Closed community self-insurance

Some communities prefer to create virtual insurance amongst themselves by other means than contractual risk transfer, which assigns explicit numerical values to risk. A number of religious groups, including the Amish and some Muslim groups, depend on support provided by their communities when disasters strike. The risk presented by any given person is assumed collectively by the community who all bear the cost of rebuilding lost property and supporting people whose needs are suddenly greater after a loss of some kind. In supportive communities where others can be trusted to follow community leaders, this tacit form of insurance can work. In this manner the community can even out the extreme differences in insurability that exist among its members. Some further justification is also provided by invoking the moral hazard of explicit insurance contracts.
In the United Kingdom, The Crown (which, for practical purposes, meant the Civil service) did not insure property such as government buildings. If a government building was damaged, the cost of repair would be met from public funds because, in the long run, this was cheaper than paying insurance premiums. Since many UK government buildings have been sold to property companies, and rented back, this arrangement is now less common and may have disappeared altogether.

Insurance financing vehicles

• Fraternal insurance is provided on a cooperative basis by fraternal benefit societies or other social organizations.
• No-fault insurance is a type of insurance policy (typically automobile insurance) where insureds are indemnified by their own insurer regardless of fault in the incident.
• Protected Self-Insurance is an alternative risk financing mechanism in which an organization retains the mathematically calculated cost of risk within the organization and transfers the catastrophic risk with specific and aggregate limits to an insurer so the maximum total cost of the program is known. A properly designed and underwritten Protected Self-Insurance Program reduces and stabilizes the cost of insurance and provides valuable risk management information.
• Retrospectively Rated Insurance is a method of establishing a premium on large commercial accounts. The final premium is based on the insured's actual loss experience during the policy term, sometimes subject to a minimum and maximum premium, with the final premium determined by a formula. Under this plan, the current year's premium is based partially (or wholly) on the current year's losses, although the premium adjustments may take months or years beyond the current year's expiration date. The rating formula is guaranteed in the insurance contract. Formula: retrospective premium = converted loss + basic premium × tax multiplier. Numerous variations of this formula have been developed and are in use.
• Formal self insurance is the deliberate decision to pay for otherwise insurable losses out of one's own money. This can be done on a formal basis by establishing a separate fund into which funds are deposited on a periodic basis, or by simply forgoing the purchase of available insurance and paying out-of-pocket. Self insurance is usually used to pay for high-frequency, low-severity losses. Such losses, if covered by conventional insurance, mean having to pay a premium that includes loadings for the company's general expenses, cost of putting the policy on the books, acquisition expenses, premium taxes, and contingencies. While this is true for all insurance, for small, frequent losses the transaction costs may exceed the benefit of volatility reduction that insurance otherwise affords.
• Reinsurance is a type of insurance purchased by insurance companies or self-insured employers to protect against unexpected losses. Financial reinsurance is a form of reinsurance that is primarily used for capital management rather than to transfer insurance risk.
• Social insurance can be many things to many people in many countries. But a summary of its essence is that it is a collection of insurance coverages (including components of life insurance, disability income insurance, unemployment insurance, health insurance, and others), plus retirement savings, that requires participation by all citizens. By forcing everyone in society to be a policyholder and pay premiums, it ensures that everyone can become a claimant when or if he/she needs to. Along the way this inevitably becomes related to other concepts such as the justice system and the welfare state. This is a large, complicated topic that engenders tremendous debate, which can be further studied in the following articles (and others):
o National Insurance
o Social safety net
o Social security
o Social Security debate (United States)
o Social Security (United States)
o Social welfare provision
• Stop-loss insurance provides protection against catastrophic or unpredictable losses. It is purchased by organizations who do not want to assume 100% of the liability for losses arising from the plans. Under a stop-loss policy, the insurance company becomes liable for losses that exceed certain limits called deductibles.

Other types

• All-risk insurance is an insurance that covers a wide-range of incidents and perils, except those noted in the policy. All-risk insurance is different from peril-specific insurance that cover losses from only those perils listed in the policy. In car insurance, all-risk policy includes also the damages caused by the own driver.
• Business interruption insurance covers the loss of income, and the expenses occurred, after a covered peril interrupts normal business operations.
• Collateral protection insurance or CPI, insures property (primarily vehicles) held as collateral for loans made by lending institutions.
• Defense Base Act Workers' compensation or DBA Insurance provides coverage for civilian workers hired by the government to perform contracts outside the U.S. and Canada. DBA is required for all U.S. citizens, U.S. residents, U.S. Green Card holders, and all employees or subcontractors hired on overseas government contracts. Depending on the country, Foreign Nationals must also be covered under DBA. This coverage typically includes expenses related to medical treatment and loss of wages, as well as disability and death benefits.
• Expatriate insurance provides individuals and organizations operating outside of their home country with protection for automobiles, property, health, liability and business pursuits.
• Financial loss insurance or Business Interruption Insurance protects individuals and companies against various financial risks. For example, a business might purchase coverage to protect it from loss of sales if a fire in a factory prevented it from carrying out its business for a time. Insurance might also cover the failure of a creditor to pay money it owes to the insured. This type of insurance is frequently referred to as "business interruption insurance." Fidelity bonds and surety bonds are included in this category, although these products provide a benefit to a third party (the "obligee") in the event the insured party (usually referred to as the "obligor") fails to perform its obligations under a contract with the obligee.
• Kidnap and ransom insurance
• Legal Expenses Insurance covers policyholders against the potential costs of legal action against an institution or an individual.
• Locked funds insurance is a little-known hybrid insurance policy jointly issued by governments and banks. It is used to protect public funds from tamper by unauthorized parties. In special cases, a government may authorize its use in protecting semi-private funds which are liable to tamper. The terms of this type of insurance are usually very strict. Therefore it is used only in extreme cases where maximum security of funds is required.
• Media Insurance is designed to cover professionals that engage in film, video and TV production.
• Nuclear incident insurance covers damages resulting from an incident involving radioactive materials and is generally arranged at the national level. See the Nuclear exclusion clause and for the United States the Price-Anderson Nuclear Industries Indemnity Act)
• Pet insurance insures pets against accidents and illnesses - some companies cover routine/wellness care and burial, as well.
• Pollution Insurance which consists of first-party coverage for contamination of insured property either by external or on-site sources. Coverage for liability to third parties arising from contamination of air, water, or land due to the sudden and accidental release of hazardous materials from the insured site. The policy usually covers the costs of cleanup and may include coverage for releases from underground storage tanks. Intentional acts are specifically excluded.
• Purchase insurance is aimed at providing protection on the products people purchase. Purchase insurance can cover individual purchase protection, warranties, guarantees, care plans and even mobile phone insurance. Such insurance is normally very limited in the scope of problems that are covered by the policy.
• Title insurance provides a guarantee that title to real property is vested in the purchaser and/or mortgagee, free and clear of liens or encumbrances. It is usually issued in conjunction with a search of the public records performed at the time of a real estate transaction.
• Travel insurance is an insurance cover taken by those who travel abroad, which covers certain losses such as medical expenses, loss of personal belongings, travel delay, personal liabilities, etc.

Credit

Credit insurance repays some or all of a loan when certain things happen to the borrower such as unemployment, disability, or death.
• Mortgage insurance insures the lender against default by the borrower. Mortgage insurance is a form of credit insurance, although the name credit insurance more often is used to refer to policies that cover other kinds of debt.
• Many credit cards offer payment protection plans which are a form of credit insurance.

Liability

Liability insurance is a very broad superset that covers legal claims against the insured. Many types of insurance include an aspect of liability coverage. For example, a homeowner's insurance policy will normally include liability coverage which protects the insured in the event of a claim brought by someone who slips and falls on the property; automobile insurance also includes an aspect of liability insurance that indemnifies against the harm that a crashing car can cause to others' lives, health, or property. The protection offered by a liability insurance policy is twofold: a legal defense in the event of a lawsuit commenced against the policyholder and indemnification (payment on behalf of the insured) with respect to a settlement or court verdict. Liability policies typically cover only the negligence of the insured, and will not apply to results of wilful or intentional acts by the insured.
• Public liability insurance covers a business against claims should its operations injure a member of the public or damage their property in some way.
• Directors and officers liability insurance protects an organization (usually a corporation) from costs associated with litigation resulting from mistakes made by directors and officers for which they are liable. In the industry, it is usually called "D&O" for short.
• Environmental liability insurance protects the insured from bodily injury, property damage and cleanup costs as a result of the dispersal, release or escape of pollutants.
• Errors and omissions insurance: See "Professional liability insurance" under "Liability insurance".
• Prize indemnity insurance protects the insured from giving away a large prize at a specific event. Examples would include offering prizes to contestants who can make a half-court shot at a basketball game, or a hole-in-one at a golf tournament.
• Professional liability insurance, also called professional indemnity insurance, protects insured professionals such as architectural corporation and medical practice against potential negligence claims made by their patients/clients. Professional liability insurance may take on different names depending on the profession. For example, professional liability insurance in reference to the medical profession may be called malpractice insurance. Notaries public may take out errors and omissions insurance (E&O). Other potential E&O policyholders include, for example, real estate brokers, Insurance agents, home inspectors, appraisers, and website developers.

