MODULE – 1

General Economics
1.1 Demand and supply analysis:
 LAW OF DEMAND
 Meaning of demand
 Demand means effective desire or want for a commodity which is backed up by the
ability and willingness to pay for it.
 Demand = Desire + ability to pay + will to spend
 Demand is always related to price and time
 Demand may be individual / market demand.
 Demand in economics means desire to buy backed by adequate purchasing power. The
demand for goods, therefore denotes that someone is able and willing to buy the goods.

 Determinants of demand/ factors influencing demand

 1). Price of the product: Ceteris paribus i.e other things being equal demand for the
commodity is inversely related to its price. That is, when price of the product falls
quantity demanded increases and vice versa.
 2). Income of the consumer: other things being equal demand for the commodity
depends upon the income of the person. Generally higher the income higher will be
quantity demanded. There is direct relationship between income and quantity demanded.
However sometimes with an increase in income demand for certain commodities
decreases eg. Inferior goods like low quality goods, cloths, or food grains etc.

 3). Taste and preferences of consumers: Goods which are more in fashion have higher
demand than goods which are out of fashion eg. Mobile handsets, LED television etc. If
taste & preferences changes than demand for goods also changes.

 4). Habits of consumer: Habits directly influences the demand for commodity. If habits
changes then demand for particular product also changes. If a person is used to a cup of
tea or reading newspapers than he will demand these products on daily basis.

 5). Customs and traditions: Certain goods are demanded due to customs or traditions.
Eg . Ganesh idols during ganesh festival, bridal dress for marriages etc.

 6). Price of substitute goods: Substitute goods are those goods which can be used in
place of one another. For example Tea and coffee, ink pen & ball pens are substitute of
each other. If price of tea rises , people will buy less of tea and more of coffee, or vice
versa.

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 7). Price of complementary goods: Complementary goods are those goods which are
consumed together eg. Car and Petrol, Pen & ink. When price of one commodity falls
than the demand for another commodity increases. Eg. When the price of car falls
demand for cars will increase and therefore demand for petrol will also rise.

 8). Size of Population: Generally, larger the size of population of a country greater is the
demand for commodities. For instance countries like India and China where population is
more demand for goods and services is also more.

 9). Composition of population: if the composition of population is such that there are
more children's than there will be more demand for toys, school bags, uniforms etc. On
the other hand if old people are more in a region then the demand for spectacles, walking
sticks etc will be more.

 10). Climatic Conditions: Certain goods are demanded only during particular seasons.
Eg. During rainy season demand for umbrellas, raincoats , etc will be more while during
the winter season demand for woolen clothes will be more.

 Demand schedule

 A tabular statement of price & quantity relationship is known as the demand schedule.

 It shows how much amount of a commodity is demanded by an individual or group of

individuals in the market at alternative prices per unit of time.

 There are 2 types of demand schedule :

1. Individual demand schedule.

2. Market demand schedule.

Individual demand schedule:

 A tabular list showing the quantities of a commodity that will be

purchased by an individual at various prices at a given time.
 Example a hypothetical demand schedule of an individual consumer
Mr. X for mangoes.

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 Market demand schedule :
 A tabular list showing the quantities of a commodity demanded by all
the buyers in the market at various prices at a given time.
 Market demand schedule is derived from individual demand
schedule.
Price Units of commodity X Demanded by Total or Market
(in Rs) demand
A + B + C =
4 1 1 3 5

3 2 3 5 10

2 3 5 7 15

1 5 9 10 24

Market demand curve

Y axis Dm
D2
Market demand
D1 curve (D1+D2)

P
PRICE

D2 Dm
D1 X axis
O
QUANTITY DEMANDED

 LAW OF DEMAND
 ASSUMPTIONS

 Law of demand is based on following assumptions:

1. No change in consumer income

2. No change in taste and preferences

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3. No change in population of a country

4. No change in fashion

5. No change in climatic conditions

6. No change in the price of substitute and complementary goods.

7. No expectations of future price changes or shortages of goods.

 Statement of the law:

 “Other things being equal, the higher the price of a commodity, the smaller is the
quantity demanded and lower the price, larger the quantity demanded.”

 Law of demand shows that there is an inverse relationship between price and quantity
demanded.

 It assumes that other things remain the same i.e other factors influencing demand like
income of the consumer, taste, habits, preferences, climate etc remains the same.

 Law of demand can be Explained with the help of demand

schedule:
Demand Schedule

Price of commodity X Quantity demanded

in Rs of commodity X
20 1
15 2
10 3
5 4
1 5

 The above demand schedule shows that as price falls quantity

demanded increases and vice versa.

 Demand curve
 Demand curve, in economics, a graphic representation of the relationship between
product price and the quantity of the product demanded.

 It is drawn with price on the vertical axis (Y) of the graph and quantity demanded
on the horizontal axis (X)

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 demand curve is said to be sloping downward from left to right because price and
quantity demanded are inversely related.

 Law of demand can be also explained with the help of demand

curve :
 When the demand schedule is plotted in the form of graph we get
demand curve. DEMAND CURVE
 Y
D
Price of commodity

P A

P1 B

D
O Q Q1 X
Quantity
demanded
 The above diagram explains the law of demand graphically.

 In the above graph on the X-axis we measure quantity demanded. On the Y- axis we measure
price of the product. DD is a downward sloping demand curve. OP is the original price and OQ is
the original quantity demanded. It shows inverse relationship between price and quantity
demanded . i.e when price falls from OP to OP1, quantity demanded increases from OQ to OQ1.
and vice versa.

 Why inverse/negative relationship exists between the price and

quantity demanded? Why demand curve slope downward from
left to right?
 Economists have mentioned the following reasons:

 1). Application of the law of diminishing marginal utility: The law states as consumer
consume more units of a commodity, the utility derived from each additional unit goes on
diminishing therefore marginal utility curve slopes downward, hence the demand curve
also slopes downward to the right.
 2. Substitution effect: when the price of a commodity fall it becomes cheaper and more
attractive to the consumer. The consumer tries to substitute this Cheaper commodity and
buy more therefore demand increases.
 3. Income effect: When the price of a particular commodity falls the consumers real
income rises and the purchasing power of the individual rises. Therefore the consumer
buys more of the commodity when price falls and it is known as income effect.

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 4. Price effect: Some commodities have multiple uses, like electricity, milk, coal, steel
etc. A fall in price of such a commodity would allow a consumer to put it to alternative
uses. For e.g Electricity can be used for cooling, cooking, heating, running machines etc.
If it is cheap people will use it for all possible purposes.
 5. Falling prices attract new consumers as the commodity now becomes affordable
to them.

 Exceptions to the law of demand

 Usually when price falls quantity demanded increases and vice –Versa. Sometimes, the
law of demand may not hold true.
 Sometimes it is found that when price falls demand also falls and when price rises
demand also rises, cases in which this happens are known as exception to the law of
demand.
 They are as follows:
 1). Giffen goods : Giffen goods are generally inferior or low quality goods. E.g Coarse
grains like bajra, low quality rice & wheat etc. in case of these low quality goods when
the price falls quantity demanded also falls.
 2. “Veblen goods”/Articles of Distinction/Snob appeal: Sometimes, certain
commodities are demanded just because they happen to be expensive or prestige goods.
They are unique goods- such goods are purchased only by few highly rich people for
snob appeal. For instance, very costly diamonds, rare paintings, Rolls-Royce- cars and
antique items. These goods are called “Veblen goods”.
 3). Ignorance of Consumers: Sometimes a consumer may buy more quantity at higher
prices as he may be not aware about the actual real price prevailing in market.
 4). Consumer illusion: illusion about the quality of commodity with price change. They
feel that high priced goods are better quality goods and low price goods are inferior
goods.
 5). Speculation/ future expectations: If consumer expects or speculate that the price of a
certain commodity will increase in future, then he may buy more quantity of goods even
at a higher price. Stock markets are the fine Example of speculative demand.
 6). No close substitute: Petroleum products , Sewing machine, salt etc . Do not have
close substitute. Therefore for this types of commodity even if price rises demand for
these products increases because there are no substitute for it.

 Exceptional demand curve:

 In exceptional demand curve is an upward sloping demand curve.
 It shows positive relationship between price and quantity demanded.

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 SHIFT IN DEMAND / INCREASE & DECREASE IN DEMAND:

 Shift in Demand - shift in entire demand curve in response to a change in a Income, taste,
habit, fashion, climate etc. price of the product remaining same.

 Shift in demand is related to ‘increase’ or ‘decrease’ in demand.

 Shift in demand take place due to changes in non-price factors such as income, taste &
preference, price of related goods etc.

