MBA- 1st Semester

Class:-MBA- 1stSemester
MANAGERIAL ECONOMICS
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MBA- Part-I Sem-I

104 - Managerial Economics

Course Overview
The main objective of this course is to understand the use of the tools of
economic analysis in classifying problems, in organizing and evaluating
information and in comparing alternative course of action. At the end of the
course, the students should be able to- (1) Identify different economic factors
and their Importance (2) understand the role played by these economic factors
in organization`s decision-making.

Course Content
Group-I:
Managerial Economist’s Role and Responsibilities. Demand Theory and
Analysis including Determinants of Demand. Demand Elasticity’s - Price,
Income, Cross and Advertising; Their use in Managerial Decision Making.
Marginal Utility Analysis, Demand Forecasting: Methods and their Application.
Market Mechanism: Interaction of Demand and Supply Forces. Production
Analysis, Cost Analysis: Cost Concepts and Determinants of Cost, Revenue
Concepts.

Group-II:
Pricing under different market structures: Perfect Competition, Monopoly,
Oligopoly and Monopolistic Market Structure. Role of Macro Economics for
managerial Decision-making. Different Economic Systems, Concept of National
Income: GDP, GNP,GDP (at Market price) Investment Multiplier, Concept of
Inflation, Business cycles.

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Note: students will receive an input of minimum 40 (class) contact hours in

each paper. In addition, students are also required to undertake a variety of
practical assignments and group work under the supervision of faculty in every
paper.

Pedagogy:-The instructor is expected to use leading pedagogical approaches

in the class room situation. Research-based methodology, innovative
instructional methods, extensive use of technology in the class room, online
modules of MOOCS, and comprehensive assessment practices to strengthen
teaching efforts and improve student learning outcomes.
The instructor of the class will engage in a combination of academic reading,
analyzing case studies, preparing the weekly assigned readings, encouraging in
the class discussions, and live project based learning.

Case/Class Discussion Assignments:

Students will work in groups of upto four to prepare a brief write-up, due before
the start of each class, covering the case study or class material to be discussed
in the next session. Questions may include a quantitative analysis of the
problem, facing the decision-maker in the case.

Class Participation:
Attendance will be taken in each class. Class participation is scored for each
student for each class.

Recommended Texts and Readings: Students should focus on material

presented in lectures. The text should be used to provide further explanation
and examples of concepts and techniques discussed in the course:
 Edwin Mansfield, W. Bruce Allen, Neil A. Doherty, Keith Weigelt,
Managerial Economics: Theory, Application and Cases, W. W. Norton &
Co. Inc., 5th Edition.
 David Begg, Stanley Fisher, RudigeerDovrbusch, Economics, McGraw-Hill
Book Company Limited (U.K.).
 W.W. Haynes, V.L. Mote and S. Paul, Managerial Economics: Analysis and
Cases, Feffers and Simons Pvt. Ltd., Bombay.

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 Michael Bays; Mote, Paul and Gupta, Managerial Economics: Concepts

and Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi,
34th Edition.
 Joel Dean, Managerial Economics, Prentice-Hall of India Pvt. Ltd., New
Delhi, 1998.
 Ravindra H. Dholakia, Microeconomics for Management Students, Oxford
University Press, Delhi, 2007.

Scheme of Examination:
 English will be the medium of instruction and examination.
 Written Examinations will be conducted at the end of each semester as
per the Academic Calendar notified in advance.
 This course carries 100 marks of which 50 marks shall be reserved for
internal assessment and the remaining 50 marks for written examination
to be held at the end of each semester.
 The duration of written examination for each paper shall be three hours.
 The internal assessment marks shall be based on factors such as: (a) Mid-
term test (20 marks), Submission of written assignments (20marks), and
Participation in case studies/ discussion, and group activities (10 marks),
The weightage given to each of these factors shall be decided and
announced at the beginning of the semester by the individual teacher
responsible for the paper, and the marks obtained shall be made open to
the students and also shown separately in the mark-sheet
 The minimum number of marks required to pass a paper shall be 40% in
the external examination and 40% in the aggregate of internal and
external examination in each paper. There is no pass percentage for
internal part of the assessment.
 A minimum of 75% of classroom attendance is required in each subject.

As per RUSA Scheme the syllabus is divided into two parts Group-I & II. The
instructions for external examiners would be as follows:-

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 “The external paper will carry 50 marks and would be of three hours
duration. The question paper will be divided into three groups i.e., I, II,
III. The question paper will consist of four questions each in group I and
II. Each question in these groups carries 7.5 marks. Candidates will be
required to attempt four questions in all selecting not more than two
questions from each of these group. The IIIrd group shall comprise
compulsory question carrying 4 short answer questions (2 from each
group) and will carry 20 marks (5 marks for each question).”

INDEX
SR.
NO. TOPICS
GROUP-I
1 Managerial Economist’s Role and Responsibilities.
2 Demand Theory and Analysis including Determinants of Demand.
Demand Elasticity’s - Price, Income, Cross and Advertising; Their use in
3 Managerial Decision Making.
4 Marginal Utility Analysis
5 Demand Forecasting: Methods and their Application.
6 Market Mechanism: Interaction of Demand and Supply Forces.
7 Production Analysis, Cost Analysis
8 Cost Concepts and Determinants of Cost
9 Revenue Concepts
10 Important Question/ Answers
GROUP-II
Pricing under different market structures: Perfect Competition,
11 Monopoly, Oligopoly and Monopolistic Market Structure.
12 Role of Macro Economics for managerial Decision-making.
13 Different Economic Systems

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14 Concept of National Income: GDP, GNP,GDP (at Market price)

15 Investment Multiplier
16 Concept of Inflation
17 Business cycles.
18 Important Question/ Answers

GROUP-I
MANAGERIAL ECONOMICS

 INTRODUCTION OF MANAGERIAL ECONOMICS

Managerial Economics (also called Business Economics) a subject first

introduced by Joel Dean in 1951, is essentially concerned with the economic
decisions of business managers. It is a branch of Economics that applies
microeconomic analysis to specific business decisions (i.e. Economics applied
in business decision-making). Managerial Economics may be viewed as
Economics applied to problem solving at the level of the firm. The problems of
course relate to choices and allocation of resources, which are basically
economic in nature and are faced by managers all the time. It is that branch of
Economics, which serves as a link between abstract theory and managerial
practice. It is based on economic analysis for identifying problems, organizing
information and evaluating alternatives. In other words Managerial Economics
involves analysis of allocation of the resources available to a firm or a unit of
management among the activities of that unit. It is thus concerned with choice
or selection among alternatives. Managerial Economics is by nature goal-
oriented and prescriptive, and it aims at maximum achievement of objectives.

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 MEANING OF MANAGERIAL ECONOMICS

MANAGERIAL
MANAGERIAL ECONOMICS
ECONOMICS

Managerial Economic is combination of two words Managerial & Economics.

Managerial means management & relating to Management & Managers.
Economics means Economic growth & relating to trade, industry, money.
Managerial Economics is a combination of Economic Theory & Managerial
Theory. Managerial economics is a discipline which deals with the application
of economic theory to business management. It deals with the use of economic
concepts and principles of business decision making. Formerly it was known as
“Business Economics” but the term has now been discarded in favor of
Managerial Economics.
Managerial Economics may be defined as the study of economic theories, logic
and methodology which are generally applied to seek solution to the practical
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problems of business. Managerial Economics is thus constituted of that part of

economic knowledge or economic theories which is used as a tool of analysing
business problems for rational business decisions. Managerial Economics is
often called as Business Economics or Economic for Firms.
 Definition of Managerial Economics:-
“Managerial Economics is economics applied in decision making. It is a special
branch of economics bridging the gap between abstract theory and managerial
practice.” – Haynes, Mote and Paul.
“Business Economics consists of the use of economic modes of thought to
analyse business situations.” - McNair and Meriam
“Business Economics (Managerial Economics) is the integration of economic
theory with business practice for the purpose of facilitating decision making
and forward planning by management.” - Spencerand Seegelman.
“Managerial economics is concerned with application of economic concepts and
economic analysis to the problems of formulating rational managerial
decision.” – Mansfield

 NATURE OF MANAGERIAL ECONOMICS

To know more about managerial economics, we must know about its various
characteristics. Let us read about the nature of this concept in the following
points:

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1] Art and Science: Managerial economics requires a lot of logical thinking and
creative skills for decision making or problem-solving. It is also considered to
be a stream of science by some economist claiming that it involves the
application of different economic principles, techniques and methods to solve
business problems.

2] Micro Economics: In managerial economics, managers generally deal with

the problems related to a particular organization instead of the whole economy.
Therefore it is considered to be a part of microeconomics.

3] Uses Macro Economics: A business functions in an external environment,

i.e. it serves the market which is a part of the economy as a whole. Therefore, it
is essential for managers to analyze the different factors of macroeconomics
such as market conditions, economic reforms, government policies, etc. and
their impact on the organization.

4] Multi-disciplinary: It uses many tools and principles belonging to various

disciplines such as accounting, finance, statistics, mathematics, production,
operation research, human resource, marketing, etc.

5] Prescriptive / Normative Discipline: It aims at goal achievement and deals

with practical situations or problems by implementing corrective measures.
Management Oriented: It acts as a tool in the hands of managers to deal with
business-related problems and uncertainties appropriately. It also provides for
goal establishment, policy formulation and effective decision making.

6] Pragmatic: It is a practical and logical approach towards the day to day

business problems.

 SCOPE OF MANAGERIAL ECONOMICS

The scope of managerial economics is not yet clearly laid out because it is a
developing science. Even then the following fields may be said to generally fall
under Managerial Economics:-
1. Analysis and Forecasting: A business firm is an economic organisation which
is engaged in transforming productive resources into goods that are to be sold
in the market. A major part of managerial decision making depends on accurate
estimates of demand. A forecast of future sales serves as a guide to management

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for preparing production schedules and employing resources. It will help

management to maintain or strengthen its market position and profit base.
Demand analysis also identifies a number of other factors influencing the
demand for a product. Demand analysis and forecasting occupies a strategic
place in Managerial Economics.

2. Cost and production analysis: A firm’s profitability depends much on its cost
of production. A wise manager would prepare cost estimates of a range of
output, identify the factors causing are cause variations in cost estimates and
choose the cost-minimising output level, taking also into consideration the
degree of uncertainty in production and cost calculations. Production
processes are under the charge of engineers but the business manager is
supposed to carry out the production function analysis in order to avoid
wastages of materials and time. Sound pricing practices depend much on cost
control. The main topics discussed under cost and production analysis are: Cost
concepts, cost-output relationships, Economics and Diseconomies of scale and
cost control.

3. Pricing decisions, policies and practices: Pricing is a very important area

of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad
as such the success of a business firm largely depends on the correctness of the
price decisions taken by it. The important aspects dealt with this area are: Price
determination in various market forms, pricing methods, differential pricing,
product-line pricing and price forecasting.

4. Profit management: Business firms are generally organized for earning

profit and in the long period, it is profit which provides the chief measure of
success of a firm. Economics tells us that profits are the reward for uncertainty
bearing and risk taking. A successful business manager is one who can form
more or less correct estimates of costs and revenues likely to accrue to the firm
at different levels of output. The more successful a manager is in reducing
uncertainty, the higher are the profits earned by him. In fact, profit-planning
and profit measurement constitute the most challenging area of Managerial
Economics.

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5. Capital management: The problems relating to firm’s capital investments

are perhaps the most complex and troublesome. Capital management implies
planning and control of capital expenditure because it involves a large sum and
moreover the problems in disposing the capital assets off are so complex that
they require considerable time and labour. The main topics dealt with under
capital management are cost of capital, rate of return and selection of projects.

6. Government Regulation: There are endless implications of government

regulations on the business firm and at times the legal environment of business
is as important as the economic environment. So, it is necessary to examine law-
related applications of economic principles.

7. Management of Public Sector Enterprises:-Managerial economics can also

be applied to the decision making process of non-profit seeking and public
sector enterprises. Economists in various government departments and public
sector organizations are also concerned with project evaluation and cost-
benefit analysis.

 MANAGERIAL ECONOMICS IN RELATION WITH OTHER DISCIPLINES

Managerial economics has a close linkage with other disciplines and fields of
study. The subject has gained by the interaction with Economics, Mathematics
and Statistics and has drawn upon Management theory and Accounting
concepts. Managerial economics integrates concepts and methods from these
disciplines and brings them to bear on managerial problems.

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1. Managerial Economics and Economics:

Managerial Economics is economics applied to decision making. It is a special

branch of economics, bridging the gap between pure economic theory and
managerial practice. Economics has two main branches—micro-economics and
macro-economics.

Micro-economics:-‘Micro’ means small. It studies the behaviour of the

individual units and small groups of units. It is a study of particular firms,
particular households, individual prices, wages, incomes, individual industries
and particular commodities. Thus micro-economics gives a microscopic view of
the economy.

The roots of managerial economics spring from micro-economic theory. In

price theory, demand concepts, elasticity of demand, marginal cost marginal
revenue, the short and long runs and theories of market structure are sources
of the elements of micro-economics which managerial economics draws upon.
It makes use of well known models in price theory such as the model for
monopoly price, the kinked demand theory and the model of price
discrimination.

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Macro-economics:-‘Macro’ means large. It deals with the behaviour of the

large aggregates in the economy. The large aggregates are total saving, total
consumption, total income, total employment, general price level, wage level,
cost structure, etc. Thus macro-economics is aggregative economics.

It examines the interrelations among the various aggregates, and causes of

fluctuations in them. Problems of determination of total income, total
employment and general price level are the central problems in macro-
economics.

Macro-economies is also related to managerial economics. The environment, in

which a business operates, fluctuations in national income, changes in fiscal and
monetary measures and variations in the level of business activity have
relevance to business decisions. The understanding of the overall operation of
the economic system is very useful to the managerial economist in the
formulation of his policies.

Macro-economics contributes to business forecasting. The most widely used

model in modern forecasting is the gross national product model.

2. Managerial Economics and Theory of Decision Making:

The theory of decision making is relatively a new subject that has a significance
for managerial economics. In the process of management such as planning,
organising, leading and controlling, decision making is always essential.
Decision making is an integral part of today’s business management. A manager
faces a number of problems connected with his/her business such as
production, inventory, cost, marketing, pricing, investment and personnel.

Economist are interested in the efficient use of scarce resources hence they are
naturally interested in business decision problems and they apply economics
in management of business problems. Hence managerial economics is
economics applied in decision making.

3. Managerial Economics and Operations Research:

Mathematicians, statisticians, engineers and others join together and

developed models and analytical tools which have grown into a specialized
subject known as operation research. The basic purpose of the approach is to

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develop a scientific model of the system which may be utilized for policy
making.

The development of techniques and concepts such as Linear Programming,

Dynamic Programming, Input-output Analysis, Inventory Theory, Information
Theory, Probability Theory, Queuing Theory, Game Theory, Decision Theory
and Symbolic Logic.

4. Managerial Economics and Statistics:

Statistics is important to managerial economics. It provides the basis for the

empirical testing of theory. It provides the individual firm with measures of
appropriate functional relationship involved in decision making. Statistics is a
very useful science for business executives because a business runs on
estimates and probabilities.

Statistics supplies many tools to managerial economics. Suppose forecasting

has to be done. For this purpose, trend projections are used. Similarly, multiple
regression technique is used. In managerial economics, measures of central
tendency like the mean, median, mode, and measures of dispersion, correlation,
regression, least square, estimators are widely used.

Statistical tools are widely used in the solution of managerial problems.

For example: Sampling is very useful in data collection. Managerial economics

makes use of correlation and multiple regression in business problems
involving some kind of cause and effect relationship.

5. Managerial Economics and Accounting:

Managerial economics is closely related to accounting. It is recording the finan-

cial operation of a business firm. A business is started with the main aim of
earning profit. Capital is invested / employed for purchasing properties such as
building, furniture, etc and for meeting the current expenses of the business.

Goods are bought and sold for cash as well as credit. Cash is paid to credit
sellers. It is received from credit buyers. Expenses are met and incomes
derived. This goes on the daily routine work of the business. The buying of

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goods, sale of goods, payment of cash, receipt of cash and similar dealings are
called business transactions.

The business transactions are varied and multifarious. This has given rise to the
necessity of recording business transaction in books. They are written in a set
of books in a systematic manner so as to facilitate proper study of their results.

 There are three classes of accounts:

(i) Personal account,

(ii) Property accounts, and
(iii) Nominal accounts.
Management accounting provides the accounting data for taking business
decisions. The accounting techniques are very essential for the success of the
firm because profit maximization is the major objective of the firm.

6. Managerial Economics and Mathematics:

Mathematics is another important subject closely related to managerial

economics. For the derivation and exposition of economic analysis, we require
a set of mathematical tools. Mathematics has helped in the development of
economic theories and now mathematical economics has become a very
important branch of economics.

Mathematical approach to economic theories makes them more precise and

logical. For the estimation and prediction of economic factors for decision mak-
ing and forward planning, mathematical method is very helpful. The important
branches of mathematics generally used by a managerial economist are
geometry, algebra and calculus.

The mathematical concepts used by the managerial economists are the

logarithms and exponential, vectors and determinants, input-out tables.
Operations research which is closely related to managerial economics is
mathematical in character.

 MANAGERIAL ECONOMICS IN DECISION MAKING.

Managerial economics uses a wide variety of economic concepts, tools, and

techniques in the decision-making process. These concepts can be placed in
three broad categories:-
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1. The theory of the firm, which describes how businesses make a variety of
decisions.
2. The theory of consumer behavior, which describes decision making by
consumers.
3. The theory of market structure and pricing, which describes the structure
and characteristics of different market forms under which business firms
operate.

 ROLE OF MANAGERIAL ECONOMICS IN DECISION MAKING

Managerial economics, or business economics, is a division of microeconomics

that focuses on applying economic theory directly to businesses. The
application of economic theory through statistical methods helps businesses
make decisions and determine strategy on pricing, operations, risk,
investments and production. The overall role of managerial economics is to
increase the efficiency of decision making in businesses to increase profit

Role Of Managerial
Economics In Decision
Making

Elastic Operations
Pricing vs. Inelastic and Investments Risk
Goods Production

1) Pricing:- Managerial economics assists businesses in determining pricing

strategies and appropriate pricing levels for their products and services. Some
common analysis methods are price discrimination, value-based pricing and
cost-plus pricing.

2) Elastic vs. Inelastic Goods:- Economists can determine price sensitivity of

products through a price elasticity analysis. Some products, such as milk, are
consider a necessity rather than a luxury and will purchase at most price points.
This type of product is considered inelastic. When a business knows they are
selling an inelastic good, they can make marketing and pricing decisions easier

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3) Operations and Production:- Managerial economics uses quantitative

methods to analyze production and operational efficiency through schedule
optimization, economies of scale and resource analyses. Additional analysis
methods include marginal cost, marginal revenue and operating leverage.
Through tweaking the operations and production of a company, profits rise as
costs decline.

4) Investments:- Many managerial economic tools and analysis models are

used to help make investing decisions both for corporations and savvy
individual investors. These tools are use to make stock market investing
decisions and decisions on capital investments for a business. For example,
managerial economic theory can be used to help a company decide between
purchasing, building or leasing operational equipment.

5) Risk:- Uncertainty exits in every business and managerial economics can

help reduce risk through uncertainty model analysis and decision-theory
analysis. Heavy use of statistical probability theory helps provide potential
scenarios for businesses to use when making decisions.

 MANAGERIAL DECISION MAKING PROCESS (5 STEPS)

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Decision making is crucial for running a business enterprise which faces a large
number of problems requiring decisions.

Which product to be produced, what price to be charged, what quantity of the

product to be produced, what and how much advertisement expenditure to be
made to promote the sales, how much investment expenditure to be incurred
are some of the problems which require decisions to be made by managers.

The five steps involved in managerial decision making process are

explained below:-

1. Establishing the Objective:-The first step in the decision making process is

to establish the objective of the business enterprise. The important objective of
a private business enterprise is to maximize profits. However, a business firm
may have some other objectives such as maximization of sales or growth of the
firm.

But the objective of a public enterprise is normally not of maximization of

profits but to follow benefit-cost criterion. According to this criterion, a public
enterprise should evaluate all social costs and benefits when making a decision
whether to build an airport, a power plant, a steel plant, etc.

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2. Defining the Problem:-The second step in decision making process is one

of defining or identifying the problem. Defining the nature of the problem is
important because decision making is after all meant for solution of the
problem. For instance, a cotton textile firm may find that its profits are
declining.

It needs to be investigated what are the causes of the problem of decreasing

profits. Whether it is the wrong pricing policy, bad labour-management
relations or the use of outdated technology which is causing the problem of
declining profits. Once the source or reason for falling profits has been found,
the problem has been identified and defined.

3. Identifying Possible Alternative Solutions (i.e. Alternative Courses of

Action):- Once the problem has been identified, the next step is to find out
alternative solutions to the problem. This will require considering the variables
that have an impact on the problem. In this way, relationship among the
variables and with the problems has to be established.

In regard to this, various hypotheses can be developed which will become

alternative courses for the solution of the problem. For example, in case of the
problem mentioned above, if it is identified that the problem of declining profits
is due to be use of technologically inefficient and outdated machinery in
production.

 The two possible solutions of the problem are:

(1) Updating and replacing only the old machinery.
(2) Building entirely a new plant equipped with latest machinery.

The choice between these alternative courses of action depends on which will
bring about larger increase in profits.

4. Evaluating Alternative Courses of Action:-The next step in business

decision making is to evaluate the alternative courses of action. This requires,
the collection and analysis of the relevant data. Some data will be available
within the various departments of the firm itself, the other may be obtained
from the industry and government.

The data and information so obtained can be used to evaluate the outcome or
results expected from each possible course of action. Methods such as
regression analysis, differential calculus, linear programming, cost- benefit

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analysis are used to arrive at the optimal course. The optimum solution will be
one that helps to achieve the established objective of the firm. The course of
action which is optimum will be actually chosen. It may be further noted that
for the choice of an optimal solution to the problem, a manager works under
certain constraints.

The constraints may be legal such as laws regarding pollution and disposal of
harmful wastes; they way be financial (i.e. limited financial resources); they
may relate to the availability of physical infrastructure and raw materials, and
they may be technological in nature which set limits to the possible output to
be produced per unit of time. The crucial role of a business manager is to
determine optimal course of action and he has to make a decision under these
constraints.

5. Implementing the Decision:- After the alternative courses of action have

been evaluated and optimal course of action selected, the final step is to
implement the decision. The implementation of the decision requires constant
monitoring so that expected results from the optimal course of action are
obtained. Thus, if it is found that expected results are not forthcoming due to
the wrong implementation of the decision, then corrective measures should be
taken.

However, it should be noted that once a course of action is implemented to

achieve the established objective, changes in it may become necessary from
time to time in response in changes in conditions or firm’s operating
environment on the basis of which decisions were taken.

 ROLE AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST

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1. To make a reasonable profit on capital employed: - He must have a strong

conviction that profits are essential and his main obligation is to assist the
management in earning reasonable profits on capital employed in the firm.

2. He must make successful forecasts by making in depth study of the

internal and external factors:-This will have influence over the profitability
or the working of the firm. He must aim at lessening if not fully eliminating the
risks involved in uncertainties. He has a major responsibility to alert
management at the earliest possible time in case he discovers any error in his
forecast, so that the management can make necessary changes and adjustments
in the policies and programmes of the firm.

3. He must inform the management of all the economic trends:-A

managerial economist should keep himself in touch with the latest
developments of national economy and business environment so that he can
keep the management informed with these developments and expected trends
of the economy

4. He must establish and maintain contacts with individuals and data

sources:

(i) To establish and maintain contacts:- A managerial economist should

establish and maintain contacts with individuals and data sources in order to
collect relevant and valuable information in the field.

(ii) To develop personal relations:- To collect information he should develop

personal relations with those having specialized knowledge of the field.

(iii) To join professional associations and should take active part in their
activities:- The success of this lies in how quickly he gathers additional
information in the best interest of the firm.

5. He must earn full status in the business and only then he can be helpful
to the management in good and successful decision-making:

For this:

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(i) He must receive continuous support for himself and his professional ideas
by performing his function effectively.

(ii) He should express his ideas in simple and understandable language with the
minimum use of technical words, while communicating with his management
executives.

 IMPORTANCE OF MANAGERIAL ECONOMICS

Business and industrial enterprises aim at earning maximum proceeds. In

order to achieve this objective, a managerial executive has to take recourse in
decision making, which is the process of selecting a specified course of action
from a number of alternatives. A sound decision requires fair knowledge of the
aspects of economic theory and the tools of economic analysis, which are
directly involved in the process of decision-making. Since managerial
economics is concerned with such aspects and tools of analysis, it is pertinent
to the decision making process.

Spencer and Siegelman have described the importance of managerial

economics in a business and industrial enterprise as follows:

(i) Accommodating traditional theoretical concepts to the actual business

behavior and conditions:- Managerial economics amalgamates tools,
techniques, models and theories of traditional economics with actual business
practices and with the environment in which a firm has to operate. According
to Edwin Mansfield, “Managerial Economics attempts to bridge the gap
between purely analytical problems that intrigue many economic theories and
the problems of policies that management must face”.

(ii) Estimating economic relationships: Managerial economics estimates

economic relationships between different business factors such as income,
elasticity of demand, cost volume, profit analysis etc.

(iii) Predicting relevant economic quantities: Managerial economics assists

the management in predicting various economic quantities such as cost, profit,
demand,capital, production, price etc. As a business manager has to function in

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an environment of uncertainty, it is imperative to anticipate the future working

environment in terms of the said quantities.

(iv) Understanding significant external forces: The management has to

identify all the important factors that influence a firm. These factors can
broadly be divided into two categories. Managerial economics plays an
important role by assisting management in understanding these factors.

(a) External factors: A firm cannot exercise any control over these factors. The
plans, policies and programs of the firm should be formulated in the light of
these factors. Significant external factors impinging on the decision making
process of a firm are economic system of the country, business cycles,
fluctuations in national income and national production, industrial policy of the
government, trade and fiscal policy of the government, taxation policy,
licensing policy, trends in foreign trade of the country, general industrial
relation in the country and so on.

(b) Internal factors: These factors fall under the control of a firm. These
factors are associated with business operation. Knowledge of these factors aids
the management in making sound business decisions.

(v) Basis of business policies: Managerial economics is the founding principle

of business policies. Business policies are prepared based on studies and
findings of managerial economics, which cautions the management against
potential upheavals in national as well as international economy. Thus,
managerial economics is helpful to the management in its decision-making
process.

 LIMITATIONS OF MANAGERIAL ECONOMICS

The limitations of managerial economics are as follows:-

(a) Managerial economics focus on management analysis based on financial

and cost accounting data. Thus, the reliability of this data depends on the
accuracy of the financial accounting information.

(b) Such analysis is based on past information. But if a new scheme is to be

introduced, the circumstances change and the conclusions cannot be predicted
using this past information.

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(c) Managerial economics is subjected to the personal preferences of the

individual manager which can influence the final decision of the manager to a
certain extent.

(d) It is an expensive process as a business firm generally requires a certain

number of managers to ensure proper functioning.

(e) The science of managerial economics is quite recent and is not fully
developed. Thus, it is subjected to ambiguity in certain scenarios.

The manager is required to have extensive knowledge in a variety of fields in

order to ensure that he completely comprehends the situation to be dealt with."

DEMAND

 MEANING OF DEMAND

Demand in terms of economics may be explained as the consumers’ willingness

and ability to purchase or consume a given item/good. Furthermore, the
determinants of demand go a long way in explaining the demand for a particular
good.
For instance, an increase in the price of a good will lead to a decrease in the
quantity that may be demanded by consumers. Similarly, a decrease in the cost
or selling price of a good will most likely lead to an increase in the demanded
quantity of the goods.
This indicates the existence of an inverse relationship between the price of the
article and the quantity demanded by consumers. This is commonly known as the
law of demand and can be graphically represented by a line with a downward
slope.
The graphical representation is known as the demand curve. The determinants
of demand are factors that cause fluctuations in the economic demand for a
product or a service.

Demand in economics means a desire to possess a good supported by

willingness and ability to pay for it. If your have a desire to buy a certain
commodity, say a car, but you do not have the adequate means to pay for it, it
will simply be a wish, a desire or a want and not demand. Demand is an effective

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desire, i.e., a desire which is backed by willingness and ability to pay for a
commodity in order to obtain it.

In the words of Prof. Hibdon "Demand means the various quantities of goods
that would be purchased per time period at different prices in a given market".

 CHARACTERISTICS OF DEMAND

There are thus three main characteristics of demand in economics.

(i) Willingness and ability to pay. Demand is the amount of a commodity for
which a consumer has the willingness and also the ability to buy.

(ii) Demand is always at a price. If we talk of demand without reference to

price, it will be meaningless. The consumer must know both the price and the
commodity. He will then be able to tell the quantity demanded by him.

(iii) Demand is always per unit of time. The time may be a day, a week, a
month, or a year.

 TYPES OF DEMAND
The demand can be classified on the following basis:

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1. Individual Demand and Market Demand: The individual demand refers to

the demand for goods and services by the single consumer, whereas the market
demand is the demand for a product by all the consumers who buy that product.
Thus, the market demand is the aggregate of the individual demand.
2. Total Market Demand and Market Segment Demand: The total market
demand refers to the aggregate demand for a product by all the consumers in
the market who purchase a specific kind of a product. Further, this aggregate
demand can be sub-divided into the segments on the basis of geographical
areas, price sensitivity, customer size, age, sex, etc. are called as the market
segment demand.
3. Derived Demand and Direct Demand: When the demand for a
product/outcome is associated with the demand for another product/outcome
is called as the derived demand or induced demand. Such as the demand for
cotton yarn is derived from the demand for cotton cloth. Whereas, when the
demand for the products/outcomes is independent of the demand for another
product/outcome is called as the direct demand or autonomous demand. Such
as, in the above example the demand for a cotton cloth is autonomous.
4. Industry Demand and Company Demand: The industry demand refers to the
total aggregate demand for the products of a particular industry, such as
demand for cement in the construction industry. While the company demand is
a demand for the product which is particular to the company and is a part of
that industry. Such as demand for tyres manufactured by the Goodyear. Thus,
the company demand can be expressed as the percentage of the industry
demand.
5. Short-Run Demand and Long-Run Demand: The short term demand is more
elastic which means that the changes in price or income are reflected

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immediately on the quantity demanded. Whereas, the long run demand is

inelastic, which shows that demand for commodity exists as a result of
adjustments following changes in pricing, promotional strategies, consumption
patterns, etc.
6. Price Demand: The demand is often studied in parlance to price, and is
therefore called as a price demand. The price demand means the amount of
commodity a person is willing to purchase at a given price. While studying the
demand, we often assume that the other factors such as income of the
consumer, their tastes, and preferences, the prices of other related goods
remain unchanged. There is a negative relationship between the price and
demand Viz. As the price increases the demand decreases and as the price
decreases the demand increases.
7. Income Demand: The income demand refers to the willingness of an
individual to buy a certain quantity at a given income level. Here the price of
the product, customer’s tastes and preferences and the price of the related
goods are expected to remain unchanged. There is a positive relationship
between the income and demand. As the income increases the demand for the
commodity also increases and vice-versa.
8. Cross Demand: It is one of the important types of demand wherein the demand
for a commodity depends not on its own price, but on the price of other related
products is called as the cross demand. Such as with the increase in the price of
coffee the consumption of tea increases, since tea and coffee are substitutes to
each other. Also, when the price of cars increases the demand for petrol
decreases, as the car and petrol are complimentary to each other.

 DEMAND SCHEDULE:

The demand schedule in economics is a table of quantity demanded of a good

at different price levels. Given the price level, it is easy to determine the
expected quantity demanded. This demand schedule can be graphed as a
continuous demand curve on a chart where the Y-axis represents price and the
X-axis represents the quantity.

According to PROF. ALFRED MARSHALL, “Demand schedule is a list of prices

and quantities”. In other words, a tabular statement of price-quantity
relationship between two variables is known as the demand schedule.

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The demand schedule in the table represents different quantities of

commodities that are purchased at different prices during a certain specified
period (it can be a day or a week or a month).

 The demand schedule can be classified into two categories:

1. Individual demand schedule;

2. Market demand schedule.

1. Individual Demand Schedule:- It represents the demand of an individual’

for a commodity at different prices at a particular time period. The adjoining
table 7.1 shows a demand schedule for oranges on 7th July, 2009.