Property

This tornado damage to an Illinois home would be considered an "Act of God" for insurance purposes
Property insurance provides protection against risks to property, such as fire, theft or weather damage. This includes specialized forms of insurance such as fire insurance, flood insurance, earthquake insurance, home insurance, inland marine insurance or boiler insurance.
• Automobile insurance, known in the UK as motor insurance, is probably the most common form of insurance and may cover both legal liability claims against the driver and loss of or damage to the insured's vehicle itself. Throughout the United States an auto insurance policy is required to legally operate a motor vehicle on public roads. In some jurisdictions, bodily injury compensation for automobile accident victims has been changed to a no-fault system, which reduces or eliminates the ability to sue for compensation but provides automatic eligibility for benefits. Credit card companies insure against damage on rented cars.
o Driving School Insurance provides cover for any authorized driver whilst undergoing tuition, cover also unlike other motor policies provides cover for instructor liability where both the pupil and driving instructor are equally liable in the event of a claim.
• Aviation insurance insures against hull, spares, deductibles, hull wear and liability risks.
• Boiler insurance (also known as boiler and machinery insurance or equipment breakdown insurance) insures against accidental physical damage to equipment or machinery.
• Builder's risk insurance insures against the risk of physical loss or damage to property during construction. Builder's risk insurance is typically written on an "all risk" basis covering damage due to any cause (including the negligence of the insured) not otherwise expressly excluded. Builder's risk insurance is coverage that protects a person's or organization's insurable interest in materials, fixtures and/or equipment being used in the construction or renovation of a building or structure should those items sustain physical loss or damage from a covered cause.[
• Crop insurance "Farmers use crop insurance to reduce or manage various risks associated with growing crops. Such risks include crop loss or damage caused by weather, hail, drought, frost damage, insects, or disease, for instance."
• Earthquake insurance is a form of property insurance that pays the policyholder in the event of an earthquake that causes damage to the property. Most ordinary homeowners insurance policies do not cover earthquake damage. Most earthquake insurance policies feature a high deductible. Rates depend on location and the probability of an earthquake, as well as the construction of the home.
• A fidelity bond is a form of casualty insurance that covers policyholders for losses that they incur as a result of fraudulent acts by specified individuals. It usually insures a business for losses caused by the dishonest acts of its employees.
• Flood insurance protects against property loss due to flooding. Many insurers in the U.S. do not provide flood insurance in some portions of the country. In response to this, the federal government created the National Flood Insurance Program which serves as the insurer of last resort.
• Home insurance, also commonly called hazard insurance or homeowners insurance (often abbreviated in the real estate industry as HOI), is the type of property insurance that covers private homes.
• Landlord insurance covers residential and commercial properties which are rented to others. Most homeowner's insurance covers only owner-occupied homes.
• Marine insurance and marine cargo insurance cover the loss or damage of ships at sea or on inland waterways, and of cargo in transit, regardless of the method of transit. When the owner of the cargo and the carrier are separate corporations, marine cargo insurance typically compensates the owner of cargo for losses sustained from fire, shipwreck, etc., but excludes losses that can be recovered from the carrier or the carrier's insurance. Many marine insurance underwriters will include "time element" coverage in such policies, which extends the indemnity to cover loss of profit and other business expenses attributable to the delay caused by a covered loss.
• Surety bond insurance is a three party insurance guaranteeing the performance of the principal.
• Terrorism insurance provides protection against any loss or damage caused by terrorist activities.
• Volcano insurance is an insurance that covers volcano damage in Hawaii.
• Windstorm insurance is an insurance covering the damage that can be caused by hurricanes and tropical cyclones.

Life

Life insurance provides a monetary benefit to a decedent's family or other designated beneficiary, and may specifically provide for income to an insured person's family, burial, funeral and other final expenses. Life insurance policies often allow the option of having the proceeds paid to the beneficiary either in a lump sum cash payment or an annuity.
Annuities provide a stream of payments and are generally classified as insurance because they are issued by insurance companies and regulated as insurance and require the same kinds of actuarial and investment management expertise that life insurance requires. Annuities and pensions that pay a benefit for life are sometimes regarded as insurance against the possibility that a retiree will outlive his or her financial resources. In that sense, they are the complement of life insurance and, from an underwriting perspective, are the mirror image of life insurance.
Certain life insurance contracts accumulate cash values, which may be taken by the insured if the policy is surrendered or which may be borrowed against. Some policies, such as annuities and endowment policies, are financial instruments to accumulate or liquidate wealth when it is needed.
In many countries, such as the U.S. and the UK, the tax law provides that the interest on this cash value is not taxable under certain circumstances. This leads to widespread use of life insurance as a tax-efficient method of saving as well as protection in the event of early death.
In U.S., the tax on interest income on life insurance policies and annuities is generally deferred. However, in some cases the benefit derived from tax deferral may be offset by a low return. This depends upon the insuring company, the type of policy and other variables (mortality, market return, etc.). Moreover, other income tax saving vehicles (e.g., IRAs, 401(k) plans, Roth IRAs) may be better alternatives for value accumulation.

Casualty

Casualty insurance insures against accidents, not necessarily tied to any specific property.
• Crime insurance is a form of casualty insurance that covers the policyholder against losses arising from the criminal acts of third parties. For example, a company can obtain crime insurance to cover losses arising from theft or embezzlement.
• Political risk insurance is a form of casualty insurance that can be taken out by businesses with operations in countries in which there is a risk that revolution or other political conditions will result in a loss.

Accident, Sickness and Unemployment Insurance

• Disability insurance policies provide financial support in the event the policyholder is unable to work because of disabling illness or injury. It provides monthly support to help pay such obligations as mortgage loans and credit cards. Short-term and long-term disability policies are available to individuals, but considering the expense, long-term policies are generally obtained only by those with at least six-figure incomes, such as doctors, lawyers, etc. Short-term disability insurance covers a person for a period generally up to six months, paying a stipend each month to cover medical bills and other necessities.
• Long-term disability insurance covers an individual's expenses for the long term, up until such time as they are considered permanently disabled and thereafter. Insurance companies will often try to find other ways to employ the person and reintegrate them back into the work force in preference to and before declaring them unable to work at all and therefore totally disabled. Insurance companies, for obvious reasons, frequently go to great lengths, including undercover surveillance via videocam and repeated independent medical evaluations by company doctors, in hopes of avoiding the necessity of paying permanent disability stipends to a claimant.
• If you are in the market to purchase long-term disability insurance, try to find out whether the prospective insurer has ONLY their own doctors handle ALL claims (including the questionable ones), or whether they hire out to firms who perform medical file reviews and Independent Medical Examinations, and whose doctors have nothing to gain or lose regardless of the opinion they derive from looking at your records or performing an exam. Your claim, should it eventuate to be disability of a permanent nature, is often more likely to be approved if "questionable" claims (those that don't involve loss of all four limbs) are hired out to independent firms for file reviews and/or IMEs as opposed to always being handled by inhouse doctors working solely for the insurance company. Independent companies, such as University Disability Consortium, for instance, perform medical file reviews and IMEs for insurance companies, plaintiff and defense attorneys, among others, and because they have no stake or say-so regarding the final determination of a claimant's disability status, provide totally unbiased reports and IMEs and are, as a result, more likely to facilitate a desirable outcome for the person seeking permanent disability status than are reports and exams performed by doctors who work for the insurance company and have a great deal to gain or lose (e.g., bonuses, their jobs) when disability claims are upheld. So, caveat emptor: beware the practices of your prospective provider regarding claims of total disability prior to handing over those exhorbitant fees they demand per LTD (long-term disability) policy.
• Disability overhead insurance allows business owners to cover the overhead expenses of their business while they are unable to work.
• Total permanent disability insurance provides benefits when a person is permanently disabled and can no longer work in their profession, often taken as an adjunct to life insurance.
• Workers' compensation insurance replaces all or part of a worker's wages lost and accompanying medical expenses incurred because of a job-related injury.

Health

Health insurance policies by the National Health Service in the United Kingdom (NHS) or other publicly-funded health programs will cover the cost of medical treatments. Dental insurance, like medical insurance, is coverage for individuals to protect them against dental costs. In the U.S. and Canada, dental insurance is often part of an employer's benefits package, along with health insurance.

Home insurance

Home insurance provides compensation for damage or destruction of a home from disasters. In some geographical areas, the standard insurances exclude certain types of disasters, such as flood and earthquakes, that require additional coverage. Maintenance-related problems are the homeowners' responsibility. The policy may include inventory, or this can be bought as a separate policy, especially for people who rent housing. In some countries, insurers offer a package which may include liability and legal responsibility for injuries and property damage caused by members of the household, including pets.

Auto insurance

Auto insurance protects you against financial loss if you have an accident. It is a contract between the insured and the insurance company. You agree to pay the premium and the insurance company agrees to pay losses as defined in the policy. Auto insurance provides property, liability and medical coverage:
1.Property coverage pays for damage to or theft of the car.
2.Liability coverage pays for the legal responsibility to others for bodily injury or property damage.
3.Medical coverage pays for the cost of treating injuries, rehabilitation and sometimes lost wages and funeral expenses.
An auto insurance policy comprises six kinds of coverage. Most countries require you to buy some, but not all, of these coverages. If you're financing a car, the lender may also have requirements. Most auto policies are for six months to a year.
In the United States, the insurance company should notify you by mail when it’s time to renew the policy and to pay the premium.

