MBA I Sem Managerial Economics1733213942352

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MASTER OF BUSINESS ADMINISTRATION (MBA)

FIRST SEMESTER
MANAGERIAL ECONOMICS

Unit - I
Managerial Economics: Basic Concept & Principles

What is Economics?
Economics is the study of firm, households, price, wage, income, industry and commodity either particularly
or aggregate. Economics deals with basically two forces i.e. demand and supply. Where consumer deals with
demand and producer deals with supply. The place where consumer and supplier interact called market.
In other words: Economics is the study of scarcity and its implications for the use of resources, production of
goods and services, growth of production and welfare over time, and a great variety of other complex issues
of vital concern to society.

Economics is more than Numbers


Economics is a social science with stakes in many other fields, including political science, geography,
mathematics, sociology, psychology, engineering, law, medicine and business. The central quest of
economics is to determine the most logical and effective use of resources to meet private and social goals.
Production and employment, investment and savings, health, money and the banking system, government
policies on taxation and spending, international trade, industrial organization and regulation, urbanization,
environmental issues and legal matters (such as the design and enforcement of property rights), are just a
sampling of the concerns at the heart of the science of economics.

Managerial Economics and Economics:


Managerial Economics has been described as economics applied to decision making . It may be viewed as a
special economics bridging the gulf between pure economic theory and managerial practice.
Economic has two main divisions: 1. Micro economics 2. Macro economics
Micro economics has been defined as that branch where the unit of study is an individual or a firm. Macro
economics, on the other hand, is aggregative in character and has the entire economy as a unit study.
Micro economics, also known as price theory (or Marshallian economics), is the main source of concepts and
analytical tools for managerial economics. To illustrate various managerial concept such as elasticity of
demand, marginal cost, the short and the long run, various market forms etc., are all of great significance to
managerial economics.
The chief contribution of macro economics is in the area of forecasting. The theory of income and
employment has been direct implications for forecasting general business conditions.
Meaning of Managerial Economics
Managerial Economics is the integration of economic theory with business practice for the purpose of
facilitating decision making and forward planning by management.
Managerial Economics is a study of application of managerial skills in Economics. It helps in anticipating,
determining, resolving potential problems these problems pertain to costs, prices or forecasting future market.

Definition of Managerial Economics:


According to Spencer and Siegleman, “Managerial Economics is the integration of economic theory with
business practice for the purpose of facilitating decision-making and forward planning by management.”

According to Joel Dean, “The purpose of Managerial economics is to show how economic analysis can be
used in formulating business policies.”
Managerial Economics thus lies on the borderline between economics and business management and serves
as a bridge the two discipline (See Chart )

Economics, Business Management and Managerial Economics

Main Characteristics of Managerial Economics:


First, Managerial Economics is micro-economic in character. This is because the unit of study is a firm it is
the problems of a business firm which are studied in it. Managerial Economics does not deal with the entire
economy as a unit of study.
Secondly, Managerial Economics largely uses that body of economic concepts and principles which is known
as „Theory of the Firm‟ or „Economics of the Firm.‟ It also seek to apply Profit Theory which part of
Distribution Theories in Economics.
Thirdly, Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory but
involves complications ignored in economy theory to face the overall situation in which decision are made.
Economic theory appropriately ignores the variety of background and training found in individual firms but
Managerial economic considers the particular environment of decision making.
Fourthly, Managerial Economics Prescriptive rather than Descriptive.
Fifthly, Macro Economics is also useful to Managerial Economics since it provides an intelligent
understanding of the environment. In business must operate. This understanding enables a business executive
to adjust in the best possible manner with external forces over which he has no control but which play a
crucial role in the well being of his concern.

Scope of Managerial Economics:


1. Demand Analysis and Forecasting
A business firm is an economic organism which transactions productive resource into goods that are to be
sold in a market. A major part of managerial decision making depends on accurate estimates of demand.
Before production schedules can be prepared and resources employed, a forecast of future sales is essential.
This forecast can also serve as a guide to management for maintaining or strengthening market position and
enlarging profits. Demand analysis helps identify the various factors influencing the demand for a firm‟s
product and thus provides guidelines to manipulating demand. Demand Analysis and Forecasting, therefore,
is essential for business planning and occupies a strategic place in Managerial Economics.

2. Cost and Production Analysis


A study of economic costs, combined with the data drawn from the firm‟s accounting records, can yield
significant cost estimates that are useful for management decisions. The factor causing variations in cost must
be recognized and allowed for if management is to arrive at cost estimates which are significant for planning
purpose. An element of cost uncertainty exists because all the factors determining costs are not always
known or controllable. The chief topic covered under cost analysis are: Cost Concepts and Classification,
Cost output Relationships, Economies and Diseconomies of Scale and Cost Control and Cost Reduction.
Production analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in
physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with
different production functions and their managerial uses.
3. Pricing Decisions, Polices and Practices:
Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm
and 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 under this area are: Price determination in various Market Forms, Pricing
Methods, Differential Pricing, Product-line Pricing and Price Forecasting.

4. Capital Management:
Of the various types and classes of business problems, the most complex ad troublesome for the business
manager are likely to be those relating to the firm‟s capital investment. Relatively large sums are involved,
and the problems are so complex that their disposal not only requires considerable time and labour but is a
matter for top-level decision. Briefly, capital management implies planning and control of capital expenditure.
The main topics dealt with are: Cost of Capital, Rate of Return and Selection of Projects.

5. Profit Management:
Business firms are generally organized for the purpose of making profits and, in the long run, profits provides
the chief measure of success. In this connection, an important point worth considering is the element of
uncertainty existing about profits because of variations in costs and revenue which, in turn, are caused by
factors both internal and external to the firm. If knowledge about the future were perfect, profit analysis
would have been a very easy task. However, in a world of uncertainty, expectations are not always realized so
that profit planning and measurement constitute the difficult area of Managerial Economic, The important
aspects covered under this area: Nature and Measurement of Profit, Profit policies and Techniques of Profit
Planning like Break Even Analysis.

Importance of Managerial Economics:


In order to solve the problem of decision making, data are to be collected and analyzed in the light of business
objectives. Managerial Economics provides help in this area. the importance of managerial economics maybe
relies in the following points:
1. It provides tools and techniques for managerial decision making.
2. It gives answers to the basic problems of business management
3. It supplies data for analyzing and forecasting.
4. It provides tools for demand forecasting and profit Planning.
5. It guides the managerial economist.
6. It helps in formulating business polices.
7. It assists the management to know internal and external factors influence the business.
Fundamental Principles of Managerial Economics
Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to
the manager in his decision-making practices. This is not to say that economics has all the answers. In fact,
actual problem solving in business has found that there exists a wide disparity between the economic theory
of firm and actual observed practice necessitating painting the use of many skills and tools which are not
available in the traditional economist's kit. It would, therefore, be quite useful to examine, on the one hand,
the basic tools of managerial economics which it has borrowed from economics and on the other hand, the
nature and extent of gap between the economic theory of the firm and the managerial theory of the firm.

1. Opportunity Cost Principle:


By the opportunity cost of a decision is made the sacrifice of alternative required by the decision this can best
be understood with the help of a few illustration:
1. The opportunity cost of the funds employed in once on business is the interest that could be earned on those
funds had they been employed in other ventures
2. The opportunity cost of the time an entrepreneur devotes to his own business in the salary he could earn by
sitting employment.
3. The opportunity cost of using a machine to produce one product is the earning for go on which would we
have been possible from other product.
4. The opportunity cost of holding Rs. 500 as cash in hand for one year is that 10% rate of interest, which
would have been earned had the money kept as fixed deposit in a bank.