2. Market Demand Schedule:- Market Demand Schedule is defined as the

quantities of a given commodity which all consumers will buy at all possible
prices at given moment of time. In a market, there are several consumers, and
each has a different liking, taste, preference and income. Every consumer has a
different demand.

The market demand actually represents the demand of all the consumers
combined together. When a particular commodity has several brands or types
of commodities, the market demand schedule becomes very complicated
because of various factors. However, for a single item, the market demand
schedule is rather simple. Study the market demand schedule for milk in table
7.2.

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 DEMAND CURVES (DIAGRAM)

The demand curve is a graphic statement or presentation of the relationship

between product price and the quantity of the product demanded. It is drawn
with price on the vertical axis of the graph and quantity demanded on the
horizontal axis.

Demand curve does not tell us the price. It only tells us how much quantity of
goods would be purchased by the consumer at various possible prices.

Depending upon the demand schedule, the demand curve can be as

follows:
1. Individual Demand Curve
2. Market Demand Curve

1. Individual Demand Curve:- An Individual Demand Curve is a graphical

representation of the quantities of a commodity that an individual (a particular
consumer) stands ready to take off the market at a given instant of time against
different prices. In Fig. 7.1, an Individual Demand Curve is drawn on the basis
of Individual Demand Schedule given above in table 7.1.

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2. Market Demand Curve:- A Market Demand Curve is a graphical

representation of the quantities of a commodity which all the buyers in the
market stand ready to take off at all possible prices at a given moment of time.
In Figure 7.2 a Market Demand Curve is drawn on the basis of Market Demand
Schedule given in Table 7.2.

Both, the individual consumer’s demand curve is a straight line. A demand

curve will slope downward to the right.

It is not necessary, that the demand curve is a straight line. A demand curve
may be a convex curve or a concave curve. It may take any shape provided it is
negatively sloped.

 DETERMINANTS OF DEMAND

Some of the important determinants of demand are as follows,

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1] Price of the Product:- People use price as a parameter to make decisions if

all other factors remain constant or equal. According to the law of demand, this
implies an increase in demand follows a reduction in price and a decrease in
demand follows an increase in the price of similar goods.
The demand curve and the demand schedule help determine the demand
quantity at a price level. An elastic demand implies a robust change quantity
accompanied by a change in price. Similarly, an inelastic demand implies that
volume does not change much even when there is a change in price.

2] Income of the Consumers:- Rising incomes lead to a rise in the number of

goods demanded by consumers. Similarly, a drop in income is accompanied by
reduced consumption levels. This relationship between income and demand is
not linear in nature. Marginal utility determines the proportion of change in the
demand levels.

3] Prices of related goods or services

1. Complementary products – An increase in the price of one product will

cause a decrease in the quantity demanded of a complementary product.
Example: Rise in the price of bread will reduce the demand for butter. This
arises because the products are complementary in nature.
2. Substitute Product – An increase in the price of one product will cause an
increase in the demand for a substitute product. Example: Rise in price of tea
will increase the demand for coffee and decrease the demand for tea.

4] Consumer Expectations:- Expectations of a higher income or expecting an

increase in prices of goods will lead to an increase the quantity demanded.
Similarly, expectations of a reduced income or a lowering in prices of goods will
decrease the quantity demanded.

5] Number of Buyers in the Market:- The number of buyers has a major effect
on the total or net demand. As the number increases, the demand rises.
Furthermore, this is true irrespective of changes in the price of commodities.

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 LAW OF DEMAND

There is an inverse relationship between quantity demanded and its price. The
people know that when price of a commodity goes up its demand comes down.
When there is decrease in price the demand for a commodity goes up. There is
inverse relation between price and demand . The law refers to the direction in
which quantity demanded changes due to change in price.

A consumer may demand one dozen oranges at $5 per dozen . He may demand
two dozen when the price is $4 per dozen. A person generally buys more at a
lower price. He buys less at higher price. It is not the case with one person but
all people liken to buy more due to fall in price and vice versa. This is true for
all commodities and under all conditions. The economists call it as law of
demand. In simple words the law of demand states that other things being
equal more will be demanded at lower price and lower will be demanded at
higher price.

 Definition

Alfred Marshal says that the amount demanded increase with a fall in price,
diminishes with a rise in price.

C.E. Ferguson says that according to law of demand, the quantity demanded
varies inversely with price.

Paul A. Samuelson says that law of demand states that people will buy more
at lower prices and buy less at higher prices, other things remaining the same.

 ASSUMPTIONS OF THE LAW

1. There is no change in income of consumers.

2. There is no change in the price of product.
3. There is no change in quality of product.
4. There is no substitute of the commodity.
5. The prices of related commodities remain the same.
6. There is no change in customs.
7. There is no change in taste and preference of consumers.
8. The size of population remains the same.
9. The climate and weather conditions are same.
10. The tax rates and other fiscal measures remain the same.
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 EXPLANATION OF THE LAW

The relationship between price of a commodity and its demand depends upon
many factors. The most important factor is nature of commodity. The demand
schedule shows response of quantity demanded to change in price of that
commodity. This is the table that shows prices per unit of commodity ands
amount demanded per period of time. The demand of one person is called
individual demand. The demand of many persons is known as market demand.
The experts are concerned with market demand schedule. The market demand
schedule means 'quantities of given commodity which all consumers want to
buy at all possible prices at a given moment of time'. The demand schedules of
all individuals can be added up to find out market demand schedule.

 DEMAND SCHEDULE
Price in dollars. Demand in Kg.

5 100

4 200

3 300

2 400

The table shows the demand of all the consumers in a market. When the price
decreases there is increase in demand for goods and vice versa. When price is
$5 demand is 100 kilograms. When the price is $4 demand is 200 kilograms.
Thus the table shows the total amount demanded by all consumers various
price levels.

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 DIAGRAM

There is same price in the market. All consumers purchase commodity

according to their needs. The market demand curve is the total amount
demanded by all consumers at different prices. The market demand curve
slopes from left down to the right.

 TYPES OF DEMAND FUNCTION

Based on whether the demand function is in relation to an individual consumer

or to all consumers in the market, the demand function cab be categorized as

1. Individual Demand Function

2. Market Demand Function

1. Individual Demand Function

Individual demand function refers to the functional relationship between

demand made by an individual consumer and the factors affecting the
individual demand. It shows how demand made by an individual in the market
is related to its determinants.

Mathematically, individual demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F)

Where,
Dx= Demand for commodity x;.
Px= Price of the given commodity x;
Pr= Price of related goods;
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Y= Income of the individual consumer;

T= Tastes and preferences;
F= Expectation of change in price in the future.

1] Price of the given commodity:- Other things remaining constant, the rise
in price of the commodity, the demand for the commodity contracts, and with
the fall in price, its demand increases.

2] Price of related goods:- Demand for the given commodity is affected by

price of the related goods, which is called cross price demand.

3] Income of the individual consumer:- Change in consumer’s level of income

also influences their demand for different commodities. Normally, the demand
for certain goods increase with the increasing level of income and vice versa.

4] Tastes and preferences:- The taste and preferences of individuals also

determine the demand made for certain goods and services. Factors such as
climate, fashion, advertisement, innovation, etc. affect the taste and preference
of the consumers.

5] Expectation of change in price in the future:- If the price of the commodity

is expected to rise in the future, the consumer will be willing to purchase more
of the commodity at the existing price. However, if the future price is expected
to fall, the demand for that commodity decreases at present.

6] Size and composition of population:- The market demand for a commodity

increases with the increase in the size and composition of the total population.
For instance, with the increase in total population size, there is an increase in
the number of buyers. Likewise, with an increase in the male composition of the
population, the demand for goods meant for male increases.

7] Season and weather:- The market demand for a certain commodity is also
affected by the current weather conditions. For instance, the demand for cold
beverages increase during summer season.

8] Distribution of income:- In case of equal distribution of income in the

economy, the market demand for a commodity remains less. With an increase
in the unequal distribution of income, the demand for certain goods increase as
most people will have the ability to buy certain goods and commodities,
especially luxury goods.

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2. Market Demand Function

Market demand function refers to the functional relationship between market

demand and the factors affecting market demand. Market demand is affected
by all the factors that affect an individual demand. In addition to this, it is also
affected by size and composition of population, season and weather conditions,
and distribution of income.

Mathematically, market demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F, Po, S, D)

Where,
Dx= Demand for commodity x;
Px= Price of the given commodity x;
Pr= Price of related goods;
Y= Income of the individual consumer;
T= Tastes and preferences;
F= Expectation of change in price in the future;
Po= Size and composition of population;
S= Season and weather;
D= Distribution of income.

1. Pattern of Income Distribution:- If National income is equitably

distributed, there will be more demand and vice-versa. If income distribution
moves in favour of downtrodden people, then demand for such commodities,
which are used by common people would increase. On the other hand, if the
major part of National income is concentrated in the hands of only some rich
people, the demand for luxury goods will increase.

2. Demographic Structure:- Market demand is influenced by change in size

and composition of population. Increase in population leads to more demand
for all types of goods and decrease in population means less demand for them.
Composition of population also affects its demand. Composition refers to the
number of children, adults, males, females etc., in the population.

When the composition changes, for example, when the number of females
exceeds to that of the males, then there will be more demand for goods required
by women folk.

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3. Government Policy:- Government policy of a country can also affect the

demand for a particular commodity or commodities through taxation.
Reduction in the taxes and duties will allow more persons to enter a particular
market and thus raising the demand for a particular product.

4. Season and Weather:- Demands for commodities also depend upon the
climate of an area and weather. In cold hilly areas woolens are demanded.
During summer and rainy season demand for umbrellas may rise. In winter ice
is not so much demanded.

5. State of Business:- The levels of demand in a market for different goods

depend upon the business condition of the country. If the country is passing
through boom, the trade is active and brisk. The demand for all commodities
tends to rise. But in the days of depression, when trade is dull and slow, demand
tends to fall.

 WHY DEMAND CURVE FALLS

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1] Marginal utility decreases:- When a consumer buys more units of a

commodity, the marginal utility of such commodity continue to decline. The
consumer can buy more units of commodity when its price falls and vice versa.
The demand curve falls because demand is more at lower price.
2] Price effect:- When there is increase in price of commodity, the consumers
reduce the consumption of such commodity. The result is that there is decrease
in demand for that commodity. The consumers consume mo0re or less of a
commodity due to price effect. The demand curve slopes downward.
3] Income effect:- Real income of consumer rises due to fall in prices. The
consumer can buy more quantity of same commodity. When there is increase
in price, real income of consumer falls. This is income effect that the consumer
can spend increased income on other commodities. The demand curve slopes
downward due to positive income effect.
4] Same price of substitutes:- When the price of a commodity falls, the prices
of substitutes remaining the same, consumer can buy more of the commodity
and vice versa. The demand curve slopes downward due to substitution effect.
5] Demand of poor people:- The income of people is not the same, The rich
people have money to buy same commodity at high prices. Large majority of
people are poor, They buy more when price fall and vice versa. The demand
curve slopes due to poor people.
6] Different uses of goods:- There are different uses of many goods. When
prices of such goods increase these goods are put into uses that are more
important and their demand falls. The demand curve slopes downward due to
such goods.

 EXCEPTIONS TO THE LAW

1] Inferior goods:- The law of demand does not apply in case of inferior goods.
When price of inferior commodity decreases and its demand also decrease and
amount so saved in spent on superior commodity. The wheat and rice are
superior food grains while maize is inferior food grain.

2] Demonstration effect:- The law of demand does not apply in case of

diamond and jewelry. There is more demand when prices are high. There is less
demand due to low prices. The rich people like to demonstrate such items that
only they have such commodities.

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3] Ignorance of consumers: - The consumer usually judge the quality of a

commodity from its price. A low priced commodity is considered as inferior and
less quantity is purchased. A high priced commodity is treated as superior and
more quantity is purchased. The law of demand does not apply in this case.
4] Less supply:- The law of demand does not work when there is less supply
of commodity. The people buy more for stock purpose even at high price. They
think that commodity will become short.
5] Depression:- The law of demand does not work during period of depression.
The prices of commodities are low but there is increase in demand. it is due to
low purchasing power of people.
6] Speculation:- The law does not apply in case of speculation. The speculators
start buying share just to raise the price. Then they start selling large quantity
of shares to avoid losses.
7] Out of fashion :- The law of demand is not applicable in case of goods out of
fashion. The decrease in prices cannot raise the demand of such goods. The
quantity purchased is less even though there is falls in prices.

 IMPORTANCE OF THE LAW

1] Price determination:- A monopolist can determine price of a commodity

on the basis of such law. He can know the effect on demand due to increase or
decrease in price. The demand schedule can help him to determine the most
suitable price level.
2] Tax on commodities:- The law of demand is important for tax authorities.
The effect of tax on different commodities is checked. The commodity must be
taxed if its demand is relatively inelastic. A commodity cannot be taxed if its
sales fall to great extent.
3] Agricultural prices

The law of demand is useful to determine agricultural prices. When there are
good crops, the prices come down due to change in demand. In case of bad
crops, the prices go up if demand remains the same. The poverty of farmers can
be determined.

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4] Planning:- Individual demand schedule is used in planning for individual

goods and industries. There is need to know the effect of change in price on the
demand of commodity at national and world level. The nature of demand
schedule helps to know such effect.

ELASTICITY OF DEMAND

The law of demand indicates the direction of change in quantity demanded to a

change in price.

It states that when price falls, demand rises. But how much the quantity
demanded rises (or falls) following a certain fall (or rise) in prices cannot be
known from the law of demand. That is to say, how much quantity demanded
changes following a change in the price of a commodity can be known from the
concept of elasticity of demand?

 MEANING OF ELASTICITY OF DEMAND

The term ‘elasticity ‘of demand indicates responsiveness of quantity demanded

due to change in any of its determinants. This is a measure of how sensitive the
quantity demanded is to the change in any of the factors affecting demand.

 There are three main types of elasticity of demand:

I. Price elasticity of demand.
II. Income elasticity of demand.
III. Cross elasticity of demand.

I. Price Elasticity of demand. Price elasticity of demand measure the degree

of responsiveness of demand for a commodity due to change in its price
Percentage Change in quantity demanded.
Ed= ------------------------------------------
Percentage Change in Price

The different kinds/ degree of Price Elasticity of demand

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1. Perfectly Elastic Demand:- When a small change in price of a product

causes a major change in its demand, it is said to be perfectly elastic demand. In
perfectly elastic demand, a small rise in price results in fall in demand to zero,
while a small fall in price causes increase in demand to infinity. In such a case,
the demand is perfectly elastic or ep = 00.

The degree of elasticity of demand helps in defining the shape and slope of a
demand curve. Therefore, the elasticity of demand can be determined by the
slope of the demand curve. Flatter the slope of the demand curve, higher the
elasticity of demand.

In perfectly elastic demand, the demand curve is represented as a

horizontal straight line, which is shown in Figure-2:

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From Figure-2 it can be interpreted that at price OP, demand is infinite;

however, a slight rise in price would result in fall in demand to zero. It can also
be interpreted from Figure-2 that at price P consumers are ready to buy as
much quantity of the product as they want. However, a small rise in price would
resist consumers to buy the product.

Though, perfectly elastic demand is a theoretical concept and cannot be applied

in the real situation. However, it can be applied in cases, such as perfectly
competitive market and homogeneity products. In such cases, the demand for
a product of an organization is assumed to be perfectly elastic.

From an organization’s point of view, in a perfectly elastic demand situation,

the organization can sell as much as much as it wants as consumers are ready
to purchase a large quantity of product. However, a slight increase in price
would stop the demand.

2. Perfectly Inelastic Demand:-A perfectly inelastic demand is one when

there is no change produced in the demand of a product with change in its price.
The numerical value for perfectly inelastic demand is zero (e p=0).

In case of perfectly inelastic demand, demand curve is represented as a

straight vertical line, which is shown in Figure-3:

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2
and OP2 to OP3 does not show any change in the demand of a product (OQ).
The demand remains constant for any value of price. Perfectly inelastic demand
is a theoretical concept and cannot be applied in a practical situation. However,
in case of essential goods, such as salt, the demand does not change with change
in price. Therefore, the demand for essential goods is perfectly inelastic.

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3. Relatively Elastic Demand:- Relatively elastic demand refers to the demand

when the proportionate change produced in demand is greater than the
proportionate change in price of a product. The numerical value of relatively
elastic demand ranges between one to infinity.

Mathematically, relatively elastic demand is known as more than unit elastic

demand (ep>1). For example, if the price of a product increases by 20% and the
demand of the product decreases by 25%, then the demand would be relatively
elastic.

The demand curve of relatively elastic demand is gradually sloping, as

shown in Figure-4:

It can be interpreted from Figure-4 that the proportionate change in demand

from OQ1 to OQ2 is relatively larger than the proportionate change in price
from OP1 to OP2. Relatively elastic demand has a practical application as
demand for many of products respond in the same manner with respect to
change in their prices.

For example, the price of a particular brand of cold drink increases from Rs. 15
to Rs. 20. In such a case, consumers may switch to another brand of cold drink.
However, some of the consumers still consume the same brand. Therefore, a
small change in price produces a larger change in demand of the product.

4. Relatively Inelastic Demand:- Relatively inelastic demand is one when the

percentage change produced in demand is less than the percentage change in
the price of a product. For example, if the price of a product increases by 30%
and the demand for the product decreases only by 10%, then the demand would
be called relatively inelastic. The numerical value of relatively elastic demand
ranges between zero to one (ep<1). Marshall has termed relatively inelastic
demand as elasticity being less than unity.

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The demand curve of relatively inelastic demand is rapidly sloping, as

shown in Figure-5:

Example-3:- The demand schedule for milk is given in Table-3:

Calculate the price elasticity of demand and determine the type of price
elasticity.

Solution:-
P= 15
Q = 100
P1 = 20
Q1 = 90
Therefore, change in the price of milk is:
∆P = P1 – P
∆P = 20 – 15
∆P = 5
Similarly, change in quantity demanded of milk is:
∆Q = Q1 – Q
∆Q = 90 – 100
∆Q = -10

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The change in demand shows a negative sign, which can be ignored. This is
because of the reason that the relationship between price and demand is
inverse that can yield a negative value of price or demand.

 Price elasticity of demand for milk is:

ep = ∆Q/∆P * P/Q
ep= 10/5 * 15/100
ep = 0.3
The price elasticity of demand for milk is 0.3, which is less than one. Therefore,
in such a case, the demand for milk is relatively inelastic.

5. Unitary Elastic Demand:- When the proportionate change in demand

produces the same change in the price of the product, the demand is referred
as unitary elastic demand. The numerical value for unitary elastic demand is
equal to one (ep=1).

The demand curve for unitary elastic demand is represented as a

rectangular hyperbola, as shown in Figure-6:

From Figure-6, it can be interpreted that change in price OP1 to OP2 produces
the same change in demand from OQ1 to OQ2. Therefore, the demand is unitary
elastic.

The different types of price elasticity of demand are summarized in Table-

4

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2. Income Elasticity of Demand:

The income elasticity is defined as the proportionate change in the quantity

demanded resulting from a proportionate change in income. Symbolically we
may write

The income elasticity is positive for normal goods. Some writers have used
income elasticity in order to classify goods into ‘luxuries’ and ‘necessities’. A
commodity is considered to be a ‘luxury’ if its income elasticity is greater than
unity. A commodity is a ‘necessity’ if its income elasticity is small (less than
unity, usually).

The main determinants of income elasticity are:

1. The nature of the need that the commodity covers the percentage of income
spent on food declines as income increases (this is known as Engel’s Law and
has sometimes been used as a measure of welfare and of the development stage
of an economy).

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2. The initial level of income of a country. For example, a TV set is a luxury in an

underdeveloped, poor country while it is a ‘necessity’ in a country with high per
capita income.

3. The time period, because consumption patterns adjust with a time-lag to

changes in income.

 Types of Income Elasticity of demand

1. Positive income elasticity of demand (E Y>0)

If there is direct relationship between income of the consumer and demand for
the commodity, then income elasticity will be positive. That is, if the quantity
demanded for a commodity increases with the rise in income of the consumer
and vice versa, it is said to be positive income elasticity of demand. For example:
as the income of consumer increases, they consume more of superior
(luxurious) goods. On the contrary, as the income of consumer decreases, they
consume less of luxurious goods.

Positive income elasticity can be further classified into three types:

a) Income elasticity greater than unity (E Y > 1)

If the percentage change in quantity demanded for a commodity is greater than

percentage change in income of the consumer, it is said to be income greater
than unity. For example: When the consumer’s income rises by 3% and the
demand rises by 7%, it is the case of income elasticity greater than unity.

In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The small rise in income from OY to OY1
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has caused greater rise in the quantity demanded from OQ to OQ1 and vice
versa. Thus, the demand curve DD shows income elasticity greater than unity.

b) Income elasticity equal to unity (EY = 1)

If the percentage change in quantity demanded for a commodity is equal to

percentage change in income of the consumer, it is said to be income elasticity
equal to unity. For example: When the consumer’s income rises by 5% and the
demand rises by 5%, it is the case of income elasticity equal to unity.

In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The small rise in income from OY to OY1
has caused equal rise in the quantity demanded from OQ to OQ1 and vice versa.
Thus, the demand curve DD shows income elasticity equal to unity.

c) Income elasticity less than unity (EY< 1)

If the percentage change in quantity demanded for a commodity is less than

percentage change in income of the consumer, it is said to be income greater
than unity. For example: When the consumer’s income rises by 5% and the
demand rises by 3%, it is the case of income elasticity less than unity.

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In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The greater rise in income from OY to OY1
has caused small rise in the quantity demanded from OQ to OQ1 and vice versa.
Thus, the demand curve DD shows income elasticity less than unity.

2. Negative income elasticity of demand ( E Y<0)

If there is inverse relationship between income of the consumer and demand

for the commodity, then income elasticity will be negative. That is, if the
quantity demanded for a commodity decreases with the rise in income of the
consumer and vice versa, it is said to be negative income elasticity of demand.
For example:

As the income of consumer increases, they either stop or consume less of

inferior goods.

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In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. When the consumer’s income rises from
OY to OY1the quantity demanded of inferior goods falls from OQ to OQ1 and
vice versa. Thus, the demand curve DD shows negative income elasticity of
demand.

3. Zero income elasticity of demand ( E Y=0)

If the quantity demanded for a commodity remains constant with any rise or
fall in income of the consumer and, it is said to be zero income elasticity of
demand. For example: In case of basic necessary goods such as salt, kerosene,
electricity, etc. there is zero income elasticity of demand.

In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The consumer’s income may fall to OY1 or
rise to OY2 from OY, the quantity demanded remains the same at OQ. Thus, the
demand curve DD, which is vertical straight line parallel to Y-axis shows zero
income elasticity of demand.

3. Cross Elasticity of Demand

t is the ratio of proportionate change in the quantity demanded of Y to a given

proportionate change in the price of the related commodity X.

It is a measure of relative change in the quantity demanded of a commodity due

to a change in the price of its substitute/complement. It can be expressed as:

Cross elasticity may be infinite or zero if the slightest change in the price of X
causes a substantial change in the quantity demanded of Y. It is always the case

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with goods which have perfect substitutes for one another. Cross elasticity is
zero, if a change in the price of one commodity will not affect the quantity
demanded of the other. In the case of goods which are not related to each other,
cross elasticity of demand is zero.

 Definition:

“The cross elasticity of demand is the proportional change in the quantity of X

good demanded resulting from a given relative change in the price of a related
good Y” Ferguson

“The cross elasticity of demand is a measure of the responsiveness of purchases

of Y to change in the price of X” Leibafsky

Types of Cross Elasticity of Demand:

1. Positive: When goods are substitute of each other then cross elasticity of
demand is positive. In other words, when an increase in the price of Y leads to
an increase in the demand of X. For instance, with the increase in price of tea,
demand of coffee will increase.

In fig. 21 quantity has been measured on OX-axis and price on OY-axis. At price
OP of Y-commodity, demand of X-commodity is OM. Now as price of Y
commodity increases to OP1 demand of X-commodity increases to OM1 Thus,
cross elasticity of demand is positive.

2. Negative: In case of complementary goods, cross elasticity of demand is

negative. A proportionate increase in price of one commodity leads to a
proportionate fall in the demand of another commodity because both are

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demanded jointly. In fig. 22 quantity has been measured on OX-axis while price
has been measured on OY-axis. When the price of commodity increases from
OP to OP1 quantity demanded falls from OM to OM1. Thus, cross elasticity of
demand is negative.

3. Zero: Cross elasticity of demand is zero when two goods are not related to
each other. For instance, increase in price of car does not effect the demand of
cloth. Thus, cross elasticity of demand is zero. It has been shown in fig. 23.

Therefore, it depends upon substitutability of goods. If substitutability is

perfect, cross elasticity is infinite; if on the other hand, substitutability does not
exist, cross elasticity is zero. In the case of complementary goods like jointly
demanded goods cross elasticity is negative. A rise in the price of one
commodity X will mean not only decrease in the quantity of X but also decrease
in the quantity demanded of Y because both are demanded together

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 Measurement of Cross Elasticity of Demand:

Cross elasticity of demand can be measured by the following formula

MARGINAL UTILITY ANALYSIS

 MARGINAL UTILITY ANALYSIS

Before we begin, let’s understand the meaning of two important terms – total
utility and marginal utility

 Total Utility or Full Satiety – is the sum of utility derived from

different units of a commodity consumed by a consumer.

Therefore, Total Utility = the sum total of all marginal utility.

 Marginal Utility or Marginal Satiety – is the additional utility derived from

the consumption of an additional unit of a commodity. Therefore, Marginal
Utility = the addition made to the Total Utility by consuming one more
unit of a commodity.

 ASSUMPTIONS OF MARGINAL UTILITY ANALYSIS

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1] The Cardinal Measurability of Utility:- This theory states that utility is a

cardinal concept. In other words, it is measurable and quantifiable. Hence, you
can say that you derive a utility of 10 units from consuming 1 unit of commodity
A and 5 from consuming 1 unit of commodity B. This can help you compare
different commodities and analyze which commodity offers better utility or
satisfaction.
The theory further states that money is the measuring rod of utility. So,
the amount of money that you are willing to spend for a unit of commodity rather
than going without it is the measure of utility that you derive from the said
commodity.

2] The constancy of the Marginal Utility of Money:- The second assumption

is that when you are spending money on a commodity, the marginal utility of
money remains constant throughout. This facilitates the measurement of the
utility of commodities in terms of money.

3] The Hypothesis of Independent Utility:- This theory ignores the

complementarily between goods. It states that the total utility that you get from
a collection of goods is a simple sum total of the separate utilities of each good.

 THE LAW OF DIMINISHING MARGINAL UTILITY

This is an important law under Marginal Utility Analysis. Alfred Marshall, British
Economist defines the law of diminishing marginal utility as follows:

“The additional benefit which a person derives from a given increase in the
stock of a thing diminishes with every increase in the stock that he already
has.”

This law is based on the fundamental tendency of human nature. Human wants
are virtually unlimited. However, every single want is satiable. Hence, as we
consume more and more units of a good, the intensity of our want for the good
decreases. Eventually, it reaches a point where we no longer want it.In other
words, as we consume more units of a good, the extra satisfaction that we derive
from the extra unit keeps falling. However, it is important to remember that the
marginal utility declines NOT the total utility.
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An Illustration:- Let us see an example. The table below presents the total and
marginal utility derived by Peter from consuming cups of tea per day.
Quantity of Total Marginal
Teas Utility Utility
1 30 30
2 50 20
3 65 15
4 75 10
5 83 8
6 89 6
7 93 4
8 96 3
9 98 2
10 99 0
11 95 -4

As seen in the table above, when Peter consumes one cup of tea in a day, he
derives a total utility of 30 utils (unit of utility) and a marginal utility of 30 utils.
When he takes two cups per day, the total utility rises to 50 utils but the marginal
utility falls to 20. This trend continues until the last row where the marginal utility
is negative. This means that if Peter consumes 11 or more cups of tea per day,
then he might fall sick. Here is a graph representing the table:

 RELATIONSHIP BETWEEN TOTAL AND MARGINAL UTILITY

1. As the total utility rises, the marginal utility diminishes

2. When the total utility is maximum, the marginal utility is zero.

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3. As the total utility starts diminishing, the marginal utility becomes

negative.
This law helps us understand how a consumer reaches equilibrium in case of a
single commodity. Typically, a consumer utilizes a commodity until its marginal
utility becomes equal to the market price. This ensures that he derives
maximum satisfaction by being in equilibrium in respect of the quantity of the
commodity.

In case of a fall in the price of the commodity, the equality between marginal
utility and price gets disturbed. Therefore, the consumer will consume more
units of the good leading to a fall in the marginal utility. He continues consuming
until the equilibrium is achieved. On the other hand, in case of a rise in the price
of the commodity, he will consume less and achieve equilibrium too.

 LIMITATIONS OF THE LAW

The law of diminishing marginal utility applies only under certain assumptions:

1. Homogeneous units – The different units of a commodity are identical in all

respects. The income, taste, temperament, habit, etc. of the consumer also
remains unchanged.
2. Standard units of consumption – The units of consumption consist of
standard units. If a man is thirsty, then water should be given in units of a
glass. If you give him a spoonful of water, then the second spoon would
conceivably have higher utility than the first.
3. Continuous consumption – There is a continuous consumption of units.
That is, there is no gap between the consumption of two units.
4. Not applicable to prestigious goods – The law does not apply to
prestigious goods like gold, cash, etc. where a greater quantity can increase
the lust for it.
5. Related goods – If you don’t have sugar, then you will consume less tea.
Hence, the utility of goods can be affected by the absence of related goods.

DEMAND FORECASTING

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 MEANING OF DEMAND FORCASTING

Demand forecasting refers to a scientific and creative approach for anticipating

the demand of a particular commodity in the market based on past behaviour,
experience, data and pattern of related events. It is not based on mere guessing
or prediction but is backed up by evidence and past trends.
Example: A printing press owner forecasts high demand for notebooks in June
and July due to the new session. Therefore, he plans for a large-scale production
during this time and arranges for the raw material, workforce, finance and
machinery accordingly.

 FACTORS AFFECTING DEMAND FORECASTING

Demand is never constant and fluctuates with the change in certain factors
related to the commodity and the market in which the business operates. With
the changing demand, it’s forecasting also varies.

Following are some of the factors which influence the demand forecasting of a
commodity:-

1. Price of Goods: Demand estimation is highly dependant on the price of

goods or services. The pricing policy and fluctuation in the present price
can give an idea of change in demand for that particular commodity.
2. Type of Goods: The type of commodity, its features and usability
determines the customer base it is going to cater. The demand for existing
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goods can be easily estimated by following the previous sales trend,

competitors’ analysis and substitutes available. Whereas, the demand for
a new product on the market is difficult to predict.
3. Competition: The level of competition in the market supports the process
of demand forecasting. It is easy to predict sales in a less competitive
market whereas the same becomes difficult in a market where the new
firms can freely enter.
4. Technology: The demand for any product or service changes drastically
with the advancement in technology. Therefore, it is essential for an
organization to be aware of technological development while forecasting
the demand for any commodity.
5. Economic Perspective: Being updated with economic changes and
growth is necessary for demand forecasting. It assists the organisation in
preparing for future possibilities and analysing the impact of economic
development on sales.

 PROCESS OF DEMAND FORECASTING

Demand forecasting is not based on assumptions but is a systematic and

scientific process of estimating future sales and performance as well as
directing the resources accordingly.

The steps involved in a standard demand forecasting process are as follows:

1. Setting the Objectives: The purpose for which the demand forecasting is
being done, must be clear. Whether it is for short-term or long-term, the
market share of the product, the market share of the organization,
competitors share, etc. By all these aspects, the objectives for forecasting
are framed.
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2. Determining the Time Perspective: The defined objectives are

supported by the period for which the forecasting is being done. The
demand for a commodity varies with the change in its determinants over
the period.
There is a negligible change in price, income or other factors in the short
run. But, the organization may notice a considerable difference in these
determinants over a long-term, affecting the demand of a commodity.
3. Selecting a Suitable Demand Forecasting Method: Demand forecasting
is based on specific evidence and is determined using a particular
technique or method. The method of prediction must be selected wisely.
It is dependent on the information available, the purpose of predicting and
the period it is done for.
4. Collecting the Data: Forecasting is based on past experiences and data.
This data or information can be primary or secondary. Primary data
comprises of the information directly collected by the analysts and
researchers; whereas secondary data includes the physical evidence of
the past performance, sales trend in the past years, financial reports, etc.
5. Estimating the Results: The data so collected is arranged in a systematic
and meaningful manner. The past performance of a product in the market
is analyzed on this basis. Accordingly, future sales prediction and demand
estimation are done. The results soo drew must be in a format which is
easy to understand and apply by the management.