TYPES OF PRODUCTION FUNCTION

In economic theory we are concerned with three types of production functions, viz.;
? The production function with one variable input.
? The production function with two variable inputs and
? The production function with all variable inputs.
THE LAW OF VARIABLE PROPORTION
This law states that if equal increments of an input are added, and the quantities of other inputs held constant, the resulting increments of product will decrease beyond some point; that is, the marginal product of the input will diminish.
The law of diminishing returns is sometimes called the law of diminishing marginal returns to emphasize the fact that it deals with the diminishing marginal product of a variable input factor. The law of diminishing returns can’t be derived deductively. It is a generalization of an empirical regularity associated with every known production system.
The law of variable proportion (law of diminishing returns) is related to short run production process. It refers to the behavior of output as the quantity of one factor is increased; keeping the quantity of other factors fixed. Further it states that the marginal and average product will eventually decline.
Assumptions
It is assumed that there is no change in the technique of production
The law specially operates in the short-run
It is assumed that some inputs are kept fixed and labour is varied
This law is based on the assumption that the variable resources are applied unit by unit
The variable factors are homogeneous
Inputs prices remain unchanged, and
The law will not be applied if the proportions between factors are fixed for example: tailor master and sewing machine, computer operators and computers.

Therefore, the above assumptions must be satisfied for the application of the law of variable proportion. The situation of total product (TP), average product (AP) and marginal product (MP) can be explained with the law of variable proportion when quantity of variable factor is to the fixed factor of production.
The law can be illustrated with the help of an iron mine industry. Lets suppose the iron mine industry has a set of mining machinery as its capital (K) which is fixed in short-run and the industry can employ more of labour to increase its iron production.
The three stages
With labour time continuously divisible, we can smooth TP, MP and AP curves. The MPL (given by the slope of kthe tangent to the TP curve) rises upto point E’ becomes zero at J’, and is negative thereafter. The APL (given by the slope of the ray from the origin to a point on the TP curve) rises upto point F’ and declines thereafter (but remains positive as long as TP is positive). Stage I of production for labour corresponds to the rising portion of the APL. Stage II covers the range form maximum APL to where MPL is zero. Stage III occurs where MPL is negative.
Stage I: Stage of increasing returns
In this stage the following states are observed
? MP>AP i.e. marginal product is greater than average product
? After point E’, MR is decreasing but it is more than AP
? Upto point E, TP increase at an increasing rate, i.e. the slope of TP curve will be increasing. So, at E’, MP will be maximally and after that MT will start decreasing.
? Stage I ends after MP equals AP.
Causes of increasing returns in stage I
The causes of increasing returns in stage I is as follows
? In the initial stage the quantity of fixed facto is abundant in comparison to the quantity of variable factor
? Increases in the efficiency or productivity of variable factor.
Stage II: Stage of diminishing returns
In the stage the following states are observed
? AP and MP both will be decreasing
? AP> MP i.e. average product is greater than marginal product
? The stage ends when marginal product becomes zero i.e., MP = 0
? When the slope of the TP is zero, the MP is also zero. Since N’ and MP both are decreasing, this stage is known as the stage of decreasing returns.
Causes of diminishing returns in stage II
The causes of diminishing returns in stage II are as follows:
? Scarcity of the fixed factor relative to the quantity of the variable factor
? Indivisibility of fixed factor
? Imperfect substitutability of the factors
Stage III: Stage of negative returns
In this stage the following states are observed
? TP is declining.
? Slope of TP is negative, i.e. slope of TP (MP) to
? AP is declining but positive
Causes of negative returns in stage III
? If we keep on adding variable factors like labour on a given quantity of fixed factor (land), this will lead to overcrowding on the fixed factor. There will be therefore, lower availability of tools and equipment per worker, which causes fall in production.
? Use of too much of variable factors like labour also creates the problem of effective management. When there are too many workers, they may shift responsibility on to others. It becomes difficult to fix responsibility. The labour can therefore avoid the work.

PRODUCTION FUNCTION

The production function is the key concept of production theory because it is the link between input usage and an attainable level of output. It describes the relation between physical rates of input usage and its rate of output. With a given state of technology, the attainable level of output depends largely, but not entirely upon the quantities of the various inputs employed in the production process.
A production function is usually defined as a schedule (or equation, table, or graph) showing the maximum output of a commodity that can be produced per period of time from a fixed amount of resources, given the existing technology or the art of production. In sort, the production function is a catalog of a firm’s output possibilities.

PRODUCTION INRODUCTION

Production refers to the transformation of inputs or resources into outputs of goods and services. So, it is the creation of goods and services from inputs or resources, such as labour, machinery and other capital equipment, land, raw materials, and so on, rather than referring merely to the physical transformation of inputs into outputs of goods and services.
Using production theory, decision makers determine how much of the variable input(s) to use in combination with the fixed input(s) to produce a particular level of output. By applying the concepts of production theory, the decision makers can determine the combination of inputs to use to produce a given amount of output at the lowest total cost. Production analysis also enables decision makers to understand the integrated nature of the firm the relationship among the various factors employed by the firm and among the functional units.
Decision makers make production decisions in two different decision-making time frames
? Short-run production decisions, and
? Long-run production decisions.
In short-run decision making situations, a decision maker must produce with at least one input that is fixed in quality. In a typical short-run situation, the decision maker has a fixed amount of plant and equipment with which to produce the firm’s output.
In long-run decision making concerns the usage of all inputs can be either increased or decreased. In the long-run, a decision maker can choose to operate in any size plant with any amount of capital equipment.
In conclusion, the short-run as the time period during which production actually takes place and the long-run as the planning horizon during which future production will take place.

LIMINATIONS OF FORECASTING

Firm makes forecasting to design production schedule, arrangement of raw materials and labor, capital expansion plan, investment and inventory policy and plant expansion or contraction plan etc. but forecasts are rarely cent percent correct. The reasons behind this are:
? The underlying phenomenon does not have in a manner that warrants the use of information from the past and present to obtain reliable cent percent correct future. ? The phenomena might behave according to some set pattern but economic science does not have the necessary tools to discover them.
? There is lack of actual data and there by hinders the reliable prediction.
? Economic relationships are not as easily deducible as in the natural sciences.
Economic forecasts are approximations or mere generalizations. They have to be modified in accordance of changing situations. The forecast of the economic events are made on the assumption that these events have some continuity for future. That is forecasting for future can be used to reduce uncertainty for tomorrow by the help of present and past information’s. Thus, the main aim of forecasting is to reduce uncertainty about tomorrow by expectation that value of forecast will lie near the truth. The real test of forecast are higher than the costs involved. But there are some limitations of the demand forecasting due to which forecast may go in wrong direction.
Use of Techniques: The degree of accuracy of the forecasting depends on the techniques used. The forecast is made on the assumption’ that there are definite relationships between certain variables such as income, price, advertising and sales. The wrong assumptions may result the forecasting errors. Forecast errors may appear because
? There is possibility of change in the relationships established on the basis of past data.
? Possibility of not following the established relationship in the future as in the past.
? Some variables like government expenditure, profit in previous year are the exogenous and lie outside the system and are unpredictable.
Economic Error: The economic error occurs out of the formulation of an inappropriate relationship between variables, because the economic relationship between the variables depends on the situation of the time of formulating relationships. These relationships are usually influenced by may such economic and political factors.
Measurability of Phenomenon: Another error may occur due to measurability of phenomenon. For example, there are many variables, which affect forecasts such as fashion, attitudes of consumers, weather etc., which are difficult to measure and collect.
Statistical Error: Statistical error also affects the accuracy of forecasting. Statistical error occurs due to the reasons, like- negligence of the persons who compile data, defective sample, unrepresentative sample size etc. The degree of accuracy can be increased but it leads higher costs and attention, which may be not profitable for the firm in view of time and resources.
Durability of Goods: The forecast of durable goods maybe less accurate because there are very little replacement demand for such goods. In the long run sudden incidence such as war, wide depression and prosperity, technological discovery, invention, development may occur.
To conclude, there may be error, uncertainties and differences in forecasting. But the importance of forecasting for the modern business enterprises is unavoidable. The forecasting plays a crucial role in the development of business activities. Therefore, efforts should be made to obtain better results from the scientific way of forecasting.

CONCEPT OF INPUT-OUTPUT ANALYSIS

Using a device known as the input-output table generates input-output forecasts. W. Leontief developed this method and it is associated with his name. Basically an input-output table is a matrix, each area of which shows an output or sales of a particular sector of the economy. Similarly, each column indicates all the input used by a particular sector of the economy. Moreover, it shows the use of the output of each industry as inputs by other industries and for final consumption. For example, it shows how an increase in the demand for trucks will lead to an increase in the demand for steel, glass, tires, plastic and so on, and how the increase in the demand for these products will in turn lead to an increase in the demand for the inputs required to produce them (including trucks). Input output analysis tables shows the purchases by a particular sector from all the other sectors.

