Module 1 NATURE & SCOPE OF MANAGERIAL ECONOMICS The terms Managerial Economics and Business Economics are often

used interchangeably. However, the terms Managerial Economics has become more popular and seems to displace Business Economics. DECISION-MAKING AND FORWARD PLANNING The chief function of a management executive in a business firm is decision ma!ing and forward planning. "ecision ma!ing refers to the process of selecting one action from two or more alternative courses of action. #orward planning on the other hand is arranging plans for the future. $n the functioning of a firm the %uestion of choice arises because the available resources such as capital, land, labour and management, are limited and can be employed in alternative uses. The decision ma!ing function thus involves ma!ing choices or decisions that will provide the most efficient means of attaining an organisational ob&ectives, for example profit maximi'ation. (nce a decision is made about the particular goal to be achieved, plans for the future regarding production, pricing, capital, raw materials and labour are prepared. #orward planning thus goes hand in hand with decision ma!ing. The conditions in which firms wor! and ta!e decisions, is characterised with uncertainty. )nd this uncertainty not only ma!es the function of decision ma!ing and forward planning complicated but also adds a different dimension to it. $f the !nowledge of the future were perfect, plans could be formulated without error and hence without any need for subse%uent revision. $n the real world, however, the business manager rarely has complete information about the future sales, costs, profits, capital conditions. etc. Hence, decisions are made and plans are formulated on the basis of past data, current information and the estimates about future that are predicted as accurately as possible. *hile the plans are implemented over time, more facts come into the !nowledge of the businessman. $n accordance with these facts the plans may have to be revised, and a different course of action needs to be adopted. Managers are thus engaged n a continuous process of decision ma!ing through an uncertain future and the overall problem that they deal with is ad&usting to uncertainty. To execute the function of +decision ma!ing in an uncertain frame wor!,, economic theory can be applied with considerable advantage. Economic theory deals with a number of concepts and principles relating to profit, demand, cost, pricing, production, competition, business cycles and national income, which are aided by allied disciplines li!e accounting. -tatistics and Mathematics also can be used to solve or at least throw some light upon the problems of business management. The way economic analysis can be used towards solving business problems constitutes the sub&ect matter of Managerial Economics. DEFINITION )ccording to Mc.air the Merriam, Managerial Economics consists of the use of economic modes of thought to analyse business situations. -pencer and -iegelman have defined Managerial Economics as /the integration of economic theory with business practice for the purpose of facilitating decision ma!ing and forward planning by management.0 The above definitions suggest that Managerial economics is the discipline, which deals with the application of economic theory to business management. Managerial Economics thus lies on the margin between economics and business management and serves as the bridge between the two disciplines. The

following #igure 1.1 shows the relationship between economics, business management and managerial economics.

APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT The application of economics to business management or the integration of economic theory with business practice, as -pencer and -iegelman have put it, has the following aspects 1 Reconciling tr !ition l t"eoretic l conce#t$ o% econo&ic$ in rel tion to t"e ct' l ('$ine$$ (e" )ior n! con!ition$* $n economic theory, the techni%ue of analysis is that of model building. This involves ma!ing some assumptions and, drawing conclusions on the basis of the assumptions about the behavior of the firms. The assumptions, however, ma!e the theory of the firm unrealistic since it fails to provide a satisfactory explanation of what the firms actually do. Hence, there is need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develop appropriate extensions and reformulation of economic theory. #or example, it is usually assumed that firms aim at maximising profits. Based on this, the theory of the firm suggests how much the firm will produce and at what price it would sell. $n practice, however, firms do not always aim at maximum profits 2as they may thin! of diversifying or introducing new product etc.3 To that extent, the theory of the firm fails to provide a satisfactory explanation of the firm,s actual behavior. Moreover, in actual business language, certain terms li!e profits and costs have accounting concepts as distinguished from economic concepts. $n managerial economics, an attempt is made to merge the accounting concepts with the economics, an attempt is made to merge the accounting concepts with the economic concepts. This helps in a more effective use of financial data related to profits and costs to suit the needs of decision ma!ing and forward planning. E$ti& ting econo&ic rel tion$"i#$* This involves the measurement of various types of elasticities of demand such as price elasticity, income elasticity, cross elasticity, promotional elasticity and cost output relationships. The estimates of these economic relationships are to be used for the purpose of forecasting.

Pre!icting rele) nt econo&ic +' ntitie$* Economic %uantities such as profit, demand, production, costs, pricing and capital are predicated in numerical terms together with their probabilities. )s the business manager has to wor! in an environment of uncertainty, the future needs to be foreseen so that in the light of the predicted estimates, decision ma!ing and forward planning may be possible.

U$ing econo&ic +' ntitie$ in !eci$ion-& ,ing

n! %or- r! #l nning 1 This involves

formulating business policies for establishing future business plans. This nature of economic forecasting indicates the degree of probability of various possible outcomes, i.e., losses or gains that will occur as a result of following each one of the available strategies. Thus, a %uantified picture gets set up, that indicates the number of courses open, their possible outcomes and the %uantified probability of each outcome. 4eeping this picture in view, the business manager is able to decide about which strategy should be chosen. Un!er$t n!ing $igni%ic nt e.tern l %orce$* )pplying economic theory to business management also involves understanding the important external forces that constitute the business environment and with which a business must ad&ust. Business cycles, fluctuations in national income and government policies pertaining to taxation, foreign trade, labour relations, antimonopoly measures, industrial licensing and price controls are typical examples. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies.

C/ARACTERISTICS OF MANAGERIAL ECONOMICS There are certain chief characteristics of managerial economics, which can help to understand the nature of the sub&ect matter and help in a clear understanding of the following terms1 Managerial economics is micro economic in character. This is because the unit of study is a firm and its problems. Managerial economics does not deal with the entire economy as a unit of study. Managerial economics largely uses that body of economic concepts and principles, which is !nown as Theory of the #irm or Economics of the #irm. $n addition, it also see!s to apply profit theory, which forms part of distribution theories in economics. Managerial economics is concrete and realistic. $ avoids difficult abstract issues of economic theory. But it also involves complications ignored in economic theory in order to face the overall situation in which decisions are made. Economic theory ignores the variety of bac!grounds and training found in individual firms. 5onversely, managerial economics is concerned more with the particular environment that influences decision ma!ing. Managerial economics belongs to normative economics rather than positive economics. .ormative economy is the branch of economics in which &udgments about the desirability of various policies are made. 6ositive economics describes how the economy behaves and predicts how it might change. $n other words, managerial economics is prescriptive rather than descriptive. $t remains confined to descriptive hypothesis.

Managerial economics also simplifies the relations among different variables without &udging what is desirable or undesirable. #or instance, the law of demand states that as price increases, demand goes down or vice versa but this statement does not imply if the result is desirable or not. Managerial economics, however, is concerned with what decisions ought to be made and hence involves value &udgments. This further has two aspects1 first, it tells what aims and ob&ectives a firm should pursue7 and secondly, how best to achieve these aims in particular situations. Managerial economics, therefore, has been described as normative microeconomics of the firm.

Macroeconomics is also useful to managerial economics since it provides an intelligent understanding of the business environment. This understanding enables a business executive to ad&ust with the external forces that are beyond the management,s control but which play a crucial role in the well being of the firm. The important forces are1 business cycles, national income accounting, and economic policies of the government li!e those relating to taxation foreign trade, anti monopoly measures and labour relations.

DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICS The difference between managerial economics and economics can be understood with the help of the following points1 Managerial economics involves application of economic principles to the problems of a business firm whereas7 economics deals with the study of these principles only. Economics ignores the application of economic principles to the problems of a business firm. Managerial economics is micro economic in character, however, Economics is both macro economic and micro economic. Managerial economics, though micro in character, deals only with a firm and has nothing to do with an individual,s economic problems. But microeconomics as a branch of economics deals with both economics of the individual as well as economics of a firm. 8nder microeconomics, the distribution theories, vi'., wages, interest and profit, are also dealt with. Managerial economics on the contrary is mainly concerned with profit theory and does not consider other distribution theories. Thus, the scope of economics is wider than that of managerial economics. Economic theory assumes economic relationships and builds economic models. Managerial economics adopts, modifies and reformulates the economic models to suit the specific conditions and serves the specific problem solving process. Thus, economics gives the simplified model, whereas managerial economics modifies and enlarges it. Economics involves the study of certain assumptions li!e in the law of proportion where it is assumed that /The variable input as applied, unit by unit is homogeneous or identical in amount and %uality0. Managerial economics on the other hand, introduces certain feedbac!s. These feedbac!s are in the form of ob&ectives of the firm, multi product nature of manufacture, behavioral constraints, environmental aspects, legal constraints, constraints on resource availability, etc. Thus managerial economics, attempts to solve the complexities in real life, which are assumed in economics. this is done with the help of mathematics, statistics, econometrics, accounting, operations research, etc.

OT/ER TERMS FOR MANAGERIAL ECONOMICS 5ertain other expressions li!e economic analysis for business decisions and economics of business management have also been used instead of managerial economics but they are not so popular. -ometimes expressions li!e +Economics of the Enterprise,, +Theory of the #irm, or +Economics of the #irm, have also been used for managerial economics. $t is, however, not appropriate t use theses terms because managerial economics, though primarily related to the economics of the firm, differs from it in the following respects1 #irst, +Economics of the #irm, deals with the theory of the firm, which is a body of economic principles relating to the firm alone. Managerial economics on the other hand deals with the, application of the same principles to business. -econdly, the term +Economics of the firm, is too simple in its assumptions whereas managerial economics has to rec!on with actual business behaviour, which is much more complex. SCOPE OF MANAGERIAL ECONOMICS )s regards the scope of managerial economics, there is no general uniform pattern. However, the following aspects may be said to be inclusive under managerial economics1 "emand analysis and forecasting. 5ost and production analysis. 6ricing decisions, policies and practices. 6rofit management. 5apital management. These aspects may also be defined as the +-ub&ect Matter of Managerial Economics,. $n recent years, there is a trend towards integrations of managerial economics and operations research. Hence, techni%ues such as linear programming, inventory models and theory of games have also been regarded as a part of managerial economics. De& n! An l0$i$ n! Forec $ting ) business firm is an economic (rganisation, which transforms productive resources into goods that are to be sold in a mar!et. ) ma&or part of managerial decision ma!ing depends on accurate estimates of demand. This is because before production schedules can be prepared and resources are employed, a forecast of future sales is essential. This forecast can also guide the management in maintaining or strengthening the mar!et position and enlarging profits. The demand analysis helps to identify the various factors influencing demand for a firm,s product and thus provides guidelines to manipulate demand. "emand analysis and forecasting, thus, is essential for business planning and occupies a strategic place in managerial economics. $t comprises of discovering the forces determining sales and their measurement. The chief topics covered in this are1 "emand determinants "emand distinctions "emand forecasting.

Co$t n! Pro!'ction An l0$i$ ) study of economic costs, combined with the data drawn from the firm,s accounting records, can yield significant cost estimates. These estimates are useful for management decisions. The factors causing variations in costs must be recognised and thereby should be used for ta!ing management decisions. This facilitates the management to arrive at cost estimates, which are significant for planning purposes. )n element of cost uncertainty exists in this because all the factors determining costs are not always !nown or controllable. Therefore, it is essential to discover economic costs and measure them for effective profit planning, cost control and sound pricing practices. 6roduction analysis is narrower in scope than cost analysis. The chief topics covered under cost and production analysis are1 5ost concepts and classifications 5ost output relationships Economics of scale 6roduction functions 5ost control.

Pricing Deci$ion$1 Policie$ n! Pr ctice$ 6ricing is a very important area of managerial economics. $n fact price is the origin of the revenue of a firm. )s such the success of a usiness firm largely depends on the accuracy of price decisions of that firm. The important aspects dealt under area, are as follows1 6rice determination in various mar!et forms 6ricing methods "ifferential pricing product line pricing and price forecasting.

Pro%it M n ge&ent Business firms are generally organised with the purpose of ma!ing profits. $n the long run, profits provide the chief measure of success. $n this connection, an important point worth considering is the element of uncertainty existing about profits. This uncertainty occurs because of variations in costs and revenues. These are caused by factors such as internal and external. $f !nowledge about the future were perfect, profit analysis would have been a very easy tas!. However, in a world of uncertainty, expectations are not always realised. Thus profit planning and measurement ma!e up the difficult area of managerial economics. The important aspects covered under this area are1 .ature and measurement of profit. 6rofit policies and techni%ues of profit planning.

C #it l M n ge&ent )mong the various types and classes of business problems, the most complex and troublesome for the business manager are those relating to the firm,s capital investments. 5apital management implies planning and control and capital expenditure. $n this procedure, relatively large sums are involved and the problems are so complex that their disposal not only re%uires considerable time and labour but also top level decisions. The main elements dealt with cost management are1 5ost of capital 9ate of return and selection of pro&ects.

The various aspects outlined above represent the ma&or uncertainties, which a business firm has to consider vi'., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty and capital uncertainty. *e can, therefore, conclude that managerial economics is mainly concerned with applying economic principles and concepts to ad&ust with the various uncertainties faced by a business firm. MANAGERIAL ECONOMICS AND OT/ER SUB2ECTS :et another useful method of explaining the nature and scope of managerial economics is to examine its relationship with other sub&ects. The following discussion helps to understand relationship between managerial economics and economics, statistics, mathematics, accounting and operations research. M n geri l Econo&ic$ n! Econo&ic$ Managerial economics is defined as a subdivision of economics that deals with decision ma!ing. $t may be viewed as a special branch of economics bridging the gulf between pure economic theory and managerial practice. Economics has two main divisions microeconomics and Macroeconomics. Microeconomics has been defined as that branch where the unit of study is an individual or a firm. $t is also called /price theory0 2or Marshallian economics3 and is the main source of concepts and analytical tools for managerial economics. To illustrate, various micro economic concepts such as elasticity of demand, marginal cost, the short and the long runs, various mar!et forms, etc., are all of great significance to managerial economics. Macroeconomics, on the other hand, is aggregative in character and has the entire economy as a unit of study. The chief contribution of macroeconomics to managerial economics is in the area of forecasting. The modern theory of income and employment has direct implications for forecasting general business conditions. )s the prospects of an individual firm often depend greatly on general business conditions, individual firm forecasts rely on general business forecasts. ) survey in the 8.4. has shown that business economists have found the following economic concepts %uite useful and of fre%uent application1 6rice elasticity of demand $ncome elasticity of demand (pportunity cost Multiplier 6ropensity to consume Marginal revenue product -peculative motive 6roduction function ;i%uidity preference Business economists have also found the following main areas of economics as useful in their wor!. "emand theory Theory of firms < price, output and investment decisions Business financing 6ublic finance and fiscal policy Money and ban!ing .ational income and social accounting

Theory of international trade Economies of developing countries. Thus, it is obvious that Managerial Economics is very closely related to Economics.

