MANAGERIAL ECONOMICS

1. Mention the demand function. What is elasticity of demand? Describe thedeterminants of elasticity of demand.

Demand Function:

The demand for a product or service is affected by its price, theincome of the individual, the price of other substitutes, population,and habit. Hence we can say that demand is a function of the price ofthe product, and others as mentioned above.

Demand function is a comprehensive formulation which specifies thefactors that influence the demand for a product. Mathematically, ademand function can be represented in the following manner.

Dx = f (Px, Ps, Pc, Ep, Y, Ey, T, W, A, U….etc) Where

Dx = Demand for commodity X Px = Price of a commodity X

Pc = Price of the complements Y = Income of the consumer

T = Tastes and preferences A = Advertisement and its impact

Ps = Price of substitutes Ep = Expected future price

Ey= Expected income in the future W= Wealth of the consumer

U = All other determinants

Elasticity of demand

In economics the term elasticity refers to a ratio of the relativechanges in two quantities. It measures the responsiveness of onevariable to the changes in another variable.

Elasticity of demand is generally defined as the responsiveness orsensitiveness of demand to a given change in the price of a commodity.It refers to the capacity of demand either to stretch or shrink to agiven change in price. Elasticity is an index of reaction.

Elasticity of demand indicates a ratio of relative changes in twoquantities.ie, price and demand.

According to professor Boulding: “Elasticity of demand measuresthe responsiveness of demand to changes in price”.

In the words of Marshall,” The elasticity (or responsiveness)of demand in a market is great or small according to as theamount demanded much or little for a given fall in price, anddiminishes much or little for a given rise in price”

Different Degree of Price Elasticity of Demand

Perfectly Elastic Demand: In this case, a very small change in priceleads to an infinite change in demand. The demand curve is ahorizontal line and parallel to OX axis. The numerical coefficientof perfectly elastic demand is infinity (ED=infinity)

Perfectly Inelastic Demand : In this case, whatever may be thechange in price, quantity demanded will remain perfectly constant.The demand curve is a vertical straight line and parallel to OY axis.Quantity demanded would be 10 units, irrespective of price changesfrom Rs. 10.00 to Rs. 2.00. Hence, the numerical coefficient ofperfectly inelastic demand is zero. ED = 0

Relative Elastic Demand: In this case, a slight change in price leads tomore than proportionate change in demand. One can notice here that achange in demand is more than that of change in price. Hence, theelasticity is greater than one. For e.g., price falls by 3 % anddemand rises by 9 %. Hence, the numerical coefficient of demand isgreater than one.

Relatively Inelastic Demand: In this case, a large change in price, say8 % fall price, leads to less than proportionate change indemand, say 4 % rise in demand. One can notice here that change indemand is less than that of change in price. This can be representedby a steeper demand curve. Hence, elasticity is less than one.

In all economic discussion, relatively elastic demand is generallycalled as ‘elastic demand’ or ‘more elastic’ demand while relativelyinelastic demand is popularly known as ‘inelastic demand’ or ‘lesselastic demand’.

Unitary elastic Demand: In this case, proportionate change in price leadsto equal proportionate change in demand. For e.g., 5 % fall in priceleads to exactly 5 % increase in demand. Hence, elasticity is equalto unity. It is possible to come across unitary elastic demand but itis a rare phenomenon.

Out of five different degrees, the first two are theoretical and thelast one is a rare possibility. Hence, in all our generaldiscussion, we make reference only to two terms relativelyelastic demand and relatively inelastic demand.

Determinants of Elasticity of Demand:

The elasticity of demand depends on several factors of which thefollowing are some of the important ones.

1. Nature of the Commodity

Commodities coming under the category of necessaries and essentialstend to be inelastic because people buy them whatever may be theprice. For example, rice, wheat, sugar, milk, vegetables etc. on theother hand, for comforts and luxuries, demand tends to be elastice.g., TV sets, refrigerators etc.

2. Existence of Substitutes

Substitute goods are those that are considered to be economicallyinterchangeable by buyers. If a commodity has no substitutes in themarket, demand tends to be inelastic because people have to pay higherprice for such articles. For example, salt, onions, garlic, gingeretc. In case of commodities having different substitutes, demand tendsto be elastic. For example, blades, tooth pastes, soaps etc.

3. Number of uses for the commodity

Single-use goods are those items which can be used for only onepurpose and multiple-use goods can be used for a variety of purposes.If a commodity has only one use (singe use product) then demand tendsto be inelastic because people have to pay more prices if they have to

use that product for only one use. For example: all kinds of eatables,seeds, fertilizers, pesticides etc. On the contrary, commoditieshaving several uses, demand tends to be elastic. For example, coal,electricity, steel etc.

4. Durability and reparability of a commodity

Durable goods are those which can be used for a long period of time.Demand tends to be elastic in case of durable and repairable goodsbecause people do not buy them frequently. For example, table, chair,vessels etc. On the other hand, for perishable and non-repairablegoods, demand tends to be inelastic e.g., milk, vegetables, electronicwatches etc.

5. Possibility of postponing the use of a commodity

In case there is no possibility to postpone the use of a commodity tofuture, the demand tends to be inelastic because people have to buythem irrespective of their prices. For example: medicines. If there ispossibility to postpone the use of a commodity, demand tends to beelastic e.g., buying a TV set, motor cycle, washing machine or a caretc.

6. Level of Income of the people

Generally speaking, demand will be relatively inelastic in case ofrich people because any change in market price will not alter andaffect their purchase plans. On the contrary, demand tends to beelastic in case of poor.

7. Range of Prices

There are certain goods or products like imported cars, computers,refrigerators, TV etc, which are costly in nature. Similarly, a fewother goods like nails; needles etc. are low priced goods. Hence,demand for them is inelastic in nature. However, commodities havingnormal prices are elastic in nature.

