to the Right It implies that when the amount of one good in combination is increased, the amount of the other good is reduced. This is essential if the level of satisfaction has to remain the same on an indifference curve.

2. Indifference Curves are Convex to Origin It has been observed that as more and more of one commodity (X) is substituted for another (Y), the consumer is willing to P-o o



"'iii

.:

E' p t-'-'-'-..L..J.....L.....L-'-u.....:~ as E

"0 C

o

as

MU

G>

.~ Q.

o '-------Q~---- X Amount of commodity

Fig. 2.19: Consumer's Surplus.

Engineering Economics : 48

The concept of consumer's surplus is illustrated graphically. Consider figure 2.19. On the X axis the amount of the commodity is measured and on the Y axis the marginal utility and the price of the commodity. MU is the marginal utility curve which slopes downwards, indicating that as the consumer buys more units of the commodity, it's marginal utility falls. Marginal utility shows the price, which a person is willing to pay for the different units rather than go without them. If OP is the price that prevails in the market, then the consumer will be in equilibrium when he buys OQ units of the commodity, since OQ units, marginal utility is equal to the given price OP. The last unit, i.e. Qlh unit does not yield any consumer's surplus because the price paid is equal to the marginal utility of the Qlh unit. But for units before the Qlh unit, marginal utility is greater than the price and hence these units fetch consumer's surplus to the consumer. In figure 2.19, the total utility is equal to the area under the marginal utility curve up to the point Q i.e. ODCQ. But given the price equal to OP, the consumer actually pays OPCQ. The consumer derives extra utility equal to PDC which is consumer's surplus. Usefulness of the Consumer's Surplus 1. The concept draws attention to the fact that the total utility derived from the consumption of a good is usually greater than the price paid for it. It helps in the assessment of enjoyment of real income. 2. Consumer's surplus indicates the benefit a person derives from the economic environment in which he lives. We can compare different localities by estimating and comparing the consumers obtained in each locality. The higher the consumer's surplus, the more advanced is the economy. 3. This concept is useful in public finance for judging the relative merits of different types of taxation. A tax generally raises the prices and reduces consumer's surplus. Against the disadvantage, the advantage accruing to the Government in the form of revenue. 4. The concept is useful in determining monopoly prices. A monopolist can charge different prices from different consumers according to the surplus earned by them.

Demand Analysis: 49

Limitations 1.

Consumer's surplus cannot be measured accurately because it is difficult to measure the marginal utilities of different units of a commodity consumed by a person.

2. In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such case, the consumer's surplus is always infinite. 3. The consumer's surplus derived from a commodity is affected by the availability of substitutes. 4. There is no simple rule for deriving the utility measure of articles like precious metals like diamonds. 5.

Consumer's surplus cannot be measured in terms of money because marginal utility of money changes as purchases are made and the consumer's stock of money diminishes. Marshall assumed that the marginal utility of money r,emains constant. But it is unrealistic. REVIEW QUESTIONS

1. What are the exceptions to the law of demand? 2. Why demand curve slopes downwards? 3. Discuss briefly cross elasticity of demand? 4. Discuss price elasticity of demand? 5. What are the factors influencing demand? 6. Measure income elasticity of demand with graphical illustration? 7. What is elasticity of substitution? 8. Discuss the salient features of the law of diminishing marginal utility theory? 9. Discuss the law of equi marginal utility? 10. Higher indifference curve represents higher level of satisfaction than lower indifference curve. Explain? 11. What is consumer's surplus? And what are it's uses? 12. Distinguish perfectly elastic and inelastic demand?

(Oct. 2001)

13. Write in detail on Elasticity of demand. State atleast 4 factors that influence the demand? (Oct. 2000, Oct. 2001 , April 2001 & 2002) 14. State the law of demand?

(April 2002)

3 Demand Forecasting

MEANING

Demand forecasting refers to an estimate of future demand for goods and services. It is an objective assessment offuture demand. It plays a significant role in business decisions related to production, inventory, control, timing and reliability of forecasts . Demand forecasting has emerged as an important aid to modern management and an essential part of the process of business decision making. The utility of demand forecasting depends largely upon the sound and objective judgment of market conditions. TYPES OF DEMAND FORECASTING

There are two types of demand forecasting, viz., Short term demand forecasting and Long term demand forecasting. 1. Short Term Forecasting: Short term forecasting denotes demand forecasting within one year period in connection with sales, purchases, price and finance. It is very useful for formulating price policy and sales policy by reducing production cost. 2. Long Term Forecasting: Businessmen can plan for new plants or expansion of existing plants depending on the demand in the long

Demand Forecasting: 51

period. Prof. Savage classified the demand forecasting into three types. viz., Macro economic forecasting, Industry forecasting and Firm level forecasting. The Macro economic forecasting relates to whole economy, the Industrial level forecasting is essential for inter industry comparison and firm level forecasting concerns with individual units. To have a broad understanding about the long term forecasting, the following other types can be known. Micro and Macro level Demand Forecasting

Micro and Macro level demand forecasting can be carried out at the level of the firm or industry. It is influenced by internal and external factors. The internal factors include changes in the pattern of demand, incentive to consumers etc. The external factors include changes in income, technology and tastes. Macro level forecasting is a study of leading macro economic indicators of the economy. It studies the behaviour of aggregate economic variables like national income, level of employment, rate of savings and investment etc. This type of forecarting enables a firm to understand the nature of business " environment and adopt suitable business policies. ' General and Specific Forecasting

General and Specific forecasting is attempted to estimate the overall demand for all the varieties of products. Specific demand forecasting is concerned with the estimation of demand for a particular variety of a product. Features of Forecasting Method

The following are the features of good forecasting method:

Plausibility: Accuracy is an important feature because the management will have confidence in the techniques used. Simplicity: Any foresting methods should be simple. Economy: The forecasting method should involve less cost therefore there is no need arise to spend huge amount of money. Availability: An ideal forecasting method is one which yields results over cost in accuracy, reasonable to meet new circumstances with flexibility and give up to date results. Accuracy: Accuracy is most important to check the past forecast against the future performance.

Engineering Economics : 52

Durability: Durability of a forecast depends upon the proper reason in which forecasting is to be made.

TYPES OF FORECASTING METHODS Forecasting methods are grouped into Survey method and Statistical method.

I.

Survey Method

In this method, details of information of consumers and opinions of experts are collected by interviewing them. This method is subdivided into four categories: (1) Opinion survey method; (2) Experts opinion method (3) Delphi method and (4) Consumers interview method. Let us see briefly the types of survey method. (1) Opinion Survey Method: This method is otherwise called as sales force composite method or collective opinion method. In this method, salesmen are asked to submit detailed estimates and these estimates are consolidated, reviewed and adjusted by the executives of companies. This method is very useful and appropriate for business decisions becaus6 salesmen in different regions have adequate knowledge of business.

This method is less costly in forecasting the sales of new products. It involves minimum statistical work and based on first hand knowledge of salesmen. Despite of the merits, long term business planning could not be done by this method due to changes in policies that affect future demand. Moreover, opinion survey method is completely subjective, personal prejudices may tend to be biased forecasting.

(2) Experts Opinion: Expert opinion method of forecasting has wide role in estimating future demand for products. Many countries use experts on various fields for forecasting short term as well as long term business situations. The main advantage of this method is to get a complete picture of the business conditions. But the possibility of unsatisfactory opinions and estimates are inevitable in this method. (3) Delphi Method: In this method, the panel of experts express their opinion anonymously. At the end of each round, a summary report is prepared. On the basis of the summary report, the panel members may give suggestions. This method is very useful in technological forecasting and non-economic forecasting. (4) Consumer Interview Method: It is an ideal method of forecasting demand. In this method, consumers are contacted personally

Demand Forecasting : 53

to know the preferences in the use of the product. The potential consumers of the product reveal information about the product as the consumers are numerous in number. This method can be undertaken in three ways: (a) Complete enumeration method; (b) Sample survey method and (c) End use method. (a) Complete Enumeration Method: Forecasting can be done by interviewing all consumers of the product in this method. (b) Sample Survey Method: In this method, a sample of customers are interviewed. The sample may be either random sampling or stratified sampling. This method is less costly and useful in many ways for production planning. (c) End Use Method: In this method, information can be drawn from various sectors like industries, consumers, export and import on the demand for the product. This aggregate data may be helpful in changing the future demand for the products.

II. Statistical Methods In this method, various statistical techniques can be used to forecast long term forecasting with the help of secondary data.

Trend Projection Method (Time Series Analysis) Secondary data are analyzed to determine the nature of trend. This trend forecast is called time series analysis. The data can be presented either in the form of a tabular or graphical presentation. Since most of the time series data are fluctuated over a period of time due to general tendency which is termed as secular trend. Fluctuations may occur due to changes in weather conditions, which is termed as seasonal variations, only secular trend is analyzed to forecast the business conditions. The trend projection method is popular in business because of its simplicity and less cost. The time series data serve as a best guide to predict the future sales. .

Example A manufacturer wants to know the future sales trend of the product. He collects the sales data of the product for the past 7 years. By fitting a trend line, the ordinary method of least squares can be used to predict the future sales of the product. The trend is assumed to be either linear or curve linear trend, the relationship bet~een the dependent variable (y) and independent variable (x) can be represented on the straight line. The equation of the trend line is y = a + bx, where a is the intercept and b shows the rate of change of the independent variable.

Engineering Economics : 54

: 1994,1995,1996,1997,1998,1999,2000.

Year

Sales Data: 65, 71, 78, 85, 89, 93, 98.

Table 3.1: Sales Data of the Company Year

1994 1995 1996 1997 1998 1999 2000 n=7

y

x

65 71 78 85 89 93 98 :Ey = 579

1 2 3 4 5 6 7 :Ex = 28

LY = na+b'Lx .... l, 'Lxy = a'Lx + b'Lx2

x2

xy

4 9 16 25 36 49 :EX2 = 140

65 142 234 340 445 558 686 :Exy = 2470

•••• (2)

by calculating the magnitudes of the required quantities, we get the following substituting the values of a and b 'Lx, 'Lx 2, Lxy, LY and n in equation 1 & 2 we get

579=7a+28b

.. : ...... (3)

2470=28a+140b ......... (4) Solving equation 3 and 4, get b

= 5.5

Substituting values of b in equation 3 we get the value of a as follows: 579 = 7a +28 (5.5) 7a = 579-154, a=

425

7' a=60.7

by substituting the calculated values of a and b in the equation, the forecast of sales for the year 2005 will be around 127.

Moving Averages This method is based on the assumption that the future is the average of past achievements. This method provides good forecasts if the demand is stable. The main issue in this method is determining the ideal number of periods to include the average.

Demand Forecasting: 55

Moving average technique can be mathematically in the following· ways: Xt+Xt-l+........... xt-N +1 St + I =----------N 1

t

=-L N i

xi

= t-n+ 1

Where St = the forecast for time t Xt = the actual value at time t n = the number of values included in the average

Exponential Smoothing In this technique, all time periods are weighted equally. The observations obtained in the recent periods will be given more importance than the earlier one. The formula used in this method is Xt St St +1=---+St

N

N

This can be written as 1 St + 1 = -

1

x Xt + 1- - St N N

Where Xt = the actual value at time t St = the forecast for time t N = the number of values included in the average

The most recent observation are valued with the weight of lIN and the most recent forecast with the value of [(I-lIN)]. If we substitute a in the place of lIN, we have St

= axt + (l

+a) st.

This equation is used in computing a forecast by the method of exponential smoothing.

Barometric Technique Under this technique, current events are made use to predict the directions of change in future. It is done with the help of economic and

Engineering Economics : 56

statistical indicators such as, Personal income, Agricultural income, Gross national income, Industrial production and Bank deposits.

Input Output Analysis An important forecasting method developed was Leontief input output model. It enables to forecast the effects of an increase in demand for one product by other industries. For instance, an increase in the demand for motor cars will lead to an increase in the output of the auto industry.

Computer Assisted Forecasting In modern days, use of software is most important and has increasing attraction in forecasting. Various software programmes are available specifically in forecasting demand. Many large companies, corporate sectors have utilized software programmes. The main advantages of computer assisted programming in forecasting is time saving, and quick results.

Correlation and Regression Methods Correlation is a study of meaning the degree of relationship between two or more related variables. A statistical technique which helps to understand the relationship between two or more related variables is known as correlation. The value of correlation co-efficient indicates the extent and nature of relationship between the variables concerned. In business forecasting we estimate the value of one variable given the value of another by correlation co-efficient. For example, in demand for a change in price by using the correlation co-efficient. There are several types of correlation they are (i) Positive and Negative correlation (2) Simple partial and multiple correlation and (3) Linear and non-linear correlation. Among them are second and third types of correlation that are most important. The distinction between simple partial and multiple correlation is based upon the number of variables studied. When only two variables are studied it is a problem of simple correlation. When three or more variables are studied it is a problem of either -multiple or partial correlation. In multiple correlation three or more variables are studied simultaneously. For example, when we study the relationship between the yield of rice per hectare and both the amount of fertilizer and labour used, it is a problem of multiple correlation. On the other hand in partial

Demand Forecasting: 57

correlation, we recognize more than two variables, but consider only two variables of the influencing variables being kept constant. Linear and Non Linear Correlation

The distinction between linear and non linear correlation is based upon the constancy of the ratio of change between the variables. If the amount of change in one is variable it tends to bear a constant ratio to the amount of change in the other variables, then the correlation is said to be linear. Correlation is said to be non-linear, if the amount of change in one variable does not bear a constant ratio to the amount of change in the other variable. Methods of Correlation

Various methods of ascertaining variables are correlated or not correlated. They are (1) Scatter diagram method, (2) Graphic method (3) Karl Pearson's Co-efficient of correlation (4) Rank correlation method and (5) Least square method. Among the above methods of studying correlation co-efficient, Rank method and least square method are rarely used in business practices. 1. Scatter Diagram Method

The simplest method of ascertaining whether two variables are related in a dot chart called scatter diagram. By using this method, the given data are plotted on a graph X and Y values, we put a dot and then obtain as many points as the number of observations. It is very simple and non mathematical way of studying correlation. The main limitation of the method is we can set an idea about the direction of correlation and also if it is higher or low. But we cannot establish the exact degree of correlation between the variables as possible by applying the mathematical methods. 2. Graphic Method

By this method, the individual values of the two variables are plotted on the graph paper by examining the direction we can infer whether or not the variables are related. If both the curves drawn on the graph are m~>ving in the same direction either upward or downward, correlation is said to be positive. On the other hand, if the curves are moving in the opposite directions, correlation is said to be negative.

Engineering Economics : 58

3. Karl Pearson's Coefficient of Correlation Karl Pearson's method is very popular among the methods used for measuring the degree of relationship of variables. Karl Pearson's coefficient of correlation is based on (i) linear relationship between the variables; (ii) there exist both cause and effect relationship of the variables; (iii) two variables under study are affected by many independent causes in order to form a normal distribution. This method applies only where deviations taken from actual mean. The value of the coefficient of correlation obtained by using the formula will always lie between + 1 and -1. When r :: + 1, there is perfect positive correlation between the variables. When r =1, there is perfect negative correlation. The formula is: l:xy

r=--:...-

Noxoy

x=(x-x) y

= (y - y)

ax = standard deviation of series X ay = standard deviation of series Y N = number of pairs of observations r = the correlation coefficient

4. Rank Correlation Coefficient This method is useful in finding out the co-variability between two variables. This method is especially useful when quantitative mean less for certain factors (Evaluating the leadership ability) cannot be fixed, but the individuals in the group can be arranged in order, theory obtaining for each individual, a number indicate the rank in the group. In symbol

6l:D 2 rs = 1- N(N 2 -1)

where,

rs

= Rank correlation

D = Rank difference of rank between the observations N = number of pairs of observations.

Demand Forecasting : 59

5. Lease Square Method The method of least squares provides a convenient device for obtaining an objective fit of a straight line trend to a set of data.The features of the least square method is (i) the sum of the vertical deviations of the observed values from the fitted straight line equals zero and (ii) the sum·of the squares of all these deviations is less than the sum of the squares vertical deviations from any other straight line. Despite of several methods for estimating the values of the parameters a and b and thereby fitting a straight line, the best one is the least square method. This method ensures that the errors of prediction, for which the regression line is used is the minimum possible line.lt can apply many complex type of trends. Regression

Regression and correlation are used for forecasting demand. In regression technique, the extent of relation between t.he variables is analysed and the results are expressed in mathematical form and it is known as economics model building. Chart 1 DEMAND FORECASTING METHODS

REVIEW QUESTIONS 1. What is demand forecasting?

2. What are the features of a good forecasting method? 3. How statistical methods are useful i.n demand forecasting a product? 4 . .Discribe the different techniques of demand forecasting.

(April, 2001)

5. What is the need for demand forecasting?

(April, 2002)

4 Production Factors

MEANING Production means transformation of one set of goods into another. It is defined as creation of utilities. In Economic sense, to produce a commodity, it should have utility but value alone is not production. Therefore production is defined as creation of utilities and also creation of value utilities. There are three types of utilities, viz., (1) Form utility, (2) Time utility and (3) Place utility. If a good is transformed by being physically changed (form utility) or being transported to the place of use (time utility) kept in store till required (place utility). FACTORS OF PRODUCTION Productive resources required to produce a given product are called factors ofproduction. These productive resources may be raw materials or services of various categories of workers or capitalist supplying capital or entrepreneurs assemble the factors and organise the work of production. They are generally called inputs. Fraser defines factors of production as a group of original productive resources. The term factor is used for a class of productive elements the individual members of which are known as units of the factor. Modern economists prefer to mention in terms of anonymous productive services in production.

Production Factors : 61

The factors of production have been traditionally classified as, land, labour, capital and organisation. These factors are complementary in the sense that their combination is essential in the production process. A factor is said to be specific when it can be used for one purpose. e.g., Machine spare parts. A factor is said to be versatile when it can be put to many uses. No factor is completely specific or versatile because it can be put to several uses but not all uses. A factor of low versatility is called a specialized factor. It plays an important role in the disposition of p~oductive resources. The factors of production are discussed in detail as follows.

I. LAND The term land has different meanings in Economics. It does not mean soil as in the ordinary speech. According to Marshall, land means the materials and the forces which nature gives freely for man's aid in land and water in air and light and heat. Land is meant that all natural resources which yield an income or which have exchange value. It represents those natural resources which are useful and scarce. Features of Land

The following are the peculiar features of land: 1. Land is gift of nature. 2. Land is fixed in quantity. 3.

It has no supply price ( i.e., high price or low price of land in the market cannot affect the supply of land).

3. Land is permanent. 4.

Land has no mobility.

5. Land provides infinite variations of degrees of fertility and no two pieces of land are exactly alike. 6. Land bears economic rent. II. LABOUR

The term labour means a mass of unskilled labour. But in economics, it is used in a broader sense. According to Marshall, any exertion of mind or body undergone partly or wholly with a view to some goods other than the pleasure derived directly from the work, is called labour. Any work, whether manual or mental is being undertaken for a monetary consideration is called as labour in Economics.

Engineering Economics : 62

Characteristics of Labour Labour is different from other factors of production. It is not only a means of production but also an ends of production. It is a living thing, makes all differences. The peculiar features of labour are as follows: (1) Labour is inseparable from the labour himself. (2) Labour has to sell his labour in person. (3) Labour is perishable. (4) Labour has a very weak bargaining power. (5) Variations in the price of labour alter the !;upply. A fall in price (wages) between a certain limit may increase the supply and vice versa. (6) No adjustment of the supply of labour is possible according to the demand situation because labour cannot be increased quickly.

Factors Determining Efficiency of Labour The following are the important factors that affect labour efficiency: 1. Racial Qualities: Efficiency of labour is largely determined on the hereditary factors.

2. Climatic Conditions: Climate is another factor which determines efficiency. A cool climate induces to more work and tropical climate does not do it. 3. Education: General education and technical education promote efficiency. 4. Personal Qualities: The personal qualities such as healthy physique, mental alertness, intelligence and initiatives can increase the efficiency. 5. Industrial Organization and Equipment: Another factor that determines efficiency of labour is the availability of best industrial organisation and modernized equipments supply. 6. Factory Environments: A good factory surroundings may enhance efficiency. 7. Working Hours: Long hours of work impair labour efficiency and the regulation of time is conducive for more efficiency. 8. Fair and Prompt Payment: A well paid worker is generally contented and is better involved in the work which may promote efficiency.

Production Factors : 63

9. Social and Political factors: Social and political factors such as eliminating unemployment problem, social security measures, workmen compensation, employment assurance, bonus, gratuity and pension etc. Apart from the socio political factors such as employment planning for more and introduction of labour welfare schemes besides, political stability of Governments. All these induce efficiency of labour. DIVISION OF LABOUR Division of labour is an important feature of modern production process which is associated with efficiency. When the process of production of an article is split up into several processes and each process is entrusted to a separate set of workers it is called division of labour. The different types of division of labour are as follows: 1. Simple Division of Labour: It means the society is divided into major occupation. For example, Carpenters, Blacksmiths, Weavers and Goldsmiths etc. It may be called as functional division of labour.

2. Complex Division of Labour: It refers to the production of an article split up into a number of processes and sub processes and each process or sub process is carried out by a separate group of people. 3. Territorial Division of Labour: It refers to certain localities, cities or towns specializing in the production of some commodities. It is called as localization of industries. Advantages The following are the advantages of division of labour: 1. Increase in Productivity: Division of labour increases the productivity of labour.

2. Increase in Dexterity and Skill: A worker becomes an expert after repetitive work of the same task is assigned. It ensures skillfulness in the particular work. 3. Inventions are Facilitated: In division of labour, movement becomes mechanical and the worker can freely think while he is at the job. New ideas often occur leading to inventions. 4. Introduction of Machinery: If a man is engaged in a particular job, he will be able to think of some mechanical contrivance to relieve himself.

Engineering Economics : 64

5. Saving of Time: In division of labour, a worker has only to do one process or a part of process in production. Therefore it reduces time and need to learn a specialized process. 6. Savings in Tools and Implements: When a worker has to perform a part of a job only (e.g.) making the legs of the chair he need not be supplied with a complete set of tools. One set of tools can serve many workers at the same time. 7. Diversity in Employment: Division of labour increases the number and variety of jobs if employment is diversified. 8. Large Scale Production: Division of labour involves production on a large scale. The society reaps all economies of large scale production. It improves both quantity and quality since goods are made by specialists. . 9. Right Man in the Right Place: Under division of labour, workers are distributed among various job and each worker is put in the right place. Disadvantages of Division of Labour The following are the disadvantages of division of labour: 1. Monotony: In division of labour, a worker has to do the same job again and again. It becomes monotonous to him.

2. Retards Human Development: A worker's development, physical and mental is greatly affected by the job in which he is engaged. Under division of labour, a worker has to repeat the same work again and again. Repetition of work may cramp a person's mind and narrows his outlook. 3. Industry De-Humanized: Under division of labour, many people combine to produce an article. The worker loses all sense of responsibility and pride in his work. Therefore, the industry is de-humanized. 4. Loss of Skill: Too much specialization creates troubles and loss of skill in other production process. 5. Risk of Unemployment: The division of labour practices a person highly a skilled person in the particular trade. He is lacking other trade skill. It affects the employment opportunities from other sector.

Production Factors : 65

6. Territorial Division of Labour: Territorial division of labour· is called localization of industries. By localization, we mean the establishment of an industry due to the availability of raw materials in certain places. For instance, Hosiery industry of Ludhiana (Punjab), Silk industry at Kancheepuram (Tamil Nadu), Bangles in (Ferozabad) Uttar Pradesh. Causes of Localization The following are the main causes of localization of industries. 1. Nearness to Raw materials: The availability of raw materials for any finished product is one of the most important factor which encourages localization of industries. It reduces considerably the transport cost and thus production will be more economical. For example, in India, Jute mills are concentrated in West Bengal, Sugar mills in Uttar Pradesh and Iron and Steel in Bihar and Orissa. 2. Nearness to Sources of Power: Another factor which causes localization of industries is availability of power or energy resources. No industry can function well without power source. Several industries are located very near to the power resources in many regions. 3. Proximity to Market: In modern days, marketing and market are the most important factors which encourage localization of industries. If an industry is located very near to market centres, there are ample opportunities to take market advantages of the product. 4. Availability of Cheap Labour: Availability of skilled labour is another factor which encourages localization of industries. The contribution of labour particularly to the country like India, productivity is relatively higher than the unskilled workers. 5. Availability of Capital: Capital is one of the factors of production, no production of any commodity is possible without capital. In India, small scale, medium scale and large scale industries are provided financial assistance by the banking and industrial development oriented financial institutions. 6. Political and Religious Factors: Political factor is responsible for the establishment of an industry. In some cases, religious factor due to a large gathering of people may start industries. It is generally seen that places of pilgrimage specialize in the manufacture and sale of goods which are generally purchased by pilgrims. Associations of small

Engineering Economics: 66

entrepreneurs are formed to safeguard and promote the common interests of industrialists like communication and transportation facilities. Besides there is ample opportunities for sharing ideas for promoting industries. Despite certain limitations, localization of industries may create favourable situation particularly to industrialists with regard to tax, finance and litigation problems.

III. CAPITAL Meaning and Significance Capital refers to that part of man's wealth which is used for producing further wealth or which yields an income. It is not a primary or original factor of production but it is a production means of production. The term capital is generally used for capital goods. For example, plant and machinery, tools and accessories, stocks of raw materials etc. Capital plays an important role in modern productive system. Production without capital is hard and it occupies an unique position in the process of economic development of the country. In fact, capital formation is the core of economic development and ensures employment opportunities. It may be of two stages, viz, when the capital is produced, some workers have to be employed to make capital goods like machinery, factories, dams, irrigation works etc. Secondly, a large number of people can be employed when capital is used for producing further goods.

Capital Formation Capital formation plays an unique position in economic development. No economic development takes place without capital. For instance, the production of agricultural tools and implements, land reclamation, construction of dams, bridges and factories, roads, railways, airports and ports are all produced means of further production. Capital formation means the increase in the stock of real capital in a country. In other words, capital formation involves the production of capital goods such as machines, tools, factories, transport equipments and electricity etc. are all used for further production of goods. According to Prof. R.Nurkse, the meaning of capital formation is that society does not apply the whole of its current productive activity to the needs and desires of immediate consumption, but directs part of it

Production Factors : 67

to the production of capita~ goods, tools and instruments, machines and transport facilities, plant and equipment all forms of real capital that greatly increases the efficiency of productive effort, the essence of the process there is the diversion ofa part of society's currently available resources to the purpose of increasing the stock of capital goods so as to make possible an expansion of consumable output in the future. To accumulate capital goods, the current consumption has to be sacrificed. The greater the extent of the citizen are willing to abstain from present consumption, the more will be the capital formation. Saving is essential for capital formation and indirectly results in the production of goods. In the modern society, savings and investments are done mainly by two different classes of people. It can be mobilized to the business sectors and entrepreneurs for the investment of capital . goods. Several stages in the processes of capital formation are given below.

1. Creation of Savings: Individual or households can save money by not spending all their income. The level of savings of a country depends upon the power to save or the saving capacity of an economy mainly depends upon the average level of income and the distribution of national income. The higher the level of income, the greater will be the amount of savings. Besides the power to save, the volume of savings depends upon the will to save. People save money in order to provide against old age and unforeseen emergencies. Many people save for future expectations and desire to start new venture to expand their level of income. Some people save money for education, marriage and other family ceremonies. Savings may be either voluntary or forced. Voluntary savings are those which people do of their own will. The voluntary savings depends upon the power to save and the will to save. The taxes collected by the Government from the people accounted in the forced savings category, because it goes directly to the Government exchequer in the savings of the country. Savings may be done by individuals, households, business enterprises and Government. The third source of savings is Government. The Government savings constitute the amount of money collected as taxes and the profits of public undertakings. The greater the amount of taxes collected and the profits made, the more will be the savings of the Government. These savings can be used for the production of new capital goods.

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2. Mobilisation of Savings: The second stage in the capital formation is that of the savings of the households' must be mobilized and transferred to businessmen or entrepreneurs who actually need them for investment. In capital market, funds are supplied by the individual investors (who may buy securities or shares issued by companies) banks, investment trusts, insurance companies, finance corporations and Government etc. A well developed capital market ensures that the savings of the society can be mobilized and transferred to the entrepreneurs who need credit for investment purposes. 3. Investment in Real Capital: Savings result capital formation if it is properly invested. A considerable number of dynamic entrepreneurs can bear risks and uncertainty of production. The investment can be made only if there is an inducement to invest. The inducement in investment depends on the Marginal Efficiency of Capital (MEC), i.e., the prospective rate of profit and the rate of interest. The Marginal efficiency of capital depends upon the cost and supply price of capital as well as the expectations of profits. The primary factor which determines the level of investment in an economy is the size of the market for goods and that determines profitable investment.

