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Wednesday, April 28, 2010

Single Entry System:










Definition and Explanation of Single Entry System:

t is difficult to define single entry system because, in fact, there exists no system like single entry system. Broadly speaking, it is a defective double entry system. Any system that falls short of complete double entry method is called single entry system. Under this method, sometimes both the aspects of transactions are recorded, sometimes only one aspect is recorded or sometime no aspects of transactions is recorded in the books. As a general rule under the single entry practice only the personal aspects of the transactions are recorded and the nominal and real aspects are omitted altogether. As the name implies, the single entry system does not take into account the double affect of every transaction. The ledger contains only the personal accounts of debtors and creditors, all impersonal accounts such as purchases, sales, wages, carriage, rent etc., are not recorded. Thus the system does not consider the two fold aspect of every transaction. In short single entry system may be called a mix of double entry, single entry and no entry.

Single entry system may be defined as a system which does not strictly conform to the double entry system of bookkeeping. Under this system what is found in practice is an intermixture of single entry, double entry and no entry.

Defects/Limitations/Disadvantages of Single Entry System:

The limitations or defects or disadvantages of single entry system may be summed up as follows:

Under this system only partial and incomplete record is maintained because two fold aspects of transactions are generally ignored.

As the two fold aspects of every transaction are not recorded, a trial balance cannot be drawn up to test the arithmetical accuracy of the records.

A nominal accounts are not maintained, a profit and loss account cannot be prepared for want of information regarding the various income and expenditures.

As no real accounts are maintained the preparation of balance sheet is not possible.

Statement of Affairs:

orrect final accounts of a business can be prepared in the records are maintained under the double entry system . How every where the record is incomplete, and it is not all possible to complete it by double entry, in such cases the final accounts can be only approximately prepared by means of a statement of affairs. In appearance the statement of affairs is similar to a balance sheet. For this purpose, two comparative statement of affairs are prepared - one at the commencement of the year and other at the end of the year. The excess of the assets over the liabilities as shown by the statement will represent the capital of the firm. If capital at the end shows an increase as compared to the amount of capital at the start the difference will represent profit and if the capital at the end is less than the capital at the beginning the difference will be loss. In this calculation, however, two more factors should be taken into account.

Where fresh capital has been introduced into the business during the account period, the closing capital may be taken to have been increased to that extent. To arrive at the true profit or loss, therefore, the amount of fresh capital introduced is deducted from the closing assets as determined under such circumstances.

Where drawings have been made by the proprietor during the accounting period, such drawings reduce the amount of capital at the close. In order to calculate net profit, it is necessary, therefore, that amount withdrawal should be added to the capital at the close before deducting from it the capital at the beginning.


Formula for determining the net profit is put as follows:

(Capital at the end + Drawings - Additional capital introduced) - Capital in the beginning

Difference Between Statement of Affairs and Balance Sheet:

As real or property accounts are not maintained and also because a capital account does not exist under the single entry system, a balance sheet cannot be prepares in the same way as is done under the double entry system. However, in order to have an idea about the financial position on a particular date information concerning the available assets and liabilities is gathered and a statement is prepared setting in it assets and liabilities on the date; this statement is called a statement of affairs. The assets and liabilities are set out in the form of a balance sheet. The excess of assets over liabilities is shown as capital.

Balance sheet and statement of affairs may be distinguished as follows:

Statement of Affairs Balance Sheet
(1) It is a statement of assets and liabilities (including capital) prepared under the single entry system (1) It is statement of assets and liabilities (including capital) prepared under the double entry system.
(2) It is prepared partly from a trader's books, partly from other sources of information and sometimes from memory (2) It is prepared with data available from the books of accounts only.
(3) It is compiled from an incomplete books and information, the accuracy of which cannot be relied upon (3) It is prepared from a set of books kept according to the double entry system, the arithmetical accuracy of which can be proved.

Conversion into Double Entry System:

Learning Objectives:

Define and explain conversion method.

How trading and profit and loss account and balance sheet is prepared under conversion method.

Conversion of books from single entry system to double entry system is possible either with retrospective (i.e., on and from a date before the date of conversion arrangements) or with a prospective effect (i.e., on and from the date on which arrangements are made for conversion).

Conversion with Prospective Effect:

If the conversion is to be made with prospective effect a statement of assets and liabilities of a trader on a given date must be prepared. Care should be taken to see that the opening cash and bank balances and also the amount of debtors and creditors appearing in the statement, tally respectively with the opening balances of the cash book and the totals of debit and credit balances, extracted from the personal accounts of the ledger. An opening journal entry is to be made taking the items of assets and liabilities of the statement of affairs thus prepared and after opening the necessary ledger accounts the above journal entry is to be posted. All subsequent transactions are to be passed through different books of original entry such as cash book, purchase book, sales book, etc., and posted into ledger according to the principles of double entry.

Conversion With Retrospective Effect:

For example a trader whose accounting period begins on 1-1-1991 and the books have been maintained under single entry till 30-04-1991. It is decided to convert the books into double entry system with effect from 1-1-1991. This is a case of retrospective conversion. The recourse of the interim period i.e., from 1-1-1991 to 30-04-1991 are to be adjusted before the double entry system is adopted.