8. Proportion of the expenditure on a commodity

When the amount of money spent on buying a product is either too smallor too big, in that case demand tends to be inelastic. For example,salt, newspaper or a site or house. On the other hand, the amount ofmoney spent is moderate; demand in that case tends to be elastic. Forexample, vegetables and fruits, cloths, provision items etc.

9. Habits

When people are habituated for the use of a commodity, they do notcare for price changes over a certain range. For example: in case ofsmoking, drinking, use of tobacco etc. In that case, demand tends tobe inelastic. If people are not habituated for the use of anyproducts, then demand generally tends to be elastic.

10. Period of time

Price elasticity of demand varies with the length of the time period.Generally speaking, in the short period, demand is inelastic becauseconsumption habits of the people, customs and traditions etc. do notchange. On the contrary, demand tends to be elastic in the long periodwhere there is possibility of all kinds of changes.

11. Level of Knowledge

Demand in case of enlightened customer would be elastic and in case ofignorant customers, it would be inelastic.

12. Existence of complementary goods

Goods or services whose demands are interrelated, such that, anincrease in the price of one of the products, results in a fall in thedemand for the other. For example, pen and ink, vehicles and petrol,shoes and socks etc have inelastic demand for this reason. If aproduct does not have complements, in that case demand tends to beelastic. For example, biscuits, chocolates, ice creams etc. In thiscase the use of a product is not linked to any other products.

13. Purchase frequency of a product

If the frequency of purchase is very high, the demand tends to beinelastic. For e.g., coffee, tea, milk, match box etc. on the otherhand, if people buy a product occasionally, demand tends to beelastic. For example, durable goods like radio, tape recorders,refrigerators etc.

2. How is demand forecasting useful for managers?

In the short run:

Demand forecasts for short periods are made on the assumption that thecompany has a given production capacity and the period is too short tochange the existing production capacity. Generally it would be oneyear period.

Production planning: It helps in determining the level of output atvarious periods and avoiding under or over production.

Helps to formulate right purchase policy: It helps in better materialmanagement of buying inputs and control its inventory level, whichcuts down cost of operation.

Helps to frame realistic pricing policy: A rational pricing policy canbe formulated to suit short run and seasonal variations in demand.

Sales forecasting: It helps the company to set realistic sales targetsfor each individual salesman and for the company as a whole.

Helps in estimating short run financial requirements: It helps thecompany to plan the finances required for achieving the production andsales targets. The company will be able to raise the required financewell in advance at reasonable rates of interest.

Reduce the dependence on chances: The firm would be able to plan itsproduction properly and face the challenges of competitionefficiently.

Helps to evolve a suitable labor policy: A proper sales and productionpolicy, helps to determine the exact number of laborers to beemployed, in the short run.

In the long run:

Long run forecasting of probable demand for a product of a company isgenerally for a period of 3 to 5 or 10 years.

Business planning:

It helps to plan expansion of the existing unit or a new productionunit. Capital budgeting of a firm is based on long run demandforecasting.

Financial planning:

It helps to plan long run financial requirements and investmentprograms by floating shares and debentures in the open market.

Manpower planning:

It helps in preparing long term planning for imparting training to theexisting staff and recruit skilled and efficient labor force for itslong run growth.

Business control:

Effective control over total costs and revenues of a company helps todetermine the value and volume of business. This in its turn helps toestimate the total profits of the firm. Thus it is possible toregulate business effectively to meet the challenges of the market.

Determination of the growth rate of the firm:

A steady and well conceived demand forecasting determine the speed atwhich the company can grow.

Establishment of stability in the working of the firm:

Fluctuations in production cause ups and downs in business whichretards smooth functioning of the firm. Demand forecasting reducesproduction uncertainties and help in stabilizing the activities of thefirm.

Indicates interdependence of different industries:

Demand forecasts of particular products become the basis for demandforecasts of other related industries, e.g., demand forecast forcotton textile industry supply information to the most likely demandfor textile machinery, color, dye-stuff industry etc.,

More useful in case of developed nations:

It is of great use in industrially advanced countries where demandconditions fluctuate much more than supply conditions.

3. Explain production function. How is it useful for business?

Production Function

“A production Function” expresses the technological or engineeringrelationship between physical quantity of inputs employed and physicalquantity of outputs obtained by a firm. It specifies a flow of outputresulting from a flow of inputs during a specified period of time. Itmay be in the form of a table, a graph or an equation specifyingmaximum output rate from a given amount of inputs used. Since itrelates inputs to outputs, it is also called “Input-output relation.”The production is purely physical in nature and is determined by thequantum of technology, availability of equipments, labor, and rawmaterials, and so on employed by a firm.

A production function can be represented in the form of a mathematicalmodel or equation as Q = f (L, N, K….etc) where Q stands for quantityof output per unit of time and L N K etc are the various factor inputslike land, capital, labor etc which are used in the production ofoutput. The rate of output Q is thus, a function of the factor inputsL N K etc, employed by the firm per unit of time.

Factor inputs are of two types

1. Fixed Inputs. Fixed inputs are those factors the quantity of whichremains constant irrespective of the level of output produced by afirm. For example, land, buildings, machines, tools, equipments,superior types of labor, top management etc.

2. Variable inputs. Variable inputs are those factors the quantity ofwhich varies with variations in the levels of output produced by afirm For example, raw materials, power, fuel, water, transport andcommunication etc.

The distinction between the two will hold good only in the short run.In the long run, all factor inputs will become variable in nature.

Short run is a period of time in which only the variable factors canbe varied while fixed factors like plants, machineries, top managementetc would remain constant. Time available at the disposal of aproducer to make changes in the quantum of factor inputs is very muchlimited in the short run. Long run is a period of time where in theproducer will have adequate time to make any sort of changes in thefactor combinations.