4. Foreign Capital: Capital formation can be taking place with the foreign capital, i.e., foreign savings. The foreign capital is in the form of (a). Direct private investment by foreigners, (b). Loans or Grants by foreign Governments,(c). Loans by international agencies like the World Bank. India receives a considerable quantum of foreign capital from abroad for investment purposes. 5. Deficit Financing: Deficit financing is another source of capital formation for a country like India. Owing to very low standard of living of the people, the extent to which the voluntary savings can be 'nobilized is limited. Moreover, taxing the people is more problematic for the Government. 6. Disguised Unemployment: Another source of capital formation is to mobilise the saving potential which exists in the form of disguised unemployment. The surplus agricultural workers can be transferred to non agricultural sector without declinIng agricultural output. The objective is to mobilise these unproductive workers and employ them on various capital creating projects like roads, canab, school buildings and health centres etc.

Production Factors : 69

Low Capital Formation in Developing Countries

The following are the important causes of low capital formation in developing countries:

1. Low Level of Domestic Savings: The main reason for the low savings is due to low per capita income. Developing countries have experienced vicious circle of poverty. This may tend to bring low income, low savings and low investment and further it leads to low productivity. The tendency of the people in most of those countries have high level of consumption with relation to their meager income. 2. Lack of Entrepreneurship: Lack of entrepreneurship impedes mobilization of scarce resources for productive investment at the regional level. 3. Lack of Encouragement to Investment: Lack of encouragement to investment impedes capital formation. The frequent changes of Government policies such as New Industrial Policy and low confidence of public sector and private sector enterprises not inducing the people to invest on productive purposes. 4. Demographic Factors: Many developing nations experience very high rate of growth of population. Consequently, per capita income declines and the life expectancy rate is relatively very low as compared to developed nations. Since the size of the families are large, which entails heavy burden to the parents to make investments on education and health. This inhibits capital formation considerably. 5. Economic Backwardness: Economic backwardness is heavily responsible for low capital formation. The present democratic set up discourages capital formation in many important sectors particularly in agriculture, and non formal sector. Economic insecurity appears in the sense, absence of assured employment opportunities to the educated masses will also be responsible for the poor growth of capital formation. 6. Poverty and Unemployment: Poverty and unemployment are the twin important factors which halt capital formation. A vast proportion (35 percent) of the total population in India live still below the poverty line whose meager income is not sufficient for their survival and no savings can be expected from such families drowning with poverty. The unemployment also have an equal incidence on the low capital growth particularly in India, where the contribution by the unemployed youths is missing tQwards national income.

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7. Absence of Appropriate Economic Policies: The adoption of the new technology in agriculture aggravated regional economic disparities by using scarce resources in the most productive way. But on the other side, non farming community who are living in the country side have been neglected. This has lead widening of the gap of income disparities. This is also one of the causes of low capital formations because there is very little cash flow to them to invest or save in the effective manner. 8. Deterioration of Public Sector: A drastic deterioration in the share of the public sector is the failure of the government to increase its revenue potentials. The net contribution of the public sector showed a decline in saving. This is also one of the causes of the low capital formation. IV. INDUSTRIAL ORGANIZATION

Organization is the fourth factor of production. The role played by the entrepreneurs are coordinating other factors of production such as starting the work, organize and supervise it. Moreover, the entrepreneurs have to pay rent to the landlord, interest to the borrowed capital and wages to labourers and bear risks and uncertainties in business. Apart from these functions, they have to make a handsome profit, whatever may be the outcome. Therefore, the final responsibility of the business is with them. The entrepreneur is an innovator. It implies a variety of things, such as introduction of new method of production, or modernize the old method of production, introduction of new commodities and discovery of new materials etc. It also includes the opening up of new markets and take the form of new techniques in the way of administration, finance, marketing or human relations such as new forms of business organisation and merger of several establishments. Functions of an Entrepreneur

The important functions of an entrepreneur are (1) Initiating a business enterprise by mobilizing and harnessing the necessary productive resources. (2)Taking the final responsibility of the business enterprise like risk bearing. (3) He is an innovator. According to Harvey Leibenstein, the role of an entrepreneur is to search and discover economic opportunities, evaluate economic opportunities, master the financial resources necessary for the enterprise, make time binding

Production Factors : 71

arrangements, take ultimate responsibility for management, be the ultimate uncertainty and/or risk bearer, provide and be responsible for the motivational system within the firm, search and discover new economic information, translate new information into new markets, techniques and goods and provide leadership for the work groups. TYPES OF ENTREPRENEURIAL ORGANISATION

In modern days, business organizations are classified into (1) Sole Proprietorship or one man business, (2) Partnership, (3) Joint stock companies, (4) Co-operative enterprises and (5) State enterprises. 1. Individual Enterprise

An individual entrepreneur or the proprietor who invests his own capital and borrowed money, he rents a shop and hire the service of an assistant. He makes alone purchases and personally attends to the sales. He initiates, organizes and directs all economic activities and takes risks. Therefore, the sole proprietor combines the functions of capital, enterprise and labour in many cases. Features Proprietorship

1. Single ownership 2. One man control 3. Undi vided risk 4.' Unlimited liability 5. No Government regulation 6.

No separate entity of the firm.

Advantages

The advantages of the individual enterprise are as follows: 1. This type of business is easy to start and easy to wind up. 2. It ensures to pay personal attention to all customers. 3. The sole responsibility of managing the business is conducive to efficiency. 4. All transactions and operations are through prudent management economically.

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Limitations The following are the shortcomings of indiyidual enterprise: 1. The advantage of economies of large scale production is absent. 2. The capital used by the sole proprietor is meager. 3. No top rank business can be built up in this line. 4. One man feels very much handicapped in looking after the many sides of the business.

2. Partnership Partnership refers to two or more people who combine and contribute capital and agree to share profits and bear losses in the agreed proportions. The legal provision relating to the partnership are contained in the Indian Partnership Act, 1932. The term partnership is defined in Section 4 of the Indian Partnership Act, which reads as partnership is the relation between persons who have agreed to share the profits of a business carried on by all or anyone of them acting for all the persons who enter into such relationship are individually called partners.

Features of Partnership 1. There must be an association of two or more persons. The maximum limit of the number of partners should not exceed lOin the case of firms carrying on the b~nking business, and 20 in the case of firms carrying on any other business. 2. There must be an agreement. The relation of partnership arises from contract and not from status. There must be some business and there must be sharing of profits. 3. There must be ,mutual agency between the partners.

Advantages The advantages of partnership business are as follows: 1. Partnership commands a large resource. 2. It is possible to establish under personal contacts. 3. The partners can manage large scale business and enjoy various economies of scale. 4. The union of ownership and management is a spurt to efficient and economical working.

Production Fsctors : 73

5. Partnership responds promptly to changes in business conditions and is highly adaptable. 6. The existence of unlimited liability curbs the speculative tendencies of the partners and prevents the rash and risky business. Disadvantages

The following are the disadvantages of partnership business 1. Partners behave selfishly. 2. According to the Partnership Act 1932, partnership must be dissolved in the event of partner's retirement, death, bankruptcy. Therefore continuity of business is questionable. 3. The unlimited liability makes the policy of a firm timid and non-enterprising. 4. The resource of partners is very limited and therefore unable to do the business in a big way. 5. This form of organisation cannot meet the requirements of modern trade and industry.

3. Joint Stock Company Joint stock company is the most important type of business organization. A joint stock company is an incorporated and voluntary association of individual for the purpose of carrying on some lawful activities in common. It has usually a capital divided into transferable shares of a fixed denomination and liability of the members is generally limited. A company is a corporate body enjoying a separate entity of its own distinct from that of individual members. It can be set up only by certain procedures laid down for the purpose under law. The whole process of the company formation can be divided into two stages such as promotion and incorporation. The following are the advantages of Joint stock company: Advantages 1.

The joint stock company can enjoy the economies oflarge scale

production. For instance, economies arising from specialized labour and machinery, buying and selling, publicity and research etc.

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2. Huge capital can be raised by the sale of shares. 3. Many people can subscribe share capital because limited liability and shares are transferable. Consequently, the capital can be mobilized for productive purposes. 4. The limited liability principle encourages the prospective investor to invest freely. He need not worry about the loss because it is widely distributed. 5. The prospective investors can invest in many companies and sell shares whenever they sell it at high prices. 6. The joint stock company is a legal person apart from the share holders or directors the investors can be persuaded to invest money. 7.

In joint stock company, the functions of capitalist and entrepreneurs have been separated. It will not affect the working of the company and enhance productive efficiency.

8. The company directors are elected by the shareholders. So the management is democratic, efficient and economical. The expert opinions and guidance of the shareholders ensure good business and fortune.

Demerits of Joint Stock Company The demerits of the Joint stock company are as follows: 1. The shareholders of the company are mainly concerned with profit. They care little about the welfare of the workers of the company. In modern days, labour welfare is most important for smooth, functioning. 2. The qirectors of the company have sometimes no professional knowledge of business development and incompetent to i'mprove the company. 3. The directors are self appointed. In practice, the management is not democratic and the shareholders have very little voice. 4. The unwary investors are given by the directors false information about the company for personal gain. 5. The shareholders take no interest for the company because liability is limited and the shares can be transferable. 6. The directors of the company can launch rash enterprises and perform unproductive activities with the public money.

Production Factors : 75

7. The company cannot take quick decision due to ponderous and unwieldiness. It is not suited for a business in which changing conditions and policy decisions or customer oriented business. Apart from the demerits of the joint stock company, in principle, industrial development and efficient utilization of available resources are impossible without the growth of joint stock companies. However, it is proved that powerful and efficient institutional arrangements can be maintained for steady economic growth. 4. Cooperative Organization Cooperative organization grew as a means of protecting the interest of the weaker sections of the society against the exploitation by big business operating for the maximization of profits. According to Claver, a co-operative society is a form of organization wherein persons voluntarily associate together as human being on the basis of equality for the promotion of economic interests of themselves. Characteristics of Cooperatives The following are the features of a cooperative organization: 1. Voluntary Associations (No one is compelled to become or continue as its members). 2. Open membership (Membership is open to all persons irrespective of caste, creed, colour, religion, race and sex etc.). 3. Democratic Control (One member has one vote). 4. Service motive not profit motive. 5. Compulsory Registration. 6. Separate legal entity. 7. Large capital formation. 8. Equitable disposal of surplus. 9. Government control. 10. Cooperative Education. Merits of Cooperatives 1. Easy information 2. Limited liability 3. Stability of the organization is long

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4. Democratic management 5. 6. 7. 8.

Low operating cost Internal financing Tax advantages Social utility

9. State patronage and 10. Community development. Demerits of Cooperatives

1. 2. 3. 4. 5. 6.

Incompetent management Limited financial resource Lack of motivation Mutual rivalries Lack of secrecy Over state regulation.

5. Public Sector Undertakings (PSUs)

The term public enterprise refers to such industrial and commercial enterprises which are owned and controlled by the central and/or state governments in India. The public sector was thought of as the engine for self reliant economic growth to develop a sound agricultural and industrial base, diversify the economy and overcome economic and social backwardness. Objectives of the Public Sector Units

1. To accelerate the growth of the core sectors oflhe economy; 2. To provide equipments to the important sectors like railways, telecommunications, nuclear power, defence etc. 3. To ensure bulk availability of articles of mass consumption through setting up of consumer oriented industries. 4. To protect employment opportunities. 5. To promote redistribution of income and wealth. 6. To promote balanced regional development. 7. To promote exports and import substitution.

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Features of Public Enterprises 1. State Ownership: A public enterprise is wholly owned by the Central Government or State Governments or local authority' or jointly owned by two or more of them. In case, the enterprise is owned both by the Government and private sector, the state must have at least 51 percent share in the equity capital. 2. State Control: The ultimate control of state enterprise lies with the Government which appoints its board of directors and a chief executive. 3. Government Financing: The whole or major portion of the capital of a state enterprise is provided by the government. 4. Service Motive: The primary aim of a state enterprise is to render service to the society at large. 5. Public Accountability: State enterprises are financed by public money. They are accountable to the committees of the Parliament and the State Legislatures. Defects of Public Enterprises Public enterprises suffer from various defects. They are as follows:

1. Poor Project Planning: Investment decisions in many state enterprises are not based upon proper evaluation of demand and supply, cost benefit analysis and technical feasibility. 2. Over Capitalization: Several PSU s suffer from over capitalization due to inefficient financial planning . It leads to high capital output ratio and wastage of scarce capital resources. 3. Excessive Overhead: State enterprises incur heavy expenditure on social responsibilities like townships, schools, hospitals etc. It leads to heavy loss in the organization. 4. Under Utilization Capacity: The main problem in public enterprises is under utilization of installed capacity. In some cases, productivity is low on account of poor management. 5. Lack of Proper Pricing Policy: There is no clear cut pricing policy for state enterprises and the rate of return earned by different undertakings sometimes will not be remunerative. 6. Lack of coordination and unsatisfactory industrial relations: Public sector enterprises lack proper networking attitude between the Government and workers. The policy decisions mostly not based on

Engineering Economics : 78

good industrial relations, and labour welfare. Recently, in few public sector units curtailment of workers and welfare packages, consequently brought down productivity, became hindrance to the economy. REVIEW QUESTIONS 1. What are the factors determining efficiency of labour? 2. What are the merits and demerits of co-operative organisation? 3. Explain the features of public enterprises. 4. Explain in detail the following ownerships. (a) Co-operatives (b) Partnership 5. Explain the various types of industrial ownership.

(Oct, 2001) (April, 2002)

5 Supply Analysis and Production Theories

Supply refers to the schedule of the quantities of a good that will be offered for sale of various prices. If price is higher, larger quantities of goods are offered by the sellers from their stock and if price is low only small quantities are brought for sale. Supply is defined as a schedule which a producer is willing to and able to produce and make available for sale in the market at specific price in a given period.

In few cases, goods supplied or produced jointly is called joint supply. Examples: (i) paddy and straw; Oi) sugar and molasses. When there are different sources of supply of a commodity we may say that composite supply. For example, light from electricity, gas, kerosene and candles. The supply ofproduct depends upon its cost of production, the physical relationship between inputs and output and the price of inputs. It plays an important role in determining the cost of production. SUPPLY FUNCTION The following is the equation of supply function . Sc = f(Px, Py, pz ... PfQ, T)

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Where Sc

= Quantity of the commodity supplied

Px = Price of the Commodity x

= Prices of other commodities Pi = Prices of factors of production needed to produce good x

Py, pz

Q T

= Objectives of the producer = State of technology used to produce commodity x THE LAW OF SUPPLY

The supply of commodity depends upon several factors. It is not possible to study the influences of all factors determining supply. Therefore, we study the price of the commodity is the major factor and its relationship with the supply. In such case, the supply function is the following form: Sc = f(Px) Sx

= Quantity of commodity supplied and

= Price of commodity X The law of supply studies the relationship between the quantity supplied and the price of commodity. The law of supply states, ceteris paribus, more of a commodity is supplied at higher price and less of it is supplied at lower price. The law of supply relates to the functional relationship between quantities that the firms are willing to produce and sell. The supply schedule is given in Table 5.1. Px

Table 5.1: Supply Schedule of Rice Price (Rs)

Quantity supplied

50 60 70 80

25 30 35 40

90

45

It wiil be seen from the table that when the price is Rs 50 the quantity supplied was 25 units. When the price increases to Rs. 60, 30 units of the goods are supplied. When the price of goods goes up to Rs. 90, the quantity supplied in the market rises to 45 units. By plotting

Supply Analysis and Production Theories : 81

the above supply schedule into supply curve in Figure 5.1. In the figure, quantity supplied is measured along the X axis and the price is measured along the Y axis. The supply curve slopes upward from left to right which indicates that as the price of goods increases the quantity supplied increases and vice versa, as evident in the figure. SUPPLY CURVE SLOPES UPWARDS

The positive relationship between price and quantity supplied is an important area of interest in economics. The price of a product serves as an incentive for the producer to produce it. The higher the price, the greater the incentive from the firm to produce and supply it, other things remain the same. Changes in quantity supplied of a product following the changes in its price depends on the possibilities of substitution of the product for another. More quantities of commodity would be supplied in the market at a high price to cover high cost of production. y

s

s o ~--------------------------~x Quantity supplied

Fig 5.1: Supply Curve.

The supply curve is the diagrammatical representation of the law of supply. It has practical utility for the manufacturer to guide him in the choice of production. Besides that, the law does not apply auction sales because of the binding rules of auctioning goods.

)

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Factors Determining Supply

Supply of a commodity depends on the price of a product and also several other factors which are as follows: 1. Factor Prices: Changes in prices of factors cause a change in cost of production consequently, change in supply.

2. Objectives of the firm: The aim of the firm is to maximize sales revenue rather than profits, supply would be large in the market. 3. Production Technology: Improvement in production technology may decline cost of production and the firm can supply more than the previous situation at the given price. 4. Prices of Products: Any change in the prices of other products would influence the supply of a product by substitution of the product. 5. Number of Producers: Supply of a product increases with the increase in the number of firms producing the product. If new firms enter in that industry in the long run, supply of the product may be increased. 6. Expectation of Future Prices: Another important factor which influences the supply of the product is expectation of future prices during inflationary trends. 7. Taxes and Subsidies: Taxes and subsides also change the supply of the product. The Government levy excise duty, sales tax which induces the firms to supply at higher prices. 8. Natural Factors: Natural factors such as vagaries of monsoon, drought, flood etc, are the influencing factors which are conducive for more supply of commodities. 9. Socio Cultural Factors: Socio cultural factors may influence the supply of commodities. For example in festival seasons, certain commodities may influence the supply. During Deepavali and Christmas festivals, the abundant supply of crackers and during religious and marriage seasons, flower supply may also be increased. 10. Trade Union Activities: Trade union activities like bargaining for higher wages, may increase the production capacity. ELASTICITY OF SUPPLY

The concept of elasticity of supply is a relative measure of the responsiveness of quantity supplied of a commodity to the change in its supply price. The greater the responsiveness of quantity supplied of

Supply Analysis and Production Theories : 83

a commodity to the change in its price, the greater its elasticity of supply. The elasticity of supply is the degree of responsiveness of supply to changes in the price of a good. In precise, it can be defined as a relative change in quantity supplied of a good in response to a relative change in price of the good. When a small fall in price leads to a large contraction in supply, the supply is elastic. When a big fall in price it leads to a very small contraction in supply, it is said to be inelastic.The small rise in price leading to a big expansion in supply shows elastic supply and big rise in price leading to a small expansion in supply indicates inelastic supply. The elasticity of supply can be defined as proportionate change in quantity supplied divided by the proportionate change in price. In symbols es

=

/lq I /lp q

Where, q

p

= /lq x ~

p q

denotes original quantity supplied

/lq denotes change in quantity supplied P denotes original price /lp denotes change in price Example If the price of a television rises from Rs.I0,000 per unit to Rs. 12,500 and in response to this rise, the quantity supplied increases from 2500 units to 3000 units, the elasticity of supply will be

Es

=

500 _ 2500 = 500 x 10000 =0.8 2500 10000 2500 2500

Determinants of Elasticity of Supply There are three important factors that determine the elasticity of supply. (1) changes in cost of production of a product. (2) responsiveness of producers and (3) facilities available to expanding the output. As in the case of changes in cost of production of product, the firm can increase its output by varying all factors and the new firms can enter in ~ the industry and thereby add to the supply. The long run supply curve of a product is more elastic than in the short run. The elasticity of supply would be less with increase in the production and marginal cost of production goes up.

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As regards to the responsiveness of producers, if the producers do not respond positively to the increase in prices, the quantity supplied of a product would not increase as a result of rise in its price. Apart from that, supply of the product in the market depends on the availability of productive resources such as fertilizer, irrigation facilities for the farming community and electricity, fuel and essential raw materials. The coefficient of elasticity of supply is positive in the case of upward sloping of supply curve. The elasticity of supply will be between zero and infinity when the supply of the quantity of a commodity does not change in response to the changes in price. The supply curve is vertical straight line parallel to the X axis and it is said to be perfectly inelastic. The elasticity will be equal to infinity and its supply curve will be a horizontal straight line parallel to the X axis, it is said to be perfectly elastic supply. If the relative change in the quantity supplied is equal to the relative change in the price, the supply is said to be unitary elastic. The co-efficient of elasticity of supply is equal to one. Iso Cost Line An Iso cost line is defined as the locus of factor combinations that can be purchased for a given total cost. It is also called th~ Price line or Outlay line. The iso cost line plays an important part in determining what combination of factors the firm will choose for production. An Iso cost line in Figure 5.2 shows various combinations of two factors that the firm can buy with a given outlay. Iso cost line depends upon two things, viz., prices of the factors of production and the total outlay which the firm has to make on the factors. Let us assume that the firm has Rs. 200 to spend on two factors K and L. The price of factor K is Rs. 8 per unit and the price of factor L is Rs. 10 per unit. With the outlay of Rs. 400, he can buy 50 units of K or 40 units of L. Let OB in Figure 5.2 represent 50 units of K and OA represent 40 units of L. The straight line AB which joins points A and B will pass through all combinations of factors K and L which the firm can buy with the outlay of Rs. 400, if it spends the entire money on them at the given prices. The line AB is called Iso cost line for which every combination lying on it the firm buys it, has to incur the same outlay at the given prices. In fact, any number of parallel iso cost line can be drawn which represent various combinations of two factors that can be purchased for a particular outlay. The higher the outlay, the

Supply Analysis and Production Theories : 85

higher the corresponding iso cost line. The slope of the iso cost line is equal to the ratio of the prices of two factors. Hence, slope of the iso cost line is AB = Price of Factor X Price of Factor Y If the producer desires to minimize his cost of production or to maximize his output level for a given cost or outlay, now the question arises which factor combination produces a given level of output. He will choose the combination of factors which minimizes the cost of production. Hence, the producer will produce the given level of output with least cost combination of factors. y

E

OL---------~B----~D----~----+X

Factor L

Fig 5.2: ISO Cost Lines.

While arriving to the least cost combination of input, a firm is guided by the principle of equi-marginal returns. According to this principle, the producer achieves the least cost combination when he combines various inputs in such a way that the marginal productivities yielded by the last rupee spent on each input are equal. Table 5.2 shows the least cost combination of two inputs producing 200 units of output.

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Table 5.2: Least Cost Combinations of Two Inputs XI

X2

PX r XI

PX2• X2

Cost (Rs)

10 20 30 40

45 28 16 12

30 60 90 120

180 112 64 48

210 172

50

8

150

32

182

15~

168

Note: PYI = Rs.3, PY2 = Rs.4 It is clear from the above table that 10 units of Xl combined with 45 units of X 2 would cost the producer Rs.210. But if X 2 is reduced by 17 units and X 2 is increased by 10 units, the resulting cost would be Rs. 172. Substituting 10 more units of Xl for 12 units of X 2 further reduces cost to Rs. 154. However, it will not be profitable to continue this substitution process further at the existing prices since the rate of substitution is diminishing. Here. the least cost combination is 30 units of Xl used with 16 units of X 2 when the cost would be minimum at Rs, 154.

Equal Product Curves The equal product curves are contour lines which trace the loci of equal outputs. An equal product curve represents all those input combinations which are capable of producing the same level of output. It is otherwise known as Isoquants (equal quantities) or production indifference curves. The term iso quant is derived from the words Iso and quant, Iso means equal and quant means quantity. Hence, iso quants ,means equal quantity. For a given level of output, the firms production becomes the function of two inputs viz., capital and labour. Hence, an Iso quant shows all possible combinations of the two inputs which are capable of producing equal level of output. The producer becomes indifferent towards these combinations.

Assumptions 1. There are two factors of production viz, labour and capital 2. These two factors can be substituted each other up to a certain limit

Supply Analysis and Production Theories : 87

3. Shape of the iso quant depends upon the extent of substitutability of the two inputs. Table 5.3 shows the equal product combinations of two variables.

Table 5.3: Equal Product Combination Combinations

Labour (Units)

Capital (Units)

Output (Units)

10

50 50 50 50

A

2

B

7

C

3

4

D

4

2

In the above table, combination A represents 1 unit of labour and 10 units of capital and produces 50 units of a product. All other combination in the table are assumed to yield the same level of the output. Thus, a producer can produce a given output of a product say 50 units by employing anyone of the alternative combinations of the two factors, viz., labour and capital. The Iso product curve is shown in Figure 5.3 y L

120 100

~

A

\.

I~c

.~D________

E

20

p

10

o

10

20

30

40

50

60

x

Factor X

Fig. 5.3: ISO Product Curve.

Labour is measured on X axis and capital on the Y axis. EP is the Iso product curve which shows all the alternative combinations, A,B,C and D which can produce 50 units of a product. An iso product is been drawn with the help of ISO product curves, as shown in the figure.

Engineering Economics : BB y

>-

gu ...

u.

O~----------Fa-c-to-r-x--------------+x

Fig. 5.4: ISO Product Map.

Properties of Iso quants 1. Isoquants slope downwards from left to right. It means increasing the employment of one factor of production results in the decreasing employment of the other factor of production to maintain the same level of output. 2. Isoquants cannot be horizontal or vertical and they cannot slope upwards. 3. Isoquants are convex to the origin. 4. The shape of the isoquants indicates the rate of substitution between the two factor inputs. 5. Two Isoquant curves cannot interest each other. 6. Higher Isoquants show higher level of output and vice versa

Production Theories The theory of production is concerned with explaining which combination of inputs (factors of production) a firm will choose to minimize its cost of production, which is the study of (i) the law of variable proportions and (ii) the laws of returns to scale. Before going

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through the law it is pertinent to understand the relationship of Total product, Marginal product and Average product of the production factors. Marginal product is the increase in output obtained by an increase in the use of a factor. If we multiply the increase in output we get the value of the marginal product or the revenue from the marginal product. This is called marginal revenue product. (MRP). It is the addition to the total revenue resulting from the use of one more unit of a factor of production. Marginal revenue product curve is the demand curve for a factor of production. To find out the marginal product, we assume that one factor is varied; the other factors are assumed to remain unchanged. If there are two factors say, land and labourers are working and the output is produced. Suppose if 4 labourers are working and the output increases to 300 units. When the number of workers is increased by one, the output increases to 325 units. Hence, the marginal product of worker is 25 when 5 workers are employed. With every additional worker, total product increases. The rate of increase in total product decreases after a stage is reached. Marginal product increases in the early stages and then starts declining. Consider Table 5.4. The behaviours of the output where the varying quantity of one factor is combined with a fixed quantity of the other can be divided into three different stages. Total output divided by the number of workers gives the average product of the worker. So long as marginal product is increasing, the average product will also increase but at a slower rate. When marginal product starts decreasing, the average product also decreases at a slower rate as evident in Table 5.4. (I) THE LAW OF VARIABLE PROPORTIONS

The law of variable proportions examines the production function with one variable. It refers to the input output relation when the output increases by varying the quantity of one input. The other name of the law is the law of diminishing returns because the effect on output of variations in factor proportion is studied. Definitions

According to Stigler, as equal increments of one input is added; the inputs of other productive services being held constant, beyond a

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certain point the resulting increments of product will decrease, i.e. the marginal product will diminish. According to P.A. Samuelson an increase in some inputs relative to other fixed inputs will, in a given state of technology, cause output to increase; but after a point the extra output resulting from the same additions of extra inputs will become less and less. Marshall defines the law as an increase in the capital and labour applied in the cultivation of land causes in general a less than proportionate increase in the amount of product raised unless it happens to coincide with an improvement in the arts of agriculture. K.E. Boulding defines as we increase the quantity of anyone input which is combined with a fixed quantity of the other inputs, the marginal physical productivity of the variable input must eventually decline. It is very clear from the above definitions that the law of variable proportions denotes to the behaviour of output as the quantity of one factor is increased, keeping the quantity of other factors fixed. It states that the marginal product and average product will eventually decline. Factor proportions are changed by keeping the quantity of one or some factors fixed and varying the quantity ofthe other. The changes in output due to the variation in factor proportions forms the subject matter of the law of variable proportions.

Assumptions of the Law The following are the important assumptions of the law: 1. The state of technology is assumed to be constant; 2. One factor of input is made variable and other factors are kept constant; 3. All units of the variable factors are homogeneous. The law of variable proportions states three types of productivities of an input factor: total, average and marginal physical productivities, as we see them in briefly. The total product (TP) is the total amount of output obtained by employing increasing quantities of one input, keeping othL'r input factors constant. The average product (AP) is obtained by dividlll~ the total product by the number of factor units employed.

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Table 5.4: Total Product, Average Product and Marginal Product Fixed factor

Variable factor

Total product

Average product

1+ 1+ 1+ 1+ 1+ 1+ 1+

1 2 3 4 5 6 7

100 210 270 300 325 330 330

100 105 90 75 65 55 47

110 60 30 25 05 0

1+

8

320

40

-10

Marginal product

Stage

1st stage

2nd stage

3,d stage

Let us see the example that a producer produce output with certain fixed and variable inputs. He has to take decision regarding the physical productivity oflabour in the first. The first three columns in Table 5.4 show production function. The third column shows average product per worker and obtained by subtracting the total product by employing Y (n-I) workers from the total product by employing Yn workers i.e., marginal product of third worker would be 270 - 210 =60 units. Further, the average product and marginal product increase at the beginning stage and then decline when the total product is maximum where the employer employs sixth worker, nothing is produced by the seventh worker and its marginal productivity is zero, while, the marginal product of eighth worker is minus 10.

