Profit Analysis: Nature and Management of Profit, Function of Profits

Profits or expected profit stream from a productive activity or an investment play a crucial role in decision making by managers.

Therefore, it is necessary to first explain the difference between business profits and economic profits. Business profits are an accounting concept and represent the residual sales revenue to the owners of the firm after making payments to all other factors or resources the firm uses.

These payments to hired factors include the wages to hired labour, interest on borrowed capital, rent on land and factory buildings and expenditure on raw materials used by the firm. The expenditures on these factors or resources hired or purchased by the firms are call explicit costs. Business profit refers to the sales revenue of the firm minus its explicit costs. Thus

Business profits = Total sales revenue – Explicit costs

It is the concept of business profits that is generally used by the business community and accountants.

In their calculation of economic profit, the economists deduct not only explicit costs but also implicit costs from the sales revenue of the firm. The implicit costs refer to the opportunity costs of the resources provided by the firm’s owners themselves including capital and entrepreneurial ability.

These self-owned factors must be paid if they are too employed by the firm in its own production process otherwise, they will be employed elsewhere on hired basis. Thus, economists take into account the normal rate of return on capital used by the owner of the firm in its own business and the transfer earnings of the owner-entrepreneur as costs of doing business.

The risk adjusted rate of return on capital is the minimum return that is necessary to attract or retain it in business and is equal to what the owner could earn from investing in other firms.

Similarly, the opportunity cost of the entrepreneurial effort made by the owner entrepreneur is the salary that he could earn in his next best activity (say, as the manager of another firm). Likewise, the opportunity costs of other self-owned factors or inputs such as land, buildings used by the owner-entrepreneur in his own business will be counted as implicit costs.

The economic profit represents the sales revenue of the firm in excess of both explicit and implicit costs.

Economic profits = Sales revenue – Explicit costs – implicit costs.

While explaining maximisation of short-run profits or present value of the stream of expected profits in the future, economists assume that it is economic profits that owner- entrepreneur or managers of corporations seek to maximise. The concept of economic profits brings into sharp focus the question why such profits which is over and above the normal rate of return on equity capital and reward for entrepreneurial ability in case of owner-entrepreneur, exists and what is its role in a free enterprise system.

In long-run equilibrium economic profits will be zero if all firms work in perfectly competitive market. Then, how does an economic profit, positive or negative, come into existence.

Function of Profits

Profits play an important role in a free market economy. Profits perform two important primary roles in such an economy.

First, profits serve as a signal to change the rate of output or for the firms to enter or leave the industry.

Second, profits play a critical role in providing incentive to introduce innovations and increase productive efficiency and take risks.

Thus, high economic profits being earned in an industry serve as a signal that consumers want more of the commodity being produced by that industry. These profits indicate to the firm to expend output of the commodity and for the new firms to enter the industry to gain a share of economic profits that exist in the industry. As a result, more resources will be allocated to the output of that industry.

On the other hand, below normal profits in an industry serve as a signal that either less output of the industry is demanded by the consumers or inefficient production methods are being used by the firms. In response to the lower demand for the product the firms will reduce their output and also some firms will leave the industry.

As a result, some productive resources will be released from that industry and made available for the production of other goods. If the lower profits are due to the inefficient production and organisation, this will induce firm to improve efficiency by changing the production methods or make organisational changes to reduce costs.

Profit motive drives a free-market economy. Although it has been observed that sometimes managers and entrepreneurs in a free market system are swayed by greed and avarice, and break laws to make money or profits by exploiting the consumers or workers but in general profits perform useful function of sending signals for changing levels of output of various products and for reallocation of resources among them.

Secondly, above normal rate of profits in a free enterprise system is an essential reward for introducing innovations and taking risks. No entrepreneur will introduce new products or more efficient of production methods or undertake investment in risky projects unless there is prospect of making profits. Some firms continue to earn above-normal rate of profit year after year as they are continually introducing new products, new production methods and providing good customer services.

In the economy changes in demand for the product often occur due to cyclical and structural changes. Besides, new strategies of rival firms also affect the demand for the product of a firm. All these uncertain and unanticipated changes involve a good deal of risk. An important function of economic profits is to reward entrepreneurs for taking these risks involved in making investment and organising factors for the production of products.

However, in some cases firms are also able to make supernormal profits by virtue of their having monopoly power. Their monopoly power may be due to some legal patent and license obtained from the government, the economies of large scale production, exclusive control over essential raw materials which prevent the other firms from producing the same product or service.

These enable the monopoly firms to charges higher prices and thereby make large economic profits. Therefore, even in free-market economies steps are taken to prevent the emergence of monopolies through anti-trust laws or Competition Acts as recently enacted in India. Of course, monopolies are legally permitted if they are needed in public interest. For example, in several cities Government grants license to some firms to provide public utility services such electricity, gas, telephone etc.

In these cases of legal monopolies government regulates them and fix reasonable prices to be charged by them from the public but at the same time ensures fair return or normal profits to them on their investment.

Profit policies

It is generally held that the main motive of a firm is to make profits. The volume of profit made by it is regarded as a primary measure of its success. Economic theory advocates profit maximisation as the chief policy of a firm. Modem business enterprises do not accept this view and relegate the profit maximisation theory to the back ground. This does not mean that modem firms do not aim at profits. They do aim at maximum profits but aim at other goals as well. All these constitute the profit policy.

(i) Industry Leadership:

Industry leadership may involve either the achievement of the maxi­mum sales volume or the manufacture of the maximum product lines. For the attainment of leadership in the industry, there has to be a satisfactory level of profit consistent with capital invested, labour force employed and volume of output produced.

(ii) Restricting the Entry:

If a firm follows a policy of restricting its profit, no competitors are likely to enter the market. Reasonable profits which guarantee its survival and growth are essential. According to Joel Dean, “Competitors can invade the market as soon as they discover its profitability and find ways to shift the patents and make necessary changes in design, technique, and production plant and market penetration.”

(iii) Political Impact:

High profits are considered to be suicidal for a firm. If the government comes to know that the firms are earning huge returns, it may resort to high taxation or to nationalisa­tion. High profits are often considered as an index of monopoly power and to prevent the govern­ment may introduce price control and profit regulation policies.

(iv) Consumer Goodwill:

Consumer is the foundation of any business. For maintaining con­sumer goodwill, firms have to restrict the profit. By maintaining low profit, the firms may seek the goodwill of the consumers. Consumer goodwill is valued so much these days that firms often make organised efforts through advertisements.

(v) Wage Consideration:

Higher profits may be taken as evidence of the ability to pay higher wages. If the labour associations come to know that the firms are declaring higher dividends to the shareholders, naturally they demand higher wages, bonus, etc. Under these circumstances in the inter­est of harmonious relations with employees, firms keep the profit margin at a reasonable level.

(vi) Liquidity Preference:

Many concerns give greater importance to capital soundness of a firm and hence prefer liquidity to profit maximisation. Liquidity preference means the preference to hold cash to meet the day to day transactions. The first item that attracts one’s attention in the balance sheet is the ratio of current assets to current liabilities. In order to give capital soundness, the business concerns keep less profit and maintain high cash.

(vii) Avoid Risk:

Avoiding risk is another objective of the modem business for which the firms have to restrict the profit. Risk element is high under profit maximisation. Managerial decision involving the setting up of a new venture has to face a number of uncertainties. Very often experienced manage­ments avoid the possibility of such risks. When there is oligopolistic uncertainty, firms may focus attention at minimising losses. The guiding principle of business economics is not maximisation of profit but the avoidance of loss.

