MA-SEM-IV-Industrial-Economics-English-Version-munotes

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1 MODULE - I
1
THEORY OF FIRM - I
Unit Structure
1.0 Objectives
1.1 Introduction
1.2 Firm Competition and Performance: Effects of Monopoly Power
1.2.1 Structure Conduct and Performance
1.2.2 Competition and Performance
1.2.3 Market Structure and Mon opoly Power
1.3 Effects of Monopoly Power
1.4 Determinants of Firm Structure
1.5 Mergers
1.5.1 Types of Mergers
1.6 Market Structure
1.7 Summary
1.8 Questions
1.9 References
1.0 OBJECTIVES  To understand the performance of a firm in perfect competition
 To study the effects of monopoly power on the market
 To evaluate the role of business integration
 To study the types of business integration
 To understand the patterns of market structure
 To bring about the determinants of market structure .
1.1 INTRODUCTION Industrial Economics is a branch of Economics. It is the application of
microeconomic theory to the analysis of firms, markets, and industries. It
explains and draws inferences about the effectiveness with which scarce
resources are us ed; and points out policies that might improve the
situation. Industrial Economics is primarily concerned with the evolution
of the industry as a process in time at both the macro level, the sector or
industry level, and the firm level. munotes.in

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2 Industrial Economics
2 One of the key are as in Industrial Economics is understanding the
structure and its effect on the performance of the industry. Industrial
Economics uses different theoretical models to understand the behaviour
of firms. Initially, the focus was to understand the structure o f the market
and observe the performance of the firm concerning the structure of the
firm. But over the years the approach has changed, and the efficiency of
individual firms is now given importance.
1.2 FIRM COMPETITION AND PERFORMANCE: EFFECTS OF MONOP OLY POWER 1.2.1 Structure Conduct and Performance:
Structure Conduct and Performance theory is an integral part of Industrial
Economics. It is based entirely upon neoclassical theory. This theory was
published by Edward Chamberlin and Joan Robinson in 193 3. The
technique was further formalized by Mason in 1939. Then the theory was
modified by Joe S. Bain in 1951. According to the theory, the market
structure determines a firm’s conduct which further determines the
performance of the firm. The relationship between the structure to conduct
and conduct to performance has been used to study industrial
organizations. The relationship is denoted as under.
Figure 1.1: Structure, Conduct, and Performance

As denoted in the figure, the structure determines the condu ct of the firm,
and the conduct of the firm determines the performance.
The structure illustrates the characteristics and composition of markets and
industries in an economy. At the micro level, it is the features of a firm
like the nature of commodities they produce and the operations on which
they are classified. The number of competitors in the industry, ease of
entry, and exit. Market structure is determined based on the degree and
nature of competition for goods and services.
Conduct refers to action s taken by the firm or its behaviour or responses of
the firm. The conduct or the action of the firm includes product
differentiation, pricing of the product, collusion, and exploitation of
market power.
Many indicators are applied to measure the performa nce of a firm.
Traditionally it was believed that profitability is the only criteria to
measure the performance of a firm, but in modern times it is measured by
many indicators like productive efficiency, allocative efficiency, etc. munotes.in

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3 Theory of Firm - I The structure conduct a nd performance have many attributes. Such
attributes make the relationship between structure, conduct, and
performance more complex. Joe S. Bain studied the cross -section behavior
of industries. He explained two situations :
1. High level of concentration :
Concentration refers to the degree of control exercised by the largest firm
in the economy over the economic activity. If there is a high level of
concentration, there will be less degree of competition. Prices will be
higher, and the profits will also be higher. Thus, when there is a high
concentration, it will lead to higher profits. Structure (High concentration)
will determine the conduct (high prices) which will further determine the
performance (high profit). In this case, the structure -conduct -performance
has a direct relationship that runs from structure to conduct and conduct to
performance.
2. Scale of Economies and Concentration :
It has been mentioned that concentration is determined by barriers to
entry. If economies of scale are lower in some industries, then the
concentration is higher in such industries. Higher concentration leads to
higher profits.
The structure conduct and performance approach were evaluated by
Baumol. According to him the cost of production rather than a market
structure determines the profit. Similar views were shared by Demsetz
from Chicago School. He suggested that high profits may be a sign not of
market power but efficiency. In any market, the firm with the lowest costs
will be likely to increase in size and market s hare, there will be pressure
on all firms to be efficient. Later the performance was regarded as the
expertise and ability of a firm to efficiently utilize the available resources
to achieve its objectives.
1.2.2 Competition and Performance :
The structu re-conduct -performance approach can be derived through the
theories of perfect competition and monopoly.
Table 1.1: Structure, Conduct, and Performance in Perfect
Competition and Monopoly Market Structure Conduct Perfect Competition  A large number of firms  Free entry to Industry  No intervention by the Government  Price is determined by the market.  P=AR=MR  P=MC in the long run Monopoly  Single firm  High barriers to entry  Price determined by the firm  Price is above MC munotes.in

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4 Industrial Economics
4 As denoted in table 1 the stru cture of perfect competition leads to the
conduct or behavior of the firms in such a way that the price of all the
firms is equal to the marginal cost. As a result, the firms in the industry
earn normal profits. But the structure of the Monopoly market is such that
the firm decides price above the marginal cost as a result the firm earns a
super normal profit.
These two models are extremes where the number of firms is infinite
versus one and free entry versus no entry. The firms or industrial units
follow the conduct which falls between these two extremes. The status of
any industry can be found between these two extremes. By observing the
structure of that industry in terms of the number of firms, ease of entry,
etc., the performance of that industry can b e predicted. As one moves from
the industries with many firms to the industry with only a few firms or
only one firm, profitability will increase. It will increase from the normal
level of profit with many firms to the super -normal level of profit in a
monopoly. This suggests that the performance of a firm in a perfect
competition structure is such that all the firms in the industries with such a
structure earn a normal profit.
1.2.3 Market Structure and Monopoly Power :
The structure of the monopoly marke t is such that there is only a single
seller in the market. As the only seller, the monopolist holds control over
the market. Monopoly power is defined as the ability of the seller or
producer to charge a greater price than the Marginal Cost. How far th e
monopolist will become successful to raise the price higher than the
marginal cost is determined by the degree of monopoly power. The
degree of monopoly power is not the same in the case of all monopolies.
It is determined by many factors.
The degree of monopoly power is determined by many factors. According
to Aba P. Lerner, the degree of Monopoly power is 0 in perfect coemption.
In perfect competition, P=MC. But in the Monopoly market, P > MC. The
difference between price and marginal cost is positiv e in a Monopoly
market, the higher the difference between price and marginal cost, the
higher the degree of Monopoly Power. This idea is supported by the
formula given below.
Lerner’s Index of Monopoly Power = PM CP Where P- Price, MC –
Marginal Cost.
Factors Determining Monopoly Power :
1. Entry Barriers :
According to Joe S. Bain the structure of a market is determined or
differentiated based on entry barriers. The extent of barriers to entry
determines the monopoly powe r. Barriers to entry are the factors that
prevent the new firm to enter the industry. According to Bain barriers to
entry is “an advantage of established sellers in an industry over potential munotes.in

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5 Theory of Firm - I entrant sellers, which is reflected in the extent to which estab lished sellers
can persistently raise their prices above competitive levels without
attracting new entrants to enter the industry.” George J. Stigler, defined it
as “a cost of producing that must be borne by a firm which seeks to enter
an industry but is not borne by firms already in the industry.” A major
barrier to entry is cost, the new firms who want to enter the market are not
able to compete with the already established firms concerning cots. Other
barriers to entry are ownership of resources, econom ies of scale, etc.
Higher the entry barrier, the higher the monopoly power.
2. The Number of Firms :
The number of firms in the market is another determinant of monopoly
power. In perfect competition, there is a large number of firms in the
industry theref ore monopoly power in a perfectly competitive market is 0.
But as the number of firms tends to reduce monopoly power improves.
There are greater chances that the firms in the market with a few numbers
of firms can charge prices higher than marginal cost. In a monopoly
market, the monopolist is in the position to charge a higher price than the
marginal cost.
3. Product Differentiation :
Product differentiation increases the monopoly power of a firm. In the
case of homogeneous products, prices different from the price of rival
firms can not be charged. As a result, the power of a firm to charge higher
prices is weak in perfect competition with homogeneous products. As the
degree of product differentiation goes up, the monopoly power becomes
higher.
Sources o f Monopoly Power :
As mentioned earlier, the formula to measure monopoly power has been
introduced by A. P. Lerner. It is called as Learner’s index. The formula is
Monopoly Power = PM CPbut it is 1e In other words, it is reciprocal to
the elasticity of demand. The smaller the elasticity of demand larger is the
monopoly power. The elasticity of demand is an important source of
monopoly power. The monopolist gets the power to control the ma rket
through the following sources.
1. Elasticity of Market Demand :
In a monopoly market, there is only one firm that produces the product. As
a result, there is no difference between the elasticity of the firm’s demand
and the elasticity of market deman d. Therefore, in this case, the firm’s
degree of monopoly power is determined directly by the elasticity of
market demand. But in any market where close substitutes are available,
the elasticity of demand determines the price charged by the producer. In a
market with close substitutes, the elasticity of demand is higher, if any
firm charges a higher price there will be a greater decrease in the quantity munotes.in

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6 demanded. In such a case the firm has very little power to influence the
price.
2. Economies of Scale :
Economies of scale determine the cost structure of the firm. As the firm
produces more units of a commodity the fixed cost is distributed over the
production . But to get the benefits of scale and lower fixed costs the
number of firms in the market needs to be less. If the number of firms in
the market is large, the output will increase but the cost may not decrease.
To get the advantage of scale the monopolist may not allow the other
firms to enter the market.
3. Control over the Resources :
In very few cas es the source of monopoly power is the ownership of
inputs required for the production. If a particular firm owns all the input
required to produce a particular good or service, then it could emerge as
the only producer of that good or service and it can create monopoly
power.
4. Sunk Costs :
The sunk costs are the expenditure or costs that cannot be recovered. The
sunk costs can be the source of monopoly power. A new firm in an
industry requires to incur costs to establish itself in the industry. If ent ry
into the industry is difficult, the cost to establish the business will be
greater. If the cost required to establish a business is unlikely to be
recovered, the business cannot be established. Such firms find it difficult
to exit the market. Their exi t is costly. Costly exits make the entry of the
firms into the industry more difficult. In such cases, monopoly power is
higher.
5. Government Restrictions :
Sometimes the Government provides some special benefits to some
business firms. Such benefits bec ome the source of monopoly power. State
and local governments have commonly assigned exclusive permission or
rights to conduct business in a specific market. Such rights or special
permissions may create monopoly power. Governments might also
regulate entr y into an industry or a profession through licensing and
certification requirements. Governments also provide patent protection to
inventors of new products or production methods to encourage innovation;
these patents may afford their holders a degree of m onopoly power.
1.3 EFFECTS OF MONOPOLY POWER The structure -conduct -performance approach implicitly explains that
monopoly leads to poor performance and is harmful to economic welfare.
Harberger was the first to measure the reduction in welfare caused by t he munotes.in

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7 Theory of Firm - I exercise of market power in 1954. He studied industry -level data and
explained that the activities of the manufacturing sector of the USA in the
1920s resulted in a reduction of welfare equivalent to 0.1 percent of GNP.
Economists like Schwartzman (1960 ), Bell (1968), Worcester (1973), and
Siegfried and Tiemann (1974), Cowling and Mueller (1978) also estimated
loss of the welfare due to monopoly power. Following are the effects of
monopoly power.
1. Effect on Consumers :
Monopoly power affects consumers welfare. It creates dead weight loss
for the consumers. The monopolist with high monopoly power can charge
a high price by controlling output. It creates a mismatch between demand
and supply.
Figure 1.2: Consumers’ surplus

In figure 1.1 in case of com petition, the price is equal to AR and MR.
Consumers get the benefit of a comparatively lower price. As indicated in
Diagram 1.1 APE is consumers’ Surplus and OPE is producers’ surplus.
The equilibrium price OP brings demand and supply to equilibrium at
point E. But when there is monopoly power in the market equilibrium
situation is different.
Figure 1.3: Deadweight loss
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8 Industrial Economics
8 But as denoted in figure 1.3 CEK is dead weight loss. It reduces
consumers’ surplus. Thus, consumers’ welfare is affected due to
deadweig ht loss arising from monopoly power.
2. Market Failure :
Market failure is a situation where there is a defective allocation of
resources. The existence of Monopoly power leads to market failure. The
monopolist with higher monopoly power will be in the p osition to set
prices higher. This limits the output. Such limited output takes away
consumers’ surplus. Output less than the demand in the market creates
inefficiency which leads to market failure. This reduces aggregate welfare.
3. Price Discrimination :
Monopoly power leads to price discrimination. Not only the monopolist is
in the position to charge a higher price, but he can reduce consumers
surplus of different consumers by charging different prices to different
consumers according to their capacity t o pay. The Monopolist with a high
degree of monopoly power is in the position to extract entire consumers’
surplus.
Although monopoly power is harmful to society some economists have
taken the opposite view.
4. Monopoly and Reduction In Cost :
The econo mists like Williamson and Demsetz argued that monopolists
may reduce the cost of production. Lower costs reduce deadweight loss
but lead to higher profits and economic growth. This is explained in the
following diagram.
Figure 1.4: Reduction of cost

In th e diagram, Op is the price charged under perfect competition. And
Op1 is a price charged under monopoly. At op price MC=Ac is cost. But
the cost at monopoly price that is op1 is lower than the cost at competitive munotes.in

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9 Theory of Firm - I price op. Thus, although the monopoly pric e is higher and output is less
(OM) than the output produced in perfect competition (OM1), the cost is
equally low and the production under monopoly is more cost -effective.
The area denoted by triangle 2 is allocative loss (deadweight loss). But the
area d enoted by 1 is productive gain. The advantage is greater than the
loss. Therefore, there will be an overall improvement in society’s welfare.
Although it is difficult to understand the effect of monopoly power on the
welfare of society, in general, it is believed that monopoly power creates
harmful effects on society. But if it the monopoly power is used to
increase the welfare of the society by reducing the cost of production it
may create improvement in the welfare of the society.
1.4 DETERMINANTS OF FI RM STRUCTURE As mentioned earlier, structure means the characteristics and components
of the market and industries in the economy. The structure of a firm is a
system that outlines how certain activities are directed to achieve the goals
of an organizatio n. These activities include rules, roles, and
responsibilities. The firm's structure also determines how information
flows between levels within the organization. For example, in a
centralized structure, decisions flow from the top down, while in a
decent ralized structure, decision -making power is distributed among
various levels of the firm.
In other words, the Structure of a firm describes the environment within
which firms in a particular market operate. It can be identified by
considering the number a nd size distribution of buyers and sellers, the
extent to which products are differentiated, how easy it is for other firms
to enter the market, and the extent to which firms are integrated or
diversified. The following are the factors that determine the s tructure of
the firm.
1. Size of the firm :
The size of the firm determines the structure of the firm . If the size of the
firm is very small, it may not have a formal structure. Individuals perform
their duties but there are no definite rules and regulatio ns. If the size of the
firm is large formal rules and regulations are applied. There is a difference
between the top management and the other employees. There is
specialization in every job. It is expected that every stakeholder follows
formal rules and re gulations. There is a delegation of authorities.
Generally, the flow of communication is from top management to the
other employees.
2. Life cycle of the Firm:
Firms have their life cycle stages. Most firms go through the stages of 1)
birth 2) youth 3 ) midlife, and 4) maturity. Such stages influence the
structure of the firm. In the Birth, stage firms may not have a formal
structure, and there are not many delegations of authority. But if the firm
is in the second stage of its life cycle that is if it is in the Youth phase, the munotes.in

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10 formal structure of the firm is designed, and some delegation of authority
occurs. The third stage of the firm’s life cycle is Midlife, In this phase, the
firm has achieved some success. The structure of the firm becomes more
formal and complex. As the firm becomes older, it may also become more
mechanistic in structure. The last phase is the phase of Maturity. Firms in
this stage are more interested in maintaining a stable, secure environment.
The emphasis is on improving effici ency and profitability. The structure
changes accordingly.
3. Business Strategy :
The structure of a firm also depends on the strategy of the firm. If the
strategy of the firm is to increase the business very quickly, then the
structure of the firm needs t o be very flexible. The employees are
empowered to take quick decisions therefore decentralization in decision -
making is always given importance. But if the strategy of the firm is to
introduce innovative products in the market, then the structure require d is
top to a down structure where decision -making flows from top -level
management to the employees.
4. Use of Technology :
The use of technology affects the firm’s structure. If the firm needs to use
mass production technology mechanical structure is most appropriate.
mass production technologies involve standardization and specialization
of work activities, so the structure needs to be more mechanical. But if the
flow of production is continuous and the production is undertaken on a
small scale, a low lev el of standardization and specialization is required.
5. Customers and Markets :
The primary determining factor of the structure of a firm is the type of
market and consumers. If the firm provides services to a wide variety of
clients at different locati ons, the structure of the firm should be such that it
may be able to deal with several branches of the company. The structure
should be designed such that decision -making flows from the central
authority to the branches.
6. Geography :
The geographical spr eading of a business influences its structure. Where
there is a considerable degree of geographical distribution, there is likely
to be more need for careful coordination and control compared to a single
site location. If the firm has a powerful requiremen t to offer services or
products in a specific geographical area, the firm may have its branches at
different locations. Every branch can operate as a fully self -contained,
small form of the parent association.
7. External Business Environment :
External env ironmental factors like the availability of raw materials,
human resources, and financial resources are examples of the external
environment. Such external factors affect the operations and long -term munotes.in

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11 Theory of Firm - I growth of the firm. If the influence of external factors is greater, the
structures need to be more flexible and there should be decentralized
decision -making.
1.5 MERGERS Traditionally believed the objective of the firms is profit maximization.
Firms adopt several strategies to maximize profits. A merger can be one of
the strategies to get the highest profits or to earn a greater market share. A
merger is a process through which two or more companies mutually form
a single venture. In other words, a merger unites two or more companies
into one new company. Th rough mergers, there is the integration of
companies’ resources, markets, manpower, capabilities, costs, revenues,
etc. Generally, firms of equal size and with similar objectives create a new
entity through a merger. There are different types of mergers a nd different
reasons why companies decide to merge.
Following are the intentions for mergers :
1. Large -Scale Production :
As the scale of production is increased, costs can be minimized. Larger
companies can get the benefit of a cost -saving competitive adv antage
which small companies generally can not get. After a merger, two
companies can increase the scale of production and can get the benefit of
economies of scale.
2. Market Share :
One of the common motives to merge is to acquire the highest share of th e
market. The integration of resources, manpower, technology, etc. enable
the merged company to acquire the largest share of the market.
3. Acquisition of assets :
A merger is also driven by a wish to obtain some assets that cannot be
obtained using other methods. It is quite common that some companies
arrange mergers to gain access to unique assets or to assets that usually
take a long time to develop internally. For example, access to new
technologies is a frequent objective in many mergers.
4. Value Cr eation :
One of the objectives of the merger is to generate additional revenue or
value. Activities like market expansion, product diversification, research,
and development after the merger will help the unit to bring better value
addition through better r evenue generation.
5. Diversification :
Mergers are often undertaken for diversification purposes. A company
can diversify its business through mergers. It may enter a new market and
may provide new services to that market. Sometimes managers of munotes.in

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12 companie s follow merges to diversify risks regarding the company’s
operations. It is thought that mergers would diversify markets and thereby
may diversify risks.
6. Taxation :
Companies follow merger practices to get taxation benefits. For a
company with large ta xable income if merges with a company with tax
losses, the total tax liability of the consolidated company will be much
lower than the tax liability of the independent company. Thus, a merger
can also be looked at as a strategy to get other advantages alon g with
taxation benefits.
7. Incentives for managers :
Mergers are also followed to pursue the personal interests and goals of the
top management of a company. A consolidated unit after a merger ensures
more power and prestige. The consolidated company aft er the merger
becomes much larger than the single unit. Managers are motivated to form
a big company after merging two units into one company. It is called
empire building, It happens when the top managers favor the size of a
company over its performance.
1.5.1 Types of Mergers :
Mergers take different forms. The form of a merger depends upon the
objectives of the companies that merge. After the merger, the firms may
have enhanced monopoly power or might have enhanced their knowledge
and expertise. The firm s apply it to get further benefits from their
knowledge and expertise. This expertise may relate to the nature of the
range of products, gained through research and development, gained in
one geographical market that can then be applied in other geographic al
markets. Such powers the firms apply in their process through choosing a
type of merges. The following are different types of merges.
1. Horizontal Integration :
Horizontal merger strategy is adopted by the firm to strengthen its position
in the compan y. The horizontal extension means how much of a given
product a firm produces and how many different products it offers. When
the objective of the firms is to expand the market for their products or
enter a new market, a horizontal integration strategy is followed.
Horizontal mergers allow the firms to explore new markets through new
products. Generally, two strategies are followed under horizontal mergers.
1) The firm increases its marketing exposure through subsidiary firms or
the sales of its products in different market segments.
2) The company establishes several branches in different parts of the city
or country where similar products are offered.
Horizontal Integration is useful for firms to establish themselves in
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13 Theory of Firm - I through horizontal mergers, the firm strengthens its position in the
industry. Mergers with another company that produces and sells the same
product or service. The Horizontal Integration strategy may create a
monopoly. The consolidated company after the merger can capture the
market, reduce competition, and achieve high profits.
The Horizontal Integration strategy is highly effective when :
 The firm competes in a growing industry
 The firm has sufficient financial r esources to handle mergers and
acquisitions
 Monopoly power emerging out of merger is allowed
 Competitors lack some capabilities, competencies, skills, or resources
that the company already possesses.
Advantages of Horizontal Integration :
1. Expansion and Growth :
This is one of the objectives of undertaking the activity of a merger. If the
firm can operate at its full capacity, a merger enables the firm to operate at
its full capacity. Sometimes it is less expensive to merge with the other
firm than to expa nd internally. In this situation mergers will provide a
wider customer base; the other firm may have distribution systems that
can be used to expand the business through marketing. If the firm merges
with another firm that operates in different regions, it can expand its
operations to new markets. The firms can diversify their products, and
services and can get long -term opportunities for your business. Thus,
mergers can help the expansion and growth of the business.
2. Reduces competition in the sector :
Horizontal integration can reduce competition. It helps in the case of
competitive products and for products for which substitutes are available
in the market. If competition is reduced firms can concentrate on
satisfying the needs of the consumers. Reduced competition can result in
higher profits. It also makes firms more powerful concerning suppliers and
distributors.
3. Complements the Existing Products :
The horizontal Integration helps the firms to widen the market as well as
product portfolio. The firm s can sell more products along with the existing
ones. It may complement the existing products. The firms also can reduce
the reliance on only one product.
4. Economies of scale and Scope :
The economy of scale describes the situation in which cost advant ages are
gained by the company due to the heavy production of goods. Companies
can achieve economies of scale by increasing their production and munotes.in

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14 lowering costs. This happens because the cost is distributed among many
goods.
The economy of scope describes t he situations in which the long -run
average and marginal cost reduction of a company happens due to the
production of complementary goods and services. It is the efficiency
formed by variety, not due to the volume of the products.
5. Increased Revenue and Reduction in Costs :
Mergers help firms reduce costs. For example, firms in the same segment
or location can combine resources to reduce costs, duplicate facilities can
be avoided. Firms can operate at a cost lower than their competitors.
Prices of the fina l products can be lowered which will drive the
competitors out of the market if they cannot compete in a pricing war.
Reducing the costs can increase the profit margin and increase the revenue
earned.
But a firm must take care because Horizontal integrat ion may impact a
company’s product line by affecting its profits adversely. Following are
some drawbacks of horizontal integration.
1. Diseconomies of Scale :
If the business if merger and vertical integration grow too large and if
there are clashes in top management there is a risk of diseconomies of
scale. It may lead to increase costs in production.
2. Affects Flexibility :
After the merger, the consolidated firm has additional manpower and more
processes, but it requires more accountability. The consolid ated firm must
have coordination and transparency in its all departments.
3. Investigations from authorities :
Horizontal integration may create a monopoly and the firms may follow
anti-competitive practices . Such monopolies may attract investigations
from competition authorities of the region. The firm must prove every
time how it is not limiting the competition in the market.
4. Strict Supervision by the managers :
As per the theory, horizontal integration results in a synergy in which the
capabilities an d resources between merging firms are expected to
complement each other. Horizontal integration also creates a monopoly. If
there is a lack of synergy, the top management expects too much from the
workers and it leads to strict supervision and control over the process
which may lead to unrest among the workers.
As there are some drawbacks of horizontal integration, the firms should
take into consideration that the benefits from horizontal integration exceed
the losses. Also, the firm should include complem entary products or
develop by -products. This will help the firms to get benefits from existing munotes.in

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15 Theory of Firm - I products and maintain existing sales. Also, it will help the firms to get
expected profits.
5. Vertical Integration :
Vertical integration, means the stages of the production process in the
firm. For example, obtaining inputs, processing the inputs, transforming
them into a final product, marketing them, etc. One of the most important
decisions that a firm must make is how to obtain its inputs. Whether to
produ ce them within the organization or to purchase them? When the
decision is taken to produce it within the organization it is vertical
integration. Vertical integration is a strategy that allows a firm to
restructure its operations by taking direct ownershi p of various stages of
its production process rather than relying on external contractors or
suppliers. The degree of vertical integration in each industry results from
the aggregation of these micro -decisions at each stage of the production
process. The m erger is used as a strategy for vertical integration. In other
words, firms a firm supplying raw materials is selected for a merger then
there will be vertical integration as the consolidated firm will produce its
raw material.
Much of the literature on v ertical integration applies the agency theory or
transactions costs framework and thus focuses on sources of efficiency
gains. But sometimes vertical integration is a reaction to imperfect
competition or it can be a source of imperfections.
The extent of vertical integration is often measured by the ratio of net
output (value added) by a firm to its gross output (sales). Net output is
measured as the sum of the wages, salaries, and profits of a firm, gross
output is equal to net output plus material input s purchased from other
firms. If a firm begins to produce some inputs that it had previously
bought for other firms, then its degree of vertical integration would rise as
its net output rises and its purchase of material inputs from elsewhere
declines. Fir ms follow vertical mergers to get greater control over their
supply and make their organization more competitive.
Degrees in Vertical Integration:
1. Full Vertical Integration :
When the firm obtains all the assets, resources, and expertise needed to
repro duce the upstream or downstream of the supply chain within the
production unit of the firm itself then it is full vertical integration. The
firms make use of vertical integration to achieve their goals. Sometimes
full vertical integration is used as a subs titute for the merger. Instead of
going for the merger, the firms adopt vertical integration.
2. Quasi Vertical Integration :
When the firm has ownership of specialized tools upstream or downstream
of the supply chain, then it is quasi -Vertical integration . For example, if munotes.in

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16 Industrial Economics
16 the firm has obtained some stake in the form of equity investment to get
the benefits of increasing ownership interest.
3. Long -term Contracts :
A mild form of vertical integration is long -term contracts. The firms keep
some components of purchasing are held constant. The purpose is to
reduce inconsistencies in product delivery, The costs are held constant to a
certain extent.
4. Spot Contracts :
When the firms need inputs or raw materials immediately, the firms go for
spot contracts. Raw m aterial procurement is made on the spot, so it is
called a spot contract.
Types of Vertical Contracts :
1. Forward Vertical Integration :
When the firm merges with the firm with a forward supply chain, it is
called forward integration. The forward supply c hain is - Producers of raw
materials – Manufacturers – Retail Distributors. If a firm is a
manufacturing unit, and if it merges with the distributor then it is forward
vertical integration.
Forward Vertical integration is also known as upstream integration .
Retailers have greater purchasing power. Or the firms at the end of the
supply chain have the money to purchase companies behind them.
Therefore, forward vertical integration is not common.
2. Backward Vertical Integration :
Backward vertical integratio n is where a firm merges with another firm at
a stage before it is in the supply chain. In other words, it incorporates one
of its suppliers. For example, it is called backward vertical integration
because the firm is behind in the supply chain. So, in a b asic supply chain
of raw material producer, manufacturer, and distribution – the distributor
could merge with the raw material supplier or the manufacturer. This type
of vertical integration is quite common. This is because the distributors at
the end of t he supply chain have the purchasing power to integrate with
the suppliers.
3. Balanced Integration :
Balanced integration is a combination of both backward and forward
integration. For example, balanced integration happens when a company
merges with a compa ny before it in the supply chain, as well as a company
that is after it in the supply chain. The balanced integration consists of
transactions toward backward as well as towards forwarding direction in
the supply chain.
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17 Theory of Firm - I Advantages of Vertical Integration :
Vertical integration enables firms more control over the supply chain.
There are other benefits or advantages of vertical integration. They are
mentioned as under.
1. Availability of information :
Vertical integration allows the firms to have greater con trol over the
production process. There is a free flow of information among supply
chain members. Such a free flow of information helps to reduce the time
required to pass the information from one member of the supply chain to
the other. As a result, there is greater flexibility in modifying the process
according to the changes in demand, which improves the elasticity of
supply.
2. Reduction in Costs :
Through vertical integration, firms can reduce input costs. When the firms
either integrate through the pr oduction of raw materials or distribution, it
can reduce cost by reducing the members in the chain and thereby
reducing their margins. Also, the firm can adopt advanced technology in
the production process which may further help to reduce costs.
3. Specia lization :
Through vertical integration organizations invest within the organization.
It can utilize the skills of the people within the organization. It also can
specialize in the skill set that is required for the process. Based on
specialization, the fir m can differentiate itself from others.
4. Quality Control :
As through vertical integration, the firms can have control over the
production process, and can also have control over the quality of the
product. If there is backward integration the firms can have control over
the quality of raw material used. In the case of forwarding integration, the
distribution can be improved, and the firm thus can set the standard for the
quality of the product.
5. Lower Consumer Prices :
At each stage of the supply cha in, the supplier gets some level of profit.
After vertical integration, the new firm earns a profit at two points of the
supply chain. Therefore, the new firm can charge lower prices.
6. Geographic Expansion :
Vertical integration helps the firms to open new centers
Disadvantages of Vertical Integration :
Following are the disadvantages of vertical integration. munotes.in