It is necessary to note that production function is assumed to be acontinuous function, i.e. it is assumed that a change in any of thevariable factors produces corresponding changes in the output.

Generally speaking, there are two types of production functions. Theyare as follows.

1. Short Run Production Function

In this case, the producer will keep all fixed factors as constant andchange only a few variable factor inputs. In the short run, we comeacross two kinds of production functions:

1. Quantities of all inputs both fixed and variable will be keptconstant and only one variable input will be varied. For example, Lawof Variable Proportions.

2. Quantities of all factor inputs are kept constant and only twovariable factor inputs are varied.

2. Long Run Production Function

In this case, the producer will vary the quantities of all factorinputs, both fixed as well as variable in the same proportion.

Each firm has its own production function which is determined by thestate of technology, managerial ability, organizational skills etc ofa firm. If there are any improvements in them, the old productionfunction is disturbed and a new one takes its place. It may be in thefollowing manner –

1. The quantity of inputs may be reduced while the quantity of outputmay remain same.

2. The quantity of output may increase while the quantity of inputsmay remain same.

3. The quantity of output may increase and quantity of inputs maydecrease.

Uses of Production Function

Though production function may appear as highly abstract andunrealistic, in reality, it is both logical and useful. It is ofimmense utility to the managers and executives in the decision makingprocess at the firm level.

There are several possible combinations of inputs and decision makershave to choose the most appropriate among them. The following are someof the important uses of production function.

1. It can be used to calculate or work out the least cost inputcombination for a given output or the maximum output-input combinationfor a given cost.

2. It is useful in working out an optimum, and economic combination ofinputs for getting a certain level of output. The utility of employinga unit of variable factor input in the production process can bebetter judged with the help of production function. Additionalemployment of a variable factor input is desirable only when themarginal revenue productivity of that variable factor input is greaterthan or equal to cost of employing it in an organization.

3. Production function also helps in making long run decisions. Ifreturns to scale are increasing, it is wise to employ more factorunits and increase production. If returns to scale are diminishing, itis unwise to employ more factor inputs & increase production. Managerswill be indifferent whether to increase or decrease production, ifproduction is subject to constant returns to scale.

Thus, production function helps both in the short run and long rundecision – making process.

4. How do external and internal economies affect returns to scale?

Economies of Scale

The study of economies of scale is associated with large scaleproduction. To-day there is a general tendency to organize productionon a large scale basis. Large scale production is beneficial andeconomical in nature. “The advantages or benefits that accrue to afirm as a result of increase in its scale of production are called‘Economies of Scale’. They help in reducing production cost andestablishing an optimum size of a firm. Thus, they help a lot and go along way in the development and growth of a firm. According to Prof.Marshall these economies are of two types, viz Internal Economies andExternal Economics.

I. Internal Economies or Real Economies

Internal Economies are those economies which arise because of theactions of an individual firm to economize its cost. They arise due toincreased division of labor or specialization and complete utilizationof indivisible factor inputs. Prof. Cairncross points out thatinternal economies are open to a single factory or a single firmindependently of the actions of other firms. They arise on account ofan increase in the scale of output of a firm and cannot be achievedunless output increases. The following are some of the importantaspects of internal economies.

1. They arise “with in” or “inside” a firm.

2. They arise due to improvements in internal factors.

3. They arise due to specific efforts of one firm.

4. They are particular to a firm and enjoyed by only one firm.

5. They arise due to increase in the scale of production.

6. They are dependent on the size of the firm.

7. They can be effectively controlled by the management of a firm.

8. They are called as “Business Secrets “of a firm.

Kinds of Internal Economies:

1. Technical Economies

These economies arise on account of technological improvements and itspractical application in the field of business. Economies oftechniques or technical economies are further subdivided into fiveheads.

a) Economies of superior techniques: These economies are the result ofthe application of the most modern techniques of production. When thesize of the firm grows, it becomes possible to employ bigger andbetter types of machinery. The latest and improved techniques giveplace for specialized production. It is bound to be cost reducing innature. For example, cultivating the land with modern tractors insteadof using age old wooden ploughs and bullock carts, use of computersinstead of human labor etc.

b) Economies of increased dimension: It is found that a firm enjoysthe reduction in cost when it increases its dimension. A large firmavoids wastage of time and economizes its expenditure. Thus, anincrease in dimension of a firm will reduce the cost of production.For example, operation of a double decker instead of two separatebuses.

c) Economies of linked process: It is quite possible that a firm maynot have various processes of production with in its own premises.Also it is possible that different firms through mutual agreement maydecide to work together and derive the benefits of linked processes,for example, in diary farming, printing press, nursing homes etc.

d) Economies arising out of research and by – products: A firm caninvest adequate funds for research and the benefits of research andits costs can be shared by all other firms. Similarly, a large firmcan make use of its wastes and by-products in the most economicalmanner by producing other products. For example, cane pulp, molasses,and bagasse of sugar factory can be used for the production of paper,varnish, distilleries etc.

e) Inventory Economies. Inventory management is a part of bettermaterials management. A big firm can save a lot of money by adoptinglatest inventory management techniques. For example, Just-In-Time orzero level inventory techniques. The rationale of the Just-In-Timetechnique is that instead of having huge stocks worth of lakhs andcrores of rupees, it can ask the seller of the inputs to supply themjust before the commencement of work in the production department eachday.

2. Managerial Economies:

They arise because of better, efficient, and scientific management ofa firm. Such economies arise in two different ways.

a) Delegation of details: The general manager of a firm cannot lookafter the working of all processes of production. In order to keep aneye on each production process he has to delegate some of his powersor functions to trained or specialized personnel and thus relievehimself for co-ordination, planning and executing the plans. This willenable him to bring about improvements in production process and inbringing down the cost of production.

b) Functional Specialization: It is possible to secure economies oflarge scale production by dividing the work of management into severalseparate departments. Each department is placed under an expert andthe rest of the work is left into the hands of specialists. This willensure better and more efficient productive management with scientificbusiness administration. This would lead to higher efficiency andreduction in the cost of production.