M n geri l Econo&ic$ n! St ti$tic$ -tatistics is important to managerial economics in several ways. Managerial economics calls for the organising %uantitative data and deriving a useful measure of appropriate functional relationships involved in decision ma!ing. #or instance, in order to base its pricing decisions on demand and cost considerations, a firm should have statistically derived or calculated demand and cost functions. Managerial economics also employs statistical methods for experimental testing of economic generalisations. The generalisations can be accepted in practice only when they are chec!ed against the data from the world of reality and are found valid. Managers do not have exact information about the variables affecting decisions and have to deal with the uncertainty of future events. The theory of probability, upon which statistics is based, provides logic for dealing with such uncertainties. M n geri l Econo&ic$ n! M t"e& tic$ Mathematics is yet another important sub&ect closely related to managerial economics. This is because managerial economics is mathematical in character, as it involves estimating various economic relationships, predicting relevant economic %uantities and using them in decision ma!ing and forward planning. 4nowledge of geometry, trigonometry ad algebra is not only essential but also certain mathematical tools and concepts such as logarithms and exponential, vectors, determinants, matrix, algebra, calculus, differential as well as integral, are the most commonly used devices. #urther, operations research, which is closely related to managerial economics, is mathematical in character. $t provides and analyses data ad develops models, benefiting from the experiences of experts drawn from different disciplines, vi'., psychology, sociology, statistics and engineering. MANAGERIAL ECONOMICS AND ACCOUNTING Managerial economics is also closely related to accounting, which is concerned with recording the financial operations of a business firm. $n fact, a managerial economist depends chiefly on the accounting information as an important source of data re%uired for his decision ma!ing purpose. for instance, the profit and loss statement of a firm shows how well the firm has done and whether the information it contains can be used by managerial economist to throw significant light on the future course of action that is whether the firm should improve its productivity or close down. Therefore, accounting data re%uire careful interpretation, reconstruction and ad&ustments before they can be used safely and effectively. $t is in this context that the lin! between management accounting and managerial economics deserves special mention. The main tas! of management accounting is to provide the sort of data, which managers need if they are to apply the ideas of managerial economics to solve business problems correctly. The accounting data should be provided in such a form that they fit easily into the concepts and analysis of managerial economics. M n geri l Econo&ic$ n! O#er tion$ Re$e rc"

(perations research is a sub&ect field that emerged during the -econd *orld *ar and the years thereafter. ) good deal of interdisciplinary research was done in the 8-). as well as other western countries to solve the complex operational problems of planning and resource allocation in defence and basic industries. -everal experts li!e mathematicians, statisticians, engineers and others teamed up together and developed models and analytical tools leading to the emergence of this specialised sub&ect. Much of the development of techni%ues and concepts, such as linear programming, inventory models, game theory, etc., emerged from the wor!ing of the operation researchers. -everal problems of managerial economics are solved by the operation research techni%ues. These highlight the significant relationship between managerial economics and operations research. The problems solved by operation research are as follows1 Alloc tion #ro(le&$* )n allocation problem confronts with the issue that men, machines and other resources are scarce, related to the number sand si'e of the &obs that need to be completed. The examples are production programming and transportation problems. Co&#etiti)e #ro(le&$* competitive problems deal with situations where managerial decision ma!ing is to be made in the face of competitive action. That is, one of the factors to be considered is1 /*hat will competitors do if certain steps are ta!en=0 6rice reduction, for example, will not lead to increased mar!et share if rivals follow suit. W iting line #ro(le&$ * *aiting line problems arise when a firm wants to !now how many machines it should install in order to ensure that the amount of +wor! in progress, waiting to be machined is neither too small nor too large. -uch situations arise when for example, a post office, or a ban! wants to !now how many cash des!s or counter cler!s it should employ in order to balance the business lost through long guesses against the cost of installing more e%uipment or hiring more labour. In)entor0 #ro(le&$* $nventory problems deal with the principal %uestion1 /*hat is the optimum level of stoc!s of raw materials, components or finished goods for the firm to hold=0 The above discussion explains that the managerial economics is closely related to certain sub&ects such as economics, statistics, mathematics and accounting. ) trained managerial economist combines concepts and methods from all these sub&ects by bringing them together to solve business problems. $n particular, operations research and management accounting are getting very close to managerial economics. USES OF MANAGERIAL ECONOMICS Managerial economics achieves several ob&ectives. The principal ob&ectives are as follows1 $t presents those aspects of traditional economics, which are relevant for business decision ma!ing in real life. #or this purpose, it pic!s from economic theory those concepts, principles and techni%ues of analysis, which are concerned with the decision ma!ing process. These are adapted or modified in such a way that it enables the manager to ta!e better decisions. Thus, managerial economics attains the ob&ective of building a suitable tool !it from traditional economics. Managerial economics also incorporates useful ideas from other disciplines such as psychology, sociology, etc. $f they are found relevant for decision ma!ing. $n fact, managerial economics ta!es the aid of other academic disciplines that are concerned with the business decisions of a manager in view of the various explicit and implicit constraints sub&ect to which resource allocation is to be optimised.

$t helps in reaching a variety of business decisions even in a complicated environment. 5ertain examples of such decisions are those decisions concerned with1 o o o o o o The products and services to be produced The inputs and production techni%ues to be used The %uantity of output to be produced and the selling prices to be subscribed The best si'es and locations of new plants Time of replacing the e%uipment )llocation of the available capital

Managerial economics helps a manager to become a more competent model builder. Thus, he can pic! out the essential relationships, which characterise a situation and leave out the other unwanted details and minor relationships.

)t the level of the firm, functional specialists or functional departments exist, e.g., finance, mar!eting, personnel, production etc. #or these various functional areas, managerial economics serves as an integrating agent by co ordinating the different areas. $t then applies the decisions of each department or specialist, those implications, which are pertaining to other functional areas. Thus managerial economics enables business decision ma!ing to operate not with an inflexible and rigid but with an integrated perspective. This integration is important because the functional departments or specialists often en&oy considerable autonomy and achieve conflicting goals.Managerial economics !eeps in mind the interaction between the firm and society and accomplishes the !ey role of business as an agent in attaining social economic welfare. There is a growing awareness that besides its obligations to shareholders, business enterprise has certain social obligations as well. Managerial economics focuses on these social obligations while ta!ing business decisions. By doing so, it serves as an instrument of furthering the economic welfare of the society through socially oriented business decisions.

Thus, it is evident that the applicability and usefulness of managerial economics is obtained by performing the following activates1 Borrowing and adopting the tool !it from economic theory. $ncorporating relevant ideas from other disciplines to achieve better business decisions. -erving as a catalytic agent in the course of decision ma!ing by different functional departments>specialists at the firm,s level. )ccomplishing a social purpose by ad&usting business decisions to social obligations.

ECONOMIC T/EOR3 AND MANAGERIAL ECONOMICS Economic theory offers a variety of concepts and analytical tools that can assist the manager in the decision ma!ing practices. 6roblem solving in business has, however, found that there exists a wide disparity between the economic theory of a firm and actual observed practice, thus necessitating the use of many s!ills and be %uite useful to examine two aspects in this regard1 The basic tools of managerial economics which it has borrowed from economics, and The nature and extent of gap between the economic theory of the firm and the managerial theory of the firm.

B $ic Econo&ic Tool$ in M n geri l Econo&ic$ The most significant contribution of economics to managerial economics lies in certain principles, which are basic to the entire range of managerial economics. The basic principles may be identified as follows1 45 O##ort'nit0 Co$t Princi#le

The opportunity cost of a decision means the sacrifice of alternatives re%uired by that decision. This can be best understood with the help of a few illustrations, which are as follows1 The opportunity cost of the funds employed in one,s own business is e%ual to the interest that could be earned on those funds if they were employed in other ventures. The opportunity cost of the time as an entrepreneur devotes to his own business is e%ual to the salary he could earn by see!ing employment. The opportunity cost of using a machine to produce one product is e%ual to the earnings forgone which would have been possible from other products. The opportunity cost of using a machine that is useless for any other purpose is 'ero since its use re%uires no sacrifice of other opportunities. $f a machine can produce either ? or :, the opportunity cost of producing a given %uantity of ? is e%ual to the %uantity of :, which it would have produced. $f that machine can produce 1@ units of ? or A@ units of :, the opportunity cost of 1 ? is e%ual to A :. $f no information is provided about %uantities produced, except about their prices then the opportunity cost can be computed in terms of the ratio of their respective prices, say 6x>6y. The opportunity cost of holding 9s. B@@ as cash in hand for one year is e%ual to the 1@C rate of interest, which would have been earned had the money been !ept as fixed deposit in a ban!. Thus, it is clear that opportunity costs re%uire the ascertaining of sacrifices. $f a decision involves no sacrifice, its opportunity cost is nil. #or decision ma!ing, opportunity costs are the only relevant costs. The opportunity cost principle may be stated as under1 /The cost involved in any decision consists of the sacrifices of alternatives re%uired by that decision. $f there are no sacrifices, there is no cost.0 Thus in macro sense, the opportunity cost of more guns in an economy is less butter. That is the expenditure to national fund for buying armour has cost the nation of losing an opportunity of buying more butter. -imilarly, a continued diversion of funds towards defence spending, amounts to a heavy tax on alternative spending re%uired for growth and development. 65 Incre&ent l Princi#le The incremental concept is closely related to the marginal costs and marginal revenues of economic theory. $ncremental concept involves two important activities which are as follows1 Estimating the impact of decision alternatives on costs and revenues. Emphasising the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at sta!e in the decision. The two basic components of incremental reasoning are as follows1 $ncremental cost1 $ncremental cost may be defined as the change in total cost resulting from a particular decision.

$ncremental revenue1 $ncremental revenue means the change in total revenue resulting from a particular decision.

The incremental principle may be stated as under1 ) decision is obviously a profitable one if1 o o o o $t increases revenue more than costs $t decreases some costs to a greater extent than it increases other costs $t increases some revenues more than it decreases other revenues $t reduces costs more that revenues.

-ome businessmen hold the view that to ma!e an overall profit, they must ma!e a profit on every &ob. 5onse%uently, they refuse orders that do not cover full cost 2labour, materials and overhead3 plus a provision for profit. $ncremental reasoning indicates that this rule may be inconsistent with profit maximisation in the short run. ) refusal to accept business below full cost may mean re&ection of a possibility of adding more to revenue than cost. The relevant cost is not the full cost but rather the incremental cost. ) simple problem will illustrate this point. $$$ustration -uppose a new order is estimated to bring in additional revenue of 9s. B,@@@. The costs are estimated as under1 ;abour Material (verhead 2)llocated at 1A@C of labour cost3 -elling administrative expenses 2)llocated at A@C of labour and material cost3 Total 5ost 9s. 1,B@@ 9s. A,@@@ 9s. 1,D@@ 9s. E@@ 9s. F,@@@

The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can be, utilised to execute this order then the order can be accepted. $f the order adds only 9s. B@@ of overhead 2that is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of supervision, and so on3, 9s. 1,@@@ by way of labour cost because some of the idle wor!ers already on the payroll will be deployed without added pay and no extra selling and administrative cost then the incremental cost of accepting the order will be as follows. ;abour Material (verhead Total $ncremental 5ost 9s. 1,B@@ 9s. A,@@@ 9s. B@@ 9s. G,B@@

*hile it appeared in the first instance that the order will result in a loss of 9s. 1,@@@, it now appears that it will lead to an addition of 9s. 1,B@@ 29s. B,@@@ 9s. G,B@@3 to profit. $ncremental reasoning does not mean that the firm should accept all orders at prices, which cover merely their incremental costs. The acceptance of the 9s. B,@@@ order depends upon the existence of idle capacity and labour that would go unutilised in the absence of more profitable opportunities. Earley,s study of /excellently managed0 large firms suggests that progressive corporations do ma!e formal use of incremental analysis. $t is, however, impossible to generalise on the use of incremental principle, since the observed behaviour is variable. 75 Princi#le o% Ti&e Per$#ecti)e

The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as on costs. The actual problem in decision ma!ing is to maintain the right balance between the long run and short run considerations. ) decision may be made on the basis of short run considerations, but may in the course of time offer long run repercussions, which ma!e it more or less profitable than it appeared at first. )n illustration will ma!e this point clear. III'$tr tion -uppose there is a firm with temporary idle capacity. )n order for B,@@@ units comes to management,s attention. The customer is willing to pay 9s. H.@@ per unit or 9s. A@,@@@ for the whole lot but not more. The short run incremental cost 2ignoring the fixed cost3 is only 9s. G.@@. Therefore, the contribution to overhead and profit is 9e. 1.@@ per unit 29s. B,@@@ for the lot. However, the long run repercussions of the order ought to be ta!en into account are as follows1 $f the management commits itself with too much of business at lower prices or with a small contribution, it may not have sufficient capacity to ta!e up business with higher contributions when the opportunity arises. The management may be compelled to consider the %uestion of expansion of capacity and in such cases7 even the so called fixed costs may become variable. $f any particular set of customers come to !now about this low price, they may demand a similar low price. -uch customers may complain of being treated unfairly and feel discriminated. $n response, they may opt to patronise manufacturers with more decent views on pricing. The reduction or prices under conditions of excess capacity may adversely affect the image of the company in the minds of its clientele, which will in turn affect its sales. $t is, therefore, important to give due consideration to the time perspective. The principle of time perspective may be stated as under1 +) decision should ta!e into account both the short run and long run effects on revenues and costs and maintain the right balance between the long run and short run perspectives.0 Haynes, Mote and 6aul have cited the case of a printing company. This company pursued the policy of never %uoting prices below full cost though it often experienced idle capacity and the management was fully aware that the incremental cost was far below full cost. This was because the management realised that the long run repercussions of pricing below full cost would ma!e up for any short run gain. The management felt that the reduction in rates for some customers might have an undesirable effect on customer goodwill particularly among regular customers not benefiting from price reductions. $t wanted to avoid crating such an /image0 of the firm that it exploited the mar!et when demand was favorable but which was willing to negotiate prices downward when demand was unfavorable. 85 Di$co'nting Princi#le (ne of the fundamental ideas in economics is that a rupee tomorrow is worth less than a rupee today. This seems similar to the saying that a bird in hand is worth two in the bush. ) simple example would ma!e this point clear. -uppose a person is offered a choice to ma!e between a gift of 9s. 1@@ today or 9s. 1@@ next year. .aturally he will choose the 9s. 1@@ today. This is true for two reasons. #irst, the future is uncertain and there may be uncertainty in getting 9s. 1@@ if the present opportunity is not availed of. -econdly, even if he is sure to receive the gift in future,

today,s 9s. 1@@ can be invested so as to earn interest, say, at D percent so that. one year after the 9s. 1@@ of today will become 9s. 1@D whereas if he does not accept 9s. 1@@ today, he will get 9s. 1@@ only in the next year. .aturally, he would prefer the first alternative because he is li!ely to gain by 9s. D in future. )nother way of saying the same thing is that the value of 9s. 1@@ after one year is not e%ual to the value of 9s. 1@@ of today but less than that. To find out how much money today is e%ual to 9s. 1@@ would earn if one decides to invest the money. -uppose the rate of interest is D percent. Then we shall have to discount 9s. 1@@ at D per cent in order to ascertain how much money today will become 9s. 1@@ one year after. The formula is1 IJ where, I J present value i J rate of interest. .ow, applying the formula, we get IJ J 9s. 1@@ 1Ki 1@@ 1.@D 9s. 1@@ 1Ki

$f we multiply 9s. LA.BL by 1.@D, we shall get the amount of money, which will accumulate at D per cent after one year. LA.BL x 1.@D J LL.@@EA J 1.@@ The same reasoning applies to longer periods. ) sum of 9s. 1@@ two years from now is worth1 IJ 9s. 1@@ 21Ki3A J 9s. 1@@ 21.@D3A J 9s. 1@@ 1.1FFH

-imilarly, we can also chec! by computing how much the cumulative interest will be after two years. The principle involved in the above discussion is called the discounting principle and is stated as follows1 /$f a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.0 95 E+'i-& rgin l Princi#le This principle deals with the allocation of the available resource among the alternative activities. )ccording to this principle, an input should be allocated in such a way that the value added by the last unit is the same in all cases. This generalisation is called the e%ui marginal principle. -uppose a firm has 1@@ units of labour at its disposal. The firm is engaged in four activities, which need labour services, vi'., ), B, 5 and ". $t can enhance any one of these activities by adding more labour but sacrificing in return the cost of other activities. $f the value of the marginal product is higher in one activity than another, then it should be assumed that an optimum allocation has not been attained. Hence it would, be profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products ta!en together. #or example, if the values of certain two activities are as follows1

Ialue of Marginal 6roduct of labour )ctivity ) J 9s. A@ )ctivity B J 9s. G@ $n this case it will be profitable to shift labour from ) to activity B thereby expanding activity B and reducing activity ). The optimum will be reach when the value of the marginal product is e%ual in all the four activities or, when in symbolic terms1 IM6;) J IM6;B J IM6;5 J IM6;" *here the subscripts indicate labour in respective activities. 5ertain aspects of the e%ui marginal principle need clarifications, which are as follows1 #irst, the values of marginal products are net of incremental costs. $n activity B, we may add one unit of labour with an increase in physical output of 1@@ units. Each unit is worth B@ paise so that the 1@@ units will sell for 9s. B@. But the increased output consumes raw materials, fuel and other inputs so that variable costs in activity B 2not counting the labour cost3 are higher. ;et us say that the incremental costs are 9s. G@ leaving a net addition of 9s. A@. The value of the marginal product relevant for our purpose is thus 9s. A@. -econdly, if the revenues resulting from the addition of labour are to occur in future, these revenues should be discounted before comparisons in the alternative activities are possible. )ctivity ) may produce revenue immediately but activities B, 5 and " may ta!e A, G and B years respectively. Here the discounting of these revenues will ma!e them e%uivalent. Thirdly, the measurement of value of the marginal product may have to be corrected if the expansion of an activity re%uires an alternative reduction in the prices of the output. $f activity B represents the production of radios and it is not possible to sell more radios without a reduction in price, it is necessary to ma!e ad&ustment for the fall in price. #ourthly, the e%ui marginal principle may brea! under sociological pressures. #or instance, du to inertia, activities are continued simply because they exist. -imilarly, due to their empire building ambitions, managers may !eep on expanding activities to fulfil their desire for power. "epartment, which are already over budgeted often, use some of their excess resources to build up propaganda machines 2public relations offices3 to win additional support. Movernmental agencies are more prone to bureaucratic self perpetuation and inertia. G #$ (et-een T"eor0 o% t"e Fir& n! & n geri l Econo&ic$ The theory of the firm is a body of theory, which contains certain assumptions, theorems and conclusions. These theorems deal with the way in which businessmen ma!e decisions about pricing, and production under prescribed mar!et conditions. $t is concerned with the study of the optimisation process. #or optimality to exist profit must be maximised and this can occur only when marginal cost e%uals marginal revenue. Thus, the optimum position of the firm is that which maximises net revenue. Managerial economics, on the other hand, aims at developing a managerial theory of the firm and for the purpose it ta!es the help of economic theory of the firm. However, there are certain difficulties in using economic theory as an aid to the study of decision ma!ing at the level of the firm. This is because for the purposes of business decision ma!ing it fails to provide sufficient analytical tools that are useful to managers. -ome of the reasons are as follows1

8nderlying all economic theory is the assumption that the decision ma!er is omniscient and rational or simply that he is an economic man. Thus being omniscient means that he !nows the alternatives that are available to him as well as the outcome of any action he chooses. The model of /economic man0 however as an omniscient person who is confronted with a compete set of !nown or probabilistic outcomes is a distorted representation of reality. The typical business decision ma!er usually has limited information at his disposal, limited computing ability and a limited number of feasible alternatives involving varying degrees of ris!. #urther, the net revenue function, which he is expected to maximise, and the marginal cost and marginal revenue functions, which he is expected to e%uate, re%uire excessive !nowledge of information, which is not !nown and cannot be obtained even by the most careful analysis. Hence, it is absurd to expect a manager to maximise and e%ualise certain critical functional relationships, which he does not !now and cannot find out.