2. Marginal Principle:
Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal generally
refers to small changes. Marginal revenue is change in total revenue per unit change in output sold.

3. Incremental Principle:
Incremental concept is closely related to the marginal costs and marginal revenues, for of economic theory. In
actual business situations it often becomes difficult to apply the concept of marginalism which has to be
replaced by incrementalism for in Real world business, one is concerned with not 'unit change' but 'chunk
change'. For instance, in a construction project. The labour which a contractor may change is not by one but
why tens.
Incremental concept involve estimation the impact of decisions alternative on cost and revenues emphasizing
the changes in the total cost and total revenue resulting from change in prices, products, procedures,
investment or whatever may be at stake in the decision.

4. Discounting Principles:
One of the fundamental Idea as in economics is that rupee tomorrow is worth less than a Rupee today. This
seems similar to saying that a bird in hand is worth two in the bush.
"If a decision effect cost and revenues and future dates, it is necessary to discount those costs and revenue to
present value before a valid comparison of alternatives is possible.”

5. Concept of Time Perspective:


The economic concept of the long-run and short- run have become part of everyday language. Managerial
economic are also concerned with the short-run and long-run effects of decision on Revenue as well as cost.
The really important problem in decision making is to maintain the right balance between long-run and the
short-run considerations. A decision may be made on the basis of short-run consideration, but may as time
elapses have long-run Reprecautions which make it more or less profitable than it at first appeared.

6. Equi-marginal Principle:
This principle deals with the allocation of available resources among the alternative activities. According to
this principle, an output should be so allocated that the value added by the last unit is the same in all cases.
This generalization is called the Equi-marginal principle.
Suppose, a firm has 100 unit of labour at its disposal. The firm engaged in four activities which needs labour
services, viz A, B, C and D. It can enhance any one of these activity by adding more labour but only at the
cost of other activities.

Utility Analysis - Cardinal Utility and Ordinal Utility:


The economic concept of the long-run and short- run have become part of everyday Utility analysis compares
costs and outcomes which are measured in different units. This differs from cost-benefit analysis, which uses
a common unit (i.e. financial value) to compare costs and benefits. Utility analysis is often referred to in the
health sector as a cost-effectiveness or cost-utility analysis.
Cardinal utility and Ordinal utility are the two predominant theories of utility. The Cardinal Utility believes in
measuring the satisfaction level in utils and the Ordinal Utility believes that the satisfaction level cannot be
evaluated; however, it can be leveled.
Managerial Economist: Role and Responsibilities:
Managerial economist can play a very important role by assisting the management in using the increasingly
specialized skills and sophisticated techniques which are required to solve the difficult problem of successful
business decision-making and forward planning. This is why, in business concerns, his importance is being
growingly recognized. In advanced countries like the U.S.A. large companies employ one or more
economists. In our country too. Big industrial houses have come to recognise the need for managerial
economists, and there is frequently advertisement for such positions. Tatas, DCM and Hindustan Lever
employee economists Indian petrochemicals Corporation Limited, a government of India undertaking, also
keep an economist.
In this connection, two important questions need be considered:
1. What role does he play in business, that is, what particular management problems lend themselves to
solution through economic analysis.
2. How can the managerial economist best serve management, that is what are the responsibilities of a
successful manager economist.

Role of Managerial Economist:


1. Environmental Studies:
An analysis and forecast of external factors constituting general business conditions, e.g., prices, National
Income and output, volume of trade, etc. are great significance since every business firm is affected by them.
1. What is the outlook for the national economy? What are the most important local, regional or world-wide
economic trends? What phase of the business cycle lies immediately ahead?
2. What about population shifts and the resultant ups and downs in regional purchasing power?
3. What are the demand prospects in new as well as established markets?
4. Where are the market and customer opportunities likely to expand or contract most rapidly?
5. Is competition likely to increase or decrease?

2. Business Operations:
A managerial Economist can also be helpful to the management in making decisions relating to the internal
operations of a firm in respect of such problems as price, investment, expansion etc. Certain relevant
questions in this context would be as follows:
1. What will be a reasonable sales and profit budget for the next year?
2. What will be the most appropriate production schedules and inventory polices for the next six months?
3. What changes in wage and price polices, should be made now?
4. How much cash will be available next month and how should it be invested?
3. Economic Intelligence:
Besides these functions involving sophisticated analysis, managerial economist may also provide general
intelligence service supplying management with economic information of general interest such as competitors
prices and products, tax rates, tariff rates, etc. In fact, a good deal of published material is already available
and it would be useful for a firm to have someone who understands it. The managerial economist can do the
job with competence.

4. Participating in Public Debates:


Many well-known business economist participating in public debates. Their advice and views are being
sought by the government and society alike. Their practical experience in business and industry adds stature
to their views. Their public recognition enhances their stature in the organization.

5. Indian Context:
In the Indian context, a managerial economist is expected to perform the following functions:
1. Macro-forecasting for demand and supply
2. Production planning at macro and micro levels
3 .Capacity planning and product-mix determination
4. Economics of various production lines
5. Economics feasibility of new production lines/process and projects
6. Assistance in preparation of overall development plans
7. Preparing briefs, speeches, articles and papers for top management for various Chambers, Committees,
Seminars, Conferences, etc.

6. Specific Functions:
1. Sales Forecasting
2. Industrial Market Research
3. Economic Analysis of Competing Companies
4. Pricing Problems of Industry
5. Capital Projects
6. Production Programmes
7. Security/ Investment Analysis and Forecasts
8. Advice on Public And Trade Relation
9. Advice on Foreign Exchange
10. Economic Analysis of Agriculture
Responsibilities of Managerial Economist:
1. Arrangements of Resources
2. Reasonable Profit on Capital
3. Successful Forecast
4. His Status in the Firm
5. To Caution Against Errors
6. Amicable Relations
7. Evaluation of Decisions
8. Effective Co-ordination
9. Determination of Decision Making Process

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MASTER OF BUSINESS ADMINISTRATION (MBA)
FIRST SEMESTER
MANAGERIAL ECONOMICS

Unit - II
Theory of Demand: Meaning
Demand in economics means desire to buy backed by adequate purchasing power. Mere desire or wish cannot
buy goods. The demand for goods, therefore, denotes that someone is able and willing to buy the goods. For
example, everyone can desire to possess Premier Audi Car but only a few have the ability to buy it. So
everybody cannot be said to have a demand for the car.
“Demand is an effective desire” -Prof. Pension

The word effective desire includes the following five elements:


1. Desire:
This is the first element of demand. Without desire, there will be no demand. Thus, we can say that,
desire gives birth to demand.
2. Means to Purchase:
The person, who desires for something, must also have means to fulfill that desire. Otherwise, the
desire will not be called demand. For example poor person desire for a car, his desire cannot become demand,
as he has so means to purchase that car.
3. Willingness to use those ‘Means’ to fulfill the desire:
Only „desire‟ and „means to purchase‟ are not sufficient, what is sufficient is willingness to use those means
to fulfill that desire. For example, if rich miser desire for a car, then his desire will not be called demand,
although there is desire and means to purchase. This is because, there is absence of third element of demand,
i.e., willingness to use those means to fulfill the desire.
4. Price:
Demand in economics is always at a price. For example, you will be willing to purchase a pen for Rs. 10/-,
but you may not buy that pen, if the price is Rs. 100/-
5. Time Period:
Demand is always expressed with references to a particular time period. For example, cars per day, cars per
week etc.