  1. Alternative Profit Policies:

Economists have suggested different profit policies which business firms may adopt as an alter­native to profit maximisation.

These alternative profit policies are listed below:

Prof. K. Rothschild observes, “Profit maximisation has until now served as the wonderful mar­ket key that opened all doors leading to an understanding of the behaviour of the entrepreneur. It was always realised that family pride, moral and ethical considerations, poor intelligences and similar factors may modify the results built on the maximum profit assumption, but it was right by assuming that these disturbing phenomena are sufficiently exceptional to justify their exclusion from the main body of price theory. But there is another motive which cannot be so lightly dismissed and which is probably a similar order of magnitude as the desire for maximum profits, namely the desire for secure profits”. He has suggested that the primary motive of an enterprise is long run survival.

According to him, the assump­tion of profit maximisation is no doubt valid to the situation of perfect competition or monopolistic competition. Under monopolistic condition, the aim of the firm is to secure monopoly profits. In the case of oligopoly, he says that the assumption of profit maximisation is not sufficient.

W.J. Baumol puts forth the maximisation of sales as the ultimate aim of the firm. He says while maximising sales the producer will not regard costs incurred as output and profits to be made. If the sales of the company increase, it means that the producer is not only covering costs but also making a usual rate of return on investment. Baumol’s theory of sales maximisation as a rational behaviour of the producer is considered as an alternative to the theory of profit maximisation.

Benjamin Higgins, Mekin Reder and Tibor Scitovsky have developed another alternative to the theory of profit maximisation, that of utility maximisation, if the producer is supposed to maximise his satisfaction. In this approach, they have introduced leisure as a variable. Leisure is an essential ingredi­ent of an individual welfare. If more work is put in by the producer, the less leisure he will be able to enjoy. It is said that the producer would get maximum satisfaction where his net profit is optimum.

Donaldson and Lorsch are of the opinion that career managers prefer policies that favour long term stability and growth of their firms which are possible only when they get maximum current profits. For the survival, self sufficiency and success, the top managers strive hard and augment corporate wealth. The more the wealth, the greater the assurance of the means of survival.

  1. Aims of Profit Policy:

The firm seeks to achieve many objectives and profit making is the main objective but it is not the only objective. Profit making is no doubt necessary. In addition to adequate profit, the firm often pursues multiple and even contradictory objectives. If a firm makes sufficient profits, it can give good dividends and attractive salaries, etc. The firm can fix a target rate for profits as its investment. There is a problem in determining the target rate of profits.

They are:

(i) Competitive rate of profit

(ii) Historical profit rate

(iii) Rate of profit sufficient enough to protect the equity, and

(iv) Plough back of profit rate.

Competitive rate of profit is the rate earned by other companies in the same industry or of selected companies in other industries working under similar conditions. It may be slightly different from the rate of profit of other companies.

Historical rate of profit is the rate of profit determined as the basis of past earnings in the normal times. The rates should be sufficient enough to attract equity capital, have provided adequate dividend to shareholders and have not encouraged much competition.

Rate of profit sufficient enough to protect the equity is the rate sufficient enough to attract equity capital and the rate of return on investment should protect the interest of present shareholders. Plough back of profit late is that late of profit Which should be such that there is a surplus after paying the dividends to finance further growth of the industry. Cyert and March have focused on five aims which represent main operative organisational goals.

They are:

(i) Production goal

(ii) Inventory goal

(iii) Sales goal

(iv) Marketing share goal and

(v) Profit goal

Production Goal:

The firms want to maintain the production of the product at a stable level to ensure stable employment and growth. The basic requirement is that the production does not fluctuate.

Inventory Goal:

To ensure a complete and convenient stock of inventory throughout the pro­duction, a minimum level of inventory has to be maintained so that the firm can prevent fluctuations in prices.

Sales Goal:

It is considered as very important from the point of view of stability and survival of the firm. Increasing sales mean progress of the firm. Sales strengthen the organisation. The more are the sales, the more is the profit.

Market Share Goal:

Company sales do not reveal how well the company is performing. If the company’s market share goes up, the company is gaining as a competitor, if it goes down the company is losing relative to competitors.

Profit Goal:

Profits are a function of the chosen price, advertising and sales promotion budgets. Normal profit is essential not only to pay dividends but also to ensure additional resources for reinvest­ment.

Profit Theories

The term profit has distinct meaning for different people, such as businessmen, accountants, policymakers, workers and economists. Profit simply means a positive gain generated from business operations or investment after subtracting all expenses or costs.

In economic terms profit is defined as a reward received by an entrepreneur by combining all the factors of production to serve the need of individuals in the economy faced with uncertainties. In a layman language, profit refers to an income that flow to investor. In accountancy, profit implies excess of revenue over all paid-out costs. Profit in economics is termed as a pure profit or economic profit or just profit.

Profit differs from the return in three respects namely:

  1. Profit is a residual income, while return is total revenue.
  2. Profits may be negative, whereas returns, such as wages and interest are always positive.
  3. Profits have greater fluctuations than returns.

 

  1. Risk-Bearing Theory of Profit:

The main proponent of this theory is Prof. Hawley. According to Hawley, one of the major functions of an entrepreneur is to bear risk that is associated first with the setting up of the business and then with the management of the business.

The risks in a business are of two types:

(i) Risk involved in the selection of the field of business; and

(ii) Risk associated with the management of the business.

After investing capital in a particular busi­ness, the entrepreneur has to wait for a long time before he can know if his selection of the field of business has been appropriate this long wait is a form of risk-bearing.

Again, while managing the business, the entrepreneur has to bear all the risks arising out of unexpected changes in the demand and supply for the product.

There may be sudden changes in the demand for a good owing to changes in the tastes, habits and incomes of the buyers, changes in the availability and prices of the substitute products, etc.

Also, there may be unexpected changes in the supply of the good owing to changes in the availability of the factors of produc­tion and changes in production techniques, etc.

Therefore, that the entrepreneur has to bear the risks associated with the unexpected changes in demand and supply of the product and also the risks associated with the consequent changes in the price of the product, total revenue and profit of the firm. The greater the ability of the entrepreneur to bear all these risks, the higher would be his level of profit. This is the main contention of the risk-bearing theory.

Critical Evaluation of the Theory:

The arguments that may be advanced in favour of the theory are:

(i) The theory attracts our attention to the fact that one of the main functions of the entrepre­neurs is to bear the risks.

(ii) The theory focuses also on the fact that a very few persons come forward to play the role of entrepreneurs because here they would have to bear the risks. That is why the supply of entrepreneurial services is very limited.

Arguments Against the Theory:

Let us now come to the arguments against the theory. These are:

(i) Risk-bearing is not the only function of an entrepreneur who has to perform many vital functions. For example, the entrepreneur has to innovate at regular intervals new products, new markets and improved methods of production and business.

He may augment his revenue and reduce his expenditures through such innovations and, consequently, his profit level would go up. Therefore, profit may also be considered as a reward for effecting innovations. Again, the entrepreneurs, all of them, have not the same ability to face risks and to perform other activi­ties.

Therefore, owing to differences in such ability, some entrepreneurs may earn rent of abil­ity. Similarly, if the entrepreneur is able to establish a monopolistic dominance in the market, then also his income, i.e., profit, would include the added income acquired through monopoly power. Therefore, profit cannot be explained only as a reward for risk-bearing.