$n micro economic theory, the most profitable output is where marginal cost 2M53 and marginal revenue 2M93 are e%ual. $n #igure 1.A, the most profitable output will be at (. where M9JM5. This is the point at which the slope of the profit function or marginal profit is 'ero. This is highlighted in #igure 1.G where the most profitable output will be again at (.. $n economic theory, the decision ma!er has to identify this uni%ue output level, which maximises profit.

$n real world, however, a complexity often arises, vi'., certain resource limitations exist. )s a result, it is not possible to attain the maximum output level 2(.3. $n practical terms the maximum output possible as a result of resource limitations is, say, (M. .ow the problem before the decision ma!er is to find out whether the output, which maximises profit, is (M or some other level of output to the left of (M. $t is obvious that economic theory is of no help for (. level of output because it is not relevant in view of the resource limitations. ) managerial economist here has to ta!e the aid of linear programming, which enables the manager to optimise or search for the best values within the limits set by ine%uality conditions. )nother central assumption in the economic theory of the firm is that the entrepreneur strives to maximise his residual share, or profit. -everal criticisms of this assumption have been made1 o The theory is ambiguous, as it doesn,t clarify. *hether it is short or long run profit that is to be maximised. #or example, in the short run, profits could be maximised by firing all research and development personnel and thereby eliminating considerable

immediate expenses. This decision would, however, have a substantial impact on long run profitability. o 5ertain %uestions create some confusion around the concept of profit maximisation. -hould the firm see! to maximise the amount of profit or the rate of profit= *hat is the rate of profit= $s it profit in relation to total capital or profit in relation to shareholders, e%uity= o There is no allowance for the existence of /psychic income0 2$ncome other than monetary, power, prestige, or fame3, which the entrepreneur might obtain from the firm, %uite apart from his monetary income. o The theory does not recognise that under modern conditions, owners and managers are separate and distinct groups of people and the latter may not be motivated to maximise profits. o o 8nder imperfect competition, maximisation is an ambiguous goal, because actions that are optimal for one will depend on the actions of the other firms. The entrepreneur may not care to receive maximum profits but may simply want to earn /satisfactory profits0. This last point is particularly relevant from the behavioural science standpoint because it introduces a concept of satiation. The notion of satiation plays no role in classical economic theory. To explain business behaviour in terms of this theory, it is necessary to assume that the firm,s goals are not concerned with maximising profit, but with attaining a certain level or rate of profit, holding a certain share of the mar!et or a certain level of sales. #irms would try to satisfy rather than maximise. But according to -imon the satisfying model damages all the conclusions that can be derived concerning resource allocation under perfect competition. $t focuses on the fact that the classical theory of the firm is empirically incorrect as a description of the decision ma!ing process. Based on this notion of satiation, it appears that one of the main strengths of classical economic theory has been seriously wea!ened. Most corporate underta!ings involve the investment of funds, which are expect to produce revenues over a number of years. The profit maximisation criterion provides no basis for comparing alternatives that can promise varying flows of revenue and expenditure over time. The practical application of profit maximisation concept also has another limitation. $t provides no explicit way of considering the ris! associated with alternative decisions. Two pro&ects generating similar expected revenues in the future and re%uiring similar outlays might differ vastly as regarding the degree of uncertainty with which the benefits to be generated. The greater the uncertainty associated with the benefits, the greater the ris! associated with the pro&ect. Baumol on the other hand is of the view that firms do not devote all their energies to maximising profit. 9ather a company will see! to maximise its sales revenue as long as a satisfactory level of profit is maintained. Thus Baumol has substituted /Total sales revenue0 for profits. )lso, two decision criteria or ob&ectives have been advanced vi'., a satisfactory level of profit and the highest sales possible. $n other words, the firm is no longer viewed as wor!ing

towards one ob&ective alone. $nstead, it is portrayed as aiming at balancing two competing and non consistent goals. Baumol,s model is based on the view that managers, salaries, their status and other rewards often appear as closely related to the companies, si'e in which they wor! and is measured by sales revenue rather than their profitability. )s such, managers may be more concerned to increased si'e than profits. )nd the firm,s ob&ective thus becomes sales maximisation rather than profits maximisation. Empirical studies of pricing behaviour also give results that differ from those of the economic theory of firm as can be seen from the following examples1 o -everal studies of the pricing practices of business firms have indicated that managers tend to set prices by applying some sort of a standard mar! up on costs. They do not attempt to estimate marginal costs, marginal revenues or demand elasticities, even if these could be accurately measured. o o #or many firms, prices are more often set to attain, a particular target return on investment, say, 1@ per cent, than to maximise short or long run profits. There is some evidence that firms experiencing declining mar!et shares in their industry strive more vigorously to increase their sales than do competing firms, which are experiencing steady or increasing mar!et shares. )n alternative model to profit maximisation is the concept of wealth maximisation, which assumes that firms see! to maximise the present value of expected net revenues over all periods within the forecasted future. )s pointed out by Haynes and Henry, a study of the behaviour of actual firms shows that their decisions are not completely determined by the mar!et. These firms have some freedom to develop decisions, strategies or rules, which become part of the decision ma!ing system within the firm. This gap in economic theory has led to what has come to be !nown as +Behavioural Theory of the #irm,. This theory, however, does not replace the former but rather powerfully supplements it. The behavioural theory represents the firm as an adoptive institution. $t learns from experience and has a memory. (rganisational behaviour, is embodies into decision rules and standard operating procedures. These may be altered over long run as the firm reacts to /feedbac!0 from experience. However, in the short run, decisions of the organisation are dominated by its rules of thumb and standard methods. CONCLUSION The various gaps between the economic theory of the firm and the actual decision ma!ing process at the firm level are many in number. They do, however, stress that economic theory seriously needs ma&or fixing up and substantial changes are in progress for creating better and different models. Thus the classical economic concepts li!e those of rational man is undergoing important changes7 the notion of satisfying is pushing aside the aim of maximisation and newer lines and patterns of thoughts are being developed for finding improved applications to managerial decision ma!ing. ) strong emphasis is laid on %uantitative model building, experimentation and empirical investigation and newer techni%ues and concepts, such as

linear programming, game theory, statistical decision ma!ing, etc., are being applied to revolutionise the approaches to problem solving in business and economics. Module A "emand analysis $n economic terminology the term demand conveys a wider and definite meaning than in the ordinary usage. (rdinarily demand means a desire, whereas in economic sense it is something more than a mere desire. $t is interpreted as a want bac!ed up by the purchasing power. #urther demand is per unit of time such as per day, per wee! etc. moreover it is meaningless to mention demand without reference to price. 5onsidering all these aspects the term demand can be defined in the following words, /"emand for anything means the %uantity of that commodity, which is bought, at a given price, per unit of time.0 "emand J "esire K willingness to buy K ability to pay L - O% De& n! - De& n! Price Rel tion$"i# This law explains the functional relationship between price of a commodity and the %uantity demanded of the same. $t is observed that the price and the demand are inversely related which means that the two move in the opposite direction. )n increase in the price leads to a fall in the demand and vice versa. This relationship can be stated as /(ther things being e%ual, the demand for a commodity varies inversely as the price0 or /The demand for a commodity at a given price is more than what it would be at a higher price and less than what it would be at a lower price0 De& n! Sc"e!'le or De& n! T (le These are the two devices to present the law. The demand schedule is a schedule or a table which contains various possible prices of a commodity and different %uantities demanded at them. $t can be an individual demand schedule representing the demand of an individual consumer or can be the mar!et demand schedule showing the total demand of all the consumers ta!en together, this is indicated in the following table.

$t can be observed that with a fall in price every individual consumer buys a larger %uantity than before as a result of which the total mar!et demand also rises. $n case of an increase in price the situation will be reserved. Thus the demand schedule reveals the inverse price demand relationship, i.e. the ;aw of "emand. De& n! C'r)e DD

$t is a geometrical device to express the inverse price demand relationship, i.e. the law of demand. ) demand curve can be obtained by plotting a demand schedule on a graph and &oining the points so obtained, li!e the demand schedule we can derive an individual demand curve as well as a mar!et demand curve. The former shows the demand curve of an individual buyer while the latter shows the sum total of all the individual curves i.e. a mar!et or a total demand curve. The following diagram shows the two types of demand curves.

$n the above diagram, figure 2)3 shows an individual demand curve of any individual consumer while figure 2B3 indicates the total mar!et demand. $t can be noticed that both the curves are negatively sloping or downwards sloping from left to right. -uch a curve shows the inverse relationship between the two variables. $n this case the two variable are price on : axis and the %uantity demanded on ? axis. $t may be noted that at a higher price (6 the %uantity demanded is (M while at a lower price say (61, the %uantity demanded rises to (M1 thus a demand curve diagrammatically explains the law of demand. A$$'&#tion$ o% t"e :L - o% De& n!: The law of demand in order to establish the price demand relationship ma!es a number of assumptions as follows1 1. A. G. H. $ncome of the consumer is given and constant. .o change in tastes, preference, habits etc. 5onstancy of the price of other goods. .o change in the si'e and composition of population.

These )ssumptions are expressed in the phrase /other things remaining e%ual0. E.ce#tion$ o% t"e :L - o% De& n!: $n case of ma&or bul! of the commodities the validity of the law is experienced. However there are certain situations and commodities which do not follow the law. These are termed as the exceptions to the law7 these can be expressed as follows1 1. 5ontinuous changes in the price lead to the exceptional behavior. $f the price shows a rising trend a buyer is li!ely to buy more at a high price for protecting himself against a further rise. )s against it when the price starts falling continuously, a consumer buys less at a low price and awaits a further in price. Miffens,s 6aradox describes a peculiar experience in case of inferior goods. *hen the price of an inferior commodity declines, the consumer, instead of purchasing more, buys less of that commodity and switches on to a superior commodity. Hence the exception. 5onspicuous 5onsumption refers to the consumption of those commodities which are bought as a matter of prestige. .aturally with a fall in the price of such goods, there is no distinction in buying the same. )s a result the demand declines with a fall in the price of such prestige goods. $gnorance Effect implies a situation in which a consumer buys more of a commodity at a higher price only due to ignorance.

A. G. H.

$n the exceptional situations %uoted above, the demand curve becomes an upwards rising one as shown in the alongside diagram. $n the alongside figure, the demand curve is positively sloping one due to which more is demanded at a high price and less at a low price. Deter&in nt$ ;F ctor$ A%%ecting< o% De& n! The law of demand, while explaining the price demand relationship assumes other factors to be constant. $n reality however, these factors such as income, population, tastes, habits, preferences etc., do not remain constant and !eep on affecting the demand. )s a result the demand changes i.e. rises or falls, without any change in price. 1. A. G. Inco&e1 The relationship between income and the demand is a direct one. $t means the demand changes in the same direction as the income. )n increase in income leads to rise in demand and vice versa. Po#'l tion1 The si'e of population also affects the demand. The relationship is a direct one. The higher the si'e of population, the higher is the demand and vice versa. T $te$ n! / (it$1 The tastes, habits, li!es, disli!es, pre&udices and preference etc. of the consumer have a profound effect on the demand for a commodity. $f a consumers disli!es a commodity, he will not buy it despite a fall in price. (n the other hand a very high price also may not stop him from buying a good if he li!es it very much. Ot"er Price$1 This is another important determinant of demand for a commodity. The effects depends upon the relationship between the commodities in %uestion. $f the price of a complimentary commodity rises, the demand for the commodity in reference falls. E.g. the demand for petrol will decline due to rise in the price of cars and the conse%uent decline in their demand. (pposite effect will be experienced incase of substitutes. A!)erti$e&ent1 This factor has gained tremendous importance in the modern days. *hen a product is aggressively advertised through all the possible media, the consumers buy the advertised commodity even at a high price and many times even if they don,t need it. F $"ion$1 Hardly anyone has the courage and the desire to go against the prevailing fashions as well as social customs and the traditions. This factor has a great impact on the demand. I&it tion1 This tendency is commonly experienced everywhere. This is !nown as the demonstration effects, due to which the low income groups imitate the consumption patterns of the rich ones. This operates even at international levels when the poor countries try to copy the consumption patterns of rich countries.

H.

B. F. E.

= ri tion & C" nge$ In De& n!

The law of demand explains the effect of only one factor vi'., price, on the demand for a commodity, under the assumption of constancy of other determinants. $n practice, other factors such as, income, population etc. cause the rise or fall in demand without any change in the price. These effects are different from the law of demand. They are termed as changes in demand in contrast to variations in demand which occur due to changes in the price of a commodity. $n economic theory a distinction is made between 2a3 Iariations i.e. extension and contraction in demand due to price and 2b3 5hanges i.e. increase and decrease in demand due to other factors. ; < = ri tion$ in !e& n! re%er to t"o$e -"ic" occ'r !'e to c" nge$ in t"e #rice o% These are two types. 1. A. E.ten$ion o% De& n!1 This refers to rise in demand due to a fall in price of the commodity. $t is shown by a downwards movement on a given demand curve. Contr ction o% De& n!1 This means fall in demand due to increase in price and can be shown by an upwards movement on a given demand curve. co&&o!it05

;(< C" nge$ in !e& n! i&#l0 t"e ri$e n! % ll !'e to % ctor$ ot"er t" n #rice5 $t means they occur without any change in price. They are of two types. 1. A. Incre $e in De& n!1 This refers to higher demand at the same price and results from rise in income, population etc., this is shown on a new demand curve lying above the original one. Decre $e in !e& n!1 $t means less %uantity demanded at the same price. This is the result of factors li!e fall in income, population etc. this is shown on a new demand lying below the original one.