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Types of Demand:
1. Joint demand
Joint demand is the demand for complementary products and services. These can be products that are
accessories for others or that people commonly purchase together. For example, cereal and milk or peanut
butter and jelly. The two are linked, but the demand for one is not necessarily dependent on the demand for
the other.
2. Composite demand
Composite demand happens when there are multiple uses for a single product. For example, corn can be used
as animal feed, ethanol and food in its whole form. The rise in demand for any of these products leads to a
shortage in supply for the others. This shortage can lead to a rise in price.
3. Short-run and long-run demand:
Short-run demand refers to how people will immediately react to price changes while elements are fixed. For
example, if the demand for a product drastically decreases and a manufacturer has high overhead costs, they
have no choice but to absorb the profits lost. Over time, or in the long run, companies have a chance to adjust
to the new situation by decreasing labor or increasing prices and supplies.
4. Price demand:
Price demand relates to the amount a consumer is willing to spend on a product at a given price. Businesses
use this information to determine at what price point a new product should enter the market. Consumers will
buy items based on their perception of that product's value. Price elasticity refers to how the demand will
change with fluctuations in price.
5. Income demand:
As consumers make more income, quantity demand increases. This means people will buy more overall when
they earn more income. Tastes and expectations also change with an increase in income, reducing the size of
one market and increasing the size of another. Consumers will often buy a product or service because it is
what they can afford but may deem it lower quality. The demand for those lower-quality products will
decrease as income increases.
6. Competitive demand:
Competitive demand occurs when there are alternative services or products a customer can choose from.
From a business's perspective, they can use fluctuations in the price of their competitors to determine how
their own will sell. An example of this is between name-brand and store-brand medicine. If a consumer
prefers a name brand but it is out of stock or the price increases significantly, the store brand will see a rise in
sales.

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7. Direct and derived demand:
Direct demand is the demand for a final good. Food, clothing and cell phones are an example of this. Also
called autonomous demand, it's independent of the demand for other products.
Derived demand is the demand for a product that comes from the usage of others. For example, the demand
for pencils will result in the demand for wood, graphite, paint and eraser materials. In this example, the
demand for wood is dependent on the demand for its uses.
Derived demand is similar to joint demand because of its connection to other products. It is different from
joint demand because it is dependent on the final product to generate a need. Without the need for those end
products, there is no demand for the intermediate product.

Determinants of Demand

Price of the Product


Price of Related Goods
Consumer‟s Income
Consumer‟s Test & Preferences
Advertisement Expenditure
Consumer Expectations
Demonstration Effect
Population of the Country
Distribution of National Income

1. Price of the Product:


Price is the most important factor of demand. Demand and price have an inverse relationship. This means that
when the prices go up, the demand goes down. The opposite is also true. Price expectation occurs when
consumers rush to purchase an item because they believe the price will increase soon, which increases that
product's demand. When they expect the price will fall, like in the case of a departmental store sale, they will
wait to purchase. Businesses use these tactics to increase demand for a product or service.

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2. Price of Related Goods:
There are two types of related goods-
1. Complementary goods
2. Substitute or competing goods

3. Consumer’s Income:
To analysis the impact of Income on the demand, the goods can be divided into two
categories:
1. Inferior goods 2. Superior goods

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4. Consumer’s Taste and Preferences:
Taste and preferences of consumer also plays a very important role in determining the demand of a
commodity. The goods, which are preferred by consumer or which are in fashion, will cover a goods, which
are out of fashion. For example, the demand for LED TV is higher than of LCD TV This is because LED TV
is preferred by consumer.
5. Consumer Expectations:
Customer expectations are any set of behaviors or actions that individuals anticipate when interacting with a
company. For Example:
*Quick and easy resolutions to customer complaints
*Access to preferred service channels
*Opportunities to answer questions themselves via help centers
*Personalized experience
*Data protection and privacy
6. Advertisement Expenditure: The purpose and effect of successful advertising is to increase the demand,
that is, to shift the demand curve for the product to the right.
7. Demonstration Effects: If a business, system, etc. has a demonstration effect, othersare influenced by it
and Try to copy it: Multinational hotel companies not only increased tourism on the island but also produced
a strong demonstration effect among local establishments.
8. Population of the Country:
The reason for this is that due to the increase (or decrease) of population size, the number of buyers of the
product increases (or decreases), the structure of the population also affects the demand; for example the
demand for goods for women increases when the population has a larger number of women.
9. Distribution of National Income:
Distribution of Income: Market demand is also influenced by changes in income distribution in society. If
income is evenly distributed, then there will be more demand. If the income is distributed unequally, then
more demand will concentrate on rich people.
Demand Function:
Demand function expresses the functional relationship between demand of the commodity and various factors
affecting it. In other words, demand function describes the relationship between quantities of the commodity
which consumers demand during the specific period and the factor which influence the demand

Demand Schedule:
In elementary economics, the relationship of price to sales or demand, or alternatively, the Price-Quantity
Relation, as it is often called is shown arithmetically in the form of table showing prices and corresponding
quantities. This table is known as „Demand Schedule‟.
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In other simple words, In economics, a demand schedule is a table that shows the quantity demanded of a
good or service at different price levels. A demand schedule can be graphed as a continuous demand curve on
a chart where the Y-axis represents price and the X-axis represents quantity.

Demand Curve:
The demand curve is a graphical representation of the relationship between the price of a good or service and
the quantity demanded for a given period of time. In a typical representation, the price will appear on the left
vertical axis, the quantity demanded on the horizontal axis.

Law of Demand:
Law of demand states that there is an inverse relation between the price of a commodity and its quantity
demanded, assuming all other factors affecting demand remain constant. It means that when the price of a
good falls, the demand for the good rises and when price rises, the demand falls.
Definition of Law of Demand:
According to Professor Marshall, “The greater amount to be sold, the smaller must be price at which it is
offered in order that it may find purchaser, or, in other words, the amount demand increases with a fall in
price and diminishes with a rise price.”
Chief Characteristics of Law of Demand:
1. Inverse relationship
2. Price, an independent variable, and demand, a dependent variable.
3. Other things remain the same
4. Reasons underlying the law of Demand (a) Income Effect (b) Substitution Effect

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Exceptions to the Law of Demand:

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Shifts in demand curve:
A shift in the demand curve occurs when a determinant of demand other than price changes. It occurs when
demand for goods and services changes even though the price didn't. Although different goods and services
will have different demand shifters, the demand shifters are likely to include.
(1) Consumer Preferences
(2) The prices of related goods and services
(3) Income
(4) Demographic Characteristics
(5) Buyer Expectations.

Elasticity of Demand: Meaning


Elasticity of demand can be defined as “the degree of responsiveness of quantity demanded to change in
price”. It thus they represent the rate of change in the quantity demanded due to a change in price.
Definition:
According to Marshall, “The elasticity of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in price or diminishes much or little for a given rise in
price.”
According to Prof. Benham, “The concept of demand to the effect of a small change inprice upon the amount
demanded.”