(ii) The entrepreneur has surely to bear risks and his profit, at least some part of it, may be considered to be a reward for risk-bearing. However, risk is a subjective concept. We cannot measure risk in an objective, cardinal manner. That is why it is not possible to establish a functional relationship between risk and profit.

(iii) The exponents of the risk-bearing theory of profit did not distinguish between insurable risk and non-insurable risk. But if we are to obtain a good estimate of the amount of risk- bearing, it is essential to remember this distinction. For, the entrepreneurs actually do not bear the burden of insurable risks, it is borne by the insurance companies.

Therefore, they cannot be considered as risks. According to Prof. Knight, the entrepreneurs bear the burden of non-insurable risks and he has called these non-insurable risks by the name of uncertainty. The entrepreneur should obtain profit as a reward for bearing this uncertainty.

  1. Uncertainty-Bearing Theory of Profit:

Prof. F. H. Knight (1885-1973) has developed the uncertainty-bearing theory of profit. He says that we may distinguish between insurable risks and non-insurable risks. This distinction is important. For, the entrepreneurs actually do not bear the burden of insurable risks it is borne by the insurance companies. Therefore, they cannot be considered as risks for the entrepreneurs.

For example, we know from experience that factory premises are exposed to the risk of fire. We also know why there may be fire in a factory premise, and so, we may adopt necessary measures for prevention of fire.

In spite of all this, there remains the risk of fire, and, once the insurance companies agree to bear this risk, it no longer remains a risk. In other words, according to Knight, insurable risks should not be considered as risks and there is no question of the entrepreneurs bearing this risk.

However, the entrepreneurs bear the burden of non-insurable risks for there is no insurance company to bear these risks on their behalf. Prof. Knight has called these risks the uncertainties.

He tells us that the entrepreneur should get profit as a reward for bearing the uncertainties of the business world. The more prudently an entrepreneur bears the uncertainties, the more should be the amount of profit to reward him with.

Critical Evaluation of the Theory:

The following arguments are advanced in favour of the uncertainty-bearing theory of profit:

(i) The theory attracts our attention to the fact that not all types of risk are to be borne by the entrepreneur. He actually bears the non-insurable risks. The insurable risks are taken care of by the insurance agencies.

(ii) The theory tells us that, like all other productive services, uncertainty-bearing is also a productive service. The entrepreneur supplies this productive service and profit is the price of this service.

(iii) Since, in general, people are averse to uncertainty-bearing, the supply of entrepreneurs in the real world is very small. This impression is also obtained from the theory.

Arguments Against the Theory:

The following arguments are advanced against the theory:

(i) Uncertainty-bearing is not the only function of an entrepreneur. The innovation of new products, new markets or new production and business techniques are also among the main tasks of an entrepreneur.

Therefore, along with the function of uncertainty-bearing, that of innovation may also be the source of profit. Again, the rent of ability and monopolistic dominance may also be the sources of profit. Similarly, a firm may earn profit owing to its goodwill in the market. Therefore, we cannot say that profit arises only as a reward for uncertainty-bearing.

(ii) Uncertainty is something subjective: It has no objective, cardinal measure. In the case of organisation and management of a particular business, different entrepreneurs may have different perceptions of the degree of uncertainty involved. Therefore, it is almost impossible to build up a functional relation between uncertainty and profit.

  1. Rent Theory of Profit:

An American economist, Francis A. Walker (1840-97), is the exponent of the rent theory of profit. Walker says that an entrepreneur acquires profit because of his ability to perform. Walker argues like this. In a certain production process, if an entrepreneur uses land, labour and capital owned by his own self, then the residual part of his revenue, after payment is made to all these factors of production, is profit.

Now, at any particular price of the product, some entrepreneurs may have this profit equal to zero. They are called the marginal entrepreneurs. Any such mar­ginal entrepreneur can have nothing in excess of the wage, interest and rent earned by his own labour, capital and land.

Therefore, if an entrepreneur’s ability to perform is more than that of a marginal entrepreneur, then his cost of production would be smaller, and he would be able to earn a positive profit. In fact, the greater the efficiency of a particular entrepreneur than that of a marginal entrepreneur, the more would be the amount of profit earned by him.

There is some similarity between profit and rent. For, in the Ricardian theory of rent also, we have seen that rent is zero on marginal land and the less the cost of production and more the productivity on a plot of land, the more would be the rent enjoyed by its owners. Because of this similarity between profit and rent, Walker’s theory is called the rent theory of profit.

Critical Evaluation of the Theory:

Like the other theories of profit, Walker’s theory cannot satisfactorily explain as to why the firm and its entrepreneur should get profit. However, the theory attracts our attention to the similarity between profit and rent. But we should remember that rent is not the only element of profit.

Walker has argued that profit of the marginal entrepreneur is zero and the profits earned by an intra-marginal entrepreneur are all rent.

This contention of Walker may be correct if:

(i) An entrepreneur may supply his services only in his present business and he has no alternative employment to go to; and

(ii) The supply of entrepreneurial services or the number of entrepre­neurs is completely fixed.

However, in the real world, we always see that the entrepreneurs can supply their services to many alternative areas and from the point of view of a particular business, supply of entrepre­neurial services is not completely fixed—the supply can increase if the reward increases. There­fore, in any particular business, the minimum supply price of entrepreneurial services is not zero.

Loosely speaking, the minimum supply price of an entrepreneur in his present business would be equal to the maximum amount of reward that he may avail of in an alternative field of engagement, other things (i.e., risk or harassment factors) remaining the same. The minimum supply price of the entrepreneur’s services in his present engagement is called his normal profit.

If an entrepreneur is able to earn profits in excess of his normal profit, then this excess is a surplus and this surplus is called pure or economic profit. The amount of pure profit an entre­preneur may earn would depend upon the efficiency of his performance.

The more his effi­ciency, the more he would be able to earn as pure profit. Therefore, pure profit which is the excess over normal profit, is of the nature of the rent of ability. However, we have to remember here that the profit of a firm also includes what is known as windfall or chance income.

There­fore, the pure profit is a surplus which includes the rental surplus as also the surplus due to the windfall or chance factors. Therefore, pure profit is a mixed surplus.

  1. Innovation Theory of Profit:

The innovation theory of profit was developed by Prof. Joseph A. Schumpeter (1883-1950). According to Schumpeter, the main function of an entrepreneur is to innovate. Here we have to remember first the distinction which Schumpeter had made between invention and innovation.

Invention is the discovery of a law of nature by a scientist. On the other hand, if an entrepre­neur manufactures a new product or introduces a new production technique by using the newly discovered law of nature, and thereby makes the commercial use of the invention possible, then this is called innovation.

For example, the scientists have discovered or invented the laws of science that are behind the manufacture of the goods like electric lights or fans, radio sets, television sets, refrigerators and such other goods. But the entrepreneurs have innovated these goods. Innovation is the commercial use of the laws of science that have been discovered by the scientists.

Schumpeter has said that if the entrepreneur can innovate new techniques of production and sale, if he can innovate a new product or a new model of an old product and if he can find new markets for selling the product, then Only, he will be able to play the role of a pioneer in the business world and increase the amount of profit. We may call this increase in profit the innovation-induced profit.

Criticisms of the Theory:

Schumpeter’s innovation theory of profit has explained nicely how an entrepreneur may increase the amount of profit by means of innovations. But this theory cannot fully explain why profit arises or why the entrepreneurs should earn profit.