#ig 2)3 Extension>5ontraction of "emand #ig 2B3 $ncrease>"ecrease in "emand $n figure ), the original price is (6 and the Nuantity demanded is (N. *ith a rise in price from (6 to (61 the demand contracts from (N to (N1 and as a result of fall in price from (6 to (6A, the demand extends from (N to (NA. $n figure, B an increase in demand is shown by a new demand curve, "1 while the decrease in demand is expressed by the new demand curve "A, lying above and below the original demand curve " respectively. (n "1 more is demand 2(N13 at the same price while on "A less is demanded 2(NA3 at the same price (6. El $ticit0 o% De& n! The law of demand explains the functional relationship between price and demand. $n fact, the demand for a commodity depends not only on the price of a commodity but also on other factors such as income, population, tastes and preferences of the consumer. The law of demand assumes these factors to be constant and states the inverse price demand relationship. Barring certain exceptions, the inverse price demand relationship holds good in case of the goods that are bought and sold in the mar!et. The law of demand explains the direction of a change as it states that with a rise in price the demand contracts and with a fall in price it expands. However, it fails to explain the extent or magnitude of a change in demand with a given change in price. $n other words, the law of demand merely shows the direction in which the demand changes as a result of a change in price, but does not throw any light on the amount by which the demand will change in response to a given change in price. Thus, the law of demand explains the %ualitative but not the %uantitative aspect of price demand relationship. )lthough it is true that demand responds to change in price of a commodity, such response varies from commodity to commodity. -ome commodities are more responsive or sensitive to change in price while some others are less. The concept of the elasticity of demand has great significance as it explains the degree of responsiveness of demand to a change in price. $t thus elaborates the price demand relationship. The elasticity of demand thus means the sensitiveness or responsiveness of demand to a change in price. )ccording to Marshall, /the elasticity 2or responsiveness3 of demand in a mar!et is great or small accordingly as the demand changes 2rises or falls3 much or little for a given change 2rise or fall3 in price.0 #rom the above discussion, it will be clear that thought different commodities react to a change in price in the same direction7 the degree of their response differs. "emand for some commodities is more sensitive or responsive to a change in price, while it is less responsive for some others. Elasticity of demand is a measure of relative changes in the amount demanded in response to a small change in price. 5ertain goods are said to have an elastic demand while others have an inelastic demand. The demand is said to be elastic

when a small change in price brings about considerable change in demand. (n the other hand, the demand for a good is said to be inelastic when a change in price fails to bring about significant change in demand. The concept of elasticity can be expressed in the form of an e%uation as1 Ep J O6ercentage change in %uantity demanded > 6ercentage change in the priceP T0#e$ o% Price El $ticit0 The concept of price elasticity reveals that the degree of responsiveness of demand to the change in price differs from commodity to commodity. "emand for some commodities is more elastic while that for certain others is less elastic. 8sing the formula of elasticity, it possible to mention following different types of price elasticity1 1. A. G. H. B. 6erfectly inelastic demand 2ep J @3 $nelastic 2less elastic3 demand 2e Q 13 8nitary elasticity 2e J 13 Elastic 2more elastic3 demand 2e R 13 6erfectly elastic demand 2e J S3

45

Per%ectl0 inel $tic !e& n! ;e# > ?< This describes a situation in which demand shows no response to a change in price. $n other words, whatever be the price the %uantity demanded remains the same. $t can be depicted by means of the alongside diagram. The vertical straight line demand curve as shown alongside reveals that with a change in price 2from (6 to (p13 the demand remains same at (N. Thus, demand does not at all respond to a change in price. Thus ep J (. Hence, perfectly inelastic demand. #ig a

65

Inel $tic ;le$$ el $tic< !e& n! ;e @ 4< $n this case the proportionate change in demand is smaller than in price. The alongside figure shows this type.

$n the alongside figure percentage change in demand is smaller than that in price. $t means the demand is relatively c less responsive to the change in price. This is referred to as an inelastic demand. #ig e 75 Unit r0 el $ticit0 !e& n! ;e > 4< *hen the percentage change in price produces e%uivalent percentage change in demand, we have a case of unit elasticity. The rectangular hyperbola as shown in the figure demonstrates this type of elasticity. $n this case percentage change in demand is e%ual to percentage change in price, hence e J 1. #ig c 85 El $tic ;&ore el $tic< !e& n! ;e A 4< $n case of certain commodities the demand is relatively more responsive to the change in price. $t means a small change in price induces a significant change in, demand. This can be understood by means of the alongside figure. $t can be noticed that in the above example the percentage change in demand is greater than that in price. Hence, the elastic demand 2eR13 #ig d 95 Per%ectl0 el $tic !e& n! ;e > B< This is experienced when the demand is extremely sensitive to the changes in price. $n this case an insignificant change in price produces tremendous change in demand. The demand curve showing perfectly elastic demand is a hori'ontal straight line. #ig b $t can be noticed that at a given price an infinite %uantity is demanded. ) small change in price produces infinite change in demand. ) perfectly competitive firm faces this type of demand. #rom the above analysis it can be concluded that theoretically five different types of price elasticity can be mentioned. $n practice, however two extreme cases i.e. perfectly elastic and perfectly inelastic demand, are rarely experienced. *hat we really have is more elastic 2e R 13 or less elastic 2e Q 1 3 demand. The unitary elasticity is a dividing line between these two cases. Deter&in nt$ o% El $ticit0

1.

A.

G.

H. B.

N t're o% t"e Co&&o!it01 Humans wants, i.e. the commodities satisfying them can be classified broadly into necessaries on the one hand and comforts and luxuries on the other hand. The nature of demand for a commodity depends upon this classification. The demand for necessities is inelastic and for comforts and luxuries it is elastic. N'&(er o% S'($tit'te$ A) il (le1 The availability of substitutes is a ma&or determinant of the elasticity of demand. The large the number of substitutes, the higher is the elastic. $t means if a commodity has many substitutes, the demand will be elastic. )s against this in the absence of substitutes, the demand becomes relatively inelastic because the consumers have no other alternative but to buy the same product irrespective of whether the price rises or falls. N'&(er O% U$e$1 $f a commodity can be put to a variety of uses, the demand will be more elastic. *hen the price of such commodity rises, its consumption will be restricted only to more important uses and when the price falls the consumption may be extended to less urgent uses, e.g. coal electricity, water etc. Po$$i(ilit0 o% Po$t#one&ent o% Con$'&#tion1 This factor also greatly influences the nature of demand for a commodity. $f the consumption of a commodity can be postponed, the demand will be elastic. R nge o% #rice$1 The demand for very low priced as well as very high price commodity is generally inelastic. *hen the price is very high, the commodity is consumed only by the rich people. ) rise or fall in the price will not have significant effect in the demand. -imilarly, when the

F. E. D. L.

price is so low that the commodity can be brought by all those who wish to buy, a change, i.e., a rise or fall in the price, will hardly have any effect on the demand. Pro#ortion o% Inco&e S#ent1 $ncome of the consumer significantly influences the nature of demand. $f only a small fraction of income is being spent on a particular commodity, say newspaper, the demand will tend to be inelastic. )ccording to Taussig, une%ual distribution of income and wealth ma!es the demand in general, elastic. $n addition, it is observed that demand for durable goods, is usually elastic. The nature of demand for a commodity is also influenced by the co&#le&ent ritie$ o% goo!$.

#rom the above analysis of the determinants of elasticity of demand, it is clear that no precise conclusion about the nature of demand for any specific commodity can be drawn. $t depends upon the range of price, and the psychology of the consumers. The conclusion regarding the nature of demand should, therefore be restricted to small changes in prices during short period. By doing so, the influence of changes in habits, tastes, li!es customs etc., can be ignored. Me $'re&ent o% El $ticit0 #or practical purposes, it is essential to measure the exact elasticity of demand. By measuring the elasticity we can !now the extent to which the demand is elastic or inelastic. "ifferent methods are used for measuring the elasticity of demand. 1. Percent ge Met"o!1 $n this method, the percentage change in demand and percentage change in price are compared. ep J O6ercentage change in demand > 6ercentage change in priceP $n this method, three values of +ep, can be obtained. Ii'., ep J 1, ep R 1, ep R 1. $f BC change in price leads to exactly BC change in demand, i.e. percentage change in demand is e%ual to percentage change in price , e J 1, it is a case of unit elasticity. o $f percentage change in demand is greater than percentage change in price, e R 1, it means the demand is elastic. o $f percentage change in demand is less than that in price, e R 1, meaning thereby the demand is inelastic. Tot l O'tl 0 Met"o!1 The elasticity of demand can be measured by considering the changes in price and the conse%uent changes in demand causing changes in the total amount spent on the goods. The change in price changes the demand for a commodity which in turn changes the total expenditure of the consumer or total revenue of the seller. o $f a given change in price fails to bring about any change in the total outlay, it is the case of unit elasticity. $t means if the total revenue 2price x Nuantity bought3 remains the same in spite of a change in price, +ep, is said to be e%ual to 1 o $f price and total revenue are inversely related, i.e., if total revenue falls with rise in price or rises with fall in price, demand is said to be elastic or e R 1. o *hen price and total revenue are directly related, i.e. if total revenue rises with a rise in price and falls with a fall in price, the demand is said to be inelastic pr e Q 1. )nother suggested by Marshall is to measure elasticity at a point on a straight line is called 6oint Method

A.

G.

Inco&e El $ticit0 o% De& n! The discussion of price elasticity of demand reveals that extent of change in demand as a result of change in price. However, as already explained, price is not the only determinant of demand. "emand for a commodity changes in response to a change in income of the consumer. $n fact, income effect is a constituent of the price effect. The income effect suggests the effect of change in income on demand. The income elasticity of demand explains the extent of change in demand as a result of change in income. $n other words, income elasticity of demand means the responsiveness of demand to changes in income. Thus, income elasticity of demand can be expressed as1

E: J O6ercentage change in demand > 6ercentage change in incomeP The following types of income elasticity can be observed1 1. A. G. H. B. $ncome Elasticity of "emand Mreater than (ne1 *hen the percentage change in demand is greater than the percentage change in income, a greater portion of income is being spent on a commodity with an increase in income income elasticity is said to be greater than one. $ncome Elasticity is unitary1 *hen the proportion of income spent on a commodity remains the same or when the percentage change in income is e%ual to the percentage change in demand, E: J 1 or the income elasticity is unitary. $ncome Elasticity ;ess Than (ne 2E:Q 131 This occurs when the percentage change in demand is less than the percentage change in income. Tero $ncome Elasticity of "emand 2E:Jo31 This is the case when change in income of the consumer does not bring about any change in the demand for a commodity. .egative $ncome Elasticity of "emand 2E:Q o31 $t is well !nown that income effect for most of the commodities is positive. But in case of inferior goods, the income effect beyond a certain level of income becomes negative. This implies that as the income increases the consumer, instead of buying more of a commodity, buys less and switches on to a superior commodity. The income elasticity of demand in such cases will be negative.

Cro$$ El $ticit0 o% De& n! *hile discussing the determinants of demand for a commodity, we have observed that demand for a commodity depends not only on the price of that commodity but also on the prices of other related goods. Thus, the demand for a commodity ? depends not only on the price of ? but also on the prices of other commodities :, TU.. etc. The concept of cross elasticity explains the degree of change in demand for ? as, a result of change in price of :. This can be expressed as1 E5 J O6ercentage 5hange in demand for ? > 6ercentage change in price of :P The relationship between any two goods is of two types. The goods ? and : can be complementary goods 2such as pen and in!3 or substitutes 2such as pen and ball pen3. $n case of complementary commodities, the cross elasticity will be negative. This means that fall in price of ? 2pen3 leads to rise in its demand so also rise in t3 demand for : 2in!3 (n the other hand, the cross elasticity for substitutes is positive which means a fall in price of ? 2pen3 results in rise in demand for ? and fall in demand for : 2ball pen3. $f two commodities, say ? and :, are unrelated there will be no change i. "emand for ? as a result of change in price of :. 5ross elasticity in cad of such unrelated goods will then be 'ero. $n short, cross elasticity will be of three types1 1. A. G. .egative cross elasticity < 5omplementary commodities. 6ositive cross elasticity < -ubstitutes. Tero cross elasticity < 8nrelated goods.

I&#ort nce o% El $ticit0 The concept of elasticity is of great importance both in economic theory and in practice. 1. A. Theoretically, its importance lies in the fact that it deeply analyses the price demand relationship. The law of demand merely explains the %ualitative relationship while the concept of elasticity of demand analyses the %uantitative price demand relationship. The 6ricing policy of the producer is greatly influenced by the nature of demand for his product. $f the demand is inelastic, he will be benefited by charging a high price. $f on the other hand, the demand is elastic, low price will be advantageous to the producer. The concept of elasticity helps the monopolist while practicing the price discrimination. The price of &oint products can be fixed on the basis of elasticity of demand. $n case of such &oint products, such as wool and mutton, cotton and cotton seeds, separate costs of production are not

G.

H. B. F.

E.

!nown. High price is charged for a product having inelastic demand 2say cotton3 and low price for its &oint product having elastic demand 2say cotton seeds3. The concept of elasticity of demand is helpful to the Movernment in fixing the prices of public utilities. The Elasticity of demand is important not only in pricing the commodities but also in fixing the price of labour vi'., wages. The concept of elasticity of demand is useful to Movernment in formulation of economic policy in various fields such as taxation, international trade etc. 2a3 The concept of elasticity of demand guides the finance minister in imposing the commodity taxes. He should tax such commodities which have inelastic demand so that the Movernment can raise handsome revenue.2b3 The concept of elasticity of demand helps the Movernment in formulating commercial policy. 6rotection and subsidy is granted to the industries which face an elastic demand. The concept of elasticity of demand is very important in the field international trade. $t helps in solving some of the problems of international trade such as gains from trade, balance of payments etc. policy of tariff also depends upon the nature of demand for a commodity.

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

COST CONCEPTS

Business decisions are generally ta!en on the basis of money values of the inputs and outputs. The cost production expressed in monetary terms is an important factor in almost all business decisions, specially those pertaining to 2a3 locating the wea! points in production management7 2b3, minimising the cost7 2c3 finding out the opt&mum level of output7 and 2d3 estimating or pro&ecting the cost of business operations. Besides, the term VcostV has different meanings under different settings and is sub&ect to varying interpretations. $t is therefore essential that only relevant concept of costs is used in the business decisions.

CONCEPT OF COST

The concepts of cost, which are relevant to business operations and decisions, can be grouped, on the basis of their purpose, under two overlapping categories such as concepts used for accounting purposes and concepts used in economic analysis of business activities. SOME ACCOUNTING CONCEPTS OF COST O##ort'nit0 Co$t n! Act' l Co$t (pportunity cost is the loss incurred due to the unavoidable situations such as scarcity of resources. $f resources were unlimited, there would be no need to forego any income yielding opportunity and, therefore, there would be no opportunity cost. 9esources are scarce but have alternative uses with different returns, 9esource owners who aim at maximising of income put their scarce resources to their most productive use and forego the income expected from the second best use of the resources. Thus, the opportunity cost may be defined as the expected returns from the second best use of the resources foregone due to the scarcity of resources. The opportunity cost is also called the alternative cost. #or example, suppose that a person has a sum of 9s. l((,((( for which he has only two alternative uses. He can buy either a printing machine or, alternatively, a lathe machine. #rom printing machine, he expects an annual income of 9s. A@,@@@ and from the lathe, 9s. 1B,@@@. $f he is a profit maximising investor, he would invest his tnoney in printing machine and forego the expected income from the lathe. The opportunity cost of his income from printing machine is,W the expected income from the lathe machine, i.e., 9s. lB,@@@. The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost of using resources in theV6rinting business is the best opportunity ahdthe expected return from the lathe machine is the second best alternative. $n assessing the alternative cost, both explicit and implicit costs are ta!en into account. )ssociated with the concept of opportunity cost is the concept of economic rent or economic profit. $n our example, economic rent of the printing machine is the excess of its earning over the income expected from the lathe machine 2i.e., 9s. A@,@@@ 9s. 1B,@@@ J 9s. B,@@@3. The implication of this concept for a businessman is that investing in printing machine is preferable as long as its economic rent is greater than 'ero. )lso, if firms have !nowledge of the economic rent of the various alternative uses of their resources, it will be helpful for them to choose the best $nvestment ) venue. $n contrast to opportunity cost, actual costs are those which are actually incurred by the firm in the payment for labour, material, plant, building, machinery, e%uipments, travelling and transport, advertisement, etc. The total money expenditures, recorded in theV boo!s of accounts are, the actual costs, Therefore, the actual cost comes under the accounting concept. B'$ine$$ Co$t$ n! F'll Co$t$ Business.costs include all the expenses, which are incurred to carry out a business. The concept of business costs is similar to the actual or the real costs. Business costs include all the payments andV contractual obligations made by the firm together with the boo! cost of depreciation on plant and e%uipment. These cost concepts are used for calculating business profits and losses, for filing returns for income tax and for other legal purposes. The concept of full costs, include business costs, opportunity cost and. normal profit. )s stated earlier the opportunity cost includes the expected earning from the second best use of the resources, or the mar!et rate of interest on the total money capital and the value of

entrepreneurVs own services, which are not charged forVin the current business. .ormal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its present occupation.