TP

STAGE 2

STAGE 3

STAGE 1

AP

o

N

Quantity of a variable factor

M ',-

". MP

Fig. 5.5: Law of Variable Proportions.

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This situation is graphically denoted in Fig 5.5. As long as TPP rises at an increasing rate MPP is also rising and p~oduction function curve is concave to the origin. Beyond point A~ TPP, MPP start declining. TPP is at its highest level at B, at which MPP falls to zero. Beyond this point, if variable input is further increased TPP will fall in this case MPP becomes negative. MPP starts declining from the inflexion point A and it intersects the APP curve at D, the point-of maxiII).um value of APP indicates the equality of MPP and APP. In summarized version, the law of variable proportion is nothing but the combination of the law of increasing and diminishing returns. The relationship when AP is rising, MP rises more than AP, when AP is maximum and constant, MP becomes equal to AP when AP starts falling, MP falls faster than AP. Therefore, the total product, marginal product and average products pass through three phases viz., increasing, diminishing and negative returns. Three Stages of the Law

First Stage: In the first stage, marginal product of the fixed factors is negative which is known as the increasing returns because average product of the variable factor increases in the stage. The peculiar features of the first stage are: 1_ Fixed factor is abundant in relation to the quantity of the variable factor. 2.

IndiviSibility of some factors may cause increasing returns.

3.

When more units of the variable factor are employed, the efficiency of the variable factor increases, greater the scope for specialization.

4.

Greater the quantity of the variable input and it will be the level of productivity and efficiency.

Second Stage: In the second stage, the total product continues to increase at a diminishing rate until it reaches the maximum point at H where the second stage ends. In this stage, both the marginal product and average product of the variable factors are diminishing but are positive. At the end of the second stage, the marginal product of the variable factor is zero, indicates diminishing returns as the average and marginal products of the variable factors continuously fall.

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The important features of the second stage are: I. Efficient use of the fixed factor as more units of the variable factors are combined to work with it. 2. The productiod made by the variable factor after a point become less and less because the additional units of the variable factor have less and less of the fixed factors to work with. 3. The fixed factor becomes scarce in relation to the variable factor, the marginal and average products of the variable factor decline. 4. The fixed factor is indivisible whether the output produced is small quantity or large quantity. 5. Diminishing returns occur if the factors of production are imperfect substitutes for one another. Third Stage: This stage is called the stage of negative returns. Since the marginal product of the variable factor is negative, the total product declines, and the total product curve slopes downward. Consequently, the marginal product of the variable factor is negative and the marginal product curve goes below X axis. A rational producer will not choose to produce in the third stage. The marginal product of the variable factor being negative, a producer can always increase his output by reducing the amount of variable factor.

The stages one and three are called the stages ofeconomic absurdity or non-economic region in production function. A rational producer always seek to produce in the second stage where both the marginal product and average product of the variable factors are diminishing at a particular point, the producer will decide to produce depending upon the prices of the factors. Hence, the second stage is the range of rational production decisions. The important features of the second stage are: 1. The number of variable factors becomes too excessi ve relative to the fixed factor so that they get in each other's way with the result that the total output falls instead of rising. 2. Many variable factors also impairs the efficiency of the fixed factor. 3. Marginal products of the fixed factor and variable factor are negative due to its excessiveness.

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Significance of the Law of Diminishing Returns The phenomenon of disguised unemployment is found in agriculture in the under developed countries reveals that marginal productivity of a worker is zero. The agricultural productivity curve is rising up to a certain point and then begin to fall due to diminishing returns. In the developed countries, food productivity has been shifting upward due to the progress of agriculture technology. If there is no progress in technology, the productivity curve had unchanged with the increase in population and therefore labour force, food productivity would have declined. In practice, with the increase in the labour force, the average productivity in agriculture is rising due to the progress in technology. As a consequence, the economies of developed countries have been moving to the rising average productivity. Unless there is continuity in the improvement of food production techniques, the population explosion must bring decline in the living standards due to insufficient food production with relation to the growth of population.

(II) THE LAWS OF RETURNS TO SCALE IN PRODUCTION The term returns to scale refers to the changes in output as all factors change by the same proportion. The behaviour of output in response to the changes in the scale. An increase in the scale means that all input factors are increased in the same proportion. It occurs when all input factors are increased keeping factor proportions unaltered. The laws of returns to scale refer to the effects of scale relationship. In the long run, output may be increased by changing all factors by the same proportions or by different proportions. It is necessary to discuss how the returns vary with the changes in scale, i.e., when all factors are increased in the same proportion. Some economists argued the concept that all factors cannot be increased and hence the proportion between factors cannot be kept constant. We shall explain below the concept of returns to scale by assuming only two factors, viz., labour and capital are needed for production. This enables us to proceed the analysis in terms of equal product curves. There are three types of returns to scale viz., (1) Constant returns to scale, (2) Increasing returns to scale and (3) Decreasing returns to scale. Let us discuss briefly the following.

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1. Constant Returns to Scale The returns to scale are said to be constant. If all factors in a given proportion and the output increases ir.. the same proportion. Mathematically, the constant return to scale is called linear and homogenous production functions or homogenous production function of the first degree.

Assumptions 1. Only two factors of production say labour and capital. 2. Returns to scale are constant. 3. The distance between the successive equal product curves being the same along any straight line through the origin. It means that if both labour and capital are increased in a given proportion, output expands by the same proportion. 4. Some factors whose quantity cannot be increased in the proportion because their supplies are scarce and limited, scarcity causes diminishing returns. Some factors are indivisible and full use of them can be made only when production is carried on quite a large scale. 5. Greater specialization of labour becomes possible. 6. Introduction of specialized machinery or other inputs of a superior technology from among the wide range of technical possibilities.

2. Increasing Returns to Scale Increasing returns to scale means that output increases in a greater proportion than the increase in inputs. For instance, all inputs are increased by 25 per cent and output increases by 40 percent than the increasing returns to scale will prevail. The distance between consecutive multiple isoquants decreases in increasing returns. By doubling the inputs, output is more than doubled. The increasing returns to scale are due to technicall or managerial indivisibilities. One of the basic characteristic of advanced industrial technology is the existence of mass production methods. They are more efficient than the best available processes for producing small levels of output. Increasing returns to scale is shown in the equal product map. When increasing returns to scale occur, the successive equal product curves will lie at decreasingly smaller distances along a straight line through the origin.

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Decreasing Returns to Scale

Decreasing returns to scale is the increase in all factors which tend to a less than proportionate increase in output. In other words, when output increases in a smaller proportion than the increase in all inputs. The decreasing returns to scale is a special case of the law of variable proportions because it treats the entrepreneur in the fixed factor. Decreasing returns scale eventually do occur due to difficulties of management, co-ordinations and control. When the successive equal product curves lie at progressively larger and larger distance on a straight line passing through the origin, the returns to scale will be decreasing. The common causes of diminishing returns to management, as the output grows, top management becomes eventually overburdened and hence less efficient in its role as decision maker. Another cause for decreasing returns may be found in the exhaustible natural resources. i.e. doubling the fishing fleet may not lead to a doubling of the catch of fish or doubling the plant in mining or an oil extraction field may'not lead to a doubling of output. (III) PRODUCTION FUNCTION

Production function expresses the relationship between quantities of output and quantities of various inputs utilized for production. In precise, it explains the maximum quantity of output that can be produced from any selected quantities of various inputs. The production function expresses flow of inputs resulting in flow of output determined by the state of technology in a specific period of time. The most popular and widely used production functions are Linear Production Function (LP), Cobb Douglas Production Function (CD) and Constant Elasticity of Substitution (CES) Production Function. 1. Linear Homogenous Production Function

A production function which is homogeneous of the first degree is known as linear homogeneous production function. The homogeneous production function of the first degree implies that if all the factors of production are increased in some proportion, output also increases in the same proportion. If there are two factors X and Y, then homogeneous production function of the first degree can be mathematically expressed as Jp= f (JX, JY)

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Where p stands for the total production and J is any real number. If factors X and Yare increased by Jlh times, total production P also increases by J times because homogeneous function of the first degree yields constant returns to scale.

2. Cobb Douglas (CD) Production Function Cobb Douglas (CD) production function is widely used in individual firms and manufacturing industries. In CD production function, only two inputs, viz., labour and capital are involved. This production function states that 75 % of the increase in manufacturing production is due to labour input and the remaining 25 % is due to capital input.This function exhibits constant returns to scale. i.e. if factors of production are each raised by one percent, the output will increase by one percent. It indicates that no economies or diseconomies of large scale operation of plant. According to the CD production function labour's share in real national product will be a constant a which is independent of the size of labour force. Cobb Douglas production function takes the following mathematical form Y = (Ale'V·a) Where, Y = output K = capital L = Labour

A, a = positive constants

The exponents a and:,I-a are the elasticities of production i.e. a and I-a measure the percentage reponse of output to percentage changes in labour and capital respectively.

Assumptions 1. Output is the function of two factors. viz., capital and labour 2. It is a linear homogeneous production function of the first degree 3. Constant returns to scale 4. Technology is unchanged 5. Market perfection.

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Although several types of production functions are commonly employed, to measure production function, but only four types are widely used in practice. These are linear function, power function, quadratic function and cubic function. Production function is known as being constant or linear. The production line will have a 45° line from the origin. The input and output figures need not be the same. For example, on horizontal axis if V2 cm shows 5 kg of fertilizer, on vertical axis Y2 cm can showl0 kg of wheat output. Thus, production function is homogenous. In Cobb Douglas production function, the value of alpha was taken as 0.75 while of beta 0.25 i.e. the share of labour and capital in the production process is of the order of % : 1;4. In Cobb Douglas production function, alpha and beta are equal to one which means that increase in income or output are equal to the marginal physical productivity of the factors of their respective increases. Cobb Douglas production function can be presented as: X = 1.01 X U·75 X K 0.25 Suppose 10 units of labour and 100 units of capital are used. Then X=I.01 X (10) .75 X (100) .25 Taking logrithms for the values Log X

= log 1.01 + .75 Log 10 + .25 Log

100

Log X = .000432 + .75 X 1+.25 X 2 Log X

= 1.250

Log X= Anti-log 1.250 X= 17.78

Now, if the units of inputs Land K are doubled, then the output X will be doubled. Let us assume that, L=20; K=200 Log X

= log 1.01

+.75 Log (20) + .25 log 200

Log X =.000432 +.75 X 1.3 +.25 X 2.3

= 1.5500432 X = Anti log 1.5500432

Log X

X= 35.56

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Uses of the Cobb Douglas Production Function The following are the uses of CD production function 1. The Cobb Douglas production function is not relevant for long period and of course non-linearity is the way of economic life. 2. In the long run, it will be either increasing cost or decreasing cost function. 3. It can be used to explain labour share in national income. 4. The Cobb Douglas production function is used by researchers in the agricultural sector make the assumption that the product is unique and factor prices are determined by the competitive forces. 5. Cobb Douglas production is an excellent rationalization of static cross section data.

Criticisms 1. The critics mainly pointed out that scant attention is paid to the sampling procedure followed in collecting the data of inputs used and output produced. 2. Problems of measurement and aggregation of inputs and output. 3. Production function fitted to cross section data is often treated as an aggregate production function. Generally. the economic behaviour of the economic agents is evaluated by comparing the marginal productivities of factors of production.

3. Constant Elasticity of Substitution Constant elastitcity of substitution function has similarity of Cobb Douglas production function by the observation that labour share in the national income was varying as the wage rate varies. Hence,

Y

w

L

d

-=-

Where, Y is the national income L is the labour force w is the wage rate and d is a constant

Engineering Economics: fDa

REVIEW QUESTIONS 1. Wha,t are the factors determining supply? 2. What is Elasticity of supply? 3. What is Iso cost line? 4. What are Iso product curves and mention its properties? 5. Explain law of variable proportions. 6. Explain constant returns to scale. 7. What is the significance of increasing returns to scale? 8. Write the law of supply.

(April 2001 , April, 2002)

6 Cost and Output Relationship

COST CONCEPTS Costs occupy a significant role in decision making process Of all enterprises in modern days . The cost of production expressed in monetary terms is an important factor identifying the negative points in production management, minimizing costs, find optimum level of output, estimate cost of business operations. Therefore, cost concepts are most relevant in business decisions. Cost concepts can be grouped into two categories,(l) Concepts used for accounting purposes and (2) Concepts used in economic analysis of business activities. We shall discuss briefly some of the important cost concepts as follows.

1. Direct Costs Direct costs are those costs which have direct relationship with a unit operation like a product, a process or a department of a firm . The other name of the direct costs is Traceable or Assignable costs. Direct costs have linked with particular product processes and vary with changes in them. All direct costs are variable in nature.

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2. Indirect Costs Indirect costs are common costs. Those costs of the source cannot be easily traced in a plant, a product or a process. For example, in operating railway services, the cost of station, track, equipment and staff etc. cannot be assigned to the passenger or goods transportation. Indirect costs are both fixed and variable in nature, For example, the cost of a factory building, the track of a railway system etc. are the fixed indirect costs, while those of machines, labour services etc. are the variable indirect costs.

3. Opportunity Cost The concept of opportunity cost is derived from the fact that in any country, the available productive resources are scarce in relation to demand, and so employing a resource in one particular use involves forgoing the opportunity of employing that resource for an alternative use. Opportunity cost is defined as the loss of expected retumsJrom a second best use of resources forgone for availing the gains from their best possible use. The opportunity cost is the income expected from the second best alternative use of resources. It is also called as alternative cost. For example, a business man has Rs. one lakh for which he has only two alternative uses. He can buy either a printing machine or a lathe. He expects an annual income ofRs. 25,0001- by printing machine, and by lathe, Rs. 20,000. He would invest his resources in printing machine and for go the expected income from the lathe if he is a profit maximizing investor. The opportunity cost arises because of the forgone opportunities. Hence, the opportunity cost of using resources in printing business, the best alternative is the ·value of the return from the lathe which is the best alternative.

4. Actual Costs Actual costs are those costs which are actually incurred by a firm in the payment made for labour, material, building, machinery and transport etc. The total money expenses recorded in the account books are the actual costs. It comes under the accounting cost.

5. Business Costs Business costs include all the expenses which are incurred in carrying out a business. The concept of business costs is similar to that

Cost and Output Relationship: 103

of actual or real costs. The business costs include all payments and contractual obligations made by a firm together with the book cost of depreciation on plant and equipments. These costs can be used to calculate profit for legal purpose.

6. Full Costs The full costs include business costs, opportunity costs and normal profit. The opportunity cost includes the expected earnings from the next best use of the resources, or the market rate or interest on the total money capital and also the value of entrepreneur's own services which are excluded in the current business. Normal profit is a minimum earnings in addition to the opportunity cost, which a firm gets to continue its present occupation.

7. Explicit Costs Economic costs are divided into two parts, viz., Explicit costs and Implicit costs. The explicit cost is otherwise called as the out of pocket costs which refers to the payments made to the factors hired from outside the control of the firm. Explicit costs are those which fall under actual or business costs entered in the book of accounts. Such payments are wages, salaries, interest, rent payments for materials, license fee, insurance premium, depreciation charges are the example of explicit costs. These costs involve cash payment and are clearly reflected in normal accounting practices.

8. Implicit Costs Implicit costs may be defined as the earning of owner's resources employed in their best alternative uses. It is otherwise known as book cost or non-cash costs, which refers to the payments made to the self owned resources used for the production. For example, an entrepreneur does not utilize his service in his own business and works as a manager in some other firm for salary. If he starts his own business, he forgoes his salary. This loss of salary is the opportunity cost of income from his own business. This is an Implicit cost of his own business because, the entrepreneur suffers the loss, but the same is not charged as the explicit cost of his own business. The Implicit costs are not taken into account while calculating the loss or gain of the business, but they form an important consideration whether or not a factor would remain in present occupation.

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9. Book Costs Certain actual business costs which do not involve cash payments, but a provision is made in the books of account and are taken into account while finalizing the profit and loss accounts. Such expenses are known as book costs. The examples of book costs are depreciation allowances and unpaid interest on the owner's own fund. 10. Fixed Costs Fixed costs are those costs which are independent of output. They do not change with changes in output. Fixed costs are also known as Overhead costs and it includes charges like contractual rent, insurance fee, maintenance costs, property tax, interest on capital invested, salary of the manager etc. The fixed cost includes (l) the cost of managerial and administrative staff, (2) depreciation of machinery and building and fixed assets, maintenance of land etc. are associated with short run. 11. Variable Costs (VC) Variable costs are those cost which vary with the changes in the total output. The variable costs include cost of raw materials, running cost of fixed capital such as factories, ordinary repairs, maintenance expenditure, direct labour charges and the costS"of other inputs. The variable costs are those costs which are incurred on the employment of variable factors of production whose amount can be altered in the short run. Thus, total variable costs changes with changes in output in the short run. It is also called as prime costs or direct costs. Thus, TC=TFC+TVC. The TVC varies with changes in output, the total cost of production will also respond to changes in the level of output. 12. Total Costs Total costs represent the value of total resources requirements for the production of goods and services. It refers to the total outlay of money expenditure, both explicit and implicit, on the resources used to produce a given level of output. It is the sum of both fixed and variable costs.

Cost and Output Relationship: 105

13. Average Costs Average cost is of statistical nature. It is not actual cost. It is obtained by dividing the total cost (TC) by the total output. Thus, AC= TQ TC Where TC is Total cost, TQ is Quantity produced, AC is Average cost.

14. Marginal Cost (MC), Marginal cost is an addition to the total cost of producing one more unit of output. In other words, Marginal cost is the addition to the total cost of producing n units instead of n-1 units where n is any given number. In symbol. MCn = Tcn - Tcn-I. It is only the variable costs which change with a change in the level of output in the short run. Therefore, marginal cost is due to the changes in variable costs. Marginal cost curve falls as output increases in the beginning. It starts rising after a certain level of output. This happens because of the influence of the law of variable proportions. The fact that marginal product rises first, reaches a maximum and then declines ensures that the marginal cost curve of a firm declines first, reaches its minimum and then rises. Let us illustrate the computation of marginal cost from Table 6.1.

Table 6.1: Computation of Marginal Cost Marginal Cost (Rs.)

Output

Total Cost (Rs.)

0 1 2

100 125 145

25 20

3 4 5 6

160 180 205 240 265

15 20 25 35 25

7

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As in Table 6.1, suppose the production of 5 units of a product involves the total cost of Rs. 205. If the increase in production of 6 units raises the total cost to Rs. 240, then the marginal cost of the sixth unit of output is Rs. 35 i.e. 240 - 205 = 35. In the above table when output is zero in the short run the producer is incurring the total cost of Rs. 100 which represents the total fixed cost of the production. When one unit of output is produced, the total cost rises to Rs. 125. The marginal cost of the first unit of output is therefore Rs. 25 (Rs. 125-100 = 25). when the output is increased to 2 units, the total cost goes upto Rs. 145. Therefore, the marginal cost is Rs. 20 (145-125=20) In this way the marginal cost is calculated. So marginal cost is a change in total cost as a result of unit change in the output. It can be written as: MCL\TC L\Q

Where ATC represents a change in total cost and L\Q represents a small change in output or total product.

15. Short Run Costs Short run costs are those costs which vary with the variations in output. While the size of a firm remains the same. In other words, short run costs are the same as variable costs which associated with variables in the utilization of fixed plant or other facilities. 16. Long Run Costs Long run is a period of time during which the firm can vary all its inputs. In the long run, none of the factor is fixed and all can be varied to increase output. The long run production function has therefore no fixed factors and the firm has no fixed costs. Long run is a period of time sufficiently very long to permit the changes in plant, i.e. in capital equipment, machinery and land to increase or decrease the output. 17. Incremental Costs Incremental costs are closely related to the concept marginal cost. It refers to the total additional cost associated with the marginal batch of output. In practice, due to lack of perfect divisibility of inputs to employ factors for each unit of output separately. Besides, in the long run, the firm expand their production, hire more men, materials, machinery and equipments. The incremental cost arises also owing to

Cost and Output Relationship: 107

the changes in product line, addition or introduction of a new product, replacement of worn out plant and machinery, replacement of obselete techniques of production with a new one etc.

18. Sunk Costs Sunk cost are those costs which cannot be increased or decreased by varying the 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 sunk. Since they accord to the prior commitment and cannot be reversed or recovered when there is a change in business decisions.

19. Historical and Replacement Costs Historical cost refers to the cost of an asset acquired in the past whereas replacement costs refers to the outlay made for replacing an old asset. These concepts own their significance to unstable nature of the price behaviour. Stable price over time, other things given keep historical and replacement costs on par with each other. The instability in asset price makes these two costs differ from each other. The historical costs of assets is used for accounting purposes, in the assessment of networth of the firm. The replacement cost figures in the business decision regarding the renovation of the firm.

20. Private Costs Private costs are those costs which are actually incurred by an individual or a firm on the purchase of goods and services. All actual costs both explicit and implicit are private costs. The private costs are internalized in the sense that a firm must compensate the resource owner to acquire the right to use. It is incorporated to the total cost of production. Private costs are the opportunity costs of resources which are borne by the owners of an enterprise who are party to a particular economic decisions. For example, when an irrigation dam is built in a river valley the pri~ate costs are only those costs incurred by the Government agency for building the dam, canals, and power stations etc.

21. Social Costs Social cost implies the total cost made to the society on account of production of a commodity. It includes both private cost and the

Engineering Economics: 108

external cost. Certain costs which arise due to functioning of the firm but do not normally include in the business decision. Such costs are borne by the society. Thus, total cost generated by a firm can be divided into two categories; those paid out by firms and those unpaid by firms. It includes the use of resources freely available and the disutility created in the process of production. For example rivers, lakes and public utility services like airports, harbouI:s, bridges etc. It is known as external costs or social costs. For instance, the Southern Viscose Company discharges its wastage into the Bhavani River which causes water pollution and soil degradation. Such pollution causes tremendous health hazards which involve health cost to the society. Such costs are termed as external costs from the firm's point of view and social cost from the society's point of view. In other words, social costs are the opportunity costs borne by a whole society or community. It includes not only the costs borne by the owners of a business but also the costs inflicted upon those who are not party to a particular economic decision. 22. Money Costs Money costs refer to the minimum amount of money spent to produce a given level of output of a commodity. It depends upon factor prices, techniques used, quantity of factors, efficiency of factors and scale of output. 23. Real Costs The real costs means the physical quantities of land, labour, capital and entrepreneurship that are required to produce a given level of output. It is also known as Engineering costs and depends upon the technical conditions of production not affected by factor prices. 24. Prime Cost Prime cost refers to all expenses which can be directly assigned to the production of a commodity. It generally varies proportionately with the size of production. It consists of direct material cost, direct labour cost and other direct expenses. Direct materials comprise those materials which are easily identified with the product. Direct labour refers to that labour which can be easily associated or identified with a particular job or product or process leading to production of a final good. Direct expenses include all other expenses which are directly related with the production process.

Cost and Output Relationship: 109

25. Engineering Cost The engineering method is based on the technical relationship between inputs and output in the production function. Engineering cost are derived from engineering production function. Each productive method is divided into sub-activities corresponding to several physical, technical phases of production for any commodity. For each phase, the quantities of factors of production are estimated and finally the cost of each phase is calculated on the basis of prevailing factor prices. Engineering production function is based on the linear programming and are characterized by a limited methods of production. The production isoquants are kinked which indicate that factor substitutability is not continuous. Factors substitution occurs directly at the kinks of the isoquants, where a production technique is substituted for another. Assume that there are two types of production, utilizing labour and capital at a fixed ratio. The factor prices are chosen initially and output is produced with the capital unemployed. The firm will be better off by using a combination of the two methods.

Short Run Engineering Costs Fixed factor of production is assumed which needs a minimum outlay with some reserve capacity of the plant. The total cost curve as shown in figure 6.1 C

Te

t il

o

o

p

0, N,

o

~--------~------~------------~x

x,

Quantity

x2

Fig. 6.1: Short Run Total Cost Curve (Engineering Cost).

Engineering Economics: 110

Along each linear segment, the slope is the marginal cost. Along the first segment (MN) the marginal cost is equal to average variable cost for each successive phase (i.e. for phases NO and OP) the marginal cost is greater than average variable cost. The marginal cost increases stage-wise while the AVC increases smoothly, at a decreasing rate N. The AC falls continuously over the range MNOP. The AC is the slope of such rays declines as we move from M to N to 0 to P. Further, this segment of TC lies on a line through the origin. Reflecting the fact that only the TVC varies in proportion to output, while the fixed outlay has already been paid at the installation of the plant. The reserve capacity of the plant allows the firm to operate by increasing only its variable costs proportionately with output. Thus, the reserve capacity phase, the AVC, MC and ATC are equal and remain constant as shown (between Xl and X 2) in Figure 6.2

c

iii o o

ATC

ATC MC

W7 ,AVC ..M.f.L/ ___

.-M..C....--,-;-or~.........e:AV'-"C=.!!=M""C=""AT""'C~~.

---

AVC=MC

o

L-----------~------~-------------+X

Xl Quantity

Fig. 6.2: Short Run Average Total Cost Curve (Engineering Cost).

It is noted that output can be increased by extra working of plant and paying overtime labour when reserve capacity is exhausted. The total cost curve having a steeper slope than the previobs one. Along each linear segment, the marginal cost is constant, but the level of marginal cost increases stage by stage. The AVC iQcreases continuously below the MC but above the AVe. The short run engineering cost curves are shown in the Figure 6.2.

Cost and Output Relationship: 111

Long Run Engineering Costs The engineering costs generally the technical cost of production. Thus, diseconomies oflarge scale associated with administration costs are not encountered but there is a minimum optimal size of plant for each production process. The TC, AC and MC are shown in figures 6.3 and 6.4. Assume that there is a large number of processes, the total cost and unit cost curves become continuous in the long run. The LAC will not turn upwards if we are considering only production costs; but if we add the administrative costs and if there are strong managerial diseconomies, the LAC will rise at very large scales of output. .

y

Te

iii o

o

o

x

Quantity

Fig. 6.3: Long Run Total Cost Curve (Engineering Cost). y

u;

o o

"'--r---------

LAC

LAC=LMC

LMC

o

.

Quantity

x

Fig 6.4: Long Run Cost Curve (Engineering Cost).

Engineering Economics: 112

Relationship between Total Cost and Marginal Cost When total cost is increasing at an increasing rate, its corresponding marginal cost is raising when total cost is increasing at a decreasing rate, its corresponding marginal cost is falling. When total cost is reached the maximum i.e. it is increasing at a zero rate its corresponding marginal cost is zero.

Relationship Between AC and MC Curves When average cost falls as a result of an increase in output, marginal cost is less than average cost. When average cost rises as a result of an increase in output, marginal cost is more than average cost. When average cost is minimum, marginal cost is equal to the average cost. As long as short run marginal cost curve MC lies below the short run average cost curve AC, the average cost curve AC is falling when MC curve lies above the average cost curve, the average cost is rising. At the point of intersection, L where MC is equal to AC, AC is neither falling nor rising i.e. at the point L, AC has just ceased to fall but has not yet begun to rise. It follows that point, where the MC curve crosses the AC curve in the minimum point on the AC curve. Hence, marginal cost curve intersects the average cost curve at the minimum points. y

MC , ,,

-

AC

t il

o

(.)

H

,

,

o

x Fig. 6.5: Shape of AC & MC Curves.

In Figure 6.5, When marginal cost (MC is above average cost (AC) the average cost rises, that is the marginal cost (MC) push the average cost (AC) upwards. On the other hand, ·if the marginal cost (MC) is

Cost and Output Relationship: 113

below the average cost, (AC) the average cost falls, i.e. the marginal cost pulls the average cost downwards: When marginal cost (MC) stands equal to the average cost (AC) the average cost remains the same, that is the marginal cost pulls the average cost horizontally. Total cost is the sum of total variable cost and total fixed cost. Symbolically, TC = TFC + TVC. It is represented diagrammatically. In figure 6.6, total fixed cost curve (TFC) is parallel to X axis. This curve starts from the point on the Y axis, thereby fixed cost will be incurred even if the output is zero. On the other hand, total variable cost curve rises upward showing that as output increases, total variable cost also increases. This curve starts from the origin which shows that the output is zero, variable costs are also nil. The total cost curve has been obtained by adding vertically total fixed cost curve and total variable cost curve. v TC TVC

1/1

o

o

r----r-'-------------

o

Output

TFC

x

Fig. 6.6: Short-Run Total Cost Total Variable Cost and Total Fixed Cos"t Curves.

Average Fixed Cost (AFC) AFC is the total fixed cost divided by the number of units of output produced. Thus, average fixed cost is the fixed cost per unit of output. Let us illustrate with an example, a firm is producing with total fixed cost at Rs. 20,000. When output is 100 units, average fixed cost Rs. 200. And now if the output increases to 200 units, average fixed cost will be Rs. 100. Since total fixed cost is a constant amount, average fixed cost will steadily fall as output increases. Therefore, average fixed cost curve slopes downward.