 Increase in demand : At the same price when more is demanded than before it is known
as increase in demand. Here increase in demand will be due to increase in income,
change in taste & preferences, change in habits etc.

 In case of an increase in demand, the demand curve is shifted to the right.

 Decrease in demand : At the same price when less is demanded than before it is known
as decrease in demand. Demand may decrease because of fall in income, change in taste,
habit , fashion , climate , population etc.

 In case of decrease in demand, the demand curve is shifted to the left.

Graphical depiction of shift in demand or

decrease & increase in demand:
Y axis D1
D
D2

P
PRICE

D D1
D2
O Q2 Q Q1 X axis

QUANTITY DEMANDED

 In the above diagram we measure price of the commodity on Y axis & quantity
demanded on X axis.

 DD is the original demand curve , OP is the initial price, OQ is the initial quantity
demanded.

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  When price remain same , Increase in demand & decrease in demand takes place due to
changes in income, taste, habits etc.

 The increase in demand is shown by shifting the demand curve to the right, D1D1 is the
new demand curve showing increase in demand. Price OP remain same but quantity
demanded increases from OQ to QQ1

 The decrease in demand is shown by shifting the demand curve to the left, D2D2 is the
new demand curve showing decrease in demand. Price OP remains same but quantity
demanded decreases from OQ to OQ2.

 Supply analysis
Meaning of Supply:
Supply means the quantities that a seller is willing and able to sell at a particular price during a
certain period of time. In economics, supply during a given period of time means the quantities
of goods which are offered for sale at particular prices.Supply is a relative term . It is always
referred to in relation to price and time.Supply is what the seller is able and willing to offer for
sale.
The ability of a seller to supply commodity depends on the stock available with him.A sellers
willingness to supply a commodity depends on market price i.e( if higher the market price for
commodity then seller will be willing to supply more quantities & if lower the market price then
seller will be not willing to supply more). There exist direct relationship between price &
quantity supplied.

 SUPPLY AND STOCK

Stock:
Stock refers to the total quantity of a commodity available with the sellers for sale.
E.g 1000 cars are produced by Honda per year.
If market price is less then stock will be more.
Stock of goods can be more then supply.
Durables goods will have larger stocks.

Supply:
Supply is actual quantity of a commodity offered for sale by seller at certain price at given
time.E.g At a price of Rs 7 lakh 500 cars are offered for sale in the month of august then it’s a
supply.
If market price is higher then supply will be more.
Supply cannot be greater then stock
For perishable goods like milk, vegetables stock will be very less but supply will be greater.

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  DETERMINANTS OF SUPPLY / FACTORS INFLUENCING SUPPLY :
1). Price of the Commodity:
The most important factor determining the supply of a commodity is its price. As a general rule,
price of a commodity and its supply are directly related. It means, as price increases, the quantity
supplied of the given commodity also rises and vice-versa. It happens because at higher prices,
there are greater chances of making profit. It induces the firm to offer more for sale in the
market.

2).Prices of Factors of Production (inputs):

When the amount payable to factors of production and cost of inputs increases, the cost of
production also increases. This decreases the profitability. As a result, seller reduces the supply
of the commodity. On the other hand, decrease in prices of factors of production or inputs,
increases the supply due to fall in cost of production and subsequent rise in profit margin.To
make ice-cream, firms need various inputs like cream, sugar, machine, labour, etc. When price of
one or more of these inputs rises, producing ice-creams will become less profitable and firms
supply fewer ice-creams.

3). State of Technology:

Technological changes influence the supply of a commodity. Advanced and improved
technology reduces the cost of production per unit of output, which raises the profit margin. It
motivates the seller to increase the supply. However, technological degradation or complex and
out-dated technology will increase the cost of production per unit of output and it will lead to
decrease in supply.

4). Number of Sellers / Firms :

Greater the number of sellers or firms, greater will be the quantity of a product or service
supplied in a market and vice versa. Thus increase in number of sellers will increase supply and
shift the supply curve rightwards whereas decrease in number of sellers will decrease the supply
and shift the supply curve leftwards.
For example, when more firms enter an industry, the number of sellers increases thus increasing
the supply.

5). Tax and Subsidy:

Increase in taxes raises the cost of production and, thus, reduces the supply, due to lower profit
margin. On the other hand, tax concessions and subsidies increase the supply as they make it
more profitable for the firms to supply goods.

6). Prices of Other Goods:

As resources have alternative uses, the quantity supplied of a commodity depends not only on its
price, but also on the prices of other commodities. Increase in the prices of other goods makes

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them more profitable in comparison to the given commodity. As a result, the firm shifts its
limited resources from production of the given commodity to production of other goods. For
example, increase in the price of other good (say, wheat) will induce the farmer to use land for
cultivation of wheat in place of the given commodity (say, rice).

7). Development of transport :

Improvement in the means of transport increases supply of goods as they facilitate movement of
goods from one place to another.

8). Factors outside the economic sphere:

Weather conditions, floods etc cause fluctuations in the supply of goods particularly of
agricultural goods. There might be decrease in supply due to floods , deficient rainfall,
earthquake etc.

 Supply function:
Supply function explains the functional relationship between supply and different determinants
of supply like price, factor inputs, technology, tax, subsidy etc.
Supply function can be written as following symbolic form:
Sx = ƒ ( Px, Pƒ, Py, …O , T, t, s )
Where, Sx = The supply of commodity x.
Px = price of x.
Pƒ = Price of factor inputs.
O = factors outside the economic sphere.
T = Technology
t = tax
s = subsidy

 Law of supply :
Law of supply depicts the producer behavior at the time of changes in the prices of goods and
services. When the price of a good rises, the supplier increases the supply in order to earn a profit
because of higher prices.
Statement of the law :
“Other things remaining the same, as the price of a commodity rises, its supply is extended,
and as the price falls, its supply is contracted.” Law of supply states that other factors
remaining constant, price and quantity supplied of a good are directly related to each
other.

 Assumptions of law of supply:

1). Cost of production is unchanged:
2). No change in technique of production:

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3). Fixed scale of production:
4). Government policies are unchanged:
5). No change in transport cost:
6). No speculation:
7). Prices of other goods are kept constant:

 Explanation of the law of supply with the help of supply schedule:

Price of ball – pen ( Rs) Quantity Supplied

5 100

10 150

15 200

20 300

In the above schedule we can observe positive relationship between price and quantity supplied.
As price increases more and more quantities are supplied. And as price decreases less and less
quantities are supplied.

 Explanation of the law of supply with the help of supply curve:

Explanation of the law of supply
with the help of supply curve:
 Supply curve
Y

 In the above graph supply curve explains the law of

supply by showing a direct relationship between price
& quantity supplied.

The above diagram shows the supply curve that is upward sloping (positive relation between the
price and the quantity supplied).
When the price of the good was at P3, suppliers were supplying Q3 quantity.
As the price starts rising from P3 to P1 , the quantity supplied also starts rising from Q3 to
Q1.And on the other hand If price falls from P1 to P3 , the quantity supplied will also starts

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falling from Q1 to Q3.Therefore the supply curve indicates that other things remaining constant
when price increases the quantity supplied will also rises , and when price decreases quantity
supplied also falls.

 There are three main reasons why supply curves are drawn as
sloping upwards from left to right giving a positive relationship
between the market price and quantity supplied:

1. The profit motive: When the market price rises following an increase in demand, it
becomes more profitable for businesses to increase their output
2. Production and costs: When output expands, a firm's production costs tend to rise,
therefore a higher price is needed to cover these extra costs of production. This may be
due to the effects of diminishing returns as more factor inputs are added to production.
3. New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in total supply.

 Exceptions to the law of supply:

1). In labour market the law of supply does not hold true: a rise in wages of laborers may
sometime leads to fall in labour supply.
2). In case of some commodities like old coins, old stamps, paintings of well known artist etc ,
when price rises the supply cannot be increased of this types of commodities.
3). During the time of depression when seller expect a fall in prices they go on supplying more &
more with every fall in the price.

 EXTENSION & CONTRACTION IN SUPPLY

Movement of the supply along the same supply curve is known as Extension and Contraction of
supply. Extension & Contraction in supply is due to changes in the price.
When other factors remain constant and price of commodity changes the extension or contraction
in supply takes place. Movement in supply curve take place due to changes in price.
 Extension in supply:
With a rise in price, the supply rises , it is called Extension of supply. Graphically an upward
movement from one point to another on the same supply curve due to rise in price is known as
Extension in supply.
 Contraction in supply :
With a fall in price, the supply declines, it is called contraction of supply. Graphically a
downward movement from one point to another on the same supply curve due to fall in price of
commodity is known as Contraction in supply.