3. Marketing or Commercial economies:

These economies will arise on account of buying and selling goods onlarge scale basis at favorable terms. A large firm can buy rawmaterials and other inputs in bulk at concessional rates. As thebargaining capacity of a big firm is much greater than that of smallfirms, it can get quantity discounts and rebates. In this wayeconomies may be secured in the purchase of different inputs.

A firm can reduce its selling costs also. A large firm can have itsown sales agency and channel. The firm can have a separate sellingorganization, marketing department manned by experts who are wellversed in the art of pushing the products in the market. It can followan aggressive sales promotion policy to influence the decisions of theconsumers.

4. Financial Economies

They arise because of the advantages secured by a firm in mobilizinghuge financial resources. A large firm on account of its reputation,name and fame can mobilize huge funds from money market, capitalmarket, and other private financial institutions at concessionalinterest rates. It can borrow from banks at relatively cheaper rates.It is also possible to have large overdrafts from banks. A large firmcan float debentures and issue shares and get subscribed by thegeneral public. Another advantage will be that the raw materialsuppliers, machine suppliers etc., are willing to supply material andcomponents at comparatively low rates, because they are likely to getbulk orders. Thus, a big firm has an edge over small firms in securingsufficient funds more easily and cheaply.

5. Labor Economies

These economies will arise as a result of employing skilled, trained,qualified and highly experienced persons by offering higher wages andsalaries. As a firm expands, it can employ a large number of highlytalented persons and get the benefits of specialization and divisionof labor. It can also impart training to existing labor force in orderto raise skills, efficiency and productivity of workers. New schemesmay be chalked out to speed up the work, conserve the scarceresources, economize the expenditure and save labor time. It canprovide better working conditions, promotional opportunities, restrooms, sports rooms etc, and create facilities like subsidizedcanteen, crèches for infants, recreations. All these measures will

definitely raise the average productivity of a worker and reduce thecost per unit of output.

6. Transport and Storage Economies

They arise on account of the provision of better, highly organized andcheap transport and storage facilities and their complete utilization.A large company can have its own fleet of vehicles or means oftransport which are more economical than hired ones. Similarly, a firmcan also have its own storage facilities which reduce cost ofoperations.

7. Over Head Economies

These economies will arise on account of large scale operations. Theexpenses on establishment, administration, book-keeping, etc, are moreor less the same whether production is carried on small or largescale. Hence, cost per unit will be low if production is organized onlarge scale.

8. Economies of Vertical integration

A firm can also reap this benefit when it succeeds in integrating anumber of stages of production. It secures the advantages that theflow of goods through various stages in production processes is morereadily controlled. Because of vertical integration, most of the costsbecome controllable costs which help an enterprise to reduce cost ofproduction.

9. Risk-bearing or survival economies

These economies will arise as a result of avoiding or minimizingseveral kinds of risks and uncertainties in a business. Amanufacturing unit has to face a number of risks in the business.Unless these risks are effectively tackled, the survival of the firmmay become difficult. Hence many steps are taken by a firm toeliminate or to avoid or to minimize various kinds of risks. Generallyspeaking, the risk-bearing capacity of a big firm will be much greaterthan that of a small firm. Risk is avoided when few firms amalgamateor join together or when competition between different firms is eithereliminated or reduced to the minimum or expanding the size of thefirm. A large firm secures risk-spreading advantages in either of thefour ways or through all of them.

· Diversification of output Instead of producing only one particularvariety, a firm has to produce multiple products. If there is loss inone item, it can be made good in other items.

· Diversification of market: Instead of selling the goods in only onemarket, a firm has to sell its products in different markets. Ifconsumers in one market desert a product, it can cover the losses inother markets.

· Diversification of source of supply: Instead of buying raw materialsand other inputs from only one source, it is better to purchase themfrom different sources. If one person fails to supply, a firm can buyfrom several sources.

· Diversification of the process of manufacture: Instead adopting onlyone process of production to manufacture a commodity, it is better touse different processes or methods to produce the same commodity so asto avoid the loss arising out of the failure of any one process.

II. External Economies or Pecuniary Economies

External economies are those economies which accrue to the firms as aresult of the expansion in the output of whole industry and they arenot dependent on the output level of individual firms. These economiesor gains will arise on account of the overall growth of an industry ora region or a particular area. They arise due to benefit oflocalization and specialized progress in the industry or region. Prof.Stonier & Hague points out that external economies are those economiesin production which depend on increase in the output of the wholeindustry rather than increase in the output of the individual firm Thefollowing are some of the important aspects of external economies.

1. They arise ‘outside’ the firm.

2. They arise due to improvement in external factors.

3. They arise due to collective efforts of an industry.

4. They are general, common & enjoyed by all firms.

5. They arise due to overall development, expansion & growth of anindustry or a region.

6. They are dependent on the size of industry.

7. They are beyond the control of management of a firm.

8. They are called as “open secrets” of a firm.

Kinds of External Economies

1. Economies of concentration or Agglomeration

They arise because in a particular area a very large number of firmswhich produce the same commodity are established. In other words, thisis an advantage which arises from what is called ‘Localization ofIndustry’. The following benefits of localization of industry isenjoyed by all the firms-provision of better and cheap labor at low orreasonable rates, trained, educated and skilled labor, transport andcommunication, water, power, raw materials, financial assistancethrough private and public institutions at low interest rates,marketing facilities, benefits of common repairs, maintenance andservice shops, services of specialists or outside experts, better useof by-products and other such benefits. Thus, it helps in reducing thecost of operation of a firm.