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18 Industrial Economics
18 1. Higher Cost :
If the firms undertake backward vertical integration and produce raw
material, they may produce it with higher costs than the othe r suppliers at
least in the initial stages of the production. This is because the people
within the firm may not have the expertise required for products which
may lead to managerial complexity. A clear result of this is an increase in
costs and a reductio n in core competency.
2. Disadvantages Due to New Technology :
If the new technology is developing very quickly the vertically integrated
firm needs to adopt the new technology. The firm needs to invest in new
technology. The adoption of new technology can be costly. It can add to
the cost of production. This can neutralize the advantages of vertical
integration.
3. Lower Profits :
Vertical integration may not be always profitable. The firm may require
huge investments and expertise. The firms may not comp ete with other
suppliers or distributors who are already established in the market.
4. Reduces Flexibility :
The established firms in the market have more flexibility than vertically
integrated firms. Vertically integrated firms have few choices with the
supply chains. But independent suppliers or distributors specialize in the
production or distribution of a specific product therefore they can have
better flexibility.
5. Conglomerate Integration :
A conglomerate merger or integration is an integration bet ween two firms
with unrelated businesses. The two firms are in totally different sectors or
different geographical areas. Such mergers are helpful for firms to extend
their functions to a different geographical area or to expand their range of
products.
Types of conglomerate mergers :
There are two types of conglomerate mergers. Pure Conglomerate Merger -
when two firms with nothing in common merge then it is a conglomerate
merger. Sometimes the objective of firms is to expand business or to
increase product range if such companies merge, then it is called a mixed
conglomerate merger.
Advantages of Conglomerate Mergers :
1. Business Diversification :
Firms with conglomerate mergers can diversify their business. The firm
gets the advantage of diversification, and it can overcome risks related to
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19 Theory of Firm - I in one business segment by keeping its good performance in another
diversified segment.
2. Expanded Customer Base :
A firm with a conglomerate merge r can cross -sell its products to the other
company. It gets a completely new set of customers that it otherwise could
not find. This broadens the customer base and helps to get better profit.
3. Economies of Scale :
The costs like costs of research and dev elopment, and costs of
advertisements can be reduced if the two firms merge. The costs are
spread out to different business units.
4. Utilization of Resources :
Conglomerate merger helps the firms to utilize unused resources like
capital and manpower. Exce ss capital can be utilized in different areas of
business. It can also use its unutilized expert manpower in different
businesses.
Disadvantages :
Although a conglomerate merger has advantages it has its disadvantages
too. following are the disadvantages o f conglomerate mergers.
1. corporate governance :
It is quite possible that the diversification of business changes the focus.
this may divert the resources away from core operations. Such diversion of
resources may result in poor performance.
2. No previ ous Experience :
In a conglomerate merger firms merging do not have any kind of
experience to work with each other. This may result in this management in
an organization.
3. Governance Issue :
When different companies with different sets up merge with each other, it
is very challenging to develop a new corporate culture. Such kind of
differences may create a problem for the smooth functioning of the
company.
1.6 MARKET STRUCTURE Market structure refers to the characteristics of an organization, that
influ ence the behavior of the firm concerning its decisions regarding the
determination of price and output. The structure of a firm is an important
element as it affects the behavior of the firm. Market structure changes
due to changes in organizational featur es like the degree of competition
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20 Industrial Economics
20 products, elasticity of demand, and the degree of control over the price of
the product. No market structure remains static, it keeps on changing d ue
to the organizational features and changes in physical, economic,
institutional, and technological factors. The market structure keeps on
changing due to the following reasons.
1. Production Pattern :
Many factors determine production patterns. The pr oduction pattern is
determined by many factors. It may change due to technological factors,
economic factors, and institutional factors. The market structure changes
with keeping pace with such factors. It changes with changes in
technology as well as othe r factors.
2. Demand Pattern :
Demand for a product change because of change in incomes, changes in
tastes and preferences of the consumers, changes in fashions, changes in
income distribution among consumers, and changes in the market structure
should be changed and updated to keep coordination with changes in the
demand.
3. Costs and Patterns of Marketing :
The raw material costs, costs of factors of production, marketing
functions, etc., further determine the changes in the structure of the
markets. Ma rketing functions like transportation, storage, financing, and
providing market information, determine the market structure.
4. Government Policies :
Government policies regarding taxes, subsidies, purchases, and sales
affect the performance of market ta sks. The market structure should be
changed as per the changes in government policy. The functions like level
of sales, purchase of raw material, inventory, quantity to be produced, and
taken to market change with changes in the Government’s policies.
5. Technological Change :
Technological changes bring changes in the market structure through
adjustments in the scale of business, the number of firms, and their
financial requirements.
Determinants of Market Structure :
1. Number of Buyers and Sellers :
The number of buyers and firms selling a particular product, determines
the effect on the level of competition in the market. If the number of
buyers and sellers is large a single seller or buyer has very little impact on
the market. The number of buyers or sellers determines the price of the
product. If there are very few firms in the market, the firms can influence
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21 Theory of Firm - I 2. Economies of Scale :
Market structure is also determined by the size of the firm or the level of
production. If th e output is produced on a large scale, the firm gets
advantages of large -scale production, it can keep the price of its products
low and gets a competitive advantage. Such firms can capture entire
market demand gradually and, it may create a monopoly in th e market.
3. Nature of Product:
Characteristics of the product determines the market structure. If the
products are homogeneous, it is sold at the same price in the market. But if
the commodity is differentiated then it is sold at a different price. If th e
product is unique and has no other substitute, it creates a monopoly in the
market.
4. Entry Barriers :
If the firms are free to move from one industry to another, the price will
remain stable. The industry with a greater number of firms getting profit
will attract other sellers in the market. This keeps the prices stable due to
competition. But if there is no freedom of entry and exit, different prices
prevail in the market. This may create a monopoly in the market.
5. Mobility of Goods :
When the factor s of production and products can move very easily, the
uniform price will prevail in the market. It will make the market
competitive. But against this, if the factors of production and products can
not move freely then different prices prevail in the marke t for a different
product.
6. Consumers’ Knowledge :
If buyers and sellers have perfect knowledge about the market conditions,
the sellers cannot charge a different price for the same product, in such a
situation the uniform price prevails in the market. then a uniform price
prevails in the market. However, if the buyers have imperfect knowledge,
sellers can charge different prices.
7. Government Intervention :
Sometimes the Government has a monopoly over the market Markets are
indirectly regulated by the government. The government either imposes
heavy taxes or makes the business license mandatory to restrict the entry
of firms.
1.7 SUMMARY One of the key areas in Industrial Economics is understanding the
structure and its effect on the performance of the industry. Industrial
Economics uses different theoretical models to understand the behaviour
of firms. Initially, the focus was to understand the structure of the market munotes.in

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22 Industrial Economics
22 and observe the performance of the firm concerning the structure of the
firm. But over the years the approach has changed, and the efficiency of
individual firms is now given importance.
Many factors determine the structure and conduct of a firm. The structure
of the firm determines the sales, revenue, and profits of the firm. The
market structure is determined by several factors. It includes some
characteristics, of the consumers like their knowledge about the market,
the number of buyers, their tastes, preferences, and habits.
Many times to manage the business work forms adopt mergers a nd
acquisitions. These types give an idea about the types of integration of the
firm and their advantages.
In short, the structure, conduct, and performance are the key drivers of
decision -making in the oligopoly market;
1.8 QUESTIONS 1. What is market structure? Explain the relationship between market
structure and monopoly power.
2. What is the structure of a firm? Explain the determinants of the
structure of a firm.
3. What are the patterns of market structures?
4. Define mergers. Explain differe nt types of mergers.
1.9 REFERENCES  Louis Philips, “ Applied Industrial Economics”, Cambridge
University Press, 1998
 paul. R. Ferguson, “Industrial Economics: Issues and Perspective”
MACMILLAN EDUCATION LTD Hound mills, Basingstoke,
Hampshire RG21 2XS an d London
 Luis M. Bill Cabral, “Introduction to Industrial Organizations” 2002,
The MIT Press Cambridge, Massachusetts. London, England
 Malcolm C. Sawyer , “The Economics of Industries and Firms” 1985,
Taylor & Francis e -Library, 2005.
 Ho Ma 2000, “ Comparat ive advantage and Firm’s performance” CR
Vol l0(2)
 Stigler, G. “A Theory of Oligopoly,” The Journal of Political
Economy, 72(1), 44 -61, (1964)
 Bresnahan, Tim “Empirical Studies with Market Power,” Handbook
of Industrial Organization, vol. II, chap. 17.
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23 2
THEORY OF FIRMS - II
Unit Structure
2.0 Objectives
2.1 Introduction
2.2 Economies of Scale
2.3 Product Differentiation
2.4 Capital Requirements
2.5 Pricing Strategy in Oligopoly
2.6 Theories of Interdependence
2.7 Tacit Collusion and Price Leadership
2.8 Limit Pricing
2.9 Summary
2.10 Questions
2.11 References
2.0 OBJECTIVES  To understand the benefits of large -scale production.
 To evaluate product differentiation tactics of a firm
 To assess the capital requirements of the firms
 To study theories of interdependence through collusion
 To examine tacit collusion strategies of the firm
2.1 INTRODUCTION Industrial economics is the study of industries, their problems, and their
relationship with society. This section discusses the adva ntages of large -
scale production for firms. By producing on a large scale, firms can
minimize the cost of production. The firms can also attract consumers by
following production differentiation strategies. By differentiating the
products it may restrict t he entry of new firms into the market. It benefits
the existing firms in the market.
But the nature of the firm varies so does the demand for the capital
requirement. Firms need to plan their capital requirements depending on
the nature of their busine ss. Recognizing the need for capital and
arranging the same in advance may make the firm well equipped to get a
good profit. Determining the price of the product is an important decision.
In an oligopoly market, there are very few firms. These firms know e ach
others’ price and output decisions if they compete with each other they
become completely interdependent. In this situation price and output, munotes.in

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24 Industrial Economics
24 decisions depend on the decisions of the other firm. If the firms in the
market come together to form collus ion they may get higher profit.
2.2 ECONOMIES OF SCALE The feature of modern business is large -scale production. The scale
economies of scale are cost advantages of large -scale production. The firm
gets scale economies or economies of scale if the averag e cost declines
with the output. In other words, the firms get cost advantages if it is
operating on a large scale. Companies with large -scale production.
The theory of Economies of Scale studies the relationship between the
scale of use of inputs and the output of the enterprise. The theory of
economies of scale studies the effect of average cost of production on
different levels of output such that all possible efforts are made to produce
the put by making efficient use of resources. The long -run average cost
curve is called a scaling curve as it denotes economies and diseconomies
of scale.
According to Chamberlin, when the size of scale of operation or the use of
factors of production increases, the efficiency of factors of production
increases due to e fficiency of factors of production due to specialization or
use of specialized technology.
The concept of economies of Scale can be explained with the help of the
following diagram
Figure 2.1: Long -run average cost curve and economies of scale

In the figu re, LAC is the long -run average cost curve, and SAC1, SAC2,
SAC3, SAC4, and SAC5 are short -run average cost curves. LAC is
tangent to all SACs. LAC is the locus of all tangency points. LAC
indicates the least possible average cost of producing any level of output.
If any firm wants to produce an OA level of output. It will select SA1 munotes.in

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25 Theory of Firm - II plant size on average cost SAC1. The firm will operate on this curve at
point G. If the wants to produce OB output, it will select the ASC2 plant
and it will operate at point H . Likewise the firm will operate at the point
which is tangent to the LAC. Figure 1.5 indicates that a firm can produce
higher output at a lower cost. OM level of output is optimum output
because at this level of output the cost of production is lowest.
LAC falls till OM level of output and then it slopes upwards. It has a U
shape. It is U shaped because LAC is not tangent to SACs at their
minimum point. Before OM level of output LAC is tangent to Sacs at their
decreasing portion indicating that there is f urther scope to increase
production by reducing the cost of production. But after a point I or OM
level of output, LAC is tangent to LAC at their increasing portion. It
indicates that beyond output level OM if production has increased the cost
of productio n increases. LAC is called an envelope curve as it envelops
SACs. It is also called a planning curve as the producer can plan any
output on LAC by choosing any level of output on LAC. The downward
sloping LAC can be attributed to economies of Scale. The fi rm can reduce
the cost of production due to economies of scale. The following
economies are observed by the firm.
Following are the sources of Economies of scale :
1. Use of Efficient Technology:
First, as the firm increases its scale of operations, it ca n use more
specialized and technically more efficient, machinery to produce large
quantities of output. It reduces the per unit cost of production.
2. Division of Labour:
Secondly, when the scale of operations is increased and more labor and
other factor s are employed, it becomes possible to divide the work into
different parts. In another word a greater degree of division of labor
becomes possible. Division of labor and specialization reduces the cost of
production at a large scale of production, workers can specialize in
performing a particular task in the production process. Generally, workers
perform one task in the production process, and they can work more
efficiently than the one who has to perform several tasks in it. This
increases production and reduces the cost of production.
3. Economies Due to Indivisibility of Factors :
Economists like Kaldor and Joan Robinson explained economies of scale
as arising from the imperfect divisibility of factors. They argue that most
of the factors are bulky. They are indivisible, when the firm uses a greater
number of variable factors, such indivisible bulky factors are used at their
highest capacity which can therefore yield higher production. This reduces
the cost of production. If a small output is produce d with these costly
indivisible units of the factors, the average cost of production will
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26 Industrial Economics
26 4. Marketing Economies :
A firm can get the commercial advantage of buying and selling on a large
scale. A firm operating on a large scale can hav e the advantage of
purchasing raw materials in bulk. the supplier of raw materials may
provide concessions as a result cost of production decreases. the firm can
pass this advantage to the consumers. it may sell the product at a lower
price. this may expan d the business of the firm.
5. Financial Economies :
A firm operating on a large scale get financial benefits. It becomes easier
for the firm to get credit from the banks because the firm has prestige in
the market. Further, large firms can sell bonds a nd stocks in the capital
market at more favorable terms. This reduces the cost of raising funds
required for business purposes.
6. Risk Bearing capacity :
A large industry can stand in adverse times. It can forecast adverse times
and can make arrangements in advance to face such situations. For
example, it can store raw materials if there is an anticipated possibility of
shortage in near future. Thus, the risk -bearing capacity of the industry
operating on a large scale is greater than any industry operati ng on a small
scale.
7. Managerial Economies :
The firm operating on a large scale can employ experts from different
fields. It can appoint managers for different departments who can use their
expertise end decision -making capacity to improve production an d
productivity. This helps to reduce the cost of production and increases
production and efficiency.
Due to the above -mentioned economies of scale, the long -run average cost
curve slopes downwards.
2.3 PRODUCT DIFFERENTIATION Product differentiation is a kind of entry barrier. Bain in his study
mentions product differentiation as an entry barrier. It makes the entry of
the new firms quite difficult. product differentiation depends upon the
behavior of the firm. It also depends upon the activities of the firm.
Chamberlin laid greater emphasis on product differentiation in
monopolistic competition. According to Chamberlin, it is the
distinguishing feature of monopolistic competition.
Under monopolistic competition, products are not homogenous. Products
of different firms are slightly different from each other; therefore, they are
close substitutes for each other. These products are differentiated there is
some degree of monopoly. Therefore, in a monopolistic competitive
market, there is competition as well as a monopoly. The greater the degree
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27 Theory of Firm - II There are two bases of product differentiation :
1. Product differentiation based on features of the product :
When any firm brings changes in size shape color des ign cover, exclusive
patented features, trademarks, and trade names its product becomes
different from others. If such kind of product differentiation exists, the
buyers are connected with the firm cording to those preferences.
Sometimes the firms bring di fferentiation in the product through
qualitative changes for example by changing the quality of raw material.
such product differentiation helps the firm to increase demand for the
product. Another way to attract buyers in the market through product
differ entiation is to make advertisements and make the buyers aware of
changes made in the packing color design of the product etc.
2. The conditions for the sale of the product :
In this case, the product is differentiated based on the services provided by
the produ cer while selling the product. I f the services provided by one
firm are different from the services provided by the other buyers get
attracted to the firms that provide better services. F or example, politeness,
courtesy, tone of the salesman, convenie nce of seller’s location, etc. may
make the differentiation.
Product differentiation is also categorized as horizontal product
differentiation and vertical product differentiation :
1. Vertical product differentiation :
Vertical product differentiation oc curs when the producer emphasizes the
quality of the product. He tries to improve the quality of the product. The
market plays different qualities of the product when the producer upgrades
the quality of the product he moves to the upper position in the hi erarchy
of lower quality to high quality. The quality of the product is improved to
attract more customers in the market who are ready to pay a high price for
high-quality products.
2. Horizontal product differentiation :
The products are differentiated ba sed on specific features then it was
called dance horizontal product differentiation. In this case, a specific
product is differentiated based on its feature of that product. For example,
the design or the color of that product is changed than other firms in the
market. This helps the producers to attract customers in the market
Implications of product differences :
1. Increase in demand :
The very purpose of the product is sensation is to attract a greater number
of customers in the market. When products ar e differentiated it creates a
monopoly on a certain element of monopoly in the market. Due to this
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28 Industrial Economics
28 number of customers for the product. The form may increase revenue by
using its mon opoly through an increase in prices for differentiated
products.
2. Consumers benefit :
Horizontal or vertical product differentiation bring changes in the product.
The changes are qualitative, or consumers get a greater variety of
products. Consumers may get the product as per their likings and
preferences.
3. High price :
As the firm introduces additional features to a product, it can charge a
high price. A single change in the product makes that product less
common and better than its substitutes. Cons umers are ready to pay a high
price as the product is different from other products.
Drawbacks of Product Differentiation :
Product differentiation may not be always beneficial. Sometimes it may
have its drawbacks.
1) It may not guarantee an increase in revenue.
2) It may require a lot of time and energy to bring differences in the
product.
3) Consumers may not pay a high price attached to price differentiation.
2.4 CAPITAL REQUIREMENTS The firm needs to recognize the amount of capital required for t he
business. Firms require to invest in the business even before it undertakes
production. Again, from the purchase of raw material to selling the
product and providing after -sell services the firm requires capital. The
capital needs of the firm are differ ent depending on the operation it has to
carry out.
Following are the categories of capital required for the business :
1. Fixed Capital :
Fixed capital is an investment of the company in fixed assets. Firms need
capital for the permanent or long -term fin ancial needs of the business.
Generally, it is used for purchasing fixed assets like land and buildings,
machinery and equipment, furniture, etc. The investment in fixed capital is
a long time investment and it can not be withdrawn quickly.
Fixed capital is required while establishing the new company as well as at
the time of expansion of the business. Fixed Capital Requirement is
influenced by the following factors :
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29 Theory of Firm - II 1) Nature of business:
The requirement of capital assets depends on the nature of the business.
For some companies the requirement is large for example, public
companies like railways. But for trading companies, the requirement for
fixed capital will be less.
2)Size of business:
If the size of the operation of the firm is large, it req uires heavy
investment in fixed assets, Fixed capital requirement of such firms is
larger than a firm operating on a small scale.
3) Type of products:
Firms producing investment goods like steel cement and automobiles
require a large amount of capital tha n a firm manufacturing consumer
goods like soap, toothpaste, stationery, etc.
4) Process of Production:
A firm with larger automation requires a larger amount of fixed capital as
compared to the firm which selects a semi -automatic plant or depends
more on manual labor for the production of goods. Similarly, if a firm
purchases the components needed for its products from the market rather
than producing these in its factory, requires less fixed capital compared to
the company that manufactures the component s on its own for example
automobile company’s assembling units.
5) Method of Payment:
If the fixed assets, specialized machinery, and equipment are purchased by
making an immediate payment, more amount of fixed capital is required if
the firm makes the pa yments installment or lease basis.
2. Working Capital :
The capital that is required to carry out day -to-day business activities is
working capital. It is the funds invested in current assets. For example,
wages or salaries to its workforce, repayment of lo ans, stock -in-trade, etc.
It is called circulating capital because most of the amount invested in
current assets is recovered through realizations of debtors and cash sale of
goods and is re -invested in current assets.
Factors Determining Working Capital Requirement :
Every firm requires adequate working capital for running the business
smoothly and efficiently. The need for working capital is different for
different firms. It depends on the nature and size of the business. The
factors that influence worki ng capital needs are -
1) Nature of Business:
The working capital requirement of the manufacturing companies is
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30 Industrial Economics
30 telephone companies and the concerns like hotels, restaurants, etc. can
manage with a small amount of working capital as most of their
transactions are undertaken on a cash basis and their inventory needs are
low.
2) Size of Business:
The size of the business is a crucial factor in determining the working
capital requirement s of every firm. If the firm is big and its volume of
business is large, the working capital requirement is huge because it
requires more inventory.
3) Production Cycle:
The time required for a firm to convert its raw material into finished goods
is call ed the business cycle. If the length of the business cycle is large, the
requirement for working capital is more and vice versa. But The length of
the production cycle depends upon the nature of the product produced and
the nature of the technology used. F or example, for products like cars and
cotton textiles, the production cycle is longer than the production of
stationery, cosmetics, etc.
4) Turnover of Inventory:
The rate or the time within which finished stock is converted into sales is
the turnover o f inventory. A firm with a high inventory turnover requires
less working capital. It is because a firm with a high turnover rate needs
less investment in stock.
5) Credit Policy of the Firms:
If firms provide generous credit facilities to their custome rs, need more
working capital than the firms that are strict while giving credit terms.
When customers are given a liberal and longer period of credit, the firm’s
funds get tied up with debtors. This results in a higher requirement for
working capital.
2.5 PRICING STRATEGY IN OLIGOPOLY An oligopoly market is a market where there are few firms. A few firms
know each other very well. A decision of a firm in the market affects the
decision of other firms. The firms in the Oligopoly market produce
homogenous or differentiated products. Since only a few firms are selling
a homogeneous or differentiated product in oligopolistic markets, the
action of each firm affects the other firms in the industry and vice versa.
1) Chamberlin’s Model :
Prof. Chamberlin develo ped the model to suggest how output and prices
are determined in an Oligopoly market. Chamberlin indicates that if the
firms in a small group realize their interdependence, they can attain stable
equilibrium with profit maximization, and all can enjoy mono poly profit.
According to him if the firms do not recognize their interdependence, they munotes.in

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31 Theory of Firm - II may have either Cournot equilibrium (where a firm assumes that its
competitors will keep the quantity of output constant) or Bertrand
Equilibrium (where the firm assume s that its competitors will keep price
constant).
But according to Chamberlin, firms are well aware of the fact that the
competitor’s price & quantity decisions are going to have a direct and
indirect effect on the firms’ equilibrium position. With the un derstanding
of such effects, oligopolistic firms can achieve stable equilibrium with
monopoly profit for all the firms in a group.
Chamberlin’s model is explained with the help of the following diagram.
Figure 2.2: Stable equilibrium

In the diagram, DD is the demand curve, and OK is firm A’s output. Pm is
firm A’s price. Firm B will consider CD as a demand curve. It will
produce quantity KB. As firm B enters the market, the price falls and
becomes equal to OP. As a result, firm A will reduce output up to O A.
This will increase the price up to Opm. Firm B realizes that this price Opm
is a good price and therefore will not change it and it will not change the
output level.
2) Kinked Demand Curve and Price Determination (Non -Collusive) :
Hall and Hitch, in the ir article ‘Price Theory and Business Behaviour’,
used the term kinked demand curve for explaining the price -stickiness in
oligopolistic markets. It was Paul Sweezy, who for the first time, used the
kinked demand curve as a tool for explaining equilibrium in the oligopoly
market.
Under an oligopoly without product differentiation, if a firm raises the
price, it will lose all its customers. So this firm will not tend to change its
price. Alternatively, firms without product differentiation may enter into a
formal or informal agreement and maintain price rigidity.
The kinked demand curve is denoted in the diagram. munotes.in

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32 Industrial Economics
32 Figure 2.3: Kinked Demand Curve

In the diagram, DKD1 is the demand curve. It has a kink at point K. DK
portion of the demand curve is more elastic while the KD1 portion of the
demand curve is less elastic. The upper part of the demand curve is more
elastic because the firms in the market do not increase the price if any firm
increases the price. They fear losing consumers if they increase the price
above the OP price. The lower part of the demand curve is inelastic
because the firms follow the firm if any firm reduces the price. They fear
that if any firm reduces the price, they will lose customers.
By increasing, the price firms may lose customers and by reducing the
price there will not be much increase in quantity demanded as other firms
follow the firm that reduces the price the same price prevails in the
market. OP price never changes. Therefore, the price becomes rigid or
sticky.
Figure 2.4: Equilibrium with Kinked demand curve and Price
Rigidity

The price determined in the market is OP. This price is rigid. In the
diagram, MR is the marginal revenue curve and AR is the average revenue
curve. MR is discontinued due to the difference in the elasticity of
demand for the AR or DKD1 demand curve. MC1 is the marginal cost
curve. E is an equilibrium situation. At equilibrium E OP price is munotes.in

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33 Theory of Firm - II determined in the market. Even though the cost of production increases the
same price prevails in the market. When cost increases, MC2 becomes the
new cost curve. E1 becomes the new equilibrium situation. At E1 the same
price OP is determined. Irrespective of changes in the cost of production,
the same price prevails in the market.
3) Price Leadership - (Collusiv e):
It is a collusive model of price determination under an Oligopoly. In an
Oligopoly market, one firm sets the price and the others follow it because
it is advantageous to them or because they prefer to avoid uncertainty.
There are four different types of Price leadership :
(1) Low -Cost Price Leadership :
The firm with low cost sets a lower price than the profit -maximizing price
of the high -cost firms. As a result, the high -cost firms are forced to agree
to the low -price set by the low -cost firm. A certa in level of profit margin
is considered while setting the price.
(2) Dominant Firm Price Leadership :
One of the firms in the oligopoly market that produces larger output and
therefore dominates the market. Such a firm has greater influence over the
marke t. The dominant firm estimates its demand and determines the price
that is most suitable for it to earn profit. The other small firms do not
influence the market, follow the price determined by the dominant firm.
(3) Barometric Price Leadership :
The old, largest, experienced most respected firm in the market determines
the price. While determining the price, the firm takes into consideration
demand for all the firms in the market and their cost of production. It
decides the price that is the best for all t he firms in the market.
(4) Aggressive Price Leadership :
A very large and dominating firm follows a very aggressive price policy
and determines the price by making it compulsory for the other firms to
follow the price.
4) Cartels - Formal Collusive Oligo poly:
Firms in the market agree to give up their rights of price and output
determination to a Central Administrative Agency of Cartel to secure
maximum joint profits for them. Under a perfect cartel, the price and
output determination of the whole industr y and each member firm is
determined by the common administrative authority. The objective is to
get maximum profit. The total profits are distributed among the member
firms in a way already agreed between them. Total demand in the market
is estimated and then the output quota is distributed among the member
firms. The allocation of output quota to each of them is made on the
grounds of minimizing cost and not as a basis for determining profit
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34 Industrial Economics
34 2.6 THEORIES OF INTERDEPENDENCE The distinguishi ng characteristic of oligopoly is interdependence. Since an
oligopolist knows that its actions will have a significant impact on the
other oligopolists in the industry, each oligopolist must consider the
possible reaction of competitors in deciding its pri cing policies, the degree
of product differentiation to introduce, the level of advertising to
undertake, the amount of service to provide, etc. There are two important
theories of interdependence’.
1. Cournot Model :
The most used model for Oligopoly is Cournot Model. It was developed
by Augustin Cournot in 1836. He argued that oligopolists compete to
determine price and output. It assumes that there are only two firms in the
market. As a result, the firms assume that their rival firm’s output is fixed.
Both firms keep on changing the level of output and finally reach a point
where the output curves of the firms meet. It is called Cournot
equilibrium. The price set at this point is higher than the competitive price.
Following are the assumptions of the the ory.
1) There are only two firms in the market. A and B.
2) Both the firms operate at Zero cost of production.
3) The firms produce identical products.
4) Firms decide their own output assuming that the other firm will not
change its output.
5) Firm A decides its output first.
The theory can be explained with the help of the following diagram.
Figure 2.5: Cournot Model of Duopoly
Price
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35 Theory of Firm - II As denoted in figure 5 DD1 is the market demand curve, MRA is the
marginal revenue curve for firm A and MRB is th e Marginal Revenue
curve for firm B. Firm A decides the price and output first. Firm A will
produce OA quantity of output and it will charge OP price. The firm earns
maximum profit because both firms do not incur any costs. The profit of
the firm is TR -TC. Where TR is OACP - 0. The firm earns OACP profit.
The firm assumes that firm A will not change its output and price. It
considers the demand curve CD1. It will produce half the quantity of AD.
Firm B will produce AB quantity for OP1 price. B’s share of m arket
demand is ½ OF ½ = 1/4Th (A’s share is ½ of total market share so B’s
share is ½ of ½ (1/2*1/2)) Profit of the firm is maximum.
Now A will assume that B will keep its output and price the same. The
remaining part of the market share or demand is BD1 . A will produce half
of BD1 now its share will be ½*3/4=3/8. Firm A will have 3/8th of the
market or output share.
As a reaction, firm B will produce ½ of the remaining market share. ½ (1 -
3/8)= 5/16. As a reaction to this, A will produce ½ of the remai ning
market share. A’s share will be ½(1 -5/16) This will continue. Finally,
equilibrium is reached where every firm will produce 1/3 of the total
market share. Both the firms together produce 2/3 of the market share. The
profits of both firms are maximum, but the profits of the industry are not
maximum.
If the firms recognize their interdependence, they may earn monopoly
profit.
Limitations :
1) Wrong assumption of zero cost – The theory assumes that the cost of
production of the firms is zero. But it is highly impossible. Every
production has a cost.
2) It is wrong to assume that the two firms in the market decide quantity
independently.
3) Firms in an Oligopoly market compete with each other on prices
rather than quantity.
4) Closed model. Entry of new firms into the market is not considered.
2. Bertrand Model:
Joseph Bertrand developed a theory for the duopoly market. According to
him, the firms in the market have the same market demand. Bith both
firms will try to get maximum profit assuming th at the other firm will
charge the same price . Bertrand modified Curnot’s model. His model is
based on the following assumptions.
1) There are two firms A and B
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36 Industrial Economics
36 3) Firms have unlimited production Cap acity
4) Each firm takes an independent decision.
5) Each firm believes that the price of the rival firm remains constant.
Firms will take into consideration various price combinations based on
their price and the prices of the other firm. If one of th e firms reduces the
price, the other firm decides whether to change the price. Price
adjustments of the firms are denoted in the following diagram.
Figure 2.6: Bertrand Reaction Curves

In the above diagram, P1 is the reaction curve of firm A and P2 is the
reaction curve of firm B. Reaction curves of the firms are drawn by taking
into consideration iso - profit. P1=f(p2) is firm A’s reaction curve based on
its price and the prices of firm B. P2= f (p1) is firm B’s reaction curve
based on its price and the pr ices of firm A. When the reaction curves
intersect, the equilibrium is reached. It is a stable equilibrium. Any
deviation from this equilibrium point leads to changes in the forces of
price and output such that ultimately the same equilibrium point is
reached. According to Bertrand’s model, output and price under a
duopoly are equal to those under pure or perfect competition . This is
in contrast with Cournot’s model, in which the equilibrium output is less
than the purely competitive output and, therefore, the price is higher than
the purely competitive price.
3. Stackelberg Theory :
A German economist Stackelberg developed this model in is different
from Cournot’s model. In Cournot’s model, both firms in case of a
duopoly adjust their output independently and simultaneously assume that
the output of the other’s will remain constant.
Stackelberg's model is different from Cournot’s model in two respects 1)
Firms recognize their interdependence. A firm knows that its rival firm
will take into account the q uantity of output determined by it. 2)The two
firms do not take their decisions simultaneously; one firm determines its
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37 Theory of Firm - II Assumptions of Stacklberg’s Theory :
1) A duopolist can sufficiently recognize market compet ition based on
the Cournot model.
2) Each firm aims to maximize its profits based on the expectation that
the decisions of its competitors will not be affected by its output.
3) It assumes perfect information for all players in the market.
4) The operati ng firms try to maximize profits based on their rivals’
decisions .
Suppose there are two firms in the market, one firm is the leading firm and
the other is the follower. If both produce the same good at the same
production cost. Each firm chooses the prod uction quantity that maximizes
its profits, taking the quantity produced by other firms in the market into
consideration. When the leader firm decides the price the follower will
maximize profit by using this price to determine its output.
Any decrease in price by the follower firm will lead to a fall in the price of
the leader firm. A fall in the price of the leader firm will increase the share
of the leader. The share of the other firms will decline. They may produce
less or exit the industry.
Thus the follower firm has no incentive to reduce the price.
Figure 2.7: Stackberge’s Equilibrium

If firm A assumes itself as a leader and B as the follower, it will produce
oq quantity. Consequently, firm B follows with q2, which is the best it can
maximize up to . In the diagram S is the Stackelberg equilibrium point
where firm A produces more than it could produce at equilibrium point C,
the Courton equilibrium point. Similarly, when firm B follows after firm
A has taken the output decision, it produces much le ss than it could have
in a Courton game.
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38 Industrial Economics
38 4. Game Theory:
Professor Neumann and Morgenstern in their book “The Theory of Games
and Economic Behaviour” published in 1944 provided the application of
games theory in the Oligopoly market. The game theory exam ines the
outcome of a situation of interactions between the parties when they have
conflicting interests. According to professors Neumann and Morgenstern,
in an oligopolistic market situation, an individual oligopolist is faced with
the problem of choosing the rational course of action, called a strategy .
The strategy that brings gain against the counter -reaction by a competitor
is called Payoffs.
A matrix of payoffs is called a payoff matrix. For example -
If there are two firms in the market and each fir m has 3 strategies the
payoff matrix is denoted in the following table.
Table 2.1 Payoff Matrix Firm B’s Strategy B1 B2 B3 A1 4 5 12 A2 5 7 9 A3 9 5 7
Firm A has 3 strategies A1, A2, and A3. Firm B has three strategi es- B1,
B2, and B3
If firm A chooses one strategy, firm B has three strategies available. It will
choose the most appropriate strategy for it out of three available strategies.
For example, if A chooses strategy A2 B has B1, B2, and B3 strategies
available . If the firm selects strategy B2. Then B’s payoff is 7. Pay off
matrix is 3X3=9. (A’s strategies X B’s Strategies)
Firms in an Oligopoly market make decisions based on the price -output
decisions of the other firms in the market. The decisions are strategi c.
Co-Operative and Non -Cooperative Game :
The games can be cooperative and noncooperative. The game is
cooperative if the firms can enter into an agreement and they can choose
such strategies that may give out a maximum joint profit.
The game is noncoop erative if the firms have conflicts of interest and they
can not enter into any agreement.
Dominant Strategy :
The payoff of the firm depends on the available strategies of the other
firm. But some strategies are so strong that the firm will get maximum
payoff irrespective of the strategy of the other firm. Firm A’s Strategy munotes.in

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39 Theory of Firm - II The dominant strategy can be explained with the help of the following
example.
Table 2.2: Dominant strategy Firm A Firm B (Rs crores) Advertising Nonadvertising Advertising A: 10 A:15 B: 5 B:0 Non-Advertising A: 6 A: 10 B:8 B:2
The pay -off matrix denotes profits of firms A and B in crores by choosing
two strategies 1) to advertise or 2) not to advertise.
 If both the firms decide to advertis e, Firm A will earn profits of Rs. 10
crores while firm B will earn 5 crores.
 If A follows advertising but B is not advertising A’s profit is Rs. 10
crores and B’s profit is 0 crores. B will not earn any profit.
 If A does not advertise and B advertises, A ’s profit is 6 crores and
B’s profit is 8 crores
 If A does not advertise and B also does not advertise, A’s profit will
be 10 crores and B’s profit will be 2 crores.
The example suggests that it is always better for firm A to adopt the
strategy of adve rtisement. Irrespective of any strategy followed by the
other firm. It is the dominant strategy of firm A because it will benefit
regardless of any counter strategy followed by firm B.
Nash Equilibrium:
Nash equilibrium is a situation in the game where th ere is no possibility of
movement for the firms. Once this equilibrium is reached there is no
incentive for any player to deviate from the chosen strategy. Nash
equilibrium has been named after John F. Nash, an American
mathematician, and economist. It ind icates that there is no possibility of
individual gain once Nash equilibrium is reached.
The Nash Equilibrium can be explained with help of the following
example.
Table 2.3: Nash Equilibrium Firm A Firm B (Rs crores) Advertising Nonadvertising Advertising A: 10 A:15 B: 5 B:0 Non-Advertising A: 6 A: 20 B:8 B:2 munotes.in

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40 Industrial Economics
40 Always the firms may not get the dominant strategy. In the above
example:
 If firm B adopts the strategy of advertising, the profits of firm A are
10 crores. If firm B adopts the strategy of not advertising A’s profits
are 6 crores. The best choice for firm A is to follow the strategy of
advertising.
 If firm B follows the strategy of not Advertising, firm A will earn
profits of 15 crores by following a strategy of advertisin g. If firm A
also follows the strategy of nonadvertising its profits are 20 crores
Thus, given that firm, B chooses the strategy of not advertising the
choice of strategy not advertising is firm A is optimal.
Thus the optimum strategy of firm A depends o n the strategy adopted by
firm B. If there is no dominant game, the firms take into consideration the
best possible strategy of the other firm.
 When firm A chooses the strategy of advertising firm B will get
profits of 5 crores by adopting the strategy o f advertising. But if it
chooses not to advertise its profits will be zero.
 If firm A chooses the strategy of not advertising firm B will get a
profit of 8 crores if it decides to advertise. If it decides not to advertise
it will earn only 2 crores. Thus, for firm B, the strategy of advertising
is better irrespective of any strategy adopted by firm A. So while
deciding on the strategy A will assume that B will follow the strategy
advertising.
When A will choose the strategy of advertising given that firm B also will
follow advertising. It will choose the best strategy given the best strategy
adopted by firm B. Firm B will also adopt the best strategy given the
strategies of firm A. In this situation, there is no incentive for the firms to
move away from the equilibrium. It is a Nash Equilibrium. There can be
more than one Nash Equilibrium.
2.7 TACIT COLLUSION AND PRICE LEADERSHIP Tacit collusion means implicit collusion. Collusion is the anti -competitive
behavior of firms. Sometimes the firms cannot come together and form
collusion. Price leadership is a situation where the firms in the market
follow the price charged by the leader firm.
Another form of collusion is formal collusion. A cartel is an example of
formal collusion where the firms in the market form the Cartel Board to
take decisions regarding price and output.
But in the case of tacit collusion, the firms do not form collusion
explicitly. But they agree to determine output and price implicitly. The
following two models of price leadership are examples of tacit collusion. munotes.in

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41 Theory of Firm - II 1. Low -cost Price Leadership :
The firm with the lowest cost of production determines the price and other
firms in the market follow the price. The price determination by a firm
with low cost is denoted in the following diagram .
Figure 2.8: Low -Cost Price Leadership

In the diagram, D is a market demand curve d is the demand curve of the
firms in the market. MR is the marginal revenue curve of firms A and B.
ACa and MCa are the average and Marginal costs Curves of firm A. ACb
and MCb are average and marginal cost curves of firm B. A is the
equilibrium of firm A. B is the equilibrium of firm B. At equilibrium, firm
A charges op1 price. At the equilibrium, firm B charges OP price. The
price charged by firm B is higher than firm A because the cost of
production of firm B is higher than the cost of production of firm A. But
as firm A takes initiative to determine the price, firm B cannot charge OP1
price. It follows firm A and charges op price. At price OP, firm B
produces Ob quant ity, and firm A produces Oa quantity. Thus as the cost
of production of firm A is the lowest, it leads the other firms in the market
and determines the price of products. The price determined by firm A is
followed by the other firms in the market.
2. Price determination by the dominant firm :
When a dominant firm in the market takes lead to determine the price it is
the dominant firm Price leadership. The dominant firm has a larger share
of the market. The other firms in the market are smaller. The small fi rms
follow the price determined by the dominant firm. This has been explained
through the following diagram.