For example, we know that an entre­preneur should obtain profit as a reward for bearing risk or uncertainty, for his ability to estab­lish monopolistic dominance, and for many other reasons. But Schumpeter did not consider these factors that might work behind the emergence of profit.

  1. Dynamic Theory of Profit:

According to J. M. Clark (1884-1963), an American economist, profit can emerge only in a dynamic society. That is why his theory is called the dynamic theory of profit. We have to remember here the distinction between a dynamic society and a static society.

The society which is constantly changing and where the socio-economic factors like population and labour force, saving and investment, volume of capital, tastes and choices of the people, the standard of education, health and culture, etc. are always changing, is called a dynamic society.

On the other hand, the society where these changes do not occur, is called a static society. According to Clark, changes do not occur in a static society. That is why here there is no risk or uncertainty. In such a society, everything goes on according to routine and everyone has a prior information of what will happen and when.

So here the entrepreneur bears no uncertainty while organising a production process, and he should not get profit as a reward. Therefore, Clark concludes that profit does not arise in a static society. The entrepreneur obtains a price for his product in this society, which would just cover only his cost (including normal profit).

The dynamic society, on the other hand, goes through changes. There the tastes, habits and fashion, the availability of factors of production and the methods and techniques of production are all changing. That is why, in such a society, the entrepreneur has to bear uncertainty. The more successful he is in managing the uncertainties, the higher would be the profit level acquired by him.

It is clear in the above analysis that in a dynamic society, the entrepreneur has to be innovative, for innovations lead to changes and changes inspire innovations. On the other hand, in a static society, innovations do not occur, for such a society does not experience changes. That is why the dynamic theory of profit is considered to be a more general form of Schumpeter’s innovation theory.

Critical Estimates:

The dynamic theory attracts our attention to the fact that dynamism is urgently necessary for the social and economic progress of a society. If the society is dynamic, the entrepreneurs would earn profit and, if they can earn profit, the supply of entrepreneurship increases and, consequently, production in the society increases.

But the dynamic theory of profit also is not a complete theory. Because, this theory also does not explain all the causes of the emergence of profit. For example, this theory does not mention that profit may also arise because of the monopoly power of the firm.

  1. Monopoly Power Theory of Profit:

Many economists think that if there is perfect competition in the markets, there cannot be any profit, because absence of competition creates opportunities in the markets to acquire profit. As we know, under perfect competition, the buyers and sellers are assumed to possess full knowledge about the conditions prevailing in the markets.

That is why if the firms in an industry happen to earn more than normal profit in the short run, then in the long run, number of firms and the supply of the product would be increasing and the price of the product would be decreasing till all the existing firms would earn just the amount of normal profit. A firm under perfect competition is one of a large number of firms.

That is why it can sell more or less any amount of its product at the market-determined price. The entrepreneur, here, is not required to take an individual initiative to increase the demand for his product and his sales. Therefore, here the entrepreneur performs his routine activities and for this he gets no more than the normal profit.

On the other hand, if the entrepreneur possesses monopoly power in the market, then he would have to exert individual initiative in giving leadership in the market. Now, in order to maintain his monopoly power and to increase this power, he would have to exercise necessary efforts.

The entrepreneur here has to bear risk and uncertainty, and he would have to expand the dominance of his firm in the market through innovations. If the entrepreneur can perform his job successfully, then he can increase the demand for his product and get a higher price. Consequently, the amount of pure profit earned by him may increase.

Criticisms:

We may argue in favour of this theory that it has rightly emphasised the role of monopoly power in the emergence of profit. But this also cannot be a complete theory of profit.

For we know that even a monopolistic firm can earn less than normal profit or negative pure profit, i.e., we may have p < AC at his MR = MC point. Therefore, the existence of monopoly elements in the market may be a necessary condition for the emergence of profit but it is not a sufficient condition.

  1. Labour Exploitation Theory of Profit:

According to the great philosopher and classical economist, Karl Marx (1818-1883), labour is the only factor of production which can produce surplus value. The capitalists acquire profit by expropriating this surplus value. Marx has said that labour is the only productive factor.

Labour is given a rate of wage which is much smaller than the net value produced by it with the help of machines, raw materials, etc. The surplus value is defined as the difference between the net value produced by labour and what it actually gets as wage.

This surplus value is the profit of the entrepreneur who represents the capitalists. There would be an increase in the productivity of labour when this profit is converted into capital and invested again, for now the labour would be able to use more of capital goods or machines.

As the productivity of labour increases, the surplus value created by labour also increases for the rate of wage of the workers generally does not increase, or, increases at a much smaller rate. Thus exploitation of labour goes on increasing at an increasing rate and, along with it, the stock of capital also increases.

Criticisms:

In the labour exploitation theory of profit, the role of labour in the creation of surplus value and the subject of labour exploitation have been rightly emphasised. However, many economists think that, like labour, the other factors of production, like land and capital, are also productive.

Besides, Marx has said that it is the capitalists that acquire profit, i.e., he thinks that capitalists are identical with entrepreneurs, although, in modern economic system, entrepreneurs and capitalists may be separate persons.

Lastly, Marx does not consider the fact that sometimes the entrepreneurs may have to bear risks and uncertainties. Therefore, Marx’s theory, too, cannot be considered to be a complete theory of profit.

  1. Marginal Productivity Theory of Profit:

We already know how the marginal productivity (MP) theory of factor pricing may be applied to the determination of the rates of wage and interest. We shall now see how far the theory is relevant in determining the rate of profit. The MP theory says that the price of a factor would be equal to the value of its marginal product (VMP).

Therefore, according to the MP theory, the rate of profit would be equal to the VMP of entrepreneurship or entrepreneurial services. According to definition, the MP of entrepreneurship is the increment in total output obtained as a result of use of the marginal unit of entrepreneurial services.

It may be noted here that if we talk of one marginal unit of entrepreneur in place of one marginal unit of entrepreneurial services, then there would be confusion since a business firm may have one, or, at best, a few entrepreneurs, and entrepreneur is not a continuous variable.

Therefore, while examining the relevance of the MP theory in the area of profit, we should talk not of entrepreneurs, but of entrepreneurial services, the quantity used of which may be measured, say, in units of time as quantity used of labour is expressed in hours.

Then we would be able to say: if the VMP of entrepreneurial services is greater than the rate of profit determined in the market, then the entrepreneur would go on increasing the amount of entrepreneurial services used till the VMP of these services diminishes owing to the law of diminishing returns, to become equal to the rate of profit.

Economies of Scope

Economies of scope are “efficiencies formed by variety, not volume” (the latter concept is “economies of scale”). In economics, “economies” is synonymous with cost savings and “Scope” is synonymous with broadening production/services through diversified products. Economies of scope is an economic theory stating that average total cost of production decrease as a result of increasing the number of different goods produced. For example, a gas station that sells gasoline can sell soda, milk, baked goods, etc. through their customer service representatives and thus gasoline companies achieve economies of scope.

Whereas economies of scale for a firm involve reductions in the average cost (cost per unit) arising from increasing the scale of production for a single product type, economies of scope involve lowering average cost by producing more types of products.

Economies of scope make product diversification, as part of the Ansoff Matrix, efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. For example, as the number of products promoted is increased, more people can be reached per unit of money spent. At some point, however, additional advertising expenditure on new products may become less effective (an example of diseconomies of scope). Related examples include distribution of different types of products, product bundling, product lining, and family branding.

Economies of scope exist whenever the total cost of producing two different products or services (X and Y) is lower when a single firm instead of two separate firms produces by themselves.