Assuming that a statement of affairs at the commencement of accounting period (31-12-1990) is available and single entry records consists of cash book and personal ledger, the process of conversion proceeds as follows:

Find out the total credit purchases and total credit sales. These can be obtained from the bought and sales ledger respectively.

A journal entry should be passed to incorporate the balances appearing in the statement of affairs. Items should be posted in the respective accounts in the ledger.

The cash book should be scrutinized and post the items of receipts and payments appearing in it in the appropriate accounts in the ledger.

Cash sales and cash purchases can also be found out from the cash book. The figures should be posted to the sales and purchases account respectively.

Post the credit sales and purchases in the ledger.

Personal ledger should be scrutinized. Pick up the items for which no corresponding double entry has been effected. These items mostly consist of discount allowed to customers, or discount received, returns inwards, allowances, transfers, bad debts, etc. These items should be posted in the ledger. It is now possible to prepare a trial balance followed by a trading and profit and loss account and balance sheet.

Abridged Conversion:

There is a way to obtain final results by short cut method. When a summary of cash and other transactions are given; information regarding assets and liabilities in the beginning and at the end of the year is available, the final accounts can be drawn. In such a case, the missing items which may be any of the following are to be found out from the given data:-


Credit purchase

credit sales

Bills receivable

Bills payable

Sundry debtors

Cash in hand and at bank

Stock in the beginning

Any of these items when unknown may be found out preparing a total debtors account and a total creditors account.

Total Debtors Account

To (1) Opening balance
To (2) Credit sales
To (3) B/R dishonoured - if any By (4) Cash received from debtors
By (5) B/R Received
By (6) Returns inwards
By (7) Discount allowed
By (8) Bad debts
By (9) Closing Balance
Total Debtors Account

By (4) Cash paid to creditors
By (5) B/p granted
By (6) Returns outwards
By (7) Discount received
By (8) Closing Balance To (1) Opening balance
To (2) Credit purchases
To (3) B/p dishonoured - if any

If capital is unknown prepare the statement of affairs. The difference of assets and liabilities will represent the capital.

Credit Purchases:

If credit purchases are unknown it can be ascertained from the total creditors account. Add item No. 4, 5, 6, 7, 8 and subtract from the result item No. 1 and 3. It can also be calculated in the following way:

Acceptance given to creditors xxxxx
Cash paid to creditors xxxxx
Discount allowed by customers xxxxx
Returns outwards xxxxx
Creditors at the close of the year xxxxx

Less creditors at the beginning xxxxx

Credit purchases for the year xxxxx
Credit Sales:

If credit sales are unknown, it can be ascertain from the total debtors account. Add No. 4, 5, 6, 7, 8, 9 and subtract from the result item No. 1 and 3. It can be calculated in the following form:

Acceptance received from debtors xxxxx
Cash received from debtors xxxxx
Discount allowed to debtors xxxxx
Returns inwards xxxxx
Debtors at the close of the year xxxxx

Less debtors at the beginning xxxxx

Credit sales for the year xxxxx
Bills Receivable:

I bill receivable are unknown the same may be ascertained from the total debtors account. The formula is:

Item Nos. [(1) + (2) + (3)] - [(4) + (6) + (7) + (8) + (9)]

It may also be ascertained in the following form:

Bills receivable in hand on 1-1-19 xxxxx
Acceptance received during the year xxxxx

Less bills dishonoured xxxxx
Less bills honored xxxxx

Bills receivable on 31st December xxxxx
Bills Payable:

If bills payable are unknown the same may be ascertained from total creditors account:

Item Nos. [(1) + (2) + (3)] - [(4) + (6) + (7) + (8)]

It may also be calculated in the following form

Bills payable in hand on 1-1-19 xxxxx
Acceptance given during the year xxxxx

Less acceptance honored xxxxx

Bills bills payable on 31st December xxxxx
Sundry Debtors:

If opening balance of sundry debtors are unknown we can calculate it by the following method:

Item Nos. [(4) + (5) + (6) + (7) + (8) + (9)] - [(3) + (2)]

If closing balance of debtors is unknown:

Item Nos. [(1) + (2) + (3)] - [(4) + (5) + (6) + (7) + (8)]

Sundry Creditors:

If opening balance of sundry Creditors are unknown we can calculate it by the following method:

Item Nos. [(4) + (5) + (6) + (7) + (8)] - [(2) + (3)]

If closing balance of Creditors is unknown:

Item Nos. [(1) + (2) + (3)] - [(4)+ (5) + (6) + (7)]

Cash in Hand and at Bank:

Prepare the cash book and balance it.

Opening Stock:

Sometime opening stock is unknown, if it is unknown it can be calculated from sales. In such a case from sales fin out the cost price of the goods sold. Add in the cost of goods sold the closing stock. Subtract from the result purchases during the year.

Decentralization, Segment Reporting and Transfer Pricing:

Decentralization and Segment Reporting:

When an organization grows beyond a few people, it becomes impossible for the top manager to make decisions about everything.
Managers have to delegate decisions to some degree to those who are at lower levels in the organization. However the degree to which decisions are delegated varies from organization to organization.