 OBJECTIVES OF DEMAND FORECASTING

Demand forecasting is one of the major components in the success of any

business. All organizational activities, whether they are short-term business
operations or long-term strategic decisions are dependent on it.

These objectives are illustrated under the following categories further sub-
divided into points:-

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1] Short-Term Objectives: To ensure the effective working of the

organisation, estimation of sales for the past six months is done. Let us now go
through the following purpose of demand forecasting in the short run:

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a) Formulation of Production Policy: Demand forecasting aims at meeting

the demand by ensuring uninterrupted production and supply of goods
and services.
b) Formulation of Price Policy: It helps in formulating an effective price
mechanism to deal with the market fluctuations and conditions like
inflation.
c) Maximum Utilization of Machines: It streamlines the production
process and operations such that there is the optimum utilisation of
machines.
d) Proper Control of Sales: Forecasting the regional sales of a particular
product or service provides a base for setting a sales target and
evaluating the performance.
e) Regular Supply of Material: Sales forecast determines the level of
production leading to the estimation of raw material. Thus, a continuous
supply of raw material and inventory management can be done.
f) Arrangement of Finance: To maintain short-term cash in the
organization it is essential to forecast the sales as well as liquidity
requirement accordingly.
g) Regular Availability of Labor: Estimation of the production capacity
provides for the acquisition of suitable skilled and unskilled labour.

2] Long-Term Objectives: Demand forecasting is inevitable for the long-term

existence of an organization. Following objectives justify the statement:

a. Long-Term Finance Management: Forecasting sales for the long-

term contributes to long-term financial planning and acquisition of
funds at reasonable rates and suitable terms and conditions.
b. Decisions Regarding Production Capacity: Demand forecast
determines the production level which provides a base for decisions
related to the expansion of the production unit or size of the plant.
c. Labour Requirement: Demand forecasting initiates expansion of
business thus leading to the estimation of required human resource
to accomplish business goals and objectives.

Estimating demand with accuracy requires a lot of expertise and knowledge.

Therefore experts are hired by the business organizations to ensure better
results and proper utilization of resources.

 TECHNIQUES & METHODS OF DEMAND FORECASTING

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Different organizations rely on different techniques to forecast demand for

their products or services for a future time period depending on their
requirements and budget.

Methods of demand forecasting are broadly categorized into two types. Let us
discuss these techniques & methods of demand forecasting in detail:

1. Qualitative Techniques

Qualitative techniques rely on collecting data on the buying behavior of

consumers from experts or through conducting surveys in order to forecast
demand. These techniques are generally used to make short term forecasts of
demand.

Qualitative techniques are especially useful in situations when historical data

is not available; for example, introduction of a new product or service. These
techniques are based on experience, judgment, intuition, conjecture, etc.

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1. Survey Methods:- Survey methods are the most commonly used methods of
forecasting demand in the short run. This method relies on the future purchase
plans of consumers and their intentions to anticipate demand.

Thus, in this method, an organization conducts surveys with consumers to

determine the demand for their existing products and services and anticipate
the future demand accordingly. The two types of survey methods are explained
as follows:

I. Complete enumeration survey: This method is also referred to as the

census method of demand forecasting. In this method, almost all potential users
of the product are contacted and surveyed about their purchasing plans.

Based on these surveys, demand forecasts are made. The aggregate demand
forecasts are attained by totaling the probable demands of all individual
consumers in the market.

II. Sample survey: In this method, only a few potential consumers (called
sample) are selected from the market and surveyed. In this method, the average
demand is calculated based on the information gathered from the sample.

2. Opinion Poll Method:- Opinion poll methods involve taking the opinion of
those who possess knowledge of market trends, such as sales representatives,
marketing experts, and consultants. The most commonly used opinion polls
methods are explained as follows:

I. Expert opinion method: In this method, sales representatives of different

organizations get in touch with consumers in specific areas. They gather
information related to consumers’ buying behaviour, their reactions and
responses to market changes, their opinion about new products, etc.

II. Delphi method: In this method, market experts are provided with the
estimates and assumptions of forecasts made by other experts in the industry.
Experts may reconsider and revise their own estimates and assumptions based
on the information provided by other experts.

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III. Market studies and experiments: This method is also referred to as

market experiment method. In this method, organisations initially select
certain aspects of a market such as population, income levels, cultural and
social background, occupational distribution, and consumers’ tastes and
preferences.

Among all these aspects, one aspect is selected and its effect on demand is
determined while keeping all other aspects constant.

2. Quantitative Techniques

Quantitative techniques for demand forecasting usually make use of statistical

tools. In these techniques, demand is forecasted based on historical data.

These methods are generally used to make long-term forecasts of demand.

Unlike survey methods, statistical methods are cost effective and reliable as the
element of subjectivity is minimum in these methods. Let us discuss different
types of quantitative methods:-

1. Time Series Analysis:- Time series analysis or trend projection method is

one of the most popular methods used by organizations’ for the prediction of
demand in the long run. The term time series refers to a sequential order of
values of a variable (called trend) at equal time intervals.

Using trends, an organization can predict the demand for its products and
services for the projected time. There are four main components of time series
analysis that an organization must take into consideration while forecasting the
demand for its products and services. These components are:

I. Trend component:- The trend component in time series analysis accounts

for the gradual shift in the time series to a relatively higher or lower value over
a long period of time.

II. Cyclical component: The cyclical component in time series analysis

accounts for the regular pattern of sequences of values above and below the
trend line lasting more than one year.

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III. Seasonal component: The seasonal component in time series analysis

accounts for regular patterns of variability within certain time periods, such as
a year.

IV. Irregular component: The irregular component in time series analysis

accounts for a short term, unanticipated and non-recurring factors that affect
the values of the time series.

2. Smoothing Techniques:- In cases where the time series lacks significant

trends, smoothing techniques can be used for demand forecasting. Smoothing
techniques are used to eliminate a random variation from the historical
demand.

This helps in identifying demand patterns and demand levels that can be used
to estimate future demand. The most common methods used in smoothing
techniques of demand forecasting are simple moving average method and
weighted moving average method.

The simple moving average method is used to calculate the mean of average
prices over a period of time and plot these mean prices on a graph which acts
as a scale.

For example, a five-day simple moving average is the sum of values of all five
days divided by five.

The weighted moving average method uses a predefined number of time

periods to calculate the average, all of which have the same importance.

For example, in a four-month moving average, each month represents 25% of

the moving average.

3. Barometric Methods:- Barometric methods are used to speculate the future

trends based on current developments. This methods are also referred to as the
leading indicators approach to demand forecasting.

Many economists use barometric methods to forecast trends in business

activities. The basic approach followed in barometric methods of demand
analysis is to prepare an index of relevant economic indicators and forecast
future trends based on the movements shown in the index.

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 The barometric methods make use of the following indicators:

a) Leading indicators: When an event that has already occurred is considered

to predict the future event, the past event would act as a leading indicator.

For example, the data relating to working women would act as a leading
indicator for the demand of working women hostels.

b) Coincident indicators: These indicators move simultaneously with the

current event.

For example, a number of employees in the non-agricultural sector, rate of

unemployment, per capita income, etc., act as indicators for the current state of
a nation’s economy.

c) Lagging indicators: These indicators include events that follow a change.

Lagging indicators are critical to interpret how the economy would shape up in
the future. These indicators are useful in predicting the future economic events.

For example, inflation, unemployment levels, etc. are the indicators of the
performance of a country’s economy.

4. Econometric Methods:- Econometric methods make use of statistical tools

combined with economic theories to assess various economic variables (for
example, price change, income level of consumers, changes in economic
policies, and so on) for forecasting demand.

The forecasts made using econometric methods are much more reliable than
any other demand forecasting method. An econometric model for demand
forecasting could be single equation regression analysis or a system of
simultaneous equations. A detailed explanation of regression analysis is given
in the next section.

5. Regression Analysis: The regression analysis method for demand

forecasting measures the relationship between two variables. Using regression
analysis a relationship is established between the dependent (quantity
demanded) and independent variable (income of the consumer, price of related
goods, advertisements, etc.).

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For example, regression analysis may be used to establish a relationship

between the income of consumers and their demand for a luxury product. In
other words, regression analysis is a statistical tool to estimate the unknown
value of a variable when the value of the other variable is known.

After establishing the relationship, the regression equation is derived assuming

the relationship between variables is linear.The formula for a simple linear
regression is as follows:

Y =a + bX
Where Y is the dependent variable for which the demand needs to be
forecasted; b is the slope of the regression curve; X is the independent variable;
and a is the Y-intercept. The intercept a will be equal to Y if the value of X is
zero.

 APPLICATIONS OF FORECASTING

1. Supply chain management:- It includes the movement and storage of raw

materials, work-in- process inventory, and finished goods from point of origin
to point of consumption.

2. Economic forecasting:- It is the process of making predictions about the

economy.

3. Earthquake Forecasting:- It defined as the specification of the time,

location, and magnitude of a future earthquake within stated limits", and
particularly of "the next strong earthquake to occur in a region.

4. Egain Forecasting:- The process of climate change and increasing energy

prices has led to the usage of Egain Forecasting of buildings.

5. Land Use Forecasting:- It undertakes to project the distribution and

intensity of trip generating activities in the urban area.

6. Player & Team Performance in Sports :- PECOTA, is a saber metric system

for forecasting Major League Baseball player performance.

7. Political Forecasting:- Its aims at predicting the outcome of elections.

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8. Transportation Forecasting • the process of estimating the number of

vehicles or people that will use a specific transportation facility in the future.

9. Telecommunications Forecasting • Telecommunications service

providers perform forecasting calculations to assist them in planning their
networks.

10. Product Forecasting • is the science of predicting the degree of success a

new product will enjoy in the marketplace.

11. Sales Forecasting:- It is helpful in sale.

12. Technology Forecasting: - It attempts to predict the future characteristics

of useful technological machines, procedures or techniques

13. Weather Forecasting:- It is the application of science and technology to

predict the state of the atmosphere for a given location.

14. Flood Forecasting:- The use of real-time precipitation and stream flow
data in rainfall-runoff and stream flow routing models to forecast flow rates
and water levels for periods ranging from a few hours to days ahead, depending
on the size of the watershed or river basin.

 SIGNIFICANCE OF DEMAND FORECASTING

Significance of demand forecasting is shown in the following points:

i. Fulfilling objectives:- Implies that every business unit starts with certain
pre-decided objectives. Demand forecasting helps in fulfilling these objectives.
An organization estimates the current demand for its products and services in
the market and move forward to achieve the set goals.

For example, an organization has set a target of selling 50, 000 units of its
products. In such a case, the organization would perform demand forecasting
for its products. If the demand for the organization’s products is low, the
organization would take corrective actions, so that the set objective can be
achieved.

ii. Preparing the budget:- Plays a crucial role in making budget by estimating
costs and expected revenues. For instance, an organization has forecasted that
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the demand for its product, which is priced at Rs. 10, would be 10, 00, 00 units.
In such a case, the total expected revenue would be 10* 100000 = Rs. 10, 00,
000. In this way, demand forecasting enables organizations to prepare their
budget.

iii. Stabilizing employment and production:- Helps an organization to

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

iv. Expanding organizations:- Implies that demand forecasting helps in

deciding about the expansion of the business of the organization. If the expected
demand for products is higher, then the organization may plan to expand
further. On the other hand, if the demand for products is expected to fall, the
organization may cut down the investment in the business.

v. Taking Management Decisions:- Helps in making critical decisions, such as

deciding the plant capacity, determining the requirement of raw material, and
ensuring the availability of labor and capital.

vi. Evaluating Performance:- Helps in making corrections. For example, if the

demand for an organization’s products is less, it may take corrective actions
and improve the level of demand by enhancing the quality of its products or
spending more on advertisements.

vii. Helping Government:- Enables the government to coordinate import and

export activities and plan international trade.

 LIMITATIONS OF DEMAND FORECASTING

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1. Lack of historical sales data:- Past sales figures may not always be available
with an organization. For example, in case of a new commodity, there is
unavailability of historical sales data. In such cases, new data is required to be
collected for demand forecasting, which can be cumbersome and challenging
for an organization.

2. Unrealistic assumptions:- Demand forecasting is based on various

assumptions, which may not always be consistent with the present market
conditions. In such a case, relying on these assumptions may produce incorrect
forecasts for the future.

3. Cost incurred:- Demand forecasting incurs different costs for an

organization, such as implementation cost, labour cost, and administrative cost.
These costs may be very high depending on the complexity of the forecasting
method selected and the resources utilized. Owing to limited means, it becomes
difficult for new startups and small-scale organizations’ to perform demand
forecasting.

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4. Change in fashion:- Consumers’ tastes and preferences continue to change

with a change in fashion. This limits the use of demand forecasting as it is
generally based on historical trend analysis.

5. Lack of expertise:- Demand forecasting requires effective skills, knowledge

and experience of personnel making forecasts. In the absence of trained
experts, demand forecasting becomes a challenge for an organization. This is
because if the responsibility of demand forecasting is assigned to untrained
personnel, it could bring huge losses to the organization.

6. Psychological factors:- Consumers usually prefer a particular type of

product over others. However, factors, such as fear of war and changes in
economic policy, could affect consumers’ psychology. In such cases, the
outcomes of forecasting may no longer remain relevant for the time period.

MARKET MECHANISM

 MEANING OF MARKET MECHANISM

Market mechanism is often interpreted as a ‘free’ market system. For a layman

‘free’ means that when you go to a market, there is no re­striction – you can buy
as much as you want OR sell any amount OR choose to do nothing.

You are free to take decisions regarding buying and selling. Adam Smith used
this freedom to formulate the notion of an ‘invisible’ hand.

‘Invisible hand’ refers to the individual actions/decisions of economic agents

that lead to maximum welfare for the economy. It is as if an in-visible force
strings together decisions, taken in self-interest by different persons, to give us
a result which is the best for all persons considered together.

These decisions operate in terms of demand and supply for a good, which are
collectively referred to as the market mechanism. Thus, the market mechanism
ensures that the benefits/welfare for the whole group of economic agents is a
maximum. This only requires that each agent operates on the basis of self-
interest and decides what is best for her alone, assuming there is freedom given
to each of them.

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Free market is also associated with a capitalist economy, as opposed to socialist

economy where markets follow plans made by the government. This reduces
the ‘freedom’ of the market mechanism, though a ‘market’ may still exist. The
‘freedom’ given to market mechanism is therefore the crucial distinction
between capitalism and socialism.

For example in India, we have a free market for medicines/drugs. Anyone can
buy a drug with a prescription or any out-the-counter drug that needs no
prescription. This implies buyers and sellers are ‘free’ to buy and sell any
quantity at any price; it is a free market. But the National Pharma Pricing
Authority (NPPA) has put limits on the prices of some selected drugs called
essential drugs. This means that producers/pharma com-panies cannot charge
any price they want. This restricts the ‘freedom’ of sellers, and is an example of
restriction on the market.

As the above example makes clear, the market mechanism refers to the forces
of demand and supply. These forces take the form of buyers and sellers in the
market. Economists show that if left ‘free’ these forces use the self-interest of
sellers and buyers to reach a point where welfare for all is maximized.

The ‘mechanism’ refers to the fact that economic agents (buyers and sellers) act
in self-interest without any force on them and without any explicit coordination
between themselves to maximize their own welfare. In this process the sum
total of welfare/gain for all economic agents in an economy is maximized. As
compared to any other mechanism (like planning by State in a socialist system)
the welfare to society as a whole is maximum in market mechanism.

 EFFICIENCY UNDER MARKET MECHANISM:

In everyday use, efficiency means to work in the best possible way, or in a

‘smart’ way that reduces time taken for any work and makes sure that efforts
are not wasted. In Economics ‘efficiency’ is defined in more clear ways. Alfred
Pareto was the first economist to define efficiency, and accordingly we define
optimality in terms of Pareto efficient states. According to Pareto, “a Pareto
efficient state of affairs is when no one can be made better off without making
someone worse off”.

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Take an example:- Original state-Suppose Vineet earns Rs.10000 per month

and Radhika earns Rs.15000 per month working for their manager Mr. Diwan.
Total income will be Rs.25000. Welfare will be measured in terms of salaries of
both workers and other office costs for Mr. Diwan (electricity, water, rent are
some costs incurred in a typical office). Assume that costs equal Rs.5000 for
simplicity. Let us consider three options to this original state of affairs. Welfare
equals the sum of salaries and other costs = Rs.30000

State 1:- Let both employees argue for higher salary with Mr. Diwan, who
refuses to do so as his costs will rise. Instead he offers to change the
distribution; he offers Rs.12000 to Vineet and Rs.13000 to Radhika. Now this
proposed state makes Vineet better off, but Radhika worse off and Mr. Diwan
do not change his costs.

Total welfare remains at Rs.30000. This proposed income change is Not a

Pareto improvement over the original income distribution, because one person
has been made better off at the cost of someone else being worse off.

State 2:- Instead if Mr. Diwan increases salary for both by an equal amount
(however small, say Rs. 500), while reducing his costs on other inputs by Rs.
1000, then it is a Pareto improvement. This is because both will be better off,
with none of them worse off.

State 3:- Another option is that Mr. Diwan increases salary for Vineet by Rs.
600 and by Rs. 400 for Radhika. If he does this by reducing his other costs by
Rs. 1000, so that Mr. Diwan does not face higher total costs, then this is also a
Pareto improvement as both have gained, while Mr. Diwan has not lost as well.

As long as we can make Pareto improvements as outlined in options 2 and 3,

we are not efficient. When no Pareto improvements are possible, we have
reached an efficient state. In other words, a Pareto efficient state is achieved
when there are no Pareto improvements are possible.

Efficiency is also sometimes used interchangeably with Pareto efficiency. Thus,

an efficient state is when no Pareto improvements are possible anymore.

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When we consider any two states, a movement from one state to another may
cause a loss to someone, while someone else may gain. The sum total of all gains
and losses can be a loss, which implies that the change was Pareto inefficient. It
is better to stay with the original state.

If the sum of gains and losses comes out to be positive number then the change
can be categorized as a Pareto improvement. We can continue to make changes
and move to new states till no more Pareto improvements are possible. The last
state will be Pareto efficient as no changes can give us ‘total’ gains.

In other words, efficiency is an outcome/state that is best/ optimal for all as

there is no change possible that can increase gains/welfare for all agents taken
together. While some agents may lose and same gain from a change, the critical
thing is to look at the sum of welfare of all agents. In this case we had 3 agents
– Mr. Diwan, Vineet and Radhika. Also note that losses and gains in Rs. terms
are interchangeably used with welfare. In the example above we used salary as
a measure of welfare.

 TYPES OF EFFICIENCY

Efficiency is further divided into two types-Productive efficiency and Allocative

efficiency. To understand these we must be clear about production possibility
curve.

1. Productive Efficiency:- Let us now move to ‘define’ productive efficiency.

This is done at micro (small) and macro (large) level. At micro level we look at
the meaning of productive efficiency of a firm. At the macro level we consider
ef-ficiency of the whole economy. When all firms (producing units) are
productively efficient, the whole economy is efficient.

We will first focus on efficiency at macro level, with the economy as the unit of
consideration. Before we understand this we must under-stand what a PPC is.
A Production Possibility Curve (PPC) shows us the combinations of two goods
that a country can produce with given resources and available technology. This
curve is typically bow shaped.

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Consider two goods – food and guns as shown in figure 1. Any point on the curve
PPC1 (like point B) tells us that we can produce F1 amount of food and G1
amount of guns. We can also be at any point inside the curve like A, where F2
food and G2 guns are produced. We cannot be at any point outside the curve as
such points (point E) are unattain-able. This is because we do not have the
resources to produce at such points. If technology improves and/or resources
increase we will see the PPC shift outwards as shown. The point E is now
attainable with new resources and technology as it lies on PPC 2.

 The PPC Assumes the Following:

1. Technology remains unchanged when a PPC is drawn. All combina-tions

that are on PPC depend on technology used and available. A new technology
that is better will cause PPC to shift out to PPC 2.

2. Resources are fixed for every PPC. This means that each PPC is drawn on
the basis on given level of resources. These resources refer to the total amount
of resources as well as their productivity levels.

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 Note the Following Points that Hold for any PPC:

1. If all resources are used, we are on PPC (like point B , C, D)

2. If some resources are unused we are inside the PPC(like A)

3. Points like E are unattainable if we refer to PPC1.

4. Any change in resources causes PPC to shift. For example assume an

earthquake hits a region. It will cause a decline in number of workers available,
which are a resource. This will cause an inward shift of the PPC.

5. Any increase in productivity of resources and/or better technology will shift

the PPC outwards, as shown by PPC 2.

Productive efficiency is achieved when we are at any point on the PPC. A

point like A, which is inside the PPC, is productively inefficient. A point like B or
C or D is productively efficient as they lie on the PPC. These points are Pareto
efficient as we cannot increase production of one good, without reducing
production of the other good. Consider points B and C, both of which are
efficient.

If we want to move from B to C then we must reduce guns and increase food.
This move from B to C is not a Pareto improvement as it entails reduction in
production of guns, to increase food production. Thus, there is no Pareto
improve-ment possible if we start of any of these points that lie on the PPC.

This implies that all points on PPC are Pareto efficient and no point is better
than any other point. But if we move from a point inside the curve to a point on
the curve then it is a Pareto improvement. Consider a move from A to B, which
is a Pareto improvement as production of both food and guns rises.

It is important to note the shape of the curve as it cannot take any shape at
random. Based on the assumptions we made for drawing PPC, it is bow shaped.
This means that to produce more of food we must reduce gun production. This
is because resources are fixed. To produce more food, we have to pull out
resources (like labour) from gun factories and put them on the fields.

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Consider figure 2. Assume that we want to increase food production. We want

to move from B to C. Since all the resources are already used up (as we are on
the curve already) we have to free up some land. This land will have to come
from the land used for gun production.

So a factory for guns may have to be shut down for freeing up land. This implies
fall in gun production as the factory shuts down. To increase production of 1
good (shown by the arrow on X axis) we must reduce production of the other
good (shown by the arrow on Y axis). This causes the bow shape of the PPC.

While the PPC looks at the economy from a ‘macro’ perspective, we can define
productive efficiency at micro level for a firm also. A firm achieves productive
efficiency when it produces at the lowest cost level. If the average cost is
minimized for a firm at point E in figure 3, then it is a point of productive
efficiency. Note that each firm acts in its own self-interest to minimize costs and
achieve productive efficiency.

For those of us who are familiar with Microeconomics, we know that typical
cost curves for any firm are U shaped. With output on the X axis and costs on
the vertical axis, we can show that a productive effi-cient point for a firm to be
E. This is the point where average costs are minimum. The efficient output level
is Q* and average cost is AC*. At any other point (like E1) average cost is higher
(AC1 > AC*). If a firm produces less than Q* it is productively inefficient. This
concept applies to an output level that exceeds Q* also. At E2 average cost is
AC2 while output is Q2. Note that AC2 > AC*.

This makes E2 also inefficient. (See Figure 3)

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2. Allocative Efficiency:- Till now we looked at efficient levels of

production/output of differ-ent goods produced in an economy. Allocative
efficiency takes a step backwards, to look at behind the scenes of production
and considers the distribution and allocation of resources used for achieving
these output levels. Let us consider figure 4, which is a simple PPC that we
borrow from figure 1. Note that E1 and B are both on the PPC which qualifies
them as productively efficient.

However, despite such efficien-cy El involves zero food production. All

resources are devoted to gun production, and we have no food. The economy
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cannot live without food, which makes El a little difficult to imagine as efficient.
A point like B where both guns and food are produced is more realistic and also
efficient in a productive sense.

Devoting all resources to guns does not ‘seem’ correct or in the best welfare of
society, (though gun makers will be really happy!). This is where allocative
efficiency comes in. It looks beyond production levels and associated costs
alone, and looks towards benefits of any activity, in marginal terms.

To understand this, consider that we want to get to the nearest Metro station.
We have 2 options – to walk for 10 minutes or hire a rickshaw that takes 5
minutes. In making a choice, we are comparing both modes of transport in
terms of the cost involved and the advantages (or benefits).

Using a rickshaw saves time (which must be considered as a benefit), but

involves a price that we pay to the driver of the rickshaw (which is a cost of this
option). We know that the cost is (assume) Rs.20, but we must put a monetary
value to the time we save. This value depends on individual preferences.

A person who has an interview in the next hour will assign a value of Rs.100 to
the time saved, while another person who has no appointments may assign only
Rs.10 to the time saved. In this case, the net benefits= 100 – 20 = 80 for the
person who has an interview or 10 – 20 = -10 for the person with no
appointment.

On the other hand, walking costs us time but give health benefits. The cost of
walking is the time we spend on it. Suppose it takes 10 minutes for any person
to walk to Metro. The cost of 10 minutes again depends on individual
preferences. For the person who has an interview this time is more valuable
than for the person with no appointments. In the same way the value of benefits
can vary across people.

The man with an interview would not like to miss it so he may value health
benefits at only Rs.5. This gives net benefits of 5 – 100 = -95 to him. If he now
compares the 2 options he has net benefits of +80 from using a rickshaw and
net benefits of -95 from walking. Common sense dictates that he will choose to
use the rickshaw.

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The above example was discussed to illustrate that each decision we take
involves comparing costs and benefits to arrive at net benefits from each option
available to us. We choose the option with higher net benefits. The difference
in some people opting for rickshaw or walking is the value they assign to
benefits and costs. The differences in these valuations lead to different choices
when two people are faced with same options

Every person attributes a different value to the cost and benefits to options
available. A calculation of net benefits (= benefits – costs) is done. The option
with highest net benefits is taken by a rational person.

The same logic applies in Microeconomics – any economic activity must be done
if the marginal benefit from that activity exceeds or equals its marginal cost, or
net marginal benefits are positive. If two activities are given and one has to be
chosen then the activity with higher net mar-ginal benefits must be done. The
use of the word marginal is done as we compare costs and benefits of the last
unit of output. The decision is always about the next unit – to produce or not
produce.

 INTERACTION OF DEMAND AND SUPPLY

We have studied demand and supply separately. Now we put them together to
get the whole market. The operation of demand and supply in a market is
known as the market mechanism.

We are familiar with the upward sloping supply curve and the downward
sloping demand curve. Combine the two on one diagram and we have a model
of a market (Figure 1).

Figure 1 The demand and supply model of a market

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The market will be in equilibrium at price P, when quantity Q will be bought

and sold. In figure 1 OP* is the equilibrium or market clearing price at which
the amount demanded exactly matches the amount supplied.

Changes in demand and supply

We can now see how shifts of supply and demand curves cause changes in
prices and quantities bought and sold. In the next two sections, there are two
example markets with a series of changes to each. Try working through each
one and check that you understand how the curves shift.

Example 1 - the market for DVD players

Try copying out Figure 1 below, but label it as the market for DVD players.

Figure 1 The demand and supply model of a market

Now work through the following changes, and adjust the diagram as you go.
After you have had a go at each change, follow the answer link below and see
if you made the right changes. Treat each change as a separate change - in
other words start with Figure 1 each time.

Change 1. The development of a new microchip enables manufacturers

to reduce the price of their products.

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Supply curve shifts right

This will influence supply. New technology will cause the supply curve to
shift to the right. S1 will be replaced by S2. Market price will fall and there
will be a movement along the demand curve. The quantity demanded and
supplied will grow to Q2 and price will fall to P2.

Change 2. The firm mounts a major successful advertising campaign for

DVD's.

Demand curve shifts right

This will affect demand. Advertising is one of the ceteris paribus factors of
demand, so will result in a shift to the right. D1 will be replaced by D2. Supply,
however, will be unchanged. Equilibrium will be re-established at price P2
and quantity Q2.

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Change 3. The government applies VAT to all home entertainment

equipment.

Supply curve shifts left

This will reduce supply. It is one of the ceteris paribus factors so will shift the
supply curve to the left to S2. Price will rise again to P2, but the market will
decline with the equilibrium quantity ending up at Q2.

Example 2 - the market for fish

Let's look at another example, and make sure that you understand how the
shifts and movements occur and interact. Now work through the following
changes, and adjust the diagram as you go. After you have had a go at each
change, follow the answer link below and see if you made the right changes.

Figure 1 represents the market for fish at the start of a week. Assume that all
demand and supply changes occur without delay, i.e. they react instantly. The
changes given are all sequential. In other words use the diagram you end up
with as the starting point for the next change.

Figure 1 The Market for fish

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Change 1. There are very rough seas, and small boats cannot fish.

Supply curve shifts left

This will cause a shift of the supply curve. It is effectively a deterioration in

technology. S1 will be replaced by S2. Demand is unchanged so price rises to
P2 and quantity falls to Q2.

Change 2. It is Thursday, a day where the demand for fish is very high.
Seas become even rougher.

Change 2 - supply shifts left and demand right

This means a further shift in the supply curve to S3 because of even rougher
seas, but there is a shift of the demand curve to D2 as well. More fish is
demanded from a reduced supply so the price rises fast. In this case sales have
fallen slightly further as even the higher price was not attractive enough to
persuade fisherman to take more risks.

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Change 3. It is Friday, when demand for fish is even higher. Storms

weaken, though, and fishing becomes easier.

Change 3 - supply shifts to right and demand to right

Supply eases back to S2, but demand rises even more to D3. Fish reaches a
new high price of P4. Sales are also now higher at Q4. The higher price and
easier weather has now been enough to persuade the fishermen to fish once
more and take a greater risk.

PRODUCTION ANALYSIS

 INTRODUCTION
Production is a process of using various material and immaterial inputs in order
to make output for consumption. Production process creates economic well-
being. The satisfaction of needs originates from the output. Production is the
result of cooperation of four factors of production (land, labour, capital and
organisation). In Economics, production refers to the creation or addition of
value. It simply transforms the inputs into output.
Production may be at varying levels. The scale of production influences the cost
of production. All manufacturers are aware that when production of a
commodity takes place on a larger scale, the average cost of its production is
low. This is the reason why the entrepreneurs are interested in enlarging the
scale of production of their commodities. They stand to benefit from the
resulting economies of scale. There is also the possibility of making their
products available in the market at lower prices.

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 FEATURES OF THE FACTORS OF PRODUCTION

Factors of production means resources used in the process of production of
commodities. There are of four types viz., land, labour, capital and organization
or enterprise. Here, land represents natural resources (such as soil, mineral
deposits, seas, rivers, natural forests, fisheries etc). Labour represents human
resources. Together, these two factors are called the ‘primary factors of
production’.
These two factors produce some units of goods for the purpose of
consumption. And as consumption of these goods takes place, there is the
possibility of some of these goods getting left over. Thus, saving is production
minus consumption. This saved amount is called as capital, which serves as
investment in the production process. Also, organisation or enterprise is a
special form of labour. The third and the fourth factors are called ‘secondary
factors of production’.
These four factors depend on each other. They have a coordinated impact on
production of goods and services.
1. Land:- In ordinary sense ‘land’ refers to the soil or the surface of the earth
or ground. But, in Economics, land means all gifts of Nature owned and
controlled by human beings which yield an income. Land is the original source
of all material wealth. The economic prosperity of a country depends on the
richness of her natural resources. The quality and quantity of
agricultural wealth are determined by the nature of soil, climate and rainfall.

The agricultural products are the basis of trade and industry. Industry survives
on the availability of coal-mines or waterfall for electricity production. Hence,
all aspects of economic life like agriculture, trade and industry are generally
influenced by natural resources which are called as “Land” in economics.

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 Characteristics of Land

1. Land is a primary factor of production.

2. Land is a passive factor of production.

3. Land is the free gift of Nature.

4. Land has no cost of production.

5. Land is fixed in supply. It is inelastic in supply.

6. Land is permanent.

7. Land is immovable.

8. Land is heterogeneous as it differs in fertility.

9. Land has alternative uses.

10. Land is subject to Law of Diminishing Returns.

2. Labour:- Labour is the active factor of production. In common parlance,

labour means manual labour or unskilled work. But in Economics the term
‘labour’ has a wider meaning.