2. Economies of Information

These economies will arise as a result of getting quick, latest and upto date information from various sources. Another form of benefit thatarises due to localization of industry is economies of information.Since a large number of firms are located in a region, it becomespossible for them to exchange their views frequently, to havediscussions with others, to organize lectures, symposiums, seminars,workshops, training camps, demonstrations on topics of mutualinterest. Revolution in the field of information technology, expansionin inter-net facilities, mobile phones, e-mails, video conferences, etc. has helped in the free flow of latestinformation from all parts of the globe in a very short span of time.Similarly, publication of journals, magazines, information papers etchave helped a lot in the dissemination of quick information.Statistical, technical and other market information becomes morereadily available to all firms. This will help in developing contactsbetween different firms. When inter-firm relationship strengthens, ithelps a lot to economize the expenditure of a single firm.

3. Economies of Disintegration

These economies will arise as a result of dividing one big unit in todifferent small units for the sake of convenience of management andadministration. When an industry grows beyond a limit, in that case,it becomes necessary to split it in to small units. New subsidiaryunits may grow up to serve the needs of the main industry. Forexample, in cotton textiles industry, some firms may specialize inmanufacturing threads, a few others in printing, and some others indyeing and coloring etc. This will certainly enhance the efficiency inthe working of a firm and cut down unit costs considerably.

4. Economies of Government Action

These economies will arise as a result of active support andassistance given by the government to stimulate production in theprivate sector units. In recent years, the government in order toencourage the development of private industries has come up withseveral kinds of assistance. It is granting tax-concessions, tax-holidays, tax-exemptions, subsidies, development rebates, financialassistance at low interest rates etc.

It is quite clear from the above detailed description that bothinternal and external economies arise on account of large scaleproduction and they are benefits to a firm and cost reducing innature.

5. Economies of Physical Factors

These economies will arise due to the availability of favorablephysical factors and environment. As the size of an industry expands,positive physical environment may help to reduce the costs of allfirms working in the industry. For example, Climate, weatherconditions, fertility of the soil, physical environment in aparticular place may help all firms to enjoy certain physicalbenefits.

6. Economies of Welfare

These economies will arise on account of various welfare programsunder taken by an industry to help its own staff. A big industry is ina better position to provide welfare facilities to the workers. It mayget land at concessional rates and procure special facilities from thelocal governments for setting up housing colonies for the workers. Itmay also establish health care units, training centers, computercenters and educational institutions of all types. It may grantconcessions to its workers. All these measures would help in raisingthe overall efficiency and productivity of workers.

5. Discuss the profit maximization model.

Profit Maximization Model

Profit-making is one of the most traditional, basic and majorobjectives of a firm. Profit-motive is the driving-force behind allbusiness activities of a company. It is the primary measure of successor failure of a firm in the market. Profit earning capacity indicatesthe position, performance and status of a firm in the market. In spiteof several changes and development of several alternative objectives,profit maximization has remained as one of the single most importantobjectives of the firm even today.

Both small and large firms consistently make an attempt to maximizetheir profit by adopting novel techniques in business. Specificefforts have been made to maximize output and minimize production andother operating costs. Cost reduction, cost cutting and costminimization has become the slogan of a modern firm.

It is a very simple and unambiguous model. It is the single most idealmodel that can explain the normal behavior of a firm.

Main propositions of the profit-maximization model

The model is based on the assumption that each firm seeks to maximizeits profit given certain technical and market constraints. Thefollowing are the main propositions of the model.

1. A firm is a producing unit and as such it converts various inputsinto outputs of higher value under a given technique of production.

2. The basic objective of each firm is to earn maximum profit.

3. A firm operates under a given market condition.

4. A firm will select that alternative course of action which helps tomaximize consistent profits

5. A firm makes an attempt to change its prices, input and outputquantity to maximize its profit.

The model

Profit-maximization implies earning highest possible amount of profitsduring a given period of time.

A firm has to generate largest amount of profits by building optimumproductive capacity both in the short run and long run depending uponvarious internal and external factors and forces. There should beproper balance between short run and long run objectives. In the shortrun a firm is able to make only slight or minor adjustments in theproduction process as well as in business conditions. The plantcapacity in the short run is fixed and as such, it can increase itsproduction and sales by intensive utilization of existing plants andmachineries, having over time work for the existing staff etc.

Thus, in the short run, a firm has its own technical and managerialconstraints. But in the long run, as there is plenty of time at thedisposal of a firm, it can expand and add to the existing capacitiesbuild up new plants; employ additional workers etc to meet the risingdemand in the market. Thus, in the long run, a firm will have adequatetime and ample opportunity to make all kinds of adjustments andreadjustments in production process and in its marketing strategies.

It is to be noted with great care that a firm has to maximize itsprofits after taking in to consideration of various factors in toaccount. They are as follows –

1. Pricing and business strategies of rival firms and its impact onthe working of the given firm.

2. Aggressive sales promotion policies adopted by rival firms in themarket.

3. Without inducing the workers to demand higher wages and salariesleading to rise in operation costs.

4. Without resorting to monopolistic and exploitative practicesinviting government controls and takeovers.

5. Maintaining the quality of the product and services to thecustomers.

6. Taking various kinds of risks and uncertainties in the changingbusiness environment.

7. Adopting a stable business policy.

8. Avoiding any sort of clash between short run and long run profitsin the business policy and maintaining proper balance between them.

9. Maintaining its reputation, name, fame and image in the market.

10. Profit maximization is necessary in both perfect and imperfectmarkets. In a perfect market, a firm is a price-taker and underimperfect market it becomes a price-searcher.

Assumptions of the model

The profit maximization model is based on tree important assumptions.They are as follows –

1. Profit maximization is the main goal of the firm.

2. Rational behavior on the part of the firm to achieve its goal ofprofit maximization.

3. The firm is managed by owner-entrepreneur.

Determination of profit – maximizing price and output

Profit maximization of a firm can be explained in two different ways.

a) Total Revenue and Total Cost approach.

b) Marginal Revenue and Marginal Cost approach.