Barometric Techniques

When there is no clear pattern in a time series data this is an alternative approach to forecast or anticipate short-term changes in economic activity or turning points in business cycles is to use the index of leading economic indicators. These are time series that tend to lead changes in the level of general economic activity Just as changes in mercury in a barometer precede changes in weather conditions so if is called barometric methods. Economic forecasters, especially in the U.S.A., have always tried to search out certain indicators of a change in economic activity. A general business indicator is a series of index of several different business activities combined into one general index of business activity. There is no simple indicator when even provides a consistent signal for change. But there are well known time series that have served as barometers of change.
The pioneering work in this area has been done by the economic at the National Bureau of economic research (U.S.A.). They have classified economic time series into three broad categories: leading indicators, coincident indicators and lagging indicators. These indicators provide signals or indications of changes in economic activity, such as national income, or national product, the level of employment or the rate of price inflation.
Leading Indicator: If the changes in one series consistently occur prior to changes in another series a leading indicator has been identified. In figure 2.8 (a) series A can be considered a leading indicator of series B because the peaks and through consistently occur ahead of series B.
Coincident Indicator: If two series of data frequently move up or down at the same time, one series may be regarded as a coincident of other. For example in figure 2.8 (b) series A is coincident indicator of series B.
Lagging Indicator: The lagging indicators move up or down after the leading indicators have moved. There is a time lag. For example, the bank rate is the leading indicator: the rate of interest charged by commercial bank is coincident indicator, and the rate of interest charged by the money lender is a lagging indicator.
Composite Indices: Composite barometric indices are established to over come the unreliability of single barometric indicator. Composite index is prepared by aggregating several leading indicators. The main merit of this method is that it takes account of movement not in one indicator but in several leading indicators. The composite leading index points out more reliably turning points in the future demand for a particular product.
Diffusion Index: Diffusion index shows the proportion of the total number of series in a selected collection that are rising at any point of time. For example, to forecast GNP, if diffusion index exceeds 50 percent, we can predict that GNP will be increasing and when it is less than 50 percent, we expect that GNP will be declining.

Survey Techniques

Surveys and opinion polls are often used to make short term forecasts when quantitative data are not available. These qualitative methods can also be very useful for supplementing quantitative forecasts that anticipate changes in consumer tastes or business expectations about future economic conditions. That can also be useful in forecasting the demand for new product that the firm intends to introduce.
Consumer Survey Methods
Consumer are asked what quantity of the product, they would be willing to buy under various conditions such as price and income levels. This method is known as direct interview method. This method may cover almost all the potential consumer’s or only selected groups of consumers from different cities or parts of the area of consumer concentration. When all the consumers are interviewed, the method is known as complete enumeration and when only a few selected representative consumer’s are interviewed, it is known as sample survey method. In case of industrial inputs, interviews or postal inquiry of only end users of a product may be required.
Regression Analysis
Regression analysis is most popular statistical techniques of demand estimation. Economic theory is employed to specify the determinants of demand and to examine the nature of relationship between the demand for a product and its determinants. In regression method of demand forecasting the firm estimates the demand function for a product. In the demand function, quantity to be forecasted is “dependent” variable and all other variables that affect the demand are called “independent” or “explanatory” variables. For example, demand for meat in Kathmandu may be said to depend largely on ‘per capita income’ of the city and its population. Here demand for ‘meat’ is a ‘dependent variable’ and ‘per capita income’ and population are the ‘explanatory’ variables.
While determining the demand function for particular commodity, the analyst may come across many commodities whose demand depends on a single independent variable. For example, suppose, in a city, demand for items like salt, gas, sugar, is found to depend on the population of the city then demand functions for such commodities are single variable demand functions. On the other hand if analyst find that demand for vegetables, fruits, beer, etc. depends on a number of variables like commodity’s own price, price of its substitutes, household income, population, customs, habits etc. such demand function are called Multi-variable demand function. Simple regression equation is used for single variable demand functions and multi-variable regression equation is used for multiple variable regression are explained below.
Simple Regression (Single Variable)
In simple regression method, a single independent variable is used to estimate a statistical value of the dependent variable which is to be forecasted. This technique is similar to trend fitting (least square) method. A key difference between trend fitting and regression method is that, in the case of trend fitting, independent variable is time (t) where as in regression equation the chosen independent variable is the single most important determinant of demand.
Multi- Variable Regression
Liner Function: The multi variety regression equation is employed for cases in which number of explanatory variables is greater than one.
The first step here is to identify the determinants of the variable to be forecasted. For example, for estimating demand for capital goods the relevant variables are additional corporate investment, rate of depreciation, cost of capital goods, cost of labor and raw materials, market rate of interest, etc. Similarly in forecasting the demand for breakfast cereals, the relevant variables are price of the breakfast cereals (p), consumer s disposable income (Y), the size of the population (pop), price of substitutes (Ps), the price of milk (Pc – a compliment), level of advertising by the firm (A). Once independent variables are specified and necessary data are collected, the next step is to0 specify the form of equation.
Power Function: In linear equation the marginal effect of independent variables on demand is assumed to be constant and independent of change in other variables. But there may cases in which the marginal effects of each independent variables as well as on the value of all other variables in the demand function.
Simultaneous Equations or Multiple Equation Method
Although single equation models (liner equation) are often used by firms to forecast demand or sales, economic relationship may be so complex that a multiple-equation model may be required. This is particularly used in forecasting macro variables such as GNP or the demand and sales of major sections or industries. Multiple-equation models may consist only a few equations or hundreds of equations.

Forecasting Techniques

Several methods are available for forecasting economic variables. They range from the very naïve that require little effort to very sophisticated ones that are very costly in terms of time and effort. Some forecasting techniques are basically qualitative, while others are quantitative. Some are based on examining only past values of the data series to forecast its future based on a great deal of additional data and relationships some are performed by e firm itself, other’s are purchased from consulting firms. In general, forecasting techniques can be divided into following two broad categories.
It is impossible to argue that any one of these forecasting techniques is superior to others. Each method has its strengths and weakness. The best forecast methodology for a particular task depends on the nature of the specific forecasting problem.
Therefore, choice of technique depends upon a number of important factors. The important factors must be considered for appropriate methodology are- distance into the future, the lead time available for making decisions, the level of accuracy required, the quality of data available for analysis, deterministic nature of forecast relations and the cost and benefits associated with the forecasting problem.
Forecasting methodology such as trend analysis, market experiments, customer surveys and the leading indicator are more useful for short term forecasts, while others, such as complex econometric models, input-output methods, are more useful for long-term forecasting of one year or longer. In general, the greater the level of accuracy required and the more complex the relationship to be forecasted, the more sophisticated and expensive will be the forecasting exercise. By considering the advantages and limitations of each forecasting technique, managers can choose the appropriate method or combinations of methods to generate required results. In this chapter we shall examine the advantages and limitations of the each forecasting technique presented in the chart.

Plant Expansion or Contraction Plan

Plant Expansion or Contraction Plan: Economic forecasts help all firms in estimating the amount of sales and production for a certain period of future. On the basis of those estimates, a firm can prepare plan for the expansion or contraction of its production capacity.

Investment and Inventory Policy

Investment and Inventory Policy: On the basis of forecasts of price trends, a firm can determine its investment and inventory policy. For example, if there is a hope of price rise in future, the firm may decide to maintain more inventories and if on the contrary, there is a hope of decline in prices in future, the firm tries to work with minimum level of stock.

Capital Expansion Plan

Capital Expansion Plan: Economic forecasts help in estimating the amount of credit that can be collected by a firm during a certain period of future from bands financial institutions and other sources. On the basis of these forecasts, a firm can easily prepare plans for capital expansion.

Importance of Economic Forecasting for a Business Firm

Importance of Economic Forecasting for a business firm are as follows:
Predicting of sales of a firm: It is a well known fact that during the phase of depression, sales of a firm start to decline and during the phase of prosperity, these sales start to increase. On the basis of economic forecasts, total sales for an industry can be easily forecasted and a firm can forecast its share easily on the basis of such forecasts.
Arrangement of Raw Materials: Economic forecasts help in the arrangement of raw materials in adequate quantity and at proper time. These forecasts help in determining the amount of sales and production for a certain period of future. Requirements of raw materials can easily be estimated on the basis of forecasts of sales and production. A firm can decide proper time for placing the order of raw materials. It can decide economic order quantity also.
Arrangement of Labor: Economic forecasts help a firm in the arrangement adequate labor also, both quantitatively and qualitatively. Forecasts of sales and production help the firm in estimating the requirements of labor for a certain period of future. These forecasts are very important for the firms, which have to train their workers before placing them on job.