It refers to any work undertaken for securing an income or reward. Such work
may be manual or intellectual. For example, the work done by an agricultural
worker or a cook or rickshaw puller or a mason is manual. The work of a doctor

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or teacher or an engineer is intellectual. In short, labour in economics refers to

any type of work performed by a labourer for earning an income.
According to Marshall, labour represents services provided by the factor
labour, which helps in yielding an income to the owner of the labour-power.
 Characteristics of Labour

a. Labour is the animate factor of production.

b. Labour is an active factor of production.

c. Labour implies several types: it may be manual (farmer) or intellectual

(teacher, lawyer etc).

d. Labour is perishable.

e. Labour is inseparable from the Labourer.

f. Labour is less mobile between places and occupations.

g. Labour is a means as well as an end. It is both the cause of production and

consumer of the product.

h. Labour units are heterogeneous.

i. Labour differs in ability.

j. Labour-supply determines its reward (wage).

k. Labour has weak bargaining power.

3. Capital:- Marshall says “capital consists of all kinds of wealth other than free
gifts of nature, which yield income”. Bohm-Bawerk defines it as ‘a produced
means of production’. As said earlier, capital is a secondary means of
production. It refers to that part of production which represents ‘saving used
as investment’ in the further production process. For example, the entire mango
is not eaten; a part of that (its nut) is used to produce more mangoes.

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It is a stock concept. All capital is wealth but all wealth is not capital. For
example, tractor is a capital asset which can be used in cultivation (production)
of farm, but due to some reason the same is kept unused (idle) for some period.
It cannot be termed as capital for that period. It is only wealth.

 Characteristics of Capital
a. Capital is a man-made factor.

b. Capital is mobile between places and persons.

c. Capital is a passive factor of production.

d. Capital’s supply is elastic.

e. Capital’s demand is a derived demand.

f. Capital is durable.

Capital may be tangible or intangible. For example, buildings, plants and

machinery, factories, inventories of inputs, warehouses, roads, highways etc
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are tangible capital. The examples for intangible capital are investment on
advertisement, expenses on training programme etc.
Financial Capital means the assets needed by a firm to provide goods and
services measured in term of money value . It is normally raised through debt
and equity issues .The prime aim of it is to a mass wealth in terms of profit.
4. Organization:- The man behind organizing the business is called as
‘Organizer’ or ‘Entrepreneur’. An organiser is the most important factor of
production. He represents a special type of labour. Joseph Schumpeter says that
an entrepreneur innovates, coordinates other factors of production, plans and
runs a business. He not only runs the business, but bears the risk of business.
His reward is residual. This residual is either positive (profit) or negative (loss)
or zero.

 Functions of an Organizer (Entrepreneur)

1. Initiation: An organizer is the initiator of the business, by considering the

situation and availability of resources and planning the entire process of
business or production.
2. Innovation: A successful entrepreneur is always an innovator. He
introduces new methods in the production process.
3. Coordination: An organizer applies a particular combination of the factors
of production to start and run the business or production.
4. Control, Direction and Supervision: An organiser controls so that nothing
prevents the organisation from achieving its goal. He directs the factors to
get better results and supervises for the efficient functioning of all the
factors involved in the process of production.
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5. Risk-taking and Uncertainty-bearing: There are risk-taking and

uncertainty-bearing obstacles. Risks may be insured but uncertainties
cannot be insured. They reduce the profit.

 PRODUCTION FUNCTION
Production function refers to the relationship among units of the factors of
production (inputs) and the resultant quantity of a good produced (output).
According to George J. Stigler, “Production function is the relationship
between inputs of productive services per unit of time and outputs of product per
unit of time.”

Production function may be expressed as: Q = f (N, L, K, T) Where, Q = Quantity

of output, N = Land; L = Labour; K = Capital; and T = Technology. Depending on
the efficiency of the producer, this production function varies.
The function implies that the level of output (Q) depends on the quantities of
different inputs (N, L, K, T) available to the firm.

 Short-run Production and Long run Production

In Micro economics, the distinction between long run and short run is made on
the basis of fixed inputs that inhibit the production.
The short-run is the period where some inputs are variable, while others are
fixed. Another feature is that firms do not enter into the industry and existing
firms may not leave the industry.
Long run, on the other hand, is the period featured by the entry of new firms to
the industry and the exit of existing firms from the industry.
In general, Production function may be classified into two
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a. Short-run Production Function as illustrated by the Law of Variable

Proportions.
b. Long-run Production Function as explained by the Laws of Returns to Scale.

 Law of Variable Proportions

The law states that if all other factors are fixed and one input is varied in the
short run, the total output will increase at an increasing rate at first instance,
be constant at a point and then eventually decrease. Marginal product will
become negative at last.
According to G.Stigler, “As equal increments of one input are added, the inputs
of other productive services being held constant, beyond a certain point, the
resulting increments of product will decrease, i.e., the marginal product will
diminish”.
Assumptions
The Law of Variable Proportions is based on the following assumptions.

I. Only one factor is variable while others are held constant.

II. All units of the variable factor are homogeneous.

III. The product is measured in physical units.

IV. There is no change in the state of technology.

V. There is no change in the price of the product.

1. Total Product (TP):- It refers to the total amount of commodity produced

by the combination of all inputs in a given period of time.

„Summation of marginal products, i.e.

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TP = ∑MP

where, TP= Total Product, MP= Marginal Product

2. Average Product (AP):- It is the result of the total product divided by the
total units of the input employed. In other words, it refers to the output per
unit of the input.

Mathematically, AP = TP/N

Where,

AP= Average Product

TP= Total Product

N= Total units of inputs employed

3. Marginal Product (MP):- It is the addition or the increment made to the

total product when one more unit of the variable input is employed. In other
words, it is the ratio of the change in the total product to the change in the
units of the input. It is expressed as

MP= ∆TP/∆ N

where,

MP = Marginal Product

ΔTP = Change in total product

ΔN = Change in units of input It

is also expressed as

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MP = TP (n) – TP (n-1)

Where,

MP = Marginal Product

TP(n) = Total product of employing nth unit of a factor

TP(n-1) = Total product of employing the previous unit of a factor, that is, (n-
1)th unit of a factor.

The Law of Variable Proportions is explained with the help of the following
schedule and diagram:

In table 3.1, units of variable factor (labour) are employed along with other
fixed factors of production.

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The table illustrates that there are three stages of production. Though total
product increases steadily at first instant, constant at the maximum point and
then diminishes, it is always positive for ever. While total product increases,
marginal product increases up to a point and then decreases. Total product
increases up to the point where the marginal product is zero. When total
product tends to diminish marginal product becomes negative.

In diagram 3.1, the number of workers is measured on X axis while TPL, APL and
MPL are denoted on Y axis. The diagram explains the three stages of production
as given in the above table.

Stage I:- In the first stage MPL increases up to third labourer and it is higher
than the average product, so that total product is increasing at an increasing
rate. The tendency of total product to increase at an increasing rate stops at the
point A and it begins to increase at a decreasing rate. This point is known
as ‘Point of Inflexion’.

Stage II:- In the second stage, MPL decreases up to sixth unit of labour where
MPL curve intersects the X-axis. At fourth unit of labor MPL = APL. After this,
MPL curve is lower than the APL. TPL increases at a decreasing rate.

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Stage III:- Third stage of production shows that the sixth unit of labour is
marked by negative MPL, the APL continues to fall but remains positive. After
the sixth unit, TPL declines with the employment of more units of variable
factor, labour.

 Relationship among Total, Average and Marginal Products

 LAWS OF RETURNS TO SCALE

In the long- run, there is no fixed factor; all factors are variable. The laws of
returns to scale explain the relationship between output and the scale of inputs
in the long-run when all the inputs are increased in the same proportion.

 Assumptions

Laws of Returns to Scale are based on the following assumptions.

1. All the factors of production (such as land, labour and capital) are
variable but organization is fixed.

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2. There is no change in technology.

3. There is perfect competition in the market.

4. Outputs or returns are measured in physical quantities.

 Three Phases of Returns to Scale

1. Increasing Returns to Scale:- In this case if all inputs are increased by one
per cent, output increase by more than one per cent.

2. Constant Returns to Scale:- In this case if all inputs are increased by one
per cen, output increases exactly by one per cent.

3. Diminishing Returns to Scale: Diminishing Returns to Scale:- In this case

if all inputs are increased by one per cent, output increases by less than one per
cent.

 Diagrammatic Illustration

The three laws of returns to scale can be explained with the help of the diagram
below.
In the diagram 3.2, the movement from point a to point b represents increasing
returns to scale. Because, between these two points output has doubled, but
output has tripled.

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The law of constant returns to scale is implied by the movement from the
point b to point c. Because, between these two points inputs have doubled and
output also has doubled.

Decreasing returns to scale are denoted by the movement from the point c to
point d since doubling the factors from 4 units to 8 units produce less than the
increase in inputs, that is, by only 33.33%

 ECONOMIES OF SCALE

‘Scale of Production’ refers to the ratio of factors of production. This ratio can
change because of availability of factors. The Scale of Production is an
important fact or affecting the cost of production. Every producer wishes to
reduce the costs of production. Hence he(he includes she as well) uses an
advantage of economy of scale. This economy of scale is effected both by the
internal and external factors of the firm. Accordingly, Economies are broadly
divided into two types by Marshall.

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1. Internal Economies and

2. External Economies

Economies of scale reduce the cost of production: and, diseconomies of scale

increase the cost of production.

1. Internal Economies of Scale:- The term Internal Economies of Scale› refers

to the advantages enjoyed by the production unit which causes a reduction in
the cost of production of the commodity. For example, a firm enjoying the
advantage of an application of most modern machinery, generation of internal
capital, an improvement in managerial skill etc. is sure to reduce the cost of
production. They are of various types:

I. Technical Economies : When the size of the firm is large, large amount of
capital can be used. There is a possibility to introduce up- to-date
technologies; this improves productivity of the firm. Here research and
development strategies can be applied easily.

II. Financial Economies: Big firms can float shares in the market for capital
expansion, while small firms cannot easily float shares in the market.

III. Managerial Economies: Large scale production facilitates specialisation

and delegation.

IV. Labour Economies: Large scale production implies greater and minute
division of labour. This leads to specialisation which enhances the quality.
This increases the productivity of the firm.

V. Marketing Economies: In the context of large scale production, the

producers can both buy raw- materials in bulk at cheaper cost and can take
the products to distant markets. They enjoy a huge bargaining power.

VI. Economies of Survival: Product diversification is possible when there is

large scale production. This reduces the risk in production. Even if the
market for one product collapses, market for other commodities offsets it.

2. External Economies of Scale:- External Economies of Scale refer to changes

in any factor outside the firm causing an improvement in the production

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process. This can take place in the case of industry also. These are the
advantages enjoyed by all the firms in the industry due to the structural growth.
Important external economies of scale are listed below.

1. Increased transport facilities

2. Banking facilities

3. Development of townships

4. Development of information and communication

 DISECONOMIES OF SCALE

The diseconomies of the scale are a disadvantage to a firm or an industry or an

organisation. This necessarily increases the cost of production of a commodity
or service. Further it delays the speed of the supply of the product to the market.
These diseconomies are of two types:

a. Internal Diseconomies of Scale: and

b. External Diseconomies of Scale

1. Internal Diseconomies of Scale:- When the scale of production increases

beyond optimum limit, its efficiency may come down.

2. External Diseconomies of Scale:- The term “External diseconomies of

scale” refers to the threat or disturbance to a firm or an industry from factor
lying outside it. For example a bus strike prevents the easy and correct entry of
the workers into a firm. Similarly the rent of a firm increases very much if new
economic units are established in the locality.

 ISO-QUANTS

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Production function may involve, at a time, the use of more than one variable
input. This is presented with the help of iso- quant curves. The two words ‘Iso’
and ‘quant’ are derived from the Greek language, meaning ‘equal’ and ‘quantity’
respectively. In our presentation only two factors, labour and capital are used.

In Economics, an iso-quant is a curve drawn by joining the combinations of

changing the quantities of two or more inputs which give the same level of
output. Isoquants are similar to indifference curves.

An iso- quant curve can be defined as the locus of points representing various
combinations of two inputs capital and labour yielding the same output. The
iso-quant is also called as the “Equal Product Curve” or the “Product Indifference
Curve”

 Definition of Iso-quant

According to Ferguson, «An iso-quant is a curve showing all possible

combinations of inputs physically capable of producing a given level of output”

It is seen from the table 3.2 that the five combinations of labour units and units
of capital yield the same level of output, i.e., 400 meters of cloth.

 Iso-quants are based on the following assumptions.

1. It is assumed that only two factors are used to produce a commodity.

2. Factors of production can be divided into small parts.

3. Technique of production is constant.

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4. The substitution between the two factors is technically possible. That is,
production function is of ‘variable proportion’ type rather than fixed
proportion.

5. Under the given technique, factors of production can be used with

maximum efficiency.

 Iso-quant Schedule

Let us suppose that there are two factors namely., labour and capital. An Iso-
quant schedule shows the different combinations of these two inputs that yield
the same level of output. It is given below.

 Iso-quant Curve

An equal product curve represents all those combinations of two inputs

which are capable of producing the same level of output. An iso-product curve
can be drawn with the help of isoquant schedule.

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3. Iso-quant Map

An iso-quant map has different iso-quant curves representing the different

combinations of factors of production, yielding the different levels of output. In
simple term, an iso-quant map is a family of iso-quants. In other words, if more
than one iso-quant is drawn in a diagram, it is called iso-quant map.

 Properties of Iso-quant

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1. The iso-quant curve has negative slope.

It slopes downwards from left to right indicating that the factors are
substitutable. If more of one factor is used, less of the other factor is needed for
producing the same level of output.

In the diagram combination A refers to more of capital K5 and less of labour L2.
As the producer moves to B, C, and D, more labour and less capital are used.

2. Convex to the origin.

This explains the concept of diminishing Marginal Rate of Technical

Substitution (MRTSLK). For example, the capital substituted by 1 unit of labour
goes on decreasing when moved from top to bottom. If so, it is called
diminishing MRTS. Constant MRTS (straight line) and increasing MRTS
(concave) are also possible. It depends on the nature of iso-quant curve.

This means that factors of production are substitutable to each other. The
capital substituted per unit of labour goes on decreasing when the iso-quant is
convex to the origin.

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3. Non inter-section of Iso-quant curves.

For instance, point A lie on the iso-quants IQ1 and IQ2. But the point C shows a
higher output and the point B shows a lower level of output IQ1. If C=A, B=A,
then C=B. But C>B which is illogical.

4. An upper iso-quant curve represents a higher level of output.

Higher IQs show higher outputs and lower IQs show lower outputs, for upper
iso-quant curve implies the use of more factors than the lower isoquant curve.

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The arrow in the figure shows an increase in the output with a right and upward
shift of an iso-quant curve.

5. Iso-quant curve does not touch either X axis or Y axis.

No iso-quant curve touches the X axis or axis because in IQ1, only capital is used,
and in IQ2 only labour is used.

 The Iso-cost Line

The iso-cost line is an important component in analysing producer’s behaviour.

The iso-cost line illustrates all the possible combinations of two factors that can
be used at given costs and for a given producer’s budget. Simply stated, an iso-
cost line represents different combinations of inputs which shows the same
amount of cost. The iso- cost line gives information on factor prices and
financial resources of the firm. It is otherwise called as “iso-price line” or “iso-
income line” or “iso-expenditure line” or “total outlay curve”.

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Suppose that a producer has a total budget of Rs.120 and for producing a
certain level of output, he has to spend this amount on two factors Labour (L)
and Capital (K). Prices of factors K is Rs. 30 and L is Rs.10. Iso Cost Curve can
be drawn by using the following hypothetical table.

As shown in Table, there are five combinations of capital and labour such as
combination A represents 4 units of capital and zero units of labour and this
combination costs Rs.120. Similarly other combinations (B,C,D and E) cost
same amount of rupees ( Rs.120).

Symbolically,

4K + 0L= Rs..120

3K + 3L= Rs..120

2K + 6L= Rs..120

1K + 9L= Rs..120, and

0K + 12L= Rs..120.

Thus, all the combinations A, B, C, D and E cost the same total expenditure.

From the figure 3.10, it is shown that the costs to be incurred on capital and
labour are represented by the triangle OAE. The line AE is called as Iso-cost line.

 PRODUCER’S EQUILIBRIUM

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Producer equilibrium implies the situation where producer maximizes his

output. It is also known as optimum combination of the factors of production. In
short, the producer manufactures a given amount of output with ‘least cost
combination of factors’, with his given budget.

 Optimum Combination of Factors implies either

a. there is output maximization for given inputs or

b. there is cost minimization for the given output.

 Conditions for Producer Equilibrium

The two conditions that are to be fulfilled for the attainment of producer
equilibrium are:

a. The iso-cost line must be tangent to iso-quant curve.

b. At point of tangency, the iso-quant curve must be convex to the origin or

MRTSLk must be declining.

When the outlay and prices of two factors, namely, labour and capital are given,
producers attain equilibrium (or least cost combination of factors is attained by
the firm) where the iso-cost line is tangent to an iso-product curve. It is
illustrated in the following Diagram 3.11.

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In the above figure, profit of the firm (or the producer) is maximised at the point
of equilibrium E.

At the point of equilibrium, the slope of the iso cost line is equal to the slope of
iso product curve (or the MRTS of labour for capital is equal to the price ratio
of the two factors)

Hence, it can be stated as follows.

At point E, the firm employs OM units of labour and ON units of capital. In other
words, it obtains least cost combination or optimum combination of the two
factors to produce the level of output denoted by the iso-quant IQ.

The other points such as H, K, R and S lie on higher iso cost lines indicating that
a larger outlay is required, which exceeds the financial resources of the firm.

 COBB-DOUGLAS PRODUCTION FUNCTION

Cobb -Douglas Production Function is a specific standard equation applied to

describe how much output can be made with capital and labour inputs. It is
used in empirical studies of manufacturing industries and in inter-industry
comparisons. The relative shares of labour and capital in total output can also
be determined. It is still used in the analysis of economies of modern, developed
and stable nations in the world.

The Cobb-Douglas Production Function was developed by Charles W. Cobb and

Paul H. Douglas, based on their empirical study of American manufacturing

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industry. It is a linear homogeneous production function which implies that the

factors of production can be substituted for one another up to a certain extent
only.

The Cobb-Douglas production function can be expressed as follows.

Q = ALα Kß

Where, Q = output; A = positive constant; K = capital; L = Labor α and β are

positive fractions showing, the elasticity coefficients of outputs for the inputs
labor and capital, respectively.

ß= (1- α) since α + ß = 1. denoting constant returns to scale.

Factor intensity can be measured by the ratio ß / α.

The sum of a + ß shows the returns to scale.

i. (α + ß) =1, constant returns to scale.

ii. (α + ß) <1, diminishing returns to scale.

iii. (α + ß) >1, increasing returns to scale.

a. The production function explains that with the proportionate increase in the
factors, the output also increases in the same proportion.

b. Cobb-Douglas production function implies constant returns to scale.

c. Cobb-Douglas production function considered only two factors like

d. Cobb-Douglas Production Function is a specific standard equation applied

to describe how much output can be made with capital and labour inputs. It
is used in empirical studies of manufacturing industries and in inter-
industry comparisons. The relative shares of labour and capital in total
output can also be determined. It is still used in the analysis of economies of
modern, developed and stable nations in the world.

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e. labour and capital. Production takes place only when both factors are
employed.

f. Labour contributes three-fourth of production and capital contributes one-

fourth of production.

g. The elasticity of substitution between the factors is equal to one.

THEORY OF COST
 Meaning of Theory of Cost

The expenses incurred in the business activity of supplying goods and services
to consumers are defined as cost. In economics, the value of the price of an
object or condition is the cost of production which is determined by the total
cost of resources employed for producing it. The composition of the cost is the
factors of production that includes labour, land, capital and entrepreneur as
well as taxation.

According to Campbell,’’ Production costs are those which must be received

by resource owners in order to assume that they will continue to supply them
in a particular time of production.’’

 Types of Cost

(1) Actual Cost

Actual cost is defined as the cost or expenditure which a firm incurs for
producing or acquiring a good or service. The actual costs or expenditures are
recorded in the books of accounts of a business unit. Actual costs are also called
as "Outlay Costs" or "Absolute Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.

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(2) Opportunity Cost

Opportunity cost is concerned with the cost of forgone

opportunities/alternatives. In other words, it is the return from the second
best use of the firms resources which the firms forgoes in order to avail of the
return from the best use of the resources. It can also be said as the comparison
between the policy that was chosen and the policy that was rejected. The
concept of opportunity cost focuses on the net revenue that could be generated
in the next best use of a scare input. Opportunity cost is also called as
"Alternative Cost". If a firm owns a land, there is no cost of using the land (ie.,
the rent) in the firms account. But the firm has an opportunity cost of using the
land, which is equal to the rent forgone by not letting the land out on rent.

(3) Sunk Cost

Sunk costs are those do not alter by varying the nature or level of business
activity. Sunk costs are generally not taken into consideration in decision -
making as they do not vary with the changes in the future. Sunk costs are a part
of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable costs"
or "Inescapable costs". Examples: All the past costs are considered as sunk
costs. The best example is amortization of past expenses, like depreciation.

(4) Incremental Cost

Incremental costs are addition to costs resulting from a change in the nature of
level of business activity. As the costs can be avoided by not bringing any
variation in the activity in the activity, they are also called as "Avoidable Costs"
or "Escapable Costs". More ever incremental costs resulting from a
contemplated change is the Future, they are also called as "Differential Costs"
Example: Change in distribution channels adding or deleting a product in the
productline.

(5) Explicit Cost

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Explicit costs are those expenses/expenditures that are actually paid by the
firm. These costs are recorded in the books of accounts. Explicit costs are
important for calculating the profit and loss accounts and guide in economic
decision-making. Explicit costs are also called as "Paid out costs" Example:
Interest payment on borrowed funds, rent payment, wages, utility expenses etc.

(6) Implicit Cost

Implicit costs are a part of opportunity cost. They are the theoretical costs ie.,
they are not recognised by the accounting system and are not recorded in the
books of accounts but are very important in certain decisions. They are also
called as the earnings of those employed resources which belong to the owner
himself. Implicit costs are also called as "Imputed costs". Examples: Rent on
idle land, depreciation on dully depreciated property still in use, interest on
equity capital etc.

(7) Book Cost

Book costs are those business costs which don't involve any cash payments but
a provision is made in the books of accounts in order to include them in the
profit and loss account and take tax advantages, like provision for depreciation
and for unpaid amount of the interest on the owners capital.

(8) Out Of Pocket Costs

Out of pocket costs are those costs are expenses which are current payments to
the outsiders of the firm. All the explicit costs fall into the category of out of
pocket costs. Examples: Rent Paid, wages, salaries, interest etc

(9) Accounting Costs

Accounting costs are the actual or outlay costs that point out the amount of
expenditure that has already been incurred on a particular process or on
production as such accounting costs facilitate for managing the taxation need
and profitability of the firm. Examples: All Sunk costs are accounting costs

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(10) Economic Costs

Economic costs are related to future. They play a vital role in business
decisions as the costs considered in decision - making are usually future
costs. They have the nature similar to that of incremental, imputed explicit and
opportunity costs.

(11) Direct Cost

Direct costs are those which have direct relationship with a unit of operation
like manufacturing a product, organizing a process or an activity etc. In other
words, direct costs are those which are directly and definitely identifiable. The
nature of the direct costs are related with a particular product/process, they
vary with variations in them. Therefore all direct costs are variable in nature.
It is also called as "Traceable Costs"
Examples: In operating railway services, the costs of wagons, coaches and
engines are direct costs.

(12) Indirect Costs

Indirect costs are those which cannot be easily and definitely identifiable in
relation to a plant, a product, a process or a department. Like the direct costs
indirect costs, do not vary ie., they may or may not be variable in
nature. However, the nature of indirect costs depend upon the costing under
consideration. Indirect costs are both the fixed and the variable type as they
may or may not vary as a result of the proposed changes in the production
process etc. Indirect costs are also called as Non-traceable costs.
Example: The cost of factory building, the track of a railway system etc., are
fixed indirect costs and the costs of machinery, labour etc.

(13) Controllable Cost:

Cost which can control

Example: Usage of raw material, Human Resources.

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(14) Uncontrollable Cost: Cost which cannot be control

Example: Obsolescence of machinery, repairs of the machinery.

(15)Original or Historical Cost:

Cost of equipment at the time of purchase.

(16)Replacement Cost:

The Cost incurred for replacing the new machinery in the place of old
machinery in the firm.

(17)Abandonment Cost:

Cost incurred for disposal of asset or machinery is called abandonment Cost.

(18) Shutdown Cost:

Cost which would be incurred in the event of suspension of plant.

Example: Storage of plant or machinery, construction of buildings, training the

employees.

(19)Urgent Cost:

Must be incurred so that the production goes on.

Example: Raw material cost fuel, power and wages for the labour.

(20)Postpone able Cost:

Cost whose postponement does not effect at least for some time on the firm and
on production process and this coast can be paid after sometime.

Example: Transportation charges, rent, interest.

(21)Fixed Cost:

Cost which does not change when there is change in the production. It remains
constant.

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Example: Rent of the building, interest on capital, salaries, and wages.

(22)Variable cost:

Cost which changes in accordance with production change.

Example: Raw material, power, fuel.

(23)Average Cost:

Cost incurred for single unit of production in the total production.

(24)Marginal Cost:

Additional cost incurred by the firm by producing one more units extra.

(25)Long run Cost:

Cost incurred for the expansion of plant, for increase in the production of goods.

(26)Short run Cost:

Cost incurred for the production of extra units with the existing plant capacity
without purchasing new machinery.

 Theories of Cost

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A. Traditional Theory

Traditional theory distinguishes between the short run and the long run. The
short run is the period during which some factors) is fixed; usually capital
equipment and entrepreneurship are considered as fixed in the short run.

The long run is the period over which all factors become variable.

1. Short-Run Costs of the Traditional Theory:

In the traditional theory of the firm total costs are split into two groups
total fixed costs and total variable costs:

TC = TFC + TVC

The fixed costs include:

(a) Salaries of administrative staff

(b) Depreciation (wear and tear) of machinery

(c) Expenses for building depreciation and repairs

(d) Expenses for land maintenance and depreciation (if any).

Another element that may be treated in the same way as fixed costs is the
normal profit, which is a lump sum including a percentage return on fixed
capital and allowance for risk.

The variable costs include:

(a) The raw materials

(b) The cost of direct labour

(c) The running expenses of fixed capital, such as fuel, ordinary repairs and
routine maintenance.

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The total fixed cost is graphically denoted by a straight line parallel to the
output axis (figure 4.1). The total variable cost in the traditional theory of the
firm has broadly an inverse-S shape (figure 4.2) which reflects the law of
variable proportions. According to this law, at the initial stages of production
with a given plant, as more of the variable factors) is employed, its productivity
increases and the average variable cost falls.

This continues until the optimal combination of the fixed and variable factors
is reached. Beyond this point as increased quantities of the variable factors(s)
are combined with the fixed factors) the productivity of the variable factors)
declines (and the A VC rises). By adding the TFC and TVC we obtain the TC of
the firm (figure 4.3). From the total-cost curves we obtain average-cost curves.

The average fixed cost is found by dividing TFC by the level of output:

AFC = TFC / X

Graphically the AFC is a rectangular hyperbola, showing at all its points the
same magnitude, that is, the level of TFC (figure 4.4).

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The average variable cost is similarly obtained by dividing the TVC with
the corresponding level of output:

AVC = TVC / X

Graphically the A VC at each level of output is derived from the slope of a line
drawn from the origin to the point on the TVC curve corresponding to the
particular level of output. For example, in figure 4.5 the AVC at X1 is the slope of
the ray 0a, the A VC at X2 is the slope of the ray Ob, and so on. It is clear from
figure 4.5 that the slope of a ray through the origin declines continuously until
the ray becomes tangent to the TVC curve at c. To the right of this point the
slope of rays through the origin starts increasing. Thus the SA VC curve falls
initially as the productivity of the variable factors) increases, reaches a
minimum when the plant is operated optimally (with the optimal combination
of fixed and variable factors), and rises beyond that point (figure 4.6).

The ATC is obtained by dividing the TC by the corresponding level of

output:

ATC = TC / X = TFC + TVC / X = AFC + AVC

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Graphically the ATC curve is derived in the same way as the SAVC. The ATC at
any level of output is the slope of the straight line from the origin to the point
on the TC curve corresponding to that particular level of output (figure 4.7).
The shape of the A TC is similar to that of the AVC (both being U-shaped).
Initially the ATC declines, it reaches a minimum at the level of optimal
operation of the plant (XM) and subsequently rises again (figure 4.8).

The U shape of both the AVC and the ATC reflects the law of variable
proportions or law of eventually decreasing returns to the variable factor(s) of
production. The marginal cost is defined as the change in TC which results from
a unit change in output. Mathematically the marginal cost is the first derivative
of the TC function. Denoting total cost by C and output by X we have

MC = ∂C / ∂X

Graphically the MC is the slope of the TC curve (which of course is the same at
any point as the slope of the TVC). The slope of a curve at any one of its points
is the slope of the tangent at that point. With an inverse-S shape of the TC (and
TVC) the MC curve will be U-shaped. In figure 4.9 we observe that the slope of
the tangent to the total-cost curve declines gradually, until it becomes parallel
to the X-axis (with its slope being equal to zero at this point), and then starts
rising. Accordingly we picture the MC curve in figure 4.10 as U-shaped.

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In summary: the traditional theory of costs postulates that in the short run the
cost curves (AVC, ATC and MC) is U-shaped, reflecting the law of variable
proportions. In the short run with a fixed plant there is a phase of increasing
productivity (falling unit costs) and a phase of decreasing productivity
(increasing unit costs) of the variable factor(s).

Between these two phases of plant operation there is a single point at which
unit costs are at a minimum. When this point on the SATC is reached the plant
is utilized optimally, that is, with the optimal combination (proportions) of
fixed and variable factors.

 The relationship between ATC and AVC:

The AVC is a part of the ATC, given ATC = AFC + AVC. Both AVC and ATC are U-
shaped, reflecting the law of variable proportions. However, the minimum
point of the ATC occurs to the right of the minimum point of the AVC (figure
4.11). This is due to the fact that ATC includes AFC, and the latter falls
continuously with increases in output.

After the AVC has reached its lowest point and starts rising, its rise is over a
certain range offset by the fall in the AFC, so that the ATC continues to fall (over
that range) despite the increase in AVC. However, the rise in AVC eventually
becomes greater than the fall in the AFC so that the A TC starts increasing. The
A VC approaches the A TC asymptotically as X increases.

In figure 4.11 the minimum AVC is reached at X1 while the ATC is at its
minimum at X2. Between X1 and X2 the fall in AFC more than offsets the rise in

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AVC so that the ATC continues to fall. Beyond X2 the increase in AVC is not offset
by the fall in AFC, so that ATC rises.

 The relationship between MC and ATC:

The MC cuts the ATC and the AVC at their lowest points. We will establish this
relation only for the ATC and MC, but the relation between MC and AVC can be
established on the same lines of reasoning.

We said that the MC is the change in the TC for producing an extra unit of
output. Assume that we start from a level of n units of output. If we increase the
output by one unit the MC is the change in total cost resulting from the
production of the (n + l)th unit.

The AC at each level of output is found by dividing TC by X. Thus the AC at the

level of Xn is

Thus:

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(a) If the MC of the (n + 1)th unit is less than ACn (the AC of the previous n units)
the AC n+1 will be smaller than the ACn.

(b) If the MC of the (n + 1)th unit is higher than ACn (the AC of the previous n
units) the ACn+1 will be higher than the ACn.

So long as the MC lies below the AC curve, it pulls the latter downwards; when
the MC rises above the AC, it pulls the latter upwards. In figure 4.11 to the left
of a the MC lies below the AC curve, and hence the latter falls downwards. To
the right of a the MC curve lie above the AC curve, so that AC rises. It follows
that at point a, where the intersection of the MC and AC occurs, the AC has
reached its minimum level.