Engineering Economics: 114

Average Variable Cost (AVC) Average variable cost is the total variable cost divided by the number of units of output produced. Thus, average variable cost is variable cost per unit of output normally falls as output increases from zero to normal output due to the occurrence of increasing returns. But beyond the normal output, average variable cost will rise steeply because of the operation of diminishing returns. The average variable cost curve will first fall, and then rise. Average Total Cost (ATC) Average total cost is a sum of average variable cost and average fixed cost. It is the total cost divided by the number of units produced. The behaviour of average total cost curve depends upon the behaviour of average variable cost curve and average fixed cost curve. In the initial period, both AVC and AFC curves fall, therefore, ATC curve will also fall sharply. When AVC curve begins to rise, AFC curve still falls steeply, ATC curve continues to fall. This is because during this stage the fall in AFC curve is greater than the rise in the AVC curve but as output increases further, there is a sharp rise in AVC, which offsets the fall in AFC. Therefore, ATC curve first falls, reaches its minimum and then rises. The average total cost curve is a U shaped curve. Figure 6.7 illustrates average fixed cost, average variable cost and average total cost. y

-., o

U

AFC

o

Output

x

Fig. 6.7: Short Run. Average and Marginal Cost Curve.

Cost and Output Relationship: 115

Costs relationship has been presented in Table 6.2.

Table 6.2: Costs Relationships Units of output

Average Average Average Marginal Total fixed Total Total cost per variable total cost (Rs.) variable cost (Rs.) fixed cost (Rs.) cost (Rs.) cost (Rs.) unit(Rs.) cost (Rs.)

0

1500

5

1500

0 500

2000

1500 300

100

400

100

15

1500

1000

2500

100

66.67

166.67

33

30

1500

1500 2000 2500

4000

40 41.67

100 70

16

1500 1500

50 30 25

50

50 60

3000 3500

66.67

10 8.33

75

1500

3000

4500

20

40

60

6.66

The above table shows that the fixed cost does not change with increase in output up to a given range, therefore, average fixed cost comes down with every increase in output. Variable cost increases but not in the same proportion as the increase in output. In the above case, average variable cost comes down gradually till 60 units are produced. Marginal cost is the additional cost divided by the additional units produced, it also comes gradually till 50 units are produced. LONG RUN AVERAGE COST CURVES Long run average cost curve is often called a planning curve. A firm can plan to produce any output in the long run by choosing a plant. on the long run average cost curve. The long run average cost curve helps the firm in the choice of the size of the plant for producing a specific output at the least possible cost. Long run cost of production is the least possible cost of producing any given level of output when all individual factors are variable. A long run cost curve depicts the functional relationship between output and the long run cost of production. In order to understand how long run average cost curve is derived we observe three short run average cost curves as shown in figure 6.8. These short run cost curves (SACs) are also called plant curves. In the short run, the firm can operate on any short run average cost curve given the size of the plant. Suppose there are only three plants which are technically possible. Given the size of the plant, the firm will be increasing or decreasing its output by changing the amount of the variable inputs. But in the long run, the firm chooses amovg the

Engineering Economics: 116

three possible sizes of plants as depicted by short run average curve (SAC], SAC z' SAC}). y

SAC1

-..,'"

SAC2 SAC3

o

G>

I I I

C> CII

t > «

I I I

I I

K

o

x Output

Fig. 6.8: Short-Run Cost Curves.

In the long run, the firm will examine with which size of plants to produce a given level of output to a minimum total cost. It will be seen from the figure that up to OD amount of output the firm will operate on the SAC], though it could also produc'e with SAC 2 , because up to OD amount of output, the production on SAC], results in lower cost than on SAC 2 • For example, if the level of output OC is produced with SAC], it will cost CL per unit and if it is produced with SAC 2 , it will cost CH and we can see that CH is more than CL. Likewise, if the firm plans to produce an output, which is larger than OD but less than OF, then it will not be economical to produce on SAC]. For this, the firm will have to use SAC 2 • Similarly, the firm will use SAC) for output larger than OF. It is clear that in the long run, the firm has a choice in the employment of plant and it will employ that plant yields minimum possible unit cost for producing a given level of output. Now the firm has a choice so that a plant can be varied by number of plants, correspondingly there are numerous average cost curves. As shown in figure 6.9, the long run average cost curve is so drawn as to be tangent to each of the short run average cost curves. Every point on the long run average cost curve will be a tangency point with some short run AC curve. If a firm interests to produce particular commodity for producing OP the corresponding point on the LAC curve

Cost and Output Relationship : 117 y

u;

LAC

o

.,u '"., :! >

4

OL-____~~~____~____~--------------. X Quantity

Fig. 6.9: Long Run Average Cost Curves.

is G and the short run average cost curve SAC2 is tangent to the long run AC at this point of lowest possible cost of production. It is clear from the figure that the Ip.rge output can be produced at the lowest cost with the larger plant. To produce OP, the firm will be using SAC2 only; if it uses SAC3 for this, it will resl}1t in higher unit cost than SAC2 • But larger output we can produce at OR is most economical with a larger plant represented by the SAC 3 • When the LAC curve is declining it is tangent to the falling portions of the short run cost curves and when the LAC curve is rising it is tangent to the rising. portions of the short run cost curves. Thus, for producing output less than as at the lowest possible unit cost, the firm will operate at less than its minimum average cost of production. On the other hand, for output larger than as the firm will operate beyond its optimum capacity. as is the optimum output. This is because as is being produced at the minimum point of LAC and corresponding SAC i.e. SAC 4 • Other plants are either used at less than their full capacity or more than their full capacity, only SAC 4 is being operated at the minimum point. In the figure, LAC curve is a U shaped curve depending upon the returns to scale. As the firm expands, returns to scale increase and the returns to scale finally decrease after a range of constant returns to scale. Increasing returns to scale cause fall in the average cost and decreasing returns to scale result in increase in long run average cost.

Engineering Economics :' 118

REVIEW QUESTIONS I. What is Engineering cost? 2. What is opportunity cost? 3. Distinguish between fixed costs and variable costs. 4. Define social costs. 5. Bring out the relationship between TC,MR and AC. 6. Distinguish short run and long run Engineering costs with illustration. 7. What are the items that come under direct costs?

(Oct, 2001)

8. Differentiate incremental cost and sunk costs.

(Oct, 2001)

9. What is semi variable cost?

(April, 2001)

10. List atleast 2 relationship between long run and short run curves. 11. What is marginal cost?

(April, 2002)

12. What is long run period?

(April, 2002)

13. Explain the long run and short run cost curves.

(April,2002)

7 Market Structure

MEANING OF THE MARKET Economists understand by the term market not any particular market place, where things are bought and sold but the whole region where buyers and sellers meet. The essentials of the market are commodity which is dealt with, existence of buyers and sellers and one price should prevail for the same commodity at the same time. Moreover, market structure can be classified on the basis of the number of firms, and nature of the product produced by the firms.

CLASSIFICATION OF MARKETS Economists have classified various market structures into (a) Perfect competition or Pure competition (b) Monopoly (c) Monopolistic competition and (d) Oligopoly. Except perfect competition, the other three categories of markets such as Oligopoly, Monopoly and Monopolistic competition are generally categorized as imperfect competition. These three forms of markets differ with respect to the degrees of imperfection in competition in the market. Monopolistic competition is the least imperfect and monopoly is the most imperfect form of market.

Engineering Economics: 120

A. PERFECT COMPETITION Perfect competition exists when there is a large number of producers (firm) producing homogenous products. The maximum output which an individual firm can produce is relatively very small to the total demand or the industry product so that a firm cannot affect the price by changing its supply of output. Perfect competition prevails when the demand for output of each producer is perfectly elastic. Firstly, the number of sellers is large so that output of anyone seller is negligibly a small proportion of the total output of the commodity. Secondly, the buyers are rivals to sellers in respect of their choice so that th~ market is perfect.

Features of Perfect Competition 1. Large number of buyers and sellers who compete among themselves and no buyer or seller is able to influence the demand and supply in the market. 2. Products are homogeneous in nature. 3. Every firm is free to enter inside the market or exit from the market. 4.

Perfect knowledge of buyers and sellers.

5. Existence of facilities for the movements of goods from one place to another place. 6. Goods are dealt on at an uniform price, in the entire market at a given point of time.

Time Elements in Price Determination Alfred Marshall, emphasise on time element in determination of price. According to him there are four situations of a market based on time element: 1. Very short period market. 2.

Short period market.

3.

Long period market.

4.

Secular period market.

1. Very Short Period Market: In this period, supply cannot be aJtered in response to a change in demand. It may be a few hours or a

Market Structure: 121

few days. A short period market can be easily understood, market for perishable commodities such as fruits, vegetables and fish. The price determined in a very short period is called as market price. In which all the commodities whose supply is static over a short period of time. Under such a condition price influences demand, and a rise in demand brings about a rise in price and vice versa. In the very short period, the supply curve is a vertical straight line. The demand curve is a downward sloping curve.

2. Short Period Market: The price prevailing in a short period is called short period normal price. It is the price of a commodity, the supply of which has adjusted to some extent to the changes in demand. 3. Long Period Market: In this period, price determined is called long period normal price. It is arrived at on the assumption that supply will change proportionately in response to changes in demand. 4. Secular Period Market: In this period, the price of commodities are affected by another type of forces of long period and supply if changes in prices that occur over a long period. It is known as secular forces. In this period, new sources of supply are discovered, and new methods of production are identified. Price Determination Under Perfect Competition Marshall's partial equilibrium approach seeks to explain the price determination of single commodity by the interaction of demand and supply curve. Given the assumption of ceteris paribus, it explains the determination of a price of good X independently of the prices of other goods with the changes in new demand and supply curve will be formed and corresponding to those new prices of the commodity will be determined. The partial equilibrium analysis of price determination studies how the equilibrium price changes as a result of changes in quantity. This analysis discusses only the price determination of the commodity in isolation and does not analyse how the prices of various goods are inter-dependent and inter-related and how they are determined.

General Equilibrium Analysis This analysis explains the mutual and simultaneous determination of prices of all goods and factors. This analysis deals with interrelationship and inter-dependence between equilibrium adjustment with

Engineering Economics: 122

each other. Thy general equilibrium analysis takes into account if X and Yare either complementary or cbmpetitive, a fall in the price of X have a substantial effect on the demand for Y. To explain the inter-relationship and inter-dependence among the prices and quantities of goods and factors and ultimately to explain the determination of the relative prices of all goods and factors, the proportion in which different goods are being produced and different factors are being used for the production of different goods is the essence of the general equilibrium analysis. Marshall gives equal importance for the force of supply and demand, which determine the price.

Equilibrium Price The price at which demand and supply are equal is known as equilibrium price. At this price, the forces of demand and supply are balanced at equilibrium. The quantity bought and sold at this equilibrium price is known as equilibrium quantity. Table 7.1 shows how price is determined between demand and supply.

Table 7.1: Equilibrium Price Price (Rs)

Demand (Units)

Supply (Units)

10

60

5

20 30

30 20

30 45

40

15

55

50

10

65

Equilibrium price for the industry thus fixed through the interaction of the demand and supply is Rs.20 per unit. The individual firms have to accept Rs. 20 per unit as the price and sell various quantities at this price.

Equilibrium of the Industry An industry consists of a large number of firms under its control. Such industry produces homogeneous products, so that there exist competition. When the total output of the industry is equal to the total

Market Structure: 123

demand, the industry is in equilibrium, the price prevailing is equilibrium price. Under competitive conditions, the equilibrium price for a product is determined by the interactive forces of supply and demand for it. It is shown in Figure 7.1 y

o

s

...

.a..g

R I--------~

o

s

o

L-------------L---------------+ x Q

Output

Fig. 7.1: Equilibrium of a Competitive Industry.

In Figure 7.1, OR is the equilibrium price and OQ is the equilibrium quantity. The equilibrium price is the price at which both the demand and supply are equal. If price is fixed at higher or lower level, demand is the same, or the quantities of goods are greater or smaller than the demand, there would not be an equilibrium in the market. When a firm is said to be in equilibrium, it maximizes its profit. The firms in a competitive market are price takers because a large number of firms are producing homogeneous products and they cannot influence the price in their capacities. They have to accept the price fixed by the industry. Consider Figure 7.1 that the demand curve facing an individual firm in a perfectly competitive market is horizontal one at the level of market price set by the industry and firms have to choose that level of output which yields maximum profit.

Engineering Economics: 124 y

y

(A) Markel

D

(8) Indlvlduals.lier

S

D/AR/MR w

2

a:

11.

D

oL-----------------------~x

oL---------~a~--*R----~X

QUANTITY

QUANTITY

Fig. 7.2: Firm's Demand Curve Under Perfect Competition.

Industry price OL is fixed through the interaction of total demand and total supply of the industry. Firms have to accept this price as given and as such they are price takers rather than price makers. They cannot increase the price OL alone because of the fear of losing of customers. They do not try to sell the product below OL because they do not have any incentive for lowering it. They will try to sell as much as they can at price OL. The L shaped line is a demand curve for them. Let us consider the firm A. Table 7.2 presents the total revenue, average revenue and marginal revenue.

Table 7.2: Total Revenue, Average Revenue and Marginal Revenue for the Competitive Firm Price (Rs.)

Quantity Sold

Total Revenue(Rs.}

Average Revenue(Rs.}

Marginal Revenue( Rs.}

20

8

16

20

20

20

10 12

20 24

20

20 20

20 20 20

20

14

28

20

20

16

32

20

20

In Table 7.2, it clears that the firm price, average revenue and marginal revenue of the firm is equal at Rs.20. Hence, in a perfectly competitive market a firm's Revenue = MR= price.

Market Structure: 125

A firm has to satisfy two conditions to attain the equilibrium position. Firstly, the marginal revenue should be equal to the marginal cost. If MR is greater than Me, there is always an incentive for the firm to expand its production further and gain by the sale of additional units. If MR is less than Me, the firm has to reduce the output since an additional unit adds more to cost than to revenue. The Me curve should cut MR curve from below. In other words, Me should have positive slope. These conditions are illustrated in Figure 7.3. In the Figure, DD and SS are the industry demand and supply curves which equilibrate at E to set the market price at OL. The firms in the competitive industry adopt OL price as given and con!>~.t~rs L shaped line as demand (Average revenue) curve which is perfectly elastic at L. As all the units are priced at the same level, MR is a horizontal line equal to AR cutting MR from above. S is not the point of equilibrium as the second condition is not satisfied. The firm will benefit if it goes beyond S as the additional cost of producing additional unit is falling. At R, the Me curve is cutting MR curve from below. Hence, V is the point of equilibrium, and OQ2 is equilibrium level of output. y

y (A) MARKET (INDUSTRY)

(B) FIRM

,Me

D

\5

I-------------~.------

III

a..

\

III

.~

.2

0:.

5

VI

~~/

)

AR=MR

/

D

oL-------------~Q--------+x

0

Ql

Output

Q2

x

Quantity

Fig. 7.3: Equilibrium Postition of a Firm Under Perfect Competition.

On the supply front in a competitive market, the Me curve of the firm is the supply curve. Let us consider Figure 7.4

Engineering Economics: 126 y (b) Mark.t

(b) Individual seller

s

Me P4=50

~ ~P3~=4~O----------~~~---03 .!::!

ii.

P2=30

02

50

--------------------

40

-----------------

30

_____________

,

__+ __ ,,

~----~V~-

,,

--------- , -------~--~------," I , S : : : :

20

I

I

, O~------Q~1--Q~2~Q-3-Q~4----+X

--t-------

I

'

,

,

I

:

OL-------~Ql---Q~2~~3--Q~4-----·X

OUTPUT

OUTPUT Fig. 7.4: Marginal Cost and Supply Curves for a Price-Taking Firm.

Assume that, the market price of a product is Rs.20 corresponding to it we have 1 as demand curve for the firm. At price Rs.20, the firm supplies Q 1 output because here MR=Me. If the market price is Rs. 30 the corresponding demand curve is 02' At Rs.3, the quantity supplied is Q2' Likewise, the demand curves at 03 and 4 and corresponding supplies are Q 3 and Q4'

°

°

The firm's marginal cost curve which the marginal cost corresponding to each level of output is nothing but firm's supply curve that gives the quantity, the firm will supply at each price. For prices below AVe, the firm will supply zero units because the firm is unable to meet even its variable cost for prices above AVe, the firm will equate price and marginal cost. Hence, in perfect competition, the marginal cost curve of the firm above Ave has the identical shape of the supply curve of the firm.

Short Run Equilibrium of the Firm In the short run, a firm will attain equilibrium position and at the same time it will earn supernormal profits, normal profits or losses depending upon its cost conditions. There is a difference between normal profits and supernormal profits. When the average revenue of a firm is just equal to its average total cost, it earns normal profits. When a firm earns supernormal profits its average revenues are more than its average total cost. Thus, in addition to normal rate of profit, the firm

Market Structure : 127

earns additional profits. The following example will make the above concepts clear. Assume that the cost of producing 1,00 units of a product by a firm is Rs. 15.00. The entrepreneur has invested Rs. 5,000 in the business and normal rate of return in the market is 10 percent. The entrepreneur must earn at least Rs. 5.00 (10% of 5,000) in this busine~s. This Rs. 5.00 will be shown as a part of cost. Thus total cost of production is Rs. 2,000 (Rs. 1,500 + 500). If the firm is selling the product at Rs. 20, it is earning normal profits because AR (Rs. 20) is equal to ATC (Rs. 20). If the firm is selu., s the product at Rs. 22 per unit, its AR (Rs.22) is greater than its ATC (Rs. 20) and it is earning supernormal profit at the rate of Rs. 2 per unit. Figure 7.5 shows how a firm earns supernormal profit in the short run. y

MC

ATC

PromTIITmmTIITmmTITIrr*--~----------

o

a

AR=MR=P

x

Quantity

Fig. 7.5: Supernormal Profit in Competitive Firm.

The Figure shows that the firm tries to equate marginal revenue with marginal cost to attain equilibrium. MR (marginal revenue) curve is a horizontal line and MC (marginal cost) curve is a U shaped curve which cuts the MR curve at E.At E, MR = Me. OQ is the equilibrium output for the firm. The firm's profit per unit is EB (AR-ATC), AR is EB and ATC is BQ. Total profits are ABEP. When the firm just meets its average total cost, it earns normal profits. Here AR=ATC.

Engineering Economics: 128

Consider Figure 7.6. The Figure shows that MR = MC at E. The equilibrium output is OQ. Since AR=ATC or OP = EQ, the firm is just earning normal profits. y MC ATC

I

~/

P~------~~~~-------

P=AR=MR

---

o

a

x

Quantity

Fig. 7.6: Short-Run Equilibrium of a Competitive Firm. (Normal Profits)

The firm is in a equilibrium position and still makes losses. This is the position when the firm is minimizing losses. When the firm is able to meet its variable cost and a part of fixed cost it will try to continue production in the short run. If it recovers a part of the fixed cost, it will be useful for it to continue the production process because fixed costs are already incurred and it will be able to recover part of it. If the firm is unable to meet its average variable cost, it is better to shut down. In Figure 7.7, it is illustrated clearly at point E is the equilibrium point and at this point AR = EQ and AC = BQ, since BQ > EQ, firm is earning BE per unit loss and total loss is AEBP.

Long Run Equilibrium of the Firm In the long run, firms are in equilibrium when they have expanded their plant to produce at the minimum point of their long run AC curve. In this period, the firms will be earning just normal profits, which are included in the AC. If they make supernormal profits, new firms will be attached in the industry. This will lead to a fall in price (a downward shift in the individual demand curves) and an upward shift of the cost curves due to the increase of the prices of factors as the industry expands.

Market Structure: 129 y

MC ATC

P=AR=MR

--o

L---------~o-------------+· X

Fig. 7.7: Short-Run Equilibrium of a Competitive Firm. (Losses)

It continues until the AC is tangent to the demand curve. If the firms make losses in the short run they will leave the industry in the long run. This will raise the price and costs may fall as the industry contracts, until the remaining firms in the industry cover their total costs inclusive of the normal rate of profit. This tendency is illustrated iA. igure7.8. Y (A}FIRM (B) INDUSTRY LMC

LAC

S

s,

PI

S o~-------------------------+

Quantity

0

0

01

Quantity

Fig. 7.8: Long Run Equilibrium of a Competitive Firm in a Perfectly Competitive Market.

In Figure 7.8, it is shown how firms adjust their long run equilibrium position. If the price is OP, the firm is making supernormal profits working with the plant whose cost is denoted by SAC!. It will have an

Engineering Economics: 130

incentive to build new capacity and it will move along its LAC. At the same time, new firms will be entering the industry attracted by the excess profits. As the quantity supplied in the market increases, the supply curve in the market will shift to the right and price will fall until it reaches the level of OP 1 (Figure 7 a) at which the firms and the industry are in the long run equilibrium. The condition for the long run equilibrium of the firm is that the marginal cost is equal to the price and the long run average cost. i.e. LMC = LAC = P. The firm adjusts its plant size to produce that level of output at which the LAC is the minimum. At equilibrium, the short run marginal cost is equal to the long-run marginal cost and the short-run average cost is equal to the long run average cost. Therefore, in the long run SMC = LMC = SAC = P =MR. It indicates that at the minimum point of the LAC, the corresponding plant is worked at its optimal capacity, so that the minimum of the LAC and SAC coincide. On the other hand, the LMC cuts the LAC at its minimum point and the SMC cuts the SAC at its minimum point. Hence, at the minimum point of the LAC, the above equality is achieved.

Long Run Equilibrium of the Industry When normal profits are earned by all the firms i.e. all the firms are in equilibrium if there is no further entry or exit from the market, the industry is said to have attained long run equilibrium. This is illustrated in Figure 7.9. y

(A)INDUSTRY

(8) FIRM

w z w > w

;:)

0

W

S

2

E

P

LAC

IE I-

a: D-

LMC

------- SI

~

p

f------=:::,,;:+~-- P=AR=MR

(,)

S

0

0

a Quantity demanded & supplied

O~----ML-------+X

Output

Fig, 7.9: Long Run Equilibrium of a Competitive Industry and Firm.

Figure 7.9 shows that in the long run AR=MR = LAC = LMC at E I . Since El is the minimum point of LAC curve. The firm produces

Market Structure: 131

equilibrium output OM at the minimum cost is called as an optimum firm. All the firms in the perfect competition in long run are optimum firms having optimum size and these firms charge minimum possible price which just covers their marginal cost. Thus, in the long run LAR = LMR = P = LMC = LAC. The firms just earn normal profits and competitive firms are of optimum size. In perfect competition, market mechanism leads to an optimal allocation of resources in the long run. But the perfectly competitive market system is a myth because of the assumptions, this market is non-existent.

Table 7.3: Features of Different Market Structure Market structure

No. of firms

Nature of products

Price elasticity of demand

Degree of competition over price

Perfect competition

Several firms

Homogenous product

Infinite

None

Imperfect competition

Several firms

Differentiated products (Close substitutes each other)

Large

Some

Pure oligopoly. (Oligopoly without product differentiation)

Few firms Homogenous product

Small

Some

Differentiated oligopoly (Oligopoly with product differentiation)

Few firms Differentiated products (also substitute of each other)

Small

Large

Monopoly

One

Very small

Very large

Unique product without close substitutes

(8) MONOPOLY

Monopoly means Single seller. It is a situation in which a seller of a product has no close substitute. Pure monopoly is never found in practice. However, in public utilities such as transport, and electricity, we find monopoly form of market conditions.

Engineering Economics: 132

Features of Monopoly 1. Single Seller of the Product: Single firm is supplying a product which constitutes the industry and there is no distinction between the firm and the industry in a monopolistic market.

2. Restrictions to Entry: There is strong barriers (economic, institutional, and legal) to entry. 3. No Close Substitutes: Monopolist product has no close substitutes. The cross elasticity of demand for the monopolist's product is zero or very small. The price elasticity of demand for monopolist's _ product is also less than one. The monopolist faces a downward sloping demand curve. 4. Immobility of Factors of Production: Immobility denotes that existing suppliers cannot be changed by the new entrants. Many firms· would create technical difficulties in important services like electricity, water and telephone. Inventions and development of new ideas by patents, copyrights and trademarks. Establishing buying and selling agencies like marketing boards and controlling the source of supply by one firm. S. Ignorance of Competitors: Monopoly may exist through ignorance of potential competitors. They may not know about the super normal profits being made by the existing firms and unable to acquire the know how involved in the technical processes of the monopolist's firm. 6. Indivisibilities: The original firm can build up its size gradually but new firms find it difficult to raise the capital required to produce in a cost competitive manner. In some cases, the scale of plant is largely relative to the market and there is no scope for new firm. Example, public utilities, like transport and electricity generation etc. 7. Deliberate Policy of Avoiding Competitors: There can be a deliberate action to exclude competitors. Firms producing or selling the same good may combine, or a competitor may be subject to a takeover bid. This will give monopoly powers to the firms who have joined together to form an association.

Market Structure: 133

Monopolist's Revenue The monopolist firm is the only producer of particular product, its demand curve is identical with the market demand curve for the product. It exhibits total quantity of a product that buyers will buy at each price and also shows the quantity that the monopolist sells at every price. The demand curve for the monopolist slopes downward from left to right. Marginal Revenue, Average Revenue, Total Revenue and Elasticity of Demand For an easy understanding of the average revenue, total revenue, marginal revenue of the selected values of price and quantity is presented in Table 7.4. Table 7.4: Average Revenue, Total Revenue and Marginal Revenue for a Monopolist Quantity

~TR

P=AR

11

MR I

=--;;:q

~TR

MR 2

=--;;:q

Revenue (TR)

sold

0 1 2 3 4 5 6 7 8 9 10

Total

10.00 9.50 9.00 8.50 8.00 7.50 7.00 6.50 6.00 5.50 5.00 4.50

10.00 9.50 18.00 25.50 32.00 37.00 42.00 45.00 48.00 49.00 50.00 49.50

10.00 9.50 8.50 7.50 6.50 5.50 4.50 3.50 2.50 1.50 0.50 -0.50

10 9 8 7 6 5 4 3 2 1 1 -1

MR,. This MR is the change in total revenue for a one unit increase in quantity. It represents an incremental change, rather than an infinitesimal. MR2• MR is computed aft the rate to total revenue for infinitesimal change in q.

Engineering Economics: 134

MR= LlTR Llq TR

= 10q _.5q2

LlTR --=lO-lq Llq If the seller wishes to charge Rs.IO, he cannot sell any unit, if he

wishes to sell 10 units, his price cannot be higher than Rs. 5 because the seller charges a single price for all units he sells, average revenue per unit is identical with price, and thus the market demand curve is the average revenue for the monopolist. In monopoly, average and marginal revenues are not identical. The monopolist knows that if he wants to increase the volume of his sales he has to reduce the price of the product. As given in the example, if a seller wishes to sell 3 units, he has to reduce the price from Rs. 9 to Rs. 8.50. The third unit is sold for Rs. 8.50. In order to sell the 3rd unit, the firm has to lower its price from Rs. 9 to Rs. 8.50 and thus receives Re. 0.50 less on each of2 units it could have sold for Rs. 9. The marginal revenue over the interval from 2 to 3 units is thus Rs. 7.50 only. Again if he- wishes to sell 4 units, he will again reduce the price from Rs. 8.50 to Rs 8. The marginal revenue will be Rs. 6.50 which is less than the price, because the firm has to lower the price to sell an extra unit further. The relationship between AR and MR in a monopoly firm are AR and MR are both negatively sloped (downward sloping) curves, MR curve lies half way between the AR curve on the Y axis, AR cannot be zero, but MR can be zero or even negative. The marginal revenue, average revenue and price elasticity of demand are inter-related to one another. Consider the formula as follows: MR=AR= e-l (e)

Where, e = price elasticity of demand 1-1 ife=1 MR=-,

(1) =0

Market Structure: 135

if e > 1, MR will be positive if e < 1, MR will be negative. The relationship of MR, AR, TR and the elasticity of demand are shown in Figure 7.10. y T

e >1 Elasticity is greater than one e = 1 Unit elasticity

(AI

e >1

e < 1 Elasticity is between zero and one

e=1

c

• •~

II:

l

Q

x

Quantity

Fig. 7.10: Shape of Total, Average, Marginal Revenue and Elestlcity of Demand.

In the figure, the straight line demand curve of the elasticity of the middle point is equal to one. The marginal revenue, corresponding to the middle point of the demand curve (or AR curve) will be zero. C is the middle point of the Average Revenue (AR) Curve. At point C, elasticity is equal to one. Corresponding to C, marginal revenue will

Engineering Economics: 136

be zero. Thus, MR is cutting the X axis (in Fig (A) at point Q, which corresponds to the point C on the AR Curve. Since MR is zero, total revenue will be maximum. This is shown in Fig (B) where TR reaches to P, the highest point. At a greater quantity than OQ, elasticity of the AR curve is less than one and the marginal revenue is negative. Marginal revenue is negative beyond OQ means that total revenue will diminish if a quantity larger than OQ is sold. Thus, TR curve is shown to be falling after reaching to point P. At a lower quantity than OQ, elasticity of the AR curve is greater than one and the marginal revenue is positive. Marginal revenue being positive before OQ means that total revenue will increase with increase in the quantity, as shown by rising portion of TR curve upto the point OQ, where it is highest. In brief, when e > 1, total revenue is rising and marginal revenue is positive. When e· zero and

= 1, total

revenue is maximum and marginal revenue is

When e < 1, total revenue is falling, and marginal revenue is negative.