Decentralization in organizations:

A decentralized organization is one in which decision making is not confined to a few top executives but rather is throughout the organization, with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity. At one extreme, a strongly decentralized organization is one in which even the lowest-level managers and employees are empowered to make decisions. At the other extreme, in a strongly decentralized organization, lower-level managers have little freedom to make decisions. Click here to read full article about definition, advantages and disadvantages of decentralization.

Traceable and common fixed costs:

The most puzzling aspect of segmented income statements is probably the treatment of fixed costs. While preparing segmented income statements the fixed cost is divided into tow parts on is traceable fixed cost and other is common fixed cost. Only traceable fixed costs are assigned to the segment. If a cost is not traceable then it is not assigned to segments. Click here to read full article for definition, examples and explanation of traceable and common fixed costs.

Segment reporting and profitability analysis-segmented income statements:

A different kind of income statement is required for evaluating the performance of a profit or investment center. This income statement should emphasize on the segment rather than the performance of the company as a whole. A contribution margin format income statement is used to evaluate the performance of different segments. In a contribution margin format income statement cost of goods sold consists only of the variable manufacturing costs. Click here to read full article.

Hindrances/Problems to Proper Cost Assignment in Segmented Reporting:

For segment reporting to accomplish its intended purposes, costs must be properly assigned to segments. If the purpose is to determine the profits being generated by particular segment or division, then all of the costs attributable to that division or segment--and only those costs--should be assigned to it. Unfortunately, three practices greatly hinder proper cost assignment:

Omission of some costs in the assignment process.
The use of inappropriate methods for allocating costs among segments of a company.
The assignment of costs to segments when they are really common costs. Click here to continue
Segmented Financial Information on External Reports:

The Financial Accounting Standards Board (FASB) now requires that companies in the united states include segmented financial and other data in their annual reports and that the segmented reports prepared for external users must use the same method and definitions that the companies use in internal segmented reports that are prepared to aid in making operating decisions. This is a very usual requirement. Click here to continue reading.

Rate of Return (The Return on Investment-ROI) for Measuring Managerial Performance:

In a truly decentralized company, segment managers are given a great deal of autonomy. Profit and investment centers are virtually independent businesses, with their managers having about the same control over decisions as if they were in fact running their own independent firms. With this autonomy, fierce competition often develops among managers, with each striving to make his or her segment the "best" in the company. Competition between investment centers is particularly keen for investment funds. How do managers in corporate headquarters go about deciding who gets new investment funds as they become available and how do these managers decide which investment centers are most profitability using the funds that have already been entrusted to their care? One of the most important ways of making these judgments is to measure the rate of return that investment managers are able to generate on their assets. This rate of return is called the return on investment (ROI). Click here to read full article.

Controlling and Improving Rate of Return on Investment:

Return on investment is normally used to judge the managerial performance in an investment center. Managers therefore try to control and improve the ROI of their investment center. Click here to read full article.

Return on Investment (ROI) and Balanced Scorecard:

Simply exhorting managers to increase return on investment (ROI) is not sufficient. Managers who are told to increase return on investment (ROI) will naturedly wonder how this is to be accomplished. Generally speaking, ROI can be increased by increasing sales, decreasing costs, and/or decreasing investments in operating assets. However it may not be obvious to managers how they are supposed to increase sales, decrease costs, and decrease investments in a way that is consistent with the company's strategy. Click here to continue reading

Criticism, Disadvantages or Limitations of Return on Investment (ROI):

Although the return on investment is widely used in evaluating performance, it is not a perfect tool. It is not without criticism. Click here to continue reading.

Residual Income-Another Method to Measure Managerial Performance:

Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. Residual income is another approach to measuring an investment center's performance. Economic Value Added (EVA) is an adoption of residual income that has recently been adopted by many companies. Under EVA, companies often modify their accounting principles in various ways. For example funds used for research and development are often treated as investment rather than as expenses under EVA. These complications are best dealt with in more advanced courses. Here we will focus on the basics and will not draw any distinction between residual income and EVA. Click here to read full article.

Limitations, Criticism or Disadvantage of Residual Income Method:

The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. You would expect larger divisions to have more residual income than smaller divisions, not necessarily because they are better managed but simply because they are bigger. Click here to continue.

Transfer Pricing:

Definition of Transfer pricing:

A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. For example, most companies in the oil industry have a petroleum refining and retail sales divisions that are usually evaluated on the basis of return on investment (ROI) or residual income method.

The petroleum refining division processes crude oil into gasoline, kerosene, and other end products. The retail sales division takes gasoline and other products from the refining division and sells them through the company's chain of service stations. Each product has a price for transfers within the company. Suppose the transfer price for the gasoline is $0.80 a gallon. Then the refining division gets credit for $0.80 a gallon of revenue on its segment report and the retailing division must deduct $0.80 a gallon as an expense on its segment report. Clearly the refining division would like the transfer price as high as possible, whereas the retailing division would like the transfer price to be as low as possible. However, the transaction has no direct effect on the entire company's reported profit. It is like taking money out of one pocket and putting it into the other.

Managers are intensively interested in how transfer prices are set, since transfer prices can have a dramatic effect on the apartment profitability of a division. Three common approaches are used to set transfer prices.

Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
Set transfer prices at cost using variable or full (absorption) cost
Set transfer prices at the market price
Divisional Autonomy and Sub optimization:

How much autonomy should be granted to divisions in setting their own transfer prices and in making decisions concerning whether to sell internally or to sell outside? Should the divisional heads have complete authority to make these decisions, or should top corporate management step in if it appears that a decision is about to be made that would result in sub optimization? For example, if the selling division has idle capacity and divisional managers are unable to agree on a transfer price, should top corporate management step in and force a settlement? Click here to continue reading

International Aspects of Transfer Pricing:

The objective of transfer pricing change when multinational corporations involved and the goods and services being transferred cross international borders. The objective of international transfer pricing focus on minimizing taxes, duties, and foreign exchange risks, along with enhancing a company's competitive position and improving its relations with foreign governments.

International Aspects of Transfer Pricing:

The objective of transfer pricing change when multinational corporations involved and the goods and services being transferred cross international borders.

The objectives of international transfer pricing, as compared to domestic transfer pricing are summarized below:

Transfer Pricing Objectives


Greater divisional autonomy
Greater motivation for managers
Better performance evaluation
Better goal congruence


Less taxes, duties and tariffs
Less foreign exchange risks
Better competitive position
Better governmental relations

The objective of international transfer pricing focus on minimizing taxes, duties, and foreign exchange risks, along with enhancing a company's competitive position and improving its relations with foreign governments. Although domestic objectives such as managerial motivation and divisional autonomy are always important, they often become secondary when international transfers are involved. Companies will focus instead on charging a transfer price that will slash its total tax bill or that will strengthen a foreign subsidiary.

For example, charging a low transfer price for parts shipped to a foreign subsidiary may reduce customs duty payments as the parts cross international borders or it may help the subsidiary to compete in foreign markets by keeping the subsidiary's costs low. On the other hand, charging charging a high transfer price may help a multinational corporation draw profits out of a country that has stringent controls on foreign remittances, or it may allow a multinational corporation to shift income from a country that has high income tax rates to a country that has low rates.

Tuesday, April 27, 2010

Cost Volume Profit Relationship - (CVP Analysis):

Cost Volume Profit Relationship - (CVP Analysis):

Learning Objectives:

What are the objectives of cost volume profit analysis (CVP Analysis)?
Define and explain contribution margin and contribution margin ratio.
Define, explain and calculate breakeven point?
What is operating leverage and operating leverage ratio?
What are the assumptions of CVP analysis?
What are the limitations of CVP analysis?
What are advantages and disadvantages of CVP Analysis?
Objectives of CVP Analysis:

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:

Prices of products

Volume or level of activity

Per unit variable cost

Total fixed cost

Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

Contribution Margin and Basics of CVP Analysis:

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Click here to read full article.

Difference Between Gross Margin and Contribution Margin:

Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses. Click here to read full article.

Cost Volume Profit (CVP) Relationship in Graphic Form:

The relationships among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph or break even chart. A CVP graph highlights CVP relationships over wide ranges of activity and can give managers a perspective that can be obtained in no other way. Click here to read full article.

Contribution Margin Ratio (CM Ratio):

The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Contribution margin ratio can be used in cost-volume profit calculations. Click here to read full article.

Applications of Cost Volume Profit (CVP) Concepts:

Now we can explain how CVP concepts developed on above pages can be used in planning and decision making. We shall use these concepts to show how changes in variable costs, fixed costs, sales price, and sales volume effect contribution margin and profitability of companies in a variety of situations. For detailed study click on a link below.

Change in fixed cost and sales volume
Change in variable cost and sales volume
Change in fixed cost, sales price and sales volume
Change in variable cost, fixed cost, and sales volume
Change in regular sales price
Importance of Contribution Margin:

CVP analysis can be used to help find the most profitable combination of variable costs, fixed costs, selling price, and sales volume. Profits can sometimes be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount. Click here to read full article.

Break Even Analysis:

Break even is the level of sales at which the profit is zero. Cost volume profit analysis is some time referred to simply as break even analysis. This is unfortunate because break even analysis is only one element of cost volume profit analysis. Break even analysis is designed to answer questions such as "How far sales could drop before the company begins to lose money." For detailed study about break even click on a link below:

Break even point analysis (calculation by contribution margin and equation method)
Target profit analysis
Margin of safety
Sales Mix and Break Even with Multiple Products
Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure:

Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some latitude in trading off between these two types of costs. For example, fixed investment in automated equipment can reduce variable labor costs. The purpose of management is to reduce the cost by choosing a blend of fixed and variable cost that maximizes the ultimate objective i.e.; profit. Click here to read full article.

Operating Leverage and degree of operating leverage:

Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. Click here to read full article.

Assumptions of Cost Volume Profit (CVP) Analysis:

A number of assumptions underlie cost volume profit analysis. Click here to read full article

Limitations of Cost Volume Profit Analysis:

Cost volume profit (CVP) is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity-based costing or throughput accounting.