3. Long-Run Costs of the Traditional Theory: The ‘Envelope’ Curve:

In the long run all factors are assumed to become variable. We said that the
long-run cost curve is a planning curve, in the sense that it is a guide to the
entrepreneur in his decision to plan the future expansion of his output. The
long-run average-cost curve is derived from short-run cost curves. Each point
on the LAC corresponds to a point on a short-run cost curve, which is tangent
to the LAC at that point. Let us examine in detail how the LAC is derived from
the SRC curves.

Assume, as a first approximation, that the available technology to the firm at a

particular point of time includes three methods of production, each with a
different plant size: a small plant, medium plant and large plant. The small plant
operates with costs denoted by the curve SAC1, the medium-size plant operates
with the costs on SAC2 and the large-size plant gives rise to the costs shown on
SAC3 (figure 4.12). If the firm plans to produce output X3 it will choose the small
plant. If it plans to produce X2 it will choose the medium plant. If it wishes to
produce X1 it will choose the large- size plant.

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If the firm starts with the small plant and its demand gradually increases, it will
produce at lower costs (up to level X’1). Beyond that point costs start increasing.
If its demand reaches the level X”1 the firm can either continue to produce with
the small plant or it can install the medium-size plant. The decision at this point
depends not on costs but on the firm’s expectations about its future demand. If
the firm expects that the demand will expand further than X” 1 it will install the
medium plant, because with this plant outputs larger than X’ 1 are produced
with a lower cost.

Similar considerations hold for the decision of the firm when it reaches the level
X”2. If it expects its demand to stay constant at this level, the firm will not install
the large plant, given that it involves a larger investment which is profitable
only if demand expands beyond X”2. For example, the level of output X3 is
produced at a cost c3 with the large plant, while it costs c’2 if produced with the
medium-size plant (c’2 > c3).

Now if we relax the assumption of the existence of only three plants and assume
that the available technology includes many plant sizes, each suitable for a
certain level of output, the points of intersection of consecutive plants (which
are the crucial points for the decision of whether to switch to a larger plant) are
more numerous. In the limit, if we assume that there is a very large number
(infinite number) of plants, we obtain a continuous curve, which is the planning
LAC curve of the firm.

Each point of this curve shows the minimum (optimal) cost for producing the
corresponding level of output. The LAC curve is the locus of points denoting the

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least cost of producing the corresponding output. It is a planning curve because

on the basis of this curve the firm decides what plant to set up in order to
produce optimally (at minimum cost) the expected level of output.

The firm chooses the short-run plant which allows it to produce the anticipated
(in the long run) output at the least possible cost. In the traditional theory of
the firm the LAC curve is U-shaped and it is often called the ‘envelope curve’
because it ‘envelopes’ the SRC curves (figure 4.13).

Let us examine the U shape of the LAC. This shape reflects the laws of returns
to scale. According to these laws the unit costs of production decrease as plant
size increases, due to the economies of scale which the larger plant sizes make
possible. The traditional theory of the firm assumes that economies of scale
exist only up to a certain size of plant, which is known as the optimum plant
size, because with this plant size all possible economies of scale are fully
exploited.

If the plant increases further than this optimum size there are diseconomies of
scale, arising from managerial inefficiencies. It is argued that management
becomes highly complex, managers are overworked and the decision-making
process becomes less efficient. The turning-up of the LAC curve is due to
managerial diseconomies of scale, since the technical diseconomies can be
avoided by duplicating the optimum technical plant size.

A serious implicit assumption of the traditional U-shaped cost curves is that

each plant size is designed to produce optimally a single level of output (e.g.
1000 units of X). Any departure from that X, no matter how small (e.g. an
increase by 1 unit of X) leads to increased costs. The plant is completely

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inflexible. There is no reserve capacity, not even to meet seasonal variations in

demand.

As a consequence of this assumption the LAC curve ‘envelopes’ the SRAC. Each
point of the LAC is a point of tangency with the corresponding SRAC curve. The
point of tangency occurs to the falling part of the SRAC curves for points lying
to the left of the minimum point of the LAC since the slope of the LAC is negative
up to M (figure 4.13) the slope of the SRMC curves must also be negative, since
at the point of their tangency the two curves have the same slope.

The point of tangency for outputs larger than XM occurs to the rising part of the
SRAC curves since the LAC rises, the SAC must rise at the point of their tangency
with the LAC. Only at the minimum point M of the LAC is the corresponding SAC
also at a minimum. Thus at the falling part of the LAC the plants are not worked
to full capacity; to the rising part of the LAC the plants are overworked; only at
the minimum point M is the (short-run) plant optimally employed.

We stress once more the optimality implied by the LAC planning curve each
point represents the least unit-cost for producing the corresponding level of
output. Any point above the LAC is inefficient in that it shows a higher cost for
producing the corresponding level of output. Any point below the LAC is
economically desirable because it implies a lower unit-cost, but it is not
attainable in the current state of technology and with the prevailing market
prices of factors of production. (Recall that each cost curve is drawn under a
ceteris paribus clause, which implies given state of technology and given factor
prices.)

The long-run marginal cost is derived from the SRMC curves, but does not ‘en-
velope’ them. The LRMC is formed from points of intersection of the SRMC
curves with vertical lines (to the X-axis) drawn from the points of tangency of
the corresponding SAC curves and the LRA cost curve (figure 4.14). The LMC
must be equal to the SMC for the output at which the corresponding SAC is
tangent to the LAC. For levels of X to the left of tangency a the SAC > LAC.

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At the point of tangency SAC = LAC. As we move from point a’ to a, we actually

move from a position of inequality of SRAC and LRAC to a position of equality.
Hence the change in total cost (i.e. the MC) must be smaller for the short-run
curve than for the long-run curve. Thus LMC > SMC to the left of a. For an
increase in output beyond X, (e.g. X’1) the SAC > LAC. That is, we move from the
position a of equality of the two costs to the position b where SAC is greater
than LAC. Hence the addition to total cost (= MC) must be larger for the short-
run curve than for the long-run curve. Thus LMC < SMC to the right of a.

Since to the left of a, LMC > SMC, and to the right of a, LMC < SMC, it follows that
at a, LMC – SMC. If we draw a vertical line from a to the X-axis the point at which
it intersects the SMC (point A for SAC1) is a point of the LMC.

If we repeat this procedure for all points of tangency of SRAC and LAC curves
to the left of the minimum point of the LAC, we obtain points of the section of
the LMC which lies below the LAC. At the minimum point M the LMC intersects
the LAC. To the right of M the LMC lies above the LAC curve. At point M we have

SACM = SMCM = LAC = LMC

There are various mathematical forms which give rise to U-shaped unit cost
curves. The simplest total cost function which would incorporate the law of
variable proportions is the cubic polynomial

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The TC curve is roughly S-shaped , while the ATC, the AVC and the MC are all U-
shaped; the MC curve intersects the other two curves at their minimum points
(figure 4.11).

B. The Modern Theory of Costs

The modem theory of costs differs from the traditional theory of costs with
regard to the shapes of the cost curves. In the traditional theory, the cost curves
are U-shaped. But in the modem theory which is based on empirical evidences,
the short-run SAVC curve and the SMC curve coincide with each other and are
a horizontal straight line over a wide range of output. So far as the LAC and LMC
curves are concerned, they are L-shaped rather than U-shaped. We discuss
below the nature of short- run and long-run cost curves according to the
modem theory.

(1) Short-Run Cost Curves:

As in the traditional theory, the short-run cost curves in the modem theory of
costs are the AFC, SAVC, SAC and SMC curves. As usual, they are derived from
the total costs which are divided into total fixed costs and total variable costs.

But in the modem theory, the SAVC and SMC curves have a saucer-type shape
or bowl-shape rather than a U-shape. As the AFC curve is a rectangular
hyperbola, the SAC curve has a U-shape even in the modem version. Economists
have investigated on the basis of empirical studies this behaviour pattern of the
short-run cost curves.

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According to them, a modern firm chooses such a plant which it can operate
easily with the available variable direct factors. Such a plant possesses some
reserve capacity and much flexibility. The firm installs this type of plant in order
to produce the maximum rate of output over a wide range to meet any increase
in demand for its product.

The saucer-shaped SAVC and SMC curves are shown in Figure 7. To begin with,
both the curves first fall upto point A and the SMC curvelies below the SAVC
curve. “The falling part of the SAVC shows the reduction in costs due to the
better utilisation of the fixed factor and the consequent increase in skills and
productivity of the variable factor (labour).

With better skills, the wastes in raw materials are also being reduced and a
better utilisation of the whole plant is reached.” So far as the flat stretch of the
saucer-shaped SAVC curve over Q:1Q2 range of output is concerned, the
empirical evidence reveals that the operation of a plant within this wide range
exhibits constant returns to scale.

The reason for the saucer-shaped SAVC curve is that the fixed factor is divisible.
The SAV costs are constant over a large range, up to the point at which all of the
fixed factor is used. Moreover, the firm’s SAV costs tend to be constant over a
wide range of output because there is no need to depart from the optimal
combination of labour and capital in those plants that are kept in operation.

Thus there is a large range of output over which the SAVC curve will be flat.
Over that range, SMC and SAVC are equal and are constant per unit of output.
The firm will, therefore, continue to produce within Q1Q2 reserve capacity of
the plant, as shown in Figure 7.
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After point B, both the SAVC and SMC curves start rising. When the firm departs
from its normal or the load factor of the plant in order to obtain higher rates of
output beyond Q2, it leads to higher SAVC and SMC. The increase in costs may
be due to the overtime operations of the old and less efficient plant leading to
frequent breakdowns, wastage of raw materials, reduction in labour
productivity and increase in labour cost due to overtime operations. In the
rising portion of the SAVC curve beyond point B, the SMC curve lies above it.

The short-run average total cost curve (SATC or SAC) is obtained by adding
vertically the average fixed cost curve (AFC) and the SAVC curve at each level
of output. The SAC curve, as shown in Figure 8, continues to fall up to the OQ
level of output at which the reserve capacity of the plant is fully exhausted.

Beyond that output level, the SAC curve rises as output increases. The smooth
and continuous fall in the SAC curve upto the OQ level of output is due to the
fact that the AFC curve is a rectangular hyperbola and the SAVC curve first falls
and then becomes horizontal within the range of reserve capacity. Beyond the
OQ output level, it starts rising steeply. But the minimum point M of the SAC
curve where the SMC curve intersects it, is to the right of point E of the SAVC
curve. This is because the SAVC curve starts rising steeply from point E while
the AFC curve is falling at a very low rate.

(2) Long-Run Cost Curves:

Empirical evidence about the long-run average cost curve reveals that the LAC
curve is L-shaped rather than U-shaped. In the beginning, the LAC curve rapidly
falls but after a point “the curve remains flat, or may slope gently downwards,
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at its right-hand end.” Economists have assigned the following reasons for the
L-shape of the LAC curve.

1. Production and Managerial Costs:

In the long run, all costs being variable, production costs and managerial costs
of a firm are taken into account when considering the effect of expansion of
output on average costs. As output increases, production costs fall continuously
while managerial costs may rise at very large scales of output. But the fall in
production costs outweighs the increase in managerial costs so that the LAC
curve falls with increases in output. We analyse the behaviour of production
and managerial costs in explaining the L-shape of the LAC curve.

 Production Costs:

As a firm increases its scale of production, its production costs fall steeply in
the beginning and then gradually. The is due to the technical economies of large
scale production enjoyed by the firm. Initially, these economies are substantial.
But after a certain level of output when all or most of these economies have
been achieved, the firm reaches the minimum optimal scale or mini mum
efficient scale (MES).

Given the technology of the industry, the firm can continue to enjoy some
technical economies at outputs larger than the MES for the following reasons:

(a) from further decentralisation and improvement in skills and productivity of

labour;

(b) from lower repair costs after the firm reaches a certain size; and

(c) by itself producing some of the materials and equipment cheaply which the
firm needs instead of buying them from other firms.

 Managerial Costs:

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In modern firms, for each plant there is a corresponding managerial set-up for
its smooth operation. There are various levels of management, each having a
separate management technique applicable to a certain range of output. Thus,
given a managerial set-up for a plant, its managerial costs first fall with the
expansion of output and it is only at a very large scale output, they rise very
slowly.

To sum up, production costs fall smoothly and managerial costs rise slowly at
very large scales of output. But the fall in production costs more than offsets the
rise in managerial costs so that the LAC curve falls smoothly or becomes flat at
very large scales of output, thereby giving rise to the L-shape of the LAC curve.

In order to draw such an LAC curve, we take three short-run average cost
curves SAC1 SA С2, and SAC3representing three plants with the same technol-
ogy in Figure 9. Each SAC curve includes production costs, managerial costs,
other fixed costs and a margin for normal profits. Each scale of plant (SAC) is
subject to a typical load factor capacity so that points A, В and С represent the
minimal optimal scale of output of each plant.

By joining all such points as A, В and С of a large number of SACs, we trace out
a smooth and continuous LAC curve, as shown in Figure 9. This curve does not
turn up at very large scales of output. It does not envelope the SAC curves but
intersects them at the optimal level of output of each plant.

2. Technical Progress:

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Another reason for the existence of the L-shaped LAC curve in the modern
theory of costs is technical progress. The traditional theory of costs assumes no
technical progress while explaining the U-shaped LAC curve. The empirical
results on long-run costs conform the widespread existence of economies of
scale due to technical progress in firms.

The period between which technical progress has taken place, the long-run
average costs show a falling trend. The evidence of diseconomies is much less
certain. So an upturn of the LAC at the top end of the size scale has not been
observed. The L-shape of the LAC curve due to technical progress is explained
in Figure 10.

Suppose the firm is producing OQ1 output on LAC1curve at a per unit cost of
ОС1 If there is an increase in demand for the firm’s product to OQ2,with no
change in technology, the firm will produce OQ2 output along the LAC1 curve
at a per unit cost of ОС2. If, however, there is technical progress in the firm, it
will install a new plant having LAC2 as the long-run average cost curve. On this
plant, it produces OQ2 output at a lower cost OC2 per unit.

Similarly, if the firm decides to increase its output to OQ3 to meet further rise
in demand technical progress may have advanced to such a level that it installs
the plant with the LAC3 curve. Now it produces OQ3output at a still lower cost
OC3 per unit. If the minimum points, L, M and N of these U- shaped long-run
average cost curves LAC1, LAC2 and LAC3are joined by a line, it forms an L-
shaped gently sloping downward curve LAC.

3. Learning:

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Another reason for the L-shaped long- run average cost curve is the learning
process. Learning is the product of experience. If experience, in this context, can
be measured by the amount of a commodity produced, then higher the
production is, the lower is per unit cost.

The consequences of learning are similar to increasing returns. First, the

knowledge gained from working on a large scale cannot be forgotten. Second,
learning increases the rate of productivity. Third, experience is measured by
the aggregate output produced since the firm first started to produce the
product.

Learning-by-doing has been observed when firms start producing new

products. After they have produced the first unit, they are able to reduce the
time required for production and thus reduce their per unit costs. For example,
if a firm manufactures airframes, the fall observed in long-run average costs is
a function of experience in producing one particular kind of airframe, not
airframes in general.

One can, therefore, draw a “learning curve” which relates cost per airframe to
the aggregate number of airframes manufactured so far, since the firm started
manufacturing them. Figure 11 shows a learning curve LAC which relates the
cost of producing a given output to the total output over the entire time period.

Growing experience with making the product leads to falling costs as more and
more of it is produced. When the firm has exploited all learning possibilities,
costs reach a minimum level, M in the figure. Thus, the LAC curve is L-shaped
due to learning by doing.

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 Relation between LAC and LMC Curves:

In the modern theory of costs, if the LAC curve falls smoothly and continuously
even at very large scales of output, the LMC curve will lie below the LAC curve
throughout its length, as shown in Figure 12.

If the LAC curve is downward sloping up to the point of a minimum optimal

scale of plant or a minimum efficient scale (MES) of plant beyond which no
further scale economies exist, the LAC curve becomes horizontal. In this case,
the LMC curve lies below the LAC curve until the MES point M is reached, and
beyond this point the LMC curve coincides with the LA С curve, as shown in
Figure 13.

Conclusion:

The majority of empirical cost studies suggest that the U-shaped cost curves
postulated by the traditional theory are not observed in the real world. Two

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major results emerge predominantly from most studies. First, the SAVC and
SMC curves are constant over a wide-range of output.

Second, the LAC curve falls sharply over low levels of output, and subsequently
remains practically constant as the scale of output increases. This means that
the LAC curve is L-shaped rather than U-shaped. Only in very few cases
diseconomies of scale were observed, and these at very high levels of output.

 Meaning of Revenue:
The amount of money that a producer receives in exchange for the sale
proceeds is known as revenue.

For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the
amount of Rs. 16,000 is known as revenue.

Revenue refers to the amount received by a firm from the sale of a given
quantity of a commodity in the market.

Revenue is a very important concept in economic analysis. It is directly

influenced by sales level, i.e., as sales increases, revenue also increases.

 Features of Revenue

1) Revenue arises from the normal trading activities of a business.

2) Revenue eventually creates an inflow of funds into the business.
3) Revenue is measured in monetary terms.
4) Revenue must be allocated to a particular accounting period.
5) Revenue is earned as a result of revenue generating activities typically
expressed as expenses.

 Concept of Revenue:
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The concept of revenue consists of three important terms; Total Revenue,

Average Revenue and Marginal Revenue.

1. Total Revenue (TR):

Total Revenue refers to total receipts from the sale of a given quantity of a
commodity. It is the total income of a firm. Total revenue is obtained by
multiplying the quantity of the commodity sold with the price of the
commodity.

Total Revenue = Quantity × Price

For example, if a firm sells 10 chairs at a price of Rs. 160 per chair, then the
total revenue will be: 10 Chairs × Rs. 160 = Rs 1,600

2. Average Revenue (AR):

Average revenue refers to revenue per unit of output sold. It is obtained by

dividing the total revenue by the number of units sold.

Average Revenue = Total Revenue/Quantity

For example, if total revenue from the sale of 10 chairs @ Rs. 160 per chair is
Rs. 1,600, then:

Average Revenue = Total Revenue/Quantity

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AR= 1,600/10 = Rs 160

AR and Price are the Same:

We know, AR is equal to per unit sale receipts and price is always per unit.
Since sellers receive revenue according to price, price and AR are one and the
same thing.

This can be explained as under:

TR = Quantity × Price … (1)

AR = TR/Quantity …… (2)

Putting the value of TR from equation (1) in equation (2), we get

AR = Quantity × Price / Quantity

AR = Price

AR Curve and Demand Curve are the Same:

A buyer’s demand curve graphically represents the quantities demanded by a

buyer at various prices. In other words, it shows the various levels of average
revenue at which different quantities of the good are sold by the seller.
Therefore, in economics, it is customary to refer AR curve as the Demand Curve
of a firm.

3. Marginal Revenue (MR):

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Marginal revenue is the additional revenue generated from the sale of an

additional unit of output. It is the change in TR from sale of one more unit of a
commodity.

MRn = TRn-TRn-1

Where:

MRn = Marginal revenue of nth unit;

TRn = Total revenue from n units;

TR n-1 = Total revenue from (n – 1) units; n = number of units sold For example,
if the total revenue realised from sale of 10 chairs is Rs. 1,600 and that from
sale of 11 chairs is Rs. 1,780, then MR of the 11th chair will be:

MR11 = TR11 – TR10

MR11 = Rs. 1,780 – Rs. 1,600 = Rs. 180

One More way to Calculate MR:

We know, MR is the change in TR when one more unit is sold. However, when
change in units sold is more than one, then MR can also be calculated as:

MR = Change in Total Revenue/ Change in number of units = ∆TR/∆Q

Let us understand this with the help of an example: If the total revenue
realised from sale of 10 chairs is Rs. 1,600 and that from sale of 14 chairs is Rs.
2,200, then the marginal revenue will be:

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MR = TR of 14 chairs – TR of 10 chairs / 14 chairs -10 chairs = 600/4 = Rs. 150

TR is summation of MR:

Total Revenue can also be calculated as the sum of marginal revenues of all the
units sold.

It means, TRn = MR1 + M2 + MR3 + ……….MRn

or, TR = ∑MR

The concepts of TR, AR and MR can be better explained through Table 7.1.

Table 7.1: TR, AR and MR:

Marginal
Total Average Revenue
Units Price Revenue Revenue (Rs.)
Sold (Rs.) (Rs.) TR = (Rs.) AR = MRn=TRn-
(Q) (P) QxP TR+Q = P TRn-1
1 10 10=1×10 10 =10 + 1 10 =10-0
2 9 18 =2×9 9 =18 + 2 8 =18-10
3 8 24 =3×8 8 =24 + 3 6 =24-18
4 7 28 = 4×7 7 =28 + 4 4 =28-24
5 6 30 = 5×6 6 =30 + 5 2 =30-28
6 5 30 = 6 x 5 5 =30 + 6 0 =30-30
7 4 28 = 7×4 4 =28 + 7 -2 =28-30

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 Shapes of revenue curve

1. Total Revenue curve

TR is obtained by multiplying amount of output sold by the given price

determined in the market by intersection of market demand and market supply
curve.

i.e. TR = Q × P

Where, Q= amount of product sale

P= Market Price which is constant.

TR increases at the same rate because, every additional unit of the commodity
is sold at the same price. In this type of market firms are price taker not price
maker.

It can be explained with the help of following table and graph.

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In above table total revenue (TR ) is obtained by multiplying output (Q) and
Price (P). When output is zero TR also zero. TR is Rs. 10, 20, 30, 40 and 50for
the 1, 2, 3, 4 and 5 units of sale respectively, where price is constant at Rs. 10.

In the above table as increase in sell of output total revenue also increasing, but
the rate of increase in total revenue is constant.

2. Average Revenue curve

Average Revenue (AR):Per unit revenue obtained by a seller by selling product

at market price in the market in certain time period is known as AR for that
time period of that seller or producer.

It is calculated by dividing total revenue (TR) by corresponding quantity sold

(Q) in the market at market price (P).

i.e. AR = TR/Q

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i.e. AR =( P×Q)/Q

i.e. AR = P

Therefore, another name of AR is the average market price of the product. Since,
price is constant in perfect competition market and hence, AR is also constant .
It can be explained with the help of following table;

In the above table as increase in sells of output of the product Average Revenue
(AR) remains constant i.e. Rs. 10 for first unit to fifth unit of output.

Above information shows that AR is constant and equal to the price for all level
of output.

In the following figure average revenue curve is found by plotting the

combination of points of the quantity sold on the horizontal axis and
corresponding AR on the vertical axis.

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AR curve is a horizontal straight line at the different level of output sold at

given price. It shows that AR is constant and equal to the price for all level of
output, i.e. AR = P.

3. Marginal Revenue curve

Marginal revenue is the change in total revenue in response to the change in

quantity sold. It is calculated by dividing the change in total revenue (ΔTR) by
the change in quantity sold (ΔQ).

In case of perfectly competitive market marginal revenue (MR) remains

constant and equal to the market price for all level of output sold, i.e. MR = P.

It can be explained with the help of following table and graph.

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In the above table as increase in output sold at market price TR increases at

constant rate. But MR remains constant i.e. Rs. 10. which is equal to price.

Form above table we conclude that Price, AR and MR are same i.e. Rs. 10. that
means P = AR = MR.

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In the above figure MR is the slope of the TR. The MR curve is found by plotting
the MR on y-axis and quantity sold on x-axis.

The MR curve is also horizontal to the x-axis as of the AR. It shows that AR and
MR are overlapped and equal to the price in perfectly competitive market.

 Significance of Revenue Curve

The main points of significance of revenue curves are as under:

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1. Estimation of Profits and Losses:

A producer aims at maximizing his profits. His profits will be maximum where
he finds AR > AC.

The maximum difference between AR and AC will show maximum profits. A

producer finds out whether he is making supernormal profits, normal profits
or sustaining losses.

2. Equilibrium:

The second point of the importance of AR and MR curves is to know how much
a producer should produce. In this case, the concept of MR is very important.
The firm will be in equilibrium at that point where MR = MC. This is a general
condition for the firm under all market situations. MR = MC determines output,
price, profits or loss.

3. Capacity Utilization:

It is through revenue curves that we come to know whether a firm is producing

at its full capacity or not. In other words, the firm will be producing at its full
capacity, if AR curve is tangent to AC curve at its minimum point. It is possible
only under perfect competition but not under imperfect competition like
monopoly, monopolistic competition etc.

4. Price Changes:

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The concepts of AR and MR are also useful to the factor services in determining
their price. In factor pricing like rent, wages, interest and profits, they become
inverted U-shaped. The AR and MR curves become ARP and MRP (Average
Revenue productivity and Marginal Revenue Productivity). It is an important
tool in explaining the equilibrium of the firm under different market conditions.

 Relationship of Total Revenue, Average Revenue and Marginal

Revenue:

The relation of total revenue, average revenue and marginal revenue can be
explained with the help of table and fig.

Table Representation:
The relationship between TR, AR and MR can be expressed with the help of a

table 1.
From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re.
1, the output sold increases from 1 to 10. Total revenue increases from 10 to
30, at 5 units. However, at 6th unit it becomes constant and ultimately starts
falling at next unit i.e. 7th. In the same way, when AR falls, MR falls more and
becomes zero at 6th unit and then negative. Therefore, it is clear that when AR
falls, MR also falls more than that of AR: TR increases initially at a diminishing
rate, it reaches maximum and then starts falling.

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The formula to calculate TR, AR and MR is as under:

TR = P x q
Or TR = MR1 + MR2 + MR3 + MR3 +….. MR„
TR

AR = TR/q MR = TRn – TRn _ x

In fig. 1 three concepts of revenue have been explained. The units of output have
been shown on horizontal axis while revenue on vertical axis. Here TR, AR, MR
are total revenue, average revenue and marginal revenue curves respectively.

In figure 1 (A), a total revenue curve is sloping upward from the origin to point
K. From point K to K’ total revenue is constant. But at point K’ total revenue is
maximum and begins to fall. It means even by selling more units total revenue
is falling. In such a situation, marginal revenue becomes negative.

Similarly, in the figure 1 (B) average revenue curves are sloping downward. It
means average revenue falls as more and more units are sold.

In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It

signifies the fact that MR with the sale of every additional unit tends to
diminish. Moreover, it is also clear from the fig. that when both AR and MR are
falling, MR is less than AR. MR can be zero, positive or negative but AR is always
positive.

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The relationship between TR, AR, and MR

In order to understand the basic concepts of revenue, it is also important to pay
attention to the relationship between TR, AR, and MR. When the first unit is sold,
TR, AR, and MR are equal.

Therefore, all three curves start from the same point. Further, as long as MR is
positive, the TR curve slopes upwards.

However, if MR is falling with the increase in the quantity of sale, then the TR
curve will gain height at a decreasing rate. When the MR curve touches the X-axis,
the TR curve reaches its maximum height.

Further, if the MR curve goes below the X-axis, the TR curve starts sloping
downwards.

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Any change in AR causes a much bigger change in MR. Therefore, if the AR curve
has a negative slope, then the MR curve has a greater slope and lies below it.

Similarly, if the AR curve has a positive slope, then the MR curve again has a
greater slope and lies above it. If the AR curve is parallel to the X-axis, then the
MR curve coincides with it.

Here is a graphical representation of the relationship between AR and MR:

In the left half, you can see that AR has a constant value (DD’). Therefore, the AR
curve starts from point D and runs parallel to the X-axis. Also, since AR is constant,
MR is equal to AR and the two curves coincide with each other.

In the right half, you can see that the AR curve starts from point D on the Y-axis
and is a straight line with a negative slope. This basically means that as the
number of goods sold increases, the price per unit falls at a steady rate.

Similarly, the MR curve also starts from point D and is a straight line as well.
However, it is a locus of all the points which bisect the perpendicular distance
between the AR curve and the Y-axis. In the figure above, FM=MA.

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 Important Questions

1. Define Managerial Economics? Explain the Nature & Scope Of Managerial

Economics?
2. Define Managerial Economics? Discuss the Relationship Between Other
Disciplines Of Managerial Economics?
3. Discuss The Role of Managerial Economics in Decision Making?
4. Define Demand? Discuss Its Characteristics, Schedule & Curve & Its
Determinants?
5. Explain The Law of Demand. Why Does Demand Curve Slopes Downwards
to the Right? Explain the Circumstances In Which Demand Curve Slope ?
Explain The Methods Of Elasticity Of Demand ?
6. Write The Short Note On Followings:-
A) Demand Estimation.
B) Demand Forecasting.
C) Types Of Demand
7. Define Theory Of Cost? Exaplain Its Types & Determinants?
8. Define Modern Theory ? Discuss Its Types & Importance?
9. Discuss Relationship Between Cost And Production Function?
10. Define Revenue? Explain Its Types, Shapes And Curves?
11. Explain Relationship Between Marginal Revenue & Elasticity of
Demand?
12. Discuss the concept of interaction of Demand & Supply forces.
13. Write the detailed note on Market Mechanism.
14. Discuss the concept of Marginal Utility.

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GROUP-II

MARKET STRUCTURE
 Meaning of Market Structure

The Market Structure refers to the characteristics of the market either

organizational or competitive, that describes the nature of competition and the
pricing policy followed in the market.

Thus, the market structure can be defined as, the number of firms producing
the identical goods and services in the market and whose structure is
determined on the basis of the competition prevailing in that market.

The term “ market” refers to a place where sellers and buyers meet and
facilitate the selling and buying of goods and services. But in economics, it is
much wider than just a place, It is a gamut of all the buyers and sellers, who are
spread out to perform the marketing activities.

 TYPES OF MARKET STRUCTURE

1. Perfect Competition Market Structure

2. Monopolistic Competition Market Structure
3. Oligopoly Market Structure
4. Monopoly Market Structure

 DETERMINANTS OF THE MARKET STRUCTURE ARE:

1. The number of sellers operating in the market.

2. The number of buyers in the market.
3. The nature of goods and services offered by the firms.
4. The concentration ratio of the company, which shows the largest market
shares held by the companies.
5. The entry and exit barriers in a particular market.
6. The economies of scale, i.e. how cost efficient a firm is in producing the goods
and services at a low cost. Also the sunk cost, the cost that has already been
spent on the business operations.

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7. The degree of vertical integration, i.e. the combining of different stages of

production and distribution, managed by a single firm.
8. The level of product and service differentiation, i.e. how the company’s
offerings differ from the other company’s offerings.
9. The customer turnover, i.e. the number of customers willing to change their
choice with respect to the goods and services at the time of adverse market
conditions.

Thus, the structure of the market affects how firm price and supply their
goods and services, how they handle the exit and entry barriers, and how
efficiently a firm carry out its business operations.

 Perfect Competition
 Meaning of Perfect Competition:

The Perfect Competition is a market structure where a large number of

buyers and sellers are present, and all are engaged in the buying and selling of
the homogeneous products at a single price prevailing in the market.

In other words, perfect competition also referred to as a pure competition,

exists when there is no direct competition between the rivals and all sell
identically the same products at a single price.

 Features of Perfect Competition

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1. Large number of buyers and sellers:

In perfect competition, the buyers and sellers are large enough, that no
individual can influence the price and the output of the industry. An individual
customer cannot influence the price of the product, as he is too small in
relation to the whole market. Similarly, a single seller cannot influence the
levels of output, who is too small in relation to the gamut of sellers operating
in the market.

2. Homogeneous Product:

Each competing firm offers the homogeneous product, such that no individual
has a preference for a particular seller over the others. Salt, wheat, coal, etc.
are some of the homogeneous products for which customers are indifferent
and buy these from the one who charges a less price. Thus, an increase in the
price would let the customer go to some other supplier.

3. Free Entry and Exit:

Under the perfect competition, the firms are free to enter or exit the industry.
This implies, If a firm suffers from a huge loss due to the intense competition
in the industry, then it is free to leave that industry and begin its business
operations in any of the industry, it wants. Thus, there is no restriction on the
mobility of sellers.

4. Perfect knowledge of prices and technology:

This implies, that both the buyers and sellers have complete knowledge of the
market conditions such as the prices of products and the latest technology
being used to produce it. Hence, they can buy or sell the products anywhere
and anytime they want.

5. No transportation cost:

There is an absence of transportation cost, i.e. incurred in carrying the goods

from one market to another. This is an essential condition of the perfect
competition since the homogeneous product should have the same price
across the market and if the transportation cost is added to it, then the prices
may differ.