Steps in Demand Forecasting

The following steps are necessary to have an efficient forecast of demand.
Identification of objective: First step of demand forecasting is to identify and clearly state the objective of the forecasting. The objective of the forecasting may be short term or long term and it may be for market share forecasts or for industry as whole. So approach of demand forecasting may be different for different objectives.
Ascertaining the demand determinants and probable relationship with demand: Second step of demand forecasting is to ascertain the factor’s influencing he demand because factor’s influencing the demand may differ widely depending upon the nature of the product under consideration such as consumer’s durable goods, capital gods and consumer’s non durable goods. Once the factor’s influencing demand (variables) have been specified and the data gathered the next necessary step is to specify the form of the equation in which the independent variables are assumed to interact to determine the level of demand. The most common specification is a linear relationship such as:
Q = a + bp + ca + dy
Here, Q refers to the quality of a particular product demanded, p is the price charged, A refer advertising expenditures, and Y is per capita income. The quantity demanded is assumed to change linearly with changes in each of the independent variable for instance, it b = -2.0, demand will decline by 2 units for each 1 unit increase in the price of the product.
Selecting a proper method of forecasting: The selection of an appropriate method of forecasting is based upon the objective of the forecasting, type of data available, period for which the forecast is to be made, etc.
Interpretation of results and present the findings in a readable form: Mere preparation of forecasts does not lead the management anywhere. Interpretation of results is of equal importance. Management is interested only in the actual forecasts and their implication in practice. Interpretation of the results or findings should be presented in simple, clear and understandable manner. It is also equal importance to revise the forecasts in the light of changing circumstances constantly because forecasts are made on the assumptions of continuation of past events.

Purposes of Long-Term Forecasting

Planning of a new unit and expansion of an existing unit: A firm should have information about long-term demand prospects for his products to make long-term demand of the products. A multi-product firm must ascertain total demand as well as individual demand for different items separately. If a firm has better knowledge than its rivals about growth trends of the aggregate demand and of the distribution of the demand over various products, its competitive position would be much better.
Planning long-term financial requirements: Purpose of long-term planning and for raising funds, it requires considerable advance information. Thus, long-term sales forecasts are quite essential to assess long-term financial requirements.
Planning manpower requirements: Training and personnel development are long term propositions, takes considerable time to complete. They can be started well in advance only on the basis of estimates of manpower requirements assessed according to long term sales forecasts.
Providing guideline for demand forecasts for related industries: Industries are interrelated in different ways. The demand forecasts of particular products can also provide a guideline for demand forecasts for related industries. For example, the demand forecasts for cotton textiles may provide an idea of the likely demand for the textile machine, industry, dyestuff industry, ready made garments industry.
Guiding the government: Macro level forecasts may also help the government in determining whether imports are necessary to meet any possible deficit in the domestic supply or in devising appropriate export promotion policies if there is a surplus product in the domestic market.

FORECASTING

Concept and Purposes of Forecasting
Business or economic forecasting is necessary for forecasting the long-term demand for the firm’s product/products. Most business decisions are made in the face of risk or uncertainty. A firm must decide how much of each product to produce? What price to charge? And how much to spend on advertising? And it must also plan for the future growth of firm. All these decisions are based on some forecast of the level of future economic activity in general and demand the firm’s product(s) in particular. The aim of economic forecasting is to reduce the risk or uncertainty that the firm faces in its short-term decision-making and in planning for its long-term growth.
Forecasting the demand and sales of the firm’s product usually begins with macro-economic forecast of the general level of economic activity for the economy as whole because demand and sales of most goods and services are strongly affected by business conditions. For example, the demand and sales of new automobiles, new houses, electricity activity. The firm uses these macro forecasts of general economic activity as inputs for their micro forecasts of the industry’s and firms demand and sales. The firm’s demand and sale’s are usually forecast on the basis of its historical market share and its planned marketing strategy. From its general sales forecast, the firm can then forecast its sales by product line and region. Those, in turn, are used to forecast the firm’s operational needs for production (raw material, equipment, warehousing, workers), marketing (distribution network, sales force, proportional campaign), finances (cash flow) profits, need for and cost of outside financing, and personnel throughout the firm. The firm utilizes long-term forecasts for the economy and the industry expenditures on plant equipment to meet its long-term growth plan and strategy.
The purposes of forecasting differ according to types of forecasting. The purposes of short term and long-term forecasting can be out lined as follows:
Purposes of Short-Term Forecasting
Formulating an appropriate production policy: Future is uncertain so there is possibility of emergence of problems of overproduction or lack of sufficient supply of goods and services in the country due to mismatch between actual and estimated sales. Both situations are harmful to the firms. So, most of the producer’s have already realized the need of production schedules so as to avoid such problems of over production and short of supply. For this purpose, production schedule have to be geared to expected sales. Thus, one of the purpose of short-term forecasting is to formulate an appropriate production policy.
Deciding appropriate price policy: Appropriate price policy is required to avoid a price increase when the market conditions are expected to be weak and a reduction when the market is going to be strong.
Setting sales targets: If sales targets are set too high, they will be discouraging salesmen who fail to achieve targets. If sales targets are if set too low, the targets will be achieved easily and hence incentives will prove meaningless.
Forecasting the financial requirement: Financial requirement for a firm depends on sales level and production operations. Arrangement for funds in advance can hardly be done without knowing the volume of future production operation and sales. Therefore, sales forecast enable arrangement of sufficient funds on reasonable terms well in advance.
Reducing cost of purchasing raw materials and controlling inventory: The appropriate sales forecasts can reduce the costs of purchasing raw materials and controlling inventory by determining its future resource requirements.

Evolving a suitable advertising and promotional programme : Short-term forecasting helps management in finding suitable advertising and promotional programme and out lay so as to avoided wastage from them.

Price Discrimination

Price Discrimination: A monopolist adopts a price discrimination policy only when he finds the elasticity of demand of different-consumer or sub-markets is different. If demand is inelastic he can charge high price than those with more-elastic demand.
Public Utility Pricing: In case of public utilities that are run as monopoly undertakings, e.g. electricity, water supply, railways, postal services, telecommunication, price discrimination is generally practiced, charging higher prices from users with inelastic demand and lower prices in case of elastic demand is desirable for them.
Joint Supply: Certain goods, being products of the same process, are jointly supplied, e.g.; wool and mutton, compressor and refrigerator, etc. Here if the demand for one product say wool is inelastic compared to the another say demand for mutton, a higher price for wool can be charged.
Factor Pricing: The factors having price-elastic demand can get a higher price than those with inelastic demand.
Use of Machine: Labors often oppose use of machine due to fear of unemployment. When machines reduce costs and hence price of products, if the products demand is elastic, the demand will go up, production will have to be increased and more labors may be employed. On the contrary, if demand for the product is inelastic, machines will lead to unemployment as – lower prices(due to lesser costs) will not increase the demand.
International Trade: The concept of elasticity of demand has great practical importance in the determination of the gains from international trade. On the basis of elasticity of demand we will gain from trade if we export goods with less elasticity of demand and import those goods for which our demand is elastic. In the first case we will be able to charge higher prices for our products and in the later case we will be paying less for the goods imported from other country.
Policy of Devaluation: The consideration of price elasticity of demand for imports and exports is important for a country, which is thinking of correcting her balance of payments by devaluation. Devaluation makes export cheaper and imports dearer of the country adopting it.
Shifting of Tax Burden: If demand is inelastic a businessman is able to shift a commodity tax to his customers but when demand is elastic, he will have to bear the tax burden himself.
Taxation Policy: Government can easily raise tax revenue by taxing commodities which are price inelastic.
Price Elasticity and Decision making/Optional Price
Information about price elasticities can be extremely useful to managers as they have sound knowledge about it. If demand for product is inelastic at the current price, a price decrease will result in a decrease in total revenue. Alternatively if demand is elastic at the current price, a price decrease would cause revenue to increase. However, if demand is unitary elasticity, price changes will not change total revenues.
Income Elasticity and Business Decisions
The concept of elasticity for a firm’s product is an important factors that influences firm’s success at different stages of the business cycles. During periods of expansion, income are rising and firms selling Luxury items will find that the demand for their products will increase at a rate faster than the rate of income growth. However, during a recession period demand may rapidly. Conversely, sellers of necessities such as fuel and basic food items will not benefit as mush during prosperity, but will also find that their markets are somewhat recession proof. That is, the change in demand will be less than that is the economy in general. Similarly, concept of income elasticity can be useful in targeting marketing efforts. For example, firm producing Luxury items should concentrate its marketing efforts on media that reach the high-income segments of the population.
Cross Elasticity and Decision-Making
The cross-price elasticity of demand is a very important concept in managerial decision-making. Firm often use this concept to measure the effect of changing the price of product they sell on the demand of other related products that the firm also sells. For example, Gillette can use the cross-price elasticity of demand to measure the effect on changing the price of razor blades on the demand for razors.
Cross elasticity are also useful in establishing boundaries between industries. Sometimes it is very difficult to determine which products should be included in an industry. For example, should the manufacturing of cars and trucks be considered one industry or two? One way of answering such question is to specify industries based on cross elasticities. High positive cross elasticity defines an industry and small or negative cross elasticities are considered to belong to different industries.
Uses of Advertising Elasticity in Decision-Making
This is the time of throat cut competition. Advertising has become more or less essential for creating, increasing and maintaining the demand for almost all the commodities in this world of competition. It is essectial for a new product to create its demand. For an existing product, it is essential to increase and maintain the demand.
Advertising includes all the activities by which visual or oral message are addressed to select respondents with a view of informing and influencing them to buy the goods and services or to act or to be inclined favorable towards the ideas, persons, trademarks or institutions features. Advertising makes the respondents familiar with the qualities of new product being introduced. In case of existing product, advertising aims at increasing demand and reducing the elasticity of demand for the products.
Knowledge of advertising elasticity of demand is important for the businessman in the following ways:
? An important advantage of the study of advertising elasticity of demand is that it helps the management in deciding whether the outlay on advertisement should be increased or decreased or maintained at present level. If EA>1, the expenditure on its advertisement should be increased. If the EA = 1, the outlay on advertisement should be maintained at present level. Similarly, if the advertising elasticity of a commodity is EA < 1, the outlay on its advertisement may be reduced.
? Study of this concept helps the management in studying the effect of advertisement on the sales revenue. If the management finds saturation point has been arrived, expenditure on advertising should be stopped.
? Study of this concept helps in evaluating the effectiveness of various media of advertisement. For example, if the management finds saturation point has been arrived, expenditure on advertising should be stopped.