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 Extension & CONTRACTION
in supply :
Y S
B
P1

Price A
P Extension in supply

P2 C

Contraction in supply
S
O Q2 Q Q1 X
Quantity supplied

In the above graph we measure Quantity supplied on X axis & on Y axis price.
Initial price is P & initial quantity is Q.
Extension in supply: when price rise from P to P1 the quantity also rises from Q to Q1 & is
known as Extension in supply. Extension in supply is shown by an upward movement from point
A to B due to rice in price.
Contraction in supply: when price fall from P to P2 the quantity also falls from Q to Q2 & is
known as Contraction in supply. Contraction in supply is shown by an downward movement
from point A to C due to fall in price.

 SHIFT IN SUPPLY / INCREASE & DECREASE IN SUPPLY

When price of commodity remain constant and supply changes because of changes in other
factors affecting supply such as improved technology, lower cost of production, improved means
of transport it is called as shift in supply / increase & decrease in supply. Increase & Decrease in
supply is due to changes in other factors & price of product remain same.
 Increase in supply : A shift in supply curve to the right due to changes in other factors
while price of the product remaining constant is called increase in supply.
 Decrease in supply : A shift in supply curve to the left due to changes in other factors
while price of the product remaining constant is called decrease in supply.

 Graphical depiction of increase & decrease in supply:

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 Graphical depiction of increase & decrease in
supply:
S2
Y S
Decrease in supply S1

Price
P Increase in supply

S2

S
S1
O Q X
Q2 Q1
Quantity supplied

 In the above graph we measure Quantity supplied on X axis & on Y axis price.
 Price remains constant at OP level.
 Increase in supply : when price remain constant and supply curve shifts to the right
from SS to S1 S1 the quantity supplied increases from Q to Q1 & is known as Increase
in supply. Graphically Increase in supply is shown by shifting the supply curve to the
right from SS to S1S1.
 Decrease in supply : when price remain constant at OP level and supply curve shifts to
the left from SS to S2S2 quantity supplied decrease from Q to Q2 & is known as
Decrease in supply. Graphically Decrease in supply is shown by shifting the supply curve
to the left from SS to S2S2.

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 Market equilibrium
Concept:
Equilibrium in general is defined as the state of rest or balance from which there is no tendency
for change.In economics, equilibrium normally refers to equilibrium in a market.
Even if there is any change, the original equilibrium position will be restored by market forces.
Market equilibrium is a position where market demand and market supply are equal ( DD = SS).
Graphically the equilibrium point is the point where Demand curve and supply curve intersect
with each other &at this point (DD = SS).

 Market demand and supply schedule:

Possible prices Total Demand Total supply Pressure on
(Rs. Per kg ) (kg. per week) (kg. per week) price
30 1000 10000 Downward
28 3000 8000 Downward
26 4000 6000 Downward
24 5000 5000 Neutral
22 7000 4000 Upward
20 10000 2000 Upward

 EXPLAINATION OF SCHEDULE:
In the above schedule we can examine four components i.e price, total demand, total supply &
pressure on price. In the schedule we can see price & total demand shows inverse relationship &
price and total supply shows positive relationship. Equilibrium price is 24, where total demand
(5000) is equals to total supply (5000).Any price above 24 shows excess supply where total
supply is greater than total demand. Because of excess & over supply there will be downward
pressure on price.
At any price below 24 there will be excess demand where demand is greater than supply &
excess demand & shortage of goods & services will put upward pressure on the price .

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Therefore any fluctuations in the price will lead to disequilibrium, but due to market forces of
demand & supply the equilibrium will be attained through price adjustment mechanism.
Therefore equilibrium price will be known as unique price

 Market equilibrium can also be illustrated with help of Figure:

Equilibrium price is PE.At price PE, the quantity demanded is equal to quantity supplied, D=S.
At other prices, there is no equality between quantity demanded and quantity supplied.
In both the cases either the consumer or the firms are dissatisfied and tend to change the price.

 Excess Supply:(S>D)
At any price above the equilibrium price (PE), supply is greater than demand(S>D). Thus there is
excess supply. When price is high, buyers prefer to reduce their purchase.
But sellers prefer to sell more as price is high. These contrasting behaviours of buyers and
sellers result in excess supply in the market which is the difference between the quantities
demanded and quantity supplied. As sellers cannot sell all of the quantity at the high price, some
of them may reduce price to sell the excess stocks.

 Excess demand: ( D > S )

Similarly, if the price is below the equilibrium price PE, there will be excess demand, D>S.
In this case some of the buyers may try to bid up the price to buy some more quantity when
supply is less. This may also encourage sellers to supply more. For instance, buying cinema
tickets off the counter (called as tickets in black) by paying a higher price than the actual price.
Thus, in both cases, the actions of buyers and sellers will move the price either upwards or
downwards and eliminate the excess demand or excess supply. Such actions also restore the
demand-supply balance to attain the market equilibrium. At equilibrium price, there is no force
to change the price or quantity demanded of a commodity.

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  Shift in Demand and Supply or changes in equilibrium price
The market equilibrium attained above is temporary. It cannot be retained for a long period.
It is because demand and supply conditions keep changing frequently. Any change in the
determinants of demand and supply will shift the demand curve and supply curve.
These shifts will also bring new equilibrium.
 Shift in demand
The ‘other things’ that affect demand are also called as the determinants of demand. They
include income of the consumer, tastes, prices of substitutes and many more.Changes in these
determinants will change demand independently of price. If income of the consumer increases,
they will buy more irrespective of the price. Similarly a fall in income will bring a fall in demand
even if there is no change in price.

 1). Shift in demand curve supply remaining constant :

Explanation
D is the original demand curve with equilibrium price OP and quantity OQ.
Any change in the determinants of demand like income and tastes will shift the demand curve.
For instance, a fall in the income of consumer shifts the demand curve D to D1 and the new
equilibrium would be at point E1.And new equilibrium price decrease from OP to OP1 &
equilibrium quantity also decreases from OQ to OQ1.
Similarly, any increase in income shifts the demand curve from D to D2 . The equilibrium also
moves from point E1 to E2 .

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  2). Shift in supply DEMAND REMAINING CONSTANT
As seen earlier, the supply curve shows the relationship between the price and quantity supplied
keeping the ‘other things’ constant.
The ‘other things’ which affect supply include number of sellers in the market, factor prices, etc.
These factors affect quantity supplied independently of price.

Explanation :
Price is the major determinant of supply. However, a fall in the price of factor (s) of production
(land and labour) will reduce the cost of production.
This in turn will encourage the firms to supply more.
Increase in supply curve is shown by shift of supply curve to the right from its original
level of S to new level of S1. As a result new equilibrium point moves from E to E1 ,
indicating Equilibrium price falls from OP to OP1 & Equilibrium quantity increases from OQ to
OQ1.
Decrease in supply:
An increase in factor price will increase the cost of production and the supply curve will shift to
the left from S to S2. Decrease in supply is shown by shifting the supply curve to the left.
Due to decrease in supply the equilibrium point moves from E to E2 .As a result equilibrium
price increases from OP to OP2 & and equilibrium quantity decreases from OQ to OQ2.

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3). Both demand & supply increase in same proportion:

 Explanation of above graph:

Increase in Demand = Increase in Supply:
When increase in demand is proportionately equal to increase in supply, then rightward shift in
demand curve from DD to D1D1 is proportionately equal to rightward shift in supply curve from
SS to S1S1. The new equilibrium is determined at E1.
As both demand and supply increase in the same proportion, equilibrium price remains the same
at OP, but equilibrium quantity rises from OQ to OQ1.

 4). Both Demand and Supply Decrease IN SAME PROPORTION:

Explanation of above graph:

Decrease in Demand = Decrease in Supply:
When decrease in demand is proportionately equal to decrease in supply, then leftward shift in
demand curve from DD to D1D1 is proportionately equal to leftward shift in supply curve from

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SS to S1S1. The new equilibrium is determined at E1 As demand and supply decrease in the
same pro-portion, equilibrium price remains same at OP, but equilibrium quantity falls from OQ
to OQ1.

1.2 National Income Terms:

National Income:
In common parlance, national income means the total value of goods and services produced
annually in a country. In other words, the total amount of income accruing to a country from
economic activities in a year’s time is known as national income. It includes payments made to
all resources in the form of wages, interest, rent and profits.