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6. Absence of Government and Artificial Restrictions:

Under the perfect competition, both the buyers and sellers are free to buy and
sell the goods and services. This means any customer can buy from any seller,
and any seller can sell to any buyer.Thus, no restriction is imposed on either
party. Also, the prices are liable to change freely as per the demand-supply
conditions. In such a situation, no big producer and the government can
intervene and control the demand, supply or price of the goods and services.

Thus, under the perfect competition, a seller is the price taker and cannot
influence the market price.

 Assumptions:
The model of perfect competition is based on the following assumptions.

1. Large numbers of sellers and buyers:

The industry or market includes a large number of firms (and buyers), so that
each individual firm, however large, supplies only a small part of the total
quantity offered in the market. The buyers are also numerous so that no
monopolistic power can affect the working of the market. Under these
conditions each firm alone cannot affect the price in the market by changing
its output.

2. Product homogeneity:
The industry is defined as a group of firms producing a homogeneous product.
The technical characteristics of the product as well as the services associated
with its sale and delivery are identical. There is no way in which a buyer could
differentiate among the products of different firms. If the product were
differentiated the firm would have some discretion in setting its price. This is
ruled out ex hypothesis in perfect competition.

The assumptions of large numbers of sellers and of product homogeneity

imply that the individual firm in pure competition is a price-taker: its demand
curve is infinitely elastic, indicating that the firm can sell any amount of
output at the prevailing market price (figure 5.1). The demand curve of the
individual firm is also its average revenue and its marginal revenue curve (see
page 156).

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3. Free entry and exit of firms:

There is no barrier to entry or exit from the industry. Entry or exit may take
time, but firms have freedom of movement in and out of the industry. This
assumption is supplementary to the assumption of large numbers. If barriers
exist the number of firms in the industry may be reduced so that each one of
them may acquire power to affect the price in the market.

4. Profit maximization:
The goal of all firms is profit maximization. No other goals are pursued.

5. No government regulation:
There is no government intervention in the market (tariffs, subsidies,
rationing of production or demand and so on are ruled out). The above
assumptions are sufficient for the firm to be a price-taker and have an
infinitely elastic demand curve. The market structure in which the above
assumptions are fulfilled is called pure competition. It is different from perfect
competition, which requires the fulfillment of the following additional
assumptions.

6. Perfect mobility of factors of production:

The factors of production are free to move from one firm to another
throughout the economy. It is also assumed that workers can move between
different jobs, which implies that skills can be learned easily. Finally, raw
materials and other factors are not monopolized and labour is not unionized.
In short, there is perfect competition in the markets of factors of production.

7. Perfect knowledge:
It is assumed that all sellers and buyers have complete knowledge of the
conditions of the market. This knowledge refers not only to the prevailing
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conditions in the current period but in all future periods as well. Information
is free and costless. Under these conditions uncertainty about future
developments in the market is ruled out. Under the above assumptions we
will examine the equilibrium of the firm and the industry in the short run and
in the long run.

 Monopoly Market
Definition: The Monopoly is a market structure characterized by a single
seller, selling the unique product with the restriction for a new firm to enter
the market. Simply, monopoly is a form of market where there is a single
seller selling a particular commodity for which there are no close substitutes.

 Features of Monopoly Market

1. Under monopoly, the firm has full control over the supply of a product. The
elasticity of demand is zero for the products.
2. There is a single seller or a producer of a particular product, and there is no
difference between the firm and the industry. The firm is itself an industry.
3. The firms can influence the price of a product and hence, these are price
makers, not the price takers.
4. There are barriers for the new entrants.
5. The demand curve under monopoly market is downward sloping, which
means the firm can earn more profits only by increasing the sales which are
possible by decreasing the price of a product.

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6. There are no close substitutes for a monopolist’s product.

Under a monopoly market, new firms cannot enter the market freely due to
any of the reasons such as Government license and regulations, huge capital
requirement, complex technology and economies of scale. These economic
barriers restrict the entry of new firms.

 Advantages of monopoly

1. Monopoly avoids duplication and hence avoids wastage of resources. (We

have to understand that duplicate and fake products are a real problem in
many countries).
2. A monopoly enjoys economies of scale as it is the only supplier of product
or service in the market. The benefits can be passed on to the consumers.
3. Due to the fact that monopolies make lots of profits, it can be used for
research and development and to maintain their status as a monopoly.
4. Monopolies may use price discrimination which benefits the economically
weaker sections of the society.
5. Monopolies can afford to invest in latest technology and machinery in order
to be efficient and to avoid competition.
6. Source of revenue for the government- the government gets revenue in
form of taxation from monopoly firms.

 Disadvantages of monopoly

1. Poor level of service.

2. No consumer sovereignty. A monopoly market is best known for consumer
exploitation. There are indeed no competing products and as a result the
consumer gets a raw deal in terms of quantity, quality and pricing.
3. Consumers may be charged high prices for low quality of goods and
services.
4. Lack of competition may lead to low quality and out dated goods and
services.

 Monopolistic Competition
Definition: Under, the Monopolistic Competition, there are a large number
of firms that produce differentiated products which are close substitutes for
each other. In other words, large sellers selling the products that are similar,
but not identical and compete with each other on other factors besides price.

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 Features of Monopolistic Competition

1. Product Differentiation: This is one of the major features of the firms

operating under the monopolistic competition, that produces the product
which is not identical but is slightly different from each other. The products
being slightly different from each other remain close substitutes of each other
and hence cannot be priced very differently from each other.
2. Large number of firms: A large number of firms operate under the
monopolistic competition, and there is a stiff competition between the existing
firms. Unlike the perfect competition, the firms produce the differentiated
products which are substitutes for each other, thus make the competition
among the firms a real and a tough one.
3. Free Entry and Exit: With an intense competition among the firms, the entity
incurring the loss can move out of the industry at any time it wants. Similarly,
the new firms can enter into the industry freely, provided it comes up with the
unique feature and different variety of products to outstand in the market and
meet with the competition already existing in the industry.

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4. Some control over price: Since, the products are close substitutes for each
other, if a firm lowers the price of its product, then the customers of other
products will switch over to it. Conversely, with the increase in the price of the
product, it will lose its customers to others. Thus, under the monopolistic
competition, an individual firm is not a price taker but has some influence
over the price of its product.
5. Heavy expenditure on Advertisement and other Selling Costs: Under the
monopolistic competition, the firms incur a huge cost on advertisements and
other selling costs to promote the sale of their products. Since the products
are different and are close substitutes for each other; the firms need to
undertake the promotional activities to capture a larger market share.
6. Product Variation: Under the monopolistic competition, there is a variation
in the products offered by several firms. To meet the needs of the customers,
each firm tries to adjust its product accordingly. The changes could be in the
form of new design, better quality, new packages or container, better
materials, etc. Thus, the amount of product a firm is selling in the market
depends on the uniqueness of its product and the extent to which it differs
from the other products.

The monopolistic competition is also called as imperfect

competition because this market structure lies between the pure monopoly
and the pure competition.

Diagram monopolistic competition short run

In
the short run, the diagram for monopolistic competition is the same as for a
monopoly.

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The firm maximises profit where MR=MC. This is at output Q1 and price P1,
leading to supernormal profit

Monopolistic competition long run

Demand curve shifts to the left due to new firms entering the market.

In the long-run, supernormal profit encourages new firms to enter. This

reduces demand for existing firms and leads to normal profit. I

Efficiency of firms in monopolistic competition

 Allocative inefficient. The above diagrams show a price set above marginal
cost
 Productive inefficiency. The above diagram shows a firm not producing on the
lowest point of AC curve
 Dynamic efficiency. This is possible as firms have profit to invest in research
and development.
 X-efficiency. This is possible as the firm does face competitive pressures to cut
cost and provide better products.

 Examples of monopolistic competition

 Restaurants – restaurants compete on quality of food as much as price.

Product differentiation is a key element of the business. There are relatively
low barriers to entry in setting up a new restaurant.
 Hairdressers. A service which will give firms a reputation for the quality of
their hair-cutting.

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 Clothing. Designer label clothes are about the brand and product
differentiation
 TV programmes – globalisation has increased the diversity of tv programmes
from networks around the world. Consumers can choose between domestic
channels but also imports from other countries and new services, such as
Netflix.

 Limitations of the model of monopolistic competition

 Some firms will be better at brand differentiation and therefore, in the real
world, they will be able to make supernormal profit.
 New firms will not be seen as a close substitute.
 There is considerable overlap with oligopoly – except the model of
monopolistic competition assumes no barriers to entry. In the real world,
there are likely to be at least some barriers to entry
 If a firm has strong brand loyalty and product differentiation – this itself
becomes a barrier to entry. A new firm can’t easily capture the brand loyalty.
 Many industries, we may describe as monopolistically competitive are very
profitable, so the assumption of normal profits is too simplistic.

 Merits of Monopolistic Competition:

1. An important merit of monopolistic competition is that it is much closer to

reality than several other models of market structure. Firstly, it incorporates
the facts of product differentiation and selling costs. Secondly, it can be easily
used for the analysis of duopoly and oligopoly.

2. Under monopolistic competition it is possible to see that even when each

individual firm produces under conditions of increasing returns, not only the
firm under consideration but also the entire group of firms can be in
equilibrium.

3. Moreover, monopolistic competition is able to show that even when each

individual firm is producing under increasing returns, it still earns only
normal profit in the long run.

4. The theory of monopolistic competition helps us in bringing in the concept

of market share of an individual firm. This opens up the possibility of
considering those situations in which a firm may be pursuing a goal other than
profit maximization.
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5. In monopolistic competition we are able to consider the interaction

between several interdependent variables on the basis of which a firm takes
its decisions.

 Demerits of Monopolistic Competition:

1. The biggest conceptual difficulty with monopolistic competition is the

concept of age group of firms. There is no standard theoretical foundation for
deciding the boundaries of a group.

2. Related with the concept of a group of firms, we face the difficulty of

defining the meaning of a ‘close substitute’. We are not told at what values of
cross elasticity, two products become close substitutes of each other.

3. The theory of monopolistic competition fails to take into account the fact
that the demand by final consumers is largely influenced by the retail dealers
because the consumers themselves are not fully aware of the technical
qualities of the product.

4. Similarly, the theory fails to fully account for the determination of

equilibrium quantities and prices of goods like raw materials and other
inputs. To a large extent, their demand is governed by a combination of the
technical quality, price and timely availability rather than by brand name, etc.
Given the technical quality of an input, its demand is governed more by its
price and availability than its brand name

 Oligopoly Market:
Definition: The Oligopoly Market characterized by few sellers, selling the
homogeneous or differentiated products. In other words, the Oligopoly
market structure lies between the pure monopoly and monopolistic
competition, where few sellers dominate the market and have control over
the price of the product.

 Under the Oligopoly market, a firm either produces:

 Homogeneous product: The firms producing the homogeneous products

are called as Pure or Perfect Oligopoly. It is found in the producers of
industrial products such as aluminum, copper, steel, zinc, iron, etc.

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 Heterogeneous Product: The firms producing the heterogeneous products

are called as Imperfect or Differentiated Oligopoly. Such type of Oligopoly is
found in the producers of consumer goods such as automobiles, soaps,
detergents, television, refrigerators, etc.

 Features of Oligopoly Market

1. Few Sellers:

Under the Oligopoly market, the sellers are few, and the customers are many.
Few firms dominating the market enjoys a considerable control over the price
of the product

2. Interdependence:

it is one of the most important features of an Oligopoly market, wherein, the

seller has to be cautious with respect to any action taken by the competing
firms. Since there are few sellers in the market, if any firm makes the change
in the price or promotional scheme, all other firms in the industry have to
comply with it, to remain in the competition.

Thus, every firm remains alert to the actions of others and plan their
counterattack beforehand, to escape the turmoil. Hence, there is a complete
interdependence among the sellers with respect to their price-output policies.

3. Advertising:

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Under Oligopoly market, every firm advertises their products on a frequent

basis, with the intention to reach more and more customers and increase their
customer base.This is due to the advertising that makes the competition
intense.

If any firm does a lot of advertisement while the other remained silent, then
he will observe that his customers are going to that firm who is continuously
promoting its product. Thus, in order to be in the race, each firm spends lots of
money on advertisement activities.

4. Competition:

It is genuine that with a few players in the market, there will be an intense
competition among the sellers. Any move taken by the firm will have a
considerable impact on its rivals. Thus, every seller keeps an eye over its rival
and be ready with the counterattack.

5. Entry and Exit Barriers:

The firms can easily exit the industry whenever it wants, but has to face
certain barriers to entering into it. These barriers could be Government
license, Patent, large firm’s economies of scale, high capital requirement,
complex technology, etc. Also, sometimes the government regulations favor
the existing large firms, thereby acting as a barrier for the new entrants.

6. Lack of Uniformity:

There is a lack of uniformity among the firms in terms of their size, some are
big, and some are small.

Since there are less number of firms, any action taken by one firm has a
considerable effect on the other. Thus, every firm must keep a close eye on its
counterpart and plan the promotional activities accordingly.

 Types of Oligopoly Market

Definition: The Oligopoly is a market structure wherein few sellers dominate
the market and sell the homogeneous or heterogeneous products.

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1. Open Vs Closed Oligopoly: This classification is made on the basis of

freedom to enter into the new industry. An open Oligopoly is the market
situation wherein firm can enter into the industry any time it wants, whereas,
in the case of a closed Oligopoly, there are certain restrictions that act as a
barrier for a new firm to enter into the industry.

2. Partial Vs Full Oligopoly: This classification is done on the basis of price

leadership. The partial Oligopoly refers to the market situation, wherein one
large firm dominates the market and is looked upon as a price leader.

Whereas in full Oligopoly, the price leadership is conspicuous by its absence.

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3. Perfect (Pure) Vs Imperfect (Differential) Oligopoly: This classification is

made on the basis of product differentiation. The Oligopoly is perfect or pure
when the firms deal in the homogeneous products. Whereas the Oligopoly is
said to be imperfect, when the firms deal in heterogeneous products, i.e.
products that are close but are not perfect substitutes.

4. Syndicated Vs Organized Oligopoly: This classification is done on the basis of

a degree of coordination found among the firms. When the firms come together
and sell their products with the common interest is called as a Syndicate
Oligopoly. Whereas, in the case of an Organized Oligopoly, the firms have a
central association for fixing the prices, outputs, and quotas.

5. Collusive Vs Non-Collusive Oligopoly: This classification is made on the basis

of agreement or understanding between the firms. In Collusive Oligopoly,
instead of competing with each other, the firms come together and with the
consensus of all fixes the price and the outputs. Whereas in the case of a non-
collusive Oligopoly, there is a lack of understanding among the firms and they
compete against each other to achieve their respective targets.

Thus, oligopoly market is a market structure that lies between the monopolistic
competition and a pure monopoly.

 List of Advantages of Oligopoly

1. It offers simple choices.

With only a few businesses offering products or services, it will be easy for
consumers to compare and choose the best option for their needs. In other
types of market, it can be very challenging to thoroughly look into all the
things offered by a huge group of companies and then compare prices.

2. It generates high profits.

Because there is only little competition in oligopoly, the businesses involved
in it enjoy the benefit of bringing in huge amounts of profits. Generally, the
products and services controlled through this type of market are highly
needed by a large majority of consumers.

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3. It offers better information, products and services.

Along with fair price competition, competition among products also plays a
huge role in this market structure, where every business would scramble to
come out with best and latest items to attract consumers. The same goes to
the amount of information, advertising and support offered to consumers.

4. It creates competitive prices.

As already implied, the ability to easily compare prices coerces business to
keep their prices in competition with their competitors. This is a great perk
for consumers, as prices could continually go down.

 List of Disadvantages of Oligopoly

1. It offers fewer choices.

In many cases, choosing the best brand in an oligopoly is like going for the
least evil. This means that consumers would have very limited options for the
products or services they are looking for.

2. It makes it difficult for smaller entities to establish a spot in the

market.
For smaller enterprises and creatives, their outlook for business in this type of
market is grim, as only the extremely advanced and large companies have
complete control over market. This makes it nearly impossible for smaller and
new entities to break into the market.

3. It eliminates motivation to compete.

Generally, companies in oligopoly become very settled with their ventures, as
their operations and profits are guaranteed. This means that they would no
longer feel the necessity to create new innovative ideas.

4. Its fixed prices can be bad for consumers.

While competitive prices are good, they are rarely far apart from those of
other companies they could go with, as businesses agree to fix prices, where
there is a set limit for how low prices could go.

Given the nature of an oligopoly form of market and the size of the businesses
that participates in it, it definitely has some benefits and drawbacks. By
weighing down the pros and cons listed above, you will be able to come up
with a well-informed opinion whether it is good to engage in or not.
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 The Sweezy Model of Kinked Demand Curve (Rigid Prices) (Non-

Collusive Oligopoly):
In his article published in 1939, Prof. Sweezy presented the kinked demand
curve analysis to explain price rigidities often observed in oligopolistic
markets. Sweezy assumes that if the oligopolistic firm lowers its price, its
rivals will react by matching that price cut in order to avoid losing their
customers.

Thus the firm lowering the price will not be able to increase its demand much.
This portion of its demand curve is relatively inelastic.

On the other hand, if the oligopolistic firm increases its price, its rivals will not
follow it and change their prices. Thus the quantity demanded of this firm will
fall considerably. This portion of the demand curve is relatively elastic. In
these two situations, the demand curve of the oligopolistic firm has a kink at
the prevailing market price which explains price rigidity.

 Its Assumptions:
The kinked demand curve hypothesis of price rigidity is based on the
following assumptions:
(1) There are few firms in the oligopolistic industry.

(2) The product produced by one firm is a close substitute for the other firms.

(3) The product is of the same quality. There is no product differentiation.

(4) There are no advertising expenditures.

(5) There is an established or prevailing market price for the product at which
all the sellers are satisfied.

(6) Each seller’s attitude depends on the attitude of his rivals.

(7) Any attempt on the part of a seller to push up his sales by reducing the
price of his product will be counteracted by other sellers who will follow his
move.

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(8) If he raises the price, others will not follow him; rather they will stick to
the prevailing price and cater to the customers, leaving the price-raising
seller.

(9) The marginal cost curve passes through the dotted portion of the marginal
revenue curve so that changes in marginal cost do not affect output and price.

The Model:
Given these assumptions, the price-output relationship in the oligopolist
market is explained in Figure 5 where KPD is the kinked demand curve and
OPo the prevailing price in the oligopoly market for the OR product of one
seller. Starting from point P, corresponding to the current price OP o, any
increase in price above it, will considerably reduce his sales, for his rivals are
not expected to follow his price increase.

This is so because the KP portion of the kinked demand curve is elastic, and
the corresponding portion KA of the MR curve is positive. Therefore, any price
– increase will not only reduce his total sales but also his total revenue and
profit.

On the other hand if the seller reduces the price of the product below OPo (or
P) his rivals will also reduce their prices. Though he will increase his sales, his
profit would be less than before. The reason is that the PD portion of the
kinked demand curve below P is less elastic and the corresponding part of
marginal revenue curve below R is negative.

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Thus in both the price-raising and price-reducing situations the seller will be a
loser. He would stick to the prevailing market price OP o which remains rigid.
In order to study the working of the kinked demand curve, let us analyse the
effect of changes in cost and demand conditions on price stability in the
oligopolistic market.

 Changes in Costs:

In oligopoly under the kinked demand curve analysis, changes in costs within
a certain range do not affect the prevailing price. Suppose the cost of
production falls so that the new MC curve is MC 1 to the right, as in Figure 6.
It cuts the MR curve in the gap AB so that the profit- maximising output is OR
which can be sold at OPo price. It should be noted that with any cost reduction
the new MC curve will always cut the MR curve in the gap because as costs fall
the gap AB continues to widen due to two reasons:

As costs fall, the upper portion KP of the demand curve becomes more elastic
because of the greater certainty that a price rise by one seller will not be
followed by rivals and his sales would be considerably reduced.

With the reduction in costs the lower portion PD of the kinked curve becomes
more inelastic, because of the greater certainty that a price reduction by one
seller will be followed by the other rivals.

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Thus the angle KPD tends to be a right angle at P and the gap AB widens so
that any AC curve below point A will cut the marginal revenue curve inside the
gap. The net result is the same output OR at the same price OPo and large
profits for the oligopolistic sellers.

In case the cost of production rises the marginal cost curve will shift to the left
of the old curve MC as MC2. So long as the higher MC curve intersects the MR
curve within the gap up to point A, the price situation will be rigid.

However, with the rise in costs the price is not likely to remain stable
indefinitely and if the Ml curve rises above point A, it will intersect the MC
curve in the portion KA so that a lesser quantity is sold at a higher price.

We may conclude that there may be price stability under oligopoly even when
costs change so long as the MC curve cuts the MR curve in its discontinuous
portion. However, chances of the existence of price-rigidity are greater where
there is a reduction in costs than there is a rise in costs.
 Changes in Demand:
 We now explain price rigidity where there is a change in demand with
the help of Figure 7, D2 is the original demand curve, MR2 is its
corresponding marginal revenue curve and MC is the marginal cost
curve. Suppose there is a decrease in demand shown by D1 curve and
MR1 is its marginal revenue curve.
 When demand decreases, a price-reduction move by one seller will be
followed by other rivals. This will make LD1 the lower portion of the
new demand curve, more inelastic than the lower portion HD2 of the old
demand curve.

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This will tend to make the angle at L approach a right angle. As a result, the
gap EF in MR1 curve is likely to be wider than the gap AB of the MR 2 curve. The
marginal cost curve MC will, therefore, intersect the lower marginal revenue
curve MR1 inside the gap EF, thus indicating a stable price for the oligopolistic
industry.
Since the level of the kinks H and L of the two demand curves remains the
same, the same price OP is maintained after the decrease in demand. But the
output level falls from OQ2 to OQ1. This case can be reversed to show increase
in demand by taking D1 and MR1 as the original demand and marginal revenue
curves and D2 and MR2 as the higher demand and marginal revenue curves
respectively.
The price OP is maintained but the output rises from OQ 1 to OQ. So long as the
MC curve continues to intersect the MR curve in the discontinuous portion,
there will be price rigidity.
However, if demand increases, it may lead to a higher price. When demand
increases, a seller would like to raise the price of the product and others are
expected to follow him. This will tend to make the upper portion MH of the
new demand curve elastic than the NL portion of the old curve.

Thus the angle at H becomes obtuse, away from the right angle. The gap AB in
the MR2 curve becomes smaller and the MC curve intersects the MR 2 curve
above the gap, indicating a higher price and lower output. If, however, the
marginal cost curve passes through the gap of MR2, there is price stability.

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Conclusion:
The whole analysis of the kinked demand curve points out that price rigidity
in oligopolistic markets is likely to prevail if there is a price reduction move on
the part of all sellers. Changes in costs and demand also lead to price stability
under normal conditions so long as the MC curve intersects the MR curve in its
discontinuous portion.

But price increase rather than price rigidity may be found in response to
rising cost or increased demand.

 Reasons for Price Stability:

There are a number of reasons for price rigidity in certain oligopoly
markets.
(1) Individual sellers in an oligopolistic industry might have learnt through
experience the futility of price wars and thus prefer price stability.

(2) They may be content with the current prices, outputs and profits and
avoid any involvement in unnecessary insecurity and uncertainty.

(3) They may also prefer to stick to the present price level to prevent new
firms from entering the industry.

(4) The sellers may intensify their sales promotion efforts at the current price
instead of reducing it. They may view non-price competition better than price
rivalry.

(5) After spending a lot of money on advertising his product, a seller may not
like to raise its price to deprive himself of the fruits of his hard labour.
Naturally, he would stick to the going price of the product.

(6) If a stable price has been set through agreement or collusion, no seller
would like to disturb it, for fear of unleashing a price war and thus engulfing
himself into an era of uncertainty and insecurity.

(7) It is the kinked demand curve analysis which is responsible for price
rigidity in oligopolistic markets.

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 Its Shortcomings:
But the theory of kinked demand curve in oligopoly pricing is not without
shortcomings.

(1) Even if we accept all its assumptions it is not likely that the gap in the
marginal revenue curve will be wide enough for the marginal cost curve to
pass through it. It may be shortened even under conditions of fall in demand
or costs, thereby making price unstable.

(2) One of its major shortcomings, according to Professor Stigler, is that “the
theory does not explain why prices that have once changed should settle
down, again acquire stability, and gradually produce a new kink.” For
instance in Figure 6 the kink occurs at P because OP o is the prevailing price.
But the theory does not explain the forces that established the initial price
OPo.

(3) Price stability may be illusory because it is not based on the actual market
behaviour. Sales do not always occur at list prices. There are often deviations
from posted prices because of trade-ins, allowances and secret price
concessions. The oligopolistic seller may outwardly keep the price stable but
he may reduce the quality or quantity of the product. Thus price stability
becomes illusory.

(4) Moreover, it is not possible to statistically compile actual sales prices in

the case of many products that may reflect stable prices for them. It is,
therefore, doubtful that price stability actually exists in oligopoly.

(5) Critics point out that the kinked demand curve analysis holds during the
short-run, when the knowledge about the reactions of rivals is low. But it is
difficult to guess correctly the rivals’ reactions in the long-run. Thus the
theory is not applicable in the long-run.

(6) According to some economists, the kinked demand curve analysis applies
to an oligopolistic industry in its initial stages or to that industry in which new
and previously unknown rivals enter the market.

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(7) The kinked demand curve analysis is based on two assumptions: first,
other firms will follow a price cut and, second, they will not follow a price rise.
Stigler has shown on empirical evidence that in an inflationary period the rise
in output prices is not confined only to one firm but is industry-wide. So all
firms having similar costs will follow one another in raising price.

(8) Economists have concluded from this that the kinked demand curve
analysis is applicable only under depression. For in an inflationary period
when demand increases, the oligopolistic firm will raise price and other firms
will also follow it.

In such a situation, the demand curve of the oligopolist will have an inverted
kink. This reverse kink is based on his expectation that all his competitors will
follow him when he raises the price of his product, but none will follow a price
cut because of inflationary condition.

This is illustrated in Figure where KPD is the reverse kinked demand curve. Its
corresponding marginal revenue curve is KABM which is composed of KA and
BM, and the AB portion is its gap. The curve MC passes through all the three
portions of this curve at L, E and H respectively.

The areas ALE and ВНЕ are of uncertainty. Whether the firm decides to
continue production at L, E and H depends on the balance of gain and loss. A
movement from L to E results in a loss because MC>MR. A movement from E
to H results in a gain because MR>MC. If the firm raises the price to Q 1P1 and

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lowers the output to OQ1 and moves from E to L, it would reduce the loss. If it
lowers the price to Q2P2, and raises the output to OQ2 and moves from E to H,
it would increase the gain. The firm would move to the larger area of gain.
Thus there would be no price rigidity.
(9) Stigler’s empirical evidence further shows that cases in oligopoly
industries where the number of sellers is either very small or somewhat large,
the kinked demand curve is not likely to be there. Thus the empirical evidence
does not support the existence of a kink.

“However”, as pointed out by Professor Baumol, “the analysis does show

how the oligopolistic firm’s view of competitive reaction patterns can
affect the changeability of whatever price it happens to be charging.”

 ROLE OF MACROECONOMIC ANALYSIS IN FORMULATION OF

BUSINESS POLICIES & DECISION MAKING
Macro economics helps the business in in-depth knowledge of macro economic
environment of business relating to industrial policy, licensing policy, economic
planning monetary and fiscal framework and overall economic policy. The role of
macro economics in business policy formulation is being discussed in the
following points:

1. Macro economic policy:- Macro economics helps in formulation of economic

policy. The subjects of an economic policy are monetary policy, fiscal policy,
incomes policies and policy on balance of payment. Economic policy should be
such that it promotes the business environment and provides impetus to
business activities.

2. Economic planning:- A serious attempt towards self sustained growth of

business is only possible by efficient planning. Planning is now a days
synonymous with growth and development. Identification of priority areas,
estimation of resources and coordination among various sectors of economy can
be done through proper planning. Planning directs the growth in desirable
corners.

3. Solving macro paradoxes:- Macro economics helps in solving macro

paradoxes like paradox of thrift related to savings, paradox of assumption by

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commercial banks that all depositors would not withdraw their money on any
particular day and their right to withdrawal.

4. Tracing effect of government policy on business:- Macro economics helps

in tracing the implications of government policy changes on existing business
activity.

5. Help in solving problem of general unemployment:- Effective demand is

the focal point of macro economics. Reduction in effective demand brings
economic depression and thereby general unemployment. Hence, the level of
effective demand should be increased in order to increase the level of
employment.

6. Analysis of trade cycles:- Macro economics tries to know about the behavior
and occurrence of booms and slumps and their implication on business activity.
This analysis is very useful for a free enterprise economy. Business cycles are
bound to occur. Macro economics helps the business in facing booms and slumps
so that negative impact is minimized.

7. Macro analysis helps in development of micro analysis:- In the deductive

method process of logic goes from general to particular. We go on deducting to
draw specific conclusions. Many of micro economic conclusions are outcome of
macro conclusion. The assumption that consumer is rational has been decided
only after knowing about the behavior of a group. A medico is allowed to
specialize in some part of human body from surgical view point only when he has
understood the anatomy and physiology of human body.

8. Inability of micro economics to study some areas:- Micro economics is not

able to study monetary problems, fiscal problems, financial sector problems,
foreign exchange regulation problems and inflationary and recessionary
situations problems. Business needs to be protected from these ticklish problems
and therefore, needs the help of macro economics.

9. Macro economic models:- Macro economics helps in building or constructing

macro economic models. The major objective function of a macro economic
model is to maintain the macro equilibrium in the country at the full employment
level. The role of government through its monetary and fiscal operations becomes
important as independent variables i.e. these policies are used to explain the
dependent variable i.e. maintaining macro equilibrium.

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ECONOMICS SYSTEM

 MEANING OF ECONOMIC SYSTEM

An economic system is a mechanism with the help of which the government plans
and allocates accessible services, resources and commodities across the country.
Economic systems manage elements of production, combining wealth, labour,
physical resources and business people. An economic system incorporates many
companies, agencies, objects, models, as well as for deciding procedures.

 TYPES OF ECONOMIC SYSTEMS

1. Capitalist Economy- In a capitalist system, the products manufactured are

divided among people not according to what people want but on the basis of
Purchasing Power—which is the ability to buy products and services. This means
an individual needs to have the money with him to buy the goods and services.
The Low-cost housing for the underprivileged is much required but will not
include as demand in the market because the needy do not have the buying power
to back the demand. Therefore, the commodity will not be manufactured and
provided as per market forces.

2. Socialist Economy- This economy system acknowledges the three inquiries in

a different way. In a socialist society, the government determines what products
are to be manufactured in accordance with the requirements of society. It is
believed that the government understands what is appropriate for the citizen of
the country, therefore, the passions of individual buyers are not given much
attention. The government concludes how products are to be created and how
the product should be disposed of. In principle, sharing under socialism is
assumed to be based on what an individual needs and not what they can buy. A
socialist system does not have a separate estate because everything is controlled
by the government.

3. Mixed Economic – Mixed systems have characteristics of both the command

and market economic systems. For this purpose, the mixed economic systems are
also called dual economic systems. However, there is no sincere method to
determine a mixed system. Sometimes, the word represents a market system
beneath the strict administrative control in certain sections of the economy.

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 ECONOMIC SECTOR

The economic sector is divided into three economic sectors

1. Primary Sector: It is that sector which relies on the environment for any
production or manufacturing. A few examples of the primary sector are mining,
farming, agriculture, fishing, etc.

2. Secondary Sector: In this sector, the raw material is transferred to a valuable

product. A few examples are construction industries and manufacturing of steel,
etc.

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3. Tertiary Sector: It is also known as Service Sector, and includes production

and exchange of services. A few examples are banking, insurance, transportation,
communication, etc.

 DIFFERENCE BETWEEN CAPITALIST, SOCIALIST & MIXED ECONOMY

Basis Capitalist Economy Socialist Economy Mixed Economy

Ownership of Private ownership Public ownership Both public and private

Property ownership

Price Prices are determined Prices are Prices are determined by

Determination by the market forces of determined by the central planning authority
demand and supply central planning and demand and supply.
authority.

Motive of Profit motive Social welfare The profit motive in the

Production private sector and welfare
motive in the public sector.