Profits of a firm are estimated by making comparison between totalrevenue and total costs. Profit is the difference between TR and TC.In other words, excess of revenue over costs is the profits. Profit =TR – TC. If TR is equal to TC in that case, there will be break evenpoint. If TR is less than TC, in that case, a firm will be incurringlosses. In this case, we take in to account of total cost and totalrevenue of the firm while measuring profits.

It is clear from the following diagram how profit arises when TR isgreater than that of TC.

2. MR and MC approach

In this case, we take in to account of revenue earned from one unitand cost incurred to produce only one unit of output. A firm will bemaximizing its profits when MR= MC and MC curve cuts MR curve frombelow. If MC curve cuts MR curve from above either under perfectmarket or under imperfect market, no doubt MR equals MC but totaloutput will not be maximized and hence total profits also will not bemaximized. Hence, two conditions are necessary for profitmaximization-

1. MR = MC. 2. MC curve cut MR curve from below. It is clear from thefollowing diagrams.

Justification for profit maximization

1. Basic objective of traditional economic theory. The traditionaleconomic theory assumes that a firm is owned and managed by theentrepreneur himself and as such he always aims at maximum return onhis capital invested in the business. Hence profit-maximizationbecomes the natural principle of a firm.

2. A firm is not a charitable institution. A firm is a business unit.It is organized on commercial principles. A firm is not a charitableinstitution. Hence, it has to earn reasonable amount of profits.

3. To predict most realistic price-output behavior. This model helpsto predict usual and general behavior of business firms in the realworld as it provides a practical guidance. It also helps in predictingthe reasonable behavior of a firm with more accuracy. Thus, it is avery simple, plain, realistic, pragmatic and most useful hypothesis inforecasting price output behavior of a firm.

4. Necessary for survival It is to be noted that the very existenceand survival of a firm depends on its capacity to earn maximumprofits. It is a time-honored hypothesis and there is common agreementamong businessmen to make highest possible profits both in the shortrun and long run.

5. To achieve other objectives. In recent years several otherobjectives have become much more popular and all these objectives havebecome highly relevant in the context of modern business set up. Butit is to be remembered that they can be achieved only when a firm ismaking maximum profits.

Criticisms

1. Ambiguous term. The term profit maximization is ambiguous innature. There is no clear cut explanation whether a firm has tomaximize its net profit, total profit or the rate of profit in abusiness unit. Again maximum amount of profit cannot be preciselydefined in quantitative terms.

2. It may not always be possible. Profit maximization, no doubt is thebasic objective of a firm. But in the context of highly competitivebusiness environment, always it may not be possible for a firm toachieve this objective. Other objectives like sales maximization,market share expansion, market leadership building its own image,

name, fame and reputation, spending more time with members of thefamily, enjoying leisure, developing better and cordial relationshipwith employees and customers etc. also has assumed greatersignificance in recent years.

3. Separation of ownership and management. In many cases, to-day wecome across the business units are organized on partnership or jointstock company or cooperative basis. In case of many largeorganizations, ownership and management is clearly separated and theyare run and managed by salaried managers who have their own selfinterests and as such always profit maximization may not becomepossible.

4. Difficulty in getting relevant information and data. In spite ofrevolution in the field of information technology, always it may notbe possible to get adequate and relevant information to take rightdecisions in a highly fluctuating business scenario. Hence, profitsmay not be maximized.

5. Conflict in inter-departmental goals. A firm has severaldepartments and sections headed by experts in their own fields. Eachone of them will have its own independent goals and many a times thereis possibility of clashes between the interests of differentdepartments and as such always profits may not be maximized.

6. Changes in business environment. In the context of highlycompetitive and changing business environment and changes inconsumer’s tastes and requirements, a firm may not be able to cope upwith the expectations and adjust its policies and as such profits maynot be maximized.

7. Growth of oligopolistic firms. In the context of globalization,growth of oligopoly firms has become so common through mergers,amalgamations and takeovers. Leading firms dominate the market and thesmall firms have to follow the policies of the leading firms. Hence,in many cases, there are limited chances for making maximum profits.

8. Significance of other managerial gains. Salaried managers havelimited freedom in decision making process. Some of them are unable toforecast the right type of changes and meet the market challenges.They are more worried about their salaries, promotions, perquisites,security of jobs, and other types of benefits. They may lack strongmotivations to make higher profits as profits would go to theorganization. They may be contented with only satisfactory level ofprofits rather than maximum profits.

9. Emphasis on non-profit goals. Many organizations give more stresson non-profit goals. From the point of view of today’s businessenvironment, productivity, efficiency, better management, customersatisfaction, durability of products, higher quality of products andservices etc. have gained importance to cope with businesscompetition. Hence, emphasis has been shifted from profit maximizationto other practical aspects.

10. Aversion to reduction in power. In case of several small businessunits, the owners do not want to share their powers with many newpartners and hence, they try to keep maximum powers in their hands. Insuch cases, keeping more power becomes more important than profitmaximization.

11. Official restrictions over profits of public utilities. Publicutilities or public corporations are legally prohibited to make hugeprofits in many developing countries like India.

Thus, it is clear that a firm cannot maximize its profits always.There are many constraints in the background of multiple objectives.Each one of the objectives has its own merits and demerits and a firmhas to strike a balance between all kinds of objectives.

6. Examine the relationship between revenue concepts and price elasticity ofdemand.

Elasticity of Demand, Average Revenue and Marginal Revenue

There is a very useful relationship between elasticity of demand,average revenue and marginal revenue at any level of output.Elasticity of demand at any point on a consumer’s demand curve is thesame thing as the elasticity on the given point on the firm’s averagerevenue curve. With the help of the point elasticity of demand, we canstudy the relationship between average revenue, marginal revenue andelasticity of demand at any level of output.