“National income is defined as the money value of all the final goods and services produced in
an economy during an accounting period of time, generally one year”

Some of the common measures of national income are Gross Domestic Product (GDP), Gross
National Product (GNP), Net Domestic Product (NDP) and Net National Product (NNP).

 i). Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within the country during a year. This is
calculated at market prices and is known as GDP at market prices. GDP at market price is
defined as “the market value of the output of final goods and services produced in the domestic
territory of a country during an accounting year.”

GDP includes income from exports and payment made on imports during the year. However, it
does not include the earnings of nationals working abroad as also of the foreign nationals
working in our country. You should note here that GDP measures final output/gods and not
intermediate goods. GDP also excludes items produced in previous years, because those goods
were calculated in previous year’s GDP, if they are included this year, it would lead to double
counting.

GDP can also be expressed as the summation of consumption expenditure, Investment

expenditure, Government expenditure and net exports(X – M), where X represents Exports and
M represents Imports. Symbolically it is expressed as follows:

GDP = C + I + G + (X – M)

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a). GDP at Factor Cost and GDP at Market Price:
GDP at factor cost is the sum of net value added by all producers within the country. Since the
net value added gets distributed as income to the owners of factors of production, GDP is the
sum of domestic factor incomes and fixed capital consumption (or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

GDP at factor cost includes:

(i) Compensation of employees i.e., wages, salaries, etc.

(ii) Operating surplus which is the business profit of both incorporated and unincorporated firms.
[Operating Surplus = Gross Value Added at Factor Cost—Compensation of Employees—
Depreciation]

(iii) Income of Self- employed.

Conceptually, GDP at factor cost and GDP at market price must be identical/This is because the
factor cost (payments to factors) of producing goods must equal the final value of goods and
services at market prices. However, the market value of goods and services is different from the
earnings of the factors of production.

In GDP at market price are included indirect taxes and are excluded subsidies by the
government. Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted and
subsidies are added to GDP at market price.

Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

GDP at Market Price = GDP at Factor Cost + Indirect Taxes - Subsidies.

 Components of Gross Domestic Product (4 Components)

Four major components of GDP are:

1. Private Consumption Expenditure (C)

2. Investment Expenditure (I)

3. Government Purchases of Goods and Services (G)

4.Net Exports (X – M)!

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Some economists have suggested an alternative approach to measure GDP as Sum of
Expenditure.

Gross Domestic Product (GDP) can be measured by taking into account all final expenditure
made during a period of account in the economy.

1. Private Consumption Expenditure (C):

(Consumption spending by households) —This component measures the money value of

consumer goods and services which are purchased by households and non-profit institutions for
current use during a period of account. These are classified into consumer durables, semi-
durables, non-durables and services; broadly, this classification of consumer goods Is based on
the length of time within which consumer goods are used. Private consumption expenditure
includes expenditure on all these categories of goods and services.

2. Investment Expenditure (I):

Investment means additions to the physical stock of capital during a period of time: Gross
Private Domestic Investment shows the aggregate value in this regard. Investment Includes
building of machinery housing construction, construction of factories and offices and additions
to a firm’s inventories of goods.

Whereas intermediate goods are used up in the process of making other goods, capital goods
(like machinery, building, etc.) get partially depleted in producing other goods and services. This
is called depreciation of fixed capital goods.

Depreciation is fall in the value of the existing capital stock which has been consumed or used up
in the process of producing output, {see Section 6.6 part 14] Investment can be gross and net.
Gross investment includes value of depreciation whereas net investment is obtained by deducting
depreciation value from gross Investment.

Investment is further classified into following four categories:

(a) Business Fixed Investment:

It is the amount which business units spend on purchase of newly produced capital goods like
plant and equipment. Gross Business Fixed Investment is the gross amount spent on newly
produced fixed capital goods. When depreciation is deducted from it, we obtain Net Business
Fixed Investment. It should be kept in mind that depreciation occurs only in fixed capital goods.

(b) Inventory Investment (or change in stock):

It is the net change in inventories (stock) of final goods awaiting sale of finished goods, semi-
finished goods and raw material. These are included because they represent currently produced
goods which are not included in the current sale of final output.

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(c) Residential Construction Investment:

This is the amount spent on construction of flats and residential houses. The investment is said to
be gross when depreciation is not deducted. Net investment is gross investment minus
depreciation.

(d) Public Investment:

This includes capital formation by government in the form of building of roads, bridges, canals,
schools, hospitals, etc. This investment is called gross when depreciation is not deducted and net
when depreciation has been subtracted.

3. Government Purchases of Goods and Services (G):

This component summarizes government spending on goods and services. It includes (i)
purchase of intermediate goods and (ii) wages and salaries paid by the government. All
government purchases are a proxy measure for government output.

Such government purchases are treated as part of the final product. Transfer payments which are
made by government to households and firms are not counted as part of GDR This is to avoid
double counting since the consumption or investment by recipients of the transfer payments is
counted in C and I.

4. Net Exports (X – M):

It shows the difference between domestic spending on foreign goods (i.e., imports) and foreign
spending on domestic goods (i.e., exports). Thus, the difference between Exports (X) and
Imports (M) of a country is called Net Exports (X- M).

To sum up, Gross Domestic Product (GDP) is the total value of sum of Consumption
Expenditure by households (C), Investment Expenditure by firms (1), Government Purchases (G)
and Net Exports. (X- M). Symbolically:

GDP = C + I + G + (X-M)

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 Price Index
A price index is a numerical measure design to help compare how the prices of some class of
goods or services, taken as a whole, differ between time periods or geographical locations.
For the purpose of preparing price index, a base year is taken and prices of that base year are
assumed to be equal to 100. Price Index is measured as follows:
Price Index = Current Years Price X 100
Base Years Price

1). Producer Price Index (PPI):

Producer Price Index measures average changes in prices received by domestic producers for
their output. PPI measures the pressure being put on producers by the cost of their raw materials.
This could be “passed on” to consumers as increase in price and inflation.

2). Consumer Price Index (CPI):

A consumer price index (CPI) is an estimate as to the price level of consumer goods and services
in an economy which is used as a way to estimate changes in prices and inflation. A CPI takes a
certain basket of common goods and tracks the changes in the prices that basket of goods over
time.
CPI is also called as cost of living index number. The CPI is the measure of changes in the
average cost of buying a basket of different goods & services for a typical household.

In India Four types of Consumer Price Indices(CPIs) are issued:

i). CPI – IW for industrial workers.
ii). CPI – UNME for urban non manual employees.
iii). CPI – AL for agricultural labourers.
iv). CPI – RL for rural labourers.

How to Calculate Consumer Price Index?

Formula to Calculate CPI for a single item
CPI for a single item can be calculated using following formula

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Four steps to calculate consumer price index (CPI)
CPI is constructed through four main steps.
Step 1– A base year is selected for the calculation. The CPI of the base year is set as 100.
Step 2 – Based on how a typical consumer spends his / her money on purchasing commodities, a
basket of goods and services is defined for the base year. In order to gather this information, the
national body of authority conducts several surveys with consumers and households. Then prices
of each of those products is added together in the base year to arrive at the price of base year.
Step 3 – Prices of the same commodity basket at the current year is added together as the third
step.
Step 4 – Calculate the CPI using the CPI formula. This includes dividing the current year prices
from the prices of base year and multiplies that by the CPI of the base year which is 100.
Following example illustrates this process in a meaningful manner.

Calculate consumer price index (CPI) – Example

Assume that the market basket of goods and services of a given economy is as mentioned below
for two given time periods.

Consider the base year as 2000.

Based on the above information, CPI can be calculated as follows.

This answer implies that the prices of the basket of goods and services have been increased by
26.32% from 2000 to 2010.

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 Inflation
 Meaning of Inflation:
Inflation can be defined as a persistent increase in general price level, or persistent decline in real
income of people i.e , decline in value of money. In other words inflation means things getting
more expensive.
Inflation is a situation in which the general price level rises or it is the same thing as saying that
the value of money falls.In other words, inflation reduces the purchasing power of money. A unit
of money now buys less.
According to Coulbrun, “too much money chasing to few goods”.
Crowther defines, “inflation is a state in which the value of money is falling”.
While measuring inflation, we take into account a large number of goods and services used by
the people of a country and then calculate average increase in the prices of those goods and
services over a period of time. A small rise in prices or a sudden rise in prices is not inflation. It
is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained
rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices
may be both slow and rapid. It is not high prices but rising price level that constitute inflation. It
constitutes, thus, an overall increase in price level. It can, thus, be viewed as the devaluing of the
worth of money.