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Types-Elasticity of Demand

1. Price Elasticity

2. Income Elasticity
Types
Elasticity
3. Arc Elasticity
of
4. Cross Elasticity
Demand

5. Advertising Elasticity.

Price elasticity:
Price elasticity of demand is the ratio of the percentage change in quantity demanded of a product to the
percentage change in price. Economists employ it to understand how supply and demand change when a
product's price changes.
Income Elasticity:
The income of consumer in another basic demand determined and affects the elasticity of demand. The
responsiveness of demand to the change in income is called the “Income Elasticity of Demand.” It is the rate
of change in quantity with respect to change in the income, if other things remaining the same. Income shows
a positive relationship with the demand, except the demand of inferior goods that shows a negative
relationship.
Arc Elasticity:
Arc elasticity is the sensitivity of one variable to another between two points on a curve. It is often used in the
context of the law of demand to measure the inverse relationship between price and demand. Arc elasticity
measures the responsiveness of demand to price changes over a range of values.

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Cross Elasticity:
Cross elasticity of demand refers to the way that changes in the price of one good can affect the quantity
demanded of another good. This relationship can vary depending on whether the two goods are substitutes,
complements, or unrelated to each other.

Advertising Elasticity:
Advertising elasticity is a measure of an advertising campaign's effectiveness in generating new sales.

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MASTER OF BUSINESS ADMINISTRATION (MBA)
FIRST SEMESTER
MANAGERIAL ECONOMICS

Unit - III

Production and Cost Analysis:

Production Concepts & Analysis:


Production is a process of transformation of the factors of production into the economic goods. So in term of
production analysis we are dealing with the physical relationships between inputs and outputs
Consumer will prefer products that are widely available and inexpensive. Focus on achieving high production
efficiency, low costs and mass distribution. It is useful when demand for a product exceeds the supply and
product’s cost is too high.
According to the Parkinson, “Production is the organized activity of transformation resources into finished
products in the form of goods and services.”

Production function:
The term “production function” refers to the relationship between the inputs and the outputs produced by
them. The term “factor of production” and “resources” are used interchangeably with the term “inputs”. The
relationship is purely physical or technological in character, that is, it ignores the prices of inputs and outputs.
The study of the production function is directed towards establishing the maximum output which can be
achieved with a given set of resources or inputs and with a given state of technology.

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Definition of production function:
According to Samuelson, “The production function is the technical relationship telling the amount of output
capable of being produced by each and every set of specified input (of factors of production). It is defined for
a given state of technical knowledge.”
According to Leftwich, “The term production function is applied to the physical relation between a firm’s
input of resources and its output of goods or services per unit of time.”
According to Lipsey & Steiner, “The technical relation between inputs and outputs is referred to in economics
as the Production Function.”

Characteristics of Production Function:


1. Production Function is an engineering problem not an economic problem
2. Production functions are Independent of Prices.
3. The Production Function is determined by the State of Technical Knowledge.
4. The Production Function is interpreted over a Given Time Period
5. The Production Function Accepts the Substitution Possibilities of Factors

Types of production function:


(A) Short-term Production Function:
When other factors of production remain constant and one factor is changed, it is called the short run
production function. This situation is also called the law of diminishing returns or the law of variable
proportions.
(B) Long-term Production Function:
When all the factors of production are variable, then that discussion is called long run production function.
This situation is also expressed by the name of the law of returns to scale.

Difference between Short-term Production Function & Long-term Production Function:


1. The short run production function is the law of variable proportions while the long run production function
is the law of returns to scale.
2. Short run production function applies in the short run while long run production function applies in the
long run.
3. Short run production function is applicable when only one factor is variable, rest of the factors remain
constant. On the contrary, long run production function is applicable when all the factors of production are
variable.
4. Due to lack of time in the short run production function the mutual coincidence ratio changes but in the
long run production the factors are increased or decreased simultaneously in the same ratio
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5. Under the short-run production function, the prices of variable factors of production do not remain
constant, according to the demand and supply, the prices can be lower or higher. In the long-run production
function, the price of the commodity produced and the prices of various factors of production are assumed to
be constant.

Laws of Production:
Law of Diminishing Return:
This rule is called by the names of Law of Diminishing Marginal Origin, Law of Variable Proportions, Law
of Diminishing Returns, etc. Classical economists have described the diminishing origin rule in the field of
production. Ricardo's Rent Theory and Malthus's Population Theory are based on this rule. This law has been
defined in various ways by classical and modern economists.

Classical Approach:
According to Marshall, “An increase in the capital and labour employed in the cultivation of land causes in
general a less than proportionate increase in the amount the produce raised, unless it happens to coincide with
an improvement in the art of agriculture.”
The main points of Marshall's definition are as follows:
1. The yield of agriculture does not increase in proportion to the increase in the quantity of labor and capital.
2. This rule applies under normal circumstances.
3. There should be no progress in agriculture.

Table: Structure of Production - Diminishing Return

Average Marginal
Unit of Labour & Capital Total Production
Production Production

1 50 50 50
2 90 45 40
3 120 40 30
4 140 35 20
5 150 30 10
6 150 25 0
7 140 20 -10

3
Important Feature in Diminishing Production:
1. Production refers to marginal production; it has nothing to do with the cost of production.
2. The rule applies only when increasing labor or other means by keeping one means of production i.e. land
constant.
3. Marginal product decreases by increasing factors only after a particular stage of production.

Assumptions of Law of Diminishing Origins:


1. Resources are limited and scarce. In the field of agriculture, land is a limited resource. It is impossible to
change its belief.
2. Other factors are variable. Labor and capital are considered variable in the field of agriculture. Change in
their quantity is possible without any improvement in the technology of production.
3. Different units of variable factor are identical.

Modern Approach: Law of Variable Proportions:


The Law of Diminishing Origin has been explained in more detail by modern economists. This rule is not
only applicable in the agricultural sector but it is applicable in all areas of production. Modern economists call
this rule The Law of Variable Proportions.
According to Mrs. Joan Robinson, “The Law of Diminishing Return, as is usually formulated states that with
a fixed amount of any one factor of production, successive increase in the amount of other factor will after a
point, yield a diminishing increment of output.”
According to Prof. Stigler, “If the quantity of one productive service is increased by the equal increments, the
quantities of other productive services remaining fixed, the resulting increments of product will decrease after
a certain point.”

Main feature of Modern Approach:


1. Any means of production can be kept fixed, land in agriculture and capital or machine can be kept fixed in
industries.
2. Total production will increase though the rate of increase will not be uniform.
3. The average yield and marginal yield will first increase and then decrease.

Main feature of Modern Approach:


1. Any means of production can be kept fixed, land in agriculture and capital or machine can be kept fixed in
industries.
2. Total production will increase though the rate of increase will not be uniform.
3. The average yield and marginal yield will first increase and then decrease.
4
Table: Three Stage of Production
Variable Total Marginal Average
Fixed Resource Different
Resource Production Production Production
Land Stages
Labor (TP) (MP) (AP)
1 0 0 0 0
1 1 20 20 20 First Stage
Law of
1 2 50 30 25
Increasing
1 3 90 40 30 Return
1 4 120 30 30
1 5 140 20 28
Second Stage
Law of
1 6 150 10 25
Diminishing
Return
1 7 150 0 21.43
Third Stage
1 8 140 -10 17.5 Law of
Negative Return

Law of returns to scale:


Increase in scale means increasing all factors of production in the same proportion, so under returns to scale,
the effect on total output is studied by changing the quantities of all factors simultaneously in the same
proportion.
According to Prof. Koyatsoviannis, “The term return to scale refers to the change in output as all factors
change by the same proportion.”