Tuesday, April 13, 2010

Tuesday, April 6, 2010

Oligopoly: its Price and Output Behaviours

An oligopoly is a market condition in which the production of identical or similar products is concentrated in a few large firms. Examples of oligopolies in the United States include the steel, aluminum, automobile, gypsum, petroleum, tire, and beer industries. The introduction of new products and processes can create new oligopolies, as in the computer or synthetic fiber industries. Oligopolies also exist in service industries, such as the airlines industry.

An oligopoly may be categorized as either a homogeneous oligopoly or a differentiated oligopoly. In a homogeneous oligopoly the major firms produce identical products, such as steel bars or aluminum ingots. Prices tend to be uniform in homogeneous oligopolies. In a differentiated oligopoly, similar but not identical products are produced. Examples include the automobile industry, the cigarette industry, and the soft drink industry. In differentiated oligopolies companies attempt to differentiate their products from those of their competitors. To the extent that they are able to establish differentiated products, companies may be able to maintain price differences.

Being part of an oligopoly affects a company's competitive behavior. In a competitive market situation that is not an oligopoly, firms compete by acting for themselves to maximize profits without regard to the reactions of their competitors. In an oligopoly, a firm must consider the effects of its actions on others in the industry. While smaller firms may operate at the fringes of an oligopoly without affecting the other firms in the industry, the actions of a major firm in the oligopoly typically cause reactions in the other firms in the industry. For example, if one company in the oligopoly attempts to undersell the others, then the other firms will respond by also lowering prices. As a result, price cuts in oligopolies tend to result in lower profits for all of the firms involved.

Prices in oligopolistic industries tend to be unstable to the extent that companies will shade, or lower, their prices slightly to gain a competitive advantage. It must be remembered that collusion between firms to fix prices is illegal under U.S. antitrust laws, so oligopolies must reach industry agreements on pricing indirectly. Companies can signal their pricing intentions indirectly in a variety of ways, such as through press releases, speeches by industry leaders, or comments given in interviews. In some cases there is a recognized price leader in the oligopoly, and other firms in the oligopoly set their prices according to that of the industry's price leader.

Industrial concentration is a matter of degree. This means that there is no absolute definition of an oligopoly in terms of the number of firms accounting for a certain percentage of an industry's output. In the United States the Census of Manufacturers reports on each industry's four-firm concentration ratio. This figure indicates what percentage of an industry's output is accounted for by its four largest companies. It is not uncommon for the four largest firms to account for 30 percent or more of an industry's output, and in some cases they account for more than 70 percent of production.

In the United Kingdom, for example, the top four food retailers accounted for 45 to 67 percent of the nation's $150 billion grocery market in 1998. In Russia, economic development under Boris Yeltsin has been described as a "new oligarchy," in which government officials and business leaders join together to gain control of industries such as banking, television, the business press, and other companies.

Oligopolies tend to develop in industries that require large capital investments. Studies have shown that industries with high four-firm concentration ratios tend to have higher margins than other industries. In order to maintain an oligopoly, potential investors must be discouraged from establishing competing companies. Oligopolies are able to perpetuate themselves and discourage new investments in several ways. In some cases the oligopoly is the result of access to key resources, which may be either natural resources or some patented process or special knowledge. New firms cannot enter the industry without access to those resources.

The established, experienced firms in an oligopoly also enjoy significant cost advantages that make it difficult for new firms to enter the industry. These cost advantages may be the result of the large scale of production required as well as of experience in keeping manufacturing or operating costs down. Another factor that tends to perpetuate oligopolies is the difficulty of introducing new products into an oligopoly characterized by a high degree of product differentiation. Prohibitively large expenditures would be required of a new firm to overcome consumer reluctance to try a new product over an established one. Finally, oligopolies perpetuate themselves through predatory practices such as obtaining lower prices from suppliers, establishing exclusive dealerships, and predatory pricing aimed at driving smaller competitors out of business.


Four possibilities: Because of the recognised mutual interdependence and uncertainty in price and output, there are four possibilities of behaviour ranging from outright price competition, price rigidity and non-price competition, price leadership and collusion.


Because different cost advantages, firms tend to compete one another by cutting prices hoping to increase market share, TR and profit. Succeed if other firms will not react to reduce their prices. The demand curve for your product is elastic; Fail if other firms do react, thus leading to zero economic profit for all firms, loss for some firms and a higher market concentration. This possibility often prevails in the oligopolistic market with a few equally sized firms.


A large firm takes the lead in setting a price which is followed by other firms. Necessary Conditions: The leading firm must be able to predict how other firms to react to (follow) its price and quantity decisions. If the reaction is as expected, there will be no pressure on the leading firm to change price other than due to new changes in costs. Two Problems: How is the first price is established ? How is the established price changed ? This possibility often prevails in the oligopolistic market with very high concentration ratio.


Without cost advantages, firms are reluctant to change their prices because, if one firm reduces its price, all other firms will follow and no increase in Q sold is possible; if one firm increases price, no other firms will follow and there is a decrease in quantity sold. No benefit but loss; Kinked Demand Curve: One firm decreases price, all other firms follow, no increase in quantity sold. One firm increases price, no other firms will follow a decrease in quantity sold. There is no benefit but loss in changing prices. There is rigidity in price.
Firms go for non-price competition such as product differentiation, product proliferation, and advertising, etc. Price rigidity in oligopoly is expressed by a kinked demand curve.