Role of No role Complete role Full role in the public

Government sector and limited role in
the private sector

Competition Exists No competition Exist only in the private

sector

Distribution of Very Unequal Quite Equal Considerable inequalities

income exist.

NATIONAL INCOME

National Income is total amount of goods and services produced within the
nation during the given period say, 1 year. It is the total of factor income i.e.
wages, interest, rent, profit, received by factors of production i.e. labour, capital,
land and entrepreneurship of a nation.

Definitions of National Income:

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The definitions of national income can be grouped into two classes: One, the
traditional definitions advanced by Marshall, Pigou and Fisher; and two,
modern definitions.

I. Traditional Definitions

1. The Marshallian Definition:

According to Marshall: “The labour and capital of a country acting on its

natural resources produce annually a certain net aggregate of commodities,
material and immaterial including services of all kinds. This is the true net
annual income or revenue of the country or national dividend.”

In this definition, the word ‘net’ refers to deductions from the gross national
income in respect of depreciation and wearing out of machines. And to this,
must be added income from abroad.

It’s Defects:

Though the definition advanced by Marshall is simple and comprehensive, yet

it suffers from a number of limitations. First, in the present day world, so varied
and numerous are the goods and services produced that it is very difficult to
have a correct estimation of them.

Consequently, the national income cannot be calculated correctly. Second, there

always exists the fear of the mistake of double counting, and hence the national
income cannot be correctly estimated. Double counting means that a particular
commodity or service like raw material or labour, etc. might get included in the
national income twice or more than twice.

For example, a peasant sells wheat worth Rs.2000 to a flour mill which sells
wheat flour to the wholesaler and the wholesaler sells it to the retailer who, in
turn, sells it to the customers. If each time, this wheat or its flour is taken into
consideration, it will work out to Rs.8000, whereas, in actuality, there is only an
increase of Rs.2000 in the national income.

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Third, it is again not possible to have a correct estimation of national income

because many of the commodities produced are not marketed and the producer
either keeps the produce for self-consumption or exchanges it for other
commodities. It generally happens in an agriculture- oriented country like
India. Thus the volume of national income is underestimated.

2. The Pigouvian Definition:

A.C. Pigou has in his definition of national income included that income which
can be measured in terms of money.

In the words of Pigou, “National income is that part of objective income of the
community, including of course income derived from abroad which can be
measured in money.”

This definition is better than the Marshallian definition. It has proved to be

more practical also. While calculating the national income now-a- days,
estimates are prepared in accordance with the two criteria laid down in this
definition.

First, avoiding double counting, the goods and services which can be measured
in money are included in national income.

Second, income received on account of investment in foreign countries is

included in national income.

It’s Defects:

The Pigouvian definition is precise, simple and practical but it is not free from
criticism. First, in the light of the definition put forth by Pigou, we have to
unnecessarily differentiate between commodities which can and which cannot
be exchanged for money.

But, in actuality, there is no difference in the fundamental forms of such

commodities, no matter they can be exchanged for money. Second, according to
this definition when only such commodities as can be exchanged for money are
included in estimation of national income, the national income cannot be
correctly measured.

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According to Pigou, a woman’s services as a nurse would be included in

national income but excluded when she worked in the home to look after her
children because she did not receive any salary for it. Similarly, Pigou is of the
view that if a man marries his lady secretary, the national income diminishes as
he has no longer to pay for her services.

Thus the Pigovian definition gives rise to a number of paradoxes. Third, the
Pigovian definition is applicable only to the developed countries where goods
and services are exchanged for money in the market.

According to this definition, in the backward and underdeveloped countries of

the world, where a major portion of the produce is simply bartered, correct
estimate of national income will not be possible, because it will always work
out less than the real level of income. Thus the definition advanced by Pigou has
a limited scope.

3. Fisher’s Definition:

Fisher adopted ‘consumption’ as the criterion of national income whereas

Marshall and Pigou regarded it to be production. According to Fisher, “The
National dividend or income consists solely of services as received by ultimate
consumers, whether from their material or from the human environments.
Thus, a piano, or an overcoat made for me this year is not a part of this year’s
income, but an addition to the capital. Only the services rendered to me during
this year by these things are income.”

Fisher’s definition is considered to be better than that of Marshall or Pigou,

because Fisher’s definition provides an adequate concept of economic welfare
which is dependent on consumption and consumption represents our standard
of living.

It’s Defects:

But from the practical point of view, this definition is less useful, because there
are certain difficulties in measuring the goods and services in terms of money.
First, it is more difficult to estimate the money value of net consumption than
that of net production.

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In one country there are several individuals who consume a particular good and
that too at different places and, therefore, it is very difficult to estimate their
total consumption in terms of money. Second, certain consumption goods are
durable and last for many years.

If we consider the example of piano or overcoat, as given by Fisher, only the

services rendered for use during one year by them will be included in income.
If an overcoat costs Rs. 100 and lasts for ten years, Fisher will take into account
only Rs. 100 as national income during one year, whereas Marshall and Pigou
will include Rs. 100 in the national income for the year, when it is made.

Besides, it cannot be said with certainty that the overcoat will last only for ten
years. It may last longer or for a shorter period. Third, the durable goods
generally keep changing hands leading to a change in their ownership and value
too.

It, therefore, becomes difficult to measure in money the service-value of these

goods from the point of view of consumption. For instance, the owner of a
Maruti car sells it at a price higher than its real price and the purchaser
after using it for a number of years further sells it at its actual price.

Now the question is as to which of its price, whether actual or black market one,
should we take into account, and afterwards when it is transferred from one
person to another, which of its value according to its average age should be
included in national income?

But the definitions advanced by Marshall, Pigou and Fisher are not altogether
flawless. However, the Marshallian and Pigovian definitions tell us of the
reasons influencing economic welfare, whereas Fisher’s definition helps us
compare economic welfare in different years.

II Modern Definitions:

From the modern point of view,

1. Simon Kuznets has defined national income as “the net output of

commodities and services flowing during the year from the country’s
productive system in the hands of the ultimate consumers.”
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On the other hand, in one of the reports of United Nations, national income has
been defined on the basis of the systems of estimating national income, as net
national product, as addition to the shares of different factors, and as net
national expenditure in a country in a year’s time. In practice, while estimating
national income, any of these three definitions may be adopted, because the
same national income would be derived, if different items were correctly
included in the estimate.

 Assumption of National Income

This basic model of national income (GDP) determination is based on the

following assumptions.

1. The economy has only two sectors, viz., households and business enterprises.
The households spend money on consumption and the business enterprises on
investment.

2. There is no government or the government does not interfere in the economy

in any manner. It neither imposes taxes, nor does it spend money on subsidies
consumption or investment.

3. The country has a closed economy. It neither exports, nor imports goods
services and thus has no economic relationship with the rest of the world.

4. Prices of all goods produced in the economy and all inputs used in production
are fixed.

5. The economy has excess capacity, i.e., all the production units are producing
less than their capacity output. Hence there are no constraints on expansion of
output.

6. In this model of GDP determination, we are dealing with a short period of

time short run here means that a deviation of actual GDP from the potential
GDP and the consequent excess capacity, unemployment and recessionary
trends, etc., are likely to be maintained during this time span as the time period
is not sufficient for the operation of the automatic adjustment mechanism to
restore equilibrium at the potential GDP level.

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 Concepts of National Income

There are various concepts of National Income, such as GDP, GNP, NNP, NI, PI,
DI, and PCI which explain the facts of economic activities.

1. GDP at market price: Is money value of all goods and services produced
within the domestic domain with the available resources during a year.
GDP = (PXQ)

Where,GDP = gross domestic product

P = Price of goods and services

Q= Quantity of goods and services

GDP is made up of 4 Components

a) Consumption
b) Investment
c) Government Expenditure
d) Net Foreign Exports Of A Country
GD=C+I+G+(X-M)

Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

2.Gross National Product (GNP): Is market value of final goods and services
produced in a year by the residents of the country within the domestic territory
as well as abroad. GNP is the value of goods and services that the country's
citizens produce regardless of their location.
GNP=GDP+NFIA or,

GNP=C+I+G+(X-M) +NFIA

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Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

NFIA= Net factor income from abroad.

3.Net National Product (NNP) at MP: Is market value of net output

of final goods and services produced by an economy during a year and net
factor income from abroad.
NNP=GNP-Depreciation

or, NNP=C+I+G+(X-M) +NFIA- IT-Depreciation

Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

NFIA= Net factor income from abroad.

IT= Indirect Taxes

4.National Income (NI): Is also known as National Income at factor cost which
means total income earned by resources for their contribution of land, labour,
capital and organisational ability. Hence, the sum of the income received
by factors of production in the form of rent, wages, interest and profit is called
National Income.
Symbolically, NI=NNP +Subsidies-Interest Taxes
or, GNP-Depreciation +Subsidies-Indirect Taxes
or, NI=C+G+I+(X-M) +NFIA-Depreciation-Indirect Taxes +Subsidies

5.Personal Income (PI): Is the total money income received by individuals

and households of a country from all possible sources before direct taxes.
Therefore, personal income can be expressed as follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-
Social Security Contribution +Transfer Payments.
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6.Disposable Income (DI) : It is the income left with the individuals after the
payment of direct taxes from personal income. It is the actual income left for
disposal or that can be spent for consumption by individuals.
Thus, it can be expressed as:

DI=PI-Direct Taxes

7.Per Capita Income (PCI): Is calculated by dividing the national income of

the country by the total population of a country.
Thus, PCI=Total National Income/Total National Population

 What Are The Factors That Affect National Income?

Several factors affect the national income of a country. Some of them have been
listed below:
1. Factors of Production:- Normally, the more efficient and richer the
resources, higher will be the level of National Income or GNP
(a) Land:- Resources like coal, iron and timber are essential for heavy
industries so that they must be available and accessible. In other words, the
geographical location of these natural resources affects the level of GNP.
(b) Capital:- Capital is generally determined by investment. Investment in turn
depends on other factors like profitability, political stability etc.
(c) Labour:- The quality or productivity of human resources is more important
than quantity. Manpower planning and education affect the productivity and
production capacity of an economy.
(d) Entrepreneur
(e) Technology:-This factor is more important for Nations with fewer natural
resources. The development in technology is affected by the level of invention
and innovation in production.
(f) Government:- Government can help to provide a favourable business
environment for investment. It provides law and order, regulations.

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(g) Political Stability:- A stable economy and political system helps in

appropriate allocation of resources. Wars, strikes and social unrests will
discourage investment and business activities.
 Methods of National Income Calculation
There are three approaches and methods of measuring National Income:
A. Income Method:- By this National Income is calculated compiling income of
factors of production viz., land, labour, capital and entrepreneur.
National Income = Total Wage + Total Rent + Total Interest + Total Profit
In Indian context, since 1993 as per the System of National Accounts (SNA),
National Income is total of the following:
GDP = Compensation of Employees + Consumption of Fixed Capital +
(Other Taxes on Production – Subsidies of Production) + Gross
Operating Surplus

(i) Compensation of employees: (Wage) salaries paid in cash and kind and
other benefits provided to employees.
(ii) Consumption of Fixed Capital: wear and tear of machinery which are
replaced by new parts.
(iii) Other Taxes on Production minus Subsidies: Net tax on production.

There is a difference between tax on products and tax on production. Tax on

products includes taxes like sales tax and excise duty. Tax on production is tax
imposed irrespective of production like license fees and land tax.

Gross Operating Surplus: balance of value added after deducting the above
three components. It goes to pay rent of land and interest of capital.

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B. Product Method (or Value Added Method, Output Method):- It is used by

economists to calculate GDP at market prices, which are the total values of
outputs produced at different stages of production.
Some of the goods and services included in production are:
(i) Goods and services actually sold in the market.
(ii) Goods and services not sold but supplied free of cost. (No
Charge/Complementary)
Some of the goods and services not included in production are:
(i)Second hand items and purchase and sale of the same. Sale and purchase of
second cars, for example, are not a part of GDP calculation as no new production
takes place in the economy.
(ii)Production due to unwarranted/ illegal activities.
(iii) Non-economic goods or natural goods such as air and water.
(iv) Transfer Payments such as scholarships, pensions etc. are excluded as
there is income received, but no good or service is produced in return.
(v) Imputed rental for owner-occupied housing is also excluded.
(vi) Here the Gross Value of final goods and services produced in a country in
certain year is calculated.
(vii) GDP is a concept of value added; it is the sum of gross value added of all
resident producer units (institutional sectors, or industries) plus that part of
taxes (total) less subsidies, on products which is not included in the valuation
of output.
Gross Value Added = Output of Final Goods and Services – Intermediate
Consumption
National Income = Gross Value Added + Indirect Taxes – Subsidies
C. Expenditure Method:- It measures all spending on currently-produced final
goods and services only in an economy.
In an economy, there are three main agencies which buy goods and services:
Households, Firms and the Government.

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This final expenditure is made up of the sum of 4 expenditure items, namely;

(i) Consumption (C): Personal Consumption made by households, the
payment of which is paid by households directly to the firms which produced
the goods and services desired by the households.
(ii) Investment Expenditure (I): Investment is an addition to capital stock of
an economy in a given time period. This includes investments by firms as well
as governments sectors.
(iii) Government Expenditure (G): This category includes the value of goods
and service purchased by Government. Government expenditure on pension
schemes, scholarships, unemployment allowances etc. are not included in this
as all of them come under transfer payments.
(iv) Net Exports (X-IM): Expenditures on foreign made products (Imports) are
expenditure that escapes the system, and must be subtracted from total
expenditures. In turn, goods produced by domestic firms which are demanded
by foreign economies involve expenditure by other economies on our
production (Exports), and are included in total expenditure. The combination
of the two gives us Net Exports.
National Income = Consumption (C) + Investment Expenditure (I) +
Government Expenditure (G) + Net Exports (X-IM)
Calculating GDP (National Income) is extremely important as the performance
of the economy is fixed by means of this method. The results would help the
country to forecast the economic progress, determine the demand and supply,
understand the buying power of the people, the per capita income, the position
of the economy in the global arena. The Indian GDP is calculated by the
expenditure method.
 Main uses of national income.
1. Since income is a flow of wealth changes in the national income give some
indication of economic welfare.

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2. National income is used to compare standards of living in different countries.

3. National income figures are used to measure the rate of growth of a country.
4. The national income accounts make it possible for an analysis of the
behaviour of the different sectors of the economy.
5. Inflationary and deflationary pressures can be estimated with the help of
national income statistics.
6 National income statistics can be used to forecast the level of business activity
at later date, and to find out trends in other annual data.
7. The national income figures are useful in providing a correct sense of
proportion about the structure of the economy.
8. In war time, the study of components of national income is of great
importance because they show the maximum possible production possibilities
of the country.
9. National income statistics can be used to determine how an international
financial burden should be an apportioned between different countries. The
quantum of national income measures the ability of a country to pay
contributions for international purposes, just as the income of a person
measures his ability to pay for the upkeep of his country.
10. Above all the national income statistics are used for planned economic
development of a country. In the absence of such data, planning will not be
possible.
 Importance Of National Income
1. For the Economy:- National income data are of great importance for the
economy of a country. These days the national income data are regarded as
accounts of the economy, which are known as social accounts.
2. National Policies:-National income data form the basis of national policies
such as employment policy because these figures enable us to know the

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direction in which the industrial output, investment and savings’ etc. change,
and proper measures can be adopted to bring the economy to the right path.
3. Economic Planning:- In the present age of planning, the national data are of
great importance. For economic planning, it is essential that the data pertaining
to a country’s gross income, output, saving and consumption from different
sources should be available.
Without these, planning is not possible. Similarly, the economists propound
short-run as well long-run economic models or long-run investment models in
which the national income data are very widely used.
4. Economic Models:- Economists build short-run and long-run economic
models in which the national income data are widely used.
5. For Research:-The national income data are also made use of by the
research scholars of economics, they make use of the various data of the
country’s input, output, income, saving, consumption, investment employment,
etc., which are obtained from social accounts.
6. Per-Capita Income:- National income data are significant for a country’s per
capita income which reflects the economic welfare of the country. The higher
the per capita income, the higher the economic welfare and vice versa.
7. Distribution of Income:- National income statistics enable us to know
about the distribution of income in the country. From the data pertaining to
wages, rent, interest and profits we learn of the disparities in the incomes of
different sections of the society.
Similarly, the regional distribution of income is revealed it is only on the basis
of these that the government can adopt measures to remove the inequalities in
income distribution and to restore regional equilibrium. With a view to
removing these personal and regional disequilibria, the decisions to levy more
taxes and increase public expenditure also rest on national income statistics.
 Difficulties or Limitations in the Measurement of National Income

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The following points highlight the eight major difficulties in the measurement
of national income.
1. Prevalence of Non-Monetized Transactions:-There are certain
transactions in India in which a considerable part of output does not come into
the market at all.
For example:-Agriculture in which a major part of output is consumed at the
farm level itself. The national income statistician, therefore, has to face the
problem of finding a suitable measure for this part of output.
2. Illiteracy:-The majority of people in India are illiterate and they do not keep
any accounts about the production and sales of their products. Under the
circumstances the estimates of production and earned incomes are simply
guess work.
3. Occupational Specialisation is Still Incomplete and Lacking:-There is the
lack of occupational specialisation in our country which makes the calculation
of national income by product method difficult. Besides the crop, farmers are
also engaged is supplementary occupations like—dairying, poultry, cloth-
making etc. But income from such productive activities is not included in the
national income estimates.
4. Lack of Availability of Adequate Statistical Data:-Adequate and correct
produc-tion and cost data are not available in our country. For estimating
national income data on unearned incomes and on persons employed in the
service are not available. Moreover data on consumption and investment
expenditures of the rural and urban population are not available for the
estimation of national income. Moreover, there is no machinery for the
collection of data in the country.
5. Value of Inventory Changes:-The value of all inventory changes (i.e.,
changes in stock etc.) which may be either positive or negative are added or
subtracted from the current production of the firm. Remember, if in the change

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in inventories and not total inventories for the year that are taken into account
in national income estimates.
6. The Calculation of Depreciation:-The calculation of depreciation on
capital consumption presents another formidable difficulty. There are no
accepted standard rates of depreciation applicable to the various categories of
machine. Unless from the gross national income correct deductions are made
for depreciation the estimate of net national income is bound to go wrong.
7. Difficulty of Avoiding the Double Counting System:- The very important
difficulty which a calculator has to face in measurement is the difficulty of
avoiding double counting.
For example:-If the value of the output of sugar and sugar cane are counted
separately, the value of the sugarcane utilised in the manufacture of sugar will
have been counted twice, which is not proper. This must be avoided for a
correct measurement.
8. Difficulty of Expenditure Method:- The application of expenditure method
in the calculation of national income has become a difficult task and it is full of
difficulties. Because in this method it is difficult to estimate all personal as well
as investment expenditures.
MULTIPLIER

 Introduction:

The concept of multiplier was first developed by R.F. Kahn in his article “The
Relation of Home Investment to Unemployment” in the Economic Journal of
June 1931. Kahn’s multiplier was the Employment Multiplier. Keynes took the
idea from Kahn and formulated the Investment Multiplier.

 CONCEPT OF MULTIPLIER

1. The Investment Multiplier:-Keynes considers his theory of multiplier as an

integral part of his theory of employment. The multiplier, according to Keynes,
“establishes a precise relationship, given the propensity to consume, between

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aggregate employment and income and the rate of investment. It tells us that,
when there is an increment of investment, income will increase by an amount
which is K times the increment of investment” i.e., ∆Y=K∆I.

In the words of Hansen, Keynes’ investment multiplier is the coefficient relating

to an increment of investment to an increment of income, i.e., K=∆Y/∆I, where
Y is income, I is investment, ∆ is change (increment or decrement) and K is the
multiplier.

In the multiplier theory, the important element is the multiplier coefficient, K

which refers to the power by which any initial investment expenditure is
multiplied to obtain a final increase in income. The value of the multiplier is
determined by the marginal propensity to consume. The higher the marginal
propensity to consume, the higher is the value of the multiplier, and vice versa.

 Assumptions of Multiplier:

Keynes’s theory of the multiplier works under certain assumptions which limit
the operation of the multiplier. They are as follows:

(1) There is change in autonomous investment and that induced investment is

absent.

(2) The marginal propensity to consume is constant.

(3) Consumption is a function of current income.

(4) There are no time lags in the multiplier process. An increase (decrease) in
investment instantaneously leads to a multiple increase (decrease) in income.

(5) The new level of investment is maintained steadily for the completion of the
multiplier process.

(6) There is net increase in investment.

(7) Consumer goods are available in response to effective demand for them.

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(8) There is surplus capacity in consumer goods industries to meet the

increased demand for consumer goods in response to a rise in income following
increased investment.

(9) Other resources of production are also easily available within the economy.

(10) There is an industrialised economy in which the multiplier process

operates.

(11) There is a closed economy unaffected by foreign influences.

(12) There are no changes in prices.

(13) The accelerator effect of consumption on investment is ignored.

(14) There is less than full employment level in the economy.

 Leakages of Multiplier:

Leakages are the potential diversions from the income stream which tend to
weaken the multiplier effect of new investment. Given the marginal propensity
to consume, the increase in income in each round declines due to leakages in
the income stream and ultimately the process of income propagation “peters
out.”

The following are the important leakages:

1. Saving:-Saving is the most important leakage of the multiplier process. Since

the marginal propensity to consume is less than one, the whole increment in
income is not spent on consumption. A part of it is saved which peters out of
the income stream and the increase in income in the next round declines.

Thus the higher the marginal propensity to save, the smaller the size of the
multiplier and the greater the amount of leakage out of the income stream, and
vice versa. For instance, if MPS = 1/6, the multiplier is 6, according to the
formula K = 1/MPS; and the MPS of 1/3 gives a multiplier of 3.

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2. Strong Liquidity Preference:- If people prefer to hoard the increased

income in the form of idle cash balances to satisfy a strong liquidity preference
for the transaction, precautionary and speculative motives, that will act as a
leakage out of the income stream. As income increases people will hoard money
in inactive bank deposits and the multiplier process is checked.

3. Purchase of Old Stocks and Securities:-If a part of the increased income is

used in buying old stocks and securities instead of consumer goods, the
consumption expenditure will fall and its cumulative effect on income will be
less than before. In other words, the size of the multiplier will fall with a fall in
consumption expenditure when people buy old stocks and shares.

4. Debt Cancellation:-If a part of increased income is used to repay debts to

banks, instead of spending it for further consumption, that part of the income
peters out of the income stream. In case, this part of the increased income is
repaid to other reditors who save or hoard it, the multiplier process will be
arrested.

5. Price Inflation:-When increased investment leads to price inflation, the

multiplier effect of increased income may be dissipated on higher prices. A rise
in the prices of consumption goods implies increased expenditure on them. As
a result, increased income is absorbed by higher prices and the real
consumption and income fall. Thus price inflation is an important leakage
which tends to dissipate increase in income and consumption on higher prices
rather than in increasing output and employment.

6. Net Imports:- If increased income is spent on the purchase of imported

goods it acts as a leakage out of the domestic income stream. Such expenditure
fails to effect the consumption of domestic goods. This argument can be
extended to net imports when there is an excess of imports over exports
thereby causing a net outflow of funds to other countries.

7. Undistributed Profits:-If profits accruing to joint stock companies are not

distributed to the shareholders in the form of dividend but are kept in the
reserve fund, it is a leakage from the income stream. Undistributed profits with
the companies tend to reduce the income and hence further expenditure on
consumption goods thereby weakening the multiplier process.

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8. Taxation:-Taxation policy is also an important factor in weakening the

multiplier process. Progressive taxes have the effect of lowering the disposable
income of the taxpayers and reducing their consumption expenditure. Similarly
commodity taxation tends to raise the prices of goods, and a part of increased
income may be dissipated on higher prices. Thus increased taxation reduces the
income stream and lowers the size of the multiplier.

9. Excess Stocks of Consumption Goods:- If the increased demand for

consumption goods is met from the existing excess stocks of consumption
goods there will be no further increase in output, employment and income and
the multiplier process will come to a halt till the old stocks are exhausted.

10. Public Investment Programmes:-If the increase in income as a result of

increased investment is affected by public expenditures, it may fail to induce
private enterprise to spend that income for further investment due to the
following reasons.

(a) Public investment programmes may raise the demand for labour and
materials leading to a rise in the costs of construction so as to make the
undertaking of some private projects unprofitable.

(b) Government borrowing may, if not accompanied by a sufficiently liberal

credit policy on the part of the monetary authority, increase the rate of interest
and thus discourage private investment.

(c) Government operations may also injure private investors’ confidence by

arousing animosity or fears of nationalisation.

 Criticism of Multiplier

The multiplier theory has been severely criticised by the post-Keynesian

economists on the following grounds:

1. Merely Tautological Concept:- Prof. Haberler has criticised Keynes’

multiplier as tautological. It is a truism which defines the multiplier as
necessarily true as K = 1/1 – ∆C/∆Y. pointed by Professor Hansen, “Such a
coefficient is a mere arithmetic multiplied i.e., a truism) and not a true
behaviour multiplier based on a behaviour pattern which establishes a
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verifiable relation between consumption and income. A mere arithmetic

multiplier, 1/1 – ∆C/∆Y is tautological.”

2. Timeless Analysis:-Keynes’s logical theory of the multiplier is an

instantaneous process without time lag. It is a timeless static equilibrium
analysis in which the total effect of a change in investment on income is
instantaneous so that consumption goods are produced simultaneously and
consumption expenditure is also incurred instantaneously.

But this is not borne out by facts because a time lag is always involved between
the receipt of income and its expenditure on consumption goods and also in
producing consumption goods. Thus “the timeless multiplier analysis
disregards the transition and deals only with the new equilibrium income level”
and is therefore unrealistic.

3. Worthless Theoretical Toy:-According to Hazlitt, the Keynesian multiplier

“is a strange concept about which some Keynesians make more fuss than about
anything else in the Keynesian system.” It is a myth for there can never by any
precise, pre-determinable or mechanical relationship between investment and
income. Thus he regards it as “a worthless theoretical toy.”

4. Acceleration Effect Ignored:-One of the weaknesses of the multiplier

theory is that it studies the effects of investment on income through changes in
consumption expenditure. But it ignores the effect of consumption on
investment which is known as the acceleration principle. Hicks, Samuelson and
others have shown that it is the interaction of the multiplier and the accelerator
which helps in controlling business fluctuations.

5. MPC does not Remain Constant:- Gordon points out that the greatest
weakness of the multiplier concept is its exclusive emphasis on consumption.
He favours the use of the term ‘marginal propensity to spend’ in place of
marginal propensity to consume to make this concept more realistic.

He also objects to the constancy of the marginal propensity to spend (or

consume) because in a dynamic economy, it is not likely to remain constant. If
it is assumed to be constant, it is not possible “to predict with much accuracy

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the multiplying effects over the cycle of a given increase in private investment
or public spending.”

6. Relation between Consumption and Income:- Keynes’s multiplier theory

establishes a linear relation between consumption and income with the
hypothesis that the MPC is less than one and greater than zero. Empirical
studies of the behaviour of consumption in relation to income show that the
relationship between the two is complicated and non-linear.

As pointed out by Gardner Ackley, “The relationship does not run simply from
current income to current consumption, but rather involves some complex
average of past and expected income and consumption. There are other factors
than income to consider.”

Other economists have not been lagging behind in their criticism of the
multiplier concept. Prof. Hart considers it “a useless fifth wheel.” To Stigler, it is
the fuzziest part of Keynes’s theory. Prof. Hutt calls it a “rubbish apparatus”
which should be expunged from text books.

But despite its scathing criticism, the multiplier principle has considerable
practical applicability to economic problems as given below.

 Importance of Multiplier:

The concept of multiplier is one of the important contributions of Keynes’s to

the income and employment theory. As aptly observed by Richard Goodwin
“Lord Keynes did not discover the multiplier; that honour goes to Mr. R.F. Kahn.
But he gave it the role it plays today by transforming it from an instrument for
the analysis of road building into one for the analysis of income building….It set
a fresh wind blowing through the structure of economic thought.”

Its importance lies in the following:

1. Investment:- The multiplier theory highlights the importance of investment

in income and employment theory. Since the consumption function is stable
during the short-run fluctuations in income and employment are due to
fluctuations in the rate of investment.

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A fall in investment leads to a cumulative decline in income and employment

by the multiplier process and vice versa. Thus it underlines the importance of
investment and explains the process of income propagation.

2. Trade Cycle:-As a corollary to the above, when there are fluctuations in the
level of income and employment due to variations in the rate of investment, the
multiplier process throws a spotlight on the different phases of the trade cycle.

When there is a fall in investment, income and employment decline in a

cumulative manner leading to recession and ultimately to depression. On the
contrary, an increase in investment leads to revival and, if this process
continues, to a boom. Thus the multiplier is regarded as an indispensable tool
in trade cycles.

3. Saving-Investment Equality:-It also helps in bringing the equality between

saving and investment. If there is a divergence between saving and investment,
and increase in investment leads to a rise in income via the multiplier process
by more than the increase in initial investment. As a result of the increase in
income, saving also increases and equals investment.

4. Formulation of Economic Policies:-The multiplier is an important tool in

the hands of modern states in formulating economic policies. Thus this
principle pre-supposes state intervention in economic affairs.

(a) To achieve full employment:- The state decides upon the amount of
investment to be injected into the economy to remove unemployment and
achieve full employment. An initial increase in investment leads to the rise in
income and employment by the multiplier time the increase in investment. If a
single dose of investment is insufficient to bring full employment, the state can
inject regular doses of investment for this purpose till the full employment level
is reached.

(b) To control trade cycles:-The state can control booms and depressions in
a trade cycle on the basis of the multiplier effect on income and employment.
When the economy is experiencing inflationary pressures, the state can control
them by a reduction in investment which leads to a cumulative decline in
income and employment via the multiplier process. On the other hand, in a

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deflationary situation, an increase in investment can help increase the level of

income and employment through the multiplier process.

(c) Deficit financing:-The multiplier principle highlights the importance of

deficit budgeting. In a state of depression, cheap money policy of lowering the
rate of interest is not helpful because the marginal efficiency of capital is so low
that a low rate of interest fails to encourage private investment.

In such a situation, increased public expenditure through public investment

programmes by creating a budget deficit helps in increasing income and
employment by multiplier time the increase in investment.

(d) Public investment:-The above discussion reveals the importance of the

multiplier in public investment policy. Public investment refers to the state
expenditure on public works and other works meant to increase public welfare.
It is autonomous and is free from profit motive.
It, therefore, applies with greater force in overcoming inflationary and
deflationary pressures in the economy, and in achieving and maintaining full
employment. Private investment being induced by profit motive can help only
when the public investment has created a favourable situation for the former.

Moreover, economic activity cannot be left to the vagaries and uncertainties of

private enterprise. Hence, the importance of multiplier in public investment lies
in creating or controlling income and employment. The state can have the
greatest multiplier effect on income and employment by increasing public
investment during a depression where the MPC is high (or the MPS is low).

On the contrary, in periods of overfull employment, a decline in investment will

have a serious effect on the levels of income and employment where the MPS is
high (or MPC is low). The best policy is to reduce investment where the MPC is
low (or MPS is high), to have gradual decline in income and employment.

The important thing, however, is the timing of public investment in such a

manner that the multiplier is able to work with full force and there is little scope
for the income stream to peter out. Moreover, public investment should not
supplant but supplement private investment so that it could be increased

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during depression and reduced during inflation. As a result, the forward and
backward operation of the multiplier will help in the two situations.

5. The Dynamic or Period Multiplier:- Keynes’s logical theory of the

multiplier is an instantaneous process without time lags. It is a timeless static
equilibrium analysis in which the total effect of a change in investment on
income is instantaneous so that consumption goods are produced
simultaneously and consumption expenditure is also incurred instantaneously.

But this is not borne out by facts because a time lag is always involved between
the receipt of income and its expenditure on consumption goods and also in
producing consumption goods. Thus “the timeless multiplier analysis
disregards the transition and deals only with the new equilibrium income level”
and is, therefore, unrealistic.

The dynamic multiplier relates to the time lags in the process of income
generation. The series of adjustments in income and consumption may take
months or even years for the multiplier process to complete, depending upon
the assumption made about the period involved.