The following points are worth mentioning about returns to scale:


1. They are concerned with the long run and are based on the long run production function.
2. In this, the mutual proportion of all means remains constant and the functions of all means are changed in
one to one ratio.
3. Technology of production remains constant.
4. Production is measured by quantity and not by value.

Distinction between Changes in Factors Proportion and Changes in Scale:


(A) Change in Factor of Proportion:
The association of a fixed factor with the subsidiary factors of change is called a ratio. A plant or plant can be
said to be a large ratio. A plant consists of machines and with this factor a number of variable factors such as
labor, raw materials, table, chairs etc. are studied. The idea of proportion is related to the short run because
in the short run we can increase production by using more and more variable factors with fixed factors.

5
(B) Changes in Scale:
Scale can be defined as the number of times all the ratios are repeated i.e. the number of times the fixed and
variable factors are increased the more it establishes the scale of the firm. In simple words increase in scale
means all the factors increase in same proportion.

Distinction between Changes in Factors Proportion and Changes in Scale:


Change in Factor of Proportion Changes in Scale
Stage Capital Labour Ratio Capital Labour Ratio
A 1 5 1:5 1 5 1:5
B 1 8 1:8 2 10 1:5
C 1 10 1:10 3 15 1:5
D 1 12 1:12 4 20 1:5

Cost Concept and Analysis:


Cost Concept:
The amount of money that has to be spent for using the means of production is called production cost.
Production cost mainly depends on the quantity of production. Generally production cost increases as
production increases, so it can be said that production cost ( C) is a function of the quantity produced (Q).
C = F (Q)
Types of Costs:
1. Monetary Cost: Monetary Cost refers to the money expenditure incurred on the production of commodity
2. Real Cost: Real Cost refers to disutility or discomfort suffered by person while rendering are known as
explicit cost.
3. Opportunity Cost: It refers to the value of a factor in its next best alternative use.
4. Explicit Costs: Actual money expenses incurred in the production of goods and services are known as
explicit cost.
5. Implicit Cost: Implicit cost defined as the cost of self producer on the self employed resources.
6. Total Cost: It refers to total expenditure incurred by the producer on the purchase of fixed as well as
variable factors of production.
7. Fixed Cost: Fixed Cost refers to the expenditure incurred on the fixed factors of production. It does not
change with output.
8. Variable Cost: Variable Cost can be obtained by dividing total cost by the factors. It varies with output.
9. Average Cost: Average Cost can be obtained by dividing total cost by the quantity of output. It is also
called as Average Cost.
10. Marginal Cost: It is the cost of producing an additional unit of a commodity.
6
Cost Output Relationship in the Short-run:
Short run is the period in which the quantity of production can be changed only with the help of variable
factors but it is not possible to change the capacity or size of the fixed plant of the firm.
In other words production quantity can be increased in short run by changing variable inputs like raw material
man power etc. with fixed plant capacity thus production cannot be increased by increasing plant size in short
run.
The study of cost in the short run can be done under the following heads-
(A) Total Cost
(B) Average Cost
(C) Marginal Cost.
(A) Total Cost

(B) Average Cost

7
Cost Output relationship in the Long-run:
The conditions of production in the long run are different from the conditions of production in the short run.
To change the quantity of production in the short run only the quantity of variable factors has to be changed
while it is not possible to change the quantity of fixed factors i.e. in the short run a firm cannot change the
size of its plant but in the long run The time is enough that it can also change its plant according to the supply.
In the long run the factors of production cannot be divided into variable factors and fixed factors because in
the long run all the factors of production are variable. Therefore, to increase the amount of production, the
quantity of all factors of production can be increased, that is, in the long run, a firm can also change the size
of its plant, therefore, in the long run, there is no fixed cost for a firm, but all costs are variable.

Since all costs are variable in the long run, only the following two occur in the long run-
Short-run Cost Trends (Per Unit Cost) In Rs. Long-run Cost

Production Unit Plant-1 Plant-2 Plant-3 Minimum in all


(I) (II) (III) (IV) Three (V)
1000 90 100 110 90

2000 110 80 120 80

3000 140 110 100 100

Estimation of revenue:
Revenue estimation involves calculating the amount of money your business is likely to earn. You can work
this out by forecasting your business growth rate, the number of customers you have (and will have) and the
prices of your products and services.

Total Revenue:
Total revenue is the total amount of money a company brings in from selling its goods and services. It
determines how well a company is bringing in money from its core operations based on demand and price.
Total Revenue = Unit Sold of Commodity (Q) x Price Per Unit (P)

Average Revenue:
Average revenue is referred to as the revenue that is earned per unit of output. In other words, it is the revenue
that is obtained by the seller on selling each unit of the commodity. Average revenue of a business is obtained
by dividing the total revenue with the total output.
Average Revenue = Total Revenue / Total Unit Sold
8
Marginal Revenue:
Marginal revenue is the increase in revenue that results from the sale of one additional unit of output. While
marginal revenue can remain constant over a certain level of output, it follows from the law of diminishing
returns and will eventually slow down as the output level increases.
Marginal Revenue = Change in Total Revenue/Change in Quantity

*************

9
MASTER OF BUSINESS ADMINISTRATION (MBA)
FIRST SEMESTER
MANAGERIAL ECONOMICS

Unit - IV

Meaning of Market:
In common parlance, the term „Market‟ refers to a particular place when goods are bought and sold. However,
in Economics the term market has a wider meaning.
In economics, the term „market‟ has no reference to a particular place. The buyers and sellers need not
assemble anywhere. They may be living in distant places. They are coming together unnecessary. They can
do business with the help of Telephone, Telegraph, Ordinary Post or by any other online medium..

Definition of Market:
According to J. M Edwards, “A market is that mechanism by which buyers and sellers are bought together. It
is not necessarily a fixed place.”
According to Joan Robinson, “Market, a means by which the exchange of goods and services takes place as a
result of buyers and sellers being in contact with one another, either directly or through mediating agents or
institutions.”

Market Structures:
Market structure shapes the most important features of a market, including the level of competition, the type
and volume of transaction costs, and the power of firms to influence the terms on which they trade with other
economic factors. Market structure reflects three key elements: the number and relative size of sellers and
buyers, brand diversity, the convenience of entry and potential for exit. At the fundamental level, it comes
down to the nature of competition and how well it encourages and weeds out innovation, quality and cost-

1
cutting. It determines whether pricing decisions are obvious or hard to measure and whether new and better
goods and services can enter or replace outdated ones.

Definition:
“Market structure refers to the way that various industries are classified and differentiated inaccordance with
their degree and nature of competition for products and services.”

Perfect Market Structures:


A Perfect Market is market that is structured to have no anomalies that would otherwise interfere with the best
prices being obtained. Examples of this perfect market structure are: A large number of buyers. A large
number of sellers, products are homogeneous.