E.#licit n! I&#licit or I&#'te! Co$t$ Explicit costs are those, which fall under actual or business costs entered in the boo!s of accounts. #or example, the payments for wages and salaries, materials, licence fee, insurance premium and depreciation charges etc. These costs involve cash payment and, are recorded in normal accounting practices. $n contrast with these costs, there are other costs, which neither ta!e the form of cash outlays, nor do they appear in the accounting system. -uch costs are !nown as implicit or imputed costs. $mplicit costs may be defined as the earning expected froin thesecond best alternative use of resources. #or example, suppose an entrepreneur does not utilise his services in his own business and wor!s as a manager in Wsome other firm on a salary basis. $f he starts his own business, he foregoes his salary as a manager. This loss of salary is the opportunity cost of income from his business. This is an implicit cost of his business. The cost is implicit, because the entrepreneur suffers the loss, but does not charge it as the explicit cost of his own business. $mplicit costs are not ta!en into account while calculating the loss or gains of the business, but they form an important consideration in whether or not a factor would remain in its present occupation. The explicit and implicit costs together ma!e the economic cost.

O't-o%-Poc,et n! Boo, Co$t$ The items of expenditure, which involve cash payments or cash transfers recurring and non recurring are !nown as out of poc!et costs. )ll the explicit costs such as wage, rent, interest and transport expenditure. (n the contrary, there are actual business costs, which do not involve cash payments, but a provision is made for them in the boo!s of account. Thes costs are ta!en into account while finalising the profit and loss accounts. -uch expenses are !nown as boo! costs. $n a way, these are payments that the firm needs to pay itself such as depreciation allowances and unpaid interest on the businessmanVs own fund. Fi.e! n! = ri (le Co$t$ #ixed costs are those, which are fixed in volume for a given output. #ixed cost does not vary with variation in the output between 'ero and any certain level of output. The costs that do not vary for a certain level of output are !nown as fixed cost. The fixed costs include cost of managerial and administrative staff, depreciation of machinery, building and other fixed assets and maintenance of land, etc. Iariable costs are those, which vary with the variation in the total output. They are a function of output. Iariable costs inclue cost of raw materials, running cost on fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with the level of output and the costs of all other inputs that vary with the output. Tot l1 A)er ge n! M rgin l Co$t$ Total cost represents the value of the total resource re%uirement for the production of goods and services. $t refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level of output. $t includes both fixed and variable costs. The total cost for a given output is given by

the cost function. The )verage 5ost 2)53 of a firm is of statistical nature and is not the actual cost. $t is obtained by dividing the total cost 2T53 by the total output 2N3, i.e., )5 J T5 N J average cost

Marginal cost is the addition to the total cost on account of producing an additional unit of the product. (r marginal cost is the cost of marginal unit produced. Miven the cost function, it may be defined as )5J aT5 aN

These cost concepts are discussed in further detail in the following section. Total, average and marginal cost concepts are used in economic analysis of firmVs producti on activities. S"ort-r'n n! Long-r'n Co$t$ -hort run and long run cost concepts are related to variable and fixed costs, respectively, and often appear in economic analysi.s interchangeably. -hort run costs are those costs, which change with the variation in output, the si'e of the firm remaining the same. $n other words, short run costs are the same as variable costs. ;ong run costs, on the other hand, are the costs, which are incurred on the fixed assets li!e plant, building, machinery, etc. -uch costs have long run implication in the sense that these are not used up in the single batch of production. ;ong run costs are, by implication, same as fixed costs. $n the long run, however, even the fixed costs become variable costs as the si'e of the firm or scale of production increases. Broadly spea!ing, the short run costs are those associated with variables in the utilisation of fixed plant or other facilities whereas long run costs are associated with the changes in the si'e and type of plant. Incre&ent l Co$t$ n! S'n, Co$t$ 5onceptually, increment natal costs are closely related to the concept of marginal sot. *hereas marginal cost refers to the cost of the macgmalunit of output, incremental cost refers to the total additional cost associated with the marginal batch of output. The concept of incremental cost is based on a specific and factual principle. $n the real world, it is not practicable for lac! of perfect divisibility of inputs to employ factors for each unit of output separately. Besides, in the long run, firms expand their production7 hire more men, materials, machinery, and e%uipments. The expenditures of this nature are the incremental costs, an% not the marginal cost. $ncrementalW costs also arise owing to the change in product lines, addition or introduction of a new product, replacement of worn out plan and machinery, replacement of old techni%ue of production with a new one, etc. The sun! costs are those, which cannot be altered, increased or decreased, by varying the rate of output. #or example, once it is decided to ma!e incremental investment expenditure and the funds are allocated and spent, all the preceding costs are considered to be the sun!W costs since they accord to the prior commitment and cannot be revised or reversed when there is change in mar!et conditions orchange

in business decisions.

/i$toric l n! Re#l ce&ent Co$t$ Historical cost refers to the cost of an asset ac%uiredW in the past whereas replacement cost refers to the outlay, which has to be made for replacing an old asset. These concepts own their sigtlificance to unstable nature of price behaviour. -table prices over a period of time, other things given, !eep historical and replacement costs on par with each other. $nstability in asset prices, however, ma!es the two costs differ from each other. Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm. Pri) te n! Soci l Co$t$ *e have so far discussed the cost concepts that are related to the wor!ing of the firm and those which are used in the cost benefit analysis of the business decision process. There are, however, certain other costs, which arise due to functioning of the firm but do not normally appear in business decisions. -uch costs are neither explicitly borne by the firms. The costs of this category are borne by the society. Thus, the total cost generated by a firmVs wor!ing may be divided into two categories1 X Those paid out or provided for by the firms, X Those not paid or borne by the firm. The costs that are not borne by the firm include use of resouces freely available and the disutility created in the process of production. The costs of the former category are !nown as private costs and of the latter category are !nown as external or social costs. ) few examples of social cost are1 Mathura (il 9efinery discharging its wastage in the :amuna 9iver causes water pollution. Mills and factories located in city cause air pollution by emitting smo!e. -imilarly, plying cars, buses, truc!s, etc., cause both air and noise pollution7 -uch pollutions cause tremendous health ha'ards, which involve health cost to the society as it whole ThesVe costs are termed external costs from the firmVs point of view and social cost from the societyVs point of view. The relevance of the social costs lies in understandipg the overall impact of firmVs wor!ing on the society as a whole and in wor!ing out the social cost of private gains. ) further distinction between private cost and social cost therefore, re%uires discussion. 6rivate costs are those, which are actually incurred or provided by an individual or a firm on the purchase of goods and services from the mar!et. #or a firm, all the actual costs both explicit and implicit are private costs. 6rivate costs are the internalised cost that is incorporated in the firmVs total cost of production. -ocial costs, on thehand refer to the total cost for the society on account of production ofa commodity. -ocial cost can be the private cost or the external cost. $t includes the cost of resources for which the firm is not compelled to pay a price such as rivers and la!es, the public, utility services li!e roadways and drainage system, the cost in the form of disutility created in through air, water and noise pollution. This category is generally assumed to be e%ual to total private and public expenditures. The private and public expenditures, however, serve only as an indicator of public disutility. They do not give exact measure of the public disutility or the social costs. COST-OUTPUT RELATIONS

The previous section discussed the variou cost concepts, which help in the business decisions. The following section contains the discussion of the behaviour of costs in relation to the change in output. This is, in fact, the theory of production cost. 5ost output relations play an importai3t role in business decisions relating to cost

minirnisalioilY(fVprofiHnaximisation and optimisation of output. 5ost output relations are specified through a cost function expressed as T253 J f2N3 where, T5 J total cost N J %uantity produced 5ost functions depend on production function and mar!et supply function of inputs. 6roduction function specifies the technical relationship between the input, and the output. 6roduction function of a firm combined with the supply function of inputs or prices of inputs determines the cost function of the firm. 6recisely, cost function is a function derived from the production function and the mar!et supply function. V"epending on whether short or long run is considered for the production, there are two !inds of cost functions1 such as short run cost function and long run cost function. 5ost output relations in relation to the changing level of output will be discussed here u.nder both !inds of cost functions. S"ort-r'n Co$t O't#'t Rel tion$ The basic analytical cost concepts used in the analysis of cost behaviour are total average and marginal costs. The totalcost 2T53 is defined as the actual cost that must be incurred to produce a given %uantity of output. The short run T5 is composed of two ma&or elements1 total fixed cost 2T#53 and total variable cost 2TI53. That is, in the short run, T5 J T#5 K TI5 2A3 213

)s mentioned earlier, T#5 2i.eY the WcostWof plant, building, e%uipment, etc.3 remains fixed in the short run, where as TI5 varies with the variation in the output. #or a given %uantity of output 2N3, the average total cost, 2)53, average fixed cost 2)#53 and, average varZable cost 2)I53 can Vbe defined as follows1

)5 J

T5 N

T#5 K TI5 N

)#5 J

T#5 N

)I5 J

TI5 N

and

)5 J )#5 K)I5

2G3

Marginal cost 2M53 is defined as the change in the total cost divided by the change in the total output, i.e., [T5 [N aT5 aN 2H3 -ince [T5 J [T#5 K [TI5 and, in the short run, [T#5 J @, therefore, [T5J[TI5 #urthermore, under marginality concept, where [N J 1,M5 J [TI5. Co$t F'nction n! Co$t-o't#'t Rel tion$ The concepts )5, )#5 and )I5 give only a static relationship between cost and output in the sense that they are related to a given output. These cost concepts do not tell us anything about cost behaviour, i.e., how )5, ) I5 and )#5 behave when output changes. This can be understood better with a cost function of empirical nature. -uppose the cost function 2$3 is specified as T5 J a K bN 5NA K dNG 2where a J T#5 and b, c and d are variable cost parameters3 )nd also the cost function is empirically estimated as T5 J 1@ K FN @.LNA K @.@BNG and TI5 J FN @.LN K @.@BN
A G

M5 J

or

2B3

2F3 2E3

The T5 and TI5, based on e%uations 2F3 and 2E3, respectively, have been calculated for N J $ to 1F and is presented in Table G.1. The T#5, TI5 and T5 have been graphically presented in #igure G.1. )s the figure shows, T#5 remains fixed for the whole range of output, and hghce, ta!es the form of a hori'ontal line, i.e., T#5. The TI5curve shows that the total variable cost first increases ataVi decreasing rate and then at an increasing rate with the increase it the total output. The rate of increase can be obtained from the slope of TI5 curve. The pattemof change in the TI5 stems directly from the law of increasing and diminishing returns to the variable inputs. )s output increases, larger %uantities of variable inputs are re%uired to produce the same %uantity of output due to diminishing returns. This causes a subse%uent increase in the variable cost for producing the same output. The following Table G.1 shows the cost output relationship. T (le 754* Co$t O't#'t Rel tion$

N 2$3 @ $ A G H B F E D

#5 2A3 1@ 1@ 1@ 1@ 1@ 1@ 1@ 1@ 1@

TI5 2G3 @.@ B.1B D.D@ 11.AB 1A.D@ 1G.EB 1H.H@ 1B.@B 1F.@@

T5 2H3 1@.@@ 1B.1B 1D.D@ A1.AB AA.D@ AG.EB AH.H@ AB.@B AF.@@

)#5 2B3 1@.@@ B1@@ G.GG A.B@ A.@@ 1.FE 1.HG 1.AB

)I5 2F3 B.1B H.H@ G.EB G.A@ A.EB A.H@ A.1B A.@@

)5 2E3 1B.1B L.H@ E.@D B.E@ H.EB H.@E G.BD G.AB

M5 2D3 B.1B G.FB A.HB 1.BB @.LB @.FB @.FB @.LB

L 1@ 11 1A 1G 1H 1B 1F

1@ 1@ 1@ 1@ 1@ 1@ 1@ 1@

1E.BB A@.@@ AG.FB AD,D@ GB.EB HH.D@ BF.AB E@.H@

AE.BB G@.@@ GG.FB GD.D@ HB.EB BH.D@ FF.AB D@.H@

1.11 1.@@ @.L@ @.DG @.EE @.E1 @.FE @.FA

1.LB A.@@ A.1B A.H@ A.EB G.A@ G.EB H.H@

G.@F G.@@ G.@B G.AG G.BA G.L1 H.HA B.@A

1.BB A.HB G.FB B.1B F.LB L.@B 11.HB 1H.1B

#rom e%uations 2F3 and 2E3, we may derive the behavioural e%uations for )#5, )I5 and )5. ;et us first consider )#5. A)er ge Fi.e! Co$t ;AFC< )s already mentioned, the costs that remain fixed for a certain level of output ma!e the total fixed cost in the short run. The fixed cost is represented by the constant term VaV in e%uation 2F3. *e !now that T#5 N 2D3

)#5 J

-ubstituting 1@ for T#5 in e%uation 2D3, we get )#5 J 1@ N 2L3

E%uation 2L3 expresses the behaviour of )#5 in relation to change in N. The behaviour of )#5 for N from 1 to 1F is given in Table G.1 2col. B3 and is presented graphically by the )#5 curve in the #igure G.1. The )#5 curve is a rectangular hyperbola.

)verage Iariable 5ost 2)I53 )s defined above, )I5 J TI5 N

Miven the TI5 function in e%uation E, we may express )I5 as follows1 )I5 J FN @.LNAK@.@BNG N J F @.LNK@.@BNG 21@3

Having derived the ) I5 function 2e%uation 1@3, we may easily obtain the behaviour of ) I5 in response to change in N. The behaviour of ) I5 for N from $ to 1F is given in Table G.1 2co 1. F3, and is graphically presented in #igure G.A by the ) I5 curve. Critic l = l'e o% A =C #rom e%uation 21@3, we may compute the critical value or N in respect of ) Ic. The critical value of N 2in respect of ) I53 is that value of N at which ) I5is minimum. The )ve will be minimum when its decreasing rate of change is e%ual to 'ero. This can be accomplished by differentiating e%uation 21@3 and setting it e%ual to 'ero. Thus, critical value of N can be obtained as NJ NJ a)I5 aN L J @.LK@.1@NJ@ 2113

Thus, the critical value of NJL. This can be verified from Table 754 A)er ge Co$t ;AC< The average cost in defined as )5 J T5 N

-ubstituting e%uation 2F3 for T5 in above e%uation, we get 1@KFN @LNAK@.@BNG )5 J N 21Aa3

1@ J N K F @.LNK@.@BNA

The e%uation 2lAa3 gives the behaviour of )5 in response to change in N. The behaviour of )5 for N from $ to 1F is given in Table G.1 and graphically presented in #igure G.A by the )5 curve. .ote that )5 curve is 8 shaped. #rom e%uation 21Aa3, we may easily obtain the critical value of N in respect of )5. Here, the critical valuepf N in respect of )5 is one at which )5 is minimum. This can be obtained by differentiating e%uation 2lAa3 and setting it e%ual to 'ero. This, critical vallie of N in respect of )5 is given by a)5 aN J 1@ NA @.L K @.1N J @ 21Ab3

This e%uation ta!es the form of a %uadratic e%uation as 1@ < @.LNA K @.1NG J @ or, NG < LNA J 1@@ J @ N J 1@ Thus, the critical value of output in respect of )5 is 1@. That is, )5 reaches its minimum at N J 1@. This can be verified from Table. G.1 shows short run cost curves. By solving e%uation 21Ab3, we get

M rgin l Co$t ;MC< The concept of marginal cost 2M53 is particularly useful in economic analysis. M5 is technically the first derivative of T5 function. That is, aT5 aN

M5 J

Miven the T5 function as in e%uation 2F3, the M5 function can be obtained as aT5 aN J F 1.DNK@.1BNA 21G3

E%uation 21G3 represents the behaviour of M5. The behaviour of M5 for N from 1 to 1F computed as M5 J T5n T5n i is given in Table G.1 2col. D3 and graphically presented by M5 curve in #igure GV.A. The critical Vvalue of N in respect of M5 is F or E. $t can be seen from Table G.1. (ne method of solving %uadratic e%uation is to factorise it and find the solution. Thus, NG < LNA < 1@@ J @ 2N < 1@3 2NA K N K 1@3 J @ #or this to hold, one of the terms must be e%ual to 'ero, -uppose Then, 2NA K N K 1@3 J @ N < 1@ J @ and N J 1@.