Functions of Profit

Profit serves a very important function in a free enterprise economy. High profits are the sign that customers want more of he output of the industry. High profits provide the incentive for firms to expand output and for more firms to enter the industry in the long run. For a firm of above-average efficiency, profits represent the reward for greater efficiency. On the other hand, lower profits or losses are the sign that customers want less of the commodity and that production are not efficient. Thus, profits provide the incentive for firms to increase their efficiency or produce less of the commodity, for some firms to leave the industry for more profitable one. Profits, therefore, provide important sign for the reallocation of society’s resources to reflect changes in customer’s tastes, preferences, and demand over time. Similarly, it provides incentive, innovation and increase productivity and takes risks.
If profit system is not perfect, government in free-enterprise economic system often take step to modify the operation of the profit system to make it more nearly consistent with broad social goals. For example, governments pass minimum wage. Legislation and pollution emission standard to internalize to polluting firms and the social cost of the pollution they create.
To understand the theory of firm behavior and the role of the firm in a free enterprise economic economy, one must understand the nature and functions of profits. Indeed, profits are such key element that the system would fail to operate without profits and profit motive. Profits and the profit motive play an important and growing role in the efficient allocation of economic resources worldwide.
Even in planned economies, where estate ownership rather than private enterprise has been typical, the profit motive is increasingly being used as a spur to efficient resource use. In the former East Bloc countries, the Soviet Union, China and other nations, new profit incentives for manages and workers have led to increasing by product quality and cost efficiency. Thus profits and the profit motive play an important role in the optimal allocation of economic resources worldwide.
In summary following points can be outlined as a role and functions of profits.
? Profit serves as a signal to change the rate of output or for the firms to enter or leave the industry.
? It provides incentive to introduce innovations.
? It is the signal of firm to know to what extent consumer attached with that firm.
? It is the signal for resource allocation (more or less).
? It is the reward for innovation and productivity. Similarly, profit is motivating factor for mew products, new production methods and providing good customer service.
? Sometime above normal profits caused by barriers to entry or monopoly power granted by state.
Use of Price Elasticity in Business Decisions
The concept of price elasticity of demand has important practical applications in business or managerial decision-making. Generally, a businessman has to consider whether a lowering of price will lead to an increase in the demand for his product, and if so, to what extent and whether his profits would increase as result therefore. In fact, many businesses have failed due to lack of attention to the elasticity of demand. If the increase in sales is more than proportionate to the decline in price, his total revenue will increase and his profits might be greater. Alternatively, if the increase in sales is less than proportionate, total revenue will decline and his profits will definitely be less. In general, for commodities whose demand is elastic it will pay businessman to charge relatively low prices, while on those whose demand is inelastic, he would be better off with a higher price. Sound understanding of the elasticity of demand is important, for much of the success of the enterprise. Some important business applications of price elasticity are as follows:

Business vs. Economic Profit

The general public and business community typically define profit using an accounting concept. This concept explains profit as the residual of sales revenue minus the explicit (accounting) cost of doing business. It is the amount available to the equity capital after payment for all other resources the firm uses. This definition of profit is referred to as accounting or business profit. Here explicit costs are paid in money. The amount paid for a resource could hace been spent on something else, so it is the opportunity cost of using the resource. For example, explicit costs for Sidney sweaters can be his expenditures on wool, utilities, wages and bank interests.
The economists also define profit as the excess of revenue over the costs of doing business. To an economist, however, the inputs provided by the firm’s owner(s), including entrepreneurial effort and capital are resources that also must be paid for it they are to be employed. Therefore, to an economists, profit is business profit minus the implicit costs of capital and other owner provided inputs (explicit costs) used by the firm. This definition is referred to as economic profit to distinguish it from business profit. A firm incurs implicit costs when operating business. A firm incurs these costs (implicit) but does not make a payment. For example when it uses its own capital and when it uses its owners time or financial resources

CONCEPT OF PROFIT

A business firm is an organization designed to make profits, and profits are the primary or key measure of its success. Social criteria of business performance usually relate to quality of good, rate of progress and behavior of price. But these are necessary elements of the whole profit system. Within that system, profits are the acid test of the individual firm’s performance.
The word “Profit” has different meanings to businessmen, accountants, tax collectors, workers, and economists, and it is often used in a loose, polemical sense that buries its real significance. In a general sense, ’Profit’ is regarded as income accruing to the equity holder’s, in the same sense as wage accrue to the labor, rent accrues to the owners of rental assets and the interest accrues to the money lenders. To a layman profit means all income that flow to the investors. To the business community business profit reefers to the revenue of the firm minus the explicit or accounting costs of the firm. Economist’s concept of profit is of “Pure profit” also called economic profit’. Economic profit is return over and above the opportunity cost or economic profit equals the revenue of the firm minus its explicit costs and implicit costs. Implicit costs refer to the inputs owned and used by the firm in its own production processes.
Specifically, implicit costs include the salary that the entrepreneur could earn form working for someone else in a similar capacity (say, as the manager of similar firm) and the return that the firm could earn form investing its capital and renting its land and other inputs to other firms. The inputs owned and used by the firm in the production processes are not free to the firm, even though the firm can use them without actual or explicit expenditures. Their implicit costs are what these same inputs could earn in their best alternative use outside the firm. Accordingly, economists include both explicit and Implicit costs in their definition of costs. That is, they include a normal return on owned resources as part of costs, so that economic profit is revenue minus explicit and implicit costs. While the concept of business profit may be useful for accounting and tax purpose, it is the concept of economic profit that must be used in order to reach correct-investment decisions.