Definition of Perfect Market Structure:


According to Prof. Leftwich, “Perfect competition is a market in which there are many firms selling identical
products with no firm large enough relative to the entire market to be able to influence market price.”
2
According to Ferguson, “Perfect competition describe a market in which, there is a complete absence of direct
competition among economic groups”
According to Prof. Bilas, “The perfect market completion is characterized by the presence of many firms.
They all sell identical products. The seller is a price taker not a price maker.

3
Imperfect Market Structures:
Imperfect markets are characterized by having competition for market share, high barriers to entry and exit,
different products and services, and a small number of buyers and sellers. Perfect markets are theoretical and
cannot exist in the real world; all real-world markets are imperfect markets.

Definition of Imperfect Market Structures:


According to Prof. Meade, “ An Imperfect market for the industry‟s product exist, if for one reason or
another, the consumers do not consider the output of each firm to be identical, but prefer the product of one
firm to that from another firm's product.”

Determination of Price under Perfect Competition:


Who determines the price? Industry or Firm.
In perfect competition no firm alone can affect the market price because its own production is negligible
compared to the production of the whole industry but many firms together can affect the market price. When
many firms do something together, it means that the whole industry is doing something. Thus, in perfect
competition, the industry, not the individual firm, sets the price. A single firm has no choice but to adopt this
price.

4
We can study price determination under perfect competition under the following heads.
1. Price Determination by Industry
2. Equilibrium or Price Determination of Firm
3. Importance of Time Element in the Price Determination

1. Price Determination by Industry:


The price is determined by the coordination between the industry and the buyers of its product. The industry
has its own supply schedule, which contains information about how much goods the industry is willing to sell
at what price. Buyers have a market demand schedule, it contains information that at what price the consumer
is ready to buy how much of the industry's product. The interests of industry and consumers are at odds with
each other. Industry wants to charge as much as possible, while consumers want to pay as little as possible.
The deal is finalized only when both agree on a price. This price is the equilibrium price because it brings
about a balance between the opposing interests.
The price is considered to be determined at the price at which the industry is ready to sell the same quantity
and the consumers are ready to buy the same quantity, thus the equilibrium point of demand and supply
determines the price.

Table: Price Determination By Industry


Price in Rs. Demand of Commodity Supply of Commodity
(P) (D) (S)
1.00 50  10
2.00 40  20
3.00 30 = 30 Balance (D = S)
4.00 20 <40
5.00 10 <50

Equilibrium or Price Determination of Firm:


A firm will go somewhere in equilibrium when there is no tendency to change the quantity of its total
production, that is, in equilibrium, the firm will decide that quantity of production and the price at which it
will get maximum profit or maximum net income.
In other words, in „Equilibrium of a Firm' and „Quantity of goods produced by a Firm and Determination of
price' both are the same thing.

5
Main feature of Equilibrium:
1. Equilibrium means the absence of change, that is, in this situation the firm does not want to make any
change in its price or quantity of production.
2. The firm reaches the stage of stagnation when it gets maximum profit.
3. In the equilibrium state, the cost of production of the firm is minimum

Importance of Time Element in the Price Determination


The time element occupies an important place in price theory. In the words of Dr. Marshall, "In general, the
shorter the period of time under consideration, the greater is the attention paid to demand in price, and the
longer the period of time, the more significant production-cost impact on price.
Although it is true that both demand and supply exert their influence on pricing like two sides of a pair of
scissors. But the dynamics of demand and supply are not the same in all directions. Sometimes demand is
more active than supply and sometimes supply is more active than demand. This variation in demand-supply
dynamics is affected by the duration of the market. Marshall has divided time into the following four parts
from the point of view of price determination.

Monopoly: Meaning:
By monopoly, we mean that market situation in which a single producer or firm has complete control over the
supply of a specific commodity.

Definition:
According to Boulding, “A pure Monopolist, therefore, is a firm producing a product which has no effective
substitutes among the products of any other firm „effective‟ in the sense though the monopolist may be
making abnormal profits, other firms cannot encroach on these profits by producing substitute commodities
which might entire purchase away from the product of the monopolist.

Feature of Monopoly:
1. Single Producer or Seller
2. Firm and Industry are Synonymous
3. No Near Effective Substitute
4. Effective Control on Entry of New Firm
5. Independence Price Policy
6. Price Discrimination Possible
7. Full Control on Supply of Goods
8. Abnormal Profit on Long Period
6
Pricing Under Monopoly
1. Total Revenue & Total Cost Curves Approach 2. Marginal Analysis

1. Total Revenue & Total Cost Curves Approach:


This policy was given by Professor Marshall, according to this method, where the distance between Total
Revenue (TR) and Total Cost (TC) is maximum, the monopolist will get maximum profit, that is, he will be in
equilibrium.
Total Cost Per Profit Per Total
Unit Price Per Total
Revenue Unit Unit Profit
Produce Unit (Rs.) Cost
(Rs.) (Rs.) (Rs.) (Rs.)
20 10 200 5 10 5 100
40 9 360 4 160 5 200
60 8 480 3 180 5 300
80 7.5 600 3.5 280 4 320
100 7 700 4 400 3 300
120 6 720 5 600 1 -120
140 5 700 6 840 -1 -140

Marginal Analysis Approach:


This policy was first put in front of us by Mrs. John Robinson. He said that the monopolist tries to make the
marginal cost equal to the marginal revenue in order to get the maximum profit and the place where these two
lines are equal, the price is fixed, because the total revenue of a pure monopolist is maximum in that case.

Price Per Total Marginal Marginal Total


Unit
Unit Revenue Revenue Total Cost Cost Profit
Produce
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
10 31 310 -- 260 -- 50
11 30 330 20 274 14 56
12 29 348 18 289 15 59
13 28 364 16 305 16 59
14 26 364 0 322 17 42
15 24 360 -4 340 18 20

Price Discrimination: Meaning:


Price Discrimination is the action of a monopolist by which he charges different prices from different buyers
of the same commodity produced by him.

7
Definition:
According to Mrs. Joan Robinson, “The act of selling the same article produced under a single control, at
different prices to different buyers is known as price discrimination.”
According to Prof. Stigler, “Price discrimination is defined as the sale of a commodity at two or more prices.”

Types of Price Discrimination:


Price discrimination of First Degree:
Under this category of price discrimination, the producer charges the highest price for each unit of the
commodity that the consumer is ready to pay, so in such a situation, the buyer does not get any savings of the
consumer.

Price discrimination of Second Degree:


In this the monopolist divides his buyers into different categories and in each category all the members of the
group are charged the minimum price which the poorest person in that group is ready to pay. In this the buyer
gets some savings of the consumer.

Price discrimination of Third Degree:


Under this, the monopolist charges different prices according to the elasticity of demand of each category by
dividing its buyers into different categories or markets.

Conditions of Price Discrimination:


1. Separation of Markets
2. Nature of Commodity
3. Transportation Expenses
4. Government Regulation
5. Ignorance of Consumer
6. Wrong Assumption
7. Insignificant Difference in Price Ignored
8. Sale on Order

Monopolistic:
Monopolistic competition refers to a situation in which the seller's products are so differentiated that they are
not complete substitutes for each other. Each producer or seller has a complete monopoly on his product, but
since he has to face competition with incompletely established products in the market, such a situation is
called a monopoly situation.
8
Definition:
According to Prof. Leftwitch, “Monopolistic Competition is a market situation in which there are many
sellers of particular product but the product of each is in some way differentiated in the minds of consumers
from the product of other product.”