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42 Industrial Economics
42 Figure 2.9: Dominant Firm Price Leadership

In the diagram, DD1 is the demand curve AS is the supply curve. S is a
market equilibrium where the op piece is determined. PM is the demand
for the dominant firm. MRd is a marginal revenue curve of the dominant
firm. DM is the market supply curve. MCd is the marginal cost curve of
the dominant firm. E is the equilibrium of the dominant firm. At
equilib rium, the firm determines Op1 as a profit -maximizing price. Out of
the total quantity produced, it produces P1C units. The other firms in the
market will follow the price but they will produce P1N units. The
dominant firm in the market determines the pric e and quantity as a market
sharing agreement.
2.8 LIMIT PRICING Limit pricing is a pricing strategy where the firm charges such a low price
that it becomes impossible for the other firms to enter the market. The
limit pricing theory has been developed by J. S. Bain in his article
‘Oligopoly and Entry Prevention’ Bain explained that the firm
determines the price above the competitive price but below the monopoly
price. A competitive price is a price with normal profit. A monopoly price
is a price where pro fits are maximized. Limit Price is the price that is
above the competitive price and below the monopoly price. It is the price
that the existing firms in the industry charge without fear of attracting new
firms to the industry. The theory of limit pricing is based on the following
assumptions -
1. The long -run demand curve for industry is determinate and is
unaffected by the price adjustments by the existing firms or by the
entry of new firms.
2. There is collusion (Agreement) among the oligopolists. munotes.in

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43 Theory of Firm - II 3. The firms can calculate the limit price .
4. Below limit price, new firms will not enter the market and above limit
price, entry is attracted.
5. Established firms aim at maximization of profits.
There are two models of limit pricing theory :
A) Limit Pr icing Without Collusion :
If there is no collusion with the new firms, the limit price is determined as
indicated in the following diagram.
Figure 2.10: Limit Pricing with no collusion

In the diagram, DD1 is the market demand curve. MR is the marginal
reven ue curve. PL is the limit price. The limit price is determined based on
1 cost of prospective entrants. 2 elasticity of demand in the market. 3)
Long run average cost 4) No. of firms in the industry. 5) Size of the
market.
DA is an uncertain part of the de mand curve as the behaviour of the new
entrants is unknown. AD1 is a certain part of the demand curve. am is a
certain part of the marginal revenue curve. In the diagram LAC1 and
LAC2 are long -run average cost curves. At LAC1 there are two possible
alterna tives. It can charge a price PL or it can charge a monopoly price.
Which is more than PL. This price will give more profit, but the profits are
not certain. So, the firm will compare certain profits with uncertain profits
and choose a price between PL and Pm.
If the LAC is LAC2, then the profit -maximizing price is OPM2. Profits
are maximum at this price and this price is less than PL. Therefore, the munotes.in

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44 Industrial Economics
44 firm will prefer this price. PL will be the limit price. If these new firms
enter the market, then the suppl y of the product would increase and for a
given price this increase in supply results in a fall in the prices below their
average cost of production. After the entry of the firms, the price would be
less than the average cost. If the new firms enter at thi s price then they
may suffer from losses.
B) Limit Pricing with Collusion :
If the newly entered firms and the established firm are in collusion, the
demand curve shifts to its left. Demand decreases. But the demand for the
newly entrant firms is certain. There is no uncertainty in the market, it can
be explained with the help of the following diagram.
Figure 2.11: Limit pricing with Collusion

In the diagram, DD is the demand curve. With the entry of new firms,
DD1 becomes the new demand curve. This demand is certain as the firms
are in collusion. There are three alternatives open to the firm.
1) To charge limit price PL without allowing the new firms in the
market.
2) To make collusion with the firms and to charge a price above the limit
price. Enter in to collusion and accept the DD1 demand curve which is
certain.
3) To charge a monopoly price.
The firm chooses the alternative which is the most profitable for her.
According to Bain if the established firms in the Oligopoly market charge
the monopoly pr ice, they get huge profits. But if firms charge a price equal munotes.in

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45 Theory of Firm - II to the long -run average cost the established firms will get the benefit but
the new entrants just earn a normal profit.
2.9 SUMMARY Firms in the market are interested in getting maximum profit by
minimizing costs, Economies of scale are the advantages of large -scale
production. The firms get many benefits from large -scale production
Economies of scale are denoted on the Long Run Average Cost curve or
envelope curve. Firms can minimize the costs and get the benefits of
large -scale production up to a certain extent beyond that extent the cost
increases. Economies may turn into diseconomies.
Firms adopt many ways to get the maximum share of the market. Product
differentiation, and understanding th e requirements of capital are some of
such efforts to improve market share and safety of the firms.
The firms can not determine their decisions independently. In an oligopoly
market, there is interdependence. The price and output determination in
this mar ket depends on the nature of collusion in the market. The theories
like the Cournot model, Stacklerberg’s theory, Games Theory, and
Bertrand's model explain the interdependence in the Oligopoly model. The
theories like price leadership and limit pricing e xplain tacit collusion in
the market. The basic model of the Kinked demand curve suggests price
rigidity.
2.10 QUESTIONS 1) Explain various economies of scale with the help of the Long Run
Average Cost Curve.
2) Explain price rigidity with the help of the Kinked demand curve.
3) What is non collusive Oligopoly? Explain any two models of
noncollusive oligopoly.
4) What is interdependence in Oligopoly? Explain how game theory is
an example of interdependence.
5) What is Nash equilibrium? Explain Nash equilibrium with the help of
an example.
6) Describe the Cournot model of Oligopoly.
7) Evaluate Limit Pricing Theory of Oligopoly market.
8) What is price leadership? explain the models of Price Leadership.
9) Write a note on
1. Staklberge model
2. Bertrand Model munotes.in

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46 Industrial Economics
46 2.11 REFERENCES  Louis Philips, “ Applied Industrial Economics”, Cambridge University
Press, 1998 .
 MACMILLAN EDUCATION LTD Hound mills, Basingstoke,
Hampshire RG21 2XS and London .
 Luis M. Bill Cabral, “Introduction to Industrial Organi zations” 2002,
The MIT Press Cambridge, Massachusetts. London, England.
 Malcolm C. Sawyer , “The Economics of Industries and Firms” 1985,
Taylor & Francis e -Library, 2005.
 Ho Ma 2000, “Comparative advantage and Firm’s performance” CR
Vol l0(2) .
 Stigler, G. “A Theory of Oligopoly,” The Journal of Political
Economy, 72(1), 44 -61, (1964) .
 Bresnahan, Tim “Empirical Studies with Market Power,” Handbook
of Industrial Organization, vol. II, chap. 17.
 Robert Pindyck, Daniel Rubinfeld,” Microeconomics “ 8th edition,
2013 (The Pearson series in economics) ISBN -13: 978 -0-13-285712 -3
ISBN -10: 0 -13-285712 -X.
 H.L. Ahuja “ Advanced Economic Theory Micro Economic
Analysis ”, S.Chand and Company Limited. 21st edition 2017 .


*****
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47 MODULE - II
3
TECHNICAL CHANGE - I
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Meaning and Measures of Market Concentration a nd Monopoly
Power
3.2.1 Meaning
3.2.2 Measures of Market Concentration a nd Monopoly Power
3.2.3 Concentratio n and The Market Performance of A Firm
3.3 Advertising
3.3.1 Optimal Advertising
3.3.2 A dvertising and Market Structure
3.3.3 Cost of Advertising
3.4 Summary
3.5 Questions
3.0 OBJECTIVES  To study the concept of Market Concentration
 To study different a spects related to Advertisement.
3.1 INTRODUCTION Advertising is a form of communication used for passing on business
information to the existing and potential customers. The information is
usually related to the firm, quality of its product, place of avai lability of its
product etc. It is necessary both for the sellers as well as customers.
However, it is more important for the sellers as it serves as a means for
them to convey all relevant information about their product. Present day
producers usually ind ulge in large scale production and it is difficult for
them to market their products without advertising. It serves as a
supplement to the forms personal efforts of selling the product.
Importance and relevance of advertising has become more significant in
recent times with more severe competition and changing technologies.
Customer’s choice, taste and preference keep changing at a very fast rate.
Thus, understanding advertising, its impact on price, demand, costs and
sales become very essential. In additio n, to have a better understanding of
the effect of advertising it is also important to assess the interaction
between market structure and advertising and effect of advertising on price
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48 Industrial Economics
48 Advertising refers to expenditure by the firm to promote sales of its
product and services. The expenditure includes the payment for the space
in print and electronic media like radio, televisions and websites.
Promotional activity like special displays or offers in shops and
commercial shows also forms the part of advertising. The main objective
is to have an impact on the consumers’ choice so that they decide in favor
of the product and services provided by the advertisers. Two major roles
of advertising have been identified by economists. Firstly, it provides
information based on facts to the consumers about the nature and
characteristics of the product, its price and availability or the ‘ informative ’
advertising. Secondly it persuades the consumers to decide in favor of a
specific product or service by highlig hting and emphasizing the quality of
the product or associating it with lifestyle or a celebrity or ‘ persuasive ’
advertising. The later one makes an attempt to persuade or motivate the
consumers to buy the product without taking the pain to supply any usef ul
or additional information to the consumer like characteristics of the
product, price, availability and location of the store. Most of the television
advertisements fall in this category. While the informative advertising
does make an attempt to provide all the relevant information. However, as
all advertisements contain some information regarding the product, it is
difficult to make a distinction between the ‘informative’ and 'persuasive’
advertising. The objective of the firm to engage in advertising re mains the
same in both types of advertising. The main objective is to bring about
change in the preference of consumers by using the superior quality or
promoting brand loyalty to persuade them. Consequently, firms are able to
sell their product more and a t a higher price. It also enables them to lower
the average production cost by producing or selling more output and
gaining more profit.
3.2 MEANING AND MEASURES OF MARKET CONCENTRATION AND MONOPOLY POWER 3.2.1 Meaning:
Market concentration measures the ex tent to which market shares are
concentrated between a small number of firms. It is often taken as a proxy
for the intensity of competition. Indeed, in recent years changes in
concentration have increasingly been used to argue that the intensity of
competi tion is falling, that the growth of large firms with high market
shares is driving up profits, damaging innovation and productivity, and
increasing inequality. Some have argued that the competition rules need to
be rewritten and a crackdown by overly antit rust agencies is required.
Market concentration or, more specially, the degree of sellers’
concentration in the market, is an important element of the market
structure which plays a dominant role in determining the behaviour of a
firm in the market. By mar ket concentration we mean the situation when
an industry or market is controlled by a small number of leading producers
who are exclusively or at least very largely engaged in that industry. Two
variables that are of relevance in determining such a situati on are (i) the
number of the firms in industry, and (ii) their relative size distribution. In munotes.in

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49 Technical Change - I the context of industrial economics, the implication of market
concentration is far wider than whatever we find in the theory of the firm.
It will be our attempt in this chapter to focus on such implication in the
framework of ‘market -structure conduct performance’ link.
3.2.2 Measures of Market Concentration and Monopoly Power:
In order to test empirically the behavioural hypotheses about the firm and
industries, we need a measurement of market concentration. Various
quantitative indexes have been suggested for this purpose which we are
going to summaries in this section. Some of them are used to measure the
monopoly power of the firms and some for -market concentra tion. These
two terms, i.e., monopoly power and market concentration, are closely
interrelated and cannot be separated from each other in the measurement
process. The degree of market concentration would vary with the
monopoly power in a particular industr y, or we may also say that existing
firms acquire monopoly power if the market is concentrated. The indexes
that we are going to discuss here would therefore be indicating to us
almost similar things with minor differences. The measures for monopoly
power would be more appropriate at firm level. They indicate the actual
monopoly power exercised by the firms. The measure of concentration on
the other hand would give us the potential monopoly power in the market
or industry as a whole. Obviously some firms wo uld be having monopoly
power in the situation of market concentration. If the market of firms and
their relative sizes in the market are changing, we expect a change in the
monopoly power of the firms. The concentration is, therefore, a necessary
condition for the monopoly power although it is difficult to say that there
is one to one proportionality between them. Before discussing the indexes,
it will be useful here to mention some general conditions or requirements
which should be satisfied by each one of them. This helps us in screening
the indexes while making the final choice for empirical work. The
conditions are:
I. The measure must yield an unambiguous ranking of industries by
concentration. Consider Fig. 1 in which concentration curves, i.e., the
graphs between cumulative number of firms from largest to smallest
and cumulative percentage of market supply are shown by J1, J2, J3
for their industries separately. J1 is above J2 and J3 everywhere. It
means the industry which is represented by it is more concentrated
than the other two. However, there is ambiguity in the ranking of the
second and third industries represented by J2 and J3 respectively. munotes.in

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50 Industrial Economics
50

Fig 3.1 Hypothetical Cumulative Number of Firms
II. The concentration measure should be a function of t he combined
market share of the firms rather than of the absolute size of the market
or industry.
III. If the number of firms increases then concentration should decrease.
However, if the new entrant is large enough, then concentration may
go up.
IV. If there is transfer of sales from a small firm to a large one in the
market, then concentration increases.
V. Proportionate decrease in the market share of all firms reduces the
concentration by the same proportion.
VI. Merger activities increase the degree of concentration.
The Concentration Ratio:
The most popular and perhaps simplest index for measurement of market
concentration or monopoly power of the few firms is the use of the
concentration ratio, that is, the share of the market or industry held by
some of the largest firms. The market share of such firms may be taken
either in production or sales or employment or any magnitude of the
market. In symbolic form the concentration ratio is written as: 1miiCP
m: 4, 8, 10, 12, …….., 20, ……. munotes.in

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51 Technical Change - I Where Pi = market share of ith firm in descending order. The normal
practice is to take the four -firm (m = 4) concentration ratio but if the total
number of firms operating in the market is large enough then one 20 -firm
concentration ratio to assess th e situation. The higher the concentration
ratio the greater the monopoly power or market concentration existing in
the industry.
There are some limitations of this index. It does not take the entire
concentration curve into account; it rather indicates mar ket concentration
at a point of the curve. The ranking of industries depends on the point
chosen. If the point is changed there may be changes in the ranking of the
industries also. This is the situation shown in Fig. 1 for J2 and J3 curves
on the basis of the 4 -firm concentration ratio, industry 3 is more
concentrated than industry 2, but on the basis of the 12 -firm concentration
ratio the ranking is reserved. For the 8 -firm concentration point both are
equally concentrated. There is thus some ambiguity as to which point is to
be chosen. Further the concentration ratios depend to a great extent on
how the market is defined. A broad market would tend to reduce the
computed concentration ratio whereas a narrow one would usually have
the opposite effect. This means, in the standard industrial classification,
the concentration ratios will be lower for the two -digit major industry
group than the ratios for the three -digit industries in the same group.
The data for the finer classification of the industries may no t be available,
hence it may be difficult to have precise idea of market concentration
using the aggregate data; moreover, it may not be comparable with other
industries or countries’ data. There are other limitations also. The ratio
does not reflect the p resence of or absence of potential entry of firms, they
being based upon national figures, do not say anything about the regional
market power; they do not describe the entire number and size distribution
of firms, only a part of that is considered by them ; they do not say
anything about monopoly power of the individual firms in the market and
ignore the role of imports in the domestic market. The ratios may give a
conflicting picture of the concentration with the use of different variables
for size of the firms.
In spite of the limitations, the ratios are widely used in industrial
economics. They are simple to compute, readily available for the
manufacturing sectors, and capable of measuring market concentration
with a finer classification of the industries . They are consistent with the
economic theory, as we know that, other things being equal, monopolistic
practices are likely to be in operation to a greater extent where a small
number of the leading firms account for the bulk of any industry’s output
than where the industry’s output is evenly distributed among the firms.
The Hirschman - Herfindahl Index:
It is the sum of the squares of the relative sizes (i.e., market shares) of the
firms in the market, where the relative sizes are expressed as proportions
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52 Industrial Economics
52 21 ( H ) = ( P )niiHerfindahl Index
where, Pi = qi/Q, qi is output of ith firm and Q is total output of all the
firms in the market, and n is the total number of firms. This index takes
account of all firms in the mar ket (i.e., industry). Their market shares are
weighted by the market share itself. The larger the firm, more will be its
weight in the index. The maximum value for the index is one where only
one firm occupies the whole market. This is the case of a monopo ly. The
index will have minimum value when the n firms in the market hold an
identical share. This will be equal to 1/n, that is 2111H = ninn
H decreases as n increases. Inverse of H gives us an equivalent measure of
the market concentration . The index is simple to calculate. It takes account
of all the firms and their relative sizes; it is therefore popular in use and
consistent with the theory of oligopoly because of its similarity to
measures of monopoly power. Adelman has explored its pro perties
extensively and related it directly to the concentration curve.
The Entropy Index:
This index has been suggested by Hart to measure the degree of market
concentration. It uses the formula 11E = P L L ; 0 E 1ninn ninpi
where E is defined as ‘Entropy C oefficient; Pi is the market share of ith
firm and n the number of firms. This coefficient in fact measures the
degree of market uncertainty faced by a firm in relation to a given
customer. This will be the situation when the number of firms is large
enoug h. i.e. the market is not concentrated. For a monopoly firm (n =) the
entropy coefficient takes the value of zero which means no uncertainty
and maximum concentration. Thus, we find opposite (inverse) relationship
between the entropy coefficient E and the degree of market concentration.
If there are n firms, all equal in size, then

Both, increased equality of market shares and an increase in the number of
firms increase the entropy coefficient but the latter factor plays a
diminishing role because of the use of logarithms which implies that
addition of an extra firm, when number is already large enough, it munotes.in

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53 Technical Change - I becomes less significant from the point of view of market concentration.
In terms of number equivalent the number can be measured as exp (E).
To take in to account the number of firms as a determinant of the entropy
coefficient one may use the relative measure of the entropy, i.e., the
entropy coefficient E divided by the maximum value of the coefficient
(log n) E = ; 0 E 1ln ln nrYE
This expression indicates the actual degree of dispersion of market share
to the maximum dispersion possible for a given number of firms. The
entropy coefficient is a useful measure of market concentration in the
sense that the population of the firms for which the entrop y coefficient is
to be computed can be decomposed or disaggregated into several groups,
say on the basis of sizes, regions, products and the classification of
industry, etc. to compute separate entropy coefficients for them, a
weighted sum of such coeffici ents would then give the overall entropy
coefficient. Such a decomposition is not possible in the case of other
indexes of market concentration.
3.2.3 Concentration and the Market performance of a Firm
There are many behavioural hypotheses about concentrat ion and market
performance as we read in microeconomics, a firm with substantial
monopoly power will tend to charge high price, produce and sell less
output, make high rates of profit, grow faster than others, capable of doing
anything it wants in connecti on with its business such as R & D,
advertisement and so on. Let us presume that concentration is an
appropriate measure of such power, we are then in a position to verify the
various propositions of the economic theory which reflect the relationship
betwe en concentration and market performance of the firm. This will
naturally be based on the empirical evidence available so far but no
attempt will be made to make an exhaustive survey of this here. Only a
few selected studies will be referred in connection w ith the individual
hypotheses.
a) Concentration and Profits:
A firm derives market power or monopoly power in the situation of
concentration. Such market power, via market conduct activities or
directly leads to an increase in the profitability of the firm . It is frequently
assumed that persistence of high rates of profits over a long period is the
consequence of high degree of intra -industry concentration. J. S. Bain was
the first to make an empirical study of this proposition, who found it valid
for the U .S. industries. The relationship was found so strong that Bain was
to argue for the profit rate as an index to measure the concentration. Since
then, there has been a flood of studies on the relationship which by and
large supported this but some of them w ere, of course, very critical also. munotes.in

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54 Industrial Economics
54 There are some difficulties in establishing the correct relationship between
the two variables (concentration & profitability) as both of them are
subject to ambiguities of measurement: which index of measurement is to
be used for concentration? There are so many of them. If one measure is
taken, it may have strong correlation with profitability, but if another is
taken, it may have a weak relationship. Further, measurement of profit
rates is also not free from bias. This is generally based on accounting data
which ignores certain opportunity cost elements related to own funds or
own labour of the entrepreneur in the business; some arbitrary valuations
are placed for such elements which may induce bias in the relationship.
What denominator is to be used to compute profit rate is also not clear
sales or assets or production or something like that. Researchers make
their own choices for such rates, without giving the proper rationale for
that. In spite of such difficulties, w e should not discard the relationship
between concentration and profitability. It is a positive one which is
consistent with the theoretical logic, through very precise estimation of
which is yet to come.
b) Concentration and Price -cost Margins:
Price -cost margin is another way to define profitability. This is a short -
term view of profitability based on current sales and cost figures. Say the
average price -cost margin is just a ratio of these two magnitudes.
Empirical studies, particularly those conducted b y Collins and Preston
supported the positive relationship between concentration and the price -
cost margin for the American four -digit industries. Shephered also
confirmed the positive relationship between them for most of the U.S.
industries Koch and Fenil i however, looked at the concentration acting as
a surrogate for other determinants of price cost margins because of its
being causally linked with them. They found it as an insignificant
predictor of price cost margins when other relevant indicators of ma rket
structure like product differentiation, rate of technological change, etc.
were also considered side by side. We may not agree with their findings
simply because when all such determinants were taken together along with
concentration, multicollinearit y might have distorted their relationship
making concentration insignificant. For its significance, there is a strong
theoretical base which cannot be demolished because of statistical
inadequacies of measurement.
In a recent book, Hay and Morris have pres ented a summary table of 67
studies on market structure and profitability for the period 1971 to 1988.
According to this, market concentration was found to be a significant
determinant of profitability with expected sign in 28 studies, insignificant
in ano ther 28 studies; and doubtful in the remaining studies. All this
reveals that no specific generalization could be made about the relevance
of the market concentration as a determinant of profitability although
major support is coming for its being a positi ve factor as per the theory.

munotes.in

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55 Technical Change - I c) Concentration and Growth of the Firm:
The growth of the firm is a topic which requires a full chapter for
discussion. Here we will just mention how concentration is relevant for
this. There are two different streams of tho ughts to explain the causal
relationship between the two variables. According to one view, a firm with
market power, as a consequence of concentration, may prefer to maintain
its high rate of profit by restricting the output and charging high prices. If
it grows, it has to sacrifice some profit margin, and lower prices which
may not be in its interest. Moreover, there will be all kinds of restrictions
imposed by the Government to stop further growth of such firms.
Furthermore, static diseconomies of scale a nd numerous dynamic factors
and bottlenecks all adversely affect the ability of such firms to grow. Thus,
we expect that the higher the monopoly power of the firm, the lesser its
growth may be. The few firms in the concentrated industry may be
dominant eno ugh to restrict the growth of the other firms and to stop the
entry of new ones because of the various barriers to entry at their disposal.
There is, thus, very little perspective for the growth of the firms in a
concentrated industry and so for the overal l growth of the industry itself.
There are some empirical studies where the inverse relationship between
initial market concentration and subsequent market growth has been
verified.
The second view about the concentration and growth of the firm and hence
of the market, is a positive one. In order to maximize the long -term profit,
firms may like to grow over time even under market concentration. They
may prefer to create excess capacity to meet the future growing demand
and to discourage new entry in the mar ket. They may have some short -
term sacrifice of profit in order to stimulate long -term benefits. So, we
find a case for the positive relationship between initial market
concentration and growth of the firms. The firms with market power may
be finding thems elves at ease regarding finances and other requirements of
growth. They would, therefore, like to avail the opportunities for those
other things remaining the same. There are empirical evidence for such
propositions also.
There are all kinds of problems in establishing which view is valid. The
empirical studies differ in scope, coverage of period, database and even
measurement of concentration and growth. No definite verdict is,
therefore, available from them. For the present, the relationship between
conce ntration and growth of the firm and market, is an open issue for
further verification.
d) Concentration and Technological change:
The issues related to technological change and market structure will be
examined later on in a full chapter of this book. At t his stage, let us look
into one aspect of this, that is, whether concentrated industries are the
most research oriented and technically progressive. It is true that the few
firms who enjoy monopoly power in a concentrated industry will be large
enough. The y will be having stability, financial resources and ability to munotes.in

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56 Industrial Economics
56 initiate the processes of R&D and gain the benefits from them. Dasgupta
and Stiglitz, in their papers clearly showed the situation when market
concentration and innovative activities are positi vely correlated. There is
no conclusive empirical evidence to prove such a proposition. In fact,
studies conducted by Williamson have shown quite opposite results.
Doubts about this have also been expressed by Bliar. It may not be the
concentration but the other attributes of market structure like size of firm,
product differentiation possibilities, etc, which may be having collinearity
with concentration and thus causing a spurious positive correlation
between concentration and thus causing a spurious posi tive correlation
between concentration and technological change. Nothing can be said in
either way about the relationship. It is open for further empirical
verification.
3.3 ADVERTISING Advertising is simply the action of drawing public attention to goods,
services, events, or to whatever you want them to pay attention.
Advertising today is a highly specialized business which owes its
development to the continuous advance in mass communication and in
manufacture even if at its heart it still is drawing publ ic attention to
something.
3.3.1 Optimal Advertising :
The Dorfman –Steiner theorem :
The Dorfman –Steiner theorem (or Dorfman –Steiner condition) is
a neoclassical economics theorem whic h looks for the optimal level
of advertising that a firm should undertake. The theorem is named
after Robert Dorfman and Peter O. Steiner who developed the approach in
their widely cited 1954 article in the American Economic Review . Firms
can increase their sales by either decreasing the price of the good or
persuading consumers to buy more by increasing advertising expenditure.
The optimal level of advertising for a firm is found where the rati o of
advertising to sales equals the price -cost margin times the
advertising elastici ty of demand . The obvious result is that the greater the
degree of sensitivity of quantity demanded to advertising and the greater
the margin on the extra output then the higher the level of advertising.
A simple textbook presentation of the mathematical statement of the
approach is as follows:

Where,
A is the price per unit of advertising
A is the amount of advertising munotes.in

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57 Technical Change - I
is the price of the good
is the output of the good
is the average or marginal, depending on the assumptions, cost of
produ ction
is the advertising elasticity of demand
3.3.2 Advertising and Market Structure :
Advertising expenditure is also determined by the size and number of the
competitor in the market. In a perfectly competitive market, advertising
will be unnecessary f or a firm that sells a homogenous product. Whereas a
monopolist would rarely need to advertise as consumers have no other
choice for the product. The monopolist may require advertisement to
increase the sale of its particular product rather than products i n general.
Thus, advertising can be used as a competitive tool in a market structure
that ranges from monopolistic competition to duopoly where products are
differentiated and also there are relatively few competitors.
Demand for products is expected to b e more price inelastic in a
monopolistically competitive market. This is because in such a market,
products are differentiated i.e. There are a large number of competitors in
the market and the product of each firm is not a perfect substitute for
others. B ased on the analysis of Dorfman and Steiner it can be concluded
that in such a market, the advertising -to-sales ratio would be higher. The
same applies to a monopolistic market with differentiated products also.
Thus, it can be concluded that it is likely that advertising -to-sales ratios
will be high in imperfectly competitive markets with differentiated
products and low in competitive markets and monopoly.
Another major issue associated with advertising and market structure that
needs attention is the way in which the firm’s advertising -to-sales ratio or
advertising intensity and price elasticities vary with market structure. As
the number of firms increases, the price elasticity of demand also
increases. By increasing the price the firm not only increases the demand
but at the same time it also increases its market share. Thus if the industry
is more fragmented, the advertising intensity would be low. The effect of
market structure on advertising intensity and demand elasticity can be
explained with the hel p of the following two cases. If we suppose that
advertising equally increases each firm’s demand for example advertising
for milk without naming the brand will increase the demand for all the
firms selling milk. The advertising for milk is considered as a public good
for all milk sellers.
If we assume that the demand is fixed and independent of the advertising,
the only effect that it will have on the firms is shifting of the demand
across the rival firms. For example, when there is competition between the
branded and corresponding generic drugs. Here advertising does not
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58 Industrial Economics
58 simply switches their choice between branded and generic drugs. In this
case, the advertising elasticity increases as the number of firms increases.
Under monopolistic condition advertising elasticity would be zero and it
would be positive under duopoly. When the number of firms increases and
the industry concentration decreases the variation in the advertising
intensi ty for each firm decreases as the number of firms decreases. The
benefits from advertising realized by the firms that pay for it decreases as
the industry becomes more fragmented. This can be explained using the
following three effects: the margin of each firm decreases, each firm
receives a lower share of the benefits of the demand -increasing effect of
advertising and each firm receives a greater share of the benefits of the
demand -shifting effect of advertising.
3.3.3 Cost of Advertising :
Advertising cost in economic theory is assumed to include all pure selling
costs. Heavy expenditure on advertising is usually undertaken by
competing firms.
Two types of advertising are:
1. Informative:
To give details to the public concerning the availability of a produc t or
service, its uses, advantages, prices, quality, etc.
2. Persuasive:
To obtain new customers and to retain existing ones, i.e., to develop or
retain brand loyalties. Advertising costs being one kind of selling costs are
designed to increase the demand for the firm’s products. The function of
advertising is to inform consumers. As pointed out earlier in economic
theory, advertising costs are known as selling costs, which may be defined
as “as the costs necessary to persuade a buyer to buy one product rat her
than another or to buy from one seller rather than another”. Selling costs
are those that adapt the demand to the product, in other words, setting
costs are incurred to get the business.
Pure selling costs are designed to shift the demand schedule. The y do not
include physical distribution expenses. Selling costs have no necessary
functional relationship to output. Advertising is a device for manipulating
the firm’s sales volume.
Advertising not only shifts the firm's demand curve to the right of where it
would otherwise be, but it may also make demand less elastic. Selling
costs are likely to induce the old purchasers to purchase more and to
attract new purchases as well, and this implies an increase in demand.
The new demand curve will be above the old demand curve or it will be to
the right of the demand curve. The elasticity of the new demand curve
depends on the buying habits of the new buyers. If they are sensitive to
price changes, it will be more elastic. If they are not sensitive to price munotes.in