 The inflation rate can be calculated by using following formula:

Current Year CPI - Base Year CPI

Inflation Rate = × 100
Base Year CPI

Example 1: If current year CPI Is 18,900. Base year CPI is 16,000. Calculate inflation rate.
Inflation Rate = (18,900 – 16,000) / 16,000 × 100
= 2,900 / 16,000 × 100
= 0.1813 × 100
= 18.13%
Example 2: Suppose, in December 2007, the consumer price index was 193.6 and, in December
2008, it was 223.8. calculate the inflation rate.

Inflation rate = 223.8- 193.6/ 193.6 x 100 = 15.6

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  Types of Inflation:
As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish
between different types of inflation. Inflation may be caused by a variety of factors. Its intensity
or pace may be different at different times. It may also be classified in accordance with the
reactions of the government toward inflation.

On the Basis of Speed or Intensity following are the types of inflation:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. What
speed of annual price rise is a creeping one has not been stated by the economists. To some, a
creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate
of price rise is kept at this level, it is considered to be helpful for economic development. Others
argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of
no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of
walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These
two types of inflation may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moderate inflation’ which is not only predictable, but
also keep people’s faith on the monetary system of the country. Peoples’ confidence get lost once
moderately maintained rate of inflation goes out of control and the economy is then caught with
the galloping inflation.

(iii) Running inflation: running inflation starts at 10% and goes up to 100%.during this type of
inflation people starts loosing faiths in their domestic currency and if there is capital
convertibility then foreign capital starts moving out of country. All international payments are
preferred in $ dollars.

(iv) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is dangerous. If it is
not controlled, it may ultimately be converted to galloping or hyperinflation. It is an extreme
form of inflation when an economy gets shattered. Inflation in the triple digit range of greater
than 100 or 200 p.c. a year is labelled “galloping inflation”.

(v) Stagflation:
This is a typical situation when stagnation and inflation exist together. In stagflation output will
be at lowest level along with high rates of unemployment accompanied by continuous rise in
price levels. Such condition is normally found in less developed economies. India too has faced
stagflation in the decade of 1970s, when industrial production was at its lowest, accompanied by
increasing prices.

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(vi) Suppressed inflation:
This is a state when inflationary conditions exist, but the government makes such policies which
temporarily keep prices at low level. Once the government curbs are lifted, the suppressed
inflation becomes open inflation. Open inflation may then result in hyperinflation. Petrol and
diesel prices in India are example of suppressed inflation

 Causes of Inflation:
Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former is
called demand-pull inflation (DPI), and the latter is called cost-push inflation (CPI). Before
describing the factors, that lead to a rise in aggregate demand and a decline in aggregate supply,
we like to explain “demand-pull” and “cost-push” inflation.

 Demand-pull Inflation:
The inflation represents a situation whereby “The pressure of aggregate demand for goods and
services exceeds the available supply of output.” In such situation, the rise in price level is the
natural consequence.

Excess demand leads to a rightward shift of the aggregate demand curve.

Now this excess of aggregate demand over supply may be the result of more than one force at
work. As we know, aggregate demand is the sum of consumer’s spending on current goods and
services and net investment being contemplated by the entrepreneurs.
Inflation is thus caused when aggregate demand for all purposes-consumption, investment and
government expenditure exceeds the supply of goods at current prices. This is called demand-
pull inflation.

There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.
According to classical economists or monetarists, inflation is caused by an increase in money
supply which leads to a rightward shift in negative sloping aggregate demand curve. Given
a situation of full employment, classicists maintained that a change in money supply brings about
an Equi-proportionate change in price level.
According to Keynesians, aggregate demand may rise due to a rise in consumer demand or
investment demand or government expenditure or net exports or the combination of these
four components of aggreate demand. Given full employment, such increase in aggregate
demand leads to an upward pressure in prices. Such a situation is called DPI. This can be
explained graphically.

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Just like the price of a commodity, the level of prices is determined by the interaction of
aggregate demand and aggregate supply. In Fig. 4.3, aggregate demand curve is negative sloping
while aggregate supply curve before the full employment stage is positive sloping and becomes
vertical after the full employment stage is reached. AD1 is the initial aggregate demand curve
that intersects the aggregate supply curve AS at point E1.
The price level, thus, determined is OP1. As aggregate demand curve shifts to AD2, price level
rises to OP2. Thus, an increase in aggregate demand at the full employment stage leads to an
increase in price level only, rather than the level of output. However, how much price level will
rise following an increase in aggregate demand depends on the slope of the AS curve.

 Factors responsible for Demand-Pull Inflation:

a).Excessive money supply will increase aggregate demand and will, thus, cause demand pull
inflation.
b). Aggregate demand may rise if there is an increase in consumption expenditure following a
tax cut.
c). There may be an autonomous increase in business investment or government expenditure.
Government expenditure is inflationary if the needed money is procured by the government by
printing additional money. Increase in aggregate demand i.e., increase in (C + I + G + X – M)
causes price level to rise.
d). Growth of population stimulates aggregate demand.
e).Higher export earnings increase the purchasing power of the exporting countries. Additional
purchasing power means additional aggregate demand.
f). There is a tendency on the part of the holders of black money to spend more on conspicuous
consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of
factors.

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  (2) Cost-Push Inflation:
Decline in aggregate supply or output causes aggregate supply curve to shift leftward.
Even though there is no increase in aggregate demand, prices may still rise. This may happen if
costs, particularly the wage costs, go on rising. Now as the level of employment rises, the
demand for workers also rises, so that the bargaining position of the workers becomes stronger.
To exploit this situation, they may ask for an increase in wage rates which are not justifiable on
grounds either of a prior rise of productivity or of cost of living. The employers in a situation of
high demand and employment are more agreeable to concede these wage claims, because they
hope to pass on this rise in cost to the consumers in the shape of rise in prices. If this happens,
we have another inflationary factor at work and the inflation thus caused is called the wage-
induced or cost-push inflation.

In addition to aggregate demand, aggregate supply also generates inflationary process. As

inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usually
associated with non-monetary factors. CPI arises due to the increase in cost of production. Cost
of production may rise due to a rise in cost of raw materials or increase in wages.
However, wage increase may lead to an increase in productivity of workers. If this happens, then
the AS curve will shift to the right- ward not leftward—direction. We assume here that
productivity does not change in spite of an increase in wages.
Such increases in costs are passed on to consumers by firms by raising the prices of the products.
Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising prices again
prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts. This
causes aggregate supply curve to shift leftward.

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This can be demonstrated graphically where AS1 is the initial aggregate supply curve. Below the
full employment stage this AS curve is positive sloping and at full employment stage it becomes
perfectly inelastic.
Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now there is a
leftward shift of aggregate supply curve to AS2. With no change in aggregate demand, this
causes price level to rise to OP2and output to fall to OY2. With the reduction in output,
employment in the economy declines or unemployment rises. Further shift in AS curve to
AS3 results in a higher price level (OP3) and a lower volume of aggregate output (OY3). Thus,
CPI may arise even below the full employment (YF) stage.

(iv) Causes of Cost-Push Inflation:

It is the cost factors that pull the prices upward. One of the important causes of price rise is the
rise in price of raw materials. For instance, by an administrative order the government may hike
the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This
leads to an upward pressure on cost of production.
Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by
OPEC compels the government to increase the price of petrol and diesel. These two important
raw materials are needed by every sector, especially the transport sector. As a result, transport
costs go up resulting in higher general price level.
Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions
demand higher money wages as a compensation against inflationary price rise. If increase in
money wages exceeds labour productivity, aggregate supply will shift upward and leftward.
Firms often exercise power by pushing prices up independently of consumer demand to expand
their profit margins.
Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of
production. For instance, an overall increase in excise tax of mass consumption goods is
definitely inflationary. That is why government is then accused of causing inflation.
Finally, production setbacks may result in decreases in output. Natural disaster, gradual
exhaustion of natural resources, work stoppages, electric power cuts, etc., may cause aggregate
output to decline. In the midst of this output reduction, artificial scarcity of any goods created by
traders and hoarders just simply ignite the situation.
Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus,
inflation is caused by the interplay of various factors.

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 FORECASTING OF DEMAND
 DEMAND FORECASTING:

Demand Forecasting is the art of predicting demand for a product or a service at some future date
on the basis of certain present and past behaviour patterns of some related events and data.
Forecasting is not a simple guessing but it refers to estimating scientifically and objectively on
the basis of certain facts and data relevant to the art of forecasting.

Demand forecasting means expectations about future course of the market demand for the
product.

 FEATURES OF DEMAND FORECASTING:

1. Demand forecasting is based on past data and present positions.
2. Demand forecasting may be monetary or physical.
3. Demand forecasting gives basis to future planning.
4. Demand forecasting is made for a certain period.