Features:
1. Large Number of Sellers
2. Product Differentiation of Product Heterogeneity
3. Free Entry of Firm
4. Selling Cost
5. Each Firm is monopolist for its Product
6. Consumer reveals his Preference
7. Existence of both Monopoly and Competition
8. No Restrictions

Pricing Under Monopolistic Competition:


In the case of Monopolistic Competition, the price is determined at the point where both marginal cost and
marginal revenue of a commodity are equal to each other because equilibrium condition occurs when
marginal revenue becomes equal to marginal cost, hence at this point Seller stops expanding production after.
(Table)
Qty. Total Marginal Marginal Average
Per Unit Total Cost Profit Per
Pen Revenue Revenue Cost Cost
Price TC Unit
In Unit TR MR MC AC
2 5 8
1 3 4 6 7
1 20 20 20 8 8 8 12
2 18 36 16 18 10 9 9
3 16 48 12 30 12 10 6
4 14 56 8 44 14 11 3
5 12 60 4 60 16 12 0

Product Differentiation:
Product Differentiation is the characteristic or characteristics that make your product or service stand out to
your target audience. It's how you distinguish what you sell from what your competitors do, and it increases
brand loyalty, sales, and growth.
In other words, “Differentiated Product” refers to products that can remain competitive despite being put
against competing products that are very similar. Cars, smart phones, computers, shoes, and perhaps most
notably, bottled water

9
Oligopoly:
An oligopoly is a market characterized by a small number of firms who realize they are interdependent in
their pricing and output policies. The number of firms is small enough to give each firm some market power.

Definition:
According to Leftwich, “Market conditions are called oligopoly conditions in which there are a small number
of sellers and so many that the actions of one are important to others.”

Features of Oligopoly:
1. Few Numbers of Sellers
2. Inter-dependence
3. Differential Product
4. Difficult Entry and Exit of New Firm
5. Uncertainty of the Demand Curve
6. Advertisement Activities
7. Price Rigid
8. Group Behavior
9. Inconsistency

Cartels:
“A group of separate companies, that agree to increase profits by fixing prices and not competing with each
other.”
Cartelization or coalition or cartel is also prevalent in imperfect oligopoly market. Cartelization can be either
complete or incomplete. Under perfect cartelization, a central body determines the price and quantity of
output for all oligopolistic firms so that all firms can get maximum profit. Under incomplete cartelization,
there is no such central body that controls price and quantity of product on oligopolistic firms. No tight
controls can be imposed, but only good men's agreements between firms and each form has the right to vary
the price and quantity of production to some extent.

Theory of Kinked Demand Curve:


In an oligopolistic market, the kinked demand curve hypothesis states that the firm faces a demand curve with
a kink at the prevailing price level. The curve is more elastic above the kink and less elastic below it. This
means that the response to a price increase is less than the response to a price decrease.

10
Assumptions of kinked Demand theory:
1. It is assumed that if one firm cuts its price, other firms will also follow it, so reducing the price of the
commodity will not give any special benefit to one firm.
2. It is assumed that the oligopolistic industry is in a mature stage. This stage can occur without product
differentiation and with product differentiation. Therefore, without any coalition, the industry can establish a
price or price pool that is considered satisfactory to all firms.
3. It is assumed that if one firm increases the price, the other firms will not follow it i.e. will not increase the
price.

Meaning of Kinked Demand Curve:


Assumptions No. 1 and 3 mentioned above result in a sharp bend or contraction in the demand curve of a firm
at the current price. In other words, the demand curve faced by the oligopolist has a contraction at the current
price level. The contraction occurs at the current price level because the portion of the demand curve that is
above the current price is highly elastic and demand at the current price is less than the current price. the
underside is inelastic.

11
Price Leadership:
Price leadership refers to a situation where prices and price changes established by a dominant firm, or a firm
are accepted by others as the leader, and which other firms in the industry adopt and follow. For example, if
companies in a particular market follow a price leader by setting higher prices, then all producers in that
market stand to profit, as long as demand remains steady. Price leadership also has the potential to eliminate
(or reduce) price wars.
According to Arthur Burns, “Price competition comes under price leadership if the same price changes are
always or often carried out by the same firm and if other sellers always or often follow the same price
changes.”

*************

12
MASTER OF BUSINESS ADMINISTRATION (MBA)
FIRST SEMESTER
MANAGERIAL ECONOMICS

Unit - V

National Income
National Income is referred to as the total monetary value of all services and goods that are produced by a
nation during a period of time.
In other words, it is the sum of all the factor income that is generated during a production year. National
income serves as an indicator of the nation's economic activity.

Concepts of National Income:


1. Gross Domestic Product: (GDP)
It is the money value of all final goods and services produced in the domestic territory of a country in a year‟s
time.
2. Gross National Product: (GNP)
Gross national product is the value of all products and services produced by the citizens of a country both
domestically and internationally minus income earned by foreign residents.
3. Net Domestic Product: (NDP)
The net domestic product (NDP) is calculated by subtracting the value of depreciation of capital assets of the
nation such as machinery, housing, and vehicles from the gross domestic product (GDP).
4. Net National Product (NNP) :
Net national product (NNP) is gross national product (GNP), the total value of finished goods and services
produced by a country's citizens overseas and domestically, minus depreciation.
5. Per Capita Income =
National Income / Total Population during the Year

Definition:
According to Prof. Alfred Marshall, “The labor and capital of a country acting on its natural resources
annually produce a net aggregate of commodities, material and immaterial including services of all kinds”
According to National Income committee of India, “National Income estimates measures the value of
commodities and services turned out during a given period”

1
1. Product Method:
This method views national income from the output side. The production method is also known as Value
Added Method. Net Output Method or simply Output method.
This method consists of finding out the Net Value of all commodities and services produced in various sectors
of the economy during a year and adding them up. The total obtained is called the Final Products Total.
Under this method first of all, the economy of a country is divided into different sectors such as agriculture,
manufacturing, trade, transport, communications, mining, constructions, banking, insurance, electricity, gas
and water supply and so on. Then the value of gross product of all producers in a sector is totaled up and from
this summation is subtracted the value of intermediate products in order to avoid double counting. When we
add up the net figure of this type from each sector, use get GNP
This production method enables us to trace the origin of national income aggregate to different sectors of the
economy. Hence this method is also known as National Income by Industrial Origin.

Some Important Fact About Product Method:


First, the sale of existing goods or services is not part of GNP.
Secondly, an increase in inventory must be considered a final good because it involves current production for
value added.
Thirdly, the value of homework by housewife e.g. cooking, baking, and cleaning does not enter GNP but the
value of a restaurant‟s cook‟s product or professional baker‟s product does enter in to GNP because it goes
through market channels.

2
Fourthly, illegal income is not in included in GNP because its counting is not possible as they are must most
often not declared and such cannot be accumulated for .
Fifthly, in case of goods and services meant for sell-consumption, for example, farmers produce kept for self-
consumption or self-occupied house of an owner, imputed values of such produce or imputed rent is included
in GNP.