In the diagram AR and MR respectively are the average revenue and themarginal revenue curves. Elasticity of demand at point R on theaverage revenue curve = RT/Rt Now in the triangles PtR and MRT.

tPR = RMT (right angles)

tRP = RTM (corresponding angles)

PtR= MRT (being the third angle)

Therefore, triangles PtR and MRT are equiangular.

Hence RT / Rt = RM / tP

In the triangles PtK and KRQ

PK = RK

PKt = RKQ (vertically opposite)

tPK = KRQ (right angles )

Therefore, triangles PtK and RQK are congruent (i.e., equal in allrespects).

Hence Pt = RQ

Elasticity at R = RT / Rt = RM / tP = RM / RQ

It is clear from the diagram that

Hence elasticity at R = RM / RM – QM

It is also clear from the diagram that RM is average revenue and QM isthe marginal revenue at the output OM which corresponds to the point Ron the average revenue curve. Therefore elasticity at R = AverageRevenue / Average Revenue – Marginal Revenue

If A stands for Average Revenue, M stands for Marginal Revenue and estands for point elasticity on the average revenue curve Then e = A /A – M.

Thus, elasticity of demand is equal to AR over AR minus MR.

By using the above elasticity formula, we can derive the formula forAR and MR separately.

e = This can be changed into (through cross multiplication)

eA – eM = A bringing A’s together, we have

eA – A = eM

A ( e – 1 ) = eM

A = eM / e – 1

A =M (e / e – 1)

Therefore Average Revenue or price = M (e / e – 1)

Thus the price (i.e., AR) per unit is equal to marginal revenue xelasticity over elasticity minus one. The marginal revenue formula canbe written straight away as

M = A ((e – 1) / e)

The general rule therefore is: at any output,

Average Revenue = Marginal Revenue x (e / e – 1) and

Marginal Revenue = Average Revenue x (e – 1 / e)

Where, e stands for point elasticity of demand on the average revenuecurve. With the help of these formulae, we can find marginal revenueat any point from average revenue at the same point, provided we knowthe point elasticity of demand on the average revenue curve. Supposethat the price of a product is Rs.8 and the elasticity is 4 at thatprice. Marginal revenue will be:

M = A (( e – 1) / e)

= 8 (( 4 – 1 / 4)

= 8 x 3 /4

= 24 / 4

= 6. Marginal Revenue is Rs. 6.

Suppose that the price of a product is Rs.4 and the elasticitycoefficient is 2 then the corresponding MR will be:

M = A ( ( e-1) / e)

= 4 ( ( 2 – 1) / 4)

= 4 x 1 / 4

= 4 / 4

= 1 Marginal revenue is Rs. 1

Suppose that the price of commodity is Rs.10 and the elasticitycoefficient at that price is 1 MR will be:

M = A ( ( e-1) / e)

=10 ( (1-1) /1)

=10 x 0/1

= 0

Whenever elasticity of demand is unity, marginal revenue will be zero,whatever be the price(or AR). It follows from this that if a demandcurve shows unitary elasticity throughout its length the correspondingmarginal revenue will be zero throughout, that is, the x axis itselfwill be the marginal revenue curve.

Thus, the higher the elasticity coefficient, the closer is the MR toAR / price. When elasticity coefficient is one for any given price,the corresponding marginal revenue will be zero, marginal revenue isalways positive when the elasticity coefficient is greater than oneand marginal revenue is always negative when the elasticitycoefficient is less than one.

Kinked Demand curve and the corresponding Marginal Revenue curve

We measure quantity on the x axis and price on the Y axis. The demandcurve AD has a kink at point B, thus exhibiting two differentcharacteristics. From A to B it is elastic but from B to D it isinelastic. Because the demand is elastic from A to B a very small fallin price causes a very big rise in demand, but to realize the sameincrease in demand a very big fall in price is required as the demandcurve assumes inelastic shape after point B. The correspondingmarginal revenue curve initially falls smoothly, though at a greaterrate. In the diagram there is a gap in MR between output 300 and 350.

Generally an Oligopolist who faces a kinked demand curve will make agood gain when he reduces the price a little before the kink (pointB), but if he lowers the price below B; the rival firms will lowertheir prices too; accordingly the price cutting firm will not be ableto increase its sales correspondingly or may not be able to increaseits sales at all. As a result, the demand curve of price cutting firmbelow B is more inelastic. The corresponding MR curve is not smoothbut has a gap or discontinuity between G and L. In certain cases, thekinked demand curve may show a high elasticity in the lower portion ofthe demand curve beyond the kink and low elasticity in higher portionof the demand curve before the kink Marginal revenue to such a demand

curve will show a gap but instead of at a lower level, it will startat a higher level.

Relationship between AR, MR, TR and Elasticity of Demand

In the diagram AR is the average revenue curve, MR is the marginalrevenue curve and OD is the total revenue curve. At the middle point Cof average revenue curve elasticity is equal to one. On its lower halfit is less than one and on the upper half it is greater than one. MRcorresponding to the middle point C of the AR curve is zero. This isshown by the fact that MR curve cuts the x axis at Q which correspondsto the point C on the AR curve. If the quantity is greater than OQ itwill correspond to that portion of the AR curve where e<1 marginalrevenue is negative because MR goes below the x axis. Likewise for aquantity less than OQ, e>1 and the marginal revenue is positive. Thismeans that if quantity greater than OQ is sold, the total revenue willbe diminishing and for a quantity less than OQ the total revenue TRwill be increasing. Thus the total revenue TR will be maximum at thepoint H where elasticity is equal to one and marginal revenue is zero.