Collusion is opposite to price competition. Oligopolistic firms always have incentives to collude by agreements to act as if they were a monopoly in order to capture the maximum monopoly profit. But the collusion is always temporary and the competition is inevitable because of the conflict of interest.


The decision behaviours of oligopolistic firms are not stable and predictable because of mutually recognised interdependence. The conflict of interest and the strategies in the context of conflicting goals are demonstrated in the game theory and expressed by a payoff-matrix. It indicates a profit gain or loss from each possible move for each possible rival reaction.


FIRM Y’s strategy FIRM X’s max loss
cut price
do not cut price

FIRM X’s strategy cut price (1) X’s profit - $3
Y’s profit - $3 (2) X’s profit +$2
Y’s profit -$5 -$3
do not cut price (3) X’s profit -$5
Y’s profit +$2 (4) X’s profit, no change
Y’s profit, no change -$5
FIRM Y’s max loss -$3 -$5

1. Firm X is worse off because it cuts price when Firm Y follows. the worse case for all
2. Firm X is better off because it cuts price when Firm Y does not follow. the case in favour of Firm X
3. Firm X is worse off because it takes no action when Firm Y cuts price. the case in favour of Firm Y
4. Both firms are better off because no price is cut. the best case for all

• Logically, the best case (No. 4) for all firms is that no one cuts price (they collude tightly). But in reality, due to the conflict of interest, the worse case (No. 1) always prevails because:
• each of them wants to seek +2 m for which the necessary condition is that one person cuts price while the other person does not cut; and ironically
• no one can get +2 m because everyone chooses to cut price due to the fact that the maximum loss -3 m (if they cut price) is smaller than -5m (if they refuse to cut price).
• Competition is inevitable and collusion is temporary.


Views on Oligopoly: The strict comparison of oligopoly with other markets is largely a fiction. Advantages: 1. Oligopoly is more realistic; 2. It is an ideal combination of the opportunity for profit giving incentive to innovation and the existence of competition encouraging efficiency. Problems: concentration ratios are higher in some industries than can be justified by economies of scale; industrial concentration and large firm size are not consistently related to inventive and innovative activity; There is also a positive relationship between industrial concentration ratio and the amount of advertising..

Challenge on Assumption of Profit Maximisation: The theory of firm is based on the assumption that the only business goal for a firm is to maximise its profit. In reality, firms may maximise either short run profit or long run profit, or something other than profits altogether, such as growth of sales revenue, market share, salary and life style package for executives, the luxury of inefficiency, etc. However, the profit maximisation is fundamentally important for firms' survival.


Daily Express News Story

Thursday, April 1, 2010

Protectionism-An Introduction

NEAR the window by which I write, a great bull is tethered by a ring in his nose. Grazing round and round he has wound his rope about the stake until now he stands a close prisoner, tantalized by rich grass he cannot reach, unable even to toss his head to rid him of the flies that cluster on his shoulders. Now and again he struggles vainly, and then, after pitiful bellowings, relapses into silent misery.

This bull, a very type of massive strength, who, because he has not wit enough to see how he might be free, suffers want in sight of plenty, and is helplessly preyed upon by weaker creatures, seems to me no unfit emblem of the working masses.

In all lands, men whose toil creates abounding wealth are pinched with poverty, and, while advancing civilization opens wider vistas and awakens new desires. are held down to brutish levels by animal needs. Bitterly conscious of injustice, feeling in their inmost souls that they were made for more than so narrow a life, they, too, spasmodically struggle and cry out. But until they trace effect to cause, until they see how they are fettered and how they may be freed, their struggles and outcries are as vain as those of the bull. Nay, they are vainer. I shall go out and drive the bull in the way that will untwist his rope. But who shall drive men into freedom? Till they use the reason with which they have been gifted, nothing can avail. For them there is no special providence.

Under all forms of government the ultimate power lies with the masses. It is not kings nor aristocracies, nor land-owners nor capitalists, that anywhere really enslave the people. It is their own ignorance. Most clear is this where governments rest on universal suffrage. The workingmen of the United States may mould to their will legislatures, courts and constitutions. Politicians strive for their favor and political parties bid against one another for their vote. But what avails this? The little finger of aggregated capital must be thicker than the loins of the working masses so long as they do not know how to use their power. And how far from any agreement as to practical reform are even those who most feel the injustice of existing conditions may be seen in the labor organizations. Though beginning to realize the wastefulness of strikes and to feel the necessity of acting on general conditions through legislation, these organizations when they come to formulate political demands seem unable to unite upon any measures capable of large results.

This political impotency must continue until the masses, or at least that sprinkling of more thoughtful men who are the file leaders of popular opinion, shall give such head to larger questions as will enable them to agree on the path reform should take.

It is with the hope of promoting such agreement that I propose in these pages to examine a vexed question which must be settled before there can be any efficient union in political action for social reform—the question whether protective tariffs are or are not helpful to those who get their living by their labor.