Equilibrium 01 the Monopoly Firm (Profit Maximization) A monopolist has to determine not only the output but also the price for his product. Since the downward sloping demand curve indicates that if he raises price of his product, his sales will go down and he cannot improve his sales volume with lesser price. This can be seen as follows.

Short Run Equilibrium In the short run eqUilibrium position twin conditions of equilibrium in a monopoly market are Marginal cost is equal to Marginal revenue and MC curve must cut MR curve from below as shown in Figure 7.11. The Figure shows that MC curve cuts MR curve at E. It means at the point E, equilibrium price is OP and equilibrium output is OQ. In order to know the monopolist profits or losses in the short run, we need to introduce average total cost curve. Figure 7.12 shows that how the firm makes profits in the short run.

Market Structure: 137 y

Me II)

::s c

~p

...

II)

-

..s C4

0

0

MR 0

Q

X

Quantity

Fig. 7.11: Short Run Equilibrium of a Monopolist. y

AC CD ~

c

!

CD

pmrr~~~~~~--~---+-------

AR=MR=P

~

8CfLW-LUJ..:..l.J..LU..;..llLJ-'-LLl.J~"t'----,,..--

AR

O~----------~Q~----~M~R--------------·X

Fig. 7.12: Firm's Equilibrium Under Monop/oy (Maximisation of Profits).

The Figure shows that MC cuts MR at E to give equilibrium output as OQ. At OQ, price charged is OP (we find this by extending line EQ till it touches AR or demand curve). Also at OQ, the cost per unit is BQ. Therefore, profit per unit is AB or total profit is ABCP. Now we want to understand whether monopolist incur losses. The general opinion about the monopolist always makes profits depends upon the demand and cost conditions. If he faces a very low demand for his

Engineering Economics: 138

product and his cost conditions are such that ATC>AR, he cannot make profits but incur losses in this situation. Long Run Equilibrium Long run is a period in which the monopolist expands his existing plant at any level which maximizes his profit. The monopolist need not produce at the optimal level but he can produce at sub optimal scale. In other words, he need not reach the minimum point of LAC curve and he can stop at any point where his profits are maximum, but he will not continue if he attains losses in the long run. He will continue to make super normal profits in the long run as entry of outside firms is restricted. Price Discrimination Price discrimination is possible only under the following conditions. Seller has control over the supply of his product, seller is able to divide his market into two or more sub markets and the price elasticity of the product should be different in different markets. PRICE OUTPUT DETERMINATION UNDER PRICE DISCRIMINATION Assume that the price discriminating monopolist has two markets (Market A and B). Both markets have different price elasticity of demand which is more elastic in market B than in market A as shown in Figure 7.13. v v v Tolal markel Submarkel(A)

Submarkel(B)

D,

AMR

o

x

o

Quantity

x

0

Quantity

Fig. 7.13: Price and Output Determination In a Monoplist Market.

x

Market Structure : 139

The Figure shows Da and Db are the average revenue curves for the respective markets. MRI and MR2 are the corresponding marginal revenue curves. Since all his output is under one organization, there is only one marginal cost curve. AMR is the total marginal revenue curve. . It is a lateral summation of the two curves viz., MRI and MRr The important conditions of equilibrium for the discriminating monopolist guided by the same rule as any other producer for maximizing his profits. He equates Me with AMR (aggregate marginal revenue). The discriminating monopolist can maximize his profits by allocating supply in two sub markets. The profit in each market is maximized by equating Me to the corresponding MR of each market i.e. Me ==MR I == MR 2. In Figure 7.13, Me and AMR intersect at point E and OM is total output of the monoP9fist. The line EM is the line of equal marginal revenue indicates that OM I will be sold in market A at the price P1M1 and OM 2 is sold in market B at the price P2 Mr Under this adjustment, the marginal cost of the total output EM is equal to marginal revenue in each market. Hence, the discriminating monopolist charges a higher price from the market, which has a relatively inelastic demand. The market, which is highly responsive, is charged less. So the monopolist benefits from both the markets. IMPERFECT COMPETITION Imperfect competition is an important category wherein individual firms exercise control over the price to a smaller or larger degree depending upon the degree of imperfection. Imperfect competition has several sub-categories. Firstly, monopolistic competition which is characterized by a large number of firms and product differentiation. In monopolistic competition, a large number of firms produce different products which are close substitutes of each other. The demand curve under monopolistic competition is highly elastic which indicates the firm enjoys some control over the price. The second sub-category of imperfect competition is oligopoly without product differentiation which is known as pure oligopoly. In this, there is competition among few firms producing identical products. The fewness of firms ensures some control over the price of the product and the demand curve facing each firm will be downward

Engineering Economics : 140

slope, indicates price elasticity of demand for each firm will not be infinite. The third sub-category of imperfect competition is oligopoly with product differentiation which is also called differentiated oligopoly. It is characterized by competition among the few firms producing differentiated products which are close substitutes to each other. The demand curve of individual firms under oligopoly with product differentiation is downward sloping indicates firms have control over price of the individual products. Under monopolistic competition, there are many firms engaged in individual firm and has relatively small part of the total market so that each firm has limited control over the price of the product. Secondly, the presence of a large number of firms ensures that collusion among them to restrict output to raise price. Thirdly, there is no situation of mutual Interdependence in each firm as it determines its price output policies without considering the reaction of the rival firms. Monopolistic competitive firms follow independent price policies. If a firm lower its price, its gain in sales will be spread negligibly over

many of its rival firms. In the long run, there is freedom of entry and exit. Competition is no longer exclusively on the price basis, there is possibility for the buyers will, but their favourite product depends on their minds because of consumer attachment to a particular brand, the sellers acquire a monopolistic influence on his market. The demand curve of a firm under monopolistic competition is downward sloping curve. If he wants to sell more, at lower price only. Let us consider the market for soaps and detergents to explain the different aspects. There are several brands like Lux, Liril, Dettol, and Lifebuoy plus etc. Since all the soaps are almost similar, it appears to be an example of perfect competition. But in reality, Lux is exhibited to be beauty soap, Liril is more associated with freshness. Dettol soap is placed as antiseptic. The product and service differentiation gives a chance to attract business by each seller other than price.

(C) MONOPOLISTIC COMPETITION It refers to a market situation in which there are many producers producing goods which are close substitutes of one another or where output is differentiated.

I

Market Structure: 141

Features of Monopolistic Competition 1. Large Number of Sellers: There are a large number of sellers who individually have a small share in the monopolistically competitive market. 2. Product differentiation: Products of different sellers are differentiated on the basis of brands, generally much advertised and consumers start associating the brand with a particular manufacturer. It enunciates to the producer over the competing product that he can raise the price of his product knowing that he will not lose all the customers to other brands due to absence of perfect substitutability. Peculiarities of packages or wrappers or difference in quality, design, colour etc. are the imagery differences created through advertising, the use of attractive packets and trade marks and brand names are more usual methods by which products are differentiated. 3. Freedom of Entry or Exit: New firms are free to enter into the market and existing firms are free to quit from the market. 4. Non Price Competition: In a monopolistically competitive market, sellers try to compete on the basis of aggressive advertising, product development, better distribution arrangements, efficient sales service etc. Such non-price competition is a deliberate policy of product differentiation. Sellers attempt to promote their products not by cutting prices but incurring heavy expenditure on publicity, advertisement and other sales promoting techniques because price competition may result in price wars which throws a few firms out of the market. S. Goods are Close Substitutes: The products are similar but not identical. There are a few examples of monopolistic competition and produce differentiation. Many firms producing tooth paste but the product is differing. Different brands of tooth paste like Colgate, Binaca and Closeup etc., and soaps like Pears, Lux, Hamam, Rexona, Cinthol are the best examples of products for monopolistic competition.

Engineering Economics: 142

PRICE OUTPUT DETERMINATION UNDER MONOPOLISTIC COMPETITION Under Monopolistic competition, different firms produce different varieties of the product. Therefore different prices for them will be determined in the market depending upon their demand and cost conditions. Each firm seeks to achieve equilibrium or profit maximizing position as regards (1) price and output, (2) product adjustment and (3) adjustment of selling costs. In a monopolistically competitive market since the product is differentiated between firms, each firm does not face a perfectly elastic demand for its products. Each firm is a price maker and is in a position to determine price of its own product. As such, the firm is faced with a downward sloping demand curve for its product. Figure 7.14 shows the demand curve for its product. The conditions for price output determination and equilibrium of an individual firm may be stated as follows: (i) Me

= MR

(ii) Me curve must cut MR curve from below. y

ATe

AR

MR O~---------Q~----O-ut-pu-t--------~X

Fig. 7.14: Short Run Equilibrium of a Monopolistic Competition Super-Normal Profits.

Figure 7.14 shows that Me curve cuts MR curve at the point E. At E, the eqUilibrium price is OP and equilibrium output is OQ. Since

Market Structure : 143

the per unit cost is QV, the per unit super normal profit is UV (or PW) and total super normal profit is AUVW.

Short Run Equilibrium of Monopolistic Market In the short run, the firm will be in equilibrium when it is maximizing profits i.e. when marginal revenue is equal to marginal cost. Average revenue is the average revenue curve, MR is marginal revenue curve, SAC is the short run average cost curve and SMC is the short run marginal cost curve. Marginal revenue curve and marginal cost curve intersects each other at the output at which price is equal to the average revenue. Further, the firm is earning super normal profits. Super normal profit per unit of output is the difference between average revenue and average cost at the equilibrium point. But if the demand and cost situations are less favourable then the monopolistically competitive firm will be realizing losses in the short run.

Long Run Equilibrium of the Industry In a monopolistically competitive industry, firms earn super normal profits in the short run, there will be an incentive for new firms to enter the industry. As more firms enter, profits per firm will go on declining. The total demand for the product will be shared among the firms. This will happen till all the profits are wiped away and all the firms earn only normal profits. Hence, in the long run, all the firms will earn only normal profits. Another point is that average revenue curve in the long run will be more elastic i.e. (flatter) since large number of substitutes are available in the long run. Therefore in the long run, equilibrium is established when the firm is earning only normal profits. Figure 7.15 shows the long run equilibrium of a firm in a monopolistically competitive market. In the figure, the average revenue curve touches the average cost curve at point X corresponding to quantity Q l and price Pl. At equilibrium (i.e. MC = MR) profits are zero, since average revenue equals average costs, all firms are earning just normal profits. In case of losses in the short run, the loss making firms will be driven out from the market and this will go on until the remaining firms make normal profits. An individual firm has excess capacity in the long run. i.e. it is producing lower quantity than its capacity. In Figure 7.15, the firm could

Engineering Economics: 144

expand its output from Q. to Q2 and reduce average costs. But it does not do so because the firm has to reduce the average revenue even more than the average costs. It would have to reduce price to P2 to gain extra sales and avoid losses. It indicates that firms in monopolistic competition has excess capacity of production. y

MC ATC

P1 I-':----';----">!' P

__'~,_.::

2

,,/1

'.,... '~ . ~~

-:.... -- ....

,,'II

'

MR

D=AR

L----L---~~----------+x

o Q1 0. Fig. 7.15: The Long Term Equilibrium of a Firm in Monopolistic Competition.

(D) OLIGOPOLY Oligopoly is an important form of imperfect competition. It is often described as competition among the few. Oligopoly is said to exit if there are few sellers selling homogeneous or differentiated products in a market. Consider the example of cold drinks industry or automobile industry. There are many firms manufacturing cold drinks and 'automobiles industry in India. These industries exhibit some special features as discussed in the following manner. Characteristics of Oligopoly Market (i) Interdependence: ,\n important feature of oligopoly is interdependence in decision making of few firms because any change in price and output by a firm will have direct effect on the fortune of the rivals. The oligopolist firm considers not only the market demand for the industry/ product but also the reactions of other firms in the industry.

Market Structure: 145

(ii) Importance of Advertising and Selling Costs: Oligopolies employ various aggressive and defensive marketing weapons to gain in greater share in the market. In this connection, various firms have to incur a good deal of costs on advertising and other measures of sales promotion. Oligopolies avoid price cutting and try to compete on nonprice basis because if they start under cutting one another, a type of price war will emerge which will drive a few of them out of the market as customers will try to buy from the sellers at the cheapest price.

(iii)Group Behaviour: Oligopoly is a theory based on group behaviour to assume profit maximizing. Each oligopolist watches closely the business behaviour of others in the industry and designs his strategy on the basis of some assumptions. Price and Output Decisions in an Oligopolistic Market The interdependence of the firms in oligopolistic firm cannot assume that its rival firms will keep their price and quantities constant, when it makes changes in its price and/or quantity. When an oligopolistic firm changes its price, its rival firms will react and change their prices which would affect the demand for the former firm. Existence of interdependence of the firms and difficulty in predicting the behaviour of other firms. The oligopolistic firm cannot have definite demand curve, when an oligopolist does not know his demand curve, what price and output he will fix cannot be ascertained. However, economists have established a number of price output models for oligopoly market depending upon the behavioural pattern of the members of the group. Many models have been evolved depending upon the behaviour of the oligopolistic group. A few important assumptions among them are: Oligopolist firms ignore interdependence. When interdependence disappears from decision-making of the oligopolistic firms, the demand curve facing the oligopolist becomes determinate and can be ascertained. Then we can easily find the equilibrium price and output of a particular oligopolist firm. 2. An oligopolist is able to, predict the reaction pattern and counter moves of his rivals. In this connection various oligopoly models based on different assumptions regarding the particular reaction 1.

Engineering Economics: 146

pattern of the rivals have been propounded. For example, Cournot's model, Chamberlin's model and Sweezy model. 3. The oligopoly firms realizing their interdependence will pursue their common interest and will form a collusion, (enter into an agreement and work in the pursuit of their common interests). They will jointly act as a monopolist firm and fix their price in such a way to share the profits, market or output as agreed between them. OPEC (organization of Petroleum Exporting Countries) is the best example of such type of agreement among oligopolists. 4.

An oligopoly can accept one firm as a leader and follow him in setting prices. The leader firm will be dominant low cost firm producing a very large proportion of the total production of the industry and wielding a great influence over the market of the product. Whatever price is charged by the price leader is generally accepted by other firms who adjust their output accordingly.

Kinked Demand Curve In many oligopolistic industries, price remain inflexible for a long time. They change infrequently, even in the face of declining costs. The most popular explanations of kinked demand curve hypothesis is given by Prof. Sweezy, an American economist for this price rigidity under oligopoly. According to the kinked demand curve hypothesis, the demand curve facing an oligopolist, has a kink at the level of the prevailing price. The kink is formed at the prevailing price level because the segment of the demand curve above the prevailing price level is highly elastic and the segment of the demand curve below the prevailing price level is inelastic. A kinked demand curve DE with a kink at point T has been shown in Fig. 7.16. The prevailing price level is OT and the firm produces and sells output OM. Now the upper segment of the demand curve DE is ET relatively elastic and lower segment TD is relatively inelastic. This difference in elasticity is due to the 'particular competitive reaction

Market Structure: 147 y E

o o

Q

x

Quantity

Fig. 7.16: Kinked Demand Curve in Oligopoly.

pattern assumed by the kinky demand curve hypothesis. This assumed pattern is: Each oligopolist believes that if he lowers the price below the prevailing level; its competitors will follow him and lower prices, whereas if he raises the price above the prevailing level, its competitors will not follow the increase in price because when an oligopolist lowers the price of its product, its competitors will feel that if they do not follow the price cut their customers will run away and buy from other firms which have lowered the price. Thus, in order to maintain their customers, they will also lower their prices. Hence, the upper portion of the demand curve is price elastic. On the other hand, if a firm increases the price of its product there will a substantial reduction in its sales as a result of the rise in its price, its customers will withdraw from it and go to its competitors which will welcome the new customers and will gain in sales. These happy competitors will have no motivation to match the price rise. The oligopolist who raises its price will lose a great deal and will refrain from increasing price. This behaviour of the oligopolists explains the inelastic lower portion of the demand curve. Thus, rigid or sticky prices are explained according to the kinked demand curve.

Engineering Economics: 148

Duopoly

In 1883, Bertrand developed Duopoly model assuming that rival firm will keep its price constant irrespective of its own price decision. Each firm aims at profit maximisation on the assumption that the price of the competitor will remain constant. The model is presented with the analytical tools of the reaction functions of the duopolists. The reaction curves are obtained from 1soprofit maps which are convex to the axes on which we measure the duopolists prices. Bertrand model does not lead to profit maximisation of the industry as firms behave naively; firms never learn from past experience. The rival did not keep its price constant. Features 1. Each firm maximises its profit but the profits of industry are not maximised. 2. The equilibrium price will be the competitive price. 3. This model is a closed one and does not allow entry. Bilateral Monopoly Bilateral monopoly is a market consisting of a seller (monopolist) and a buyer (monopsonist). The equilibrium of this market type cannot be determined by the forces of demand and supply but by non-economic factors like bargaining power, skill and other strategies of the firms. It is obvious that a bilateral monopoly is rare in commodity markets, but is quite common in labour markets, where workers are organised in a union.The bilateral monopoly arises when a single seller faces single buyer. The bilateral monopoly situation is an-indeterminate one. The following are the important assumptions: "Assumptions 1. 2.

All firms are organised in a single body which acts like a monoponist.

There are two monopolies, one on the supply side and the other on the demand side. The monopsonist maximises his profit where his marginal expense on labour is equal to the marginal revenue product of labour. The

Market Structure: 149

monopolist maximises his profit where his marginal cost is equal to his marginal revenue. The price desired by the monopolist seller is the upper limit price which could be realised if he could force the monopsonist buyer to act as a perfect competitor. The price and quantity in the bilateral monopoly market are indeterminate. The economic analysis cannot provide a determinate solution to a bilateral monopoly market. REVIEW QUESTIONS 1. What are the features of perfect competition? 2. What is product differentiation? 3. Explain the price and output determination in monopoly market. 4. Explain the kinky demand curve. 5. Explain short run equilibrium of the firm . 6. What are the features of monopolistic competition? 7 . Mention price output decisions in an oligopolistic market. 8. Discuss in detail the different market types based on Nature of competition and the commodity. (Oct, 2001)

8 Break Even Analysis

MEANING

Break Even Analysis is an analytical study of costs, revenue and sales of firms and to know the volume of sales when firms costs and revenues are equal. The break even point indicates that the net income is equal to zero. It is the zone of no profit and no loss as the costs are equal to the revenue earned by the firms. This analysis creates a strong link between business behaviour and the theory of the firm. Objectives

The main objectives of the Break Even Analysis (BEA) is to create an understanding and to know the relationship between costs, revenues and output that could be sold by the firm. This analysis abridges the business behaviour and the theory of firms. When the volume of production and the volume of sales are equal i.e. the firm is able to sell all the units of the commodity and there is no change in the closing inventory.

Break Even Analysis: 151

Assumptions of BEA 1. The price is assumed to be constant 2. All revenue is perfectly variable with the physical volume of output and 3.

All costs are either perfectly variable or absolutely fixed over the entire range of production.

Break even point can be found in two methods, viz., (1) in terms of physical units or volume of output and (2) in terms of money value or value of sales. Let us discuss the following briefly. 1. Physical Units or Volume of Output Method: The method is used to find out the break even point for the firms producing single output. It is the meeting point of total revenue and total cost curve of the firm.

2. Sales Value: Firms producing multi products cannot measure break even point in terms of unit of commodity. They find it easy to determine the break even point in terms of total sales volume. However, break even point is expressed as a ratio to sales. The formula for calculating the break even point in terms of sales value is BEP

=

Fixed costs Contribution margin ratio

USEFULNESS OF BREAK EVEN ANALYSIS The break even analysis provides a microscopic picture of the business to find out the profitability region for the management. It highlights the areas of economic strength and weakness of the firm. It is the management to take effective decision in the context of changes in government policies.

Break Even Point Break even point is that point of activity where total revenue and total expenses are equal. It is the point of zero profit. It is taken to indicate the minimum level of production/sales which a company has to undertake economically viable business activity.

Engineering Economics: 152

Table 8.1: Break Even Point Output (Qty)

Total Revenue (Rs.)

TFC (Rs.)

TVC (Rs.)

Total Cost TC (Rs.)

0 50 100 150 200 300

0 250 500 750 1000 1500

500 500 500 500 500 500

0 500 1000 1500 2000 25000

500 1000 1500 2000 2500 3000

350

1750

500

3000

3500

There are two approaches to represent a break even point. (i) Graphic Method and (ii) Algebraic Method.

Break Even Chart (Graphic Method) Break even chart is defined as an analysis in graphic presentation of the relationship of production and sales to profit. It is very useful in the break even analysis. It helps the management in visualizing the profit or loss at different levels. It shows the extent of profit or loss to the firm at different levels of activity. Consider Figure 8.1. y

Iii"

~ 20

'"

.....I

Total Cost LIne (Rs.20)

..

:§. 16

Total Variable Cost

::J

..

; 12 >

~

8

o (.)

4

Fixed Cost Line

u;

4

8

12

16

20

24

28

Sales In (Iakhs)

X

Fig. 8.1: Break even pOint.

In the above break even chart, the horizontal axis shows output and the vertical axis indicates the costs and revenue. Total cost (TC)

Break Even Analysis: 153

and total revenue (TR) curves are shown as linear. Break even chart is used for determining (1) Break even production volume (2) Profit appropriation (3) Choice of optimum level of output and (4) Impact of sales on costs and profits. Assumption of Break Even Analysis



No improvement in technology and labour efficiency



No changes in input prices.

Limitations of Break Even Analysis

The limitations of break even analysis are as follows: •

Break even analysis is based on the past data.



It is static in nature and it assumes a constant relationship of output to cost and revenue.



It is based on accounting data and it ignores imputed costs.



It ignores selling costs and concentrates on the production costs.

Advantages of Break Even Analysis

The advantages of break even analysis are as follows: •

Break even analysis is widely accepted method of profit planning and control.



It can be used for various purposes, like determining the sales volume etc.



This analysis is quite helpful to the industries which are not subject to fast changes in technology as well as changes in input prices and product mix.



It helps in determining optimum level of output.



It helps in determining the target capacity of a firm to get the benefit of minimum unit cost of production.



The firm can determine minimum cost for a given level of output.



This analysis helps in plant expansion or contraction decisions.



It is helpful to analyse the impact of changes in prices and costs on profits of the firm.



It can be used in finding the selling price to prove most profitable for the firm.

Engineering Economics : 154

Margin of Safety Margin of safety concept is an important concept in the break even analysis., It is the excess of budgeted or actual sales over the break even sales volume. It represents the difference between the actual sales volume and the sales volume suggested by the break even point.

Measurement of Margin of Safety Margin of safety is measured by ratio or monetary terms. It is calculated in two ways:

= Profit I TFC

1. MS 2.

MS

Where, QS

= =

QB =

QS- QB QS Number of units sold Break even quantity.

To have a clear idea about the measurement of margin of safety, consider the following illustration.

Illustration By using the following data, find the margin safety of firms X and Y and which company is better placed with respect to its margin of safety. Firm Y Details Firm X Actual total sales Rs. 1,00,000 60,000 1,00,000 80,000 Budgeted sales Rs. Break even sales Rs.

50,000

50,000

Break Even Analysis : 155

Firm X 1. Margin of safety percentage = 1,00,000 - 50,000 x 100 = 50% Based on budgeted sales 1,00,000 Firm Y = 60,000 - 50,000 x 100 = 125% 80,000 2. Based on actual sales Firm X = 1,00,000 - 50,000 x 100 = 50% 1,00,000 forfrrm Y 80,000-50,000 x 100= 375% 80,000 3. Margin of Safety (Value) Based on budgeted sales for firm X 1,00,000 - 50,000 for firm Y 80,000 - 50,000 = 30,000

=50,000

Based on actual sales for firm X 1,00,000 - 50,000 = Rs. 50,000 for firm Y 60,000 - 50,000 = 10,000 It is clear from both the margin of safety percentage and the margin of safety, value of the firm X has a better safety margin than firm Y.

Application of Break Even Analysis The application of break even analysis is to help the management in planning and control. This analysis would help a firm in deciding about a product mix, changes in the product mix, evaluating, budgetary control system, understanding shifts in costs and profitability. In fact, break even concept has been found useful in all types of managerial decisions viz., strategic, technical and policy decisions. Application in the following situations: • •

Choice of production process. Estimating profits at given sales volume.



Estimating sales volume required to produce desired profits.



Finding sales volume required to meet the proposed expenditure.

Engineering Economics: 156



Plant expansion and shut down decisions.



Determining safety margins.



Changes in prices and costs.



Decisions regarding changes in capacity.

• •

Choice of product mix. Decision regarding dropping or adding a product.

• •

Make or buy decisions. Advertising decisions and decisions of production mix.

Profit Forecasting Profit forecasting is an essential function of a management. It involves a careful analysis of cost and revenue data in terms of the relationship between sales volume, price, fixed costs and variable costs. It is directly related to the extent of competition particularly, in competitive situations. Profit forecasting is inevitable to achieve profits in the long run. The relation between profit forecast and profit improvement plan is mentioned as follows:

Profit Forecast

Profit Improvement Plan

Sales forecast

Change in sales and sales mix

Cost budget (Production cost, selling and distribution cost, Administration cost and Rand D Cost)

Cost reduction policies

Capital expenditure budget

Developing a rational capital expenditure policy

Planned profit level

Enhancing return on investment

Profit Forecasting Methods Profit can be forecasted by three ways: •

By spot protection



By environment based forecasts



By forecasting with the help of break even analysis.

Break Even Analysis : 157

Break Even Analysis in Profit Forecasting Break even analysis is one of the scientific techniques of forecasting profits. The break even point indicates that volume or value of sales at which the firm's costs and revenue are equal. It makes neither profits nor losses. This technique is not only to help in ascertaining the level of sales required to break even but also enable the firm to know the margin in sales over the break even level of sales which this firm is enjoying. The break even analysis is helpful in profit forecasting sales volume, given costs and planned level of output, changes in variable costs and profits; effects of changes in fixed costs on profits and charges in selling price. In addition to that, break even analysis is useful in the following situations. To profit forecasting•

Determining sales volume for a pre-determined profit.



Finding the impact of change in sales volume on profit.



Finding the impact of change in product mix on profits.



Determining a product line for a predetermined profit;



Inter firm comparison of profits and intra firm comparison of the contribution to profits by different divisions of the firm.

Illustration Three firms A, Band C manufacture the same product. The selling price is Rs. 8 per unit of the product equal for all the firms. The fixed costs for the firms A,B and C respectively are Rs. 80,000, Rs. 20,000 and Rs. 3,30,000; while the variable costs per unit are Rs. 6, Rs. 4 and Rs.3. •

Determine the break even point for all the firms in units.



How much profits are earned by the firms if each of them sells 80000 units?



What will be the impact percentage wise on profits if sales increase by 20 percent?

Engineering Economics : 158

Solution B. E. P. (Physical Unit) =

B. E. P. for A

=

Fixed cost Contribution margin per unit 80,000 = 40,000 units 8-6

= 50,000 units for C = 66,000 units

B.E.P. for B B.E.P.

= Profit for A = Profit for B = Profit for C =

(b) Profit

Total Revenue - Fixed Cost - Variable cost Rs. 80,000 Rs. 1,20,000 Rs. 70,000

(c) If sales go up by 20 percent, Then profit for A = = Percentage of profit of A = Similarly, profit for B = Percentage of profit of B = Profit for C = Percentage of profit of C =

Rs.7,68,000-8,000-5,76,000 Rs.I,12,000 17.1% Rs.l,84,000 28 % Rs.l,50,000 24.3%

REVIEW QUESTIONS 1. What are the applications of break even analysis? 2. What is profit forecasting? 3. Give at least four benefits of break even analysis.

(Oct, 2001)

4. Write at least limitations of break even analysis.

(April, 2001)

5. State the 3 important variables of break even analysis.

(April, 2001)

6. What is break even point?

(April, 2002)

7. Three firms A,B and C manufacture an instrument. The selling price is Rs. 10 per unit for all the three firms. The fixed cost for A,B and Care Rs. 1,00,000. Rs. 2,00,000 and Rs. 3,00,000 while the variable costs are Rs. 8, Rs. 5 and Rs.4. Determine the break even point for all firms. How much profit is made by each firm if they sell 75,000 units? What will be the impact on their profit if the sales increase by 25% and decrease by 20 %? (Oct, 2001)

Break Even Analysis: 159

8. The fixed cost for a commodity for the year 1999-2000 is Rs. 4,000. The sales for the period is Rs. 1,20,000. The variable cost per unit is Rs. 3, selling price for each commodity is Rs . 3. The number of units involved coincides with the expected volume of output. Construct a BEP, grade and determine (a) BEP (b) How many minimum number is to be sold to earn profit? (c) Margin of safety (d) Angle of incidence

(Oct, 2001)

9 Pricing Methods and Policies

PRICING METHODS

Business decision making involves several aspects of policy formulations. A suitable price policy is most important business decision. Pricing is an essential one which decides the creation and maintenance of a secure market for a product. The general factors governing pricing are basically the same for all business firms. They may be divided into external factors and internal factors affecting the pricing of the firm. The external factors are: (i) The phase of the business cycle indicating the market trend. (ii) Price elasticity of supply and demand. (iii) Extent of competition in the market.