DSC = TC(q1) + TC(q2) – TC(q1, q2) / TC(q1, q2)

Where:

  • TC(q1) is the cost of producing quantity q1 of good a separately
  • TC(q2) is the cost of producing quantity q2 of good b separately
  • TC(q1+q2) is the cost of producing quantities q1 and q2 together
  • Economies of Scope (S) is the percentage cost saving when the goods are produced together. Therefore, S would be greater than 0 when economies of scope exist.

If DSC > 0, there is economies of scope. It is recommended that two firms can corporate and produce together.

If DSC = 0, there is no economies of scale and economies of scope.

If DSC < 0, there is diseconomies of scope. It is not recommended to work together for the two firms. Diseconomies of scope means that it is more efficient for two firms to work separately since the merged cost per unit is higher than the sum of stand-alone costs.

Joint costs

The essential reason for economies of scope is some substantial joint cost across the production of multiple products. The cost of a cable network underlies economies of scope across the provision of broadband service and cable TV. The cost of operating a plane is a joint cost between carrying passengers and carrying freight, and underlies economies of scope across passenger and freight services.

Natural monopolies

While in the single-output case, economies of scale are a sufficient condition for the verification of a natural monopoly, in the multi-output case, they are not sufficient. Economies of scope are, however, a necessary condition. As a matter of simplification, it is generally accepted that markets may have monopoly features if both economies of scale and economies of scope apply, as well as sunk costs or other barriers to entry.

Advantages

Economies of scope have the following advantages for businesses:

  • Extreme flexibility in product design and product mix
  • Rapid responses to changes in market demand, product design and mix, output rates, and equipment scheduling
  • Greater control, accuracy, and repeatability of processes
  • Reduced costs from less waste and lower training and changeover costs
  • More predictability (e.g., maintenance costs)
  • Faster throughput thanks to better machine use, less in-process inventory, or fewer stoppages for missing or broken parts. (Higher speeds are now made possible and economically feasible by the sensory and control capabilities of the “Smart” machines and the information management abilities of computer-aided manufacturing (CAM) software.)
  • Distributed processing capability made possible and economical by the encoding of process information in easily replicable software
  • Less risk: A company that sells many product lines, sells in many countries, or both will benefit from reduced risk (e.g., if a product line falls out of fashion or if one country has an economic slowdown, the company will likely be able to continue trading).

Strategies Economies of Scope

  1. Related Diversification

If a company is able to use its operational expertise, resources, and capabilities across its organization, then it can take advantage of related diversification. For example, hiring designers and marketers who can use their skills across different product lines allows for the production of a wide range of products.

  1. Flexible Manufacturing

Flexible manufacturing exists if multiple products can be produced using the same manufacturing systems and inputs for example, using the same preparation and storage facilities when making hamburgers and fries, as opposed to using two separate facilities.

  1. Mergers

Mergers often enable a company to share research and development expenses to reduce costs and diversify its product portfolio or knowledge. For example, two pharmaceutical companies might merge to combine their research and development expenses to create new products.

  1. Linking the Supply Chain

Integrating vertical supply chain assists in reducing costs and wastage. For example, operating multiple businesses under the same entity or having combined management rather than running as separate entities.

  1. Acquisition of Companies with Similar Products

Mergers with horizontal acquisition or strategic acquisitions will help achieve the economies of scope as the company will benefit from synergies due to utilization of similar raw materials, production and assembly lines.

  1. Diversification

Companies producing different products using similar inputs and production processes will improve productivity.

Cost function and Cost curves

A cost function is a formula used to predict the cost that will be experienced at a certain activity level. This formula tends to be effective only within a range of activity levels, beyond which it no longer yields accurate results. Beyond the outer thresholds of these activity levels, the cost function must be adjusted to account for such factors as changes in volume discounts and the incurrence of step costs.

Cost functions are typically incorporated into company budgets, so that modelled changes in sales and unit volumes will automatically trigger changes in budgeted expenses in the budget model.

In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms optimize their production process by minimizing cost consistent with each possible level of production, and the result is a cost curve. Profit-maximizing firms use cost curves to decide output quantities. There are various types of cost curves, all related to each other, including total and average cost curves; marginal (“for each additional unit”) cost curves, which are equal to the differential of the total cost curves; and variable cost curves. Some are applicable to the short run, others to the long run.

Notation

There are standard acronyms for each cost concept, expressed in terms of the following descriptors:

SR = Short-run (when the amount of physical capital cannot be adjusted)

LR = Long-run (when all input amounts can be adjusted)

A = Average (per unit of output)

M = Marginal (for an additional unit of output)

F = Fixed (unadjustable)

V = Variable (adjustable)

T = Total (fixed plus variable)

C = Cost

These can be combined in various ways to express different cost concepts (with SR and LR often omitted when the context is clear): one from the first group (SR or LR); none or one from the second group (A, M, or none (meaning “level”); none or one from the third group (F, V, or T); and the fourth item (C).

From the various combinations we have the following short-run cost curves:

  • Short-run average fixed cost (SRAFC)
  • Short-run average total cost (SRAC or SRATC)
  • Short-run average variable cost (AVC or SRAVC)
  • Short-run marginal cost (SRMC)
  • Short-run fixed cost (FC or SRFC)
  • Short-run total cost (SRTC)
  • Short-run variable cost (VC or SRVC)

and the following long-run cost curves:

  • Long-run average total cost (LRAC or LRATC)
  • Long-run marginal cost (LRMC)
  • Long-run total cost (LRTC)

SRTC and LRTC

The short-run total cost (SRTC) and long-run total cost (LRTC) curves are increasing in the quantity of output produced because producing more output requires more labor usage in both the short and long runs, and because in the long run producing more output involves using more of the physical capital input; and using more of either input involves incurring more input costs.

With only one variable input (labour usage) in the short run, each possible quantity of output requires a specific quantity of usage of labour, and the short–run total cost as a function of the output level is this unique quantity of labor times the unit cost of labor. But in the long run, with the quantities of both labour and physical capital able to be chosen, the total cost of producing a particular output level is the result of an optimization problem: The sum of expenditures on labor (the wage rate times the chosen level of labor usage) and expenditures on capital (the unit cost of capital times the chosen level of physical capital usage) is minimized with respect to labor usage and capital usage, subject to the production function equality relating output to both input usages; then the (minimal) level of total cost is the total cost of producing the given quantity of output.

Short-run variable and fixed cost curves (SRVC and SRFC or VC and FC)

Since short-run fixed cost (FC/SRFC) does not vary with the level of output, its curve is horizontal as shown here. Short-run variable costs (VC/SRVC) increase with the level of output, since the more output is produced, the more of the variable input(s) needs to be used and paid for.

Short-run average variable cost curve (AVC or SRAVC)

Average variable cost (AVC/SRAVC) (which is a short-run concept) is the variable cost (typically labor cost) per unit of output: SRAVC = wL / Q where w is the wage rate, L is the quantity of labor used, and Q is the quantity of output produced. The SRAVC curve plots the short-run average variable cost against the level of output and is typically drawn as U-shaped. However, whilst this is convenient for economic theory, it has been argued that it bears little relationship to the real world. Some estimates show that, at least for manufacturing, the proportion of firms reporting a U-shaped cost curve is in the range of 5 to 11 percent.

Short-run average fixed cost curve (SRAFC)

Since fixed cost by definition does not vary with output, short-run average fixed cost (SRAFC) (that is, short-run fixed cost per unit of output) is lower when output is higher, giving rise to the downward-sloped curve shown.