Goals of the Firm Satisfying Behavior

The goals of the firm are set ultimately by the top management. ‘There are five main goals of the firm: (a) production goal (b) Inventory goal (c) sales goal (d) share of the market goal (e) profit goal.
The production goal originates from the production department. The main goal of this department is the smooth running of the production process. Production should be distributed over time, irrespective of possible seasonal fluctuations of demand, so as to avoid excess capacity and layoff workers at some periods and overworking the plant and resorting to rush recruitment of worker in another.
The inventory goal originates from the inventory department which wants an adequate stock of output for the customers, while the production department requires adequate stocks of raw materials etc. for c smooth flow of the output process.
The sales goal and share of the market goal originate from the sales department. This department set the ‘sales strategy’ such as advertising campaigns, the market research programmes and other sales promoting activities.
The profit goal is set by the top management so as to satisfy the demands of share holder’s and the expectations of bankers and other finance institutions and also to create funds with which they can accomplish their own goals and projects.
What we discuss earlier about the goals; they are dynamic and can change overtime depending on the past history of the firm, as well as on the conditions of the external environment and on the changes of aspiration of groups within the organization. The goals of the firm, take the form of aspiration levels rather than strict maximizing constraints. The firm in the behavioral theories seeks to satisfice, which is, to attain a ‘satisfactory’ overall performance, as defined by the set aspiration goals, rather than maximize profits, sales or other magnitudes. The firm is a satisficing organization rather than a maximizing entrepreneur.
The top management is responsible for the coordination of the activities of the various members of the firm, wishes to attain a ‘satisfactory’ level of production, to attain a ‘satisfactory’ share of the market, to earn a ‘satisfactory’ level of profit, to divert a ‘satisfactory’ percentage of their total receipts to research and development or to advertising, to acquire a ‘satisfactory’ public image, and so on. However, it is not clear in the behavioral theories what is a satisfactory and what an unsatisfactory attainment is.
Means for the Resolution of the Conflict
The top management can use various means to resolve the conflict within the firm. The most important means for resolution for the conflict are money payments (workers and employees are getting their wages and salaries, shareholder’s get their dividends, and so on.), side payments policy commitments by top management, slack payments. Origanizational slack consists in payment to members of the coalition in excess of what is required to maintain the organization for e.g. Manager’s may be paid higher salaries and other prerequisites, shareholder’s may be paid higher dividends than the minimum required to satisfy their demands, customers may be given discounts etc. The existence of slack has a stabilizing effect of the performance of the firm. According to Cyert and March stabilizing effect of the slack can be tested empirically by observing the behavior of costs in bad and good business periods. Top management also uses sequential attention to demand depending on the urgency of the different demand and decentralization of decision making for the resolution of the conflict.
The Process of Decision Making
The goals of the firm, as set by the top management and approved by the board of directors, have to be implemented by decisions. Decisions are taken at various levels of administration. We will examine two levels of decision making:
a. Decision at the top level management and
b. Decisions at lower levels of administration
The decision-making process at the level of top management: Given the goals of the firm and the resources available, the allocation of there resources to the various departments is decided by the top management and it is implemented by the tool like budget. The heads of sections present demand (projects) to the top management and by bargaining they attempt to secure as large as possible share from the firm’s total budget. Two crude criteria are set by top management for the evaluation of any particular proposal. The first is a budgetary criterion: are there funds available for the realization of the proposed project? The second is an ‘improvement criterion’ does the project being proposed improve the existing situation beyond doubt? If these two criterions are satisfied the top management may approve the project without further consideration. In the decision process, a search is made whenever problems are is identified and directed to the particular area in which some problems are is identified and directed to the particular area in which some problems appear. Four points are stressed by the behavioral theories regarding the search activity: search is problem oriented, it is not costless, it may be biased due to ‘position bias’, and it flow within the organization is not always smooth.
Decisions at lower level of management (administration): The decision process at lower levels of administration involves various degrees of freedom of action. Once the budget-share is allocated, each manager has considerable discretion in spending the budget allocated to his department. Generally, all the routine, day-to-day decisions are simplified by delegation of authority within each section and by simple rules which form the ‘blue print’ of the organization. The staffs learn by the mistakes ad success of the past. The top management uses controlling devices for the lower levels to various activities like employment of supervisors etc.
Uncertainty and the Environment of the Firm
Cyert and March distinguishes two types of uncertainties like market uncertainty and Uncertainty of competitor’s reactions. Market uncertainty (inherent characteristics of market) means possible changes in customer’s preferences or changes in the techniques of production. This form of uncertainty can partly be avoided by search activity and information gathering. The behavioral theory postulates the view that firm considers only short run ignores the long-run consequences.
Another uncertainty arises from competitor’s actions and reactions due to oligopolistic interdependence. According to Cyert and March such ‘negotiated environment’ can be solved by assuming collusive action of the firms.
Critical Evaluation of Behavioural Theory
The behavioral theory has contributed a lot for the further development of the theory of the firm. The main contributions of the theory are: Firstly, the insight into the process of goal formation and the internal resource allocation, and Secondly, the systematic analysis of the stabilizing role of ‘slack’ on the activity of the firm which enables the firm to maintain its aspiration levels during fluctuating environment. The behavioral theory has however been criticized on the following grounds firstly though the behavioral theory deals realistically with the search activity of the firm, it cannot explain the firm’s behavior under dynamic conditions in the long run. Secondly, it cannot be used to predict exactly the future course of firm’s activities. Thirdly, this theory does not deal with equilibrium of industry. Fourthly, no exact predictions can be derived from the postulations of the behavioral theory. Fifthly, like other alternative theories, this theory also fails to deal with interdependence and interaction of the firms, especially when new entry takes place in industry.
This theory is based on only four actual case studies and two experimental studies. We cannot ignore its apparition to a theory of the firm for decision-making process and the allocation of resources in large complex organizations.
Conclusion
There exist wide differences of opinion regarding goals and objectives of the firm. It is indeed true that profit maximizing or value maximizing are not the only objectives firms seek to pursue. It is observed that firms do not pursue just s single objective, but most of them, big or small pursue multiple objectives. The economists have postulated a numbers of alternative objectives or goals. These objectives include both short-run and long-run objectives. Fair return of capital, long-run survival, obtaining large market share, building an industrial empire, profit maximization, wealth maximization, sales maximization, managerial discretion and soon. Different firms may pursue different objectives at different times. More or less, a wide range of business decisions are, however, made on the basis of the goals of profit maximization because profit maximization hypothesis is a time-honored and easier to handle. The empirical evidence against this hypothesis is not unambiguous and strong enough to replace this hypothesis. More importantly, profit maximization hypothesis has a greater explanatory and predictive power than any of the alternative hypotheses. Therefore, it still forms the basis of firm’s behavior.

The Behavioral Model of Cyert and March

The behavioral theories of the firm started to mention in the early 1950’s. Some of the seminal work may be traced in Simon’s article. “A behavioral model of rational choice”, published in quarterly journal of Economics in 1955. The Theory has been subsequently been elaborated by Cyert and March. Now, this theory has been associated with the names of Cyert & March, The writes founded their studies on four case studies and two’s laboratory experimental studies’. Cyery and March model can be explained in the following sequence.
The Firm is a Coalition of Group’s with Conflicting Goals
The Behavioural theory focuses on the decision-making process of the ‘Large multi-product firm under uncertainty in an imperfect market where ownership is divorced from management. According to behavioral theory the firm is not treated as a single-goal single decision unit, as in the traditional theory, but as a multigoal, multidecision organizational coalition. The firm connected with its activity in various ways: Managers, worker’s, is conceived as a coalition of variety of groups such as shareholder’s, customers, suppliers, bankers, tax inspectors, lawyers and so on. Each group has its own set of goals or demands. For instance, workers want high wages, hood pension schemes and good conditions of work. The managers want high salaries, power, prestige etc. The shareholder’s want high profits growing capital and market size. Customers want goods & services of high quality along with low price. The suppliers want steady or growing contracts for the materials they sell to the firm, and so on.
Thus most important groups within the framework of the behavioral theories are those who directly connected with the firms’ activities, namely the manager’s, the workers and the shareholders with conflicting interest in the firms.
The Process of Goal Formation the Concept of the Aspiration Level
The behavioral theory recognizes explicitly that there exists a basic dichotomy in the firm between individual members of the coalition-firm and organization-coalition called the firm’. The consequence of this dichotomy is a conflict of goals. Individuals may have different goals to the organization. In order to reconcile the conflicting goals, managers set an aspiration level of the firm on the basis of previous history of the firm, that is, on previous levels of achievement, previous aspiration levels and their assessment of the future market conditions. Cyert and March argue that the relationship between demand-aspirations and past achievement depends on actual and expected changes in the performance of the firm and changes in its environment, firstly, in a ‘steady situation’(with no growth), aspirations (demands) and past achievement tend to become equal. Secondly, in a dynamic situation with growth, aspiration levels lat behind achievement. This time-lag is crucial to the behavioral theory. During this time lag the firm is able to accumulate ‘excess profit’ which may be used as a means of resolution of the conflict in the firm that act as a stabilizer of the firm’s activity in a changing environment. Thirdly, in a period of decline of the activity of the firm, demand are larger than past achievements, because the aspiration levels of the members of the coalition adjust downwards slowly.

Williamson’s Model of Managerial Discretion

Williamson’s model depends on the same assumptions as Baumol’s a weakly competitive environment, a divorce of ownership from control, but a capital market imposed minimum profit constraint. Williamson argues that the most important motives of businessmen are desires of salary, security, dominance, and professional excellence. These can be gained by additional values of expenditure on staff (S), managerial emoluments (M), and discretionary investment (ID). It is argued that these provide additional utility, U, which managers aim to maximize. Hence the manager’s goal is to maximize his/her utility (U). Manager’s utility function (U) is expressed as
U = f (S, M, ID)
Where, the quality and number of staff reporting to a manager enables him to gain promotion, salary and dominance and also security through greater confidence as to his departments survival, and greater professional excellence due to the better services which a larger staff can provide.
Managerial emoluments (M), represent the type and amount of perquisites the manager receives (the lavish offices, personal secretary, expenses account and so on) beyond the level necessary for efficient operation. The greater the M, it is argued, that greater will be the manager’s status, prestige, and satisfaction.
Discretionary investment expenditure (ID) is that investment which exceeds that necessary to achieve the minimum post-tax profits demanded by shareholder’s (denoted p0). Such spending allows managers to pursue their pet-projects, personal investment preferences and to exercise their power and hence it provides utility.
Unlike the models presented earlier, Williamson’s firm announces only ‘reported’ profits, whereas Baumol’s and the profit-maximizing firm report actual profits. Reported profits, the profits admitted by the firm, equal actual profits minimum M. M is deducted because it is an expenditure made and is also tax deductible. Notice that in Willianson’s model, actual profits may not equal maximum profit if the model predicts, S exceeds the profit maximization level.

Theory of Satisfying Behaviour

Dissatisfaction with the profit-maximizing model, economists have developed other models of the firm. One of the first of these was Simon in 1995.
According to Simon Managers will have imperfect knowledge to take appropriate decision. If full knowledge or information’s will be available, the calculations involved in decision-making would be too complex and costly. Therefore, he argued that if this fact and the other inevitable uncertainties surrounding the business environment is real, business men never know whether they are to maximize profit or not. Indeed, he says, businessmen ‘satisfy and they do not maximize they aim at satisfactory profits.
If neither searches behavior, nor the lowering of aspiration levels results promptly enough in the achievement of a ‘satisfactory’ situation then, Simon argued that the manager’s behavior pattern will become one of apathy or of aggression. This model may seem a long way removed from managerial usefulness. This may not be true, but it represents a major departure from traditional ways of thinking about how firms operate and may results of utility. For example, it does not aware with the facts so that where businessmen price on a full cost basis, adding a satisfactory margin of profit, not knowing where the MR = MC Price and output combination does help to explain why some firms, faced with a falling market share, act more vigorously than competitor’s halt.