Income Method:
This method is also called Factor Income Method, Factor Share Method, Income Distributed Method or
National Income by Distributive Share Method.
In this method: we calculate national income from distribution side. In other words, this method national
income after it has been distributed and appears as income earned or received by individuals of the country.
According to this method national income is obtained by totalling all the incomes according to the various
factors of production used in producing national product. Thus national income is calculated for example by
adding up the rent of land, wages and salaries of employees, profit of entrepreneurs. Interest on capital and
income of self-employed people.
Notably transfer payments are not counted as national income. For example, if an individuals sells his house,
the purchase price is not income. It is a transfer payment which represents no addition to national output.
Likewise income of a beggar, scholarships to orphans, aid to needy person or relief payments are not counted
as income because they are obtained without producing anything.

Expenditure Method:
National Income under this method, is arrived at by adding up all the expenditure made on the goods and
services during the specific period. As such GNP is found out by totalling:
1. Personal Consumption expenditure (C), that is total of private individuals expenditure on
Consumption of consumer goods and services.
2. Domestic Private investment (I) that is, total of private businesses spending on new investments,
replacement and renewals (that is expenditure on plants and equipment)
3. Net Export of Goods and Services (X-M), is also called loosely as „Foreign Investments‟ in other
words, surplus of all the goods and services we provide to foreigners over and above what they
provide to us. Thus we calculate:
(a) The total of our exports to foreigners (wheat, shipping etc.,) plus our earnings from factors of
production we own abroad (dividends and interest payable to us).
(b) The total what we import from foreigners plus what we must pay them for their ownership of
production factors located in our country.
(c) The surplus of (a) over (b) which represents our net export figures.
3
Circular Flow of Income
The circular flow of income or circular flow is a model of the economy in which the major exchanges are
represented as flows of money, goods and services, etc. between economic agents. The flows of money and
goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow
analysis is the basis of national accounts and hence of macroeconomics.

Two
Sector
Model

Three
Sector
Model
Four
Sector
Model

4
Circular Flow of Income - Two Sector Model
In the basic two-sector circular flow of income model, the economy consists of two sectors: Households and
Firms. Some sources refer to Households as Individual or the Public and to Firms as Businesses or the
Productive Sector.
The model assumes that there is no Financial Sector, no Government Sector and no Foreign Sector.
The model assumes that
(a) Through their expenditures, households spend all of their income on goods and services or consumption.
(b) Through their expenditures, households purchase all output produced by firms.
This means that all household expenditures become income for firms. The firms then spend all of this income
on factors of production such as labor, capital and raw materials, transferring all of their income to the factor
owners (which are households). The factor owners (households), in turn, spend all of their income on goods,
which leads to a circular flow of income.

5
Circular Flow of Income in two Sector Economy

Circular Flow of Income – Three Sector Model


The Three-Sector model adds the Government Sector to the Two-Sector Model. Thus, the Three-Sector model
includes (1) Households, (2) Firms, and (3) Government.
It excludes the Financial Sector and the foreign sector.
The government sector consists of the economic activities of local, state and federal governments. Flows from
households and firms to government are in the form of taxes. The income the government receives flows to
firms and households in the form of subsidies, transfers, and purchases of goods and services. Every payment
has a corresponding receipt that is, every flow of money has a corresponding flow of goods in the opposite
direction. As a result, the aggregate expenditure of the economy is identical to its aggregate income, making a
circular flow.

Circular Flow of Income in Three Sector Economy

6
Circular Flow of Income - Four Sector Economy:
The Four-Sector Model adds the Foreign Sector to the Three-Sector Model. (The foreign sector is also known
as the External Sector, the Overseas Sector, or the Rest of the World.
Thus, the four-sector model includes:
(1) Households (2) Firms (3) Government (4) the Rest of the world.
The foreign sector comprises:
(a) Foreign Trade (imports and exports of goods and services)
(b) Inflow and Outflow of capital (foreign exchange).
Again, each flow of money has a corresponding flow of goods (or services) in the opposite direction. Each of
the four sectors receives some payments from the other in lieu of goods and services which makes a regular
flow of goods and physical services. The addition of the foreign sector

Circular Flow of Income in Four Sector Economy

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Inflation- Meaning:
In economics, Inflation refers to a general increase in the prices of goods and services in an economy. When
the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation
corresponds to a reduction in the purchasing power of money.

Definition:
According to Crowther, “Inflation is a stage in which the volume of money is falling i.e.price are rising.”
According to Milton Friedman, “Inflation is a steady and sustained rise in price.”

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Types of Inflation:
1. Open and Suppressed Inflation
2. Credit Inflation
3. Deficit Induced Inflation
4. Wage Induced Inflation
5. Profit Induced Inflation
6. Demand Induced Inflation
7. Comprehensive and Sectoral Inflation
8. Full or Partial Inflation
9. War Time Inflation
10.Post war Inflation

Causes of Inflation:
1. Demand Pull Inflation
2. Increasing Public Debt
3. Increasing in Private Investment
4. Reduction in Taxes
5. Reduction in Public Debt
6. Increased Money Supply
7. Increase in Population
8. Natural Causes
9. Rising Wages
10.Policies and Regulations

Effect of Inflation:
• Poor Economic Growth
• Increase wages
• Income Distribution
• Unemployment
• International Competitiveness
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Differentiation between Deflation, Stagflation & Inflation:

Inflation Deflation Stagflation


Inflation refers to a general Deflation is when consumer and Stagflation is the simultaneous
increase in the prices of goods asset prices decrease over time, appearance in an economy of
and services in an economy. and purchasing power increases. slow growth, high
When the general price level Essentially, you can buy more unemployment, and rising
rises, each unit of currency buys goods or services tomorrow prices. Once thought by
fewer goods and services; with the same amount of money economists to be impossible,
consequently, inflation you have today. This is the stagflation has occurred
corresponds to a reduction in the mirror image of inflation, which repeatedly in the developed
purchasing power of money. is the gradual increase in prices world since the 1970s. Policy
across the economy solutions for slow growth tend
to worsen inflation, and vice
versa.

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Business Cycle:
Meaning:
Business cycles are a type of fluctuation found in the aggregate economic activity of a nation -- a cycle that
consists of expansions occurring at about the same time in many economic activities, followed by similarly
general contractions (recessions). This sequence of changes is recurrent but not periodic.
Definition:
A Business cycle is the natural expansion and contraction of economic growth that happens in an economy
over a period of time. The rise and fall of an economy's gross domestic product (GDP) defines the start and
end of a business cycle, which is also known as an economic cycle or a trade cycle.

Characteristics of the Business Cycle:


1. Fluctuation in aggregate business activity
2. Characteristics of a market driven economy
3. Regular sequence of changes from expansion downturn, contraction, recovery.
4. Not periodic in duration, intensity, or scope,
5. Expansion and contraction occur in many phases of economic activity in both the real and financial sectors.
6. Cycles cannot be further subdivided into shorter cycles with similar characteristics.

Phases of Business Cycle:


A typical business cycle has two phases expansion phase or upswing or peak and contraction phase or
downswing or trough. The upswing or expansion phase exhibit a more Rapid growth of GNP than the long
run trend growth rate. At some point, GNP reaches its upper turning point and the downswing of the cycle
begin. In the contraction phase GNP Declines.
At some time, GNP reaches its lower turning point and expansion begins starting from a lower turning point,
a cycle experience the face of recovery and after sometime it reaches the upper turning point the peak. But,
continuous prosperity can never a cure and the process of Downhill start. In this contraction phase, a cycle
exhibits first edition and then finally reaches the bottom -The depression.
Thus a trade cycle has four phases:
1. Depression
2. Revival
3. Boom
4. Recession

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