Short-run and long-run average total cost curves (SRATC or SRAC and LRATC or LRAC)

The average total cost curve is constructed to capture the relation between cost per unit of output and the level of output, ceteris paribus. A perfectly competitive and productively efficient firm organizes its factors of production in such a way that the usage of the factors of production is as low as possible consistent with the given level of output to be produced. In the short run, when at least one factor of production is fixed, this occurs at the output level where it has enjoyed all possible average cost gains from increasing production. This is at the minimum point in the above diagram.

STC = Pk*K + PL*L

Short-run marginal cost curve (SRMC)

A short-run marginal cost (SRMC) curve graphically represents the relation between marginal (i.e., incremental) cost incurred by a firm in the short-run production of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost curve is usually U-shaped. Marginal cost is relatively high at small quantities of output; then as production increases, marginal cost declines, reaches a minimum value, then rises. The marginal cost is shown in relation to marginal revenue (MR), the incremental amount of sales revenue that an additional unit of the product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns). Marginal cost equals w/MPL. For most production processes the marginal product of labour initially rises, reaches a maximum value and then continuously falls as production increases. Thus, marginal cost initially falls, reaches a minimum value and then increases. The marginal cost curve intersects both the average variable cost curve and (short-run) average total cost curve at their minimum points. When the marginal cost curve is above an average cost curve the average curve is rising. When the marginal costs curve is below an average curve the average curve is falling. This relation holds regardless of whether the marginal curve is rising or falling.

Long-run marginal cost curve (LRMC)

The long-run marginal cost (LRMC) curve shows for each unit of output the added total cost incurred in the long run, that is, the conceptual period when all factors of production are variable. Stated otherwise, LRMC is the minimum increase in total cost associated with an increase of one unit of output when all inputs are variable.

The long-run marginal cost curve is shaped by returns to scale, a long-run concept, rather than the law of diminishing marginal returns, which is a short-run concept. The long-run marginal cost curve tends to be flatter than its short-run counterpart due to increased input flexibility. The long-run marginal cost curve intersects the long-run average cost curve at the minimum point of the latter. When long-run marginal cost is below long-run average cost, long-run average cost is falling (as additional units of output are considered).  When long-run marginal cost is above long run average cost, average cost is rising. Long-run marginal cost equals short run marginal-cost at the least-long-run-average-cost level of production. LRMC is the slope of the LR total-cost function.

Discounting Principle

Discounting principle is a continuation of time perspective & we can say it is a corollary of time perspective.

The old proverb “A bird in hand is better than two in the bush” is a representative of this discounting principle. The worth of a rupee receivable tomorrow is less than that of a rupee receivable today. Since the future is unknown & incalculable, also there is a lot of risk & uncertainty about the future. If the return is same for now & future, then definitely present return will be given importance. So, the future must be discounted both for the elements of waiting & risk of the future. Even if one is certain that he will get some income in the future, it is essential to make a discount in the income because he has to wait for the future, which involves sacrifice. Moreover, inflation may reduce the purchasing power. For making a decision regarding investment which will yield a return over a period of time, it is important to find its net present worth. To know the returns over a period of years to decide over an alternative investment, it is necessary to use discounting principle.

This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surround­ing the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.

The formula is:

PV = 100/(1+i)

Where,

PV = Present Value

i = Rate of Interest.

The principle involved in the above discussion is called the discounting principle and is stated as follows: “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.”

The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting.

Incremental principle

The incremental concept is closely related to the marginal costs and marginal revenues of economic theory. Incremental concept in managerial economics involves two important activities which are as follows:

  • Estimating the impact of decision alternatives on costs and revenues.
  • Emphasizing the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision.

The two basic components of incremental reasoning are as follows:

  • Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.
  • Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.

The incremental principle in economics may be stated as under:

A decision is obviously a profitable one if:

  • It increases revenue more than costs
  • It reduces costs more that revenues.
  • It decreases some costs to a greater extent than it increases other costs.
  • It increases some revenues more than it decreases other revenues.

Some businessmen hold the view that to make an overall profit, they must make a profit on every job. Consequently, they refuse orders that do not cover full cost (labour, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit maximization in the short run. A refusal to accept business below full cost may mean rejection of a possibility of adding more to revenue than cost. The relevant cost is not the full cost but rather the incremental cost.

A Simple problem will illustrate this point.

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

Labor Rs. 1,500
Material Rs. 2,000
Overhead (Allocated at 120% of labour cost) Rs. 1,800
Selling administrative expenses
(Allocated at 20% of labour and material cost) Rs. 700
Total Cost Rs. 6,000

The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can be, utilised to execute this order then the order can be accepted. If the order adds only Rs. 500/- of overhead (that is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of supervision, and so on), Rs. 1,000/- by way of labour cost because some of the idle workers already on the payroll will be deployed without added pay and no extra selling and administrative cost then the incremental cost of accepting the order will be as follows.

Labor Rs. 1,500/-
Material Rs. 2,000/-
Overhead Rs. 500/-
Total Incremental Cost Rs. 3,500/-

While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears that it will lead to an addition of Rs. 1,500/0 (Rs. 5,000/- Rs. 3,500/-) to profit. Incremental reasoning does not mean that the firm should accept all orders at prices, which cover merely their incremental costs. The acceptance of the Rs. 5,000/- order depends upon the existence of idle capacity and labour that would go underutilized in the absence of more profitable opportunities. Earley’s study of “excellently managed” large firms suggests that progressive corporations do make formal use of incremental analysis. It is, however, impossible to generalize on the use of incremental principle, since the observed behavior is variable.

Principle of Time perspective

The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short-run and long-run effects of decisions on revenues as well as on costs. The actual problem in decision-making is to maintain the right balance between the long-run and short-run considerations. A decision may be made on the basis of short-run considerations, but may in the course of time offer long-run repercussions, which make it more or less profitable than it appeared at first.

The time perspective concept states that the decision maker must give due consideration both to the short run and long run effects of his decisions. He must give due emphasis to the various time periods. It was Marshall who introduced time element in economic theory.

The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as costs. The main problem in decision making is to establish the right balance between long run and short run.

In the short period, the firm can change its output without changing its size. In the long period, the firm can change its output by changing its size. In the short period, the output of the industry is fixed because the firms cannot change their size of operation and they can vary only variable factors. In the long period, the output of the industry is likely to be more because the firms have enough time to increase their sizes and also use both variable and fixed factors.

In the short period, the average cost of a firm may be either more or less than its average revenue. In the long period, the average cost of the firm will be equal to its average revenue. A decision may be made on the basis of short run considerations, but may as time elapses have long run repercussions which make it more or less profitable than it at first appeared.

illustration:

The firm which ignores the short run and long run considerations will meet with failure can be explained with the help of the following illustration. Suppose, a firm having a temporary idle capacity, received an order for 10,000 units of its product. The customer is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more.

The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm executes this order, it will have to face the following repercussion in the long run:

(a) It may not be able to take up business with higher contributions in the long run.

(b) The other customers may also demand a similar low price.

(c) The image of the firm may be spoilt in the business community.

(d) The long run effects of pricing below full cost may be more than offset any short run gain.

Haynes, Mote and Paul refer to the example of a printing company which never quotes prices below full cost due to the following reasons:

(1) The management realized that the long run repercus­sions of pricing below full cost would more than offset any short run gain.

(2) Reduction in rates for some customers will bring undesirable effect on customer goodwill. Therefore, the managerial econo­mist should take into account both the short run and long run effects as revenues and costs, giving appropriate weight to most relevant time periods.