 Foreign Trade Multiplier

The foreign trade multiplier, also known as the export multiplier, operates like
the investment multiplier of Keynes. It may be defined as the amount by which
the national income of a country will be raised by a unit increase in domestic
investment on exports.

As exports increase, there is an increase in the income of all persons associated

with export industries. These, in turn, create demand for goods. But this is
dependent upon their marginal propensity to save (MPS) and the marginal
propensity to import (MPM). The smaller these two marginal propensities are,
the larger will be the value of the multiplier, and vice versa.

It’s working:

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The foreign trade multiplier process can be explained like this. Suppose the
exports of the country increase. To begin with, the exporters will sell their
products to foreign countries and receive more income. In order to meet the
foreign demand, they will engage more factors of production to produce more.

This will raise the income of the owners of factors of production. This process
will continue and the national income increases by the value of the multiplier.
The value of the multiplier depends on the value of MPS and MPM, there being
an inverse relation between the two propensities and the export multiplier.

The foreign trade multiplier can be derived algebraically as follows:

The national income identity in an open economy is Y = C + I + X – M

Where

Y is national income,

C is national consumption,

I is total investment,

X is exports and

M is imports.

The above relationship can be solved as:

Y-C = 1 + X-M

or S = I+X-M (S=Y-C)

S+M=I+X

Thus at equilibrium levels of income the sum of savings and imports (S+M)
must equal the sum of investment and export (1+X).

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In an open economy the investment component (I) is divided into domestic

investment (Id) and foreign investment (If)

I=S

Id + If = S… (1)

Foreign investment (If) is the difference between exports and imports of goods
and services.

If =X-M…. (2)

Substituting (2) into (1), we have

ld+ X-M – S

or Id + X = S+M

Which is the equilibrium condition of national income in an open economy. The

foreign trade multiplier coefficient (Kf) is equal to

Kf = ∆Y/∆X

And ∆X = ∆S + ∆M

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It shows that an increase in exports by Rs. 1000 crores has raised national
income through the foreign trade multiplier by Rs. 2000 crores, given the values
of MPS and MPM.

 Assumptions foreign trade multiplier

The foreign trade multiplier is based on the following assumptions:

1. There is full employment in the domestic economy.

2. There is direct link between domestic and foreign country in exporting and
importing goods.

3. The country is small with no foreign repercussion effects.

4. It is on a fixed exchange rate system.

5. The multiplier is based on instantaneous process without time lags.

6. There is no accelerator.

7. There are no tariff barriers and exchange controls.

8. Domestic investment (Id) remains constant.

9. Government expenditure is constant.

10. The analysis is applicable to only two countries.

 Implications of Foreign Repercussion:

The following are the implications of foreign repercussion effects:

1. The foreign repercussion effects suggest a mechanism for the transmission

of income disturbances between trading countries. If a country is small, it will
be affected by change in income of other countries that will alter the demand
for its exports. But it will not be able to transmit its own income disturbances
to the latter.

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If a country is large, it may transmit its own income disturbances to other

countries and, in turn, be affected by income disturbances in them. It implies
that a boom or slump in one country has repercussion on the incomes of other
countries. Thus swings in business cycles are likely to be internationally
contagious, as happened in the 1930s and 2008.

2. The repercussion effects also suggest that since the backwash effects
ultimately peter out, automatic income changes cannot eliminate completely
the current account BOP deficit or surplus produced by an automatic
disturbance.

3. The policy implications of the backwash effects suggest that export

promotion policies raise national income in the trading partners at a lower rate
than by an increase in domestic investment. The export promotion measures
raise national income via the simple foreign trade multiplier, whereas increase
in domestic investment policies raise national income many times in multiplier
rounds via the repercussion effects.

 Criticisms of Foreign Trade Multiplier:

The two models of the foreign trade multiplier presented above are based on
certain assumptions which make the analysis unrealistic.

1. Exports and Investment not Independent:-The analysis of simple foreign

trade multiplier is based on the assumption that exports and investment (both
domestic and foreign) are independent of changes in the level of national
income. But, in reality, this is not so. A rise in exports does not always lead to
increase in national income. On the contrary, certain imports, of say capital
goods, have the effect of increasing national income.

2. Legless Analysis:- The foreign trade multiplier is assumed to be an

instantaneous process whereby it provides the final results. Thus it involves no
lags and is unrealistic.

3. Full Employment not Realistic:-The analysis is based on the assumption of

a fully employed economy. But there is less than full employment in every
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economy. Thus the foreign trade multiplier does not find clear expression in an
economy with less than full employment.

4. Not Applicable to More than two Countries:-The whole analysis is

applicable to a two-country model. If there are more than two countries, it
becomes complicated to analyse and interpret the foreign repercussions of this
theory.

5. Neglects Trade Restrictions:-The foreign trade multiplier assumes that

there are no tariff barriers and exchange controls. In reality, such trade
restrictions exist which restrict the operations of the foreign trade multiplier.

6. Neglects Monetary-Fiscal Measures:-This analysis is based on the

unrealistic assumption that the government expenditure is constant. But
governments always interfere through monetary and fiscal policies which
affect exports, imports and national income. Despite these shortcomings, the
foreign trade multiplier is a powerful tool of economic analysis which helps in
formulating policy measures.

INFLATION

 Meaning of Inflation
The aggregate demand increases due to expenditure by the households, firms
and government (usually excessive spending by the government). This increase
in demand due to expenditure by either government or households can be
effectively controlled by fiscal measures. Thus, fiscal policy and budgetary
measures are the effective weapons to control demand-pull inflation.

In case, government expenditure is the main cause behind the demand-pull

inflation, then it can be controlled by cutting down the public expenditure. With
a cut in public expenditure, the government demand for goods and services

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decreases along with a decrease in the private income and consumption

expenditure. In case, the demand rises due to the rise in private
expenditure, taxing income is the most appropriate way to control inflation.
The taxation on private income reduces the disposable income in hand, as a
result of which the consumption expenditure also reduces. This results in the
reduction in aggregate demand.

In case of a very high persistent inflation rate, the government may adopt both
these measures simultaneously to control inflation. Such as along with the
reduction in public expenditure the rate of taxation shall be raised on the
private income to keep the demand under control. This kind of policy of using
both the measures simultaneously is called as “ Policy of Surplus
Budgeting,” which says that “government should spend less than the tax
revenue.”

 Characteristics Of Inflation

1. Inflation is always associated with a rise in prices which is continuous and

persistent. It should be distinguished from price rise which may occur
temporarily or during a cyclical upswing.

2. Inflation is a dynamic process which can be observed over the long period.

3. Inflation is basically an economic phenomenon. It originates within the

economic system and is fostered by interaction of economic forces.

4. Excess of demand over the available supply is the hall mark of inflation. It is
a condition of economic disequilibrium.

5. Inflation is generally considered a monetary phenomenon for it is normally

characterized by an excessive money supply. Though all increases in the stock
of money may not be inflationary yet a persistent rise in prices cannot be
sustained unless the quantity of money rises as well.

6. Inflation may be caused by ‘demand-pull’ factors or ‘cost push’ factors or both

working together.

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7. Inflation is always cumulative in the sense that a mild inflation in the first
instance gathers momentum leading to rapid price rises. Its effects on an
economy depends on how rapid it is.

 Types of Inflation

1. Creeping Inflation:-‘Creeping inflation occurs when there is a sustained rise

in prices over time at a mild rate, say around 2 to 3 percent per year. It is also
known as ‘mild inflation’. This type of inflation is not much of a problem.
It is generally known as conducive to economic progress and growth. In this
form the prices rise gradually over a long period.

2. Walking or Trotting Inflation:-When the rate of rise in inflation is of

international range of 3 to 8 percent per annum, it is called walking or trotting
inflation. It is an alarming signal for the government to control it before it
worsens.

3. Running Inflation:-When the sustained rise in prices is over 8 percent and

generally around 10 percent per annum, it is called running inflation. It
normally shows two-digit inflation. Running inflation is a warning signal
indicating the need for controlling it. It affects the poor and middle class people
adversely.

4. Hyper or Galloping Inflation:- Hyperinflation occurs when monthly

increase in prices is 20 percent to 30 percent or more. At this stage there is no
limit to price rise, and price rise goes out of control. Money becomes almost
worthless causing severe hardship to people. There is complete collapse of
currency, the monetary system collapses and the economic and political life
gets disrupted.

5. Open Inflation:-Inflation become open when there is no barrier to price rise.

It occurs in the economy where there are no control and checks on price rise.
Rising prices by large magnitude is the symptom of open inflation.

6. Suppressed Inflation:-Suppressed inflation refers to a situation when there

exists inflationary pressures in the economy but prices are controlled by
certain administrative measures, such as price-control and rationing. The
increase in prices are suppressed (or repressed) here. However, prices rise by
large magnitude after the price controls are removed.
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The symptoms of suppressed inflation are long queues of buyers at government

controlled ration shops and the existence of excess demand and black- markets.
The controls ensued by the government on the prices of essential commodities
in times of war is an example of suppressed inflation.

 Theories of Inflation

The theories of inflation try to explain the causes of inflation and can be studied
from the perspective of:

1. Demand-pull Inflation
Definition: The Demand-pull Inflation occurs when, for a given level of
aggregate supply, the aggregate demand increases substantially. In other
words, demand-pull inflation exists when the aggregate demand increases
rapidly than the aggregate supply.

The increase in aggregate demand may be due to:

(i) Monetary Factors, i.e., an increase in the supply of money

(ii) Real Factors, i.e., an increase in the demand for real output

(i) Demand-pull Inflation due to Monetary factors: The increase in money

supply more than the increase in potential output is one of the major reasons
for demand-pull inflation. Let’s see how the money supplies causes the
demand-pull inflation. At a given level of output, when the monetary and real
sectors are in equilibrium, then the economy is also in equilibrium. Since the
economy is in general equilibrium, the general price level corresponding to it is
called as equilibrium price level.

With an increase in the money supply, the other things remaining the same, the
real stock of money at each price level increases. As a result, the interest rate
decreases and the people’s desire to hold money increases. With a decrease in
the interest rates, the investment also increases, which leads to more income.

The increase in income causes an increase in the consumption expenditure and

thus, a rise in investment and consumption expenditure increases the
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aggregate demand and aggregate supply, other things remaining the same.
This increase in the aggregate demand is exactly proportional to the increase
in the money stock. Thus, a rise in aggregate demand, for a given level of
aggregate supply, leads to an increase in the general price level in the economy,
which may be inflated.

(ii) Demand-pull Inflation due to Real Factors: The following are some of the
real factors that cause demand-pull inflation in the economy:

I. Increase in government expenditure without any change in the tax

revenue.
II. Cut in the tax rates without any change in the government expenditure.
III. Upward shift in the Investment Function
IV. Downward shift in the Saving Function
V. Upward shift in the Export Function
VI. Downward shift in the Import Function.
The first four factors directly contribute towards an increase in the level of
disposable income. Since the aggregate demand being the function of income,
an increase in aggregate income leads to an increase in the aggregate demand,
thereby causing the demand-pull inflation. Let’s see how real factors cause
demand-pull inflation.

Suppose, the government increases its spending financed through external

borrowings from abroad. The rise in government expenditure generates
additional demand and thus, the aggregate demand increases. Since it is
assumed that there is full employment, then the additional resources can be
acquired only by bidding a higher price. As a result, the prices rise while the
output remains unchanged.

Thus, the transaction of demand for money increases and in order to meet the
increased demand for money people sell their financial assets such as bonds
and securities. Eventually, the prices of bonds and securities go down and the
rate of interest increases. In the product market, the price rises to such a level
that the additional spending by the government is absorbed by such price rise.
This shows that the real factors also cause inflation.

II. Cost-push Inflation

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Definition: The Cost-Push Inflation occurs when the price rise due to the
increase in the price of factors of production, Viz. Labor, raw materials, and
other inputs which are essential for the final production of a product. As a
result, the aggregate supply decreases, demand remaining the same, an
increase in the price of commodities leads to an overall increase in the general
price level.

Often, the cost-push inflation is caused by the monopolistic groups in the

society such as labor unions and firms operating in monopolistic and
oligopolistic market setting. The following are the major kinds of cost-push
inflation:

1. Wage-push Inflation: The Strong labor unions force the money wages to go
up, due to which the price increases. This kind of rise in the general price level
is called as wage-push inflation. The powerful and well-organized labor unions
exercise their monopoly power and compel their employers to increase their
wages above the competitive level irrespective of their productivity (output).

An increase in wage money brings a corresponding increase in the cost of

production and this increase in the cost of production causes an aggregate
supply curve to shift backward (aggregate supply decreases). A backward shift
in the aggregate supply causes the prices level to go up. It is to be noted that
every time a rise in the wage money is not considered to be inflationary. The
following conditions supplement this:

I. Increase in wage rate due to an increase in the productivity.

II. Rise in wage rate due to inflation caused by other factors.
III. Rise in wage where the unionized wage bill is very small.
IV. Wage rises due to the shortage of labor.

III. Profit-push Inflation: The profit-push inflation is attributed to the

monopoly power exercised by the firms under the monopolistic and
oligopolistic market that tries to enhance their profit margins by keeping the
prices relatively high.

The wage-push inflation and profit-push inflation goes hand-in-hand, which

means as the labor unions force their employer to increase their wage money
the cost of production also increases. And in order to meet the increased cost,
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the monopolistic and oligopolistic firms raise the price level often more than
proportionately. This is done to enhance the profit margins of the firm. If this
process of; a hike in the price of the commodity following an increase in the
wage money continues, then this is called as ‘profit-wage spiral.’

IV. Supply-Shock Inflation: This kind of cost-push inflation is caused due to

an unexpected decline in the supply of major consumer goods and key
industrial inputs. Such as the prices of food product shoots up due to a crop
failure and the prices of key industrial inputs Viz. Coal, iron, steel, etc., increases
because of the natural calamities, lockouts, labor strikes, etc.

Also, the prices may rise due to the supply bottlenecks in the domestic economy
or international events (generally, war), thereby restricting the movement of
internationally traded goods. As a result, the supply decreases and the import
of industrial inputs increases.

 Measures to Control Inflation

I. Monetary Measures to Control Inflation

The monetary measures which are widely used to control inflation are:

1. Bank Rate Policy: The bank rate policy is used as an important instrument
to control inflation. The Bank rate, also called as the Central Bank rediscount
rate is the rate at which the central bank buys or rediscounts the eligible bills
of exchange and other commercial papers presented by commercial banks to
build their reserves. Here, the central bank performs the function as “lender of
the last resort”.The bank rate policy as a monetary measure to control inflation
work in two ways:

During inflation, the central bank raises the interest rates due to which the
borrowing costs go up. As a result, commercial bank borrowings from the
central bank reduces. With the reduced borrowings from the central bank, the
flow of money from the commercial bank to the public also gets reduced. This
is how the bank credit decides the extent to which the inflation is controlled.
The bank rate sets the trend for general market interest rate, specifically in the
short-run. As the central bank raises the interest rate with a view to curtailing
the money supply in the market, the commercial banks also raise their
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commercial borrowing rates for the public, thereby making the borrowings
dear. Other general market rate follows the suit and with the decreased
borrowing capacity of individual, the inflation is controlled due to reduced
money flows to the society.

2. Variable Reserve Ratio: The variable reserve ratio, also called as the Cash
Reserve Ratio(CRR) is a certain proportion of total demand and time deposits
that the commercial banks are required to maintain in the form of cash reserves
with the central bank.

The cash reserve ratio is often determined and imposed by the central bank
with a view to controlling the money supply. When the central bank raises the
CRR, the lending capacity of the commercial banks reduces due to which the
flow of money from the banks to the public also decreases. Thus, it helps in
controlling the rise in the price to the extent it is caused by the bank credit to
the public.

3. Open Market Operations: The open market operations are characterized

by the sale and purchase of government securities and bonds by the central
bank. The central bank buys and sells the government securities and bonds to
the public through commercial banks. The government securities are sold via
commercial banks such that a certain amount of bank deposits is transferred to
the central bank. As a result, the credit creation capacity of the commercial
banks reduces. Thus, the flow of money from the banks to the public also gets
reduced.

II. Fiscal Measures to Control Inflation

Definition: The Fiscal Measures to Control Inflation is comprised of

government expenditure, public borrowings, and taxation. The Keynesian
economists, also called as “Fiscalist” assert that the demand-pull inflation is
caused due to an excess of aggregate demand over aggregate supply.

The aggregate demand increases due to expenditure by the households, firms

and government (usually excessive spending by the government). This increase
in demand due to expenditure by either government or households can be
effectively controlled by fiscal measures. Thus, fiscal policy and budgetary
measures are the effective weapons to control demand-pull inflation.

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In case, government expenditure is the main cause behind the demand-pull

inflation, then it can be controlled by cutting down the public expenditure. With
a cut in public expenditure, the government demand for goods and services
decreases along with a decrease in the private income and consumption
expenditure. In case, the demand rises due to the rise in private
expenditure, taxing income is the most appropriate way to control inflation.
The taxation on private income reduces the disposable income in hand, as a
result of which the consumption expenditure also reduces. This results in the
reduction in aggregate demand.

In case of a very high persistent inflation rate, the government may adopt both
these measures simultaneously to control inflation. Such as along with the
reduction in public expenditure the rate of taxation shall be raised on the
private income to keep the demand under control. This kind of policy of using
both the measures simultaneously is called as “ Policy of Surplus
Budgeting,” which says that “government should spend less than the tax
revenue.”

 Effects of Inflation

The main effects of inflation and higher prices in India are discussed below:

(I) Effect on Production:-During inflation, the producers and businessmen

gain in the short-period. Usually the cost of production does not rise as fast as
the price of their product and so there is an artificial margin of profit. As against
this, they may also be affected adversely in the long run. If the price level goes
on increasing, the total consumption of their product would fall.
The reduced consumption will ultimately raise the cost of production per unit
and reduce the profits.

1.Misallocation of Resources and Disrupted Price Mechanism:- Inflation

disrupts the smoothness of price mechanism. It finally ends in mal-adjustments
in production. Producers turn towards more production of luxury goods which
are non-essential over essential commodities, from which they expect higher
profits.

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2. Hoarding:-In times of inflation, people, like traders hoard stocks of essential

commodities with an idea to earn more profits in the near future. As a result,
the available supply of goods in relation to increasing monetary demand,
decreases. This results in black marketing, i.e., artificial scarcity of goods in the
market.

3. Encourages Speculation:- A non-anticipated steep rise in prices creates a

situation of uncertainty in the economy. People indulge more in speculative
activities than in increasing production.

4. Lack of Quality Control:-Inflation tries to create a sellers’ market. Sellers

get a command on prices because of excessive demand in the market. In such
conditions, the sellers overlook the quality of their goods, instead they
concentrate more on earning great profits.

(II) Effect on Distribution of Income:- Inflation redistributes income because

prices of all factors do not rise in the same proportion. Here, prices rise faster
but incomes do not. There is an inequality in distribution of wealth. During
inflation, producers and traders are the gainers. As a result, rich get richer and
poor get poorer. It leads to concentration of wealth in the hands of a few rich
people.

1. Effect on the Working Class:- Labour is the lowest paid class. This class is
badly affected by inflation, especially if the prices of the basic necessities of life
rise steeply. It adversely affects the family budget of the working class. Their
consumption level goes down tolling upon their health and lowering their
efficiency. It may also create unrest.
No doubt, through trade unions, workers may manage to get increased
dearness allowance but this does not provide them with desired relief. Price
hike generally precedes any increase in dearness allowance. In turn, the
increased wages further push up the price level owing to an increased demand.
A vicious circle is formed, resulting in wage-push or cost push inflation.
2. Effect on Fixed Income Groups:-This group includes pensioners,
government servants, owners of government securities and promissory notes
and others who get a fixed money income. They are known as renters. This class
is worst affected by inflation because the purchasing power of their fixed
income goes on decreasing with rising prices.

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3. Effect on Debtors and Creditors:-Debtors gain when they pay back their
debt during inflation. It is because the value of money was high when they
borrowed but came down when they repaid their debts. As against this, the
creditors are losers during inflation. However, if debtors take loans during
inflationary period, the position is reversed. In that case, the debtors are losers
and the creditors are gainers.

(III) Other Effects:

1. Cost Increases:-As prices increase, cost of projects both in private and public
sectors goes-up. Consequently, the total outlay of each plan exceeds the one
provided as per original plan yet physical targets are not fully achieved.

2. Effect on Economic Development and Reduction in Savings:-Due to rise

in prices, economic development of a country has adverse effects on savings
and investments.

3. Wage Spiral:- A rapid increase in prices is not suitable as workers demand

more wages. Under such circumstances, wages are raised to compensate the
workers. Thus, price spiral affects the economy.

4. Effect on Foreign Investment:-A rapid increase in prices has an adverse

effect on the foreign investment in the country. Foreign investors do not invest
their money in those countries where the value of money is falling on account
of rise in prices. Value of money falls and the investors suffer losses.

5. Adverse Balance of Payment:-Price rise has an adverse effect on the export

of the country. Exporters fail to increase the exports to the desired extent.
Actually, our exportable become relatively expensive in the world market,
resulting in the fall of export and our importable become relatively cheaper,
this increases our imports.The demand for country’s exports decreased and
imports increased. Therefore, balance of payment continues to be
unfavourable.
6. Lack of Confidence in the Currency:-Money stops functioning as money
because people lose confidence in currency and do not like to hold it. In 1923,
during hyperinflation in Germany people refused to accept ‘Marc’ as their unit
of currency. Money was replaced by Barter system because people preferred
goods over money.

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7. Social and Moral Degradation:-Inflation leads to thefts and robberies

because some people would like to get an income in undesirable ways so as to
survive. Corruption breeds during inflation and moral ethical values take a
down stride.

8. Effect on Political Stability:-Continued inflation results in shaking the

foundation of any political system. It even results in the fall of any government.

BUSINESS CYCLE

 Meaning of Business Cycle

The term business cycle is referred to the recurrent ups and downs in the level
of economic activity that extend over a period of time. The business fluctuations
occur in aggregate variable such as national income, employment and price
level.

Business cycle is also called as “Trade Cycle” Business Cycle-Martin Thomas

 Characteristics of Business Cycle

1. Movement in Economic Activity :- A trade cycle is a wave-like movement

in economic activity showing an upward trend and a downward trend in the
economy.

2. Periodical :- Trade cycles occur periodically but they do not show the same
regularity.

3. Different Phases :- Trade cycles have different phases such as Prosperity,

Recession, Depression and Recovery.

4. Types :- There are minor and major trade cycles. Minor trade cycles operate
for 3-4 years, while major trade cycles operate for 4-8 years or more. Though
trade cycles differ in timing, they have a common pattern of sequential phases.

5. Duration :- The duration of trade cycles may vary from a minimum of 2 years
to a maximum of 12 years.

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6. Dynamic :-Business cycles cause changes in all sectors of the economy.

Fluctuations occur not only in production and income but also in other
variables like employment, investment, consumption, rate of interest, price
level, etc.

7. Phases are Cumulative :- Expansion and contraction in a trade cycle are

cumulative, in effect, i.e. increasing or decreasing progressively.

8. Uncertainty to businessmen:- There is uncertainty in the economy,

especially for the businessmen as profits fluctuate more than any other type of
income.

9. International Nature:- Trade Cycles are international in character. For e.g.

Great Depression of 1930s.

 Types of Business Cycle

1. The Minor Cycle:-This is also known as Short Kitchin Cycle. This has gained
popularity after the name of the British economist Joseph Kitchin in the year
1923. He made a research and came to this conclusion that a cycle takes place
within duration of approximately 30 to 40 months.

2. The Major Cycle:-This has been emphasised as the fluctuation of business

activity between successive crises. This is also known as “The Long Jugler
Cycle.” A French economist Clement Jugler showed that the periods of
prosperity, crisis and liquidation followed each other always within a span of
the average of nine and half years.

3. The Very Long Period Cycle:-This is also known as Kondratieff Cycle. This
was propounded by N. D. Kondratieff the Russian economist in the year 1925.
He has written that there are longer waves of cycles of more than fifty years
duration.

4. Kuznets Cycle:-This type of business cycle was propounded by the famous

American economist Professor Simon Kuznet. His view was that the secular

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swing of the cycle generally occurs in between 7 to 11 years and this can show
effect within that period.

5. Building Cycles:-Such cycles are associated with the name of two American
economists namely Warren and Pearson. They expressed their views in World
Prices and the Building Industry book in the year 1937. Their view was that
business cycle occurs in the duration of an average of 18 years and the cost of
such cycle has major effect on building construction and on the industrial
development.

 Phases of Business Cycle

1. Prosperity: Expansion & Peak When there is an expansion of output, income,

employment, prices and profits, there is also a rise in the standard of living. This
period is termed as Prosperity phase.

 Rise in the national output & trade

 Rise in consumer and capital expenditure
 Rise in the Price of raw materials and finished goods
 Rise in the level of income & employment Business Cycle-Martin
Thomas.

2. Recession& Turning Point During a recession period, the economic activities

slow down. When demand starts falling, the overproduction and future
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investment plans are also given up. There is a steady decline in the output,
income, employment, prices and profits. Business Cycle-Martin Thomas

3. Depression& Trough When there is a continuous decrease of output,

income, employment, prices and profits, there is a fall in the standard of living
and depression sets in.

During the phase of Depression:

 The growth rate become negative

 The level of national income and expenditure declines
 Price of consumer and capital goods decline
 Workers lose their job Business Cycle-Martin Thomas

4. Recovery Phase As the recovery gathers momentum, some firms plan

additional investment; some undertake renovation programmes, and some
undertake both. These activities generate construction activities in both
consumer & capital goods sector. As a result more employment is generated
and wage rates moving upward. Business Cycle-Martin Thomas.

 Causes of Business Cycle

I. Factors of Business Cycle

1. Wars:- In war days all the available resources are utilized for the production
of weapons which greatly affect the product of both capital and consumer
goods. This fall in production decreases income, profits which further create
unemployment. These create contraction in the economic activity.

2. Postwar Period:- In the post war period the level of consumption and
investment goes upward. Both the government and individuals involve the
construction (houses, roads, bridges etc). All these activities increases the
effective due to which the economic variables, output, income and employment
goes upward.

3. Scientific Development:- Another cause of business cycle is scientific

development. Every day new products come to the markets like mobile phone,
laptops etc. These products require huge amount of investment through which

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new technology of production is adopted. All this increases income,

employment and profit etc. and plays an important part in the revival of
economy.

4. Gold Discoveries:- The discoveries of gold and mines stimulate the volume
of international trade and help in adjusting trade deficit, loans etc. the rising
income lead to expansion in economic activity.

5. Surplus, Exports and Foreign Aid:- Surplus, exports and foreign aid raises
the level of consumption and investment spending which helps in increasing
output, income and employment level.

6. Weather:- Weather is one of the causes of business cycle. It is an important

factor which can cause economic activities. If in any year, weather is good the
output of agricultural sector will goes upward.

7. Population Growth Rate:- Population growth rate is one the factors of

business cycle. If the population growth rate is higher than the economic
growth rate, income level and consumption expenditure and savings will be
low.

II. Factors of Business Cycle

Internal causes of business cycle are those, which are built in within economic
system. These are the internal factors of business cycle:

1.Psychological Factors:- According to Pigou business cycle appears because

of the optimistic and pessimistic mood of the entrepreneur. When
entrepreneurs are in optimistic about future market conditions they take up
investment. Here the expanses phase of business cycle starts which ultimately
ends in a boom.

On the contrary, the pessimism reduces investment, production, employment

and shifts to downward trend in business activity.

2.Money Supply:-Hawtrey and Friendman relate trade cycle to fluctuation in

money and credit supply. If there is expansion in money and credit supply,

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there will be raise in economic activity. If there is contraction there will be

down fall in economic activity.

3.Over Investment:-Hayek relates business cycle to variation in capital goods

industries. Excessive investment in capital goods industries brings upswing
and downswing when there is a fall in investment.

4.Marginal Efficiency of Capital (MEC):- According to Keynes changes in the

rate of marginal efficiency of capital are responsible for business cycle. When
the rate of marginal efficiency of capital gets higher the expansion phase of
trade cycle commences. There is a contraction phase when the rate of marginal
efficiency of capital is lower.

 Measures to Control Business Cycles or Stabilisation Policies

Various measures have been suggested and put into practice from time to time
to control fluctuations in an economy. They aim at stabilising economic activity
so as to avoid the ill-effects of a boom and a depression. The following three
measures are adopted for this purpose.

1. Monetary Policy:-Monetary policy as a method to control business

fluctuations is operated by the central bank of a country. The central bank
adopts a number of methods to control the quantity and quality of credit. To
control the expansion of money supply during a boom, it raises its bank rate,
sells securities in the open market, raises the reserve ratio, and adopts a
number of selective credit control measures such as raising margin
requirements and regulating consumer credit. Thus the central bank adopts a
dear money policy. Borrowings by business and trade become dearer, difficult
and selective. Efforts are made to control excess money supply in the economy.

 Limitations of Monetary Policy:

To control a recession or depression, the central bank follows an easy or cheap

monetary policy by increasing the reserves of commercial banks. It reduces the
bank rate and interest rates of banks. It buys securities in the open market. It
lowers margin requirements on loans and encourages banks to lend more to
consumers, businessmen, traders, etc.

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But monetary policy is not so effective as to control a boom and a depression. If

the boom is due to cost- push factors, it may not be effective in controlling
inflation, aggregate demand, output, income and employment. So far as
depression is concerned, the experience of the Great Depression of 1930s tells
us that when there is pessimism among businessmen, the success of monetary
policy is practically nil.

In such a situation, they do not have any inclination to borrow even when the
interest rate is very low. Similarly, consumers who are faced with reduced
incomes and unemployment cut down their consumption expenditure. Neither
the central bank nor the commercial banks are able to induce businessmen and
consumers to raise the aggregate demand. Thus the success of monetary policy
to control economic fluctuations is severely limited.

II. Fiscal Policy:

Monetary policy alone is not capable of controlling business cycles. It should,

therefore, be supplemented by compensatory fiscal policy. Fiscal measures are
highly effective for controlling excessive government expenditure, personal
consumption expenditure, and private and public investment during a boom.
On the other hand, they help in increasing government expenditure, personal
consumption expenditure and private and public investment during a
depression.

III. Policy during Boom:

The following measures are adopted during a boom. During a boom, the
government tries to reduce unnecessary expenditure on non-development
activities in order to reduce its demand for goods and services. This also puts a
check on private expenditure which is dependent on the government demand
for goods and services. But it is difficult to cut government expenditure.
Moreover, it is not possible to distinguish between essential and non-essential
government expenditure. Therefore, this measure is supplemented by taxation.

 Important Question

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1. Define Business Cycle? Discuss the various phases and types of business
cycle?
2. Explain the features of Multiplier. Show it’s forward and backward
working. What are its main limitations?
3. What are the leakages of multiplier?
4. Distinguish between static multiplier and dynamic multiplier. Explain
them with the help of appropriate graphs?
5. Write the detailed note on Foreign Trade Multiplier?
6. What is Inflation? Discuss its Theories of Inflation & How to control it?
7. What are causes of Inflation? Critically examine the effects of Inflation on
different sections of society.
8. What is inflation? Distinguish between demand-pull inflation and cost-
push inflation. Suggest measures to control cost-push inflation.
9. What are the methods of measuring national income? What conceptual
problems arise in estimating national income?
10. What is the income method of estimation of national income? What
precautions should be taken while using income method ?
11. What is the income method of estimation of national income? What
precautions should be taken while using income method ?
12. Write detailed note on economic system.
13. What Is Market Structure? Discuss Its Types & Determinants?
14. Discussed The Concept Of Perfect Competition Under Equiblirium?
15. Define Monoply? Explian Its Features & Types?
16. Define Monoplistic Competition? Discuss Its Under Short & Long Run?
17. Discuss Price And Output Determination Under Collusive & Non-
Collusive Oligopy?

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Last page

Reference/Source:

1. Managerial Economics, V.K Publishers, T.R Jain.

2. Micro Economics, Kalyani Publishers, R.K Lekhi, S.L Aggarwal &Charanjit

Kaur

3. Business Economics, Kalyani Publishers, P.N Chopra.

4. https://www.tutorialspoint.com

5. https://www.slideshare.net

6. https://www.toppr.com

7. https://economictimes.indiatimes.com

8. https://www.investopedia.com

9. http://www.brainkart.com

10. https://www.ukessays.com

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