COST CUR=ES AND T/E LAWS OF DIMINIS/ING RETURNS *e now return to the laws of variable proportions and explain it through the .cost curves. #igures G.1 and G.A clearly bring out the short term laws of production, i.e., the laws of diminishing returns. ;et us recall the law1 it states that when more and more units of a variable input are applied to those inputs which are held constant, the returns from the marginal units of the variable input may initially increase but will eventually decrease. The same law can also be interpreted in termVs of decreasing and increasing costs. The law can then be stated as, if more and more units of a variable inputs are applied to the given amount of a fixed input, theV marginal cost initially decreases, but eventually increases. Both interpretations of the law yield the same information1 one in terms of marginal productivity of the variable input, and the other, in terms of the marginal cost. The former is expressed through production function and the latter through a cost function. #igure G.A represents the short run laws of returns in terms of cost of production. )s the figure shows, in the initial stage of production, both )#5 and )I5 are declining because of internal economies. -ince )5 J )#5 K )I5, )5 is also declining, this shows the operation of the law of increasing returns. But beyond a certain level of output 2i.e., L units in out example3, while )#5 continues to fall, )I5 starts increasing because of a faster increase in the TI5. 5onse%uently, the rate of fall in )5 decreases. The )5 reaches its minimum when output increases to 1@ units. Beyond this level of output, )5 starts increasing which shows that the law of diminishing returns comes in operation. The M5, curve represents the pattern of change in both the TI5 and T5 curves due to change in output. ) downward trend in the M5 shows increasing marginal productivity of the variable input mainly due to internal economy resulting from increase in production. -imilarly, an upward trend in the M5 shows increase in TI5, on the one hand, and decreasing marginal productivity of the variable input, on the other.

SOME IMPORTANT COST RELATIONS/IPS -ome important relationships between costs used in analysing the short run cost behaviour may now be summed up as follows1 )s long as )#5 and )I5 fall, )5 also falls because )5 J )#5 K)I5. *hen )#5 falls but ) I5 increases, change in )5 depends on the rate of change in )#5 and )I5 then any of the following happens1 ifthereisdecrease in )#5 and increase in ) I5, )5 falls, if the decrease on )#5 is e%ual to increase in )ve, )5 remains constant, and if the d\crease in )#5 is less than increase in ) I5, )5 increases.

The relationship between )5 and M5 is of varied nature. $t may be described as follows1 *hen M5 falls, )5 follows, over a certain range of initial output. *hen M5is failing, the rate of fall in M5 is greater than that of )5 This is because in case of M5 the decreasing marginal cost is attributed, 1 to a single marginal unit while7 in case of )5, the decreasing marginal cost is distributed overall the entire output. Therefore, )5 decreases at a lower rate than M5. -imilarly, when M5 increase, )5 also increases but at a lower rate fbr the reason given inVthe above point. There is however a range of output over which this relationship does not exist. #or

example, compare the behaviour of M5 and )5 over the range of output frbm F units to 1@ units 2see #igure G.A3. (ver this range of \utput, M5 begins to increase while )5 continues to decrease. The reason for this can be seen in Table. G.1. *hen M5 starts increasing, it increases at a relatively lower rate, which is sufficient only to reduce the rate of decrease in )5, i.e., not sufficient to push the )5 up. That is why )5 continues to fall over some range of output even, if M5 falls. M5 i]1tetsects )5 at its minimum point. This is simply a mathematical relationship between M5 and )5 curves when both of them are obtained from the same T5 function. $n simple words, when )5 is at its minimum, then it is neither increasing nor decreasing it is constant. *hen )5 is constant, )5 J M5. O#ti&'& O't#'t in S"ort-r'n )n optimum level of output is the one, which can be produced at a minimum or least average cost, given the re%uired technology is available. Here, the leastVtcostV combination of inputs can be understood with the help of iso%uants and isocosts. The least cost combination of inputs also indicates the optimum level of output at given investment and factor prices. The )5 and M5 cost 5urves can also be used to find the optimum level of output, given the si'e of the plant in the short run. The point of intersection between )5 and M5 curves deterinines the minimum level of )5. )t this level of output )5 J M5. 6roduction belo* or beyond thislevelwill be in optimal. $f production is less than 1@ units 2#igure G.A3 it will leave some scope for reducing )5 by producing more, because M5 Q )5. -imilarly, if production is greater than 1@ units, reducing output can reduce )5. Thus, the cost curves can be useful in finding the optimum level of output. $t may be noted here that optimum level of output is not necessarily the maximum profit output. 6rofits cannot be !nown unless the revenue curves of firms are !nown. Long-r'n Co$t-o't#'t Rel tion$ By definition, in the long run, all the inputs become variable. The variability of inputs is based on the assumption that, in the long run, supply of all the inputs, including those held constant in the short run, becomes elastic. The firms are, therefore, in a position to expand the scale of their production by hiring a larger %uantity of all the inputs. The long run cost output relations, therefore, imply the relationship between the changing scale of the firm and the total output7 conversely in the short run this relationship is essentially one between the total output and, the variable cost 2labour3. To understand the long run costoutput relations 2lnd to derive long run cost curves it will be helpful to imagine that a long run is composed of a series of short run production decisions. )s aV corollary of this, long run cost curves are composed of a series of short run cost curves. *e may now derive the long run cost curves and study theirV relationship with output. Long-r'n Tot l Co$t C'r)e ;LTC< $n order to draw the long run total cost curve, let us begin with a short run situation. -uppose that a firm having only one plant has its short mn total cost curve as given by -T5 l in panel 2a3 of #igure G.G. $n this example if the firm decides to add two more plants to its si'e over time, one after the other then in accordance two more short run total cost curves are added to -T5l in the manner shown by -T5A and -T5G in #igure G.G 2a31. The ;T5 can now be drawn through the minimum points of -T5 l, -T5A and -T5G as

shown by the ;T5 curve corresponding to each -T5. Long-r'n A)er ge Co$t C'r)e ;LAC< 5ombining the short run average cost curves 2-)5s3 derives the long run average cost curve 2;)53. .ote that there is one -)5 associated with each -T5. Miven the -T5 1 -T5A, and -T5G curves in panel 2a3 of #igure G.G, there are three corresponding -)5 curves as given by -)5 1 -)5A arid -)5G curves in panel 2b3 of #igure G.G. Thus, the firm has a series of -)5 curves, each having a bottom point showing the minimum -)5. #or instance, 51N1 is the minimum )5 when the firm has only one plant. The )5 decreases to 5 ANA when the second plant is added and then rises to 5 GNGafter the inclusion of the third plant. The ;)5 carl be drawn through the bottom of -)51 -)5A and -)5G as shown in #igureWG.G 2b3 The ;)5 curve is also !nown as +Envelope 5urveV or V6lanning 5urveV as it serves as a guide to the entrepreneur in his planning to expand production.

The -)5 curves can be derived from the data given in the -T5 schedule, from -T5 function or straightaway from the ;T5 curve. -imilarly, ;)5 can be derived from ;T5 schedule, ;T5 function or from ;T5 curve. The relationship between ;T5 and output, and between ;)5 and output can now be easily

derived. $t is obvious. from the ;T5 that the long run cost output relationship is similar to the short run cost output relationship. *ith the subse%uent increase in the output, ;T5 first increases at a decreasing rate, and then at an increasing rate. )s a result, ;)5 initially decreases until the optimum utilisation of the second plant and then it begins to increase. #rom these relations are drawn the Vlaws of returns to scaleV. *hen the scale of the firm expands, unit cost of production initially decreases, but it ultimately increases as shown in #igure G.G 2b3. Long-r'n M rgin l Co$t C'r)e The long run marginal, cost curve 2;M53 is derived from the short run marginal cost curves 2-M5s3. The derivation of ;M5 is illustrated in #igure G.H in which -)5 GVand ;)5 arethe same asVin #igure G.G2b3. To derive the ;M5G, consider the points of tangency between -)5G and the ;)5, i.e., points ), Band 5. $n the long run production planning, these points determine the output levels at the different levels of production. #or example, if we draw perpendiculars from points ), Band 5 to the ? axis, the corresponding output levels will be (N1 (NA and (NG The perpendicular )N1 intersects the -M51 at point M. $t means that at output BNA, ;M5, is MN1. $f output increases to (NA, ;M5 rises to BNA. -imilarly, 5NG measures the ;M5 at output (NG. ) curve drawn through points M GB and ., as shown by the ;M5, represents the behaviour of the marginal cost in the long run. This curve is !nown as the long run marginal cost curve, ;M5. $t shows the trends in the marginal cost in response to the change in the scale of production. -ome important inferences may be drawn from #igure G.H. The ;M5 must be e%ual to -M5 for the output at which the corresponding -)5 is tangent to the ;)5. )t the point of tangency, ;)5 J -)5. #or all other levels of output 2considering each -)5 separately3, -)5 R ;)5. -imilarly, for all levels of outout corresponding to ;)5 J -)5, the ;M5 J -M5. #or all other levels output, i1he ;M5 is either greater or less than the -M5. )nother important point to notice is that the ;M5 intersects ;)5 when the latter is at its minimum, i.e., point B. There, is one and only one short run plant si'e whose minimum -)5 coincides with the minimum ;)5. This point is B where, -)5A J -M5A J ;)5 J ;M5.

O#ti&'& Pl nt SiCe n! Long-r'n Co$t C'r)e$ The short run cost curves are helpful in showing how a firm can decide on the optimum utilisation of the plant which is the fixed factor7 or how it can determine the least cost output level. ;ong run cost curves, on the other hand, can be used to show how the management can decide on the optimum si'e of the firm. )n (ptimum si'e of a firm is the one, which ensures the most efficient utilisation of resources. Miven the state1 of technology overtime, there is technically a uni%ue si'e of the firm and lever of output associated with the least cost 5oncept. This urii%ue si'e of the firm can be obtained with the help of ;)5 and ;M5$n #igur G.H the optimum si'e consists of two plants, which produce (NA units of a produd, at minimum long run average cost 2;)53 of BNA.

The downtrend in the ;)5 ihdicates that until output reaches the level of (N A, the firm is of non optimal si'e. -imilarly, expansion of the firm beyond production capacity (N A causes a rise in -M5 as well as ;)5. $t follows that given the technology, a firm trying to mini mise its average cost over time must choose a plant which gives minimum ;)5 where -)5 J -M5 J ;)5 J ;M5. This si'e of plant assures most efficient utilisation of the resource. )ny change in output level, i.e., increase or decrease, will ma!e the firm enter the area of in optimality. ECONOMIES AND DISECONOMIES OF SCALE -cale of enterprise or si'e of plant means the amount of investment in relatively fixed factors of production 2plant and fixed e%uipment3. 5osts of production are generally lower in larger plants than in the smaller ones. This is so because there are a number of economies of large scale production. Econo&ie$ o% Sc le Marshall classified the economies of large scale production into two types1 1. ExternalEconomies 2. $nternal Economies E.tern l Econo&ie$ are those, which are available to all the firms in an industry, for example, the construction of a railway line in a certain region, which would reduce transport cost for all the firms, the discovery of a new machine, which can be purchased by all the firms, the emergence of repair industries, rise of industries utilising by products, and the establishment of special technical schools for training s!illed labour and research institutes, etc. These economies arise from the expansion in the si'e of an industry involving an increase in the number and si'e of the firms engaged in it. Intern l Ecno&ie$ are the economies, which are available to a particular firm and give it an advantage over other firms engaged in the industry. $nternal economies arise from the expansion of the si'e of a particular firm. #rom the managerial point of view, internal economies are more important as they can be affected by managerial decisions of an individual firm to change its si'e or scale. T0#e$ o% Intern l Econo&ie$

There are various types of internal economies such as labour, technical, managerial, mar!eting and so on. *e will discuss the types of internal economies in detail in the following section1 L (o'r Econo&ie$* $f an firm decides to expand its scale of output, it will be possible for it to reduce the labour costs per unit by practising division of labour. Economies of division of labour arise due to increase in the s!ill of wor!ers, and the saving of time involved in changing from one operation to the other. )gain, in many cases, a large firm may find it economical to have a number of operations performed mechanically rather than manuaily. These economies will be of great use in firms where the product is complex and the manufacturing processes can be sub divided. Tec"nic l Econo&ie$* These are economies derived from the use of subsi'e machines and such scientific processes li!e those which can be carried out in large production units. ) small establishment cannot afford to use such machines and processes, because their use would bring a saving only when they are used intensively. (n the other hand, their use will be %uite uneconomical if they were to lie idle over a considerable part of the time. #or example, a large electroplating plant costs a great deal to !eep it in operation. Therefore, the cost per unit will be low only if the output is large. -imilarly, a machine that facilitates the pressing out a side of a motorcar will ta!e a wee! or more to be put ready for operation to produce a particular design. The greater the output of cars of this particular designs the lower the cost per unit of getting the machine ready for operation. -imilarly, if a dye is made to produce a particular model of cars, the cost of dye per unit of cars will depend upon the output of the cars. Iery often large firms may find it economical to produce or manufacture parts and components for their products rather than buy them from outside sources. #or example, Hind 5ycles, unli!e small mariufacturers, produced parts and components themselves. Moreover, large firms may find it profitable to utilise their by products and waste products. #or example, Tata use the smo!e from their furnaces to manufacture coal tar, naphthalene, etc. ) small firmVs output of smo!e would not be large enough to &ustif: setting up the .e%uipment necessary to do so. M n geri l Econo&ie$* *hen the si'e of the fern increases, the efficiency of the management usually increases because there can be greater specialisationin managerial staff. $n a large firm, experts can be appointed to loo! after the various sections or divisions of the business, such as purchasing, sales, production, financing, personnel, etc. But a small firm cannot provide full time employmWentto these experts naturally, the various aspects of the business have to be loo!ed after by few people only who may not necessarily be experts. Moreover, a large firm can afford to set up data processing and mechanised accounting, etc., whereas small firms cannot afford to do so. M r,eting Econo&ie$* ) large firm can secure economies in its purchasing and sales. $t can purchase its re%uirements in bul! and thereby get better terms. $t usually receives prompt deliveries, careful attention and special facilities from its suppliers. This is sometimes due to the fact that a large buyer can exert more pressureW, at times compulsive in nature, for specially favoured treatment. $t can also get concessions from transport agencies. Moreover, it can appoint expert buyers and expert salesmen. #inally, a large firm can spread its advertising cost over bigger output because advertising costs do not rise in proportion to a rise in sales. Econo&ie$ o% =ertic l integr tion* ) large firm may decide to have vertical integration by combining

a number of stages of production. Thisintegration has the advantage that the flow of goods through various stages in production processes is more readily controlled. -teady supplies of raw materials, on the one hand, and steady outlets for these raw materials, on the other, ma!e production planning more certain and less sub&ect to erratic and unpredictable changes. Iertical integration may also facilitate cost control, as most of the costs become controllable costs for the enterprise. TransportV costs may also be reduced by planning transportation in such a way that cross hauling is reduced to the minimum. Fin nci l Econo&ie$* ) large firm can offer better security and is, therefore, in a position to secure better and easier credit facilities both from its suppliers and its ban!ers. "ue to a better image, it en&oys easier access to the capital mar!et. Econo&ie$ o% Ri$,-$#re !ing* The larger the si'e of the business, the greater is the scope for spreading of ris!s through diversification. "iversification is possible.on two lines as follows1 o Di)er$i%ic tion o% O't#'t* $f there are many products, the loss in the sale of one product may be covered by the profits from others. By diversification, the firm avoids what may be called putting all eggs in the same bas!et. #or example, Iic!ers ;td., ma!e aircrafts, ships, armaments, food processing plant, rubber, plastics, paints, instruments arid a wide range of other products. Many of the larger firms have ta!en to diversification. $T5 diversified to include marine products and hotel business in its operations. o Di)er$i%ic tion o% M r,et$* The larger producer is glenerally in a position to sell his goods in many different and even far off places. By depending upon one mar!et, he runs the ris! of heavy loss if sales in that mar!et decline for one reason or the other. S rg nt Floren:ce n! Econo&ie$ o% Sc le -argant #lorence has attributed the economies of scale the three principles, which are in operation in a large si'ed business, namely, the principle of bul! transactions, the principle of massed reserves, and the principle of multiples. Princi#le o% B'l, Tr n$ ction$* This principle implies that the cost of dealing with a large batch is often no greater than the cost of dealing with a small batch, for example,V the cost of placing an order, large or small7 availability of discounts on bul! orders, or annual purchase contracts7 economies in the use orVlarge containers such as tan!s or truc!s of special design, for a container holding, say, twice as much as the other one, does not cost double the amount. X Princi#le o% M $$e! Re$er)e$* ) large firm has a number of departments or sections and its overall demand for services, say, transport services, is li!ely to be fairly large. But it is unli!ely that all departments will ma!e heavy demands of the particular service at the saine time. Thus the firm can afford to have its own transport fleet and fully utilise it and thereby ultimately reduce its costs. The larger the firm, the greater are the advantages. Princi#le o% M'lti#le$* This principle was first raised by Babbage in 1DGA and has also been referred to as VBalancing of 6rocessesV. The principle can be better explained through an example. -uppose a manufacturing, operation involves three processes, first in which a machine 21an ma!e G@ units a wee!7 second in which an automatic machine can ma!e 1,@@@ units per wee!7 and a third in which a

semi automatic machine can ma!e H@@ units per wee!. 8nles\ the output of the plant is some common multiple of G@,1,@@@ anti H@@, one or more of the processes will have unutilised capacity. Their ;5M is F,@@@ and, therefore, to best utilise all the machines the plant si'e must be of at least F,@@@ units or any of its multiples. Econo&ie$ o% Sc le n! E&#iric l E)i!ence )ccording to the surveys conducted by the 6re investment -urvey Mroup 2#)M3 and later on by the .5)E9, it has been pf23Ied that in paper industry, profitability decreases with lower scaly of operations and bigger plants beneht from economies of scale. The report of the 6re investment -urvey Mroup 2#)M3 reveals that the manufacturing cost of writing and printing paper would fall from 9s. 1,HDL in a 1@@ tonne per day plant to 9s. 1,AGD in a A@@ tonne per day plant and further to 9s. 1,1@H in a G@@ tonne per day plant. The following Table G.A further shows the capital cost of raw materials and operating cost per tonne of paper according to the si'e of the unit, as estimated by the .5)E9. T (le 756* P #er In!'$tr0* In)e$t&ent n! Ot"er Co$t$ o% P #er Mill$ ccor!ing to SiCe