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59 Technical Change - I changes , the new demand curve will be less elastic. Naturally, every firm
is interested in increasing its sales by shifting the demand curve to the
right.
From the foregoing discussion, we can infer that advertising costs are one
kind of selling costs which are i ncurred to boost the sales of a company’s
product. It is primarily directed by the company at increasing the demand
for its products. One of the objectives of advertising is to make the
demand less elastic.
The elasticity which results from the issue of ad vertisements may be
called a promotional elasticity of demand. A promotional elasticity may be
said to be the measurement of the responsiveness of sales to the changes in
the extent of advertising while the price is constant.
This elasticity is of two kind s, namely, industrial elasticity and market
share elasticity. The former refers to the degree of responsiveness of the
total industry’s sales to advertising. The latter refers to the extent of the
responsiveness of a company’s market share to a given chang e in its share
of the industry’s advertising.
Advertisements encourage counter advertisements. Therefore, the selling
costs are influenced by what rival businessmen are doing. The
effectiveness of a company’s advertising will depend upon how rivals
react t o it. Retaliation against competitors’ successful advertising may take
the form of an attempt to match or better the advertising or an effort to
improve other merchandising activities or the product itself. All
advertising has in some degree a delayed and cumulative result that gives
it the characteristic of an investment outlay.
Shape of the Advertising Cost Curve:
Incremental advertising costs if drawn as a curve will first decline, will be
constant over some range of output and then will rise at an incre asing rate.
This is due to the operation of the economies of scale. Advertisement
outlays may be in fixed proportions or in varying proportions.
Sometimes both the methods may be combined. Economic theory usually
deals with the U -shaped cost curve. Therefo re, advertisement outlay is
also assumed to show three stages. The three phases of the advertising
outlay namely, the decreasing, constant and increasing phase can be
explained in the following manner.
Under usual conditions of static analysis, it is reaso nable to assume that
when an advertising outlay is increased, its unit cost first declines then
levels to a minimum and thereafter rises. In other words, the advertising
cost curve takes a U -shape.
The declining phase of the curve is partly explained by ec onomies of
specialisation. Longer appropriations may make feasible the use of expert
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60 Industrial Economics
60 usually are economies of repetition. Often repetition of a particular
advertising strategy becomes m ore economical.
The rising phase of the advertising cost curve is caused primarily by
tapping successively poorer prospects as the advertising effort is
intensified. A firm is generally forced into such a situation when there is
keen competition. The rise in advertising outlay may also be due to
progressive expansion of the most efficient advertising media.
The short run marginal advertising cost curve will probably have the same
form for all commodities regardless of their elasticity of promotion. The
shape of the curve is determined by variations among prospects in
accessibility and in susceptibility to advertising and by the diminishing
utility of additional units of the product to any one user. The relationship
of advertising to sales is more intricate t han short run marginal analysis
indicates. The selling cost function will differ with the nature of the
business strategy involved.
In the above analysis, we assumed production cost to be constant in the
short period. We have also assumed constant price wh ich implies that
average and marginal revenues are constant. However, to be more realistic
we have to introduce an average cost curve that slopes upward and an
average revenue curve that slopes downward.
A sloping average revenue function introduces compli cations, since both
price and advertising are then variable. It is possible to keep the
advertising costs constant and vary the price, or to keep the price constant
and vary the advertising costs. This is what is done by Chamberlin.
Chamberlin was the pion eer in attempting to include the economics of
advertising in the general economic principles.
As a second step, both the advertising costs and price are varied
simultaneously. This was done by Buchanan. He uses the downward
sloping demand curve and the cor responding marginal revenue curve
(MR) and arrives at the optimum price with the help of the production cost
curve (PCC). He then assumes various advertising outlays. Every
advertising outlay is expected to raise the demand for the product. Such an
adverti sement cost curve is explained below.
Advertisement is based on the assumption that there is quite a large
number of customers who are prepared to change the brand which they are
using. But this is not always true. Sometimes the people stick to those
brand s of goods which they have been using for a long time.
But in any case, advertising costs are likely to increase the sale of a
commodity. They would induce the old customers to buy more and at the
same time attract some new customers as well. Thus, the adv ertising costs
are likely to raise the demand curve of a commodity. To illustrate, a firm’s
original demand curve is DD in Fig. 1 and its corresponding marginal
revenue curve is MR. PCC is the production cost curve inclusive of
advertising costs. Now the o utput is OQ and the price is OP. Profit is
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Fig. 3.2 Shape of the Advertising Cost Curve
To get more business, some more advertisements are made by the firm.
The additional cost of getting more business through advertisements must
be at least equal to the additional profit. As the result of additional
advertisement, the demand curve shifts to the right as D 1D1. The
horizontal distance KS between the old demand curve and the new
demand curve is the result of advertising.
The firm now sells more output O Q1 at the same price OP and its profit
also increases due to higher sales. (Profit not shown to keep the figure
simple). If a series of curves are drawn and joined together, we get the
price output curve against the advertisement. Here the assumption is th at
the advertiser knows the effects of his outlay on sales.
3.4 SUMMARY  Advertising is a form of communication used for passing on business
information to the existing and potential customers.
 Market concentration measures the extent to which market shares are
concentrated between a small number of firms. It is often taken as a
proxy for the intensity of competition.
 A firm derives market power or monopoly power in the situation of
concentration. Such market power, via market conduct activities or
directly leads to an increase in the profitability of the firm.
 The Dorfman –Steiner theorem (or Dorfman –Steiner condition) is
a neoclassical economics theorem which looks for the optimal level
of advertising that a firm should undertake.
 Advertising cost in economic theory is assumed to include all pure
selling costs. Heavy expendit ure on advertising is usually undertaken
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62 3.5 QUESTIONS Q.1 (A) Answer the following questions :
1. Discuss the concept of the advertisement in detail.
2. What do you mean by market concentration? Explain its measures.
3. Discuss the c oncept of concentration and the market performance of a
firm.
(B) Short Notes.
a. The concentration ratio
b. The Hirschman -Herfindahl Index
c. The Entropy Index
d. The Dorfman -Steiner Theorem
e. Types of Advertising





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63 4
TECHNICAL CHANGE - II
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Process and Product Innovation
4.3 Effects of Innovation on Welfare and Employment
4.4 Adoption and Diffusion of Innovation
4.5 Summary
4.6 Question s
4.0 OBJECTIVES  To study the concepts of Invention and Innovation.
 To study the effects of Innovation on Welfare and Employment.
 To study the Adoption and Diffusion of Innovation.
4.1 INTRODUCTION J. A. Schumpeter found innovation as the outstanding fact in the economic
history of capitalistic society. Innovation is not confined to such a society
only. It is a common feature in almost every economic system whether
capitalistic or socialistic or something else. Science and technology are the
instruments for rapid economic progress of a society. They become
operative through innovation. Innovation is one of the several strategies
through which a firm could change its situation in the market in pursuit of
its objectives.
It is an instrument which the firm uses to enhance its competitive power in
the market. It provides a basis for greater degree of diversification and
hence growth of the firm. New products, new methods of production, new
markets and new forms of industrial organization etc. which are elements
of innovation or technological change, make the firms and industries run
efficiently over time.
An invention is the creation of a new technology. By ‘technology' we
mean “any tool or technique, and product or process, any physical
equipment or method of doi ng or making, by which human ability is
extended”. It is an intellectual act which involves a perception of a new
image, of a new connection between old conditions, or of a new area for
action. All inventions, big or little, are made for some practical use s. The
process of adopting an invention in a practical use is called ‘innovation’.
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64 4.2 PROCESS AND PRODUCT INNOVATION Process of Innovation:
Innovation is a multi -dimensional concept. There are three terms used in
the process of innovation.
A. Invention;
B. Innovation and;
C. Imitation.
A. Invention:
The most important concept of innovation is invention. An invention is the
creation of new technology. By technology we mean any tool or
technique, any product process, any physical equipment or method of
doing or making, by which human capability is extended. It is an
intellectual act which involves a perception of a new image, of a new
connection between old conditions, or of a new area for action. All
inventions small or big are made for some practical use s. The process of
adopting an invention in a practical use is called innovation. Innovation is
a multi -dimensional concept.
B. Innovation:
It is a very broad and multi -dimensional concept.
i. Product Innovation:
If the existing product line is changed by a firm, i.e., it introduces a new
product with or without displacement of the old ones, then it is defined as
product innovation.
ii. Process Innovation:
If a new method is initiated to produce existing products, then it is called
process -innovation. Both o f these are the elements of technological
Innovation.
iii. Market Innovation:
When a firm makes changes in its marketing strategy it is defined as
market -innovation. The entrepreneur or manager when performs the act of
innovation is called
iv. Innovator:
He invests sources for the innovation and takes the risks involved in that.
This is a very important role indeed a pivotal one for the growth of
industries.
Thus, the concept of innovation is very broad. In Schumpeter’s
terminology, it is the intrusion into the system of new production functions munotes.in

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65 Technical Change – II “by exploiting an invention or more generally an untried technological
possibility..., by opening up a new source of supply of materials or new
outlet for products by reorganizing an industry and so on.
C. Imitation:
All the three terms -invention, innovation and imitation are the successive
stages of the process of innovation or technological changes i.e., imitation
is not possible without innovation which in turn is not possible without
invention.
Product Innovation:
Product innovation is necessitated because of a variety of reasons.
Primarily, a product change may be stimulated either by change in relative
prices of existing products or new technology. Change in consumer
preference and cost of production are the sour ces of change in relative
prices of the product. If a product is costly for the firm and at the same
time its prices decline in the market because of unfavorable circumstances,
it is likely to be replaced by a new one.
This stage of innovation is a planned one. It has a well -defined goal and
the adaptation of the new technology or product to achieve the goal is an
orderly management function of the firm. The process of innovation takes
time and costs money. It is just like gambling where output of the game is
uncertain, yet the activity is undertaken with a hope of future gains.
4.3 EFFECTS OF INNOVATION ON WELFARE AND EMPLOYMENT Technological upgrading is often seen to be a source of economic growth
in the long run. In the seventeenth and eighteenth centuri es, the
introduction of new crops and the abandonment of the practice of
fallowing land led to a strong increase in agricultural production per
hectare and per worker. In the nineteenth and twentieth centuries, mastery
of the powers of steam, electricity, and internal combustion made it
possible greatly to increase the ratio of industrial production to the
quantities of inputs used. At the end of the twentieth century, innovations
in the areas of computerization and telecommunications improved
productivity in the service sector. Over a span of centuries, history has
been marked by technological innovations that have strongly increased the
efficiency of the inputs in the rich countries."
The importance of technological upgrading as an important driver of
sustained economic growth and development have been recognized by
international institutions and governments in developing countries.
Through the positive correlation of per capita income with socio -economic
indicators such as health and education outcomes, an d standards of living
in general, this is likely to have important implications for improving
social welfare. However, especially in the short run a country might face a
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66 structures. This pr ocess is usually characterized with what Schumpeter
(1942) calls creative destruction, in which jobs get destroyed but at the
same type new employment opportunities are created. The net effect of
this mechanism of creative destruction, which is inherent in the process of
technological innovation, is a priori unclear.
While more rapid economic growth spurs demand for new products and
production activities and thus has the potential to create new employment
opportunities (see also Okun's law for the negative relationship between
economic growth and unemployment), this new demand might be satisfied
by employing more machines rather than more workers in the production
process. Especially in the short - and medium -run, when the full growth
potential cannot yet be realized, the substitution of labour for machines
might lead to a loss of jobs. This fear has occurred through various points
in history. A famous example is the Luddite movement in nineteenth
century Britain, in which textile workers destroyed weaving and spinning
machines out of the fear that their jobs would be taken over by these
machines. This fear is also reflected in the still ongoing, prominent debate
on whether automation and technological progress lead to a destruction of
jobs and makes human labo ur obsolete or whether it rather contributes to a
higher demand for labour.
4.4 ADOPTION AND DIFFUSION OF INNOVATION Diffusion of Innovations:
Diffusion is the process by which an innovation is communicated through
certain channels over time among the memb ers of a social system. It is a
special type of communication, in that the messages are concerned with
new ideas.
Elements in the diffusion of innovations:
The four main elements in diffusion of innovations are:
1. Innovation
2. Communication channels
3. Time
4. Socia l system
The description for these elements is given below:
1) The innovation:
An innovation is an idea, practice or object that is perceived as new by an
individual or other unit of adoption. The perceived newness of the idea for
the individual determines his or her reaction to it. The "newness" aspect
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67 Technical Change – II decision to adopt. In this context, to know about the perceived attributes of
innovation would be appropriate which are described in the succeeding
paras:
a. Relative advantage:
It is the degree to which an innovation is perceived as better than the idea
it supersedes. The degree of relative advantage may be measured in
economic terms, but social -prestige factors, convenience and satisf action
are also often the important components.
b. Compatibility:
It is the degree to which an innovation is perceived as being consistent
with the existing values, past experiences and needs of potential adopters.
c. Complexity:
It is the degree to which an innovation is perceived as difficult to
understand and use. In general, new ideas that are simpler to understand
will be adopted more rapidly than innovations that require the adopter to
develop new skills and understandings.
d. Trialability:
It is the degree to which an innovation may be experimented with on a
limited basis. An innovation that is trailable represents less uncertainty to
the individual who is considering it for adoption, as it is possible to learn
by doing.
e. Observability:
It is the de gree to which the results of an innovation are visible to others.
The easier it is for individuals to see the results of an innovation, the more
likely they are to adopt.
2) Communication channels:
A communication channel is the means by which messages get from one
individual to another. The following classification of channels would help
the communicator to use them appropriately:
a. Interpersonal channels:
It refers to those which are used for face -to-face communication between
two or more individuals.
b. Mass media channels:
These enable the messages to reach a larger, diverse audience
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68 Industrial Economics
68 c. Locality channels:
They originate within the social system of the receiver. eg: neighbors,
relatives, o pinion leaders etc.
d. Cosmopolite channels:
They originate outside a particular social system. eg: Extension worker,
sales personnel etc.
3) Time:
It is an important element in the diffusion process. Time is an obvious
aspect of any communication process. Time does not exist independently
of events, but it is an aspect of every activity. The time dimension is
involved in diffusion (i) in the innovation - decision process, (ii) in the
innovativeness of an individual or other unit of adoption, and (iii)
innovation's rate of adoption in a system.
4) Social System:
It is defined as a set of interrelated units that are engaged in joint problem
solving to accomplish a common goal. The members or units of a social
system may be individuals, informal groups, organi zations and / or
subsystems. The social system constitutes a boundary within which an
innovation diffuses.
Innovation - Decision Process:
As an alternative to the "Stages in the adoption process" viz., Awareness,
Interest, Evaluation, Trial and Adoption, d ue to the advancements in
diffusion research, currently" Innovation Decision process" is proposed
which enlightens the sequential stages in the adoption - decisions made by
individuals or other units of adoption. The "Innovation - Decision
Process" is the process through which an individual (or other decision -
making unit) passes from first knowledge of an innovation, to forming an
attitude towards the innovation to a decision to adopt or reject, to
implementation of the new idea, and to confirmation of th is decision.
This process consists of a series of actions and choices over time through
which an individual or an organization evaluates a new idea and decides
whether or not to incorporate the new idea into ongoing practice.
The conceptualization of the m odel of the innovation decision process
consists of the following five stages


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69 Technical Change – II Fig. 4.1. Paradigm on Stages in the Innovation -Decision Process

1) Knowledge stage:
Knowledge occurs when an individual (or the decision - making unit) is
exposed to the innova tion's existence and gains some understanding of
how it functions. The following three types of knowledge possessed by an
individual influence the decisions:
a. Awareness:
knowledge motivates an individual to seek "how -to" knowledge and
principles knowledg e. This type of information - seeking is concentrated
as the knowledge stage of the innovation - decision process, but it may
also occur at the persuasion and decision stages.
b. How to knowledge:
Consists of information necessary to use an innovation prop erly. When an
adequate level of how -to knowledge is not obtained prior to the trial and
adoption of an innovation, rejection or discontinuance is likely to result.
Change agents could perhaps play their distinctive role to concentrate on
"how -to knowledge" at the trial and decision stage in the process.
c. Principles knowledge
Consists of information dealing with the functioning principles underlying
how innovation works. It is usually possible to adopt an innovation
without principles knowledge, but the da nger of misusing the new idea is
greater, and discontinuance may result. The long -range competence of
individuals to judge future innovations is facilitated by principles of
knowledge.
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70 2) Persuasion stage:
Persuasion occurs when an individual (or other de cision - making unit)
forms a favorable or unfavorable attitude toward innovation.
While the mental activity as the knowledge stage was mainly cognitive
(or knowing), the main type of thinking at the persuasion function is
affective (or feeling). At this stage, a general perception of the innovation
is developed. The individual becomes more psychologically involved with
the innovation and hence he or she seeks information about the new idea.
3) Decision stage:
Decision occurs when an individual (or other d ecision - making unit)
engages in activities that lead to a choice to adopt or reject the innovation.
Adoption is a decision to make full use of an innovation as the best course
of action available. Rejection is a decision not to adopt an innovation.
The s mall - scale trial is often part of the decision to adopt, and is
important as a means to decrease the perceived uncertainty of the
innovation for the adopter.
4) Implementation stage:
Implementation occurs when an individual (or other decision - making
unit) puts an innovation into use. Until the implementation stage, the
innovation -decision process has been a strictly mental exercise. But
implementation involves overt behavior change as the new idea is actually
part into practice.
Problems of implementati on are likely to be more serious when the
adopter is an organization rather than an individual. Reason is that in an
organizational setting, a number of individuals are usually involved in the
innovation - decision process, and the implementers are often a different
set of people from the decision makers.
5) Confirmation stage:
Confirmation occurs when an individual (or other decision - making unit)
seeks reinforcement of an innovation - decision already made, but he or
she may reverse this previous decisio n if exposed to conflicting messages
about the innovation.
The confirmation stage continues after the decision to adopt or reject for
an indefinite period in time. At this stage, the change agents have the
additional responsibility of supporting messages t o individuals who have
previously adopted.
As a sequential effect, there is a possibility for "discontinuance". A
discontinuance is a decision to reject an innovation after having previously
adopted it. There are two types of discontinuances: munotes.in

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71 Technical Change – II i) Replaceme nt discontinuance: is a decision to reject an idea in order
to adopt a better idea that supersedes it
ii) Disenchantment discontinuance: is a decision to reject an idea as a
result of dissatisfaction with its performance.
Adopter Categories:
There are dif ferent categories of farmers. According to Rogers (1971), the
farmers based on their innovativeness can be classified as:
1. Innovators (Venturesome)
2. Early adopters (Respectable)
3. Early majority (Deliberate)
4. Late majority (Skeptical)
All individuals in a socia l system do not adopt an innovation at the same
time. Rather, they adopt in an ordered time sequence, and they may be
classified into adopter categories on the basis of when they first begin
using a new idea. In technology transfer programmes, it is of gre at
practical utility for the extension workers to identify the individuals who
are likely to adopt innovations early and who may lag behind.
The adoption of an innovation over time follows a normal, bell -shaped
curve when plotted over time on a frequency b asis. If the cumulative
number of adopters is plotted, it results in an S -shaped curve. The S -
shaped curve rises slowly at first when there are few adopters in a time
period, accelerates to a maximum when about half of the individuals in the
system have ad opted and then increases at a gradually slower rate as the
few remaining individuals finally adopt (Fig. 2). The S -shaped curve is
like that of a 'learning curve' as propounded by the psychologists. Each
adoption in the social system is in a sense equivale nt to a learning trial by
an individual.
Fig. 4.2 The bell -shaped frequency curve and the S -shaped cumulative
curve for adopter categories
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72 Industrial Economics
72 Both of these curves are for the same data, the adoption of an innovation
over time by the members of a social system. But the bell -shaped curve
shows these data in terms of the number of individuals adopting each year,
whereas the S -shaped curve shows these data on a cumulative basis.
The distribution of adopters over time closely approaches normality, and
may be explain ed by the statistical concept of normal curve. The
distribution of the adopters may be partitioned into five adopter categories
by using the mean (x) and standard deviation. The area lying to the left of
the mean time of adoption minus two standard deviati ons includes 2.5
percent of the individuals who are the first to adopt an innovation and are
known as innovators. The next 13.5 per cent between the mean minus one
standard deviation and the mean minus two standard deviations to adopt
the new idea are call ed as early adopters. The next 34 per cent of the
adopters between the mean date of adoption and minus one standard
deviation are known as early majority. Between the mean and one
standard deviation to the right of the mean are located the next 34 per cent
to adopt the new idea, the late majority. The last 16 per cent to the right of
mean plus one standard deviation are the last to adopt the innovation of
the laggards. The five -adopter categories are conceptualized as ideal types
and are presented in Figure 3.
Fig. 4.3 Adopter categorization on the basis of innovativeness

The innovativeness dimension, as measured by the time at which an
individual adopts an innovation, is continuous. However, this variable may
be partitioned into five adopter categories by l aying of standard deviations
from the average time of adoption.
The detailed information on the characteristics of adopter categories is
given below:
Innovators: Venturesome :
Observers have noted that venturesomeness is almost an obsession with
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73 Technical Change – II a local circle of peers and into more cosmopolitan social relationships.
Communication patterns and friendships among a clique of innovators are
common, even though the geographical distance between the innovators
may be great. Being an innovator has several prerequisites. These include
control of substantial financial resources to absorb the understanding and
apply complex technical knowledge.
The salient value of the innovator is venturesom eness. He desires the
hazardous, the rash, the daring, and the risky. The innovator also must be
willing to accept an occasional setback when one of the new ideas he
adopts proves unsuccessful.
These are the first people to adopt a new idea, much ahead of other people.
They are very few in numbers, probably not more than one or two in a
community.
Characteristics:
1. Have larger industries.
2. High net worth and risk capital.
3. Willing to take risks.
4. Usually not past middle age
5. Generally, well educated
6. Have respect and prestige in progressive communities but not in
conservative type of communities.
7. Mentally alert and actively seeking new ideas.
8. Their sphere of influence and activity often goes beyond the
community boundaries.
9. They have many formal and informal conta cts outside the immediate
locality.
10. They often by -pass the local extension worker in getting information
from the originating sources, and may learn about new things even
before he does.
11. They subscribe to many farm magazines and specialized publications.
12. Other industries may watch the innovators and know what they are
doing but the innovators are not generally named by other industries
as "neighbors and friends" to whom they go for information.
Early Adopter: Respectable :
Early adopters are a more integrate d part of the local social system than
are innovators. Whereas innovators are cosmopolites, early adopters are
localities. This adopter’s category, more than any other, has the greatest
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74 Industrial Economics
74 look to early adopters for advice and information about the innovation.
The early adopter is considered by many as "the man to check with"
before using a new idea. This adopter category is generally sought by
change agents to be a local missionary for sp eeding the diffusion process.
Because early adopters are not too far ahead of the average individual in
innovativeness, they serve as a role model for many other members of a
social system. Members of a social system respect the early adopter. The
early a dopter is respected by his peers. He is the embodiment of successful
and discrete use of new ideas. And the early adopter knows that he must
continue to earn this esteem of his colleagues if his position in the social
structure is to be maintained.
Charact eristics:
1. Younger than those who have a slower adoption rate, but not
necessarily younger than the innovators
2. They are not the persons who test the untried ideas but they are
quickest to use tried ideas in their own situations.
3. Have large industries.
4. Highe r education than those who adopt more slowly.
5. High income.
6. They participate more in the format activities of the community.
7. They also participate more in government programmes.
8. This group usually furnishes a disproportionate amount of the formal
leadership (elected positions) in the community.
9. They read papers and farm journals and receive more bulletins than
people who adopt later.
10. They may be regarded as community adoption leaders.
Early Majority: Deliberate (Local Adoption Leaders) :
The early majority ad opt new ideas just before the average member of a
social system. The early majority interact frequently with their peers, but
leadership position; are rarely held by them. The early majority's unique
position; between the very early and relatively late to adopt make; them an
important link in the diffusion process.
The early majority may deliberate for some time before completely
adopting a new idea. Their innovation -decision is relatively longer than
that of the innovator and the early adopter. "Be not the last to lay the old
aside, nor the first by which the new is tried", might be the motto of the
early majority. They follow with deliberate willingness in adopting
innovations, but seldom lead.
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75 Technical Change – II Characteristics:
1. Slightly above average in age, education and industrial experience.
2. They take a few more farm journals and bulletins than the average.
3. They have medium high social and economic status.
4. Less active in formal groups than early adopters, but more active than
those adopting later.
5. In many cases, they ar e not formal leaders in the association
6. They also attend extension meetings and farm demonstrations.
7. They are most likely to be informal resources than early adopters and
innovators, and so cannot afford to make hasty or poor decisions.
8. They associate main ly with people of their own community.
9. They value highly the opinions their neighbors and friends hold about
them; for this is their main source of status and prestige.
10. They are mostly mentioned as "neighbors and friends" from whom the
majority of farmers seek information.
Late Majority: Skeptical :
The late majority adopt new ideas just after the average member of a
social system. Adoption may be both an economic necessity and the
answer to increasing social pressures. Innovations are approached with a
skeptical and cautious air, and the late majority do not adopt until most
others in their social system have done so. The weight of system norms
must definitely favor innovation before the late majority are convinced.
They can be persuaded of the utility of ne w ideas, but the pressure of peers
is necessary to motivate adoption.
Characteristics:
1. Those in this group have less education and are older than the early
majority.
2. They take fewer leadership roles than the earlier adopters.
3. They take and read fewer paper s, magazines and bulletins, than the
early majority.
4. They do not participate in as many activities outside the community
as do people that adopt earlier.
Laggards: Traditional :
Laggards are the last to adopt an innovation. They possess almost no
opinion le adership. They are the most locality in their outlook of all
adopter categories, many are near isolates. The point of reference for the munotes.in

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76 Industrial Economics
76 laggard is the past. Decisions are usually made in terms of what has been
done in previous generations. This individual interacts primarily with
others who have traditional values. When laggards finally adopt an
innovation, it may already have been superseded by another more recent
idea which the innovators are already using. Laggards tend to be frankly
suspicious of innov ations, innovators, and change agents. Their traditional
direction slows the innovation decision process to a crawl. Adoption lags
far behind knowledge of the idea. Alienation from a too -fast-moving
world is apparent in much of the laggard's outlook. While most individuals
in a social system are looking to the road of change ahead, the laggards
have his attention fixed on the rear -view mirror.
Characteristics:
1. Least education.
2. Oldest.
3. Participate least in formal organizations, cooperatives and government
programmes.
4. They hardly read farm magazines and bulletins.
4.5 SUMMARY  J. A. Schumpeter found innovation as the outstanding fact in the
economic history of capitalistic society.
 Innovation is a multi -dimensional concept. There are three terms used
in the pro cess of innovation.
 All inventions small or big are made for some practical uses. The
process of adopting an invention in a practical use is called
innovation.
 More rapid economic growth spurs demand for new products and
production activities and thus has the potential to create new
employment opportunities
 Diffusion is the process by which an innovation is communicated
through certain channels over time among the members of a social
system.
4.6 QUESTIONS Q.1 (A) Answer the following questions:
1. Elaborate th e difference between invention and innovation.
2. What is the process of innovation?
3. Discuss the effects of innovation on welfare and employment.
4. What are the e lements in the diffusion of innovations? munotes.in

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77 Technical Change – II (B) Write Short notes:
a. Product Innovation
b. Innovat ion - Decision Process
c. Early Adopter: Respectable
d. Early Majority: Deliberate (Local Adoption Leaders)





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78 MODULE - III
5
FINANCIAL ANAL YSIS - I
Unit Structure
5.0 Objectives
5.1 Introduction
5.2 Meaning Importance o f Funds Flow Statement
5.3 Understanding Cash Flow Statement
5.4 Analysis o f Balance Sheet
5.5 Definition and Importance o f Income Statemen t
5.6 Meaning and Types o f Ratio Analysis
5.7 Meaning, Nature and Scope o f Investment Decision
5.8 Meaning and Types o f Capital Budgeting of A Firm
5.9 Questions
5.0 OBJECTIVES After going through this unit, you must be able to understand:
 Meaning of Funds Flow in Financial Analysis
 The Cash Flow Statement
 Balance Sheet Analysis
 Importance of Income Statement in Financial Statement
 Meaning and Importance of Ratio Analysis
 Meaning, Nature and Scope of Investment Decision
 Various types of Capital Budgeti ng
5.1 INTRODUCTION Financial analysis is used to evaluate economic trends, set financial policy,
build long -term plans for business activity, and identify projects or
companies for investment. This is done through the synthesis of financial
numbers and da ta. A financial analyst will thoroughly examine a
company's financial statements —the income statement, balance sheet, and
cash flow statement. Financial analysis can be conducted in both corporate
finance and investment finance settings.
One of the most co mmon ways to analyze financial data is to calculate
ratios from the data in the financial statements to compare against those of
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79 Financial Analysis - I The goal of financial analysis is to analyze whether an en tity is stable,
solvent, liquid, or profitable enough to warrant a monetary investment. It
is used to evaluate economic trends, set financial policy, build long -term
plans for business activity, and identify projects or companies for
investment.
5.2 MEANIN G IMPORTANCE OF FUNDS FLOW STATEMENT Meaning:
A funds flow statement is a statement that comprises the inflows and
outflows of funds. It includes the sources of funds and application of funds
for the particular period. Therefore, you can analyse the reaso ns behind
the change in a company’s financial position.
A funds flow statement explains the changes in a company’s working
capital. It considers the inflows and outflow of funds (source of funds and
application of funds) for a particular period. The statem ent helps in
analysing the changes in a company’s financial position between two
balance sheet periods.
The statement helps in determining how the funds are being used. As a
result, analysts can assess the company’s fund flow in the future.
The statement c omprises of the following 2 components:
 Sources of Funds: Includes where the funds have come from and their
source.
 Application of Funds: Denotes the usage of funds for short term and
long-term needs.
Fund inflows can be through issues of shares or debentu res or from the
sale of fixed assets. Or through business operations.
Importance of a Funds Flow Statement:
 Financial Position: A profit and loss statement or balance sheet does
not explain the reasons for the change in a company’s financial
position. The statement will give information about where the funds
have come (Source of Funds) and where the funds have been used
(Application of Funds).
 Company Analysis: Often, companies that are making profits end up
in cash crunch scenarios. In such scenarios, the funds flow statement
offers a clear picture of the source and usage of funds.
 Management: The funds flow statement assists management in
determining its future course of action and also serves as a
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80  Changes in Assets and Liabilities : The statement shows the reason
behind the change in assets and liabilities between two balance sheet
dates. As a result, you can conduct an in -depth analysis of the balance
sheet.
 Creditworthiness: Lending institutions use the this statement of a
company to analyse the creditworthiness. They compare the statement
over the years before approving a loan. Therefore, the statement
depicts a company’s credibility in terms of fund management.
5.3 UNDERSTANDING CASH FLOW STATEMENT A cash flow statement is a fina ncial statement that provides aggregate data
regarding all cash inflows a company receives from its ongoing operations
and external investment sources. It also includes all cash outflows that pay
for business activities and investments during a given perio d.
A company's financial statements offer investors and analysts a portrait of
all the transactions that go through the business, where every transaction
contributes to its success. The cash flow statement is believed to be the
most intuitive of all the f inancial statements because it follows the cash
made by the business in three main ways —through operations,
investment, and financing. The sum of these three segments is called net
cash flow.
These three different sections of the cash flow statement can he lp
investors determine the value of a company's stock or the company as a
whole.
How Cash Flow Statements Work:
Every company that sells and offers its stock to the public must file
financial reports and statements with the Securities and Exchange
Commissi on (SEC).1 The three main financial statements are the balance
sheet, income statement, and cash flow statement. The cash flow statement
is an important document that helps interested parties gain insight into all
the transactions that go through a company .
There are two different branches of accounting —accrual and cash. Most
public companies use accrual accounting, which means the income
statement is not the same as the company's cash position. The cash flow
statement, though, is focused on cash accounting .
Profitable companies can fail to adequately manage cash flow, which is
why the cash flow statement is a critical tool for companies, analysts, and
investors. The cash flow statement is broken down into three different
business activities: operations, in vesting, and financing.
Let's consider a company that sells a product and extends credit for the
sale to its customer. Even though It recognizes that sale as revenue, the
company may not receive cash until a later date. The company earns a munotes.in