A Single-Product Model, with Advertising

A second implication is that the sales maximize will spend more on advertising than the profit maximizing firm. In Boumol’s simplified explanation it is assumed that advertising does not affect a products price. It does, however. Lead to increased output sold (with diminishing returns) and it is assumed that advertising will always lead to a rise in TR, MR will never become negative. By assuming that advertising does not affect total non-advertising costs, and by measuring advertising expenditure also along the vertical axis, the TC line of figure 1.7 is derived.
Since advertising will always increase TR, the business will increase advertising until prevented by the profit constraint. In fig. 1.7, A1 is the profit maximizing level of advertising expenditure, at which the profit curve reaches it maximum point. It pC and firm chooses to maximize its TR with pC as the minimum profit constraint, it will spend OA2 on advertisement which is greater than OA1. We thus see that the objective of constraint revenue maximization leads to a greater level of advertising outlay than the objective of profit maximization.
Some comments
? The sales maximization hypothesis cannot be against competing behavioral hypothesis unless the demand function and cost function of individual firms are measured but such data are not disclosed by firms to researchers, and are commonly unknown to the firm.
? It has been argued that in the long run the profit maximization and sales maximization hypothesis converges into one, because profits attain their normal level in the long-run and the minimum profit constraint will coincide with the maximum attainable (‘normal) level of profit.
? The sales maximization theory does not show sales maximiser’s equilibrium position in an industry. The relationship between the firm and industry is not established by Baumol.
? Baumol’s hypothesis is based on the implicit assumption like firm has market power and can take decisions (price, expansion)without being affected by competitor’s reactions which is unrealistic.
? This theory cannot explain the core problem of uncertainty in non-collusive oligopoly market and market situations in which price is kept for considerable time periods in the range of in elastic demand.
? M.H. Peston ventured the idea that sales maximization is not incompatible with the goal of long-run profit maximization. He argues a firm can be willing to keep sales at a high level, even though they are unprofitable in the short run, hopping that eventually (in the long run) the product will become profitable once established in the market, especially for mew products. Such behavior, however, does not by itself provide a proof that the firm is a sales maximiser or a profit maximiser. Thus in Baumol’s model, sales and profits are mot competing goals up to the level of output at which profit is maximizing output. Thus, Peterson’s argument does not seem to invalidate Buamol’s theory.
? J.R. Wildsmith attacks Baumol model on the ground that the this model has the unacceptable implication that whenever profits aboue the minimum required level are earned Managers would derive extra satisfaction from huge outlays on advertising which brought negligible increase in sales and large reduction in profits. The argument by Wildsmith seems plausible enough. However, Wildsmith seems to overlook Baumol’s statement that although in his model only advertising is explicitly introduced for simplicity. Other activities (such as change is style of product, increase of staff, increase of prerequisites of managers, research and development expenses) mat be incorporated in it without altering it basic modality. Such activities are often undertaken (as well as additional advertising) when profits above the minimum required level is earned, and presumably they increase the utility of manager’s. Moreover generalized Baumol’s model’ allows increases of output as well as increases is advertising when surplus profits are earned. Thus Wildsmith’s argument does not seem valid.
? W.G. Shepherd has argued that if the demand curve has a steep kink, so that to the right of the kink MR is negative shown in fig. 1.8 (a), the maximization and R maximization objectives would not be competing as Baumol implies, because under these conditions and firm’s equilibrium would be at the point of the kink.
Mathematically, necessary condition of equilibrium for both (p, R maximiser) types of firms is aTR/aX>0 (provided that the profit constraint in operative).
Since at the output corresponding to the kink MR>0, while at any larger output MR>0, it is clear that irrespective of goal (p, R) the firm will choose to produce the output corresponding to the kink.
Kinky solution or argument has been attacked by C.J. Hawkins by saying that shepherd would be right were the only competitive weapon of firms, but there are various non-price weapons in the modern oligopolistic industry (for example advertising, product changes). Therefore, shepherd’s argument is not valid. With advertising taking place the kinked curve of a R maximiser, because sales revenue maximize allows in heavier advertising expenditures. Thus both types of firms will operate at the kink of their demand curves but the output of the p - maximiser will be smaller than the output of the sales maximize, because at the same price level the kink of the sales maximize’s demand will occur to the right of the kink of the profit maximiser. This situation is shown is shown in figure 1.8 (b), from which it is obvious that Xpm < Xsm at the same price p.

Sales Maximization

William J. Boumol (Economic Theory and operations Analysis, 1970) has postulated maximization of sales revenue model as an alternative to profit maximization objective. The separation of ownership from management, characteristic of the modern firm, gives discretion to the managers to pursue goals which maximize their own utility and deviate from profit maximization, which is the desirable goal of owners. Given this discretion, Baumol argues that sales maximization seems the most plausible goal of managers. From his experience as a consultant to large firms, he found that manager’s are preoccupied with maximization of the sales rather than profits. The reasons which explain the pursuance of this attitude of the top management are following.
? There is evidence that salaries and other slack (payments above minimum necessary) earnings of top managers are correlated more closely with sales than with profits.
? The banks and other financial institutions keeps a close eye on the sales of firms and are more willing to finance firms with large and growing sales.
? Personnel problems can be handled more satisfactorily when sales are growing. Generally there is positive relations growing sales, higher earnings and better terms of work there of.
? Larger sales, growing over time, give prestige to the manager’s, while large profits go into the pockets of share-holders.
? Managers find profit maximization a difficult objective to fulfill consistently over time and at the same level. Profits may fluctuate with changing conditions.
? Large, growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis-a-vis its rivals.
Baumol’s Static Models: The basic assumptions of the static model are as follows:
? The time-horizon of a firm is a single period.
? During these period the firm attempts to maximize its total sales revenue (not physical volume of output) subject to a profit constraint.
? The minimum profit constraint is exogenously determined by the demands and expectations of the shareholders, the banks and other financial institutions.
? ‘Conventional’ cost and revenue functions are assumed. That is, Baumol accepts that cost curves are U-shaped and the demand curve of the firm is of downward sloping.
A Single Product Model, without Advertising
The total revenue and total cost curves under the above assumptions are shown is figure 1.3 below. Total sales revenue is at its maximum level at the highest point of the TR curve, where the price elasticity of demand is unity the slope of this TR.
If the firm is a profit maximize, it would produce OXpm level of output (See figure 1.1). However, as it stands this argument is incomplete. Baumol argued that there is some minimum level of profit, a profit constraints, which must be earned. This level is determined by a firm’s desire to keep its dividends and share prices sufficiently high to keep existing shareholder’s desire and to enable it to raise new capital at a future date.
The prediction is contrary to the traditional hypothesis of p maximization. A p maximizer will not change his equilibrium position is the short-run, since fixed costs do not enter into the determination of the equilibrium of the firm. So long as the fixed costs do not vary with the level of output (provided that the increase in TFC does not lead the firm to close down altogether) the change in the TFC will not lead the profit maximize to change his price and output in the short-run.
Baumol claims that firms in the real world do in fact change their output and price whenever their overhead costs increase. Thus, he says that the sales maximization hypothesis has a better predictive performance than the traditional profit maximization hypothesis.
The imposition of a lump-sum tax will have similar type of effects which is shown in fig 1.6 that the imposition of specific tax will shift the profit curve downwards from p to p1 (fig. 1.6). Given profit constraint line p, the sales maximizer will reduce his output from Xs to X1s and will raise his price, passing the tax to the buyers. The profit maximize will also reduce his output from Xp to Xp and raise his price. However, the decrease in output of sales maximize will larger than the decrease of the output of a profit maximize.

Resource Constraints

Resource Constraints: Firms frequently face limited availability of essential inputs, such as skilled labor, key raw materials, energy, specialized machinery and warehouse space. Manager’s also often face capital constraints that place limitation on the amount of investment funds available for a particular project or activity.
Contractual Requirements: Many managerial decisions can also be affected by contractual requirements. For instance, labor constraints limit flexibility in working scheduling and job assignment, sometimes even affecting whether labor costs are fixed or variable. Contracts often require that a minimum level of output be produced to meet delivery requirements. Similarly, output must meet certain minimum quality requirements such as nutritional requirements for feed mixtures, audience exposure requirements for marketing promotions, reliability requirements for electronic products, and requirements for minimum customer service satisfaction levels.
Legal Constraints: Legal constraints are of the nature of legal restrictions which affect both production and marketing activities. Laws- that define minimum wages, anti-pollution measure, fuel efficiency, health and safety standards and fair pricing and marketing practices etc. all limits managerial flexibility.
Implicit Constraints: Implicit constraints such as environmental, structure behavioral and value-based are implicit in nature and cannot be explicitly defined. But, these constraints also affect in managerial decision making.