-i'e Tonnes per day3 V. 1@@ A@@ AB@

#ixed investment cost per tonne X H,HEG H,@E@ G,LHB

5ost of raw ma terials per tonne of paper GAH AFG ABD

(perating cost per tonne of paper 1,G@E 1,11F 1,@BF

)nother study of cement industry by the Economic and -cientific 9esearch undation shows that the per unit of capacity capital investment of a G,@@@ tonne perV day 2T6"3 capacity cement plant islower than the plants of B@ T6" si'e. Thus a single cement plant producing G,A@@ T6" re%uires HF per cent less capital investment than D plants of H@@ T6" productions would. )s regards cost of production, a D@@ T6" plant has a 1B per cent cost advantage over a H@@ T6" plant. The difference between the cost of production of a tonne of cement by a G,@@@ T6" plant and of aB@ T6" plant is as high as 9s. 1@@ per tonne. $n fact, there has been a perceptible increase in the si'e of cement plants in $ndia. #or example, the F@@ tonnes per day capacity cement plants during the early 1LF@s gave way with their si'e going up to 1,A@@ tonnes per day. The latest preference is for G,A@@ tonnes per day capacity plants. ) significant policy implication of economics of scale is that in order to earn a reasonable return and at the same time ensure a fair deal to the consumers, the industry should go in for larger plants and expand the existing plants to .the optimum level.

T"e DE4? R'le ) useful rule that see!s to measure economies of scale is the F>1 @ rule. )ccording to this rule, if we want to double the volume of a container, the material needed to ma!e it will have to be increased by F>1@, i.e., F@ per cent. ) proofoftheVF>l@ rule is easy and can be given here with its advantage. ;et us begin with the volume of a container and the material re%uired to ma!e it. -uppose the container is of the shape of a Mube with its side. The volume of the container then is1 Io J ao x ao x ao J aoG

.ow, to find out the area of material needed, we !now that the container will have six e%ual s%uare faces, each of area an A so, the area of total material needed $-1 Mo J F x aoA J FaoA -uppose now, that the containerVs dimension increases from an to all the volume of the container will then increase to alG and the area of t\e material needed will increase to Fa1A. Thus, for two containers of dimensions an and al the ratio of the areas of material needed will be1 M1 M@ Fa1>A Fa@>A a1>A a@

The corresponding ratio of the volumes will be1 I1 I@ a1>G a@>G a1>G a@

#rom the above, it follows that1 M1 M@ a1>A a@>A a1>G.A>G a@ J I 1 A>G I@

.ow, if we double the volume, i.e., if I1 I1 J Then, M1 M@ I1 A>G I@ AI@ or I@ JA

J M1 J 1.BL M@

J 2A@3 A>G

J 1.BL

$n other words, doubling the volume re%uires BL per cent increase in material. This is rou]ded off as F@ per cent, which is the same as F>1(. $t may be added that, if in place of a cubical container, we had ta!en the example of a spherical or a rectangular or a cylindricai or for that matter a conical container, we would have ai&ived at the same relationship, vi'., M1 M@ J I1A>G I@

The F>1@ rule is of great practical significance. $ts significance can well be realised if we visualise, for example, blast furnaces as boxes containing the ingredients needed to produce iron, or tan!ers as large boxes containing oil. Mini&'& Econo&ic C # cit0 ;MEC< Sc"e&e -mall si'e firms do not en&oy economies of scale. )s such, in pursuance of governmentVs policy to encourage minimum efficient capacity in industrial und\i1a!ings, the Movernment of $ndia has introducedV

ME5 -cheme to petrochemical industries, for example, .aphtha > Mas 5rac!er 2G to H la!hs tonnes3, Bopp #ilm 2BF,@@@ tonnes3, 6olyster #ilm 2B,@@@ tonnes3, 6olyster #ilament :am 2AB,@@@ tonnes3, )crylic #ibre 2A@,@@@ tonnes3, MEM 2(ne la!h tonnes3, 6T) 2Ala!h tonnes3, etc. Worl! Sc le *ith recent trends towards globalisation of industries in $ndia, the concept of Y*orld -caleY has emerged. The term V*orld -caleV refers to that scale or si'e of the enterprise, which is large enough to enable the firm to reap various large scale economies so as to compete successfully on the world basis with global rivals. Thus 9eliance $ndustries ;imited has recently announced to build a world scale polyester facility at Hn'ira and a crac!er pro&ect with capacity expanding from earlier H@,@@@ tonnesWto the world scale of E,B@,@@@ tonnes per annum. Di$econo&ie$ o% Sc le Economies of increasing si'e do not continue indefinitely. )fter a certain point, any further expansion of the si'e leads to diseconomies of scale. #or example, after the division of labour has reached its most efficient point, further increase in the number of wor!ers will lead to a duplication of wor!ers. There will be too many wor!ers per machine for really efficient production. Moreover, the problem of co ordination of different processes may become difficult. There may be divergence of views concerning policy problems among specialists in management and reconciliation may be difficult to arrive. "ecision ma!ing process becomes slow resulting in missed opportunities. There may be too much of formality, too many individuals between the managers and wor!ers, and supervision mayV become difficult. The management problems thus get out of hand with conse%uent adverse effects on managerial efficiency. The limit of scale economics is also often explained in terms of the possible loss of control and conse%uent inefficiency. *ith the growth in the si'e of the firm, the control by those at the top becomes wea!er. )dding one more hierarchical level removes the superior further away from the subordinates. )gain, as the firm expands, the incidence of wrong &udgements increases and errors in &udgement become costly. ;ast be not the least, is the limitation where the larger the plant, the larger is the attendant ris!s of loss from technological changes as technologies are changing fast in modern times. Di$econo&ie$ o% Sc le n! E&#iric l E)i!ence ;arge petro chemical plants achieve economies in both full usage and in utilisation of a wider range ofby products, which would otherwise, be wasted. But above B,@@,@@@ tonnes, diseconomies of scale sets in because of the following occurrences1 The plant becomes so large that on site fabrication of some parts is re%uired which is much more expensive7 -tarting up costs are much higher, more capital is tied up and delays in commissioning can be extremely expensive7 and The technical limit to compressor si'e has been reached. There is, however, no substantial evidence of diseconomies of large scale production. $n the final

analysis, however, a significant test of efficiency is survival. $f small firms tend to disappear and large ones survive, as in the automobile industry, we must conclude that small firms are relatively inefficient. $f small firms survive and large ones tend to disappear as in the textile industry, then large firms are relatively inefficient. $n reality, we find that in most industries, firms of very different si'es tend to survive. Hence, it can be concluded that usually there is no significant advantage or disadvantage to si'e over a very wide range of outputs. $t may mean, of course, that the businessman in his planning decisions determines that beyond a certain si'e, plants do have higher costs and, therefore, does not build them. -omewhat surprisingly, some $ndian entrepreneurs have been perceptive enough to attempt to derive the advantages of both large and small scale enterprises. $n the late sixties, the ]ay Engineering 5o. ;td. evolved a strategy of blending large units with small enterprises to obtain the best of both worlds. $t manufactures its 8sha fans in three different plants 25alcutta, Hyderabad and )gra3, with each plantV manu facturing the same or a similar range of products. Each unit is autonomous and is free to ta!e operational decisions except in highly strategic areas. *ithin each unit, the wor! force is !ept small to carry out vital operations such as forgoing, blan!ing, notching and final assembly. The rest of the wor! is sub contracted to neighbouring small scale units, which over a period or time have become almost integral parts of each plant. ;oans for the purchase of machinery are also advanced and technical !now how and sometimes eve training is provided to these ancillary units. 6ayments are made promptly. The whole system operates li!e families within a larger family. Managers in the 8-, who are always %uic! in innovating, have also begun adopting this blended system during the past few years. Meneral Motors encourages the creation ofa cluster of independent enterprises in an area, with ade%uate autonomy granted to the companyVs area chief to encourage their growth and developm.ent. 5onse%uently, though a giant in the automobile industry, Meneral Motors en&oys a large number of the privileges that acerue to small units and also reaps the special benefits accruing to large business firms. Econo&ie$ o% Sco#e This concept is of recent development and is different from the concept of economies of scale. Here, the cost efficiency in production process is brought out by variety rather than volume, that is, the cost advantages follow from variety of output, for example, product diversification within the given scale of plant as against increase in volume of production or scale Ff output. ) firm can add new and newer products if the si'e of plant and type of technology ma!e it possible. Here, the firm will en&oy scope economies instead of scale economies. COST CONTROL AND COST REDUCTION Co$t Control The long run prosperity of a firm depends upon its ability to eam sustaid profits. 6rofit depends upon the difference between the selling price and the cost of production. Iery often, the selling price is not within the control of a firm but many costs are under its control. The firm should therefore aim at doing whatever is done at the minimum cost. $n fact, cost control is ail essential element for the successful operation of a business, 5ost control by management means a search for better and more economical ways of completing each operation. $n effect, cost control would mean a reduction in the percentage of costs and, in turn, an increase in the percentage of profits. .aturally, cost control is and will continue to be of perpetual concern to

the industry. 5ost control has two aspectsV such as a reduction in specific expenses and a more efficient use of every rupee spent. #or example, if sales can be increased with the same amount of expenditure, say, on advertising and saTesmen, the cost as a percentage of sales is cut down. $n practice, cost control will ultimately be achieved by loo!ing into both these aspects and it is impossible to assess the contribution, which each has made to the overall savings. 6otential savings in individual businesses will, however, vary between wide extremes depending upon the levels of efficiency already achieved before cost controls are introduced. $t is useful to bear in mind the following rules covering cost control activities1 $t is easier to !eep costs down than it is to bring costs down. The amount of effort put into cost control tends to increase when business is bad and decrease when business is good. There is more profit in cost control when business is. good than when $ business is bad. Therefore, one should not be slac! when conditions are good. 5ost control helps a firm to improve its profitability and competitiveness. 6rofits may be drastically reduced despite a large and increasing sales volume in the absence of cost control. ) big sales volume does not necessarily mean a big profit. (n the other hand, it may create a false sense of prosperity while in reality7 increasing costs are eating up profits. 6rofit is in danger when good merchantdising and cost control do not go hand in hand. 5ost control may also help a firm in reducing its costs and thus reduce its prices. ) reduction in prices of a firm would lead to an increase in its competitiveness. The aspect is of particular relevance to $ndian conditions because of high costs, $ndia is being priced out of the world mar!ets. Tool$ o% Co$t Control #ollowing ar.e the tools that are used for the cost control1 St n! r! Co$t$ n! B'!get$* The techni%ue of standard, costing has been developed to establish standards of performance for producing gvuus and services. These standards serve Yas a goal for the attainment and as basis of comparison with actual costs in chec!ing performance. The analysis of variance between actual and standard costs will1 2i3 help fix the responsibility for non standard performance and 2ii3 focus attention on areas in which cost improvement should be sought by pinpointing the source of loss and inefficiency. The principle here is that or controlling by exception. $nstead of attempting to follow a mass of cost data, the attention of those responsible for cost control is concentrated on significant variances from the standard. $f effective action is to be ta!en, the cause and responsibility of a variance, as well as its amount, must be established. The prime ob&ective of standard costs is to generate greater cost consciousness and help in cost control by directing attention to specific areas where action is needed. To those who are immediately concerned, variances wou1d indicate whether any action is re%uired on their part. $t must be noted that 5osts are controlled at the points where they are incurred and at the time of occurrence of events, and )t the same time they may be uncontrolled at some points. $t is, therefore, necessary to understand the difference between controllable and uncontrollable

costs. The variances may also be controllable and uncontrollable. #or example, if the material cost variance is due to rise in prices, it is not within the control of the production manager. But if the variance is due to greater usage, control action is certainly possible on his part. The higher management can also de5ide whether or not they should intervene in the matter. -ometimes, variances may be so significant that a complete reap9raisal of the standard costs themselves may be needed. #or example, if the variances are always favourable, it may point to the fact that the standards have not been properly fixed. -tandard costing can also provide the means for actual and standard cost comparison by type of expense, by departments or cost centres. :ields and spoilage can be compared with the standard allowance for loss. ;abour operations and overheads also can be chec!ed for efficiency. #lexible budgets constitute yet another effective techni%ue of cost control, especially control of factory overheads. #lexible budgets, also !nown as variable budgets7 provide a basis for determining costs that are anticipated at various levels of activity. $t provides a flexible standard for comparing the costs of an actual volume of activity with the cost that should be or should have been. The variances can then be analysed and necessary action can be ta!en in the matter. Table G.G gives a specimen flexible budget.

Table G.G1 #inishing "epartment, Modern Manufacturing 5o.

-tandard hours of direct labour GB,@@@ ;abour cost hour at 9s. G per (ther variable costs -emi variable costs #ixed costs Total 9s. 1,@B,@@@ 1EB@@ L,AB@ B@,@@@ 9s.l,D1,EBN H@,@@@ 9s. 1,A@,@@@ A@.@@@ 1@,@@@ B@,@@@ 9s. A,@@,@@@ HB,@@@ 9s. 1,GB,@@@ AA,B@@ 1@,AB@ B@,@@@ 9s.A,1E,EB@

The scientific establishment of standards of performance through standard costs and budgets has not only provided better cost control but has led to cost reduction in a number of companies. This has been the case especiil$$y in companies where standards were tied to wage incentive plans and improyement in control is part of a general programme of better management. The above table shows three budgets, one each for GB,@@@, H@,@@@ and VHB,@@@ standard hours of wor!. $n practice, one may come across B@ or more cost items in the budget and not &ust four as shown in the table. R tio An l0$i$ 9at$o is a statistical yardstic! that provides a measure of the relationship betweeri two figures. This relationship may be expressed as a rate 2costs per rupee of sales3, as a per cent 2cost of sales as a percentage of sales3, or as a %uotient 2sales as a certain number of time the inventory3. 9atios are commonly used in the analysis of operations because the use of absolute figures might be misleading. 9atios provide standards of comparison for appraising the performance of a business firm. They can be used for cost control purposes in two ways1

) businessman may compare his firmVs ratios for the period under scrutiny with similar ratios of the previous periods. -uch a comparison would help him identify areas that need his attention.

The businessman can compare his ratios with the standard ratios in his &ndustry. -tandard ratios are averages of the results achieved by thousands, of firms in the same line of business.

$f these comparisons reveal any significant differences, tht:management call analyse the reasons for these differences and can ta!e appropriate action to removeV the cause- responsible for increase in costs. -ome of the most commonly used ratios for cost corrtparisons are given below1 X .ot profits>sales. Mross profits>sales. .et profits>total assets. -ales>tota;assets.