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81 Financial Analysis - I profit on the in come statement and pays income taxes on it, but the
business may bring in more or less cash than the sales or income figures.
Cash Flows From Operations:
The first section of the cash flow statement covers cash flows from
operating activities (CFO) and inc ludes transactions from all operational
business activities. The cash flows from operations section begins with net
income, then reconciles all non -cash items to cash items involving
operational activities. So, in other words, it is the company's net incom e,
but in a cash version.
This section reports cash flows and outflows that stem directly from a
company's main business activities. These activities may include buying
and selling inventory and supplies, along with paying its employees their
salaries. Any other forms of in and outflows such as investments, debts,
and dividends are not included.
Companies are able to generate sufficient positive cash flow for
operational growth. If there is not enough generated, they may need to
secure financing for externa l growth in order to expand.
For example, accounts receivable is a non -cash account. If accounts
receivable go up during a period, it means sales are up, but no cash was
received at the time of sale. The cash flow statement deducts receivables
from net inc ome because it is not cash. The cash flows from the operations
section can also include accounts payable, depreciation, amortization, and
numerous prepaid items booked as revenue or expenses, but with no
associated cash flow.
Cash Flows From Investing:
This is the second section of the cash flow statement looks at cash flows
from investing (CFI) and is the result of investment gains and losses. This
section also includes cash spent on property, plant, and equipment. This
section is where analysts look to fi nd changes in capital expenditures
(capex).
When capex increases, it generally means there is a reduction in cash flow.
But that's not always a bad thing, as it may indicate that a company is
making investment into its future operations. Companies with hig h capex
tend to be those that are growing.
While positive cash flows within this section can be considered good,
investors would prefer companies that generate cash flow from business
operations —not through investing and financing activities. Companies can
generate cash flow within this section by selling equipment or property.
Cash Flows From Financing:
Cash flows from financing (CFF) is the last section of the cash flow
statement. The section provides an overview of cash used in business
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82 its creditors, and its source is normally from debt or equity. These figures
are generally reported annually on a company's 10 -K report to
shareholders .
Analysts use the cash flows from financing secti on to determine how
much money the company has paid out via dividends or share buybacks. It
is also useful to help determine how a company raises cash for operational
growth.
Cash obtained or paid back from capital fundraising efforts, such as equity
or de bt, is listed here, as are loans taken out or paid back.
When the cash flow from financing is a positive number, it means there is
more money coming into the company than flowing out. When the number
is negative, it may mean the company is paying off debt , or is making
dividend payments and/or stock buybacks.
5.4 ANALYSIS OF BALANCE SHEET The term balance sheet refers to a financial statement that reports a
company's assets, liabilities, and shareholder equity at a specific point in
time. Balance sheets p rovide the basis for computing rates of return for
investors and evaluating a company's capital structure.
In short, the balance sheet is a financial statement that provides a snapshot
of what a company owns and owes, as well as the amount invested by
shareholders. Balance sheets can be used with other important financial
statements to conduct fundamental analysis or calculate financial ratios.
How Balance Sheets Work:
The balance sheet provides an overview of the state of a company's
finances at a moment i n time. It cannot give a sense of the trends playing
out over a longer period on its own. For this reason, the balance sheet
should be compared with those of previous periods.
Investors can get a sense of a company's financial wellbeing by using a
number o f ratios that can be derived from a balance sheet, including the
debt-to-equity ratio and the acid -test ratio, along with many others. The
income statement and statement of cash flows also provide valuable
context for assessing a company's finances, as do any notes or addenda in
an earnings report that might refer back to the balance sheet.
The balance sheet adheres to the following accounting equation, with
assets on one side, and liabilities plus shareholder equity on the other,
balance out:
Assets = Liab ilities+Shareholders’ Equity
This formula is intuitive. That's because a company has to pay for all the
things it owns (assets) by either borrowing money (taking on liabilities) or
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83 Financial Analysis - I If a company takes o ut a five -year, $4,000 loan from a bank, its assets
(specifically, the cash account) will increase by $4,000. Its liabilities
(specifically, the long -term debt account) will also increase by $4,000,
balancing the two sides of the equation. If the company t akes $8,000 from
investors, its assets will increase by that amount, as will its shareholder
equity. All revenues the company generates in excess of its expenses will
go into the shareholder equity account. These revenues will be balanced
on the assets sid e, appearing as cash, investments, inventory, or other
assets.
Special Considerations:
As noted above, you can find information about assets, liabilities, and
shareholder equity on a company's balance sheet. The assets should
always equal the liabilities a nd shareholder equity. This means that the
balance sheet should always balance, hence the name. If they don't
balance, there may be some problems, including incorrect or misplaced
data, inventory or exchange rate errors, or miscalculations.
Each category c onsists of several smaller accounts that break down the
specifics of a company's finances. These accounts vary widely by
industry, and the same terms can have different implications depending on
the nature of the business. But there are a few common compon ents that
investors are likely to come across.
Components of a Balance Sheet:
Assets:
Accounts within this segment are listed from top to bottom in order of
their liquidity. This is the ease with which they can be converted into cash.
They are divided into current assets, which can be converted to cash in one
year or less; and non -current or long -term assets, which cannot.
Here is the general order of accounts within current assets:
 Cash and cash equivalents are the most liquid assets and can include
Treasu ry bills and short -term certificates of deposit, as well as hard
currency.
 Marketable securities are equity and debt securities for which there is
a liquid market.
 Accounts receivable (AR) refer to money that customers owe the
company. This may include an allowance for doubtful accounts as
some customers may not pay what they owe.
 Inventory refers to any goods available for sale, valued at the lower of
the cost or market price.
 Prepaid expenses represent the value that has already been paid for,
such as ins urance, advertising contracts, or rent.
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84 Long -term assets include the following:
 Long -term investments are securities that will not or cannot be
liquidated in the next year.
 Fixed assets include land, machinery, equipment, buildings, and other
durable, gen erally capital -intensive assets.
 Intangible assets include non -physical (but still valuable) assets such
as intellectual property and goodwill. These assets are generally only
listed on the balance sheet if they are acquired, rather than developed
in-house . Their value may thus be wildly understated (by not
including a globally recognized logo, for example) or just as wildly
overstated.
Liabilities:
A liability is any money that a company owes to outside parties, from bills
it has to pay to suppliers to int erest on bonds issued to creditors to rent,
utilities and salaries. Current liabilities are due within one year and are
listed in order of their due date. Long -term liabilities, on the other hand,
are due at any point after one year.
Current liabilities ac counts might include:
 Current portion of long -term debt is the portion of a long -term debt
due within the next 12 months. For example, if a company has a 10
years left on a loan to pay for its warehouse, 1 year is a current
liability and 9 years is a long -term liability.
 Interest payable is accumulated interest owed, often due as part of a
past-due obligation such as late remittance on property taxes.
 Wages payable is salaries, wages, and benefits to employees, often for
the most recent pay period.
 Customer prepayments is money received by a customer before the
service has been provided or product delivered. The company has an
obligation to (a) provide that good or service or (b) return the
customer's money.
 Dividends payable is dividends that have been auth orized for payment
but have not yet been issued.
 Earned and unearned premiums is similar to prepayments in that a
company has received money upfront, has not yet executed on their
portion of an agreement, and must return unearned cash if they fail to
execu te.
 Accounts payable is often the most common current liability.
Accounts payable is debt obligations on invoices processed as part of
the operation of a business that are often due within 30 days of
receipt.
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85 Financial Analysis - I Long -term liabilities can include:
 Long -term d ebt includes any interest and principal on bonds issued
 Pension fund liability refers to the money a company is required to
pay into its employees' retirement accounts
 Deferred tax liability is the amount of taxes that accrued but will not
be paid for anot her year. Besides timing, this figure reconciles
differences between requirements for financial reporting and the way
tax is assessed, such as depreciation calculations.
Some liabilities are considered off the balance sheet, meaning they do not
appear on t he balance sheet.
Shareholder Equity:
Shareholder equity is the money attributable to the owners of a business or
its shareholders. It is also known as net assets since it is equivalent to the
total assets of a company minus its liabilities or the debt it owes to non -
shareholders.
Retained earnings are the net earnings a company either reinvests in the
business or uses to pay off debt. The remaining amount is distributed to
shareholders in the form of dividends.
Treasury stock is the stock a company has rep urchased. It can be sold at a
later date to raise cash or reserved to repel a hostile takeover.
Some companies issue preferred stock, which will be listed separately
from common stock under this section. Preferred stock is assigned an
arbitrary par value ( as is common stock, in some cases) that has no bearing
on the market value of the shares. The common stock and preferred stock
accounts are calculated by multiplying the par value by the number of
shares issued.
Additional paid -in capital or capital surplu s represents the amount
shareholders have invested in excess of the common or preferred stock
accounts, which are based on par value rather than market price.
Shareholder equity is not directly related to a company's market
capitalization. The latter is ba sed on the current price of a stock, while
paid-in capital is the sum of the equity that has been purchased at any
price.
Importance of a Balance Sheet:
Regardless of the size of a company or industry in which it operates, there
are many benefits of a bala nce sheet,
Balance sheets determine risk. This financial statement lists everything a
company owns and all of its debt. A company will be able to quickly
assess whether it has borrowed too much money, whether the assets it
owns are not liquid enough, or wh ether it has enough cash on hand to meet
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86 Balance sheets are also used to secure capital. A company usually must
provide a balance sheet to a lender in order to secure a business loan. A
company must also usually provide a balance sheet to private investors
when attempting to secure private equity funding. In both cases, the
external party wants to assess the financial health of a company, the
creditworthiness of the business, and whether the company will be able to
repay its short -term debt s.
Managers can opt to use financial ratios to measure the liquidity,
profitability, solvency, and cadence (turnover) of a company using
financial ratios, and some financial ratios need numbers taken from the
balance sheet. When analyzed over time or compa ratively against
competing companies, managers can better understand ways to improve
the financial health of a company.
Last, balance sheets can lure and retain talent. Employees usually prefer
knowing their jobs are secure and that the company they are wo rking for is
in good health. For public companies that must disclose their balance
sheet, this requirement gives employees a chance to review how much
cash the company has on hand, whether the company is making smart
decisions when managing debt, and wheth er they feel the company's
financial health is in line with what they expect from their employer.
Limitations of a Balance Sheet:
Although the balance sheet is an invaluable piece of information for
investors and analysts, there are some drawbacks. Because it is static,
many financial ratios draw on data included in both the balance sheet and
the more dynamic income statement and statement of cash flows to paint a
fuller picture of what's going on with a company's business. For this
reason, a balance alone may not paint the full picture of a company's
financial health.
A balance sheet is limited due its narrow scope of timing. The financial
statement only captures the financial position of a company on a specific
day. Looking at a single balance sheet by its elf may make it difficult to
extract whether a company is performing well. For example, imagine a
company reports $1,000,000 of cash on hand at the end of the month.
Without context, a comparative point, knowledge of its previous cash
balance, and an under standing of industry operating demands, knowing
how much cash on hand a company has yields limited value.
Different accounting systems and ways of dealing with depreciation and
inventories will also change the figures posted to a balance sheet. Because
of this, managers have some ability to game the numbers to look more
favorable. Pay attention to the balance sheet's footnotes in order to
determine which systems are being used in their accounting and to look
out for red flags.
Last, a balance sheet is subje ct to several areas of professional judgement
that may materially impact the report. For example, accounts receivable
must be continually assessed for impairment and adjusted to reflect
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87 Financial Analysis - I company is likely to actually receive, a company must make estimates and
reflect their best guess as part of the balance sheet.
Example of a Balance Sheet:
The image below is an example of a comparative balance sheet of Apple,
Inc. This balance sheet compa res the financial position of the company as
of September 2020 to the financial position of the company from the year
prior.

Apple Balance Sheet:
In this example, Apple's total assets of $323.8 billion is segregated
towards the top of the report. This as set section is broken into current
assets and non -current assets, and each of these categories is broken into
more specific accounts. A brief review of Apple's assets shows that their
cash on hand decreased, yet their non -current assets increased.
This bal ance sheet also reports Apple's liabilities and equity, each with its
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88 out similarly as the assets section, with current liabilities and non -current
liabilities reporting balance s by account. The total shareholder's equity
section reports common stock value, retained earnings, and accumulated
other comprehensive income. Apple's total liabilities increased, total
equity decreased, and the combination of the two reconcile to the
company's total assets.
5.5 DEFINITION AND IMPORTANCE OF INCOME STATEMENT An income statement is a financial statement that shows you the
company’s income and expenditures. It also shows whether a company is
making profit or loss for a given period. The incom e statement, along with
balance sheet and cash flow statement, helps you understand the financial
health of your business.
The income statement is also known as a profit and loss statement,
statement of operation, statement of financial result or income, o r earnings
statement.
Importance of an income statement :
An income statement helps business owners decide whether they can
generate profit by increasing revenues, by decreasing costs, or both. It also
shows the effectiveness of the strategies that the busi ness set at the
beginning of a financial period. The business owners can refer to this
document to see if the strategies have paid off. Based on their analysis,
they can come up with the best solutions to yield more profit.
Following are the few other thin gs that an income statement informs :
1. Frequent reports:
While other financial statements are published annually, the income
statement is generated either quarterly or monthly. Due to this, business
owners and investors can track the performance of the b usiness closely
and make informed decisions. This also enables them to find and fix small
business problems before they become large and expensive.
2. Pinpointing expenses:
This statement highlights the future expenses or any unexpected
expenditures which are incurred by the company, and any areas which are
over or under budget. Expenses include building rent, salaries and other
overhead costs. As a small business begins to grow, it may find its
expenses soaring. These expenditures may involve hiring worke rs, buying
supplies and promoting the business.
3. Overall analysis of the company:
This statement gives investors an overview of the business in which they
are planning to invest. Banks and other financial institutions can also
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89 Financial Analysis - I Who uses an income statement? :
There are two main groups of people who use this financial statement:
internal and external users. Internal users include company management
and the board of directors, who use this information to analyze the
business’s standing and make decisions in order to turn a profit. They can
also act on any concerns regarding cash flow. External users comprise
investors, creditors, and competitors. Investors check whether the
company is posit ioned to grow and be profitable in the future, so they can
decide whether to invest in the business. Creditors use the income
statement to check whether the company has enough cash flow to pay off
its loans or take out a new loan. Competitors use them to g et details about
the success parameters of a business and get to know about areas where
the business is spending an extra bit, for example, R&D spends.

Income statement format with the major components :
The following information is covered in an income st atement. The format
for this document may vary depending on the regulatory requirements, the
diverse business needs and the associated operating activities.
Revenue or sales:
This is the first section on the income statement, and it gives you a
summary of gross sales made by the company. Revenue can be classified
into two types: operating and non -operating. Operating revenue refers to
the revenue gained by a company by performing primary activities like
manufacturing a product or providing a service. Non -operating revenue is
gained by performing non -core business activities such as installation,
operation, or maintenance of a system.
Cost of goods sold (COGS):
This is the total cost of sales or services, also referred to as the cost
incurred to manufacture goods or services. Keep in mind that it only
includes the cost of products which you sell. COGS does not usually
include indirect costs, like overhead.
Gross profit:
Gross profit is defined as net sales minus the total cost of goods sold in
your business . Net sales is the amount of money you brought in for the
goods sold, while COGS is the money you spent to produce those goods.
Gains:
Gain is a result of a positive event that causes an organization’s income to
increase. Gains indicate the amount of mon ey realized by the company
from various business activities like the sale of an operating segment.
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90 included as gains for the business. For example, company selling off old
vehicles or unu sed lands etc.
Expenses:
Expenses are the costs that the company has to pay in order to generate
revenue. Some examples of common expenses are equipment
depreciation, employee wages, and supplier payments. There are two main
categories for business expen ses: operating and non -operating expenses.
Expenses generated by company’s core business activities are operating
expenses, while the ones which are not generated by core business
activities are known as non -operating expenses. Sales commission,
pension c ontributions, payroll account for operating expenses while
examples of non operating expenses include obsolete inventory charges or
settlement of lawsuit.
Advertising expenses:
These expenses are simply the marketing costs required to expand the
client ba se. They include advertisements in print and online media as well
as radio and video ads. Advertising costs are generally considered part of
Sales, General & Administrative (SG&A) expenses.
Administrative expenses:
It can be defined as the expenditure inc urred by a business or company as
a whole rather than being the ones associated with specific departments of
the same company. Some of the examples of administrative expenses are
salaries, rent, office supplies, and travel expenses. Administrative
expenses are fixed in nature and tend to exist irrespective of the level of
sales.
Depreciation:
Depreciation refers to the practice of distributing the cost of a long -term
asset over its life span. It is a management accord to write off a company’s
asset value b ut it is considered a non -cash transaction. Depreciation
mainly shows the asset value used up by the business over a period of
time.
Earnings before tax (EBT):
This is a measure of a company’s financial performance. EBT is
calculated by subtracting expens es from income, before taxes. It is one of
the line items on a multi -step income statement.
Net income:
Net profit can be defined as the amount of money you earn after deducting
allowable business expenses. It is calculated by subtracting total expenses
from total revenue. While net income is a company’s earnings, gross profit
can be defined as the money earned by a company after deducting the cost
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91 Financial Analysis - I An income statement is a rich source of information about the key factors
responsible for a co mpany’s profitability. It gives you timely updates
because it is generated much more frequently than any other statement.
The income statement shows a company’s expense, income, gains, and
losses, which can be put into a mathematical equation to arrive at the net
profit or loss for that time period. This information helps you make timely
decisions to make sure that your business is on a good financial footing.
5.6 MEANING AND TYPES OF RATIO ANALYSIS Ratio analysis can be defined as the process of ascertaini ng the financial
ratios that are used for indicating the ongoing financial performance of a
company using a few types of ratios such as liquidity, profitability,
activity, debt, market, solvency, efficiency, and coverage ratios and few
examples of such rat ios are return on equity, current ratio, quick ratio,
dividend payout ratio, debt -equity ratio, and so on.
Ratio analysis is a process used for the calculation of financial ratios or in
other words, for the purpose of evaluating the financial wellbeing of a
company. The values used for the calculation of financial ratios of a
company are extracted from the financial statements of that same
company.
Types of Ratio Analysis :
Types of ratios are given below:
1. Liquidity Ratios :
This type of ratio helps in mea suring the ability of a company to take care
of its short -term debt obligations. A higher liquidity ratio represents that
the company is highly rich in cash.
The types of liquidity ratios are:
1) Current Ratio:
The current ratio is the ratio between the current assets and current
liabilities of a company. The current ratio is used to indicate the liquidity
of an organization in being able to meet its debt obligations in the
upcoming twelve months. A higher current ratio will indicate that the
organization is highly capable of repaying its short -term debt obligations.
Current Ratio = Current Assets / Current Liabilities
2) Quick Ratio:
The quick ratio is used to ascertain information pertaining to the capability
of a company in paying off its current liabi lities on an immediate basis.
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92 The formula used for the calculation of a quick ratio is :
Quick Ratio = (Cash and Cash Equivalents + Marketable Securities +
Accounts Receivables) / Current Liabilities
2. Profitability Ratios :
This type of ratio helps in mea suring the ability of a company in earning
sufficient profits.
The types of profitability ratios are:
1) Gross Profit Ratios:
Gross profit ratios are calculated in order to represent the operating profits
of an organization after making necessary adjustm ents pertaining to the
COGS or cost of goods sold.
The formula used for the calculation of gross profit ratio is -
Gross Profit Ratio = (Gross Profit / Net Sales) * 100
2) Net Profit Ratio:
Net profit ratios are calculated in order to determine the overall
profitability of an organization after reducing both cash and non -cash
expenditures.
The formula used for the calculation of net profit ratio is -
Net Profit Ratio = (Net Profit / Net Sales) * 100
3) Operating Profit Ratio:
Operating profit ratio is used to determine the soundness of an
organization and its financial ability to repay all the short term and long
term debt obligations.
The formula used for the calculation of operating profit ratio is -
Operating Profit Ratio = (Earnings Before Interest and T axes / Net
Sales) * 100
4) Return on Capital Employed (ROCE):
Return on capital employed is used to determine the profitability of an
organization with respect to the capital that is invested in the business.
The formula used for the calculation of ROCE i s:
ROCE = Earnings Before Interest and Taxes / Capital Employed
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93 Financial Analysis - I 3. Solvency Ratios :
Solvency ratios can be defined as a type of ratio that is used to evaluate
whether a company is solvent and well capable of paying off its debt
obligations or not.
The type s of solvency ratios are:
1) Debt Equity Ratio:
The debt -equity ratio can be defined as a ratio between total debt and
shareholders fund. The debt -equity ratio is used to calculate the leverage
of an organization. An ideal debt -equity ratio for an organiz ation is 2:1.
The formula for debt -equity ratio is :
Debt Equity Ratio = Total Debts / Shareholders Fund
2) Interest Coverage Ratio:
The interest coverage ratio is used to determine the solvency of an
organization in the nearing time as well as how many ti mes the profits
earned by that very organization were capable of absorbing its interest -
related expenses.
The formula used for the calculation of interest coverage ratio is :
Interest Coverage Ratio = Earnings Before Interest and Taxes /
Interest Expense
4. Turnover Ratios :
Turnover ratios are used to determine how efficiently the financial assets
and liabilities of an organization have been used for the purpose of
generating revenues.
The types of turnover ratios are:
1) Fixed Assets Turnover Ratios:
Fixed assets turnover ratio is used to determine the efficiency of an
organization in utilizing its fixed assets for the purpose of generating
revenues.
The formula used for the determination of fixed assets turnover ratio is :
Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets
2) Inventory Turnover Ratio:
Inventory turnover ratio is used to determine the speed of a company in
converting its inventories into sales.
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94 The formula used for calculating inventory turnover ratio is :
Inventory Turnover Rati o = Cost of Goods Sold / Average Inventories
3) Receivable Turnover Ratio:
Receivable turnover ratio is used to determine the efficiency of an
organization in collecting or realizing its account receivables.
The formula used for calculating t he receivable turnover ratio is:
Receivables Turnover Ratio = Net Credit Sales / Average Receivables
5. Earnings Ratios :
Earnings ratio is used for the purpose of determining the returns that an
organization generates for its investors.
The types of earnings ratios are :
1) Profit Earnings Ratio:
P/E ratio indicates the profit earning capacity of the company.
The formula used for the calculation of profit earnings ratio is:
Profit Earnings Ratio = Market Price per Share / Earnings per Share
2) Earnings per Share (EPS):
EPS signifies the earnings of an equity holder based on each share.
The formula used for EPS is:
EPS = (Net Income – Preferred Dividends) / (Weighted Average of
Outstanding Shares)
Conclusion – Ratio Analysis Types :
Ratio analysis lays the framework for financial analysis. Ratio analysis is
also used by the readers of the financial statements for gaining a better
understanding of the wellbeing of a company. A few basic types of ratios
used in ratio analysis are profitability ratios, debt or leverage ratio s,
activity ratios or efficiency ratios, liquidity ratios, solvency ratios,
earnings ratios, turnover ratios, and market ratios.
5.7 MEANING, NATURE AND SCOPE OF INVESTMENT DECISION Meaning of Investment Decision:
Investment decisions concerned with the al location of funds into different
investment opportunities for the purpose of earning the highest possible
return. It simply assists firms in selecting the right type of assets for
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95 Financial Analysis - I level managers who properly analyses each opportunity before investing
any fund into them.
Investment decisions are crucial decisions for every organization as it
determines its profitability. It should be ensured that a proper study is
done regarding the risk and return before committing any capital into
available investment avenues. Investment decisions are of two types: Long
term and short term investment decisions.
Long term investment decisions are concerned with the investment of
funds in long term assets and are termed as Capital budgeting. Whereas,
short term decisions relate to investment in short term assets which is also
called working capital management.
Nature of Investment Decision:
1. Require Huge Funds: Investment decisions requires a large amou nt
of funds to be deployed by firm for earning profits. These decisions
are very imperative and requires due attentions as firms have limited
funds but the demand for the funds is excessive. Every firm should
necessarily plan its investment programmes and control its
expenditures.
2. High Degree of Risk: These decisions involve a high amount of risk
as they are taken on the basis of estimated return. Large funds are
invested for earning income in future which is totally uncertain. These
return fluctuates w ith the changes in fashion, taste, research and
technological advancement thereby leading to a greater risk.
3. Long Term Effect: Investment decisions have a long lasting effects
on future profitability and growth of firm. These decisions decide the
posit ion of a firm in future. Any wrong decision may have very
adverse effects on return of an organization and may even endanger
its survival. Whereas, right decision taken brings good returns for firm
leading to better growth.
4. Irreversibility: Decisions r elated to investment are mostly
irreversible in nature. It is quite difficult to revert back from decisions
once taken related to the acquisition of permanent assets. Disposing
off these high value assets will cause heavy losses to firm.
5. Impacts Cost S tructure: Investment decisions widely impacts the
cost structure of an organization. Firms by taking these decisions
commit themselves to various fixed cost such as interest, rent,
insurance, supervision etc. for the sake of earning profits. If these
inves tments do not provide the anticipated return, then firm overall
cost will raise thereby causing losses.
6. Long term Commitment of Funds: Funds are deployed for a longer
term by organisations through these decisions. Firm deployed high
amount of capital f or long period on permanent basis. Financial risk in
investment decisions increases due to long term commitment of funds.
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96 7. Complexity: Investment decision are most complex decisions as they
are based on future events which is totally uncertain. Future cash
flows of an investment cannot be estimated accurately as they are
influenced by changes in economic, social, political and technological
factors. Therefore, uncertainty of future c onditions makes it difficult
to accurately predict the future returns.
Scope of Investment Decision:
1. Selection of Right Assets: Investment decisions help in choosing
right type of investment plan for deploying the funds. Each of
available opportunity is properly analyzed by management while
taking investment decisions. This way every aspect of asset available
for investment is taken into consideration which leads to building up a
strong portfolio.
2. Identify Degree of Risk: These decisions help in ident ifying the level
of risk associated with an investment opportunity. Decisions are taken
on the basis of expected return and risk required for earning such
return. Managers properly evaluate assets using various tools for
finding out the risk while taking i nvestment decisions.
3. Determines firm Profitability: Decisions regarding investment plans
determines the future profit earning potential of a firm. A right
decision may bring large amount of funds to an organization leading
to better growth. Whereas, any wrong decision regarding deployment
of funds may cause heavy losses and even adversely affect the
continuity of firm.
4. Enhance Financial Understanding: Investment decisions imparts
large amount of beneficial financial knowledge to individuals taking
these decisions. Investors while choosing the asset uses a variety of
tools and techniques for analyzing its profitability. It provides a lot of
information which enhances the overall financial knowledge and
enables investors in taking rational decisions rega rding investment.
5. National Importance: These decisions are of national importance for
a nation as it leads to overall development and growth. Investment
decisions taken determines the level of employment, economic
growth and economic activities in a cou ntry. More amount of
investment creates better supply of funds in an economy which
increase the pace of overall economic development.
5.8 MEANING AND TYPES OF CAPITAL BUDGETING OF A FIRM The capital budgeting process allocates a company’s investment funds to
major projects. The process becomes more elaborate as organizations
become larger and the value and complexity of projects increase. Many
large companies have formal capital expenditure planning committees
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97 Financial Analysis - I expenditures. These committees generally consist of a team of experts
from across the company and its different disciplines including
accounting, finance, marketing, operations, and human resources. They
critically review all project s from their varying perspectives to ensure that
they are financially and operationally sound and consistent with the
company’s strategic plans. As the size of capital expenditures decrease
and become more routine, investment decision making is pushed dow n
into a company’s divisions and departments and the processes used to
assess projects become simpler. Most organizations establish cost limits
that determine which level of management has authority to approve a
project.
The five steps in the capital budg eting process include:
Step 1 - Project idea generation :
Ideas can be found internally or by scanning the external business
environment, benchmarking the company against its competitors, or
acquiring innovative companies or product ideas. Smaller invest ment
proposals may originate at the department level among junior managers
and line workers formed into autonomous work teams. As projects grow
in value, divisional and corporate management becomes more involved.
Pay and human resource systems at all lev els should be designed to
encourage employees to contribute.
Step 2 - Screening of proposals :
Before committing to an expensive evaluation of a project, the capital
expenditure planning committee or senior management will review the
project to ensure it has a reasonable chance of success and is consistent
with the company’s strategic plans.
Step 3 - Project evaluation :
A project’s profitability is determined using different evaluation methods
including payback period, discounted payback period, accounti ng rate of
return (ARR), net present value (NPV), internal rate of return (IRR), or
profitability indexes (PI). In addition to a thorough quantitative analysis,
business units must also prepare a written description and justification
which describes how t he project supports the organization’s strategic
goals. All forecasts should be consistent with a common economic
outlook provided by the company.
Step 4 - Preparation of the capital budget :
All unprofitable or strategically undesirable projects are elim inated and
the remaining projects are ranked based on their profitability along with
any resource constraints such as limited funding or a lack of manpower
availability. Some projects are mandatory and must be done in order to
comply with health and safet y or environmental regulations in which case
the goal to complete the project efficiently. Others may lose money but
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98 a new industry or to development new competencies in hopes of ea rning
positive returns in the future. Pet projects championed by influential
managers that usually do not go through the normal approval process or
are approved based on overly optimistic projections should be avoided.
Step 5 - Monitoring and post -complet ion audits :
During implementation, a project must be monitored on an ongoing basis
to ensure that construction targets are met, there are no cost overruns, and
key inputs such as the price of the product do not need to be adjusted. If
problems arise, th e company has to decide whether to stay the course, alter
its plans, or abandon the project. Post -completion audits also occur at the
end of a project to help improve a company’s capital budgeting system.
Benefits include:
 Ascertains why variation betwee n planned and actual performance
occurred so any lessons learned can be applied to current and future
projects.
 Strengthens a manager’s estimating abilities by holding them
accountable for their forecasts and project selections.
 Detects biases by managers who consistently over estimate benefits or
underestimate costs.
 Discourages pet projects by influential managers.
 Provides an excellent training opportunity for new managers and can
be part of their performance review.
 Provides an excellent source of new p roject ideas.
Monitoring and post -completion audits should be conducted by
individuals who are not involved in the project selection process to ensure
their objectivity and help eliminate the psychological and internal political
barriers to cancelling a pr oject. Once a manager or business unit receives
approval for a project, they are very hesitant to admit that they might have
made a mistake and relinquish resources. Losses will continue longer than
necessary especially if these managers are able to use their connections
within the organization to gather support.
Project Evaluation Methods :
1. Net present value (NPV) : This is the present value of a project’s
future cash flows minus the initial investment or its profitability in
dollar terms. The discount rate used to determine the present value of
future cash flows is the RRR that investors require to be fairly
compensated for a project’s risk. A project with a positive NPV is
generating a higher return than the RRR or what economists call
excess profits . In competitive markets, there should be few excess
profits due to the entry of new competitors. The advantages of this
method are the NPV is in dollars so it can be added directly to the
company’s market value to determine the effect on share price. A lso, munotes.in

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99 Financial Analysis - I the RRR can be adjusted to reflect the varying risk levels of different
projects or specific cash flows within project. In order to maximize a
company’s share price, all positive NPV projects should be accepted.
Excel provides a function to calculat e a project’s NPV.
2. Internal rate of return (IRR) : This a project’s rate of return that
equates its initial investment with its future cash flows. If the IRR
was used as the RRR, a project’s NPV would be zero. The difference
between the IRR and RRR is the project’s excess profits expressed as
a percentage. Some company’s prefer IRR because it is easier to
communicate than NPV which is in dollars. IRR can also be used if a
company cannot accurately estimate its RRR. Its disadvantages are
IRR cannot be adjusted for the risk of specific projects or cash flows
like the RRR. Also, IRR has a number of mathematical problems that
may result in the wrong project being selected.
3. Discounted payback period : This is the time it takes to recover a
project’s ini tial investment from its discounted future cash flows. The
advantages and disadvantage of this method are similar to the payback
period method except present value is used and the discount rate can
be adjusted to reflect varying levels of risk. If a proj ect pays back its
investment on a discounted basis it will make a profit, but it still may
be rejected if the arbitrary cut -off point is not reached.
5.9 QUESTIONS Q.1 Explain the meaning and importance of funds flow statement.
Q.2 Define income statemen t. Give the importance of income statement.
Q.3 What are the types of Ratio analysis.
Q.4 Discuss the scope of investment decision.
Q.5 Explain the meaning and types of capital Budgeting of a firm.