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5. Future sales and profit estimate can be made by demand forecasting.

The objectives/Purposes of short term demand forecasting are discussed as

follows:
 Short-term Objectives/ purposes:
Include the following:
a. Formulating production policy:
Helps in covering the gap between the demand and supply of the product. The demand
forecasting helps in estimating the requirement of raw material in future, so that the regular
supply of raw material can be maintained. It further helps in maximum utilization of resources as
operations are planned according to forecasts. Similarly, human resource requirements are easily
met with the help of demand forecasting.
b. Formulating price policy:
Refers to one of the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy enters into
depression or recession phase, the demand for products falls. In such a case, the organization sets
low prices of its products.

c. Controlling sales:
Helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization make demand forecasts for different regions and fix sales targets for each region
accordingly.

d. Arranging finance:
Implies that the financial requirements of the enterprise are estimated with the help of demand
forecasting. This helps in ensuring proper liquidity within the organization.

 2. Long-term Objectives/ Purposes:

Include the following:
a. Deciding the production capacity:
Implies that with the help of demand forecasting, an organization can determine the size of the
plant required for production. The size of the plant should conform to the sales requirement of
the organization.

b). Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the forecasted
demand for the organization’s products is high, then it may plan to invest in various expansion
and development projects in the long term.

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c). Evaluating Performance:
Helps in making corrections. For example, if the demand for an organization’s products is less, it
may take corrective actions and improve the level of demand by enhancing the quality of its
products or spending more on advertisements.

d). Helping Government:

Enables the government to coordinate import and export activities and plan international trade.

e). Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing according to
the forecasted demand of products helps in avoiding the wastage of the resources of an
organization. This further helps an organization to hire human resource according to
requirement. For example, if an organization expects a rise in the demand for its products, it may
opt for extra labor to fulfill the increased demand.

 METHODS OF DEMAND FORECASTING:

 1). The consumer survey
A sample survey of the consumers may be undertaken questioning them.
Questionnaire may be prepared and information may be collected
The data collected through questionnaire may be classified and tabulated for systematic
presentation and analysis. Consumer survey method is used when there is small sample size.

 Merits of consumer survey:

1). It helps in knowing consumers expectations regarding future price, income, inflation and its
impact on demand .
2). Is use full for obtaining short term forecast.
3). It is useful for knowing demand for new products where no past sales data are available.
4). It is useful in case of industrial products, engineering goods, consumer durables , housing etc
where buyers plan their purchases well in advance.
 Demerits/ Drawbacks of consumer survey method:
1).This method is expensive.
2). It is time consuming.
3). Most of the times consumer may not give correct answers & may not cooperate also.
4) Information obtained through consumer survey is likely to be limited or incomplete.
5) The success of this method depends on designing of questionnaire. If questionnaire is false
then information's will be unreliable.

 2). Collective Opinion / Sales Force Composite :

It is also referred to as sales force polling and experts’ opinion survey. Under this method, the
salesmen have to report to the head officer their estimates of expectations of sales in their
territories. In this method information can also be obtained from the retailers & wholesalers,

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dealers & distributers by the company. This method is based on value judgment and collective
opinion of top sales representative, executives, marketing manager, managerial economist all
together.
 Merit of collective opinion method:
1). This method is cheaper.
2). It is easy to handle.
3). It is less time consuming.
4). It can be used for forecasting the sales of new products.
 Demerits / Drawbacks of collective opinion method:
1). It is subjective and leads to high element of biased data from sales persons.
2). It is based on value judgment of the experts or salesperson, which may lead to over or under-
estimation.
3). This method is not useful for long term forecasting.
4). Depends on data provided by sales representatives who may have inadequate information
about the market.
5).Salesman may be unaware of the broader economic changes likely to have an impact on the
future demand.
6). Ignores factors, such as change in Gross National Product, availability of credit, and future
prospects of the industry, which may prove helpful in demand forecasting.

 3). Experts’ Opinion Poll:

Refers to a method in which experts are requested to provide their opinion about the product.
Generally, in an organization, sales representatives act as experts who can assess the demand for
the product in different areas, regions, or cities.

Sales representatives are in close touch with consumers; therefore, they are well aware of the
consumers’ future purchase plans, their reactions to market change, and their perceptions for
other competing products. They provide an approximate estimate of the demand for the
organization’s products. This method is quite simple and less expensive.

However, it has its own limitations, which are discussed as follows:

a. Provides estimates that are dependent on the market skills of experts and their experience.
These skills differ from individual to individual. In this way, making exact demand forecasts
become difficult.

b. Involves subjective judgment of the assessor, which may lead to over or under-estimation.

c. Depends on data provided by sales representatives who may have inadequate information
about the market.

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d. Ignores factors, such as change in Gross National Product, availability of credit, and future
prospects of the industry, which may prove helpful in demand forecasting.

 4). Delphi Method:

Delphi method is a group decision-making technique of forecasting demand. In this method,
questions are individually asked from a group of experts to obtain their opinions on demand for
products in future. These questions are repeatedly asked until a consensus is obtained.

In addition, in this method, each expert is provided information regarding the estimates made by
other experts in the group, so that he/she can revise his/her estimates with respect to others’
estimates. In this way, the forecasts are cross checked among experts to reach more accurate
decision making.

Every expert is allowed to react or provide suggestions on others’ estimates. However, the names
of experts are kept anonymous while exchanging estimates among experts to facilitate fair
judgment and reduce halo effect.

The main advantage of this method is that it is time and cost effective as a number of experts are
approached in a short time without spending on other resources. However, this method may lead
to subjective decision making.

Merits of Delphi method:

i). Decisions are enriched with the experience of competent experts.

ii).The firm need not spend time and resources in collection of data by survey.

iii). Very useful when the product is absolutely new to all the markets.

Demerits of Delphi Method:

i). This technique relies more on the experience of experts than on available data, and may thus
involve some amount of bias.

ii). In case external experts are invited for opinion, the firm may be exposed to the risk of loss of
confidential information to rival firms.

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  Economies of Scale
‘Economies’ mean advantages. Scale refers to the size of unit.
‘Economies of Scale’ refers to the cost advantages due to the larger size of production. As the
volume of production increases, the overhead cost/ per unit cost will come down.

 Definition of Economies of Scale in Broad sense :

Anything which leads to minimize Average Cost of production in the long run as scale of output
increases is referred to as ‘Economies of Scale’.
The bulk purchase of inputs will give a better bargaining power to the producer which will
reduce the average variable cost . All these advantages are due to the large scale production and
these advantages are called economies of scale.

 There are two types of economies of scale

a) Internal economies of scale;
b) External economies of scale

 Internal Economies of Scale

‘Internal economies of scale’ are the advantages enjoyed within the production unit or within the
firm itself. In internal economies of scale the Average cost will decrease due to factors internal to
the firm. These economies are enjoyed by a single firm independently of the action of the other
firms.
Internal economies of scale cannot be realized unless the firm increases its output or expand its
size. For instance, one firm may enjoy the advantage of good management; another may have the
advantage of more up-to-date machinery.

 There are six kinds of internal economies.

1. Technical Economies:
As the size of the firm is large, the availability of capital is more. And use of more advance
technology leads to increase efficiency. Due to this, a firm can introduce up- to-date
technologies; thereby the increase in the productivity becomes possible. It is also possible to
conduct research and development which will help to increase the quality of the product. In
technical economies the large firms use Automatic Machines which are quicker & more efficient
& their output increases and per unit cost decreases.

2. Financial Economies:
Financial Economies means the company has cheaper access to capital. A large firm’s usually
have huge assets & good reputation in the market. Therefore it is able to get cheap & timely
credit from banks as well as other financial institutions at lower interest rates. It is possible for
big firms to issue shares & bonds in the market for raising capital and finance. Big firms are

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regarded less risky by investors hence they may be willing to lend capital to such firms even at
lower rates.

3. Managerial Economies:
Managerial economies: It arise when firms can hire specialists, such as seasoned sales
executives, to manage specific areas of the company. It can also hire Specialised managers which
will lead to functional specialisation & reduces unit cost of management. Right person can be
employed in the right department only if there is division of labour. This will help a manager to
fix responsibility to each department and thereby the productivity can be increased and the total
production can be maximised.

4. Labour Economies:
As firm expands its output it employs more & more labour . It leads to division of work and
specialization. Increased division of labour is a major source of labour economies. Large firms
can attract more efficient labour, as it can offer a wide vertical mobility, better prospects of
promotion, as a result of increasing specialisation in the production process.
Large Scale production paves the way for division of labour. This is also known as specialisation
of labour. The specialisation will increase the quality and ability of the labour. As a result, the
productivity of the firm increases.