X 6roduction costs>costs of sales. -elling 5osts>costs of sales. )dmiriistration costs>costs of sales. -ahes>iriventory or inventory turnover. Material costs>prod1, ]ction costs. ;abour costs>production costs. (verhead>pr%duction costs. = l'e An l0$i$* Ialue analysis is an approach to cost saving that deals with product design. Here, before ma!ing or buying any e%uipment or materials, a study is made of the purpose to which these things serve. *ould other lower cost designs wor! as well= 5ould another less costly item fill the need= *ill less expensive material, do the &ob= 5an scrap be reduced by changing the design or the type of raw materia]= )re the sellerVs costs as low as they ought to be= -uppliers of alternative mater$als can provide the ample data to ma!e the appropriate choice. (f course, absorbing and reviewing the data will need some time. Thus the ob&ective of value analysis is the identification of such costs in a product that do not in any manner contribute to its specifications or functional value. Hence, value analysis is the process of reducing the cost of the prescribed function without sacrificing the re%uired standard of performance. The emphasis is, first, on identificati%n of the re%uired function and, secondly, on determination of the best way to perform it at a lower cost. This novel method of cost reduction is not yet seriously exploited, in our country. Ialue analysis is a supplementary device in addition to the con\entional cost reduction methods. Ialue analysis is closely related to value engineering, though they are not identical. Ialue analysis refers to the wor! that purchasing department does in this direction whereas value engineering usually refers to what engineers are doing in this area. The purchasing department raises %uestions and consults the engineering department and even the vendor companyVs department. Ialue analysis thus re%uires wholehearted co operation of not only the firmVs expertise in design, purchase, production and costing but also that of the vendor and other company expertise, if necessary. -ome examples of savings through value analysis are given below1 "iscarding tailored products where standard components can do. "ispensing with facilities not specified or not re%uired by the customer, for example, doing away

with headphone in a radio set. 8se ofnewly deyeloped, better and cheaper materials in place of traditional materials. Ta!ing the specific case of TI industry, there are various components of cost, which can be %uestioned. The various items are as under1 *hether to have vertical holding chassis or the chassis should be tied down hori'ontally. $n case, chassis is held vertically, additional expenditure in terms of holding clamps is re%uired. *hether to have plastic cabinet or wooden cabinet. *hether to have two spea!ers or one spea!er. *hether to have sliding switches or stationary switches. *hether to have 6I5 bac! cover or wooden bac! cover. *hether to have costly !nobs or cheaper !nobs. *hether to have moulded mas! or extruded plas!. *hether to have Electronic Tuner or Turret Tuner. *hether to have digital operating unit or noble operating unit. 5ost control is applicable only to such costs, which can be altered by the management on their own initiative. $t may be noted in this context that, by and large, non controllable costs exceed far more than controllable ones thereby restricting the scope of profit impfoyement through cost, control. (f course, attempts may be made to convert an uncontrollable cost into a controllable one. Iertical combinations to secure control over sources of supply provide an example. -o also instead of buying a component, a firm may decide to ma!e the conversion possible.

AREAS OF COST CONTROL #olloviing are the areas where the cost can be controlled1 45 M teri l$ There area number of ways that help in reducing the cost ofmatenals. $fbuying is done properly, a firm avails itself of %uantity discounts. *hile buying from a particular source, in addition to the cost of materials, consideration should be given to freight charges. $n some cases, lower prices of materials may be offset by higher freiight to the firmVs godown. *hiie buying, one may attempt to buy from the cheapbt source by inviting bids. )t times, it may be possible to have more economical substitutes for raw materials that the firm is using. Many a times, improvell1ent in product design may lead to reduction in material usage. $t is desirable to concentrate attention on the areas where saving potential is the highest. )nother area, which needs examination in this respect, is whether to ma!e or buy components from outside source. Iery often firm may find it advantageous to manufacture certain parts and components in oneVs own factory rather than buying them. :et in many cases there are specific advantages in purchasing spares and components from outside because suppliers may deliver goods at low cost with high %uality. #or example, #ord and 5hrysler of the 8- )uto $ndustry purchase their components from outside source. But Meneral Motors could not do so because the firm has its own departments for handling the process of production. This type of firm is referred as vertically integrated firm where it owns the various

aspects of ma!ing se$ling and delivering a product Hind 5ycles, which has now been ta!en over by the Movernment, manufactures all its components. But manufacturers of Hero and )von 5ycles purchased most of their components from outside source and successfully competed with Hind 5ycles. 5ontinuous 9esearch and "evelopment 29 ^ "3 may also lead to a reduction in raw material costs. #or example, )sian 6aints made high savings in costs of raw materials by its phenomenal success on 9esearch and "evelopment front, by manufacturing synthetic resins for captive consumption. Total materials consumed as a ratio of value of production fell from FE.FF per cent in 1LEG to F@ FE per cent in 1LEE. Meneral Motors have reduced the weight of their cars to ma!e them more fuel efficient. Better utilisation of materialsV may also save the cost of materials by avoiding wastes in storing, handling and processing. -ome of the factors, responsible for excessive wastage of materials are1 lac! of laid down re%uirements for raw materials, bad process planning, re&ects due to faulty materials or poor wor!manship, lac! of proper tools, &igs and fixtures, poor %uality of materials, loose pac!ing, careless and negligent handling and careless storage. Exploration of the possibilities of the use of standardised parts and components and the utilisation of waste and by products, may also lead to a significant reduction in the cost of materials. $nventory control is yet another area for reducing materials cost. Thro inventory control, it is possible to maintain the investment in inventories at lowest amount consistent with the production and the sales re%uirements of firm. The cost of carrying inventories ranges from 1B to A@ per cent per annum account of interest on capital, insurance, storage and handling charges, spilla brea!age, physical deterioration, pilferage and obsolescence. )gain B@ per cent the gross wor!ing capital may be loc!ed up in inventories. -ome important ways of reducing inventories are1 $mproved production planning. Having dependable sources of supplies, which can ensure prompt deliver of materials at short notice. Elimination of slow moving stoc!s and dropping of obsolete items. $mproved flow of part and materials leading to increased machine utilisation and shorter manufacturing cycles. 6ac!aging constitutes a significant proportion of raw materials 2L to AH per cent3 and of the total manufacturing expenses 2E to AA per cent3. #irm should mal attempts to reduce the pac!aging costs to the minimum. #or example, instead discarding containers that the materials come in it may be used for shipping tl goods and thus, the pac!aging cost can be saved. The manufacturing firms such7 cars and motor bi!es may re%uest its customers to return the containers in whic are goods were sent so that they could be used in future. This is because pac!in of such goods as well as the materials used for pac!ing is very expensive. 65 L (o'r 9eduction in wages for reducing labour costs is out of %uestion. (n the other hand, wages might have to be increased to provide incentives to wor!ers. :et there is good scope for reduction in the wage cost per unit. ) reduction in labour costs is possible by proper selection and training, improvement in productivity and by

automation, where possible. ) study by cn 25onfederation of $ndian $ndustry3 showed that Hero 5ycles improved their productivity per employee by F.H per cent. V6urolatorsV were able to increase their productivity by 1@@ per cent. *or!W study might result in a lot of savings by reducing overtime and idle time and providing better wor!loads. ;abour productivity might increase if fre%uent change of tools is avoided. $mprovement in wor!ing conditions may reduce absenteeism and thus reduce costs per unit. -crutiny of overtime may reveal substantial scope for savings. )ll efforts must be made to redllce wastage of human effort. *astage of human effort may be due to lac! of co ordination among various departments by having more wor!ers than necessary, Wunder utilisation of existing manpower, shortage of materials, improper scheduling, absenteeism, poor methods and poor morale. #or example, Metal Box adopted a Ioluntary -everance -cheme in 1LEBEF to reduce their wor! force by LB@ wor!ers after they faced a huge operating loss of9s. A.H crores. Meneral Motors eliminated 1H,@@@ white collar &obs through attrition to reduce cost. ]apanVs big B steel producers announced substantial retrenchment programmes and wor!ers co operated with the management. )ttempts must be made to secure co operation of employees in cost reduction by inviting suggestions from them. These suggestions should be carefully examined and implemented if found satisfactory. Hindustan ;ever has a suggestion box scheme and employees who come out with good suggestions receive awards. These suggestions may either lead to savings or improve safety and wor! conven]ence. The basic idea is to motivate wor!ers and ma!e them perceive wor!ing in the firm as a participative endeavour. 75 O)er"e !$ #actory overheads may be reduced by proper selection of e%uipment, effective utilisation of space and .e%uipment, proper maintenance of e%uipment and reduction in power cost, lighting cost, etc. #or example, fluorescent lighting can reduce lighting cost. #aulty designs may lead to excessive use of materials or multiplicity of components, waste of steam, electricity, gas, lubricants, etc. ) British team invited by the Movernment of $ndia to report on standards of fuel efficiency in $ndian industry found that fuel wastages might be as high as an average of AB per cent. 4eeping them in chec! even in the face of increasing sales may reduce overhead costs per unit. #or example, Metal Box maintained their fixed costs in 1LEF EE even when there was an increase in sales of over 1D per cent. Ta!ing advantage of truc! or wagonloads may reduce transportation cost. 5areful planning of movements may also save transportation cost. )nother point to be examined is whether it would be economical to use oneVs own transport or hire a transport. #or reasons of economy, many transport companies hire truc!s rather than owning them. This is because purchase and maintemince of truc!s can be more expensive. By chartering vehicles the problems of maintenance is left to the owner who in turn 5uts cost for the firm. Thus by !eeping a smaller wor! force on rolls and by introducing a contract rate lin!ed to a safe delivery schedule it is possible to ensure speedy point to point delivery of goods. Many firms now prefer to use private taxis rather than have their own staff cars. 9eduction of wastes in general can also reduce manufacturing costs considerably. (f course, a certain amount of waste and spoilage is unavoidable because employees do ma!e mista!es, machines do get out of order and sometimes raw materials are faulty. However, attempts can be made to reduce these mista!es and faulty handling to the minimum. The normal figure for the waste and spoilage depends upon the complexity of the product, the age of the manufacturing plant, and the s!ill and experience of the wor!ers. (nce normal wastage is found out, production reports must be watched carefully to find out

whether the wastages are excessive. *astes can be reduced considerably by educating operators in the causes and cures of the wastes. Bad debt losses can be reduced considerably by selecting customers carefully, and !eeping an eye on the receivables. 5oncentrating on areas and media can reduce advertising costs, which give the best results. -elling costs can be controlled by improving the supervision and training of salesmen, rearrangement of sales territories, replanting salesmenVs routes and calls and redirecting of the sales efforts, to achieve a more economic product mix. $t may be possible to save selling costs by the use of warehouses, ma!ing bul! shipments to the warehouses and giving faster deliveries to the customers. 5entralisation, reduction, clerical and accounting wor! may also lead to cost savings. ) loo! at the telephone bills and the communication cost in general may also reveal areas for substantial savings. #or example a telegram may be sent in place of a trun! call. ; < Co$t Re!'ction The $nstitute of 5ost and *or!s )ccounts of ;ondon has defined cost reduction as Ythe achievement of real and permanent reductions in the unit costs of goods manufactured or services rendered without impairing their suitability for the use intendedY. Thus, cost reduction is confined to savings in the cost of manufacture, administration, distribution and selling by eliminating wasteful and unnecessary elements from the product design and from the techni%ues and practices carried out in coil(ection with cost reduction= ;(< Co$t ControE n! Co$t Re!'ction )ccording to the $nstitute of 5ost and *or!s )ccounts, ;ondon, Ycost control, as generally practised, lac!s the dynamic approach to many factors affecting costs, which determine the need of cost reduction.Y #or example, under cost control, the tendency is to accept standards once they are fixed and leave them unchallenged over a period. $n cost reduction, on the other hand, standards must be constantly challenged for improvement. )nd there is no phase of business, which is exempted from the cost reduction. 6roducts, processes, procedures and personnel are sub&ected to continuous scrutiny to see where and how they can be reduced in cost. To achieve success in cost reduction, the management must be convinced of the need for cost reduction. The formulation of a detailed and co ordinated plan of cost reduction demands a systematic approach to the problem. The first step would be the institution of a 5ost 9eduction 5ommittee consisting of all the departmental heads to locate the areas of potential savings and to determine the priorities. The 5ommittee should review progress and assign responsibilities to appropriate personnel. Every business operation should be approached in the belief that it is a potential source of economy and may benefit from a completely new appraisal. (ften, it may be possible to dispense entirely with routines, which, by tradition, have come to be regarded as a permanent feature of concern. 5ost reduction is &ust as much concerned with the stoppage of unnecessary activity as with the curtailing of expenditure. $t is imperative that the cost of administering any scheme of cost reduction must be !ept within reasonable limits. *hat is reasonable must be determined in all cases from the relationship between the expenditure and the savings, which result from it.

E$$enti l$ %or t"e S'cce$$ o%

Co$t Re!'ction Progr &&e

#ollowing are the some of the points that firms should ta!e care in order to achieve success in the cost reduction programme1 Every individual within the firm should recogniseW his responsibility. The co operation of every individual re%uires a careful dissemination of the ob&ectives and interest of the employees in the achievement of the firmVs goals. Employee resistance to change should be minimised by disseminating complete information about the proposed changes and convincing the emplcyees that the changes are concerned with the problems faced by the firm and that they would ultimately benefit. Efforts should be concentrated in the areas where the savings are li!ely to be the maximum. 5ost reduction efforts should be continuously maintained. There should be periodic meetings with the employees to review the progress made towards cost reduction.

;c< F ctor$ / &#ering Co$t Control in In!i The cost of raw material and other intermediate products is generally high. $n many cases1 the cost of raw materials is substantially higher than their international prices, which ma!es it difficult for the $ndian firms to compete in foreign mar!ets. The sharp rise in oil prices in recent years also gave a severe push to the cost of raw materials with petrochemical base. -hortages of raw materials are a usual phenomenon. *ith a view to insuring against these shortages, manufacturers !eep larger inventories, which result in increase in their costs. This occurs especially in case of imported raw materials. *ages are always being lin!ed to cost of living. There are wage boards for almost every industry and management has little control on wage rates. (verheads are also higher in $ndia due to the following reasons1 The si'e of the plant is very often uneconomic due to the MovernmentVs desire to prevent concentration of economic power. However, there is now a mar!ed change in the policy. $n 1LDF, the Movernment announced that FB industries would be started with minimum economic capacity so as to Vma!e $ndiaVs products competitive. This process got a boost after the new $ndustrial 6olicy was announced in ]uly 1LL1. There is under utilisation of capacities due to lac! of raw materials and power shortage. However a manufacturer can exceed his capacity by improving the techni%ues of production process. Even after ma!ing improvements, a manufacturer lac!s the way to completely minimise the possibilities of increase in the overheads. Machinery and e%uipment obtained under tied credits usually cost G@ to H@ per cent more than what it wouid cost if purchased in the open mar!et. There are delays in the issue of licences and by the time licences are issued, cost of e%uipment goes up. The number of industries sub&ect to licensing has now been drastically reduced. $ncrease in administered prices for many items crucial to the industrial production by the Movernment from time to time also pushes up costs. #inally, there is what lis called by businessmen as Vunseen overheadsV in the nature of demands for

illegitl gratification by various Movernment officials at different administrative levels. There are indirect taxes, which also tend to raise the overall costs of production in $ndia. Excise duties and saies taxes also heighten the impact of indirect taxes on the cost of production. $ndia is perhaps the only country where basic raw materials carry heavy excise duties. )ccording to an estimate by Mr. -. Moolgao!ar, 5hairman, TE;5(, as much as 9s. AB crores of wor!ing capital is loc!ed up in inventories and wor! in progress with TE;5( and its suppliers solely due to the present tax structure. 8ntil recent times the $ndian industrialists operated in a sheltered domestic mar!et. They were protected against foreign competition by import controls and against domestic competition due to industrial licensing. -o long as this sellersV mar!et prevailed competition among sellers was absent and there was no compelling reason for the industrialists to pay any attention to cost reduction. 5ost consciousness was thus by and large absent in $ndia. The price fixation for products under price control ensured that the rise in costs was fully reflected in the prices. This made it possible for the industrialists to pass on any increase in costs to the consumers. However, now with the advent of recession tendencies, and liberalisation in licensing policies, the $ndian industrialist is compelled to pay greater attention to cost reduction and cost control.