(tv) Purchasing power of the people.

General policy of the government and (vi) Good will of the company. (v)

Pricing Methods and Policies: 161

The internal factors are : (j) Cost of production (ii) Objectives of the management

(iii) Managerial policy regarding security of market, profit and sales

revenue.

Objectives The objectives of the business firms are multifarious. Pricing policies form a part ofthe strategy for achieving many objectives such as: (i) Realization of maximum possible money profit. (ii) Preventing the entry of rivals into the market.

(iii) Create and preserve a secure market. (iv) Stabilization of prices and margin. (v) Maximization of sales revenue. (vi) Maintenance of the market share. (vii) Flexibility to vary

prices to meet changes in economic conditions. (viii) Achieving a high return on investment. Flexible pricing is needed to meet the changes in economic conditions while rigid pricing policy is followed for market security. There is no infallible formula of determining the right price for a product. Therefore, pricing decision should result from various objectives. Generally, there are two methods followed by businessmen in pricing. They are cost oriented methods and competition oriented methods. I.

COST ORIENTED METHOD

In this method, price is fixed largely on the basis of costs. The most important cost oriented methods are (1) cost plus or full cost pricing (2) rate of return pricing and (3) marginal cost pricing.

1. Full Cost Pricing It is an important approach to profit maximization. Full cost pricing is otherwise known as average cost pricing or cost plus pricing or mark up pricing. The business firms fixed prices on the basis of direct cost (variable cost) per unit of output by adding to it overhead cost

Engineering Economics: 162

per unit and a margin of normal profits. If they fix prices above the average cost which would yield abnormal profits. Full cost pricing is the result of a tracit open collusion, consideration of long run demand and costs, moral conviction of firms and uncertain effects of increase and decrease in prices. A constant or inflexible mark up or a margin for overhead cost and normal profit. Full cost pricing is criticized by many economists, costing margin or mark up is chosen by considering and guessing the price elasticity of demand for a particular product. If the elasticity of demand is greater, less mark up is fixed and if the elasticity of demand for the product is less, greater mark up is fixed. Why full cost pricing is used or what is the motivation behind pricing on the basis of full cost. It is that firms are satisfiers and not maximizers i.e. firms make a reasonable level of profit and not the maximum possible level.

2. Return on Investment Pricing (ROI) Return on investment pricing or rate of return pricing is another important method pricing. In this method, the total cost at various levels of output is estimated. The price is set to cover the standard costs at standard volume and the margin necessary to return the target rate of profit over the long run. It is an important way of measuring business efficiency. The ROI based pricing is of particular importance in multi product firms in which capital investment is required for different products. Formula P= F +V SV+R FC, SV/1-4, WC P

= Price

F V

= Fixed cost = Variable cost

SV = Annual sales volume in units R

= Return on investment

FC = capital investment fixed assets WC = Working capital expressed as percent of sales value. 3. Marginal Cost Pricing Marginal cost pricing is based on the idea that the recovery of full cost is not necessary for a profitably running business firm. Under marginal cost pricing, price is fixed on the basis of variable cost or marginal cost. It is more appropriate for long term survival of the firm.

Pricing Methods lind Policies: 163

The advantages of the marginal cost pricing are: •

The price is competitive.



It facilitates the firms to adopt more aggressive price policy.



It is more useful for pricing over a life cycle of a product.



It is a very convenient method as the total costs of individual

products cannot be estimated. The major lacunae in the marginal cost pricing is, it does not cover the entire costs. This method is followed only for public utilities. CONTROL AND REGULATION OF PRICES

An important part of the regulatory power of the Government impinging on the freedom of private enterprises is the power of the government to fix, control, and regulate prices of semi finished and finished products. The general authority is given by the industries (Development and Regulation) Act, 1951. The Act empowers the Government to order investigation if there has been or is likely to be unjustifiable fall in the volume of production in the industry or undertaking or when there is market deterioration in quality or an increase in price not justified by proper reasons. In exercising this power, the Government may adyise the industry concerned to fix reasonable price in the interests of the consumers. Legal Restrictions on Pricing

There are several legislations followed in India, to protect consumers interests. The Government interference is a major influencing factor in framing of suitable pricing policies. For example: (A) Monopolies Restrictive Trade Practices Act, 1969 (B) The Essential Commodities Act, 1955 and (C) Drugs (price control) Order. (A) The Monopolies and Restrictive Trade Practices Act, 1969 (MRTP)

The Monopolies and Restrictive Trade Practices Act, 1969 (MRTP) is an important economic legislation designed to ensure that operation of the economic system does not result in the concentration of economic power to the common detriment. The MRTP came into force in June, 1970.

Engineering Economics: 164

Objectives •

To control and regulate concentration of economic power.



To control monopolies and monopolistic trade practice in the public interest and



To prohibit restrictive trade practices and monopoly pricing. Applicability of MRTP Act in Price Fixation •

The terms and conditions relating maintenance in any contract are void.

to minimum price



The provisions relating to resale price maintenance are applicable to the resale of goods in India only.



The manufactures and wholesalers are prevented from fixing the minimum price to the sellers.



No retailer is compelled to sell goods at the retail price fixed by the suppliers.

(8) ESSENTIAL COMMODITIES (SPECIAL PROVISIONS) ACT, 1981 The Essential Commodities (Special Provisions) Act, 1981 came into force with effect from September 2, 1981, to deal effectively with persons indulging in anti social activities like hoarding, black marketing and inflationary prices. The object of the act is to maintain or increase in the supply of essential commodities and to make availability to all people at fair prices in the interest of the general public. The Act empowered to control production, supply and distribution of trade and commerce in essential commodities. The Act is to secure equitable distribution in the interest of the consumers and not of the producers. It is providing for direct governmental intervention to control production as well as trade and commerce in commodities which are essential for the community at reasonable rates.

Controlled Price: The Act provides for the promulgation of an order for controlling the price at which any essential commodity may be bought or sold. In fixing the prices, a price lien has to be followed to give preference to the interest of the general public in respect of essential commodities. The price fixed in respect of an essential commodity governs both sales and purchases of the commodity.

Pricing Methods airiJ Policies: 165

It is a price which is required to determine by taking into consideration of circumstances like interest of the producer, the consumer and the general public. It must be fair from the point of view of the consumer, however the producer should not be driven out of his business. The controlled price enables both the consumers and the producers to tide over difficulties. Therefore, any restriction in excess of what would be necessary in the interest of general public to be carefully considered so that the producers do not perish and the consumers are not crippled.

(C) Essential Commodities Act, 1955 The basic legal frame for the commodity control is provided by the Essential Commodities Act, 1955. This Act provides in the interest of general public for government control over production, supply and distribution of essential commodities, which fall under three categories. viz., (1) Food items (2) Raw materials for Industries and (3) Products of centrally controlled industries. The central government is empowered to declare any commodity for the purpose of the Act, the government has listed over 70 commodities as essential commodities. A few examples are cattle feed, cotton and woollen textiles, drugs and medicine, food st~ffs and edible oils.

Guidelines for Fixation of Prices •

Prices should be fixed on the basis of the average costs of relatively more efficient firms which accounted for two third of the total output.



Common rules would be embarked with respect to technical issues involved in price fixation.



Minimum bonus would not be included as part of the cost of production.



The rate of return is calculated on the network of the company.



Price determining bodies will be required to suggest cost reduction measures where feasible and necessary.



A review of prices and costs in price controlled industries should be taken up once in three years.

Engineering Economics: 166

Drugs (Price Control) Order, 1970 The Drugs Prices (Display and Control) Order 1966 was passed under Section 3 of the Essential Commodities Act, 1955 to control the prices of drugs. It was subsequently replaced by the Drugs (prices control) order, 1970. According tt? the order, any substance including pharmaceutical, chemical, biological or plant product or medicinal gas conforming to drugs and cosmetics etc. and any medicine processed out of drugs with the use of any pharmaceutical aids for the diagnosis, treatment, mitigation or prevention of disease of human being or animals. The government may fix the maximum sale price of bulk drug. In the case of an import drug formulation, the landed cost (the cost of import of drugs plus customs duty and clearing charges) shall form the basis for fixing price along with such margin to cover selling and distribution expenses including the interest and importer's profit which shall not exceed 50 percent of the landed cost. The retail price of the drug formulation shall be calculated in accordance with the following formula: Retail price = Mc + Cc + pm + pc x or 1 + MAPE /100 + ED Mc = material cost Cc+ conversion cost pm = packaging material pc = packaging charges Mape = Maximum allowances post manufacturing expenses Ed = Excise duty

II. PRICING BASED ON MARKETING CONSIDERATION There are different categories of pricing based on marketing consideration.

1. Odd Pricing: The term odd prices is used in two ways. It may be price ending in an odd number or a price just under a round number. This type of pricing is commonly adopted by the sellers of specialty or convenience goods. For example, Bata company mentioning price of their products like Rs. 599.95, 699.95 etc.

Pricing Methods and Policies: 167

2. Psychological Pricing: In this method, pricing is fixed at a full number. Such a price has an apparent psychological significance from the view point of buyers. For example, price mentioned like Rs. 50, Rs. 70 , Rs. 100, Rs. 300 etc. 3. Customer Pricing: This type of prices is fixed by custom. For example, snacks manufactures price their products in this way that a particular variety of snack sold approximately at the same price. Soft drinks are priced in the same manner. 4. Prestige Pricing: Many customers judge the quality of a product by its price. It is also known as price illusion. Generally, prestige pricing is applied to luxury goods where the sellers are successful in creating a prestige for this product. For example, Godrej, Philips etc. 5. Geographic Pricing: This policy is used where a manufacture serves a number of distinct regional markets. He can adopt different prices in each area. Example. Petrol is priced in this way depending on the distance from the storage area to the retail bunk. Price variations are caused by transportation cost. There are three methods that relate to the absorption of distribution cost in the price, viz., Fob Pricing (free on board), Zone pricing and Base point pricing. 6. Dual Pricing: When a producer sells the same product at two or more different prices is called dual pricing. This is possible only if in the same market, different brands are marketed. Example, Railway department is adopting dual pricing for the same distance of travel in the same train, the services are sold to passengers at different prices under different classes. The first class passenger do not gain either in speed or in the distance travelled as compared to the second class passengers. 7. Monopoly Pricing: New product pricing is monopoly pricing if no competition. The seller has free hand in fixing the price. Such price will be maximizing the profits. 8. Going Rate Pricing: In this method, the competitors fix price without considering the demand and cost factors. This system of pricing is considered when products are close substitutes and the firm does not have any pricing decisions under competitive conditions.

Engineering Economics: 168

9. Sealed Bid Pricing: This method is used in tendering to win contracts. As such, the quoted price depends on expectations of how the competitors are likely to bid for the tender. 10. Product Life Cycle Pricing: In this method, pricing strategy tends to be different even for the same product depending on the particular stage in the life cycle of the product. 11. Basing Point Pricing: Basing point pricing has been adopted by oligopolies producing homogeneous product whose transportation costs are relatively high and whose production requires a large plant. There are two types of basing point pricing viz., .Single basing point pricing and Multiple basing point pricing. The single basing point pricing is the collusive pricing model of the oligopolies who ~gree on a common place as the basing point and all firms quote prices and transportation cost from the basing point to the place of destination. It is also called the Pittsburgh plus pricing, widely used by the American steel industry in the 1920s with Pittsburgh being the basing point. In multiple basing point pricing, the price is higher than the production cost plus transportation cost may be reduced. The basing point pricing reduces competition, identical prices prevail in all locations and the share of each oligopolies is determined by chance or by non-price competition.

12. Limit Pricing or Entry Preventing Pricing: Limit pricing is the highest price which the established firms believe that they can charge without inducing entry. It depends on the estimation of costs of the potential entrant, market elasticity of demand, shape and level of the LAC, size of the market, number of firms in the industry. Why firms over a long period of time were keeping their price at a level of demand where the elasticity was below unity. i.e. they did not charge the price that would maximize their revenue. It is explained by assuming that there are barriers to entry and that the existing firms do not set the monopoly price but the limit price. The price is set by the firm with the lowest cost, and the less efficient firms are price followers. The rationale of this pricing is that long run profits are maximized preventing entry.

Pricing Methods and Policies: 169

PROBLEMS IN PRICING After fixing a price, a producer is often set with the problems of price reduction. It is needless to say that this should be considered even before fixing the price. Hence, there must always be built in flexibility in the price structure to accommodate discounts, allowances, and guarantees etc.

Discounts and Allowances Discounts are deductions allowed by the sellers from the base price of product. Discounts are of four types: Trade discounts , Quantity discounts, Cash discounts, and Seasonal discounts. Allowances are the same as discounts but are usually given as a consideration for performing specific services. The important types are allowances are Promotional allowances, and Brokerage allowances. Samples are given at concession rates or supplying advertising materials like posters, stickers, calendars etc. come under this type. While the brokerage allowance is another type of trade discount, a broker usually performs the functions of linking together the seller and buyers. (a) Trade Discounts: It is allowed by manufacturers to wholesalers and wholesalers to retailers usually found in bulk purchasing. These are given as a consideration for performing marketing functions. It is the customary to give discounts to create differential prices for different customers on the basis of marketing functions performed by them. (b) Quantity Discounts: These deductions are offered from the price lists by sellers to encourage customers to buy larger quantities. This is applicable to the wholesalers and retailers. It induces small buyers to order in large quantities. (c) Cash Discounts: Cash discount is a deduction granted by the sellers to the buyers for paying his dues in time. Some suppliers offer a special discount for payment within a stipulated period from the date of invoice. Cash discounts are offered to discourage credit sales and reduce collection charges and the risk. (d) Seasonal Discount: It refers to discounts offered during a particular season. It is usually done during the slack peak period. For example : Refrigerators, Fans, Air-condition machines sold in winter season.

Engineering Economics : 170

PRICING POLICIES

Price is the exchange value of goods or service in terms of money. If there were no money, the exchange could still be undertaken, such

exchange were common in barter economy. The advantage of using monetary standards is that a buyer can use an universally accepted medium of exchange for any other commodity or service desired. The factors governing the prices can be divided into Internal factors and External factors. The internal factors are cost of production, management objectives, return on investment, stability in prices, preventing comretition and maximizing profits generally carried out within the organization. The external factors generally belong to perfect control in deciding the prices. These factors demand for the goods, competitors strength, market trend, distribution channel, purchasing power of buyers, Government policy, prices and legal aspects etc. Objectives of Pricing Policy

Pricing decisions are a part of general strategy for achieving a defined goal of a firm. A firm aims at one or more of the objectives such as maximization of profits, promotion of long range welfare of the firm, flexibility to vary prices to meet changes in economic conditions affecting various consumer industries, stability of prices and margin, avoid over pricing or under pricing etc. Some of the objectives are discussed briefly as follows: 1. Merket Penetration: It means low price is set to induce market growth and capture bulk market share.

2. Market Skimming: It refers to high initial price charged to take advantages of some buyers willing to buy much at high price, as the product has high value to them. 3. Early Cash Recovery: Some firms try to set a price to enable fast cash recovery. 4. Satisfying: A satisfactory rate of return can be achieved though another price provides even larger return.

Pricing Methods and Policies : 171

Role of Cost in Pricing

Costs constitute the fundamental elements in the price setting process. Higher costs are including promotional expenses connected with salesmen commission, advertisement, gifts to sales, taxation may make an upward adjustment of price. For example, the increase in textiles prices is due to changes in the cost of raw materials, wages, other establishment expenses and central sales taxes, excise duty etc., in India. If cost goes up, price rise can be justified. All costs have covered by pricing decision of a firm in the long run. Demand Factor in Pricing

The pricing policy of the firm depends upon the elasticity of demand as well. If the demand is inelastic it would not be profitable for the firm to reduce it prices. On the other hand, a policy' of price increase would prove profitable if the demand is inelastic. Conversely, if the demand is elastic, it is a policy of price reduction rather than a policy of price increase which would be profitable for a firm. Consumer Psychology in Pricing

Consumer psychology plays a vital role in pricing policy. Sensitivity to price changes will vary from consumer to consumer. In a particular situation, the behaviour of one individual may not be the same as that of other. In fact, the pricing decision is more incisive reasonable than simple elasticity. Whatever may be the price, the consumers prefer product quality, product image, customer services etc. Competition Oriented PriCing Policy

Many companies fix prices with due care of the competitive price structure. Deliberate policies may be formulated to sell the products in competition. One important feature is that there cannot be any rigid relation between the price of a product and the firms own cost or demand, which may change but it maintains the prices. In contrast, some firms will change its prices when the competitors change theirs prices even if its cost or demand has not changed.

Engineering Economics : 172

Information for Pricing Decisions The following information are essential for facilitating correct pricing decisions.

Micro Level Firm 1. Production capacity of the firm. 2.

Market share of the firm.

Product 1. Production cost details. 2.

Excise duties, cess etc.

3. Floor price and ceiling price regulations. 4. Packing costs. 5. Production guarantees. 6.

After sale services.

7.

Percentage of incidence of rejections.

Market 1. Ruling market price including substitutes prices 2. Terms of payment. 3.

Major competitors.

4. 5.

Production statistics. Consumption pattern.

6.

Brand image, brand loyalty and, consumer preferences.

7.

Sales promotion requirements.

8. Distribution channels and its margins.

REVIEW QUESTIONS 1. Explain the objectives of pricing techniques.

2. What is marginal cost pricing and state its advantages and limitations? 3. Briefly state the cost oriented and competition oriented pricing techniques. 4. What is product line pricing? 5. What is differential pricing?

'P ricing Methods and Policies : 173

6. Explain the importance of MRTP Act, 1969 in price fixation. 7. Define basing point pricing. 8. Discuss full cost pricing. 9. List atleast four external factors that govern pricing.

(Oct, 2001)

10. What are the major laws that affect price fixation? 11 Explain the different pricing methods.

(April,2001)

12. What are the factors influencing price determination? Explain any four pricing methods. (April. 2002)

10 National Income

National Income is the money value of all final goods and services produced by a country during a year. It can be defined as the total market value of all final goods and service produced in a year. The concepts of National income and National products are most significant in macro economic accounting which are often used to measure the economic performance of an economy. They serve as better yardstick to indicate the performance of the economy both in the short period and. in the . long period. In modern economy, economic activities generate two kinds of flows. (i) Money flows (for services of factors of production in the form of wages, rent, interest and profit). (ii) Product flows (flows of consumer goods and services and productive assets). On the basis of these two kinds of flows, some of the concepts of national income could be studied easily. They are Gross national product (GNP) and Net national product (NNP). NATIONAL INCOME CONCEPTS

1. Gross Domestic Product (GDP) Gross domestic product (GDP) is the money value of all the final goods and services produced in the country during an accounting year.

National Income : 175

GDP can be estimated at current prices and at constant prices. If the domestic product is estimated on the basis of the prevailing prices, it is called gross domestic product at current prices. If GDP is measured on the basis of the fixed prices, that is, prices prevailing at a point of time or in some base year, it is known as GDP at constant prices or real gross domestic product. For calculation, all goods and services produced in a given year must be counted only once. Final goods are those goods which are being purchased for final consumption. Intermediate goods are those goods which are being purchased for resale or further processing. The sale of intermediate goods is excluded from gross national product because the value of final goods includes the value of all intermediate goods used for production. 2. Net National Product(NNP) or National Income at Market Prices The second important concept of national·income is Net National Product. (NNP). In the production of GNP the use of some capital goods like machinery has fall in value as a result of its use in the production process. It is termed as depreciation. The charges for depreciation are deducted from the gross national product, we get net national product. It means the market value of all final goods and services after providing for depreciation. Net National Product or National Income at Market Prices = Gross National Product - Depreciation.

3. National Income or National Income at Factor Cost National income at factor cost means the sum of all income earned by resource suppliers for their contribution of the factors of production. The difference between national inco~e (or national income at factor cost) and net national product (national income at market prices) arises from the fact that indirect taxes and subsidies cause market prices of output to be different from the factor income resulting from it. National Income at Factor Cost = Net National Product - Indirect Taxes + subsidies. 4. Personal Income Personal Income is the sum of all incomes actually received by all individuals or households in a given year. Personal Income = National Income - Social Security Contributions - Corporate Income Taxes Profit + Transfer Payments.

Engineering Economics: 176

5. Disposable Income Disposable income refers to the remaining amount of personal income after paying personal taxes like income tax and property tax to the government. Disposable Income = Personal Income - Personal Taxes and Disposable Income - Consumption + Saving.

National Income at Current and Constant Prices National Income at current prices is mUltiplying the physical output of various commodities and services produced annually in a nation by the current market prices. National Income in terms of money value will increase when the prices of commodities have risen in order to find out whether real national output has increased. We have to adjust the national income figures for the changes in prices that have taken place during a period. It is known as deflating the national income figures for change in prices. We calculate national income at constant prices by adjustment or deflating the changes in prices. National income at current prices is deflated by the price index number. To obtain national income at constant prices (real National Income) the following formula is used to calculate national income at current prices of national income. . . . National income at current prices NatIonal Income at constant pnces = X 100 Price index numbers

For instance, in India for measuring changes in price level, price index numbers with 1970 -71 as the base year have been calculated. Therefore, we adopt the wholesale price index numbers of all commodities with 1970-71 prices as the base to estimate the national income at constant prices (real national income).

MEASUREMENT OF NATIONAL INCOME There are three methods of measuring national income, viz., Output Method or Value Added Method or Product Method, Income Method and Expenditure Method 1. Output Method (Value Added MethodIProduct Method)

Under this method, the economy is divided into different sectors such as agriculture, mining, manufacturing, small enterprises, commerce, transport, communication and other services. The gross product is found out by adding up the net value added that has taken place in various production units and industries during a year. This

National Income : 177

method is also called national incom~ by industrial origin. In order to arrive at the net value added of a given industry, the purchases of the produces of this industry from the producers of other industries are deducted from the gross value of production of that industry. For calculating the net product of the industrial sector, we need to know about gross output of the sector, the raw materials and intermediate goods, services used by the sector and the amount of depreciation. For the individual unit, we subtract from the value of its gross output, the value of the raw materials and intermediate goods and services used by it and from this we subtract the amount of depreciation of net product or value added by the sub sector. Again adding value added or net products of all the sub sectors we get value added or net product of that sector. For the economy as a whole, we add net products contributed by each sector we get net goods available in terms of market prices, we can easily convert it in terms by subtracting net income from abroad, we get net national product (NNP) at factor cost which is the national income.

Steps 1. Identify the producing enterprises and classifying them into industrial sectors according to their activities. 2.

Estimating net value added by each producing enterprises and industrial sector and add the value by all the sectors.

2. Income Method Under this method, national income is obtained by summing up of the income of all individuals of a country. Individual earn income by contributing their own services and the services of their property such as land and capital to the national production. Hence, national income is calculated by adding up the rent of land, wages and salaries of employees. Interest on capital, profits of entrepreneurs and income of self employed people. This method is called national income by distributive share. 3. Expenditnre Method This method arrives at national income by adding up all the expenditure made on goods and services during a year. Income can be spent either on consumer goods or investment goods. Hence, we get national income by summing up all consumption expenditure and investment expenditure made by all individuals as well as government during a year.

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(1) Expenditure on consumer goods and services by private

individuals is called private consumption expenditure. Symbolically, it is denoted as C. (2) Expenditure on replacement, renewal and new investment by the private businessmen is called gross domestic private investment which is denoted as I. (3) Purchases of goods and services by government is called government expenditure. It is denoted as G. (4) Foreign countries expenditure on goods and services, i.e. net exports indicated as Xn. In brief, the national income measured by the expenditure method is by adding up of all flows, viz, C,I, G. and Xn. Therefore Y = C+I+G+ Xn.

In India, the Central statistical organization (CSO) computes national income. The CSO uses output and income methods to estimate national income. The output method is used for the commodity procuring sectors like agriculture and manufacturing. For this sector, the value added approach is added. For the service sectors like trade, commerce, transport, insurance etc. the income method is used. The national illcome is estimated at both constant and current prices. Difficulties in Computing National Income There are several difficulties in computing national income due to various factors. They are as follows:

1. Changes in Price Level: Prices always change. Such changes complicate the estimation of income. But some techniques can solve the problem by suitably adjusting the prices. 2. Differences in Purchasing Power of Money: In India the purchasing power of money is more in rural India than in urban India. The problem in which value of money is to be taken into account for National income computations. 3. Availability of Data: National income estimation is constrained by lack of data. Many income details are not properly recorded and even the recorded details of income are either understated or overstated.

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Factors Governing the Size of National Income

It is well known that the size of national income for the advanced countries like England. USA and other European countries are very high. But under developed countries like India, the national income is very low. There are certain factors responsible for the size of national income which are as follows: (1) Efficiency of agriculture in all aspects and fertility of soil.

(2) Efficiency of industrial organization. (3) Efficiency of commercial organization. (4) State of the development communication

of means of transport and

(5) Development of banking and credit. (6) Human factors i.e., like character, capacity, energy, initiative and resourcefulness of the people. (7) Natural resources like mineral resources, power resources, forest resources etc. (8) Provision of general and technical education. (9) State support and policy and (10) Social and political will. REVIEW QUESTIONS 1. Define per capita income. 2. What are the methods of measuring national income? 3. How is per capita income arrived at?

(Oct, 2001)

4. Distinguish between GNP and GDP.

(April, 2001)

5. Define GNP.

(April, 2002)

6. What is national income? How can it be calculated?

(Oct, 2000)

11 Inflation and Deflation

INFLATION

The origin of inflation is found in the ruling of unstable governments in many countries. There is no reason why India should not be able to carry out her future plans without generating serious inflationary pressure on the general price level. By inflation, we mean a general rise in prices. In precise, inflation is a persistent rise in the general price level rather them a once for all rise in it. Inflation is the most persistent and pressing problem in modern economies and it is common to capitalist as well as socialist countries. Inflation may be defined as state of disequilibrium in which, an expansion of purchasing power tends to cause or in the effects of an increase of the price level. Prof. Einzig makes a distinction between money inflation and price inflatiOIi. Money inflation is considered as the initial stage of inflation due to excess of money supply. The price inflation is the last stage of inflation, when rising prices necessitates a faster expansion of money supply. According to the traditional approach, inflation is caused by an increase in the quantity of money in circulation which results in ail

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inflationary rise in the price level. Keynesian approach considers inflation in relation to the phenomenon of full employment. Inflation represents a condition where total demand for goods exceeds total supply of goods at current prices.

Types of Inflation The following are the main types of inflation: 1. Demand pull inflation: Demand pull inflation is caused by an increase in the aggregate demand for goods and services while the aggregate supply of goods and services is either stagnant or increasing gradually. The increase in the aggregate demand may be caused by the rapid expenditure for financing economic development. To start with, there will be an increase in the supply of money and followed by investment and an increase in factor income. This will lead to increase in consumption and investment expenditures. Thus, demand pull inflation is characterized by a significant increase in the prices of products as well as factors of production. 2. Cost push inflation: The cost push inflation arises due to changes in the supply or cost independently of any excess demand in product and factors markets. As the level of unemployment falls, certain income group may exert pressure to get increased income. These cost push factors exert their influence in all the industries by rise in prices and also cause an increase in the imports of raw materials. 3. Creeping inflation: Creeping inflation is a mild type of inflation in which there is a slow and gradual increase in prices. It is likely to have a cushioning in the context of a developing economy. 4. Walking inflation: The rate of increase in prices is considered to be at a faster rate, if this type of inflation is not properly checked, the rate of inflation will be intensified. 5. Running inflation: The rate of annual increase in price level is approximately at the rate of five percent. If this type of inflation persists for a longer period, the inflationary pressure will increase further. 6. Galloping inflation: This is otherwise known as hyper inflation. There is a persistent increase in the price level. Theoretically, such a type of inflation is expected to set beyond the level of full employment. This type of inflation occurred during the I and II World Wars.