Evolution of Business Organization

The economic development of a country is measured by the development of commerce and industry. The development of business activities in India has been going on with the changes in civilisation. There was a time when there was no commerce at all and now its development has brought the whole world together. There have been different stages through which the development of trade and industry has passed.

Barter System:

Barter is a system of exchange of goods for goods. The earlier system of producing or percuring only for one’s needs gave way to barter system. With the increase in demand for more and more goods and surplus in one’s own production, there was a search for those who wanted to exchange goods for goods. The families started producing more than their needs.

The surpluses were exchanged with those goods which they needed. At a later stage some places were fixed where people used to come for exchanging their surplus products with others. The payment for using the services of other people was also in kind. Though commerce had come into being but it was at an elementary level. There was a problem of bringing together persons who needed each other’s goods. There was no common yardstick for measuring the value of goods to be exchanged.

Village Economy:

People started setting at particular places and began to sow seeds and rearing cattle on the land which they shared with community. These tribes started producing the things which they required and it was a system of self-sufficiency. With the advent of private ownership of land and cattle, the tribe system split into families. Some families started concentrating on occupations other than agriculture.

This led to exchange of goods for satisfying family needs. There was a system of village economy and all the requirements of the village were met by the people themselves. In order to facilitate exchange, a class of people called traders also emerged. Different families started specialising in producing different goods or taking up specific jobs. All these developments led to a self-reliant village economy.

Introduction of Money:

The difficulties faced in barter system compelled people to find out some common medium for exchange. In the beginning some commodities were used as a denominator for exchange. The commodities like stones, shells, cattle, feathers etc. were used to value the goods to be exchanged. Gradually, metals like iron, copper, bronze, silver and gold were taken to be more convenient, as a medium of exchange.

The metals were weighed and stamped to fix their value. The metal money facilitated trade not only in the country but also with foreign countries. The coins were also used to make payments for various types of services availed. It was ultimately the use of paper currency which led to all round development of business activities.

Town Economy:

With the use of money for exchange purposes, the volume of trade started increasing. The system of self-sufficiency gave way to division of labour. Instead of producing for family needs people started meeting needs of the whole village. People started specialising in different products. Certain places were being fixed where people could come to buy and sell goods.

There used to be weekly mandis or fairs where people from nearby villages would come to sell their surplus products and buy goods for their needs. The mandis or fairs became a regular feature. The increased volume of trade encouraged more and more division of labour. A separate class of traders and artisans came into existence.

These persons started settling at central places and established their business premises there. These places were known as towns and became trade centres for people living in villages. The villagers brought raw materials, cattle, milk, etc. to the towns for sale. The artisans would manufacture goods as per the needs of the people. The traders became a link between farmers and artisans.

The traders also started bringing luxury goods from outside places for sale in towns. As the journey was risky, the traders used to move in caravans and with the protection of armed men. The town economy gave further philip to commerce.

Industrial Revolution:

The word ‘Industrial Revolution’ is used to describe a series of changes in the industrial field in England during the period between 1760 and 1850. The changes of far reaching effects took place during this period. Generally, the word ‘Revolution’ is used for an abrupt change but in this case it is used to describe ‘fundamental change’.

A number of inventions took place in England which changed the entire technique of production. Some of the important inventions were the Spinning Jenny of Hargreaves, the Water Frame of Arkwright, the Mule of Crompton and the Power-loom of Cartwright. With the help of these inventions industrial production started at a mass scale.

The machinery was used for production, division of labour was introduced and the modes of transport were improved. The use of steam-engine in place of labour helped to increase production manifold. The use of machines required more capital investments and it led to the change in ownership from a sole proprietorship to a joint stock company.

According to Mr. L.C.A Knowles, “The so-called Industrial Revolution comprised of six great changes or developments-all of which were inter-dependent”.

These changes were:

(i) Development of Engineering:

Industrial revolution brought about a change in engineering skill. Engineers were required to design machines for textile and coal-mixing industries. The tool making for repairing ships and locomotives were also essential. There was a need for sufficient number of trained persons for taking up these jobs. The development of trained people was a part of industrial revolution.

(ii) Revolution in Iron-making:

The casting of iron for manufacturing machines was the other need of this revolution. A sufficient quantity and goods of iron was the need of the time. This development helped in producing sufficient number of machines.

(iii) Use of Steam Power in Textiles:

The use of mechanical devices in textile industry raised its production. First steam power was used in spinning. It created a surplus of yarn because man-made and traditional methods of weaving could not cope with the situation. It necessitated the use of power for weaving purposes also. The use of power was also extended to other aspects of textile industry.

(iv) Rise of Chemical Industry:

The use of power in textile industry necessitated suitable changes in the processes like bleaching, dying, finishing or printing so that production could be accelerated to keep pace with the output of piece goods. All this was possible only with the development of chemical industry.

(v) Development of Coal Mining:

The development of coal mining was inter-dependent on other developments. The coke was needed for smelting and refining iron and pig iron respectively in blast furnaces as also for producing the steam power which had also become the motive power of the industry.

(vi) Revolution in Transport:

The above-mentioned developments could not have been possible without the improved modes of transport. The horse driven carriages could not cope with the needs of large-scale production. The moving of inputs to centres of industrialization and then distribution of manufactured goods to places of consumption will be possible only with better transport means.

The industrial revolution led to large scale production. The production large scale reduced prices of goods. The commodities which were considered luxuries earlier were within the reach of a common man. The division of labour was introduced in factories and this led to specialisation.

Revolution in Transport and Communication:

Industrial production increased manifold after the mechanisation of production methods. There was a need for more and more markets to sell the goods. The discovery of new sea routes, opening of Suez Canal, introduction of railways, steamships, aeroplanes and automobiles revolutionised transport system. The movement of goods among different countries became easy and fast. The trade crossed national boundries.

The trade expanded from local to national and from national to international boundries. The facilities such as insurance and banking also gave philip to the development of trade. The revolution in communication methods has further facilitated the growth of business activities.

The use of telephone, telegraph, radio, T.V. etc. has helped in creating world market for goods. The latest edition of internet, intranet, e-commerce and advanced IT methods has radically changed the structure of trade and commerce both at national and international levels.

Advancements in Modern Business:

A number of advancements have occurred in commerce and industry in the last fifty years. These changes have revolutionised production and distribution.

Some of these changes are described as follows:

(i) Improved Methods of Production:

The use of latest technology has revolutionised production methods. The rate of production has increased substantially. Mechanisation and automation have also helped in controlling wastes and reducing cost of production. Productivity of workers has also gone up.

(ii) Large Scale Production:

The growth of multinational companies has increased the scale of production. The goods are not produced for local or national markets only but international demand is taken into consideration.

(iii) Specialisation:

The division of labour has led to specialisation in every industrial activity. Industrial units produce small number of components but specialise in them. Big industrial units also encourage specialisation in small units. The specialisation helps in raising productivity and competitive strength of the units. Even at international level countries produce only those goods in which they can specialise and have natural advantage. This specialisation has further increased international trade.

(iv) Research and Development:

The focus of industrial units is to devise better and better products on a regular basis. This has necessitated an emphasis on research and development. The thrust now is on revolution and not on evolution. Research and development helps in controlling costs, increasing production and raising standards of living of people.

(v) Expansion of International Trade:

International trade is expanding at a greater pace. The organisations like WTO are helping to bring together the whole world by removing various hindrances imposed by countries in the flow of goods and services. The whole world is now becoming one big market.