This is a question important in itself, yet far more important in what it involves. Not only is it true that its examination cannot fail to throw light upon other social-economic questions, but it leads directly to that great "Labor Question" which every day as it passes brings more and more to the foreground in every country of the civilized world. For it is a question of direction—a question which of two divergent roads shall be taken. Whether labor is to be benefited by governmental restrictions or by the abolition of such restrictions is, in short, the question of how the bull shall go to untwist his rope.

In one way or another, we must act upon the tariff question. Throughout the civilized world it everywhere lies within the range of practical politics. Even when protection is most thoroughly accepted there not only exists a more or less active minority who seek its overthrow, but the constant modifications that are being made or proposed in existing tariffs are as constantly bringing the subject into the sphere of political action, while even in that country in which free trade has seemed to be most strongly rooted, the policy of protection is again raising its head. Here it is evident that the tariff question is the great political question of the immediate future. For more than a generation the slavery agitation, the war to which it led and the problems growing out of that war have absorbed political attention in the United States. That era has passed, and a new one is beginning, in which economic questions must force themselves to the front. First among these questions, upon which party lines must soon be drawn and political discussion must rage, is the tariff question.

It behooves not merely those who aspire to political leadership, but those who would conscientiously use their influence and their votes, to come to intelligent conclusions upon this question, and especially is this incumbent upon the men whose aim is the emancipation of labor. Some of these men are now supporters of protection; others are opposed to it. This division, which must place in political opposition to each other those who are at one in ultimate purpose, ought not to exist. One thing or the other must be true—either protection does give better opportunities to labor and raises wages, or it does not. If it does, we who feel that labor has not its rightful opportunities and does not get its fair wages should know it, that we may unite, not merely in sustaining present protection, but in demanding far more. If it does not, then, even if not positively harmful to the working classes, protection is a delusion and a snare, which distracts attention and divides strength, and the quicker it is seen that tariffs cannot raise wages the quicker are those who wish to raise wages likely to find out what can. The next thing to knowing how anything can be done, is to know how it cannot be done. If the bull I speak of had wit enough to see the uselessness of going one way, he would surely try the other.

My aim in this inquiry is to ascertain beyond per adventure whether protection or free-trade best accord with the interests of those who live by their labor I differ with those who say that with the rate of wages the state has no concern. I hold with those who deem the increase of wages a legitimate purpose of public policy. To raise and maintain wages is the great object that all who live by wages ought to seek, and workingmen are right in supporting any measure that will attain that object. Nor in this are they acting selfishly, for, while the question of wages is the most important of questions to laborers, it is also the most important of questions to society at large. Whatever improves the condition of the lowest and broadest social stratum must promote the true interests of all. Where the wages of common labor are high and remunerative employment is easy to obtain, prosperity will be general. Where wages are highest, there will be the largest production and the most equitable distribution of wealth. There will invention be most active and the brain best guide the hand. There will be the greatest comfort, the widest diffusion of knowledge, the purest morals and the truest patriotism. If we would have a healthy, a happy, an enlightened and a virtuous people, if we would have a pure government, firmly based on the popular will and quickly responsive to it, we must strive to raise wages and keep them high. I accept as good and praiseworthy the ends avowed by the advocates of protective tariffs. What I propose to inquire is whether protective tariffs are in reality conducive to these ends. To do this thoroughly I wish to go over all the ground upon which protective tariffs are advocated or defended, to consider what effect the opposite policy of free trade would have, and to stop not until conclusions are reached of which we may feel absolutely sure.

To some it may seem too much to think that this can be done. For a century no question of public policy has been so widely and persistently debated as that of Protection vs. Free Trade. Yet it seems to-day as far as ever from settlement—so far, indeed, that many have come to deem it a question as to which no certain conclusions can be reached, and many more to regard it as too complex and abstruse to be understood by those who have not equipped themselves by long study.

This is, indeed, a hopeless view. We may safely leave many branches of knowledge to such as can devote themselves to special pursuits. We may safely accept what chemists tell us of chemistry, or astronomers of astronomy, or philologists of the development of language, or anatomists of our internal structure, for not only are there in such investigations no pecuniary temptations to warp the judgment, but the ordinary duties of men and of citizens do not call for such special knowledge, and the great body of a people may entertain the crudest notions as to such things and yet lead happy and useful lives. Far different, however, is it with matters which relate to the production and distribution of wealth, and which thus directly affect the comfort and livelihood of men. The intelligence which can alone safely guide in these matters must be the intelligence of the masses, for as to such things it is the common opinion, and not the opinion of the learned few, that finds expression in legislation.

If the knowledge required for the proper ordering of public affairs be like the knowledge required for the prediction of an eclipse, the making of a chemical analysis, or the decipherment of a cuneiform inscription, or even like the knowledge required in any branch of art or handicraft, then the shortness of human life and the necessities of human existence must forever condemn the masses of men to ignorance of matters which directly affect their means of subsistence. If this be so, then popular government is hopeless, and, confronted on one side by the fact, to which all experience testifies, that a people can never safely trust to any portion of their number the making of regulations which affect their earnings, and on the other by the fact that the masses can never see for themselves the effect of such regulations, the only prospect before mankind is that the many must always be ruled and robbed by the few.