5. Marketing Economies:
Marketing economies are economies of buying and selling. In production, the first buyer is the
producer who buys the raw materials. As the size is large, the quantity bought is larger. This
gives the producer a better bargaining power. And he buys the bulk raw material at low costs.
Similarly large firms can sell goods of high quality with attractive packaging. All these are
possible because of large scale production.

6. Economies of survival / risk bearing economies :

A large firm can produce variety of goods therefore, Even if one product fails in the market, the
loss incurred in that product can be managed by the profit earned from the other products.
Similarly large firms sells its products in different markets internally as well as internationally. If
demand is not there in one market there will be demand in the other markets. Large firms buys
raw materials from different sources therefore there is no risk of shortages of raw materials.

 b) External economies of scale

When many firms expand in a particular area – i.e., when the industry grows – they enjoy a
number of advantages which are known as external economies of scale.
This is not the advantage enjoyed by a single firm but by all the firms in the industry due to the
structural growth.

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External economies are function of the size of the industry. They are not confined to one or two
firms , but shared by all the firms. External economies can never be monopolized by any one
firm in an industry.
 Following are the Types/ Forms of External Economies of scale:
1.Economies of localisation/ concentration
When a number of firms are located in one place, all of them derive some mutual benefits
through training of skilled labour, provision of better transport facilities etc. Concentration of a
particular industry in one area result in the development of conditions helpful to the industry and
all the firms enjoy some common benefits like: a) availability of skilled & trained labour force,
b). Transport & communication facilities, c) banking, insurance, storage facilities, d) adequate
power supply etc. All this facilities will lead to lower the cost of production. The cost of
production is thereby reduced.

2. Economies of information or technical and market intelligence

A large industry can bring out trade and technical publications to which every firm can have
access. An industry can set up research centre's by employing highly qualified & trained
personnel. Producer are thus saved from independent research which is very costly
Statistical, technical, and other market information becomes more readily available to all firms in
growing industry.

3. Economies of vertical disintegration

The growth of industry will make it possible to split up production and some subsidiary jobs can
be left to do more efficiently by specialized firms. New subsidiary industries may grow up to
serve the needs of the main industry. When a particular process is split up and performed on a
large-scale by a specialized firm, it can yield all the internal economies of large scale. Eg. Textile
industry , the color manufacturing process may be taken up by a specialised chemical firms &
the textile mills may get better products at low cost.

4.Economies of by-products
A large industry can make use of waste materials for manufacturing by-products.
The firm using it can flourish when waste material available to the industry is converted into by-
products. For Example- a sugar factory can set up a separate plant for manufacturing paper from
its waste product namely molasses.

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  Diseconomies of Scale
The diseconomies of scale are the disadvantages arising to a firm or a group of firms due to large
scale production. The diseconomies of scale means increase in long term average cost of
production as the scale of operation increases beyond a certain level. Diseconomies of scale is a
cost disadvantage where Average cost of production increases as output expands beyond the
limit. Diseconomies of scale occur due to following reasons:
1). Poor communication in large firm
2). Alienation: in large firm there is a increased gap between top and bottom. E.g. call centres
3) Lack of control: when there are a large number of workers it becomes difficult to control
them.

1).Difficulties of management
As firm expands, complexities and problems of management increase. Thus after a point the
manager finds it difficult to control the whole production organisation. The entrepreneur and
management will not be able to maintain contact with each other and check on all the
departments. The problem of supervision becomes complex leading to increasing
mismanagement.

2).Difficulties of coordination
Organization and coordination becomes more difficult with the increasing size of the firm. The
management of the firm will gradually face numerous problems of decision making. It may,
therefore, not find enough time to give careful thought to individual problems. Decisions so
taken in a hurry result in inefficiency and increase in the cost of goods.

3). Difficulties in decision making

A large firm cannot take quick decisions and make quick changes as and when they are needed ,
for it has to consult various departments for making any decisions and so urgent matters
requiring timely decisions are inevitably delayed. This may sometimes cause loss to the firm.

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4). Increased risks
As the scale of production increases, investment also increases so also the risk of business. The
larger the output, the greater will be the loss. To bear greater risks is an important limitation the
expansion of the size of a firm from an error of judgement or misfortune in the business.

5). Labour diseconomies

Extreme division of labour with a growing scale of output results in lack of initiative and drive in
the executive personnel. Thus a large firm becomes more impersonal and contact between
management and workersbecomes less. As such, there are more chances of occurrence problems
and industrial disputes which prove to be costly to the firm.
6). Scarcity of factor supplies
Due to increase in concentration of firms in a particular locality, each firm will find scarcity of
available factors. Hence, competition among firms in purchasing labour, raw materials, etc. will
result in increased factor prices

7). Financial difficulties

A big concern needs huge capital which cannot be easily obtainable. Hence, the difficulty in
obtaining sufficient capital frequently prevents the further expansion of such firms.

8). Marketing diseconomies

When the industry expands and the firm grows, competition in the market tends to become stiff.
Thus, firms under monopolistic competition (which is the most realistic market situation in many
lines of production) will have to undertake extensive advertising and sales promotion efforts and
expenditure which ultimately lead to higher costs.

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 Mergers, Acquisitions and Takeover

 Mergers
 Definition of Merger

Merger refers to the mutual consolidation of two or more entities to form a new enterprise with a
new name. In a merger, multiple companies of similar size agree to integrate their operations into
a single entity, in which there is shared ownership, control, and profit. It is a type of
amalgamation. For example M Ltd. and N Ltd. Joined together to form a new company P Ltd.

The reasons for adopting the merger by many companies is that to unite the resources, strength &
weakness of the merging companies along with removing trade barriers, lessening competition
and to gain synergy. The shareholders of the old companies become shareholders of the new
company

 Types of mergers:

1).Horizontal Mergers
Horizontal mergers happen when a company merges or takes over another company that offers
the same or similar product lines and services to the final consumers, which means that it is in
the same industry and at the same stage of production. Companies, in this case, are usually direct

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competitors. For example, if a company producing cell phones merges with another company in
the industry that produces cell phones, this would be termed as horizontal merger. The benefit of
this kind of merger is that it eliminates competition, which helps the company to increase its
market share, revenues and profits. Moreover, it also offers economies of scale due to increase in
size as average cost decline due to higher production volume. These kinds of merger also
encourage cost efficiency, since redundant and wasteful activities are removed from the
operations i.e. various administrative departments or departments suchs as advertising,
purchasing and marketing.

2). Vertical Mergers

A vertical merger is done with an aim to combine two companies that are in the same value chain
of producing the same good and service, but the only difference is the stage of production at
which they are operating. For example, if a clothing store takes over a textile factory, this would
be termed as vertical merger, since the industry is same, i.e. clothing, but the stage of production
is different: one firm is works in territory sector, while the other works in secondary sector.
These kinds of merger are usually undertaken to secure supply of essential goods, and avoid
disruption in supply, since in the case of our example, the clothing store would be rest assured
that clothes will be provided by the textile factory. It is also done to restrict supply to
competitors, hence a greater market share, revenues and profits. Vertical mergers also offer cost
saving and a higher margin of profit, since manufacturer’s share is eliminated.

3). Concentric Mergers

Concentric mergers take place between firms that serve the same customers in a particular
industry, but they don’t offer the same products and services. Their products may be
complements, product which go together, but technically not the same products. For example, if
a company that produces DVDs mergers with a company that produces DVD players, this would
be termed as concentric merger, since DVD players and DVDs are complements products, which
are usually purchased together. These are usually undertaken to facilitate consumers, since it
would be easier to sell these products together. Also, this would help the company diversify,
hence higher profits. Selling one of the products will also encourage the sale of the other, hence
more revenues for the company if it manages to increase the sale of one of its product. This
would enable business to offer one-stop shopping, and therefore, convenience for consumers.
The two companies in this case are associated in some way or the other. Usually they have the
production process, business markets or the basic technology in common. It also includes
extension of certain product lines. These kinds of mergers offer opportunities for businesses to
venture into other areas of the industry reduce risk and provide access to resources and markets
unavailable previously.

4). Conglomerate Merger

When two companies that operates in completely different industry, regardless of the stage of
production, a merger between both companies is known as conglomerate merger. This is usually
done to diversify into other industries, which helps reduce risks.