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100 6
FINANCIAL ANAL YSIS - II
Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Meaning and Importance of Cost o f Capital
6.3 Capital Asset Pricing Model (C APM )
6.4 Weighted Average Cost of Capital (W ACC )
6.5 Capital Structure
6.6 Modigliani - Miller T heorem
6.7 Questions
6.8 References
6.0 OBJECTIVES After going through this unit, you must be able to understand:
 Meaning and Importance of Cost of Capital
 Model of Capital Asset Pricing
 Model of Weighted Average Cost of Capital
 Srtucture of the Capital
 Modigliani - Miller Theorem
6.1 INTRODUCTION Cost of capital is an integral part of investment decision as it is used to
measure the worth of investment proposal provided by the business
concern. It is used as a discount rate in determining the present va lue of
future cash flows associated with capital projects. Cost of capital is also
called as cut -off rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance manager
must take careful de cision with regard to the cost of capital; because it is
closely associated with the value of the firm and the earning capacity of
the firm.
6.2 MEANING AND IMPORTANCE OF COST OF CAPITAL Meaning of Cost of Capital:
Cost of capital is the rate of return th at a firm must earn on its project
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101 Financial Analysis - II Cost of capital is the required rate of return on its investments which
belongs to equity, debt and retained earnings. If a firm fails to earn return
at the exp ected rate, the market value of the shares will fall and it will
result in the reduction of overall wealth of the shareholders.
Definitions:
The following important definitions are commonly used to understand the
meaning and concept of the cost of capital.
According to the definition of Joh n J. Hampton “ Cost of capital is the rate
of return the firm required from investment in order to increase the value
of the firm in the market place”.
According to the definition of Solomon Ezra, “Cost of capital is the
minimum required rate of earnings or the cut -off rate of capital
expenditure”.
According to the definition of James C. Van Horne, Cost of capital is “A
cut-off rate for the allocation of capital to investment of projects. It is the
rate of return on a pr oject that will leave unchanged the market price of the
stock”.
According to the definition of William and Donaldson, “Cost of capital
may be defined as the rate that must be earned on the net proceeds to
provide the cost elements of the burden at the tim e they are due”.
Importance:
The determination of the firm's cost of capital is important from the point
of view of the following:
i) It is the basis of appraising new capital expenditure proposals. This
gives the acceptance / rejection criterion for capi tal expenditure
projects.
ii) The finance manager must raise capital from different sources in a
way that it optimizes the risk and cost factors. The source of funds
which have less cost involve high risk. Cost of capital helps the
managers in determining the optimal capital structure.
iii) It is the basis for evaluating the financial performance of top
management.
iv) It helps in formulating appropriate dividend policy.
v) It also helps the organization in developing an appropriate working
capital po licy.
6.3 CAPITAL ASSET PRICING MODEL (CAPM) The Capital Asset Pricing Model (CAPM) describes the relationship
between systematic risk, or the general perils of investing, and expected
return for assets, particularly stocks. CAPM evolved as a way to measu re munotes.in

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102 this systematic risk. It is widely used throughout finance for pricing risky
securities and generating expected returns for assets, given the risk of
those assets and cost of capital.
Understanding the Capital Asset Pricing Model (CAPM) :
The formula for calculating the expected return of an asset, given its risk,
is as follows:

Investors expect to be compensated for risk and the time value of money.
The risk -free rate in the CAPM formula accounts for the time value of
money. The other components of the CAPM formula account for the
investor taking on additional risk.
The beta of a potential investment is a measure of how much risk the
investment will add to a portfolio that looks like the market. If a stock is
riskier than the market, it will have a beta greater than one. If a stock has a
beta of less than one, the formula assumes it will reduce the risk of a
portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the
return expected from the market above the risk -free rate. The risk-free rate
is then added to the product of the stock’s beta and the market risk
premium. The result should give an investor the required return or
discount rate that they can use to find the value of an asset.
The goal of the CAPM formula is to evaluat e whether a stock is fairly
valued when its risk and the time value of money are compared with its
expected return. In other words, by knowing the individual parts of the
CAPM, it is possible to gauge whether the current price of a stock is
consistent with its likely return.
For example, imagine an investor is contemplating a stock valued at $100
per share today that pays a 3% annual dividend. The stock has a beta
compared with the market of 1.3, which means it is riskier than a market
portfolio. Also, assu me that the risk -free rate is 3% and this investor
expects the market to rise in value by 8% per year.
The expected return of the stock based on the CAPM formula is
9.5%:
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103 Financial Analysis - II The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding
period. If the discounted value of those future cash flows is equal to $100,
then the CAPM formula indicates the stock is fairly valued relative to risk.
Problems with the CAPM :
Several assumptions behind the CAPM formula have been shown not to
hold up in reality. Modern financial theory rests on two assumptions:
1. Securities markets are very competitive and efficient (that is, relevant
information about the companies is quickly and universally
distributed and absorbed).
2. These markets are dominated by rational, risk -averse investors, who
seek to maximize satisfaction from returns on their investments.
As a result, it’s not entirely clear whether CAPM works. The big sticking
point is beta. When professors Eugene Fama and Kenneth French looked
at share returns on the New York Stock Exchange, the American Stock
Exchange, and Nasdaq, t hey found that differences in betas over a lengthy
period did not explain the performance of different stocks. The linear
relationship between beta and individual stock returns also breaks down
over shorter periods of time. These findings seem to suggest t hat CAPM
may be wrong.
Despite these issues, the CAPM formula is still widely used because it is
simple and allows for easy comparisons of investment alternatives.
Including beta in the formula assumes that risk can be measured by a
stock’s price volatilit y. However, price movements in both directions are
not equally risky. The look -back period to determine a stock’s volatility is
not standard because stock returns (and risk) are not normally distributed.
The CAPM also assumes that the risk -free rate will r emain constant over
the discounting period. Assume in the previous example that the interest
rate on U.S. Treasury bonds rose to 5% or 6% during the 10 -year holding
period. An increase in the risk -free rate also increases the cost of the
capital used in th e investment and could make the stock look overvalued.
The market portfolio used to find the market risk premium is only a
theoretical value and is not an asset that can be purchased or invested in as
an alternative to the stock. Most of the time, investor s will use a major
stock index, like the S&P 500, to substitute for the market, which is an
imperfect comparison.
The most serious critique of the CAPM is the assumption that future cash
flows can be estimated for the discounting process. If an investor co uld
estimate the future return of a stock with a high level of accuracy, then the
CAPM would not be necessary.
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104 Practical Value of the CAPM :
Considering the critiques of the CAPM and the assumptions behind its use
in portfolio construction, it might be dif ficult to see how it could be useful.
However, using the CAPM as a tool to evaluate the reasonableness of
future expectations or to conduct comparisons can still have some value.
Assume in this example that the peer group’s performance over the last
few ye ars was a little better than 10% while this stock had consistently
underperformed, with 9% returns. The investment manager shouldn’t take
the advisor’s recommendation without some justification for the increased
expected return.
An investor also can use th e concepts from the CAPM and the efficient
frontier to evaluate their portfolio or individual stock performance vs. the
rest of the market. For example, assume that an investor’s portfolio has
returned 10% per year for the last three years with a standard deviation of
returns (risk) of 10%. However, the market averages have returned 10%
for the last three years with a risk of 8%.
The investor could use this observation to reevaluate how their portfolio is
constructed and which holdings may not be on the SML . This could
explain why the investor’s portfolio is to the right of the CML. If the
holdings that are either dragging on returns or have increased the
portfolio’s risk disproportionately can be identified, then the investor can
make changes to improve ret urns. Not surprisingly, the CAPM contributed
to the rise in the use of indexing, or assembling a portfolio of shares to
mimic a particular market or asset class, by risk -averse investors. This is
largely due to the CAPM message that it is only possible to earn higher
returns than those of the market as a whole by taking on higher risk (beta).
6.4 WEIGHTED AVERAGE COST OF CAPITAL (WACC) Weighted average cost of capital (WACC) represents a firm’s average
after-tax cost of capital from all sources, including c ommon stock,
preferred stock, bonds, and other forms of debt. WACC is the average rate
that a company expects to pay to finance its assets.
WACC is a common way to determine required rate of return (RRR)
because it expresses, in a single number, the return that both bondholders
and shareholders demand to provide the company with capital. A firm’s
WACC is likely to be higher if its stock is relatively volatile or if its debt
is seen as risky because investors will require greater returns.
WACC and its formu la are useful for analysts, investors, and company
management —all of whom use it for different purposes. In corporate
finance, determining a company’s cost of capital is vital for a couple of
reasons. For instance, WACC is the discount rate that a company uses to
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105 Financial Analysis - II WACC is also important when analyzing the potential benefits of taking
on projects or acquiring another business. For example, if the company
believes that a merger will generate a return higher than its cost of capi tal,
then it’s likely a good choice for the company. If its management
anticipates a return lower than what their own investors are expecting,
then they’ll want to put their capital to better use.
As the majority of businesses run on borrowed funds, the co st of capital
becomes an important parameter in assessing a firm’s potential for net
profitability. WACC measures a company’s cost to borrow money. The
WACC formula uses both the company’s debt and equity in its
calculation.
In most cases, a lower WACC ind icates a healthy business that’s able to
attract investors at a lower cost. By contrast, a higher WACC usually
coincides with businesses that are seen as riskier and need to compensate
investors with higher returns.
If a company only obtains financing thr ough one source —say, common
stock —then calculating its cost of capital would be relatively simple. If
investors expected a rate of return of 10% to purchase shares, the firm’s
cost of capital would be the same as its cost of equity: 10%.
The same would be true if the company only used debt financing. For
example, if the company paid an average yield of 5% on its outstanding
bonds, its cost of debt would be 5%. This is also its cost of capital.

WACC is calculated by multiplying the cost of each capital so urce (debt
and equity) by its relevant weight and then adding the products together.
In the above formula, E/V represents the proportion of equity -based
financing, while D/V represents the proportion of debt -based financing.
The WACC formula thus involves the summation of two terms:
The former represents the weighted value of equity capital, while the latter
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106

Cost of equity can be a bit tricky to calculate because share capital does
not technically have an ex plicit value. When companies reimburse
bondholders, the amount they pay has a predetermined interest rate. On
the other hand, equity has no concrete price that the company must pay.
As a result, companies have to estimate cost of equity —in other words, the
rate of return that investors demand based on the expected volatility of the
stock.
Because shareholders will expect to receive a certain return on their
investments in a company, the equity holders’ required rate of return is a
cost from the company’s pe rspective; if the company fails to deliver this
expected return, shareholders will simply sell off their shares, which leads
to a decrease in both share price and the company’s value. The cost of
equity, then, is essentially the total return that a company must generate to
maintain a share price that will satisfy its investors.
Companies typically use the Capital Asset Pricing Model (CAPM) to
arrive at the cost of equity (in CAPM, it’s called the expected return of
investment). Again, this is not an exact c alculation because firms have to
lean on historical data, which can never accurately predict future growth.
Determining cost of debt (Rd), on the other hand, is a more
straightforward process. This is often done by averaging the yield to
maturity for a com pany’s outstanding debt. This method is easier if you’re
looking at a publicly traded company that has to report its debt
obligations.
For privately owned companies, one can look at the company’s credit
rating from firms such as Moody’s and S&P and then ad d a relevant
spread over risk -free assets (for example, Treasury notes of the same
maturity) to approximate the return that investors would demand.
Businesses are able to deduct interest expenses from their taxes. Because
of this, the net cost of a company ’s debt is the amount of interest it is
paying minus the amount it has saved in taxes. This is why Rd (1 - the
corporate tax rate) is used to calculate the after -tax cost of debt.
Limitations of WACC :
The WACC formula seems easier to calculate than it real ly is. Because
certain elements of the formula, such as the cost of equity, are not
consistent values, various parties may report them differently for different
reasons. As such, although WACC can often help lend valuable insight
into a company, one should always use it along with other metrics when
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107 Financial Analysis - II The WACC can be difficult to calculate if you’re not familiar with all the
inputs. Higher debt levels mean that the investor or company will require
higher WACCs. More complex balance sheets, such as varying types of
debt with various interest rates, make it more difficult to calculate WACC.
There are many inputs to calculating WACC —such as interest rates and
tax rates —all of which can be affected by market and economic
conditions.
Also, WACC is not suitable for accessing risky projects because to reflect
the higher risk, the cost of capital will be higher. Instead, investors may
opt to use adjusted present value (APV), which does not use WACC.
6.5 CAPITAL STRUCTURE Capi tal structure is the particular combination of debt and equity used by a
company to finance its overall operations and growth.
Equity capital arises from ownership shares in a company and claims to its
future cash flows and profits. Debt comes in the form of bond issues or
loans, while equity may come in the form of common stock, preferred
stock, or retained earnings. Short -term debt is also considered to be part of
the capital structure.
Understanding Capital Structure :
Both debt and equity can be found on the balance sheet. Company assets,
also listed on the balance sheet, are purchased with debt or equity. Capital
structure can be a mixture of a company's long -term debt, short -term debt,
common stock, and preferred stock. A company's proportion of short -term
debt versus long -term debt is considered when analyzing its capital
structure.
When analysts refer to capital structure, they are most likely referring to a
firm's debt -to-equity (D/E) ratio, which provides insight into how risky a
company's borrowing practices are. Usually, a company that is heavily
financed by debt has a more aggressive capital structure and therefore
poses a greater risk to investors. This risk, however, may be the primary
source of the firm's growth.
Debt is one of the two main ways a company can raise money in the
capital markets. Companies benefit from debt because of its tax
advantages; interest payments made as a result of borrowing funds may be
tax-deductible. Debt also allows a company or business to retain
ownership, unlike eq uity. Additionally, in times of low -interest rates, debt
is abundant and easy to access.
Equity allows outside investors to take partial ownership of the company.
Equity is more expensive than debt, especially when interest rates are low.
However, unlike d ebt, equity does not need to be paid back. This is a
benefit to the company in the case of declining earnings. On the other
hand, equity represents a claim by the owner on the future earnings of the
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108 Companies that use more debt than equity to fina nce their assets and fund
operating activities have a high leverage ratio and an aggressive capital
structure. A company that pays for assets with more equity than debt has a
low leverage ratio and a conservative capital structure. That said, a high
levera ge ratio and an aggressive capital structure can also lead to higher
growth rates, whereas a conservative capital structure can lead to lower
growth rates.
Analysts use the D/E ratio to compare capital structure. It is calculated by
dividing total liabilit ies by total equity. Savvy companies have learned to
incorporate both debt and equity into their corporate strategies. At times,
however, companies may rely too heavily on external funding and debt in
particular. Investors can monitor a firm's capital stru cture by tracking the
D/E ratio and comparing it against the company's industry peers.
Firms in different industries will use capital structures better suited to their
type of business. Capital -intensive industries like auto manufacturing may
utilize more debt, while labor -intensive or service -oriented firms like
software companies may prioritize equity.
Assuming that a company has access to capital (e.g. investors and
lenders), they will want to minimize their cost of capita l. This can be done
using a weighted average cost of capital (WACC) calculation. To calculate
WACC the manager or analyst will multiply the cost of each capital
component by its proportional weight.
6.6 MODIGLIANI - MILLER THEOREM Introduction :
According to many research of corporation finance, the capital structure
decision is one of the most fundamental issues facing to the executives and
management level. The corporate finance is a specific area of finance
dealin g with the financial decisions corporations make and the tools as
well as analysis used to make these decisions. The discipline as a whole
may be divided among long -term and short -term decisions and techniques
with the primary goal being maximizing corpora te value while managing
the firm’s financial risks. Capital investment decisions are long -term
choices that investment with equity or debt, and the short -term decisions
deals with the balance of current assets and current liabilities which is
managing cash , inventories, and short -term borrowing and lending.
Corporate finance can be defined as the theory, process and techniques
that corporations use to make the investing, financing and dividend
decisions that ultimately contribute to maximizing corporate val ue.Thus, a
corporation will first decide in which projects to invest, then it will figure
out how to finance them, and finally, it will decide how much money, if
any, to give back to the owners. All these three dimensions which are
investing, financing and distributing dividends are interrelated and
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109 Financial Analysis - II The capital structure of a company refers to a combination of debt,
preferred stock, and common stock of finance that it uses to fund its long -
term financing. Equity and debt capital are the two major sources of long -
term funds for a firm. The theory of capital structure is closely related to
the firm’s cost of capital. As the enterprises to obtain funds need to pay
some costs, the cost of capital in the investment activities is also the main
consideration of rate of return. The weighted average cost of capital
(WACC) is the expected rate of return on the market value of all of the
firm’s securities. WACC depends on the mix of different securities in the
capital structure; a change in the mix o f different securities in the capital
structure will cause a change in the WACC. Thus, there will be a mix of
different securities in the capital structure at which WACC will be the
least. The decision regarding the capital structure is based on the object ive
of achieving the maximization of shareholders wealth.
With regard to the capital structure of the theoretical basis, most well -
known theory is Modigliani -Miller theorem of Franco Modigliani and
Merton H.Miller (1958 and 1963). Yet the seeming simple qu estion as to
how firms should best finance their fixed assets remains a contentious
issue.
Modigliani -Miller Proposition I :
The Modigliani -Miller Proposition I Theory (MM I) states that under a
certain market price process, in the absence of taxes, no tran saction costs,
no asymmetric information and in an perfect market, the cost of capital
and the value of the firm are not affected by the changed in capital
structure. The firm’s value is determined by its real assets, not by the
securities it issues. In ot her words, capital structure decisions are irrelevant
as long as the firm’s investment decisions are taken as given.
The Modigliani and Miller (1958) explained the theorem was originally
proven under the assumption of no taxes. It is made up of two proposi tions
that are (i) the overall cost of capital and the value of the firm are
independent of the capital structure. The total market value of the firm is
given by capitalizing the expected net operating income by the rate
appropriate for that risk class. (i i) The financial risk increase with more
debt content in the capital structure. As a result, cost of equity increases in
a manner to offset exactly the low cost advantage of debt. Hence, overall
cost of capital remains the same.
The assumptions of the MM t heory are:
1. There is a perfect capital market. Capital markets are perfect when
 investors are free to buy and sell securities
 investors can trade without restrictions and can borrow or lend funds
on the same terms as the firms do
 investors behave ration ally
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110 Industrial Economics
110  capital markets are efficient
 no costs of financial distress and liquidation
 there are no taxes
2. Firms can be classified into homogeneous business risk classes. All
the firms in the same ri sk class will have the same degree of financial
risk.
3. All investors have the same view for the investment, profits and
dividends in the future; they have the same expectation of a firm’s net
operating income.
4. The dividend payout ration is 100%, whi ch means there are no
retained earnings.
In the absence of tax world, base on MM Proposition I, the value of the
firm is unaffected by its capital structure. In other words, regardless of
whether a company has liabilities, the total risk of its securities holders
will not change even the capital structure is changed. As the weighted
average cost of capital unchanged, so must the same as the total value of
the company. That is VL = VU = EBIT/ requity where VL is the value of a
levered firm = price of buying a firm that is composed of some mix of
debt and equity, VU is the value of an unlevered firm = price of buying a
firm composed only of equity and EBIT is earnings before interest and
tax. Whether or not the company has loans or the loans for high or low,
investors are all accessible through the following two kinds of investment
on their own to create the desired type of earning.
1. direct invested in the company’s stock borrowing
2. if shares of levered firms are priced too high, investors will try to tak e
advantage of borrowing on their own and use the money to buy shares
in unlevered firms. The use of debt by the investors is known as
homemade leverage.
The investors of homemade leverage can obtain the same return as the
levered firms, therefore, for inv estors; the value of the firm is not affected
by debt -equity mix.
The MM Proposition I assumptions are quite unrealistic, there have some
implications, (i) Capital structure is irrelevant to shareholder wealth
maximization. (ii) The value of the firm is de termined by the firm’s capital
budgeting decisions. (iii) Increasing the extent to which a firm relies on
debt increases both the risk and the expected return to equity – but not the
price per share. (iv) Milton Harris and Artur Raviv (1991) illustrated th e
asymmetric information that firm managers or insiders are assumed to
possess private information about the characteristics of the firm’s return
stream or investment opportunities. They will know more about their
companies’ prospects, risks and values tha n do outside investors. Then it
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111 Financial Analysis - II Based on the inadequate of MM Proposition I, Franco Modigliani and
Merton H.Miller revised their theory in 1963, which is MM Proposition II.
Modigliani -Miller Proposition II :
The Modigliani -Miller Proposition II Theory (MM II) defines cost of
equity is a linear function of the firm’s debt/equity -ratio. According to
them, for any firm in a given risk class, the cost of equity is equal to the
constant average cost of capital plus a premium for the financial risk,
which is equal to debt/equity ratio times the spread between average cost
and cost of debt. Also Modigliani and Miller (1963) recognized the
importance of the existence of corporate taxes. Accordingly, they agreed
that th e value of the firm will increase or the cost of capital will decrease
with the use of debt due to tax deductibility of interest charges. Thus, the
value of corporation can be achieved by maximizing debt component in
the capital structure.
This theory of capital structure for the study provided an important and
analytical framework. According to this approach, value of a firm is VL =
VU = EBIT (1 -T) / requity + TD where TD is tax savings. MM
Proposition II is assuming that the tax shield effect of each is the same,
and continued in sight. Leverage firms are increased in interest expense
due to reduced tax liability, has also increased the allocation to the
shareholders and creditors of the cash flow. The above formula can be
deduced from the company debt th e more the greater the tax saving
benefits, the greater the value of the company. The revised capital
structure of the MM Proposition II, pointed out that the existence of tax
shield in a perfect capital market conditions cannot be reached, in an
imperfect financial market, the capital structure changes will affect the
company’s value. Therefore, the value and cost of capital of corporation
with the capital structure changes in different leverage, the value of the
levered firm will exceed the value of the u nlevered firm.
MM Proposition theory suggests that the higher the debt ratio is more
favorable to corporate, but though borrowing adds an interest tax shield it
may lead to costs of financial distress. Financial distress occurs when
promises to creditors a re broken or honored with difficulty. Financial
distress may lead to bankruptcy. The trade -off theory of capital structure
theory in MM based on the added risk of bankruptcy and further improves
the capital structure theory, to make it more practical signi ficance.
Conclusion :
The capital structure decision is one of the most fundamental issues in
corporate finance. Regardless of which kind of capital structure, to achieve
one of the most optimal capital structures, the company should be mixture
of equity an d debt and it cannot only focus on equity or debt. Equity is a
cushion and debt is a sword, debt is always cheaper than equity, partly
because lenders bear less risk and partly because of the tax advantage
associated with debt. In general, there are differ ences in the capital
structures of different industries; they are having their own characteristic.
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112 Industrial Economics
112 making the decision of how to allocate the fund in which type of assets,
the com pany has to consider and compare the different factors such as
NPV, IRR and payback period. In evaluating the NPV, IRR and payback
period, cash inflow is fund of the vital element. Therefore the company
should know how to obtain the financing and how to in vest it. They should
carefully to allocate their resources to maximize the firm value.
6.7 QUESTIONS 1. Write the Meaning and Importance of Cost of Capital.
2. What are the Determining components of Cost of Capital?
3. Explain the Model of Capital Asset Pricing.
4. Explain Model of Weighted Average Cost of Capital.
5. Write a note on Srtucture of the Capital.
6. Analyse the Modigliani - Miller Theorem.
6.8 REFERENCES  Bruner, R.F., K.M. Eades, R.S. Harris and R.C. Higgins, 1998, Best
Practices in Estimating the Cost of Capit al: Survey and Synthesis,
Financial Practice and Education
 Cooper, I. and E. Kaplanis, 1995, Home Bias in Equity Portfolios and
the Cost of Capital for Multinational Firms, Journal of Applied
Corporate Finance, v8(3)
 Eberhardt, M.C., 1994, The Search for V alue: Measuring the
Company's Cost of Capital, Harvard Business School Press.
 Keck, T., E. Levengood, and A. Longfield, 1998, Using Discounted
Cash Flow Analysis in an International Setting: A Survey of Issues in
Modeling the Cost of Capital, Journal of Ap plied Corporate Finance,
v11(3), 82 -99.
 Modigliani, F. and M. Miller, 1958, The Cost of Capital, Corporation
Finance and the Theory of Investment, American Economic Review,
v48, 261 -297.

*****
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113 MODULE - IV
7
INDIAN INDUSTRY - I
Unit Structure
7.0 Objectives
7.1 Introduction to Industrial Growth
7.2 Trends in Industrial Growth in India
7.3 Industrial Location (Factors) and Location Policy in India
7.3.1 Industrial Location (Factors)
7.3.2 Indu strial Policy in India
7.4 Questions
7.0 OBJECTIVES The main objectives behind the study of this unit are as follows:
 To study the concept of industrial growth.
 To see the trends in industrial growth in India.
 To study industrial factors in India.
 To stu dy the location policy in India.
7.1 INTRODUCTION TO INDUSTRIAL GROWTH  Industry or the secondary sector of the economy is another important
area of economic activity. After independence, the government of
India emphasized the role of industrialization in the country’s
economic development in the long run. Accordingly, the blue print for
industrial development was made through the Industrial
Policy Resolution (IPR) in 1956.
 The 1956 policy emph asized on establishment of heavy industries
with public sector taking the lead in this area. Adoption of heavy or
basic industries strategy was justified on the ground that it will reduce
the burden on agriculture, enable growth in the production of
consum er goods industries as well as small industries that are helpful
for employment generation and achieving self reliance.
 After the adoption of the IPR, 1956 there was tremendous growth in
industrialization during the second and third plan periods i.e. 1956 -61
and 1961 -66. Public sector contributed maximum to this growth.
 But towards the end of 1960s, investment in industries was reduced
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114 Industrial Economics
114  In the 1980s, this trend was reversed and investment in industries was
increased by making the infrastructure base such as power, coal, rail
much stronger.
 In early 1990s it was found that the public sector undertakings were
not performing upto expectation. There has been reports of
mismanagement in these under takings resulting in los s. So in 1991
the government of Indian decided to encourage the role of private
sector in industrial development, remove the rigid licence system
which is known as liberalization and allow international players to
compete in the domestic country as well as domestic players to
explore foreign territories.
 The aim of taking all these steps was to strengthen the process of
industrialization in the country. Such a model of industrial
development is called Liberalization, Privatization and Globalization
(LPG) model . After the adoption of this new policy in 1991, there has
been phases of growth followed by slowdown in the industrial
development process.
 In the early years of 1990s there was significant growth in
industrialization due to increase in investment in infrastructure,
reduction in excise duty, availability of finance etc.
 But towards the end of 1990s the growth rate slowed down due to stiff
competition from international companies, inadequate infrastructure
support etc. However, in the beginning of the new millennium,
between 2002 -08 there was again some recovery due to increase in
saving rate from 23.5 percent in 2001 -2 to 37.4 percent in 2007 - 08.
 Even the competition from the foreign companies helped during this
phase as the domestic companies could create enough internal
strengt h in term of quality control, finance and customer care etc. to
withstand the competition. However after 2008 -09 there was some
slow down in industrial growth due to rise in petroleum price, interest
rate and borrowings from abroad which has created lot of liabilities
for the domestic companies.
7.2 TRENDS IN INDUSTRIAL GROWTH IN INDIA  Industry or the secondary sector of the economy is another
important area of economic activity. After independence, the
government of India emphasized the role of industrialization in
the country’s economic development in the long run.
Accord ingly, the blue print for industrial development was made
through the Industrial Policy Resolution (IPR) in 1956.
 The 1956 p olicy emphasized on establishment of heavy
industries with public sector taking the lead in this area.
Adoption of heavy or basic industries strategy was justified on
the ground that it will reduce the burden on agriculture, enable
growth in the production of consumer goods industries as well as munotes.in