Growth of Public and Private Enterprises:

Industrialisation in India mainly started after 1947. British rulers wanted India to be the supplier of raw materials and consumer of their finished goods. After independence the government devised specific roles to public and private sectors. Basic and strategic industries were developed under public sector and consumer goods industries were left to be developed under private sector.

There were a number of changes in industrial policy from time to time. The public sector enterprises could not provide the required quantum for industrial development. It was in 1991 when government decided to limit the role of public sector only to a few industries and rests of the industries were left to be developed by private sector. Foreign entrepreneurs were freely allowed to set up unit in India.

A number of multinational companies, especially in automobile sector and durable consumer goods, have set up their manufacturing facilities in India. Foreign investors are allowed to own majority of equity in a number of Indian industries.

There are basic structural changes in Indian industrial sector in the last 15 years. Under world trade treaties every country has to .allow free access to foreign goods. Indian industries are now operating under intense competition from foreign undertakings. This competition has created awareness about quality and cost among Indian entrepreneurs. Indian exports are now finding good foreign markets.

Businessmen are exploring newer and better foreign markets for Indian goods. The government is also giving proper attention to export promotion. Though public sector is also continuing but the thrust has shifted to private sector. Private sector will have to show results in a fairly competitive environment.

Meaning, Definition, Characteristics and objectives of Business Organization

Business is all around us and it is the mainspring of modern life. But very few people understand its true nature and its role in society. The study of business is essential for training oneself for a career. Study of the principles and practices of business organisation helps in understanding events in their right perspective and in tackling the problem of satisfying human wants through the use of available resources.

Every human being is busy in one activity or the other to satisfy his unlimited wants and desires. The sum total of human activities may broadly be divided into two categories-economic activities and non-economic activities. Economic activities are designed to attain and use the material resources of life. They are concerned with the production, distribution and consumption of goods and services. Human being as undertake economic activities in order to earn their livelihood.

According to L.R. Dicksee, “Business is a form of activity pursued primarily with the object of earning profit for the benefit of those on whose behalf the activity is conducted.” Business involves production and/or exchange of goods and services to earn profit, or to earn a living. However, profit is not the sole objective of the business. It may have other objectives like promotion of welfare of the workers and the general public.

“Business is an institution organised and operated to provide goods and services to society under the incentive of private gain.” :B.O. Wheeler

“All the activities including the production and sale of goods or services may be classified as business activities.”: William Spriegel

Characteristics

(i) Continuous Economic Activity:

In business an economic activity must be repeated again and again because if an entrepreneur does not do that it will not be treated as business. For example, if a person sells his own house, this activity does not come under the framework of business.

(ii) It is a Human Activity:

Business is a human activity which makes available goods and services to the society. It is not only dependent on making available the goods and services or the mere production of these but also depends on the exchange of value which is provided in return because if you are engaged in giving gifts to somebody then it will not be treated as business.

(iii) Profit Motive:

Any economic activity which leads to generation of profit is considered as business. Therefore, intension should be to earn profit otherwise if a person is engaged in social service or preaching about the religion cannot be treated as business.

(iv) Creation of Utility:

A man does not produce anything in a way, he only converts the form of resources which are provided by the nature. The business changes the form, place and possession utility of goods and makes them available in usable form. The business creates the utility of the things so that these can be consumed.

(v) Entrepreneurship:

One cannot run any sort of business without the element of entrepreneurship irrespective of the size of the business. Business can only be run by a daring person who has the ability to face risk of loss. Because no business is there where the element of risk is missing. Involvement of element of risk of loss makes the business world more challenging and to face financial challenge is not everybody’s cup of tea.

Objectives

A business objective may be defined as the purpose or the reason for the existence of the business in the society. The objective provides the direction towards which all business activities will be directed.

Though profit motive constitutes the primary objective of business activities, it should not lead us to conclude that profit is the sole objective of a business. The objectives of the business are to be laid down keeping in view the prevailing social, economic and political environment. Objectives of a business are multi-dimensional in nature.

They can be classified into four categories, namely:

(1) Economic objectives

(2) Social objective

(3) Human objectives

(4) National objectives

These objectives are inter­related in nature.

(1) Economic Objectives:

The economic objectives of a business are discussed below:

(i) Earning of Profits: Profits are needed to provide adequate reward to the entrepreneur and to provide funds for future growth. Entrepreneurship is one of the important factors of production. Just as other factors get their rewards, the entrepreneur must get reward for his efforts and taking of risk. Moreover, every businessman will like to see that the business he is managing should grow. This is possible only if the business earns sufficient profits for investing them into the business for expansion.

(it) Satisfaction of Customers: The survival of the business depends upon the satisfaction of customers. Thus, the business must aim at winning and satisfying the customers. Peter F. Drucker has rightly said, “There is only one valid definition of business purpose, i.e., to create a customer.” Customers are created through advertisement and sales promotion and delivering them ‘want satisfaction’.

(iii) Innovation: Innovation means developing new technology, new products and their multiple uses. Business cannot succeed without designing new products and finding their new uses.

(iv) Effective Utilisation of Resources: Business requires the use of men, machines and materials which are considered scarce resources. Every business is expected to make the best possible use of these resources. This objective can be achieved by employing efficient personnel, making full utilisation of machines and reducing wastage of raw materials.

(2) Social Objectives:

Social objectives of a business denote its obligations towards various stakeholders including customers, employees, community and the government.

The important social objectives include the following:

(i) Supply of Quality Goods at Fair Prices: The business must supply quality products as desired by the customers. The products should be durable, genuine (not duplicate) and safe. The prices charged for the goods should also be reasonable.

(ii) Adoption of Fair-Trade Practices: The business should follow fair business practices at all times. It should avoid anti-social practices like hoarding, black-marketing, over-charging the buyers, etc. It should also not indulge in unfair trade practices like spurious products or misleading advertisements.

(iii) Generation of Employment Opportunities: Every business should grow and expand its operations to create new jobs for the society. Further, a business should employ suitable people without any discrimination based on caste, creed, sex or religion.

(iv) Employees’ Welfare: It is an important responsibility of the business to promote the welfare of its employees. Besides providing fair wages, the business should also provide good working conditions, canteen facility, housing, transport and medical facilities, etc., to the employees.

(v) Community Service: Modern business organisations engage in community service to fulfil their social responsibility and thereby enhance their public image. Community service may be carried out by running dispensaries and schools, encouraging social activities and setting up training centres for the unemployed youths in the backward areas.

(vi) Protection of Environment: Every business house should ensure safety of the local surroundings and the protection of neighbourhood environment. It should take adequate measures to check air, water or noise pollution.

(3) Human Objectives:

A business is directly linked with two important groups, namely, (a) customers, and (b) employees. Both these groups must have a feeling of having been treated as human beings by the business enterprise. As human beings, customers expect courteous service and fair dealings from the business.

The employees look forward to the business enterprise for the following objectives:

(i) The employees are treated as partners in the business and not as inferior lot; they should get fair wages and healthy working conditions;

(ii) They are able to acquire and develop new skills in the process of employment; and

(iii) They derive job satisfaction.

(4) National Objectives:

These objectives are concerned with the goals of the nation.

Every business enterprise must contribute to the national goals such as:

(i) Achievement of self-sufficiency in production of goods and services,

(ii) Import substitution and export promotion,

(iii) Development of small scale and ancillary industries,

(iv) Development of backward regions,

(v) Economic development of the nation.

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