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  Reasons / Advantages / favors for mergers and Acquisition
There are various reasons as to why a company might to decide to merge or acquire another
company, although there has to be a strategic reasoning or logic behind the merger. All the
successful mergers and acquisitions have a specific, well thought-out logic behind the strategic
move. Mergers and acquisitions usually create value for the company in different ways, some of
which are listed below:

1). Improve the company’s performance

This involves improving the performance of the target company, as well as the company itself. It
is one of the most important reasons of value-creating strategies of M&A. If another company is
taken over, its performance can be radically improves, due to economies of scale. Also, the two
companies combined would have a greater impact in the market as they are more likely to
capture a greater market share, hence higher revenue and profits. Operating-profit margins can
be significantly improved under the new management if wastage and redundancies are removed
from the operations.

2). Remove Excess capacity

In many cases, as industries grow, there comes a point of maturity, which leads to excess
capacity in the industry. As more and more companies enter the industries, the supply continues
to increase, which brings the prices considerably down. Higher production from existing
companies and entry of new companies in the industry disrupts the balance as supply increases
more than demand, which lead to a fall in price. In order to correct this, companies merge with or
acquire other companies in the industry, hence getting rid of excess capacity in the industry.
Factories and plants can be shutdown, since it is no longer profitable to sell at that low a price.
Usually least productive plants or factories are retired in order to bring the balance back to the
industry. It makes companies rethink their strategy, and nudges them to work towards improving
quality rather than quantity.

3). Accelerate growth

Mergers and acquisitions are often undertaken to increase the market share. If Competitor
Company is taken over, its share of sales is also absorbed. As the result, the acquirer gets higher
sales, revenues and consequently higher profits. Some industries have a mix of very loyal
customers, which means that it is very difficult to attract customers from competition by other
means, as the industry is highly competitive and consumers are disinclined to make the switch.
In such circumstances, merger or acquisition are highly beneficial, since they provide an
opportunity to drastically increase market share. It also allows economies of scale, as per unit
cost decrease due to higher volume. Smaller players in the market are sometimes taken over to
penetrate the market further, where big companies fail to make an impact. Controlling smaller
firms in the industry can greatly accelerate sales of those smaller companies’ products and
services, since a big name is now attached to them. The acquirer also brings in its expertise and
experience to bring efficiency to the operations of the target company. The combined company
also benefit from exposure to various segments of the industry, which were previously unknown
to the acquirer. The new combined company could help introduce new products tailored for the
unchartered markets, hence finding new consumers for the same products and services.

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4). Acquire skills and technology
Companies often acquire or merge with other companies in hopes to acquire skills and/or
technology of the target company. Some companies control certain technologies exclusively, and
it is too costly to develop these technologies from scratch. This means that it is easier to take
over a company with the desired technology. A merger / an acquisition provides an opportunity
for both companies to combine their technological progress and generate greater value from the
sharing of knowledge and technology. These kinds of merger usually lead to innovation and
entirely new products and services, hence are beneficial not only to the companies themselves,
but to the industry as well. Same goes for skills, which are in certain cases exclusive, and can
only be sought out, if the said company is taken over.

5). Roll-up strategies

Some firms are too small in the market and are highly fragmented, which means they experience
higher costs, and it is not feasible for them to keep up operations because there are no economies
of scale due to a very small volume. An acquisition is such case is more common and can be
hugely beneficial to the target company, as it could keep on operating only with an element of
economies of scale. It would also help an acquirer, since it would be able to penetrate smaller
fractions of the market, as smaller companies have access to these markets. Hence this kind of
merger creates value for both companies, and promises greater efficiency in the operational
activities. Advertising campaigns can be coordinated together in order to increase revenues and
save on costs.

6). Encourage competitive behavior

Many companies decide to take over other companies in an attempt to improve the overall
competitive behavior in the industry. This is done by eliminating price competition, which leads
to improvement in rate of internet return of the industry. If the competition is kept at bay, and
new entrants are not allowed, firms don’t have to compromise on quality as price is no longer a
competing factor. Smaller businesses can only gain share through offering at lower prices, but
price competition reduces overall profits for the industry. In order to restore the balance, and
invest all effort an energy on quantity, mergers and takeovers are initiated to improve the overall
competitive environment in the industry.

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  Acquisition:
 Definition of Acquisition

The purchase of the business of an enterprise by another enterprise is known as Acquisition. This
can be done either by the purchase of the assets of the company or by the acquiring ownership
over 51% of its paid-up share capital.

In acquisition, the firm which acquires another firm is known as Acquiring company while the
company which is being acquired is known as Target company. The acquiring company is more
powerful in terms of size, structure, and operations, which overpower or takes over the weaker
company i.e. the target company.

Most of the firm uses the acquisition strategy for gaining instant growth, competitiveness in a
short notice and expanding their area of operation, market share, profitability, etc.

Companies acquire other firms to increase their market share, obtain new facilities and acquire
advanced technology. In an acquisition, the board of directors of an acquired firm agrees to allow
another company to control the firm for a certain price. The firm making the acquisition usually
agrees to purchase the acquired company’s assets or stock. Purchasing the assets allows the
acquiring company to avoid needing shareholders' approval. The company desiring to make the
acquisition must perform due diligence before the acquisition process begins.

Acquisition Process

The first step of a friendly acquisition includes developing a strategy and researching the
financial benefit of acquiring the target company. Acquiring companies must know the resources
needed to purchase another company. The next step in the acquisition process includes
identifying and performing a valuation of the target firm. Companies perform valuations by
examining financial statements, identifying market positions, researching legal obligations and
performing a SWOT analysis on the target firm. After the valuation process, a company must
determine how much the target company is worth, and the best way to raise the resources needed
for the acquisition. The last step includes both companies agreeing to the terms of the acquisition
and meeting all legal requirements.

 Key Differences between Merger and Acquisition

The following are the major differences between Merger and Acquisition:

1. A type of corporate strategy in which two companies amalgamate to form a new company is
known as Merger. A corporate strategy, in which one company purchases another company and
gain control over it, is known as Acquisition.

2. In the merger, the two companies dissolve to form a new enterprise whereas, in the
acquisition, the two companies do not lose their existence.

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3. Two companies of the same nature and size go for the merger. Unlike acquisition, in which the
larger company overpowers the smaller company.

4. In a merger, the minimum number of companies involved are three, but in the acquisition, the
minimum number of companies involved is 2.

5. The merger is done voluntarily by the companies while the acquisition is done either
voluntarily or involuntarily.

6. In a merger, there are more legal formalities as compared to the acquisition.

Examples of Mergers and Acquisitions in India

• Acquisition of Corus Group by Tata Steel in the year 2006.
• Acquisition of Myntra by Flipkart in the year 2014.
• The merger of Fortis Healthcare India and Fortis Healthcare International.
• Acquisition of Ranbaxy Laboratories by Sun Pharmaceuticals.
• Acquisition of Negma Laboratories by Wockhardt

 Takeover

Takeovers and acquisitions are common occurrences in the business world. In some cases, the
terms takeover and acquisition are used interchangeably, but each has a slightly different
connotation. A takeover is a special form of acquisition that occurs when a company takes
control of another company without the acquired firm’s agreement. Takeovers that occur without
permission are commonly called hostile takeovers. Acquisitions, also referred to as friendly
takeovers, occur when the acquiring company has the permission of the target company’s board
of directors to purchase and take over the company.

Hostile Takeovers

Hostile takeovers occur without the consent of the acquired firm's board of directors. The first
step of a hostile takeover includes the acquiring firm taking over the company through a tender
offer or proxy fight. Hostile takeovers through tender offers involve the acquiring company
purchasing the shares of the target firm directly from shareholders, or on the secondary markets.
Shares of a stock represent ownership of a company. Therefore, buying all or a majority of the
company’s shares allows the acquiring company to possess ownership of the target company. To
purchase shares, the acquiring corporation offers a higher price to shareholders than the market
value of the stock. A proxy fight involves the acquiring company seeking the voting rights of the
target firm's shareholders to win control of the target's firms board of directors. The last step
involves filing a 30-day acquisition notice with the Securities and Exchange Commission and the
target firm's board of directors. After receiving the notice, the target company must formulate
defensive tactics, or risk a hostile takeover.

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Defending Against a Takeover

Some target companies implement defensive tactics to prevent a hostile takeover. Undervalued
public companies are more vulnerable to hostile takeovers, because the public owns the majority
of the company’s shares. A preventive measure includes a company buying a sizable portion of
its own shares, which prevents the acquiring company from purchasing the shares and becoming
the majority owner. A company may file an anti-trust lawsuit against the acquiring firm in an
attempt to defend itself from takeover, or restructure its assets and liabilities to prevent another
company from financially benefiting from a takeover.

********End of Module – 1*******

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