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115 Indian Industry - I small industries that are helpful for employment generation and
achieving self reliance.
 After the adoption of the IPR, 1956 there was tremendous
growth in industrialization during the second and third plan
periods i.e. 1956 -61 and 1961 -66. Public sector contributed
maximum to this growth.
 But towards the end of 1960s, investment in industries was
reduced which adversely affected its growth rate.
 In the 1980s, this trend was reversed and investment in
industries was increased by making the infrastructure base such
as power, coal, rail much stronger.
 In early 1990s it was found that the public sector undertakings
were not performing upto expectation. There has been reports of
mismanagement in these under takings result ing in loss. So in
1991 the government of Indian decided to encourage the role of
private sector in industrial development, remove the rigid
licence system which is known as liberalization and allow
international players to compete in the domestic country as well
as domestic players to explore foreign territories.
 The aim of taking all these steps was to strengthen the process of
industrialization in the country. Such a model of industrial
development is called Liberalization, Privatization and
Globalization (LPG) model . After the ad option of this new
policy in 1991, there has been phases of growth followed by
slowdown in the industrial development process.
 In the early years of 1990s there was significant growth in
industrialization due to increase in investment in infrastructure,
reduction in excise duty, availability of finance etc.
 But towards the end of 1990s the growth rate slowed down due
to stiff competition from international companies, inadequate
infrastructure support etc. However, in the beginning of the new
millennium, bet ween 2002 -08 there was again some recovery
due to increase in saving rate from 23.5 percent in 2001 -2 to
37.4 percent in 2007 - 08.
 Even the competition from the foreign companies helped during
this phase as the domestic companies could create enough
intern al strength in term of quality control, finance and customer
care etc. to withstand the competition. However after 2008 -09
there was some slow down in industrial growth due to rise in
petroleum price, interest rate and borrowings from abroad which
has crea ted lot of liabilities for the domestic companies.
The structure of industries is dynamic and keep changing from time to
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116 Industrial Economics
116 growth during the planning era can be divided into four phases di scussed
as follows
1. First Phase of High Growth
2. Second Phase of Industrial Retrogression
3. Third Phase of Industrial Recovery
4. Fourth phase of Industrial Reforms
1. First Phase of High Growth:
The first phase was of high growth between beginning of fi rst plan to end
of third plan i.e. 1950 -51 to 1965 -66. During this period, the central
government led by Nehru laid great emphasis on industrialisation;
particularly since the Second five year plan. Under the Industrial Policy of
1948 and 1956, huge public investment in heavy industries was done
because such investment was thought to be out of capital -raising capacity
of the private sector. During this phase, average industrial growth was
nearly 9%.
2. Second Phase of Industrial Retrogression:
Second Phase between 1966 to 1980 is called Low Growth Phase or
phase of Industrial Deceleration in India or “Industrial
retrogression” during fourth and fifth plan. During this phase, the average
Industrial growth rate remained 4.1%. However, the capital goods
industr ies registered a high growth during this period. There are several
explanations of this phenomenon of Industrial retrogression between
1966 -1980.
 As per the government, the wars of 1965 and 1971, back -to-back
drought conditions, infrastructural bottlenecks were responsible.
 Some scholars held low farm growth responsible for slowdown,
because it restricted the supply of raw materials.
 Others blamed the small size of market for industrial goods. Their
argument was that such goods were not in the reach of the people
beyond top 10% of the population (by income) because of huge
inequalities of income and wealth. Once that market got saturated,
there was no further expansion among the other strata of the
population.
 Few more other blamed the wrong industrial / oth er government
policies that led to complex licensing system, inefficient control and
infrastructure bottlenecks.
3. Third Phase of Industrial Recovery:
The third phase from 1980s to 1991 can be called phase of Industrial
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117 Indian Industry - I  The main cause of this revival was gradual liberalization of the
industrial licensing.
 The green revolution resulted in increased prosperity of the large
farmers in some parts of the country, that led to increased deman d of
farm mechanization.
 Further, the government had taken several other budgetary / fiscal
measures aimed at infrastructure investment. These measures included
maintenance of heavy budgetary deficit and huge public borrowing
(to invest in infra).
 This per iod saw a changed consumption pattern in favour of
Consumer durables. People started having Radio sets, TVs, VCRs,
Refrigerators, Bikes, Scooters etc. in their homes. This was the reason
that the consumer durable were called the “forefront of growth”
durin g this phase.
4. Fourth phase of Industrial Reforms:
The manufacturing growth was in negative zone in 1991 -92 with a dismal
overall industrial growth of 0.8%. After that, the PV Narsimharao
government announced New Industrial Policy 1991 and growth started
taking pace. However, there was no sustainable economic growth initially.
As the Indian economy integrated with the rest of the global economy, it
started responding to global slowdowns and recovery.
7.3 INDUSTRIAL LOCATION (FACTORS) AND POLICY IN INDIA 7.3.1 Industrial Location (Factors):
The location of the industry at a particular place is the result of a number
of decisions taken at various levels. There are certain geographical factors
that facilitate this decision -making. There are other factors that fall outside
the subject matter of geography. The validity or importance of a factor
also changes with time and space.
Many important geographical factors involved in the location of individual
industries are of relative significance, e.g., availability o f raw materials,
power resources, water, labour, markets, and transport facilities.
But besides such purely geographical factors influencing industrial
location, there are factors of historical, human, political, and economic
nature which are now tending t o surpass the force of geographical
advantages. Consequently, the factors influencing the location of the
industry can be divided into two broad categories i.e.
 Geographical factors, and
 Non-geographical factors
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118 Industrial Economics
118 Geographical Factors:
Following are the im portant geographical factors influencing the location
of industries.
1. Raw Materials:
The significance of raw materials in the manufacturing industry is so
fundamental that it needs no emphasizing. Indeed, the location of
industrial enterprises is sometim es determined simply by the location of
the raw materials. Modern industry is so complex that a wide range of raw
materials is necessary for its growth.
Further, we should bear in mind that the finished product of one industry
may well be the raw material of another. For example, pig iron, produced
by the smelting industry, serves as the raw material for steel making
industry. Industries that use heavy and bulky raw materials in their
primary stage in large quantities are usually located near the supply of the
raw materials.
It is true in the case of raw materials which lose weight in the process of
manufacture or which cannot bear high transport costs or cannot be
transported over long distances because of their perishable nature. This
has been recognized s ince 1909 when Alfred Weber published his theory
of location of industry.
The jute mills in West Bengal, sugar mills in Uttar Pradesh, cotton textile
mills in Maharashtra, and Gujarat are concentrated close to the sources of
raw materials for this very rea son. Industries like iron and steel, which use
very large quantities of coal and iron ore, losing a lot of weight in the
process of manufacture, are generally located near the sources of coal and
iron ore.
Some of the industries, like watch and electronics industries use a very
wide range of light raw materials, and the attractive influence of each
separate material diminishes. The result is that such industries are often
located with no reference to raw materials and are sometimes referred to
as ‘footloose industries’ because a wide range of locations is possible
within an area of sufficient population density.
2. Power:
Regular supply of power is a prerequisite for the localization of industries.
Coal, mineral oil, and hydroelectricity are the three import ant
conventional sources of power. Most of the industries tend to concentrate
on the source of power.
The iron and steel industry which mainly depends on large quantities of
coking coal as source of power are frequently tied to coal fields. Others
like the electro -metallurgical and electrochemical industries, which are
great users of cheap hydroelectric power, are generally found in the areas
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119 Indian Industry - I As petroleum can be easily piped and electricity can be transmitted over
long distances by wires, it is possible to disperse the industry over a larger
area. Industries moved to southern states only when hydro -power could be
developed in these coal -deficient areas.
Thus, more than all other factors affecting the location of large and heavy
industries, quite often they are established at a point that has the best
economic advantage in obtaining power and raw materials.
Tata Iron and Steel Plant at Jamshedpur, the new aluminum producing
units at Korba (Chhattis garh) and Renukoot (Uttar Pradesh), the copper
smelting plant at Khetri (Rajasthan), and the fertilizer factory at Nangal
(Punjab) are near the sources of power and raw material deposits, although
other factors have also played their role.
3. Labour:
No on e can deny that the prior existence of a labour force is attractive to
industry unless there are strong reasons to the contrary. Labour supply is
important in two respects
(a) workers in large numbers are often required;
(b) people with skill or technica l expertise are needed.
Estall and Buchanan showed in 1961 that labour costs can vary between
62 percent in clothing and related industries to 29 percent in the chemical
industry; in the fabricated metal products industries they work out at 43
percent.
In our country, modern industry still requires a large number of workers in
spite of increasing mechanisation. There is no problem in securing
unskilled labour by locating such industries in large urban centres.
Although, the location of any industrial unit i s determined after a careful
balancing of all relevant factors, yet the light consumer goods and agro -
based industries generally require a plentiful of labour supply.
4. Transport:
Transport by land or water is necessary for the assembly of raw materials
and for the marketing of the finished products. The development of
railways in India, connecting the port towns with hinterland determined
the location of many industries around Kolkata, Mumbai and Chennai. As
industrial development also furthers the improv ement of transport
facilities, it is difficult to estimate how much a particular industry owes to
original transport facilities available in a particular area.
5. Market:
The entire process of manufacturing is useless until the finished goods
reach the mar ket. Nearness to market is essential for quick disposal of
manufactured goods. It helps in reducing the transport cost and enables the
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120 Industrial Economics
120 It is becoming more and more true that industries are seeking locations as
near as possible to their markets; it has been remarked that market
attractions are now so great that a market location is being increasingly
regarded as the normal one, and that a location elsewhere needs very
strong justification.
The ready market is most ess ential for perishable and heavy commodities.
Sometimes, there is a considerable material increase in weight, bulk or
fragility during the process of manufacture and in such cases industry
tends to be market -oriented.
6. Water:
Water is another important re quire-ment for industries. Many industries
are established near rivers, canals and lakes, because of this reason. The
iron and steel industry, textile industries and chemical industries require
large quantities of water, for their proper functioning.
7. Site:
Site requirements for industrial development are of considerable
significance. Sites, generally, should be flat and well served by adequate
transport facilities. Large areas are required to build factories. Now, there
is a tendency to set up industries in rural areas because the cost of land has
shot up in urban centres.
8. Climate:
Climate plays an important role in the establishment of industries at a
place. A harsh climate is not much suitable for the establishment of
industries. There can be no indu strial development in extremely hot,
humid, dry, or cold climates.
The extreme type of climate of northwest India hinders the development
of industries. In contrast to this, the moderate climate of west coastal area
is quite congenial to the development of industries. Because of this reason,
about 24 percent of India’s modem industries and 30 percent of India’s
industrial labour is concentrated in the Maharashtra -Gujarat region alone.
Cotton textile industry requires a humid climate because thread breaks in
dry climate. Consequently, the majority of cotton textile mills are
concentrated in Maharashtra and Gujarat. Artificial humidifiers are used in
dry areas these days, but it increases the cost of production.
Non-Geographical Factors:
Nowadays alternative r aw materials are also being used because of
modern scientific and technological developments. Availability of electric
power supply over wider areas and the increasing mobility of labour have
reduced the influence of geographical factors on the location of industries.
The non -geographical factors are those including economic, political,
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121 Indian Industry - I industries to a great extent. Following are some of the important non -
geographical factors influencing the location of industries.
1. Capital:
Capital or huge investment is needed for the establishment of industries.
Modern industries are capital -intensive and require huge investments.
Capitalists are available in urban centres. Big cities like Mumbai, Kolkata ,
Delhi, and Chennai are big industrial centres, because the big capitalists
live in these cities.
2. Government Policies:
Government activity in planning the future distribution of industries, for
reducing regional disparities, elimination of pollution of air and water and
for avoiding their heavy clustering in big cities, has become no less an
important locational factor.
There is an increasing trend to set up all types of industries in an area,
where they derive common advantage of water and power and su pply to
each other the products they turn out. The latest example in our country is
the establishment of a large number of industrial estates all over India
even in the small -scale industrial sector.
It is of relevance to examine the influence of India’s F ive Year plans on
industrial location in the country. The emergence of suitable industries in
south India around new nuclei of public sector plants and their dispersal to
backward potential areas has taken place due to Government policies.
The state policy of industrial location has a greater hand in the
establishment of a number of fertiliser factories, iron and steel plants,
engineering works and machine tool factories including railway, shipping,
aircraft and defense installations, and oil refineries in various parts in the
new planning era in free India.
We may conclude by noting that the traditional explanation of a location
of the industry at a geographically favorable point is no longer true.
Location of the oil refinery at Mathura, coach factory at K apurthala, and
fertilizer plant at Jagdishpur are some of the results of government
policies.
3. Industrial Inertia:
Industrial inertia is the predisposition of industries or companies to avoid
relocating facilities even in the face of changing economic ci rcumstances
that would otherwise induce them to leave.
Industries tend to develop at the place of their original establishment,
though the original cause may have disappeared. This phenomenon is
referred to as inertia, sometimes as geographical inertia, an d sometimes as
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122 Industrial Economics
122 Often the costs associated with relocating fixed capital assets and labour
far outweigh the costs of adapting to the changing conditions of an
existing location.
4. Efficie nt Organisation:
Efficient and enterprising organization and management is essential for
running modern industry successfully. Bad management sometimes
squanders away the capital and puts the industry in financial trouble
leading to industrial ruin.
Bad ma nagement does not handle the labour force efficiently and tactfully,
resulting in labour unrest. It is detrimental to the interest of the industry.
Strikes and lock -outs lead to the closure of industries. Hence, there is an
imperative need of effective man agement and organization to run the
industries.
5. Banking Facilities:
The location that has better banking facilities and Insurance are best suited
for the establishment of industries.
The establishment of industries involves the daily exchange of crores of
rupees which is possible through banking facilities only. So the areas with
better banking facilities are better suited to the establishment of industries.
6. Insurance:
In the face of changing economic circumstances and local conditions,
Insurance faci lities are mandatory to avoid any circumstance which would
jeopardize the industrial setup.
There is a constant fear of damage to machines and men in industries for
which insurance facilities are badly needed.
7.3.2 Industrial Policy in India :
Industrial P olicy is the set of standards and measures set by the
Government to evaluate the progress of the manufacturing sector that
ultimately enhances economic growth and development of the country.
The government takes measures to encourage and improve the
compet itiveness and capabilities of various firms.
Objectives of Industrial Policy :
1. To maintain steady growth in productivity.
2. To create more employment opportunities.
3. Utilize the available human resources better
4. To accelerate the progress of the country through different means
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123 Indian Industry - I Industrial Policy in India :
The various industrial policy introduced by the Indian government are as
follows:
Industrial Policy Resolution, 1948 :
 It declared the Indian econ omy as Mixed Economy
 Small scale and cottage industries were given the importance
 The government restricted foreign investments
 Industries were divided into 4 categories
 Exclus ive monopoly of central government(arms and ammunitions,
production of atomic energy and management of railways)
 New undertaking undertaken only by state(coal, iron and steel,
aircraft manufacturing, ship building, telegraph, telephone etc.)
 Industries to be regulated by the government(Industries of basic
importance)
 Open to private enterprise, individuals and cooperatives(remaining)
Industrial Policy Resolution, 1956 (IPR 1956) :
 This policy laid down the basic framework of Industrial Policy
 This policy is also known as the Economic Constitution of India
 It is classified into three sectors
 Schedule A – which covers Public Sector (17 Industries)
 Schedule B – covering Mixed Sector (i.e. Public & Private) (12
Industries)
 Schedule C – only Private Industries
This has provisions for Public Sector, Small Scale Industry, Foreign
Investment. To meet new challenges, from time to time, it was modified
through statements in 1973, 1977, and 1980.
Industrial Policy Statement, 1977 :
 This policy was an extension of the 1956 policy.
 The main was employment to the poor and reduction in the
concentration of wealth.
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124 Industrial Economics
124  It created a new unit called “Tiny Unit”
 This policy imposed restrictions on Multinational Companies (MNC).
Industrial Policy Statement, 1980 :
 The Industrial Policy Statement of 1980 addressed the need for
promoting competition in the domestic market, modernization,
selective Liberalization, and technological up -gradation.
 It liberalised licensing and provided for the automatic expansion of
capacity.
 Due to this policy, the MRTP Act (Monopolies Restrictive Trade
Practices) and FERA Act ( Foreign E xchange Regulation Act , 1973)
were introduced.
 The objective was to liberalize the industrial sector to increase
industrial productivity and competitiveness of the industrial sector.
 The policy laid the foundation for an increasingly competitive export -
based and for encouraging foreign investment in high -technology
areas.
New Industrial Policy, 1991 :
The New Industrial Policy, 1991 had the main objective of providing
facilities to market forces and to increase efficiency.
Larger roles were provided by
 L – Liberalization (Reduction of government control)
 P – Privatization (Increasing the role & scope of the private sector)
 G – Globalisation (Integration of the Indian economy with the world
economy)
Because of LPG, old domestic firms have to compete with New Domestic
firms, MNC’s and imported items
The government allowed Domestic firms to import better technology to
improve efficiency and to have access to better technology. The Foreign
Direct Investment ceiling was increased from 40% to 51% in selected
sector s.
The maximum FDI limit is 100% in selected sectors like infrastructure
sectors. Foreign Investment promotion board was established. It is a
single -window FDI clearance agency. The technology transfer agreement
was allowed under the automatic route.
Phase d Manufacturing Programme was a condition on foreign firms to
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125 Indian Industry - I Under the Mandatory convertibility clause, while giving loans to firms,
part of the loan will/can be converted to equity of the company if the
banks want the loan in a specified time. This was also abolished.
Industrial licensing was abolished except for 18 industries.
Monopolies and Restrictive Trade Practices Act – Under his MRTP
commission was established. MRTP Act was i ntroduced to check
monopolies. The MRTP Act was relaxed in 1991.
On the recommendation of the SVS Raghavan committee, Competition
Act 2000 was passed. Its objectives were to promote competition by
creating an enabling environment.
To know more about the Competition Commission of India , check the
linked article.
Review of the Public sector under this New Industrial Policy, 1991
are:
 Public sector investments (Disinvestment o f Public sector)
 De-reservations –Industries reserved exclusively for the public sector
were reduced
 Professionalization of Management of PSUs
 Sick PSUs to be referred to the Board for Industrial and financial
restructuring (BIFR).
 The scope of MoUs was st rengthened (MoU is an agreement between
a PSU and concerned ministry).
7.4 QUESTIONS Q1. What are the influencing factors of industrial location?
Q2. Elaborate the trends in industrial growth in India.
Q3. Explain the industrial policy in India.
Q4. What are the factors of industrial location?

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126 8
INDIAN INDUSTRY - II
Unit Structure
8.0 Objectives
8.1 Small -Scale Industries
8.1.1 Definition of Small -Scale Industries
8.1.2 Role of Small -Scale Industries
8.1.3 Policy Issues of Small -Scale Industries
8.1.4 Performanc e of Small -Scale Industries
8.2 Public Enterprises in India
8.2.1 Performance
8.2.2 Constraints
8.3 Competitiveness of Indian Industries
8.3.1 Competition Policy
8.3.2 Foreign Direct Investment
8.4 Questions
8.5 Refer ences
8.0 OBJECTIVES The main objectives behind the study of this unit are as follows :
 To know the role, policy issues and performance of the small scale
industries.
 To study the performance and constraints of public enterprises in
India.
 To acquire the knowledge of competition policy.
 To study the foreign direct investment (FDI).
8.1 SMALL -SCALE INDUSTRIES 8.1.1 Definition of Small -Scale Industries:
To define a small -scale industry effectively, it is imperative to first learn
about the meaning of industr y. The term industry refers to a group of
companies that are related to each other, based on the primary business
activities they undertake. Small scale industries, thus, refer to those
partnerships, corporations, or sole proprietorships that function on a lower
scale, employing a smaller workforce and generating less revenue than
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127 Indian Industry - II Small scale enterprises can also refer to those businesses that apply for
government support or avail preferential tax policies, de pending on their
area of operation.
Small Scale Industries (SSI): These are those industries in which the
manufacturing, production and rendering of services are done on a small
or micro scale. These industries make a one -time investment in machinery,
plant, and equipment, but it does not exceed Rs. 10 crore and annual
turnover does not exceed Rs. 50 crores. These industries work on a
medium resource platform. They have limited labour, capital, as well as
machinery. Small Scale Industry are those industrie s in which start
business on a small scale or micro scale as a manufacturing, providing,
servicing etc.
Small Scale Industries play an important role in social and economic
development of India. They are a very important sector of the economy
from a finan cial and social point of view.
These are generally labor -intensive industries, so they create much
employment.
Examples and Ideas of Small -Scale Industries:
 Bakeries
 School stationery
 Water bottles
 Leather belt
 Small toys
 Paper Bags
 Photography
 Beauty parl ors
8.1.2 Role of Small -Scale Industries:
Small scale industries play an important role for the development of
Indian economy in many ways. About 60 to 70 percent of the total
innovations in India comes from the SSIs. Many of the big businesses
today were all started small and then nurtured into big businesses. The
roles of SSIs in economic development of the country are briefly
explained below.
1. Small Scale Industries Provides Employment:
 SSI uses labour intensive techniques. Hence, it provides employmen t
opportunities to a large number of people. Thus, it reduces the
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128 Industrial Economics
128  SSI provides employment to artisans, technically qualified persons
and professionals. It also provides employment opportunities to
people engaged in t raditional arts in India.
 SSI accounts for employment of people in rural sector and
unorganized sector.
 It provides employment to skilled and unskilled people in India.
 The employment capital ratio is high for the SSI.
2. SSI Facilitates Women Growth:
 It provides employment opportunities to women in India.
 It promotes entrepreneurial skills among women as special incentives
are given to women entrepreneurs.
3. SSI Brings Balanced Regional Development:
 SSI promotes decentralized development of industries as most of the
small scale industries are set up in backward and rural areas.
 It removes regional disparities by industrializing rural and backward
areas and brings balanced regional development.
 It promotes urban and rural growth in India.
 It helps to reduce the problems of congestion, slums, sanitation and
pollution in cities by providing employment and income to people
living in rural areas. It plays an important role by initiating the
government to build the infrastructural facilities in rural areas.
 It he lps in improving the standard of living of people residing in
suburban and rural areas in India.
 The entrepreneurial talent is tapped in different regions and the
income is also distributed instead of being concentrated in the hands
of a few individuals or business families.
4. SSI Helps in Mobilization of Local Resources:
 It helps to mobilize and utilize local resources like small savings,
entrepreneurial talent, etc., of the entrepreneurs, which might
otherwise remain idle and unutilized. Thus it helps in effective
utilization of resources.
 It paves way for promoting traditional family skills and handicrafts.
There is a great demand for handicraft goods in foreign countries.
 It helps to improve the growth of local entrepreneurs and self -
employed profession als in small towns and villages in India.
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129 Indian Industry - II 5. SSI Paves for Optimization of Capital:
 SSI requires less capital per unit of output. It provides quick return on
investment due to shorter gestation period. The pay back period is
quite short in small scale ind ustries.
 SSI functions as a stabilizing force by providing high output capital
ratio as well as high employment capital ratio.
 It encourages the people living in rural areas and small towns to
mobilize savings and channelize them into industrial activities .
6. SSI Promotes Exports:
 SSI does not require sophisticated machinery. Hence, it is not
necessary to import the machines from abroad. On the other hand,
there is a great demand for goods produced by small scale sector.
Thus it reduces the pressure on the country’s balance of payments.
 SSI earns valuable foreign exchange through exports from India.
7. SSI Complements Large Scale Industries:
 SSI plays a complementary role to large scale sector and supports the
large scale industries.
 SSI provides parts, com ponents, accessories to large scale industries
and meets the requirements of large scale industries through setting up
units near the large scale units.
 It serves as ancillaries to large Scale units.
8. SSI Meets Consumer Demands:
 SSI produces wide range o f products required by consumers in India.
 SSI meets the demand of the consumers without creating a shortage
for goods. Hence, it serves as an anti -inflationary force by providing
goods of daily use.
9. SSI Ensures Social Advantage:
 SSI helps in the develo pment of the society by reducing concentration
of income and wealth in few hands.
 SSI provides employment to people and pave for independent living.
 SSI helps the people living in rural and backward sector to participate
in the process of development.
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130 Industrial Economics
130 10. Develops Entrepreneurship:
 It helps to develop a class of entrepreneurs in the society. It helps the
job seekers to turn out as job givers.
 It promotes self -employment and spirit of self -reliance in the societ y.
 Development of small scale industries helps to increase the per capita
income of India in various ways.
 It facilitates development of backward areas and weaker sections of
the society.
 Small Scale Industries are adept in distributing national income in
more efficient and equitable manner among the various participants of
the society.
8.1.3 Policies of Small -Scale Industries:
In India, Small -scale enterprises have been given an important place for
both ideological and economic reasons. It is well document ed that the
small scale industries have an important role in the development of the
country. It contributes almost 40% of the gross industrial value added in
the Indian economy. Government's approach and intention towards
industries in general and SSIs in particular are revealed in Industrial policy
Resolutions. There are many Government Policies for development and
promotion of Small -Scale Industries in India. These are mentioned as
below:
 Industrial Policy Resolution (IPR) 1948
 Industrial Policy Resolutio n (IPR) 1956
 Industrial Policy Resolution (IPR) 1977
 Industrial Policy Resolution (IPR) 1980
 Industrial Policy Resolution (IPR) 1990
1. Industrial Policy Resolution (IPR) 1948:
The IPR, 1948 acknowledged the importance of small -scale industries in
the ove rall industrial development of the country. It was well understood
that small -scale industries are mainly suited for the utilization of local
resources and for creation of employment opportunities. However, they
have to face severe problems of raw material s, capital, skilled labour,
marketing since a long period of time (B.narayan, 1999). Therefore,
government put more emphasis on the IPR, 1948 so that these problems of
small -scale enterprises should be solved by the Central Government with
the cooperation of the State Governments. It can be established that the
main drive of IPR 1948, as far as small -scale enterprises were concerned,
was 'safeguard'. The IPR of 1948 indicated that "Cottage and small scale
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131 Indian Industry - II they do scope for individual, village or cooperative enterprise, and means
for the rehabilitation of displaced persons. These industries are particularly
suited for the better utilization of local resources and for the achievement
of the local self -sufficiency in respect of certain types of essential
consumer goods like food, cloth and agricultural implements" (Industrial
Policy Resolution, 1948).
The IPR of 1948 revealed the emergence of a dualistic approach in
government policy i.e. emphasis on both traditional and modern small
scale sector. This approach has continued to form the basis of industrial
policy towards the small scale sector ever since. The industrial
Development and Regulation Act, 1951 which was transmitted in order to
provide the organizational support to IPR of 1948 provide scope for a
synchronized development of cottage and small scale industries within the
general framework of large scale development programmes.
2. Industrial Policy Resolution (IPR) 1956:
This poli cy was first comprehensive statement on industrial development
of India. The 1956 policy continued to constitute the basic economic
policy for a long time. This fact has been confirmed in all the Five -Year
Plans of India (B.narayan, 1999). According to thi s Resolution, the
objective of the social and economic policy in India was the establishment
of a socialistic pattern of civilization. It provided more powers to the
governmental mechanism. It laid down three categories of industries
which are mentioned be low:
I. Schedule A : Those industries which were to be an exclusive
responsibility of the state.
II. Schedule B : Those which were to be progressively state -owned and
in which the state would generally set up new enterprises, but in
which private enterpris e would be expected only to supplement the
effort of the state.
III. Schedule C : All the remaining industries and their future
development would, in general be left to the initiative and enterprise
of the private sector.
The main contribution of the IPR 19 48 was that it set in the nature and
pattern of industrial development in the country. The post -IPR 1948
period was marked by substantial developments taken place in the
country. For example, planning has proceeded on an organised manner
and the First Five Year Plan 1951 -56 had been completed. Industries
(Development and Regulation) Act, 1951 was also announced to legalise
and control industries in the country. The parliament had also
acknowledged 'the socialist pattern of society' as the basic objective of
social and economic policy during this period. It was this background that
the declaration of a new industrial policy resolution appeared essential.
This came in the form of IPR 1956. The IPR has aim to guarantee that
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132 Industrial Economics
132 development is incorporated with that of large - scale industry in the
country.
Besides, the Small -Scale Industries Board (SSIB) established a working
group in 1959 to scrutinize and formulate a development plan for s mall-
scale industries during the, Third Five Year Plan, 1961 -66. In the Third
Five Year Plan period, specific developmental projects like 'Rural
Industries Projects' and 'Industrial Estates Projects' were started to support
the small -scale sector in the na tion. The IPR 1956 for small -scale
industries intended at 'Protection plus Development.' In a way, the IPR
1956 started the modern SSI in India.
It was documented that in 1955, Planning Commission setup a Committee
on village and small scale industries pop ularly known as Karve
Committee. The Committee suggested some important measures like:
I. Reservation of certain items only for village and small scale
industries.
II. Restriction of capacity expansion of large industry.
III. Management of supply of raw materials.
IV. A scheme of concessions and benefits to small producers.
The IPR of 1956 advocated the policy of protection as endorsed by Karve
Committee to improve economic feasibility and competitive power of
small scale industries. This policy stated that "The State has been
following a policy of supporting cottage and village and small scale
industries by restricting the volume of production in the large scale sector
by differential taxation or by direct subsidies. While such measures will
continue to be taken, whenever necessary, the aim of the State Policy is to
ensure that the decentralised sector acquires sufficient vitality to be self -
supporting and its development is integrated with that of large -scale
industry. The State, therefore, concentrates on measures designed to
improve the competitive strength of the small scale producer. For this it is
essential that the technique of production should be constantly improved
and the pace of transformation being regulated so as to avoid as far as
possible, technological unemployment. Lack of technical and financial
assistance, of suitable working accommodation and inadequacy of
facilities for repair and maintenance are among the serious handicaps of
small scale producers. A start has been made with the esta blishment of
industrial estates and rural community workshops to make good to these
deficiencies. The extension of rural electrification, and the availability of
power at prices, which the workers can afford, will also be of considerable
help. Many of the activities relating to small scale production will be
greatly helped by the organisation of industrial cooperatives. Such
cooperatives should be encouraged in every way and the State should give
constant attention to the development of cottage and village and small
scale industry" (Industrial Policy Resolution, 1956). Main emphasis of this
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133 Indian Industry - II taxation or direct grants in the form of financial assistance to improve and
modernize the t echniques of production and competitive strength of SSIs.
3. Industrial Policy Resolution (IPR) 1977:
This policy was announced by Janata Dal in 1977. During the two decades
after the IPR 1956, the economy countersigned uneven industrial
development skewe d in favour of large and medium sector, on the one
hand, and increase in joblessness, on the other. This situation led to a
transformed emphasis on industrial policy. This gave advent to IPR 1977.
This policy supported the development of small scale and co ttage
industries as a remedy to common problem of unemployment and regional
dissimilarities in industrial development (B.narayan, 1999). This policy
proclaimed that "The main thrust of the new Industrial Policy will be on
effective promotion of cottage and small industries widely dispersed in
rural areas and small towns. It is the policy of the Government that
whatever can be produced by small and cottage industries must only be so
produced" (Industrial Policy Resolution, 1977).
The important attributes of the IPR were:
1. 504 items were reserved for exclusive production in the small -scale
industries.
2. The concept of District Industries Centres (DICs) was introduced so
that in each district a single agency could meet all the requirements of
SSIs under on e roof.
3. Technological up gradation was emphasized in traditional sector. 4.
Special marketing arrangements through the provision of services,
such as, product standardization, quality control, market survey, were
laid down.
The IPR 1977 grouped small s ector into three broad categories:
1. Cottage and Household Industries which provide self -employment on
a large scale.
2. Tiny sector incorporating investment in industrial units in plant and
machinery up to Rs.one lakh and situated in towns with a popul ation
of less than 50,000 according to 1971 Census.
3. Small -scale industries comprising of industrial units with an
investment of up to Rs.10 lakhs and in case of ancillary units with an
investment up to Rs.15 lakhs. The measures suggested for the
promot ion of small -scale and cottage industries included:
I. Reservation of 504 items for exclusive production in small -scale
sector.
II. Proposal to set up in each district an agency called "District Industry
Centre" (DIC) to serve as a focal point of develop ment for small -scale
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134 Industrial Economics
134 1978. The main goal of setting up DICs was to promote under a single
roof all the services and support required by small and village
businesspersons.
4. Industrial Policy Resolution (IPR) 1980 :
The Industrial Policy of 1980 marked a major breakthrough in the policy
of development of small scale industries in India. The Government of
India accepted a new Industrial Policy Resolution (IPR) on July 23, 1980.
The IPR wanted to synchronise the development in small scale industries
with the large and medium scale industries. Industrially backward districts
were identified for faster growth of existing network of SSIs. The main
purpose of IPR 1980 was defined as assisting an incre ase in industrial
production through optimum utilization of installed capacity and
expansion of industries. This policy statement focused on the need for
promoting competition in domestic market, technological up gradation and
modernization (Sangram Keshar i Mohanty, 2005).
As to the small sector, the resolution visualized following measures:
I. Increase in investment ceilings from Rs.1 lakh to Rs.2 lakhs in case
of tiny units, from Rs.10 lakhs to Rs.20 lakhs in case of small -scale
units and from Rs.15 lakh s to Rs.25 lakhs in case of ancillaries.
II. Introduction of the concept of nucleus plants to replace the earlier
scheme of the District Industry Centres in each industrially
backward district to promote the maximum small -scale industries
there.
III. Promotion of village and rural industries to generate economic
feasibility in the villages well compatible with the environment.
IV. Reservation of items and marketing support for small industries was
to continue.
V. Availability of credit to growing SSI un its was continued.
VI. Buffer stocks of critical inputs were to continue.
VII. Agricultural base was to strengthen by providing preferential
treatment to agro based industries.
VIII. An early warning system was to establish to avoid sickness and take
appropriate remedial measures.
Thus, the IPR 1980 reemphasized the spirit of the IPR 1956. The small -
scale sector still continued the best sector to create employment and self -
employment based opportunities in the country.
5. Industrial Policy Resolution (IP R) 1990:
The IPR 1990 was declared during June 1990. As to the small -scale sector,
the resolution continued to give significance to small -scale enterprises to
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135 Indian Industry - II the need of modernizatio n and technology up gradation to meet the
objectives of employment generation and dispersal of industry in rural
areas, and to enhance the contribution of small scale industries to exports.
The important elements included in the resolution to increase the
development of small -scale sector were as follows:
I. The investment ceiling in plant and machinery for small -scale
industries (fixed in 1985) was raised from Rs.35 lakhs to Rs.60 lakhs
and correspondingly, for ancillary units from Rs.45 lakhs to Rs.75
lakhs.
II. Investment ceiling for small units had been increased from Rs.2 lakhs
to Rs.5 lakhs provided the unit is located in an area having a
population of 50,000 as per 1981 Census.
III. As many as 836 items were reserved for exclusive manufacture in
small- scale sector.
IV. A new scheme of Central Investment Subsidy entirely for small -scale
sector in rural and backward areas capable of generating more
employment at lower cost of capital had been mooted and
implemented.
IV. In order to improve the comp etitiveness of the products manufactured
in the small -scale sector; programmes of technology up gradation will
be executed under the umbrella of an apex Technology Development
Centre in Small Industries Development Organisation (SIDO).
V. To guarantee bot h satisfactory and timely flow of credit services for
the small - scale industries, a new apex bank known as "Small
Industries Development Bank of India (SIDBI)" was established in
1990.
VI. There is more emphasis on training of women and youth under
Entre preneurship Development Programme (EDP) and to establish a
special cell in SIDO for this purpose.
Other industrial policies: Industrial Policy Resolution of 1991: In the year
of 1991, the Government lunched "Structural Adjustment Programme"
which has resul ted in radical change in the policies governing the different
facets of Indian economy. In order to impart more vitality and growth to
small scale sector, the Government of India declared a separate policy
statement for small, tiny and village enterprises. The basic drive of this
resolution was to make simpler regulations and procedures by delicensing,
deregulating, and decontrolling.
Important features of this policy are as under:
I. SSIs were exempted from licensing for all articles of manufacture.
II. The investment limit for tiny enterprises was raised to Rs.5 lakh
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136 Industrial Economics
136 III. Equity participation by other industrial undertakings was permitted up
to a limit of 24 percent of shareholding in SSIs.
IV. Factoring services were to launc h to solve the problem of delayed
payments to SSIs.
V. Priority was accorded to small and tiny units in allocation of
indigenous and raw materials.
VI. Market promotion of products was highlighted through co -operatives,
public institutions and other mark eting agencies and corporations.
Basically, the Industrial Policy Resolution of 1991 delineated
developmental, deregulatory and de -bureaucratic measures and
underscored the need to shift from subsidized and cheap credit to a system
which would ensure accep table flow of credit on timely and normative
basis to the small scale industrial sector.
Contemporary policy measures for small scale and cottage Industries:
1. Comprehensive Policy Package for small scale and tiny sector,
2000:
This policy was declared by t he Government of India for the development
and promotion of small scale and tiny sector which has major objective to
increase the competitiveness of the sector.
The main focus of the policy package was:
I. The exemption for excise duty limit raised from R s.50 lakh to Rs.1
crore.
II. The limit of investment was increased in industry related service and
business enterprises from Rs.5 lakh to Rs.10 lakh.
III. The coverage of ongoing Integrated Infrastructure Development (IID)
was enhanced to cover all areas in the country with 50 percent
reservation for rural areas and 50 percent earmarking of plots for tiny
sector.
IV. The family income eligibility limit of Rs.24000 was enhanced to
Rs.40000 per annum under the Prime Minister Rozgar Yojana
(PMRY).
V. The s cheme of granting Rs.75000 to each small scale enterprise for
obtaining ISO 9000 certification was continued till the end of 10th
plan.
2. Industrial Policy Packages for small scale industries, 2001 -02:
This policy underlines the following measures:
I. The investment limit was enhanced from Rs.1 crore to Rs.5 crore for
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137 Indian Industry - II II. The corpus fund set up under the Credit Guarantee Fund Scheme was
increased from Rs.125 crore to Rs.200 crore.
III. Credit Guarantee cover was provided against an aggregate credit of
Rs.23 crore till December 2001.
IV. Fourteen items were de -reserved in June 2001 related to leather
goods, shoes and toys.
V. Market Development Assistant Scheme was launched exclusively for
SSI sector.
VI. Four UNIDO assisted projects were commissioned during the year
under the Cluster Development Programme.
3. Policy Package for small and medium enterprises, 2005 -06:
In 2005 -06, the Government declared a policy package for small and
medium enterprises. The ma in attributes of this policy package were:
I. The Ministry of Small Scale Industries has identified 180 items for
de-reservation.
II. Small and Medium Enterprises were recognized in the services sector,
and were treated at par with SSIs in the manufactur ing sector.
III. Insurance cover was extended to approximately 30,000 borrowers,
identified as chief promoters in the small scale sector.
VI. Emphasis was placed on Cluster Development model not only to
promote manufacturing but also to renew industrial towns and build
new industrial townships. The model is currently being implemented,
in nine sectors including khadi and village industries, handlooms,
handicrafts, textiles, agricultural products and medicinal plants.
4. Enactment of Micro, Small and Mediu m Enterprises Development
Act, 2006:
In May' 2006, the President has modified the Government of India
(Allocation of Business) Rules, 1961; Ministry of Agro and Rural
Industries and Ministry of Small Scale Industries have been merged into a
single Ministry , namely, "Ministry of Micro, Small and Medium
Enterprises. As a result, the Micro, Small and Medium enterprises
Development (MSMED) Act was endorsed, which offers the first ever
legal framework for recognition of the concept 'enterprises' against
'industr ies' and integrating the three tiers of these enterprises viz. micro,
small and medium and clearly fixed the investment limits for both
manufacturing and service enterprises. It also provides for a statutory
consultative tool at the national level with wid e representation of all
sections of stakeholders, particularly the three classes of enterprises.
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138 5. North east industrial and investment promotion policy (NEIIPP),
2007:
Due to backwardness of the North Eastern region, the Government of
India broadcasted a new industrial policy for the NER including Sikkim.
The policy termed as 'North East Industrial and Investment Promotion
Policy (NEIIPP), 2007'. Its major objective is to encourage investment in
the industrial sector by announcing fiscal and other incen tives for the
purpose of overall economic growth of this region. The policy with its
package of incentives is intended to encourage development of industries
so that the region overcomes its continuous backwardness. To summarize,
Small scale and cottage in dustrial sector has developed rapidly in several
developing and industrialised economies of the world. In India, they have
emerged as a dynamic sector of Indian economy through their important
contribution to GDP, industrial production and export. The adva ncement
of small scale industries has been one of the major objectives of economic
planning in India. The policies have undergone change from time to time.
The six Industrial Policy Resolutions and eleven Five Year Plans sustained
a continuous flow of ince ntives, both protective and promotional in nature,
as an element of development strategy to meet socioeconomic objectives
such as employment generation, removal of poverty and regional
disparities, and optimum utilization of local resources.
8.2.4 Issues o f Small Scale Industries :
The following are the problems faced by Small Scale Industries
1. Poor capacity utilization:
In many of the Small Scale Industries, the capacity utilization is not even
50% of the installed capacity. Nearly half of the machinery r emains idle.
Capital is unnecessarily locked up and idle machinery also occupies space
and n8eeds to be serviced resulting in increased costs.
2. Incompetent management:
Many Small Scale Industries are run in an incompetent manner by poorly
qualified entre preneurs without much skill or experience. Very little
thought has gone into matters such as demand, production level and
techniques, financial availability, plant location, future prospects etc.
According to one official study, the major reason for SSI si ckness is
deficiency in project Management i.e., inexperience of promoters in the
basic processes of production, cash flow etc.
3. Inadequate Finance:
Many Small -Scale Industries face the problem of scarcity of funds. They
are not able to access the domest ic capital market to raise resources. They
are also not able to tap foreign markets by issuing ADR‟s (American
Depository Receipts) GDR‟s (Global Depository Receipts) etc because of
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139 Indian Industry - II procedures and formalities to be completed. Even after a long delay, the
funds allocated are inadequate.
Bank credit to the small -scale sector as a percentage of total credit has
been declining. It fell from 16% in 1999 to 12.5% in 2002. Small Scale
Indus tries are not able to get funds immediately for their needs. They have
to depend on private money lenders who charge high interest. Finance, as
a whole, both long and short term, accounts for as large as 43% of the
sectors sickness.
4. Raw material shortag es:
Raw materials are not available at the required quantity and quality. Since
demand for raw materials is more than the supply, the prices of raw
materials are quite high which pushes up the cost. Scarcity of raw
materials results in idle capacity, low p roduction, inability to meet demand
and loss of customers.
5. Lack of marketing support:
Small Scale Industries lack market knowledge with regard to competitors,
consumer preferences, market trends. Since their production volume is
small and cannot meet de mand for large quantities their market is very
restricted. Now with the process of liberalization and globalization they
are facing competition from local industries as well as foreign competitors
who sell better quality products at lower prices. For e.g. heavily subsidized
but better quality imports from China has made most of the Indian SSI
units producing toys, electronic goods, machine tools, chemicals, locks
and paper etc., unviable.
6. Problem of working capital:
Many Small -Scale Industries face the p roblem of inadequate working
capital. Due to lack of market knowledge their production exceeds
demand, and capital gets locked in unsold stock. They do not have enough
funds to meet operational expenses and run the business.
7. Problems in Export:
They lac k knowledge about the export procedures, demand patterns,
product preferences, international currency rates and foreign buyer
behavior. Small Scale Industries are not able to penetrate foreign markets
because of their poor quality and lack of cost competit iveness. In countries
like Taiwan, Japan etc. products produced by Small Scale Industries are
exported to many foreign countries. But in India not much thought and
focus has gone into improving the export competitiveness of Small -Scale
Industries.
8. Lack of technology up -gradation:
Many Small -Scale Industries still use primitive, outdated technology
leading to poor quality and low productivity. They do not have adequate
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140 develop new technol ogies. Acquiring technology from other firms is
costly. Therefore, Small Scale Industries are left with no choice but to
continue with their old techniques.
9. Multiplicity of labour laws:
One of the merits of Small Scale Industries are that they are labou r
intensive and can provide employment to a large number of people. But
the multiplicity of labour laws, need to maintain several records (PF, ESI,
Muster Rolls etc.), fines and penalties for minor violations etc. place Small
Scale Industries at a great di sadvantage.
10. Inability to meet environmental standards:
The government lays down strict environmental standards and Courts have
ordered closure of polluting industries. Small Scale Industries which are
already facing shortage of funds to carry out their business are not able to
spend huge sums on erecting chimneys, setting up effluent treatment
plants etc.
11. Delayed payments:
Small Scale Industries buy raw materials on cash but due to the intense
competition have to sell their products on credit. Buyin g on cash and
selling on credit itself places a great strain on finances. The greater
problem is payments are delayed, sometimes even by 6 months to one
year. It is not only the private sector but even government departments are
equally guilty. Delayed pay ments severely impact the survival of many
Small -Scale Industries.
12. Poor industrial relations:
Many Small -Scale Industries are not able to match the pay and benefits
offered by large enterprises, because their revenues and profitability are
low and also uncertain. This leads to labor problems. Employees fight for
higher wages and benefits which the SSI is not able to provide. This may
lead to strikes, resulting in damage to property in case of violence by
employees, production losses etc.
13. Strain on g overnment finances:
Marketing of products manufactured by Small Scale Industries is a
problem area. The government has to provide high subsidies to promote
sales of products produced by Khadi and Village Industries. This places a
great strain on government finances.
14. Concentration of industrial units:
There is high concentration of small -scale industrial units in a few states.
Of the estimated 1.37 million registered units as on 2020 -21, nearly 35%
were located in three states. Uttar Pradesh, Tamil Nadu and Kerala alone
account for 35% of Small -Scale Industries. Due to concentration, there is
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141 Indian Industry - II industrial inputs. This leads to high costs and scarcity of raw materials and
other inputs affecting t heir production and increasing costs.
15. Inadequate dispersal:
One of the objectives of the government in promoting Small Scale
Industries was to increase industrial development and employment
opportunities throughout the country. Since nearly 60% of the Small -Scale
Industries are concentrated in few states, the objective of balanced
regional development and promotion of backward areas has not been
achieved. Further majority of Small -Scale Industries are located in urban
areas and the aim of industrial dev elopment in rural areas has also been
defeated.
16. Widespread sickness:
Sickness among Small Scale Industries is widespread. Sickness is not
detected in the initial stages and large amount of funds are locked in them.
Due to these new entrepreneurs are no t able to get loans, workers in the
sick units lose their jobs and industrial and economic development is
affected.
17. Lack of awareness:
The government has set up many organizations to support and provide
assistance to Small Scale Industries. But, many o f the entrepreneurs
running Small Scale Industries are not aware of the various support
services.
18. Government interference:
Small Scale Industries have to maintain a number of records and there are
endless government inspections. A lot of time, money an d effort is wasted
in complying with various inspections and records verification. This
prevents Small Scale Industries from fully concentratin g on their business
activities.
8.2.5 Performance of Small -Scale Industries:
The Micro, Small & Medium Enterprise s (MSMEs) have been
contributing to the expansion of the entrepreneurial endeavours through
business innovations significantly. The Micro, Small & Medium
Enterprises are widening their domain across sectors of the economy,
producing diverse range of produc ts and services to meet demands of
domestic as well as the global markets. According to the data available
with Central Statistics Office (CSO), M/o Statistics & Programme
Implementation, the contribution of MSME sector in Country’s Gross
Value Added (GVA) and Gross Domestic Product (GDP) at current prices
from 2014 -15 to 2018 -19 is as below:

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142 Table No . 8.1
Share of Gross Value Added (GVA) of MSME in all India GDP Figures in Rs. Crores adjusted for FISIM at current price Year Total MSME GVA Growth (%) Total GVA Share of MSME in GVA (%) All India GDP Share of MSME in All India GDP (in %) 2014-15 3658196 - 11504279 31.80 12467959 29.34 2015-16 4059660 10.97 12574499 32.28 13771874 29.48 2016-17 4502129 10.90 13965200 32.24 15391669 29.25 2017-18 5086493 12.98 15513122 32.79 17098304 29.75 2018-19 5741765 12.88 17139962 33.50 18971237 30.27 (Source: Central Statistics Office (CSO), Ministry of Statistics and
Programme Implementation)
8.3 PUBLIC ENTERPRISES IN INDIA 8.3.1 Performance :
The Public Enterprises Survey 2021 -22 presents a summary of the
financial performance of Central Public Sector Enterprises for the
Financial Year 2021 -22. The Section 2 (45) of Companies Act, 2013
defines Government Company to mean – any company in which not less
than 51 percent of the paid -up share capital is held by Central
Government, or by any State Government or Governments, or partly by
the Central Government and partly by one or more State Governments and
includes a company which is a subsidiary company of such a Governmen t
Company.
The survey provides essential statistical data for all CPSEs from various
perspectives by segregating these enterprises into various sectors such as
Agriculture, Mining & Exploration, Manufacturing, Processing &
Generation and Services. The key highlights of the survey outcomes in
terms of certain important parameters is depicted in the below Figure.
Figure 8.1: CPSEs Performance Highlights ( lakh crores)
o Total Paid -up Capital of all CPSEs was 3.69 lakh crore as on March
31, 2022 as against 2.84 lakh crore on March 31, 2021 showing an
increase of 29.82%.
o Total Financial Investments in all CPSEs was 22.81 lakh crore as on
March 31, 2022 against 21.58 lakh crore as on March 31, 2021,
recording a growth of 5.71%.
 Among the sectors, Services sect or had the highest investments
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143 Indian Industry - II followed by Manufacturing, Processing & Generation with 23.92%,
and Mining & Exploration with 4.86%. The share of Agriculture was
negligible.
 Among the cogn ate groups, Financial Services accounted for 53.65%
of the outstanding Financial Investments followed by Power
Generation with 15.01%, Petroleum (Refinery & Marketing) with
6.19% and Power Transmission with 5.88%. The share of other
cognate groups was comp aratively lower.
 Top five CPSEs having highest financial investments are Indian
Railway Finance Corporation Ltd, Power Finance Corporation Ltd,
REC Ltd, NTPC Ltd & Power Grid Corporation of India.
o Capital Employed by all CPSEs was 35.21 lakh crore as on M arch
31, 2022 against 32.93 lakh crore as on March 31, 2021, showing a
growth of 6.93%.
o Total Gross Revenue from the operations of operating CPSEs during
FY 2021 -22 was 31.95 lakh crore as against 24.08 lakh crore in
FY 2020 -21, showing an increase of 3 2.65%.
 This increase in FY 2021 -22 was largely due to increase in the
Petroleum (Refinery & Marketing), Crude oil & Transport and
logistics Cognate Group.
 Among the sectors, Manufacturing, Processing & Generation sector
continues to command the highest sha re followed by Services, and
Mining & Exploration. Three Cognate Groups Petroleum (Refinery &
Marketing), Trading & marketing and Power Generation together
contributed 69.08 % to the Gross Revenue in FY 2021 -22.
 Top five CPSEs having highest Revenue during FY 2021 -22 are
Indian Oil Corporation Ltd, Bharat Petroleum Corporation Ltd,
Hindustan Petroleum Corporation Ltd, Food Corporation of India and
NTPC Ltd.
o Net Profit of profit -making CPSEs stood at 2.64 lakh crore in FY
2021 -22 against 1.89 lakh crore in FY 2020 -21 showing an increase
of 39.85%. Top five CPSEs with highest Net profits are ONGC Ltd,
Indian Oil Corporation Ltd, Power Grid Corporation of India, NTPC
Ltd & Steel Authority of India Ltd.
o Net Loss of loss -incurring CPSEs was 0.15 lakh crore in FY 2021 -
22 as against 0.23 lakh crore in FY 2020 -21 showing a decrease of
37.82%. Major loss making CPSEs are Bharat Sanchar Nigam Ltd,
Mahanagar Telecom Nigam Ltd, Air India Assets Holding Ltd,
Eastern Coalfields Ltd & Alliance Air Aviation Ltd.
o Overall Net Profit of operating CPSEs during FY 2021 -22 stood at
2.49 lakh crore as against 1.65 lakh crore during FY 2020 -21
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144 Industrial Economics
144  Amajor proportion of the profit is contributed by Crude oil cognate
group, where it increased from 0.13 lakh crore in FY 2020 -21 to
0.46 lakh crore in FY 2021 -22. Within the crude oil cognate group,
the major contribution towards increase in Overall Net Profit is
contributed by ONGC Ltd. (by 0.29 lakh crore.)
o Reserves and Surplus of all CPSEs stood at 12.40 lakh crore as on
March 31, 2022 as against 11.35lakh crore as on March 31, 2021,
showing an increase of 9.25%.
o Net Worth of all CPSEs increased from 13.81 lakh crore as on
March 31, 2021 to 15.58 lakh crore as on March 31, 2022, showing
an increase o f 12.81%.
Figure 8.2: CPSEs Performance Highlights ( lakh crore)
 Dividend declared by operating CPSEs (112) in FY 2021 -22 stood at
1.15 lakh crore against 0.73 lakh crore in FY 2020 -21, showing an
increase of 57.58%.
 Contribution of all CPSEs to Central Exchequer by way of excise
duty, custom duty, GST, corporate tax, interest on Central
Government loans, dividend, and other duties and taxes stood at
5.07 lakh crore in FY 2021 -22 as against 4.97 lakh crore in FY
2020 -21, showing an increase of 2.14%. T he collection has increased
due to an increase in GST collection from 0.38 lakh crore (in FY
2020 -21) to 0.58 lakh crore (in FY 2021 - 22). Top five CPSEs
contributing to Central Exchequer are Indian Oil Corporation Ltd,
Bharat Petroleum Corporation Ltd, Hindustan Petroleum Corporation
Ltd, Bharat Oman Refineries Ltd & Chennai Petroleum Corporation
Ltd.
 Foreign Exchange Earnings of operating CPSEs through the export of
goods and services stood at 1.50 lakh crore in FY 2021 -22 against 0.87
lakh crore in F Y 2020 -21, showing an increase of 72.16%. Top Five
CPSEs under this category are Mangalore Refinery & Petrochemicals Ltd,
Indian Oil Corporation Ltd, GAIL (India) Ltd, ONGC Videsh Ltd &
Bharat Petroleum Corporation Ltd.
Figure 8.3: CPSEs Performance Highli ghts-CSR and R&D
expenditure ( crore)
 CSR Expenditure of all CSR eligible CPSEs (160) stood at 4,600
crore in FY 2021 -22 against 4,483 crore in FY 2020 - 21 showing an
increase of 2.61%. Top five CPSEs contributing highest under CSR
are ONGC Ltd, NTPC Lt d, Indian Oil Corporation Ltd, NMDC Ltd
and Power Grid Corporation Ltd.
 R&D Expenditure of all CPSEs stood at 6,894 crore in FY 2021 -22
against 4,892 crore in FY 2020 -21 showing an increase of 40.95%.
Top five CPSEs contributing highest under this head a re Hindustan munotes.in

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145 Indian Industry - II Aeronautics Ltd., Indian Oil Corporation Ltd, Steel Authority of India
Ltd, Bharat Heavy Electricals Ltd and ONGC Ltd
8.3.2 Constraints:
(i) Endowment Constraints:
Some of the public sector enterprises, particularly some of the loss -
incurring enterprises are suffering from endowment constraints as the
selection of sites of these enterprises were done on political considerations
rather than on rational considerations.
(ii) Under -Utilization of Capacity:
Under - utilization of the production capa cities are one of the common
constraints from which almost all public sector enterprises are suffering.
In 1986 -87, out of the 175 public sector units 90 units had been able to
utilize over 75 per cent of its capacities, 56 units achieved utilization of
capacities between 50 and 75 per cent and the rest 29 units could
somehow managed to utilize under 50 per cent of its capacities. This had
been mainly due to the reasons such as long gestation periods, huge in -
built capacities, ambitious scales of planning b ased on inadequate
economic (particularly market) data, inadequate motivation, lack of
initiatives and obsolescence of the product mix.
(iii) Absence of Rational Pricing:
Public sector enterprises in India are suffering from absent of rational
pricing as t he prices of their products are determined by such a price
policy which has three considerations like:
(a) Profit as the basis of price fixation,
(b) No-profit basis of public utility approach, and
(c) Import -parity price.
Thus, formal and informal regu lations of prices by the Government in the
interest of the economy and consumers, in general, and of price
stabilization are also responsible for huge losses incurred by some of these
enterprises of our country. Moreover, subsidization of the prices of som e
of the produce by these public enterprises had added a new dimension to
the problems.
(iv) Technological Gap:
Some of the public sector enterprises in India are suffering from
technological gap as these enterprises could not adopt up -to-date
technologies in their production system leading to high unit cost and lower
yield. Enterprises like I.I.S.C.O., E.C.L. etc. are suffering from this
constraint.
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146 Industrial Economics
146 (v) Government Interference:
Much government interference in the day to day activities of the public
sector enterprises has reduced the degree of autonomy of the managements
in respect of employment, pricing, purchase etc.
(vi) Heavy Social Costs:
Public sector enterprises are suffering from heavy social costs such as the
outlays on townships and allied provisi on of amenities to its employees.
(vii) Operational and Managerial Inadequacies:
The public sector enterprises in India are also suffering from operational
and managerial inadequacies and inefficiencies leading to huge wastages
and leakages of funds in the ir day -to-day activities.
(viii) Evil Competition and Sabotage:
Between the public sector and private sector units within the same
industry sometimes there exists evil competition which leads to sabotaging
of public sector units at a large scale.
(ix) Mark eting Constraint:
Some public sector units are even faced with marketing constraints where
due to repetitive type of production mix they could not collect a good
market for some of their products where the market is already captured by
some big private ind ustrial houses leading to a constant increase in
inventories.
(x) Surplus Manpower:
In some of the public sector units there is the problem of surplus
manpower which is creating drainage of resources unnecessarily leading
to increase in the unit cost of pr oduction. Political considerations have also
contributed towards overstaffing of unskilled workers in these units.
(xi) External Factors:
Workers engaged in the public sector enterprises are lacking sincerity and
devotion to their job leading to wastage of working hours which finally
affects productive capacities of these enterprises. Moreover, external
factors like too much trade unionism, union rivalries and labour troubles
are also disrupting the smooth functioning of the production system of
these publi c sector enterprises in the country.
Considering the problems of sickness faced by the Public enterprises, the
Standing Conference on Public Enterprises (SCOPE) had recently
constituted a committee to study various aspects of sickness of public
enterprises .
In its recently submitted report (in December, 1995) on its analysis of PSU
problems, the committee felt that too much interference by the munotes.in

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147 Indian Industry - II Government in areas like autonomy and accountability, constitution of
board of directors, continuity to top managem ent and little discretionary
powers to management for investment, employment, pricing and wages
affected the PSU performance.
Bad financial planning was another cause of PSU sickness and many sick
companies had over - borrowed.
The SCOPE Committee further r egretted that the Government as a
promoter, was charging one per cent fee from its own sick companies for
providing guarantees to bank loans and that too for a limited period of one
year at a time whereas private sector promoters were not charging any fee
for such guarantee.
Various other problems such as allocation of resources, delays in filling up
top-level posts, tight regulations and procedures for investment and
restrictions on functional autonomy of the enterprises, e.g., in respect of
labour and wag e policy etc. have been creating serious constraints on the
operational efficiency of public sector enterprises of the country.
8.4 COMPETITIVENESS OF INDIAN INDUSTRIES 8.4.1 Competition Policy :
National Competition Policy is formulated by the Government o f India
with a view to achieve highest sustainable levels of economic growth,
entrepreneurship, employment, higher standards of living for citizens,
protect economic rights for just, equitable, inclusive and sustainable
economic and social development, pro mote economic democracy and
support good governance by restricting rent -seeking practices. Dhanendra
Kumar was the Chairman of the committee which was entrusted the task
of formulating India's National Competition Policy.
Objectives:
The policy is aimed at ushering in a second wave of financial reforms. The
salient features of the policy are stated below:
1. To guarantee consumer welfare by encouraging optimal allocation of
resources and granting economic agents appropriate incentives to
pursue productive effi ciency, quality and innovation.
2. To remove anti -competition outcome of existing acts, harmonize laws
and policies of Centre and State and proactively promote competition
principles.
3. Strive for single national market.
4. Establish a level playing field by provi ding competitive neutrality'.

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148 Industrial Economics
148 Competition Commission of India :
The Competition Commission of India (CCI) is the chief national
competition regulator in India. It is a statutory body within the Ministry of
Corporate Affairs and is responsible for enforcin g the Competition Act,
2002 to promote competition and prevent activities that have an
appreciable adverse effect on competition in India. The CCI looks into
cases and investigates them if the same has a negative impact on
competition.
CCI also approves co mbination under the act so that two merging entities
do not overtake the market.
The commission was established on 14 October 2003. It became fully
functional in May 2009 with Dhanendra Kumar as its first chairman. The
current Chairperson of the CCI is San geeta Verma, who was appointed to
the role in October 2022.
The Competition Act, 2002 :
The Competition Act, 2002 was enacted by the Parliament of India and
governs Indian competition law. It replaced the archaic The Monopolies
and Restrictive Trade Practic es Act, 1969. Under this legislation, the
Competition Commission of India was established to prevent the activities
that have an adverse effect on competition in India. This act extends to
whole of India.
It is a tool to implement and enforce competition p olicy and to prevent and
punish anti -competitive business practices by firms and unnecessary
Government interference in the market. Competition law is equally
applicable on written as well as oral agreement, arrangements between the
enterprises or persons.
The Competition Act, 2002 was amended by the Competition
(Amendment) Act, 2007 and again by the Competition (Amendment) Act,
2009.
The Act establishes a Commission which is duty bound to protect the
interests of free and fair competition (including the pr ocess of
competition), and as a consequence, protect the interests of consumers.
Broadly, the commission's duty is:
 To prohibit the agreements or practices that have or are likely to have
an appreciable adverse effect on competition in a market in India,
(horizontal and vertical agreements / conduct);
 To prohibit the abuse of dominance in a market;
 To prohibit acquisitions, mergers, amalgamations etc. between
enterprises which have or are likely to have an appreciable adverse
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149 Indian Industry - II In addition to this, the Competition Act envisages its enforcement with the
aid of mutual international support and enforcement network across the
world.
8.4.2 Foreign Direct Investment (FDI) :
Foreign direct investment (FDI) is when a company takes controlling
ownership in a business entity in another country. With FDI, foreign
companies are directly involved with day -to-day operations in the other
country. This means they aren’t just bringing money with them, but also
knowledge, skills and te chnology.
Generally, FDI takes place when an investor establishes foreign business
operations or acquires foreign business assets, including establishing
ownership or controlling interest in a foreign company.
Where is FDI made?
Foreign Direct Investment s are commonly made in open economies that
have skilled workforce and growth prospect. FDIs not only bring money
with them but also skills, technology and knowledge.
FDI in India :
FDI is an important monetary source for India's economic development.
Econom ic liberalisation started in India in the wake of the 1991 crisis and
since then, FDI has steadily increased in the country. India, today is a part
of top 100 -club on Ease of Doing Business (EoDB) and globally ranks
number 1 in the greenfield FDI ranking.
 This is primarily attributed to ease in FDI rules in India. India, today
is a part of the top 100 clubs on Ease of Doing Business (EoDB).FDI
inflows in India stood at $45.15 bn in 2014 -15 and have consistently
increased since then. Moreover, total FDI infl ow grew by 65.3%, i.e.
from $266.21 bn in 2007 -14 to $440.01bn in 2014 -21 and FDI equity
inflow also increased by 68.6% from $185.03 bn during 2007 -14 to
$312.05 bn (2014 -21).
 India has attracted a total FDI inflow of $27.37 bn during the first four
months of F.Y. 2021 -22 which is 62% higher as compared to the
corresponding period of F.Y. 2020 -21 ($ 16.92 bn).
 India received the highest annual FDI inflows of $84,835 mn in FY
21-22 overtaking last year’s FDI by $2.87 bn. Also, FDI equity inflow
in FY 2021 -22 were $ 59,825 mn.
 FDI Equity inflow in Manufacturing Sectors have increased by 76%
in FY 2021 -22 ($ 21.34 bn) compared to previous FY 2020 -21 ($
12.09 bn).
 Total FDI inflows in the country in the last 22 years (April 2000 -
March 2022) are $ 847 bn while the total FDI inflows received in the munotes.in

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150 Industrial Economics
150 last 8 years (April 2014 - March 2022) was $ 523 bn which amounts to
nearly 40% of total FDI inflow in last 22 years.
 In FY 2014 -15, FDI inflow in India stood at mere $ 45.15 bn, which
increased to $ 60.22 bn in 2016 -17 and further to the highest ever
annual FDI inflow of $ 83.57 bn reported during the FY 2021 -22.
 Total FDI inflows in the country in the second quarter of FY 2022
(July - September) is $ 16.6 Bn and total FDI equity inflows stands at
$ 10.3 Bn.
 Singapore (27.01%), USA (17.94%), Mauritius (15.98%), Netherland
(7.86%) and Switzerland (7.31%) emerge as top 5 countries for FDI
equity inflows into India FY 2021 -22.
 Top 5 sectors receiving highest FDI Equity Inflow during FY 2021 -22
are Computer Software & Hardw are (24.60%), Services Sector (Fin.,
Banking, Insurance, Non Fin/Business, Outsourcing, R&D, Courier,
Tech. Testing and Analysis, Other) (12.13%), Automobile Industry
(11.89%), Trading 7.72% and Construction (Infrastructure) Activities
(5.52%).
 Top 5 States receiving highest FDI Equity Inflow during FY 2021 -22
are
1. Karnataka (37.55%),
2. Maharashtra (26.26%),
3. Delhi (13.93%),
4. Tamil Nadu (5.10%) and
5. Haryana (4.76%)
Routes through which India gets FDI :
1. Automatic route: The non -resident or India n company does not
require prior nod of the RBI or government of India for FDI.
2. Govt route: The government's approval is mandatory. The company
will have to file an application through Foreign Investment
Facilitation Portal, which facilitates single -window clearance. The
application is then forwarded to the respective ministry, which will
approve/reject the application in consultation with the Department for
Promotion of Industry and Internal Trade (DPIIT), Ministry of
Commerce. DPIIT will issue the Sta ndard Operating Procedure (SOP)
for processing of applications under the existing FDI policy.
Sectors which come under the ' 100% Automatic Route' category are:
Agriculture & Animal Husbandry, Air -Transport Services (non -scheduled
and other services under c ivil aviation sector), Airports (Greenfield +
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151 Indian Industry - II Automobiles, Biotechnology (Greenfield), Broadcast Content Services
(Up-linking & down -linking of TV channels, Broadcasting Carriage
Services, Capit al Goods, Cash & Carry Wholesale Trading (including
sourcing from MSEs), Chemicals, Coal & Lignite, Construction
Development, Construction of Hospitals, Credit Information Companies,
Duty Free Shops, E -commerce Activities, Electronic Systems, Food
Processi ng, Gems & Jewellery, Healthcare, Industrial Parks, IT & BPM,
Leather, Manufacturing, Mining & Exploration of metals & non -metal
ores, Other Financial Services, Services under Civil Aviation Services
such as Maintenance & Repair Organizations, Petroleum & Natural gas,
Pharmaceuticals, Plantation sector, Ports & Shipping, Railway
Infrastructure, Renewable Energy, Roads & Highways, Single Brand
Retail Trading, Textiles & Garments, Thermal Power, Tourism &
Hospitality and White Label ATM Operations.
Sectors wh ich come under up to 100% Automatic Route' category
are:
 Infrastructure Company in the Securities Market: 49%
 Insurance: up to 49%
 Medical Devices:up to 100%
 Pension: 49%
 Petroleum Refining (By PSUs): 49%
 Power Exchanges: 49%
Government route :
Sectors whic h come under the 'up to 100% Government Route' category
are:
 Banking & Public sector: 20%
 Broadcasting Content Services: 49%
 Core Investment Company: 100%
 Food Products Retail Trading: 100%
 Mining & Minerals separations of titanium bearing minerals and ore s:
100%
 Multi -Brand Retail Trading: 51%
 Print Media (publications/ printing of scientific and technical
magazines/ specialty journals/ periodicals and facsimile edition of
foreign newspapers): 100%
 Print Media (publishing of newspaper, periodicals and Indi an editions
of foreign magazines dealing with news & current affairs): 26%
 Satellite (Establishment and operations): 100% munotes.in

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152 Industrial Economics
152 FDI prohibition :
There are a few industries where FDI is strictly prohibited under any
route. These industries are:
 Atomic Energy Gene ration
 Any Gambling or Betting businesses
 Lotteries (online, private, government, etc)
 Investment in Chit Funds
 Nidhi Company
 Agricultural or Plantation Activities (although there are many
exceptions like horticulture, fisheries, tea plantations, Piscicult ure,
animal husbandry, etc)
 Housing and Real Estate (except townships, commercial projects, etc)
 Trading in TDR’s
 Cigars, Cigarettes, or any related tobacco industry
8.5 QUESTIONS Q1. Discuss the role of Small -Scale Industries.
Q2. What are the policy i ssues of small scale industries?
Q3. Discuss the performance of small scale industries.
Q4. Discuss the performance and constraints of public enterprises in India.
Q5. Write a detail note on Foreign Direct Investment (FDI).
Q6. Write a note on competi tion policy.
8.6 REFERENCES  Annual report 2021 -22, GOI, Ministry of MSME
 https://dpe.gov.in/
 https://msme.gov.in/


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