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7. Comprehensive inflation: Comprehensive inflation occurs when there is a rise in the prices of all commodities. This is a normal feature of inflation. 8. Sporadic inflation: Sporadic inflation occurs when prices go up in a particular sector of the economy. But if it persists, it may develop into a comprehensive inflation. 9. Partial inflation: Partial inflation is said to exist when there is a rise in price level due to expansion of money supply before the stage of full employment in the economy. This is considered to be mild increase in price level. 10.Full inflation: Full inflation occurs when expansion of money supply is beyond the level of employment. It does not lead to increase in output and employment, and lead to a steady increase in prices. 11. Open inflation: Open inflation is a type of inflation in which there is no government intervention to check the rise in prices. The market forces of demand and supply bring price stability. 12. Repressed inflation: Repressed inflation is a type of inflation in which the government takes various measures like price controls and rationing to check the rise in prices. 13. Peace time inflation: Peace time inflation arises when there is a rise in price level due to increased public expenditure. For instance, the inflation caused by increased public expenditure under five year plans. 14. Post war inflation: When inflationary rise in the post war period may be more severe than that under war period. This is because of the release of pent up demand for all goods and services after the war. This upsurge in the demand of the community will lead to a severe inflation in the post-war years. 15. Currency inflation: This is caused by an excessive increase in the supply of money in circulation. The supply of goods and services may not be enough to meet the excessive demand. Hence, there will be an inflationary rise in prices. 16. Credit inflation: When the commercial banks resort to the process of expansion of credit to various sectors of the economy, there

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will be a rise in prices. But in credit inflation, economy is initiated to speeding up'the rate of economic growth, 17. Profit induced inflation: During certain times, businessmen are able to make huge profits. This is possible either in the absence of price control or ineffective government control. Consequently, the prices are also fixed at high level. Such inflation is called profit induced inflation. 18. Wage induced inflation: Trade unions can bring pressure on the employers and secure substantial increase in wages. This will lead to high costs of production and rise in prices. Such a situation is called as wage induced inflation. 19. Deficit induced inflation: In recent years, governments resort to the policy of deficit budgets. Then huge budgetary deficits are covered by the creation of new money, there will be increased purchasing power in the community which will push up the demand and pri ::es. The situation is made worse in developing countries where slow growth of supply of goods and services is experienced. 20. Scarcity induced inflation: Scarcity of goods and services may suddenly develop due to natural calamities and market imperfections. The resulting rise in prices is called as scarcity induced inflation. 21. Ratchet inflation: It refers to a situation when prices are not allowed to fall though there is scope for these prices to fall. In certain sectors, prices may go up due to excessive demand. While the prices should fall in these sectors where the demand is deficient. But trade unions and industrialists resist the fall and keep prices at an artificially high level. Thus, when prices go up in excess demand sectors, they are not allowed to fall in deficient demand sectors. This will cause a general rise in price level which is called as Ratchet inflation, STAGFLATION

The concept of stagflation has been used to describe inflation under conditions of unemployment. This is much evident in countries facing the problems of high prices along with high level of unemployment. Stagflation represents a situation where the combination of stagnation and inflation prevails.

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Causes of Inflation The causes of inflation are listed as follows: 1. Growth of public expenditure. 2. Growth of private consumption and investment expenditures. 3. Tax cuts imposed by the government will increase the purchasing power. 4. Repayment of internal debt by the government increases the purchasing power. 5. Growth of exports will reduce the domestic supply of goods and will lead to inflationary trend. 6. The increase in supply of currency and credit. 7. Transport bottlenecks also cause artificial scarcity and rise in prices. 8. Growth of population tend to raise the price level. 9. Deficit financing induces inflationary pressure. 10. Slow growth of agricultural output may increase the price level. 11. Slow growth of industrial production may increase the price level. 12. High price of imported goods may cause inflationary trend.

Measures Control of Inflation Inflation has to be controlled because it produces many economic, social and political consequences. The inflation leads to a strong desire for huge profits. It encourages corruption. It results in public dissatisfaction over economic conditions and lead to political agitations and disturbances. The methods of controlling inflation can be grouped as follows: 1. Monetary measures, 2. Fiscal measures and 3. Other measures.

Inflation and Deflation : 185

1. Monetary Measures The monetary policy of the central bank can change to offset inflationary situation. A dear money policy is pursued to control inflation. The central bank will raise the bank rate during the period of inflation, by adopting open market operations which involves the sale of securities to commercial banks. The cash reserve ratio is raised to reduce the volume of credit with commercial banks

2. Fiscal Measures Fiscal measures to control inflation are taxes, public expenditure and public borrowings. Taxation can be used as a powerful antiinflationary weapon in all economies. During the period of inflation, government can increase the existing rates of taxation or introduce new taxes. Both direct and indirect taxes can serve as anti-inflationary weapons. The direct taxes reduce the purchasing power of the people, while the indirect taxes raise the prices of commodities and reduce the demand and bring down the rise in prices.

3. Other Measures Over valuation of the currency in terms of foreign currencies also produce anti-inflationary effects. It will reduce exports and increase imports. 1. Rationing: Rationing of essential goods is adopted as an effective method of checking inflationary prices. Public distribution system enables the government to distribute the available limited supply of essential goods among all sections of the society. This can prevent black marketing and speculative deals by private trade.

2. Price Controls: Government can check inflationary rise in prices by various price controls like fixing the fair prices for raw material industrial and agricultural products. This will revert unauthorized increase in prices. However, the success of price control measures depend upon efficient administration. 3. Wage Policy: During the periods of inflation, wages increase which may push up the costs as well as prices. Hence, wage freeze is suggested as an effective method of controlling inflation.

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4. Check on Black Money: If government can effectively check the black money through effective enforcement of tax policies, inflation can be controlled. CONSEQUENCES OF INFLATION It is rather difficult to analyze the effects of inflation that can produce desirable and undesirable effects. A mild inflation will have healthy effect on investment and production. It encourages the rise in prices, consequently the producers will increase the level of investment and production. When an economy faces hyper inflation, it will have adverse effects on production, employment and investment. Inflation can cause erosion of savings and lead to slow rate of capital formation. The businessmen may become pessimistic and reluctant to take business risks. It will encourage unfair trade practices like hoarding on the economy.

Inflation leads economic recession in many sectors as a result prices of certain articles such as textiles may be increased. With increasing expenditure on essential goods the expenditure on other goods has declined. It brought about mal distribution of income, hoarding, speculation and the working class people have suffered badly whose money wages have remained almost stable. It accentuates for increasing poverty and gross inequality of income and wealth. We have seen three sets of price statistics, viz., wholesale prices, consumer prices and implicit deflators for price analysis. The most important application of the price data is measurement of inflation and a matter of widespread concern. Neverthless to add, a large proportion of households live in a state of absolute poverty and deprivation in India.

1. Wholesale Price Index Wholesale price indexes are the most widely used, most often quoted in professional discussions and most frequently published of all price data. Index number of wholesale price in India is issued by the Economic Advisor, Ministry of Industry, Government of India. It was in 1942 a wholesale price index was first published which covered 23 commodities falling into four categories viz., (1) food and tobacco (2) Agricultural products (3) Raw Materials and (4) Manufactures.

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A new index was constructed with 1952-53 as the base and published in 1956. Unlike the earlier indexes, the new index was a weighted arithmetic mean rather than a geometric mean and included 112 commodities following the Standard International Trade Classification (SITC) with five groups as: (a) Food articles, (b) Liquor and tobacco, (c) Fuel, power, light and lubricants, (d) Industrial raw materials and, (e) Manufactures. In the beginning of 1977 a WPI came into existence with 360 commodities and for 1295 price quotations. The items included were those for which the total value of output exceeded Rs. 1 crore in 1965 as per ASI data as well as items with large import volume. The fiscal year 1970-71 serves as the base year for this series. In this index weights for commodities were determined according to the value of sales plus the value of imports. Tariffs and excise duties were included in calculating these values. For agricultural commodities and lubricants, sale values were obtained as averages of figures for the three years 1967 -68, 1968-69 and 1969-70. For manufactures they were based on ASI data for 1968. The revised wholesale price index which was effective from July 1989 brought forward the base to 1981-82. The number of commodities covered too was raised to 447 and the number of price quotations raising to 2371. The distinguishing feature of this index is taking into account the value of output of the unregistered manufacturing and agricultural commodities. Weights were determined on the basis of the value of actual marketed surplus. The revised wholesale prices available since April 2000 has 1993-94 as the base. Price quotations used are those prevailing in wholesale markets for agricultural products and ex-factory/ex-mine prices inclusive of excise duty in the case of manufacturer. Prices of imported items are similarly inclusive of import duties. Items whose value of trade is equal to or exceeds Rs. 120 crores according to the Annual Survey of Industries in 1993-94 and items whose value of output

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plus net imports is equal to at least Rs. 120 crores are also included in the index. All data on WPI are available on the web site http// eaindustry.nic.in. The wholesale price index for Tamil Nadu has decreased from 1227.71 points in March 2001 to 1254.41 points in June 2001. The group index for primary articles has shown an increasing trend during this quarter i.e. it has increased from 1222.58 points in March 2001 to 1255.98 in June 2001. The index for fuel, power and light has remained unchanged from March 2001 to June 2001. The sub group index for food articles has increased from 1339.62 points in March 2001 to 1413.56 points in June 200.1. The Index for non food articles has decreased from 1032.65 points in March 2001 to 999.85 June 2001 and the index for manufactured products has increased from 1177 .23 points in March 2001 to 1197.88 points in June 2001.

2. Consumer Price Index A committee appointed in 1978 to review the ways and means to improve the construction of consumer price index for industrial workers, has gone into a number of ticklish issues like black market prices or prices of rationed goods supplied under the public distribution system. The WPI is an excellent measure of general price movement in the economy, it is not capable of capturing the welfare implications of inflation. Features Consumer Price Indexes (CPI) are characterised by the following: (1) CPI is specific to a given area and an economic class of

population. (2) CPI is based on retail prices. (3) There are three series CPIIW, CPIAL and CPINM for industrial workers, agricultural labour and non-manual urban workers respectively at the All India level. (4) There are two sets of CPI series for various centres in India, one set is prepared by the state government agencies and another by the Labour Bureau (LB).

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(5) The CPI is compiled by the states which do not have the same base. (6) The Labour Bureau does have a common base in case of all 15 centres for which it compiles CPI. (7) The Labour Bureau compiles cost of living index for workers in different locations with considerable industrial activity. The Consumer Price Index for industrial workers for 38 centres and an All India Index had also been published by the Labour Bureau, and 17 centres by the state governments with the base as 1951. Using the CPI for 27 centres, the Lau. ur Bureau compiles an All India Consumer Price Index for Industrial workers. The All India Index for Industrial Workers (CPIIW) is computed as a weighted arithmetic mean of the indexes for the 27 centres. The weights assigned to each centre is proportional to the factory employment at that centre which it was published in April 1954 with base 1949. A revision was undertaken with effect from October 1988 when the base was shifted to 1982. In January 1994, CSO has also been publishing all India average retail prices of 260 commodities and services in the Monthly Abstract of Statistics. Since 1958, the Labour Bureau has also published a preliminary CPI for agricultural labour, CPIAL, with 1950-51 as the base. The base prices and weights used in the index were taken from the first Agricultural Labour Enquiry conducted during March 1950 and February 1951. The consumer price index for agricultural labour (CPIAL) with base 1984-85 covers four categories of items, viz., (1) Food (2) Fuel and light (3) Clothing, bedding and footwear (4) Other miscellaneous items. For urban non-manual employees, the Central Statistical Organisation has been publishing a separate Consumer Price Index CPINM. It was started with base 1960 and weights obtained from middle class family by the surveys undertaken with the help of NSS in 195859 for 41 centres. Commodities covered for the index include:

Engineering Economics: 190

(a) food, beverages and tobacco (b) fuel and light. (c) housing (d) clothing, bedding and footwear and (e) miscellaneous items like medical care, education, recreation, transport etc. We have a variety of state specific consumer price indexes by rural urban disaggregation for 1988-89. The latest of these also relate to general population with weights corresponding to the average consumption basket and also those appropriate to the poverty line with weights relating to the middle range income groups. Wholesale price indexes are used in a variety of ways in calculating the real and nominal values of output and expenditures relating to different sectors and uses. The most important application of the price data is measurement of inflation. Inflation is a sensitive issue and a matter of widespread concern is hardly surprising in case of India, where a large proportion of households live in a state of absolute poverty and deprivation. Many households living near the poverty line get pushed below it as a result of persistent inflation. (a) ultimate consumers pay retail rather than whC'lesale price, (b) households need services in addition to commodities, (c) consumers do not buy many of the items included in WPI. The government agencies rely on WPI for policy formulation, policy evaluation and general public information. (1) The implicit GDP deflator though more comprehensive is

available only on an annual basis and with a considerable lag. (2) Easy access of the data on WPI are readily available in diskets and obtained from the Economic Advisor, Ministry of Industry and also available on the WEB site, [http/eaindustry.nic.in].

CPI for Industrial Workers The consumer price index with base 1982 = 100 for the quarter ended June 2001 has increasd as compared to the previous quarter. The all India consumer price index (with base 1982 = 100) has shown an

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increasing trend during the quarter ended June 2001 when compared to th.e previous quarter. The consumer price index for urban non-manual employees (with base 1984 - 85 = 100) for the month of June 2001 has increased. REVIEW QUESTIONS 1. Define inflation and mention the different types of inflation. 2. What is stagflation? 3. Explain the measures to control inflation. 4. What are the uses of consumer F;ce index? 5. What are the merits of wholesale price Index? 6. Give at least two causes of inflation. 7. What is deflation? 8. What do you understand by price Index?

(Oct. 2001) (April. 2001 & 2002) (April. 2001)

12 Production and Productivity Analysis

PRODUCTION

Production is defined as a process of transforming a set of inputs into a set of output. The inputs are Men, Machine, Materials, Money and Methods, etc. the output is finished products. According to Buffa, Production is a process by which goods and services are created. The essence of production is creation of a volume of goods and services which may be achieved by transforming raw materials or by assembling many small parts or by repacking of raw materials. Production Management . It is the process of planning, organizing, directing and controlling the production activities of an organisation for actual transformation of inputs into marketable finished goods or services.

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Types of Production There are four types of production, which are briefly explained as follows: 1. Job Production: In job production, the whole production is taken as one job which is completed before going on to next.

Examples: Ship building, Civil Engineering Construction, and Castings etc. 2. Batch Production: In batch production, the process of production is split into a series of manufacturing stages. Each stage iscompleted as one of the single items being made, before the next stage is started. In this way, a group of identical products, or a batch are made, which move through the production process together. If more than one types of product is made, then the batches of different products may be moving around the shop floor requiring operations from the same machine. For example. Machine tools, furniture making and clothes. . 3. Mass Production: In mass production, the factory is concentrated to large scale and continuous production where machinery is designed for one range of products. All machines and processes will be arranged in operation sequence to suit the products. In this type of production, the products move forward from one stage to the next stage of manufacturing operation. For Example: food products, electric lamps, television, motor car and pharmaceuticals etc. 4. Process Production: In this method of production, the entire factory is completely integrated at all stages without any isolated items of equipment to produce a specific product, the flow of which is continuous. For example, chemicals manufacturing, oil extraction and bulk drugs.

Production System The production system is a part of a business organisation. It is the framework of activities within which the creation of value takes place. A simplified production system is depicted in Chart 2. The chart depicts an example of a production system approach from manufacturing of tablets. At one end is the inputs and at the other end is output, connecting the inputs and outputs a series of process like storage, quality control, inspection, package and sales can be performed.

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Chart 2 Production System Receiving

Inventory Information Schedules Route sheets Production reports Time and cost records

Analytical Reports

Inspection Reports

Inventory reports

Sales Reports

PRODUCTIVITY Productivity is defined as the ratio between output in the form of goods and services and the input resources used in the process of production. It is often termed as output per man, or output per man hour, or per unit of labour. The input of labour is only a part of the resources that go into production. Measuring productivity in terms of labour time spend is an important perspective of the concept of productivity. The input and output aggregates have all to be viewed for determining productivity ratio. Broadly speaking, productivity may be taken to account the ratio of all available goods and services to the potential resources of the country. In the context of economic development of a country, productivity is assumed more important and increasingly recognized. Higher productivity is not an end in itself but a means of promoting social progress along with strengthening the economic foundations of human well-being. Hence, the level of productivity determines the national wealth and per capita income and the standard of living of the people.

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In a broad sense, the drive of increasing productivity implies proper and efficient utilization of available resources like men, machines, materials, money, power, and land etc. It implies that development of safer ways of doing a job, manufacturing of product and providing a service. It aims at the maximum utilization of resources for yielding as many goods and services as possible, at the lowest possible cost. It eventually leads to the lightening of the burden of men while increasing the burden of machines making men work more humanly. In the present competitive world economy, we cannot afford to lag behind of our techniques and processes which reflect on the measure of productivity. The increase in productivity substantially contributing to the nation only if the competition against the prices and quality of goods stand up effectively. To the nation, increase in productivity means more national wealth and higher standard of living. It also means to the nation more markets, both internal as well as abroad. To the workers, increase of productivity means higher wages. Wages of workers are highest in countries when the level of productivity is high. It leads to shorter working hours, improvement in working condition, more leisure and greater standard of Ii ving. To the consumers, increase of productivity results in lower prices, better quality of the goods and consequently greater level of satisfaction. Difference Between Productivity and Production Productivity should not be confused with production. We can increase the production in a manufacturing unit by employing more labour, installing more machinery, and materials regardless of the cost of production. Production is a mere volume of output. Increase in production does not necessarily mean increase in productivity, through higher productivity will lead to higher production. For instance, 100 men employed in a factory may be producing same volume of goods over the same period as 125 men working in another similar factory. Production of these two plants is equal, but productivity of the former is higher than the latter. Production itself does not raise the standard of living. It must be accomplished by increasing the real income, purchasing power of people through increase of productivity. Scope of Productivity Any production process involves input resources and output of goods. In other words, it means a ratio of output to input. Productivity can be increased by:

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(1) Reduction in wastes of resources,

(2) Increase in value product, (3) Marginal increase in input resources but proportionately higher output in the value of product. The main responsibility of increase in productivity is that of management, but there are certain fears behind good intentions of increasing productivity. They must be considered if significant increase in productivity has to be achieved. The fears are retrenchment, increase in the work load and uneven distribution of gains of pro(luctivity. Application of productivity techniques leads to increase in employment, improved working conditions and higher purchasing power, adequate safeguards to improve the productivity. APPLICATION OF PRODUCTIVITY TECHNIQUES Management is defined as the organization and control of human activity directed towards specified ends to achieve higher-productivity. Productivity techniques are used to achieve higher productivity by employing them. In manufacturing, time of job is made up of total work content of the job and the total ineffective time. The total work content of the job consists of basic work content and the work content added due to defects in the design time. The shortcomings of the management are due to the poor attitude of the workers, which are explained in the following manner: (i) Basic work content of product and operation. (ii) Work content added by specification of products. (iii) Work content added by inefficient methods of manufacturing

operation. (iv) Ineffective time due to shortcomings of the management. (v) Ineffective time within the control of the worker.

Total work content

= Basic work content + excess work content.

Where, excess work content mentioned as above in the item (ii) and (iii). The productivity techniques are applied to overcome the troubles and achieve higher productivity. The productivity techniques are related in which they are applied are given below:

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Weak Areas Work content added due to defect in design Work content added due to effective method of manufacture Work content added due to management shortcoming Work content added due to poor attitude

Relevant Productivity Techniques

Standardization, quality control, product development, value analysis Work study, tool design, plant layout, process planning Production planning and control preventive maintenance, industrial control, supervision, training Sound personnel policies, better supervision, incentives, employee training, job evaluation, better working environment

Management Techniques can reduce Excess Basic Work Content (1) Product development reduces excess work content due to

defective design and due to excess material. (2) Specialization and standardization enables high production process to be adopted. (3) Market, consumer and product research ensures correct quality standards. Management Techniques Reduce Excess Work Content (1) Process planning ensures selection of correct machines. (2) Process planning and research ensures correct operation processes. (3) Process planning and method study ensures correct selection of tools. (4) Method study reduces work content due to bad layout. (5) Method study and operator training reduces work content due to poor working methods.

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Management Techniques Reduce Ineffective Time

Marketing and specialization Lead to reduction in product variety and hence the idle time. Product Development

• Production control

Material control Maintenance

Improved maintenance

Working conditions Safety measures Training

Reduces the scope of design changes and thereby rework and stoppages are avoided . By using work measurement and proper planning of loading, idle time is reduced. By making available raw material at the right time, idle time is reduced. By prompt attention to breakdown the ideal time of men and machine is reduced. Through proper up keep and good repair of the plant scrap and rework are minimized and ineffective time is reduced. Enables workers to work steadily and happily. Reduces incidence of accidents and thereby ineffective time is reduced. Proper training to improve the morale.

Personal policies

Sound personal policies encourage workers against absence and tardiness and thereby reduce ineffective time.

Operator Training

Skill development of operators reduces rework and scrap thereby reducing ineffective time.

FACTORS AFFECTING PRODUCTIVITY

The factors affecting productivity can be viewed in two ways viz., factors affecting national productivity and factors affecting productivity in the industry. Let us discuss the following in detail.

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I. Factors Affecting National Productivity 1. Human Resources: It is one of the most vital factors affecting national productivity. Their level of education, training, knowledge can contribute to productivity. The influence of automation demands more and more educated employees. The employees should not only be motivated to be productive offering financial incentives such as pay, and offering non-financial incentives such as safe working conditions, promotion, and responsibilities etc. The labour management relations should be smooth and should cooperate in seeking productivity improvements.

2. Technology and Capital Investment: The technology supremacy and upgradation can result in higher productivity. New technology depends on the constant monitoring of research and development demand investment on new machinery and capital investment. The government can encourage research and development and provide tax incentives as well as other incentives to attract capital investment. 3. Government Regulation: The government should come forward in reducing the excessive regulations which are detrimental to productivity movement. II. Factor. Affecting Productivity in Industry 1. Produtt Design: Product design should be simplified by eliminating unnecessary parts that can save material cost. The value analysis technique can bring out many product design improvements which improve productivity and also standardization and continued research and development efforts can bring improved product design. 2. Machinery and Equipment: The equipment used to produce the products can greatly affect the productivity. The well maintained machines, tools, material handling system, factory layout etc., can eliminate unnecessary work content, delay, wastage, scraps, defects etc., and can contribute the promotion of productivity. The recent development of Computer Aided Design (CAD) and Computer Aided Manufacturing (CAM) using CNC machines become the essential jngredients in productivity improvement. - 3. Skill and Effectiveness of Worker: Well trained and skilled workers can do the work in much shorter time and with for effectiveness than

Engineering Economics: 200

new workers. The National Productivity Council (NPC) through its 50 local productivity councils in promoting training in productivity.

4. Raw Materials: The right quantity and quality of raw materials, its substitutes, the inspection and quality control programmes should be adopted before accepting the raw materials and after it has been converted into finished goods. For example, pharmaceuticals formulation industry can contribute for proper productivity in industry. 5. Energy: The energy conservation techniques in an industry enhance productivity. The energy savings schemes, maintenance of equipments to save different forms of energy use, use of renewable energy sources, use of alternate energy sources such as solar energy, wind energy, tidal wave energy, bio-gas energy, photo-voltaic cell etc. are considered to be very important to improve productivity. 6. National Factors: National factors such as physical, geographical and climatic differences have significant influence on the industrial productivity. The geological and physical conditions particularly determine the productivity of extractive industries. Climatic differences have a significant influence on industrial efficiency and productivity. In equatorial and tropical climates, workers have physical capacity for continuous and sustained work. 7. Managerial Factors: The management must possess organizational capacity, imagination and willingness to assume risk. 1he cumulative influence of these factors contribute substantially to increase in industrial productivity. There is a greater need of energetic, enterprising, far sighted managerial talents imbued with the spirit of adventure and vigilance to control and guide their destinies. 8. Financial Factors: Ample 'financial resource is essential for technical improvements and innovations. The movement of productivity has made the greatest stride where capital is relatively abundant. Hence, a large scale capital is needed to spent on techno-economic research, provision of improved amenities and facilities to workers, modernization of equipments and machinery. All these greatly influence the industrial producti vi ty.

Production and Productivity Analysis : 201

HUMAN FACTORS RESPONSIBLE FOR LOW PRODUCTIVITY

(1) Improper planning and scheduling of work on the part of the management. (2) Unclear and untimely instructions to employees in the shop floor. (3) Conflicting instructions to workers from various supervisors. (4) Due to incoherent ideas among team members in team work. (5) Unresolved human conflicts among workers. (6) Low morale among workers due to lack of proper motivational schemes. (7) Workers lack of faith in the management. (8) Management's inability to adjust the workforce size during peak and slack period. (9) Poor working environment results in easy fatigue of the workers. (10) Absenteeism of workers which may cause great inconvenience to supervisor and adjusting the work schedule. It may result in low productivity. (11) Lateness, idleness, carelessness, etc., also cause low

(12) (13)

(14)

(15) (16)

productivity. Failure to observe work ethics. Worker's unions, non-cooperation, unnecessary interference in management's regulations are also main reasons for low production. Frustration among workers because of unjust, early promotion and unqualified workers getting favouritism from management may promote low productivity. Workers fear about loss of job or insecurity in their job gives rise to low productivity. Introduction of automation, upgradation of technology may install a sense of insecurity among workers which may result in low productivity.

Engineering Economics : 202

(17) Improper training and lack of experience may also promote low productivity. Tools of Productivity

The tools of industrial productivity comprise the following: (1) Scientific management technique for practice. (2) Work, and motion studies for scientifically determining better and quicker ways of doing of job and stream lining the operations.

(3) Human relations including the modern concept of industrial relations. (4) Wage and bonus incentives, collective bargaining, management workers consultation, training of workers and labour welfare. (5) Simplification, standardization and specialization. (6) Control techniques including production and planning control, and quality control. (7) Determining improvements in plant layout, working conditions and materials handling, and (8) Selection and training of the personnel at various levels of management. REVIEW QUESTIONS 1. State the application of productivity techniques. 2. Give the relationship between productivity. economic growth and standard of living. (Oct, 2001) 3. List the methods to increase productivity.

(Oct. 2001)

4. Differentiate production and productivity.

(April. 2001)

5. What is material productivity?

(April. 2001.April. 2002)

6. Define productivity. What are the factors affecting productivity? How can standard of living be improved with productivity? (April. 2002)

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13 Capital Budgeting

MEANING OF CAPITAL

The term Capital refers to fixed assets used in production while a budget is a plan detailing projected inflows and outflows for future period. The capital budget outlines the planned expenditure on fixed assets, and capital budgeting is the process of analyzing projects and deciding whether they should be included in the capital budget. Capital budgeting means conceiving, generating, evaluating and selecting the most profitable projects for investing scarce funds available to the firm. It is also means investment decision making or equipment replacement policy or capital expenditure analysis. Essentially, it is the management of fixed capital and fixed assets which include not only additions (new purchase) to fixed asset but also replacement and improvement. It is the matter of fundamental importance of the company and the economy as a whole. Capital budgeting decision includes financial analysis of various proposals regarding capital expenditure to evaluate their impact on financial conditions of the company and to choose the best alternatives.

Engineering Economics : 204

Definitions

Charles Homgren defines capital budgeting as a long term planning for making and financing the proposed capital outlays. Joel Dean defines capital budgeting as an executive function. Planning and control of capital expenditures is the basic executive function, since management is originally hired to take control of stock holders funds and to maximize their earning power. Bamoul defines as the selection of projects, the timing of the investments, the determination of the amount to be invested with in any given time period and the arrangement of the financial means necessary for the completion of the projects. OBJECTIVES OF CAPITAL BUDGETING

The objectives of capital budgeting are to maximize profits either by increasing the revenue or by reducing the cost of production. Capital Expenditure

Capital expenditure refers to the expenditure on research and development, advertising and training of executives. In the long run, it depends on the functional period of the project, generally the items included in capital budgeting are expenditure on new capital equipment, expenditure on expansion or diversification of assets, addition to the stock or capital, expenditure on replacement of depreciated capital, expenditure on advertisement, expenditure on research and development and innovation. Necessity of Capital Budgeting

Capital budget decisions are crucial in financial decision making: (1) It affects the profitability of firm because they relate to a large magnitude of capital. (2) It effects on long run investment. (3) Investment decisions broaden the base on which profit will be earned and measured. (4) Proper mix of capital investment is necessary to ensure adequate rate of return on investment. (5) Implication of long term investment are subject to high degree of risk and uncertainty.

Capital Budgeting: 205

(6) The effect of the decision extends beyond the current accounting period.

Steps in Investment Decision Making Process (1) Search for new investment opportunities. (2) Forecasting the changes in cash flow that will accrue from investment projects. (3) Determining the method of computing the cost of capital which will take into account the availability of funds. (4)

D~termining

the method of converting the changes in future cash flows into a common unit that will reflect on the discounting principle.

(5) Selecting the most profitable investments. (6) Conducting post audit of the results pertaining to previous investments. The main steps in the process of capital budgeting are: (1) Project formation, (2) Project evaluation, (3) Project selection, and (4) Project execution.

Project Formation: This step involves either for expanding the existing capacity or for adding new products to the product line. Another important aspect is reducing the costs of production of existing products without altering the scale of operation. Project Evaluation: This is an important step, which involves estimating the benefits and costs and selecting the appropriate criteria for the feasibility of projects. Project Selection: There is no uniform selection procedures for investment proposals. Project Execution: It refers to implementation of the Project. There are three kinds of capital budgeting decisions. (i) Accept and Reject decision (ii) Mutually exclusive choice decision and (iii) Capital rationing.