But this is not so. Political economy is only the economy of human aggregates, and its laws are laws which we may individually recognize. What is required for their elucidation is not long arrays of statistics nor the collocation of laboriously ascertained facts, but that sort of clear thinking which, keeping in mind the distinction between the part and the whole, seeks the relations of familiar things, and which is as possible for the unlearned as for the learned.

Whether protection does or does not increase national wealth, whether it does or does not benefit the laborer, are questions that from their nature must admit of decisive answers. That the controversy between protection and free trade, widely and energetically as it has been carried on, has as yet led to no accepted conclusion cannot therefore be due to difficulties inherent in the subject. It may in part be accounted for by the fact that powerful pecuniary interests are concerned in the issue, for it is true, as Macaulay said, that if large pecuniary interests were concerned in denying the attraction of gravitation, that most obvious of physical facts would have disputers. But that so many fair-minded men who have no special interests to serve are still at variance on this subject can only, it seems to me, be fully explained on the assumption that the discussion has not been carried far enough to bring out that full truth which harmonizes all partial truths.

The present condition of the controversy, indeed, shows this to be the fact. In the literature of the subject, I know of no work in which the inquiry has yet been carried to its proper end. As to the effect of protection upon the production of wealth, all has probably been said that can be said; but that part of the question which relates to wages and which is primarily concerned with the distribution of wealth has not been adequately treated. Yet this is the very heart of the controversy, the ground from which, until it is thoroughly explored, fallacies and confusions must constantly arise, to envelop in obscurity even that which has of itself been sufficiently explained.

The reason of this failure is not far to seek. Political economy is the simplest of the sciences. It is but the intellectual recognition, as related to social life, of laws which in their moral aspect men instinctively recognize, and which are embodied in the simple teachings of him whom the common people heard gladly. But, like Christianity, political economy has been warped by institutions which, denying the equality and brother-hood of man, have enlisted authority, silenced objection, and ingrained themselves in custom and habit of thought. Its professors and teachers have almost invariably belonged to or been dominated by that class which tolerates no questioning of social adjustments that give to those who do not labor the fruits of labor's toil. They have been like physicians employed to make a diagnosis on condition that they shall discover no unpleasant truth. Given social conditions such as those that throughout the civilized world today shock the moral sense, and political economy, fearlessly pursued, must lead to conclusions that will be as a lion in the way to those who have any tenderness for "vested interests." But in the colleges and universities of our time, as in the Sanhedrim of old, it is idle to expect any enunciation of truths unwelcome to the powers that be.

Adam Smith demonstrated clearly enough that protective tariffs hamper the production of wealth. But Adam Smith—the university professor, the tutor and pensioner of the Duke of Buccleugh, the prospective holder of a government place—either did not deem it prudent to go further, or, as is more probable, was prevented from seeing the necessity of doing so by the atmosphere of his time and place. He at any rate failed to carry his great inquiry into the causes which from "that original state of things in which the production of labor constitutes the natural recompense or wages of labor" had developed a state of things in which natural wages seemed to be only such part of the produce of labor as would enable the laborer to exist. And, following Smith, came Malthus, to formulate a doctrine which throws upon the Creator the responsibility for the want and vice that flow from man's injustice—a doctrine which has barred from the inquiry which Smith did not pursue even such high and generous minds as that of John Stuart Mill. Some of the publications of the Anti-Corn-Law League contain indications that if the struggle over the English corn laws had been longer continued, the discussion might have been pushed further than the question of revenue tariff or protective tariff; but, ending as it did, the capitalists of the Manchester school were satisfied, and in such discussion as has since ensued English free traders, with few exceptions, have made no further advance, while American advocates of free trade have merely followed the English free traders.

On the other hand, the advocates of protection have evinced a like indisposition to venture on burning ground. They extol the virtues of protection as furnishing employment, without asking how it comes that any one should need to be furnished with employment; they assert that protection maintains the rate of wages, without explaining what determines the rate of wages. The ablest of them, under the lead of Carey, have rejected the Malthusian doctrine, but only to set up an equally untenable optimistic theory which serves the same purpose of barring inquiry into the wrongs of labor, and which has been borrowed by Continental free traders as a weapon with which to fight the agitation for social reform.

That, so far as it has yet gone, the controversy between protection and free trade has not been carried to its logical conclusions is evident from the positions which both sides occupy. Protectionists and free traders alike seem to lack the courage of their convictions. If protection have the virtues claimed for it, why should it be confined to the restriction of imports from foreign countries? If it really "provides employment" and raises wages, then a condition of things in which hundreds of thousands vainly seek employment, and wages touch the point of bare subsistence, demands a far more vigorous application of this beneficent principle than any protectionist has yet proposed. On the other hand, if the principle of free trade be true, the substitution of a revenue tariff for a protective tariff is a ridiculously inefficient application of it.

Like the two knights of allegory, who, halting one on each side of the shield, continued to dispute about it when the advance of either must have revealed a truth that would have ended their controversy, protectionists and free traders stand to-day. Let it be ours to carry the inquiry wherever it may lead. The fact is, that fully to understand the tariff question we must go beyond the tariff question as ordinarily debated. And here, it may be, we shall find ground on which honest divergences of opinion may be reconciled, and facts which seem conflicting may fall into harmonious relations.


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