Engineering Economics: 206

Features of Good Capital Expenditure Proposal

A good capital expenditure proposal contains the following informations which are vital for evaluating and monitoring the progress. 1. A description of the proposal 2. A proposed investment outlay 3. The likely savings or earnings 4. The expected life of the project 5. The pay back period 6. The expected rate of return. Methods of Preparing Capital Budget

In general, the method of preparing a capital budget depends upon the activities and the performance of firms. A firm can follow the important approaches such as last resort approach, product mission approach and functional approach. 1. Expenditure Approach or Last Resort Approach: The expenditure approach or last resort approach is an ad hoc type of incurring capital expenditure when exigency arises. If crisis arises, some efforts are needed to tide over the crisis. Mostly, public sector and government industrial establishments will adopt this approach. 2. Production Mission Approach: In the long run, firms are interested in producing multi products. For instance, a pharmaceutical firm produces several drugs, vitamins and lonics. A machinery for drug manufacturing cannot be used for vitamins. 3. Functional Mission Approach: It deals with the type of service rendered in production and marketing of a product. The rendering of post sale service is conditioned by the availability of financial resources. It is considered as functional aspect of a capital budget. Measuring Capital Productivity

Prof. Joel Dean indicates that the capital productivity is the key factor in sound budget of internal investments, the care and precision with which estimates are likely to make the difference between good investment decisions and bad ones.

Capital Budgeting: 207

1. It is essential to recognize the source of productivity of capital. 2. Earning of each project should be estimated separately. 3. Future profit on additional investmept is more relevant concept in measuring capital productivity. 4. It is necessary to compare future costs and future profits with proper alternatives. 5. The earning of capital asset over the whole life of the asset should be considered for measuring the productivity of capital. 6. The stream of capital earning in future must be appropriately discounted to know its present value, particularly in the case of long term projects. 7. The sum of investments to be used for comparison with earnings should be the average capital tied up in the asset over the period which may be less than full economic life of the asset. 8. The indirect effects of the proposed capital outlay in the operation of the existing facilities should also be considered. 9. The risk of destroying economic opportunity that creates profitability should be considered in relation to each profitability estimate. 10. The assessment of the riskiness of projects may involve a varying margin of error. Some systematic method should be followed to make the necessary adjustments on account of margin of error. 11. Rate of return estimate would be impracticable for certain kinds of investment projects. APPROACHES TO CAPITAL BUDGETING

There are three approaches to determine the size of the capital budget. They are: 1. Rationing approach, 2. Financing approach, and 3. One at a time approach. 1. Rationing Approach: The is the supply approach. In this approach the available cash flow, the supply of internal capital determines the size of the capital budget. The avail,ability of cash flow

Engineering Economics : 208

is estimated and then the best project is selected on the basis of the available fund. Thus, the amount of capital budget is first determined there rationed among the most desirable investment proposal. The limitation of this approach is that the project so chosen need not be more prosecutable. The benefit lies in minimization ofthe cost of capital.

2. Financing Approach: This approach may be called as the demand side approach. In the financing approach, the financial requirements of the desirable projects are estimated first, the rate of return which the company should earn on investment is determined. The potential projects are selected on the basis of their prospective yield. After finalizing the projects, finance is arranged to invest on these projects. The size of the capital budget is decided by these projects. The financial approach is most flexible so far as the size of the budget is determined by the investment opportunities available rather than the funds. 3. One at a Time Approach: In this method, the projects are taken one by one on the basis of their relative merits and availability of funds. In any company various proposals may not be accepted and implemented. The relative importance of the proposals and the funds at the disposal of management are the limiting factors. In this approach, each capital expenditure project is selected on merit as and when the proposals come forth during the year but the proposals may be dropped if funds are not available. (A) Supply of Capital

There are two sources of capital funds such as internal sources and external sources. The internal sources consist of depreciation charges, retained earnings and internal borrowings. Retained earnings are most important as it makes the plough back policy as an integral part of capital budgeting. The major problems in connection with the internal sources of funds are extent of cash generated within the firm, the amount of dividends to be paid, and the amount to be tied up in the long term projects. The external sources of capital funds are the shares and debentures to the public, which are determined by the capital market, the reputation of the company and the financial soundness of the management. Projections are not merely a matter of forecasting the level of costs and prices but they also invoive management decisions on the liquidity.

Cspits' Budgeting : 209

There are several factors which influence the choice of source. The most important among them are cost, convenience and control. As to cost, equity share capital does not involve any cost in the sense that there is no commitment as to the payment of interest. As the convenience, the management prefers to have funds as long as it needs, with a right to repay the funds to new units. As to control, the management would be reluctant to give any voting rights to the prospective creditors. In practice, no one source of capital meets the preferences of management. There are no hard and fast rules to indicate what source would be ideal under what circumstances and what percentage of capitalization should be represented by equity shares, preference shares or debentures. It may differ in industry trade, and company. The ratio of funded debts to equity should be geared to the degree of stability of earnings. The capital structure must be balanced with adequate equity cushion to afford flexibility. (B) Demand for Capital

Business capital includes those business activities which are concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprises. Capital is needed for investment purpose with a view to get profit. It is measured by the rate of return and prospective yield. Demand for capital refers to the amount in which, a firm would like to invest based on the cost of capital and the return on investment. The overall demand for capital is determined by the marginal revenue productivity of capital. TWO TYPES OF CAPITAL 1. Fixed Capital

Fixed capital is that portion of capital which is invested in fixed assets. Fixed assets are those assets which are required for permanent use by the company like land, buildings, machinery and equipments. It is the capital which will be used to gain and to generate revenue to the company.

Engineering Economics: 210

Factors Affecting Fixed Capital (1) Nature of Business: Marketing enterprises require a small amount of fixed capital as compared with the industrial enterprises in general.

(2) Scale Enterprises: Generally, large scale enterprises require more fixed capital than small scale enterprises. For instance, public utility concerns like railways and electric supply companies require huge investments in fixed assets. (3) Type of Manufacturing: Service and assembling industries require a much smaller amount of fixed capital than synthetic processing industries. If an industry is technology oriented, its investment in the form of fixed capital is very high as compared to the industries having less degree of technology. (4) Acquiring Fixed Assets: Fixed assets can be purchased outright by cash payment or on the basis of installment payment. In the former case, the requirement of fixed capital will be very high. 2. Working Capital Working capital is used to represent the total value of current assets held. It is the difference between current assets and current liabilities. The current assets includes cash and other assets which are convertible into cash in the normal course of business. The main items under the category are cash on hand, cash at bank, short term investment, sundry debtors, bills receivables, inventory, prepaid expenses, advances to suppliers etc. The current liabilities which accrue for payment in the normal course of the business within a year or less. It includes bank over draft, sundry creditors, bills payable, taxes and dividends due, long term borrowings due for pre payment, share capital to be returned etc. Factors Affecting Working Capital 1. Size of Business: Generally, the size of the concern has a direct relation with working capital requirements. Big enterprises have to keep higher working capital for investment in current assets, and for paying current liabilities. 2. Terms of Purchase: Credit facilities obtained from suppliers would reduce the investment in stocks.

Capital Budgeting : 211

3. Production Cycle: Longer the process time, greater would be the amount of funds locked up in the working process. 4. Terms of Sale: Longer the credit items offered to buyers, greater will be the investment in stocks. 5. Stocks Turn over: Stock includes raw materials, finished products and working process. In short, any factor which affects the size of current assets or current liabilities effects the size of the working capital. In estimating the future needs for working capital, such factors require careful analysis.

Methods of Appraising Profitability Project appraisal involves the following six different aspects such as economic, technical, organizational, managerial, operational and financial. It varies considerably among different projects. Some investments are independent, while others are mutually exclusive and still many of them are complementary in nature. These projects are categorized and evaluated with regard to their profitability. For evaluating various projects under consideration, we need to know the basic data about the alternative proposals like initial investment, economic life of the project, the value of scrap, the annual earnings, and the cash flow etc. Several methods of appraising the profitability of the investment projects are: 1. Pay Back Method, 2. Accounting Rate of Return, 3. Internal Rate of Return, 4. Net Present Value Index Method, and 5. Net Benefit Investment Ratio (N/K ratio).

(1) Pay Back Method The pay back period is the length of time from the beginning of the project until the net value of the incremental production stream reaches to the total amount of the capital investment. It is a common means of choosing among investments in business enterprises, when the choice entails a high degree of risk. The pay back period is the length of the time necessary for the initial investment to be recouped out of the

Engineering Economics: 212

actual cash flow produced by the investment. It indicates only the number of years to recover ~he initial investment, and does not count the rate of return. In payback period, cash flow means net profits (after tax) plus depreciation which is deduced from the gross profit to find out the net profit. It does not involve any outflow of cost, we have to add it to the net profit to find out the cash flows. Payback period is calculated as follows: Payback period = original cost of investment - annual net cash flow.

Merits 1. This method is simple and easy for calculation. 2. It takes into account the liquidity concept, and net profitability concept.

Limitations 1. It ignores returns beyond payback period

2. It ignores the possibility of long term growth 3. It overlooks the interest factor, capital wastage, economic life of the asset, return on capital investment, the scrap value of the asset etc.

(2) Accounting Rate of Return (ARR) This method is also called financial statement method ( book return investment method). It provides an estimate of the rate of return. Hence, the capital utilized on related income are ascertained by following principles and practices used in accounting. The formula of the ARR is ARR = Estimated Net Projects x 100 Capital Employed Some firms compute ARR on the initial amount invested and some firms on the average amount invested over the life of the project. The initial investment is only the amount of cash flow needed to make the investment.

Capital Budgeting: 213

Hence, Average Investment

Investment + Scrap Value =-Initial --------=---2

Merits 1. The ARR takes regular periodic recovery of capital over the life. 2. This method is more realistic and frequently used.

Limitations 1. It does not take into account the time value of money.

2. It gives equal stress to the money received. 3. It pays the same value to the receipt of the last year as to the first year. 4.

Expected profit is unlikely to be same every year.

(3) Internal Rate of Return (IRR)

Another way of using the incremental net benefit stream or incremental cash flow for measuring the worth of a project is to find the discount rate which makes the net present worth of the incremental net benefit stream or incremental cash flow equal zero. This discount rate is called the internal rate of return. It is the maximum interest that a project could pay for the resources used if the project is to recover its investment and operating costs and still break even. It is the rate of return on capital outstanding per period while it is invested in the project. The IRR is a very useful measure of project worth. It is the measure, the world bank uses for all its economic and financial analyses of projects and used by other international financial agencies. The formal selection criterion for the internal rate of return measure of project worth is to accept all independent projects having an internal rate of return equal to or greater than the opportunity cost of capital. In the case of mutually exclusive projects, direct comparison of internal rate of return can lead to an erroneous investment choice. In the discounted cash flow method the amount of money received today is more valuable than the one received after a year and so on. The reason is the money received today can be invested to earn certain amount of interest. In this way, a claim to get Rs. 100 after one year is

Engineering Economics: 214

not equivalent to Rs. 100 received today. The present value of future cash flows is less than their face value. The later the payment is due, the lower is the present value. The discounted rate of return is that interest rate which a series of future cash flows, brings the sum of their present values to the same level. The rate of interest is calculated with the help of an arithmetical formula. The formula of IRR is

~Bt-Ct -0 ~ (l +i)t where, Bt = benefit in each year

= cost in each year Nt = incremental net benefit in each year after stream has turned Ct

positive Kt =incremental net benefit in initial year when stream is negative t

= 1,2,

n

= number of years

1

n

= interest (discount) rate

Merits (i) It considers the time value of money

(ii) It considers the cash flows over the entire life of the project (iii) The cost of capital calculation is not a pre-condition for the

use of this method.

limitation It is difficult to use in practice as its computation is complicated.

(4) Net Present Value Index (NPVI) Net present worth (NPW) is called as Net present value(NPV). It is the most straight forward discounted cash flow measure of project worth. It is simply, the present worth of the incremental net benefit or incremental cash flow stream. The net present worth of the benefit

Capital Budgeting: 215

stream less the present worth of the cost stream. Net present worth is interpreted as the present worth of the income stream generated by an investment. In financial analysis, it is the present worth of the income stream accruing to the individual or entity from whose point of view, the analysis is being undertaken. The net present value of an investment proposal is the difference between the total of present values of th~ estimated annual cash flows over the life of the project and the initial investment of the project. NPVI = Total present value of cash flows Initial investment Merits

1. The NPVI makes no difference at what point in the computation the netting out takes place. 2. The NPVI is preferred to choose among mutually exclusive projects. 3. The NPVI has all the merits of the IRR method and duly recognize the time value of money. 4. It involves discounting of cash flows only once if the proposal is attractive. Limitations

1. No ranking is acceptable in this measure. 2. The desired rate of return by the process of trial and error which is very tedious. (5) Net Benefit Investment Ratio (N/K ratio)

A suitable and very convenient criterion for ranking projects which is reliable in all but the most extreme cases is the net benefit investment ratio(NIK ratio). This is simply, the present worth of the investment. The net benefit investment ratio is simple to determine when an incremental net benefit or cash flow, has been calculated for a project. The net benefit may be taken to be the net present worth of the incremental net benefit stream in those years after the stream has turned positive and investment may be taken to be the present worth of the incremental net benefit stream in those early years of the project when the stream is negative. Hence, to calcu,late N/K ratio simply divide the

Engineering Economics: 216

sum of the present worth after the incremental net benefit stream has turned positive by the sum of the present worth of the negative incremental net benefit in the early years of the project. The formula of Net benefit investment ratio is t=n

~

Nt

f:t (1 +i)t t=n

~

Kt

f:t (1 +i)t Merits

1. The net benefit investment ratio is very convenient to use in real life project investment decisions. 2. It can be used to rank projects when sufficient funds are not available to implement all projects. 3. It can be used to make a quick estimate of how much the investment cost could rise without making the project economically unattractive. Limitations

1. The net benefit investment ratio can be used to rank mutually exclusive projects only. 2. It can indicate incorrect investment decisions. 3. It does not hold if one is undertaking what is called dynamic optimization. REVIEW QUESTIONS 1. What is capital rationing? 2. Explain the approaches of capital budgeting. 3. What are the merits and demerits of pay back method? 4. What is internal rate of return? 5. What is net present value method? 6. Explain the significance of discounted cash flow (DCF) technique.

14 Decision Making Process and Principles of Motion Analysis

DECISION MAKING PROCESS

Decisions as means rather than ends. Every decision is the outcome of a dynamic process influenced by multiple forces. A process is basically a dynamic concept rather than static. It is more applicable to non-programmed decisions than the programmed one. Many problems that occur infrequently are unstructured, and are featured by a great deal of uncertainty in their outcome. Objectives of Decision Making

Before taking an effective decision, the decision maker must keep in mind the following factors: •

The objectives of the organization is given top priority.

• •

Maximize profit. Produce quality good.

Engineering Economics: 218



Optimize customer service.



Ensure adequate skilled labour.



Employees should motivate to work and provide, adequate promotional chances to them.

Two important types of decision making process are:Economic decision making and technical decision making.

1. Economic Decision Making Every day, we make a number of decisions, we may be working on many of them some are undoubtedly complex and wider critical decisions. In olden days, decisions were made based on old, irrelevant or rather ill defined data. In the present context, it is essential that decisions can be made on economIc costs, relevant data and based on formal decision making process. Various aspects of decision making process are: •

Analysis of decision making environment.

• •

Objectives of the decision maker Alternative plan of '~ ctions or strategies



Deterministic decision payoff

• •

Probabilistic decision payoff Decision payoff under competitive conditions



Measures of value or worth of a decision.

Decision making involves the following aspects • •

Problems to be solved .Many conflicting objectives to be reconciled



A number of possible alternative courses of action is chosen

• ' 'Measuring the value and payoff' each alternative course of action •

Identifying the decision maker



Identifying the situation to make the decision . .

Decision Making Process and Principles of Motion Analysis: 219

2. Technical Decision Making In many situations, the decision maker is an individual but many a times a group of individuals like a board of directors or a committee has to take decision. Mostly one manager interacts closely with other departments. Let us consider in a situation where the product manager might like to reduce the inventories (stock) in order to cut his production costs. His objective is to reduce the inventory carrying cost. At the same time, the marketing manager of the same company may decide to reduce the price of his product in order to increase his market share. His objective is to sell more and raise his market share. Some times decisions of one executive in a company may affect or interact very strongly in other competing organizations. Internal Factors: Decision making starts with an individual's values and goals. His behaviour is to be need oriented, values governed and goal achiever. This is super imposed by group need, values, goals and organizational needs. These are called internal factors. External Factors: The organization is superimposed by national factors like social, political, economics and government policies. Each of these factors will affect the decision making process. These are super imposed by International environment and is known as external factors. For the effective decision making, both internal and external factors are essential. All the factors are shown in Chart 3.

Technical Efficiency and Economic Efficiency Efficiency can be defined but there are many factors connected to it. It can be explained according to the situation. Efficiency of a man or machine or an organization is the power or ability to adequately meet the demand made on it. It is nothing but doing ajob at the lowest cost. In order to increase the efficiency, time, effort, planning and designing have to be taken into consideration in physical utilization of resources. It is called technical efficiency. Technical efficiency is measured with the standard performance. In simple words technical efficiency is output divided by input. It can be improved by the following ways: by' increasing output while keeping input at the same level, by reducing input while keeping output at the

Engineering Economics: 220

Chart 3

,-1 Deline Company

Mission! goal (sJ

Decision Making

Fl~w

Chart

I Setup Company Goals and Objectives

I

I

Feed Back and Control

Solve the' Problems

I Examine Internal and External

Environment

-

Evaluate Vmoos Routes StrategIes and Pay offs

I Organize and Implement the DecISion

same level, by increasing output proportionately more than the increase in input, and by reducing input proportionately more than decrease in output. The concept of economic efficiency is the efficiency of an economic system which has ability to distribute its resources. The most desirable way of distributing the resources is to meet the needs of demand which is tested by the satisfaction of consumers. Economic efficiency is also termed as optimum utilization of available resources.

Economic Decision Vs. Technical Decision According to Sastri, Higher efficiency means more efficient use of all resources and to produce as many goods and services as possible with adequate in reasonable costs and also giving importance to avoid wastage. The technical efficiency and economical efficiency are interrelated. Hence, the decision maker should provide proper consideration for them to take an appropriate decision. Decision making process links with both ecol)omic and technical decisions. They are as follows: •

Proper layout of plant, shop and machine tools.



Right methods of material handling and internal transport.



Implementation of adequate inspection procedures.



Elimination of waste.



Standardization.

Decision Making Process and Principles of Motion Analysis : 221



Concentration on Research and Development.



Proper working conditions.

Techno economic decisions are of vital importance for fast industrialization and economic development for India. The available resources have to be used in such a manner to raise total output and productivity and capital investment in new projects. Importance of Techno Economic Efficiency •

Reduction in cost of raw materials.



Reduction in price of gU\.l':!S.



Increase in wages and salaries.



Increase the strength of export market. MOTION ANALYSIS

Human effort is the most important of all factors of production. His involvement in the job is most critical as he assembles other factors of production using his sense. In manufacturing a product, a worker uses a number of movements of the limbs. Research has indicated that unnecessary and unproductive movements can be identified and eliminated by carefully observing the movements made by a worker while doing a job. The simple analysis of operation in terms of movements made by the worker is known as motion analysis. Motion analysis of a worker is useful to design an improved and productive method which eliminates unnecessary motions and develop a better method. A set of rules designed to develop better methods of doing a job focuses on minimizing the time, and energy spend in performing limb motions to complete the job. This is possible only by economizing the motions in the job. The set of rules of human motions are called the principles of motion economy. The sub-divisions of the principle of motion analysis is motion economy and it is related to the arrangement of the place, related to the design of tools, and equipments. Rules Related to Use of the Human Body

1. The two hands of a worker should begin as well as end their motion at the same time. 2. The two hands except in rest periods, should not be idle. 3. Both the hands should be utilized for productive work.

Engineering Economics : 222

4. The motion of the arms of hands should be opposite, symmetrical and simultaneous. 5. The motions should be simple and contain minimum number of limbs (finger, wrist, arms, shoulders, foot, leg etc.) for the purpose of performing the work in minimum time with minimum fatigue. 6. Momentum should be employed and it should be minimum if it overcomes by muscular effort. 7. Smooth, continuous curved motions are preferable to straight line motions without sudden and sharp changes in direction. 8. Easy and accurate ballistic movements are preferred over controlled one. The Blillistic movements is fast and easy motion caused by a single contraction of a positive muscle group with no antagonistic muscle group contracting to oppose it. 9. Eye fixations should be as few and as close together as possible. 10. Work should be arranged in easy and rhythmical movements. Rules Related to the Use of Work Place

1. There should be definite and fixed place for all tools, materials and controls, easily accessible and understandable. 2. Keep materials, tools and controls within easy reach. 3. The work places should be provided by gravity feed, or bins or containers of transfer machines. 4. Materials, tools and controls should be located to permit the best sequence of operations to reduce mental strain of the operator. 5. The final product should be dropped on a cover (or chute) near. the work place, so gravity and not the operator delivers the job at the required place. 6. Good and adequate illumination, i.e. light of sufficient intensity, proper colour and without glare from the right direction should be arranged at the work place. 7. The height of the work place and the chair should preferably be arranged so that alternate sitting and standing at work are possible.

Decision Making Process and Principles of Motion Analysis : 223

8. The seating arrangements of the worker should provide comfort and adjustable in order to reduce fatigue. Rules Related to the Design of Tools and Equipment

1. The hands should be relieved of all work that can be done more advantageously by a tool operated device. 2. Levers, hand wheels and other controls should be located in convenient positions when the operator can manipulate them with ease and speed. 3. Two or more tools should be combined and used to save time. 4. Tools and materials should be pre-positioned and located near the wQrk place to save the time. 5. Each finger performs some specific movement. The work load should be distributed to each finger as per the normal capacity of the fingers. REVIEW QUE;STIONS 1. Explain decision making process of a firm?

2. What are the principles of motion analysis? 3. What are the rules related to design of tools and equipment? 4. What does the motion study?

(April,2001)

5. What is the role of Human factor in method study?

(April, 2001)

6. What is Micro motion study?

(April, 2002)

7. What is economic activity? How to measure the level of economic activity? (April, 2002)

8. Discuss the step by step procedure of method study.

(April, 2002)

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References Ahuja, H.L., Advanced Economic Theory, S. Chand and Co, New Delhi, 1983. Bowers, David. Statistics for Economists, ELBS, Macmillan, London, 1982. Croxton, F.E D. J Cowden and Klein, Applied General Statistics, Prentice Hall of India, New Delhi, 1975. Dobb. Maurice, On Economic Theory and Socialism, (Collected Papers), Routledge, London, 1972. Dutt. R. K.P. M. Sundaram, Indian Economy, S. Chand, Co, New Delhi.1999. Gittenger, Price. Economic Analysis of Agricultural Projects, World Bank, EDl, Washington, 1987. Gujarati, Damodar, Essentials of Econometrics. McGraw Hill International Edition, 1998. Gupta, S.P. Statistical Methods, Sultan Chand and Co, New Delhi, 1998. Hague, Managerial Economics, Longman, London, 1992. Klein, R Lawrence. An Introduction to Econometrics, Prentice Hall of India, New Delhi, 1975. Koutsoyiannis, A, Modern Micro Economics, Macmillan Press Ltd, 1982. Marshall, Alfred, Principles of Economics, As introductory volume, Macmillan, London, 1962. Medhi, J. Statistical Methods, Wiley Eastern Ltd, New Delhi, 1992. Misra, B. Capitalism, Socialism and Planning, Oxford and IBH Publishing Co, New Delhi, 1974. Nevin, Edward, Text Book of Economic Anlaysis, Macmillan, 1978. Paish, FW & A.J. Culyer, Benham's Economics, English Language Book Society, London, 1979. Reserve Bank ofIndia, Annual Reports, 1998-99 and 1999-2000. RBI, Hand Book of Statistics on Indian Economy, Mumbai, 1999.

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Samuelson, P.A. Foundations of Economic Analysis, Harvard University Press, 1947. Samuelson, Paul,A. Micro Economics, McGraw Hill International. Samuelson, Paul, A. Economics, McGraw Hill International Book Company, 1980. Salvatore, D, E.A. Dinlio, Principles of Economics, Schaum's outline series, McGraw Hill Book Company, 1980 .. Shumpeter, J.A. Capitalism, Socialism and Democracy, Unwin University Books, London, 1974. Stonier, A. W & D.C. Hague, A Text book of Economic Theory, Longman, 1980. Weiss, Neil, A. Introductory Statistics, Addition- Wesley. Publishing Inc,1982.

Subject Index A Accounting rate of return, 212 - 213 Actual costs, 103 Average costs, 106 Average fixed cost, 114 Average variable cost, 115 Average total cost, 115

B Barometric technique, 56 Basing point pricing,l68 Batch production, 193 Bilateral monopoly, 149 Break even point, 151-152 Break even analysis, 150-159 Break even chart, 152 Business costs, 103 C Capital expenditure, 204 Capital formation, 67 CES, 100 Cobb douglas, 98-100 Constant returns to scale, 96 Cooperative, 76-77 Consumer price index, 188 Consumer's Surplus, 46-49 Consumption, 10 Controlled price, 164 Cost oriented method, 161 Cross elasticity of demand, 27 Customer pricing, 167

D Definitions of economics, Wealth,2 Welfare,3 Scarcity. 4 Modern, 5-7 Delphi method, 53 Decreasing returns, to scale, 97 Demand for capital, 209 Demographic factors, 70 Direct costs, 102 Discounts, 169 Disguised unemployment, 69 Distribution. 11 Disposable income, 176

Divisions in economics, 7-12 Drug order, 165 Dual pricing, 167 Duopoly, 148

E Economic backwardness, 70 Elasticity of supply, 84 Elasticity of demand. 21 Elasticity of substitution, 30 Engineering cost, 110 Engineering economics, 9-10 Expenditure method, 177 Explicit costs, 104 Equal product curve, 87-88 Equilibrium of industry, 124 Essential commodities, 164Exchange, 10 F

Factors of production, 60 Fixed capital, 210 Fixed costs, 105 Foreign capital, 69 Full cost pricing, 161 G

Geographic method, 58 Geographic pricing, 167 Going rate pricing, 167 Gross national product, 174-175 Imperfect competition, 140 Income elasticity demand, 24 Income method, 177 Incremental costs, 107 Increasi ng returns to scale, 96 Indifference curve Analysis, 39-46 Indifference curve, 39-41. Indifference map, 41. Indirect costs, 103 Industrial organisation, 71 Individual enterprise, 72 Inflation, 180 Iso cost line, 85-86

J Job production, 193 Joint stock company, 74-75

Subject Index: 228 K

Kinked demand curve, 147-148 L Labour, 61-65 Land, - 61 Law of demand, 17-20 Law of equi - marginal utility, 36-39 Laws of returns to scale, 95-97 Law of supply, 81-84 Law of variable proposition, 90-94 Least square method, 58 Limit pricing, 16l.! Linear homogenous, 97 Long run costs, 107 Long run engineering cost, 112 Long run equilibrium, 129-132, 144-145. M Macro economics, 8-9 Managerial economics, 11-12 Marginal cost, 106 Margin safety, 154 Mass production, 193 Marginal utility analysis, 32-36 Measurement of national income, 176 Methods of capital budget, 206 Micro economics, 7 Mobilisation of saving, 68 Monopoly pricing, 167 Monopolistic competition, 141 Motion analysis, 221 N

Net national product, 175 Net present investment ratio, 215-216 Net present value index, 214-215

o Odd pricing, 166 Oligopoly, 145 Opinion survey method, 52 Opportunity cost, 103 Output method, 176

Personal income, 175 Poverty, 70 Prestige pricing, 167 Price elasticity, 21 Pricing policies, 170 Prime costs, 109 Private costs, 108 Product differentiation, 142 Production functions. 97 Productivity, 194 Profit forecasting, 156 Psychological pricing, 166 Public sector, 77-79

R Ratchet inflation, 184 Relatively elastic, 23 Replacement costs, 108 Return on investment pricing, 162 S Samuelson's definition, 5-6 Scatter diagram, 57 Shape of demand curve, 14 Short run cost, 107 Short run engineering cost, 110-111 Short run equilibrium, 127, 129. 137-138,143-144 Social costs, 108 Stagflation, 184 Stock costs, 108 Supply of capital, 208 Supply function, 80 T Technical decision making, 218 Tools for productivity, 202 Total costs, 105 Types of demand, 14 Types of demand forecasting, 50-51 Trend projection method, 53-54 U

Unit elasticity, 24

v

p

Partnership, 73-74 Perfect competition, 121 Perfectly elasticity, 23 Perfectly inelastic, 23

Variable costs, 105 W

Wholesale price index, 187-188 Working capital, 210