Name SB SrivastavaRoll No. 511017032Program MBASubject Managerial

Economics [Set 2]Code MB0042Learning Centre

Karrox Technologies(Andheri Centre, Mumbai.Centre Code: 02974).

MANAGERIAL ECONOMICS

1. Under perfect competition how is equilibrium price determined in the short and longrun?

Equilibrium of the Industry in the short run

The term ‘Equilibrium’ in physical science implies a state of balanceor rest. In economics, it refers to a position or situation from whichthere is no incentive to change. At the equilibrium point, an economicunit is maximizing its benefits or advantages. Hence, always therewill be a tendency on the part of each economic unit to move towardsthe equilibrium condition. Reaching the position of equilibrium is abasic objective of all firms.

In the short period, time available is too short and hence all typesof adjustments in the production process are impossible. As plantcapacity is fixed, output can be increased only by intensiveutilization of existing plants and machineries or by having moreshifts. Fixed factors remain the same and only variable factors can bechanged to expand output. Total number of firms remains the same inthe short period. Hence, total supply of the product can be adjustedto demand only to a limited extent.

In the short run, price is determined in the industry through theinteraction of the forces of demand and supply. This price is given tothe firm. Hence, the firm is a price taker and not price maker. On thebasis of this price, a firm adjusts its output depending on the costconditions.

An industry under perfect competition in the short run, reaches theposition of equilibrium when the following conditions are fulfilled:

1. There is no scope for either expansion or contraction of the outputin the entire industry. This is possible when all firms in theindustry are producing an equilibrium level of output at which MR =MC. In brief, the total output remains constant in the short run atthe equilibrium point. Thus a firm in the short run has only temporaryequilibrium.

2. There is no scope for the new firms to enter the industry orexisting firms to leave the industry.

3. Short run demand should be equal to short run supply. The price sodetermined is called as ‘subnormal price’. Normal price is determinedonly in the long run. Hence, short run price is not a stable price.

Equilibrium of the competitive firm in the short run

A competitive firm will reach equilibrium position at the point whereshort run MR equals MC. At this point equilibrium output and price isdetermined.

The firm in the short run will have only temporary equilibrium. Theshort run equilibrium price is not a stable price. It is also calledas sub – normal price.

The competitive firm, in the short run, will not be in a position tocover its fixed costs. But it must recover short run variable costsfor its survival and to continue in the industry. A firm will notproduce any output unless the price is at least equal to the minimumAVC. If short run price is just equal to AVC, it will not cover fixedcosts and hence, there will be losses. But it will continue in theindustry with the hope that it will recover the fixed costs in thefuture.

If price is above the AVC and below the AC, it is called as “Lossminimization” zone. If the price is lower than AVC, the firm iscompelled to stop production altogether.

While analyzing short term equilibrium output and price, apart frommaking reference to SMC and AVC, we have to look into AC also. If AC =price, there will be normal profits. If AC is greater than price,there will be losses and if AC is lower than price, then there will besuper normal profits.

In the short run, a competitive firm can be in equilibrium at variouspoints E1, E2 and E3 depending upon cost conditions and market price.At these various unstable equilibrium points, though MR = MC, the firmwill be earning either super normal profits or incurring losses orearning normal profits.

In the case of the firm:

1. At OP4 price the firm will neither cover AFC nor AVC and hence ithas to wind up its operations. It is regarded as shut-down point.

2. At OP1 price, OQ1 is the equilibrium output. E1 indicates the priceor AR = AVC only. It does not cover fixed costs. The firm is ready tosuffer this loss and continue in business with the hope that price maygo up in the future.

3. At OP2 price, OQ2 is the equilibrium output. E2 indicates the price= AR = AC. At this point MR is also equal to MC. At this level ofoutput total average revenue = total average cost hence, the firm isearning only normal profits. It is also known as Break – even point of

the firm, a zone of no loss or no profit. The distance between twoequilibrium points E2 and E1 indicates loss-minimization zone.

4. At OP3 price, OQ3 is the output produced by the firm. At E3, MR =MC. But AR is greater than AC. For OQ3 output, the total cost isOQ3AB. The total revenue is OQ3E3P3. Hence, P3E3AB is the total supernormal profits.

Thus in the short run, a firm can either incur losses or earn supernormal profits. The main reason for this is that the producer does nothave adequate time to make all kinds of adjustments to avoid losses inthe short run.

In case of the industry, E indicates the position of equilibrium whereshort run demand is equal to short run supply. OR indicates short runprice and OQ indicates short run demand and supply.

Equilibrium of the Industry in the long run

In the long run, there is adequate time to make all kinds of changes,adjustments and readjustments in the productive process. All factorinputs become variable in the long run. Total number of firms can bevaried and plant capacity also can be changed depending upon thenature of requirements. Economies of scale, technologicalimprovements, better management and organization may reduce productioncosts substantially in the long run. Hence, production can be eitherincreased or decreased according to the needs of the individual firmsand the industry as a whole. In short, supply of the product can befully adjusted to its demand in the long period.

An industry, in the long run will be reaching the position ofequilibrium under the following conditions:

1. At the point of equilibrium, the long run demand and supply of theproducts of the industry must be equal to each other. This willdetermine long run normal price.

2. There will be no scope for the industry to either expand orcontract output. Hence, the total production remains stable in thelong run.

3. All the firms in the industry should be in the position ofequilibrium. All firms in the industry must be producing anequilibrium level of output at which long run MC is equated to longrun MR. (MC = MR).

4. There should be no scope for entry of new firms into the industryor exit of old firms out of the industry. In brief, the total numberof firms in the industry should remain constant.

5. All firms should be earning only normal profits. This happens whenall firms equate AR (Price) with AC. This will help the industry inattaining a stable equilibrium in the long run.

Equilibrium of the firm in the long run

A competitive firm reaches the equilibrium position when it maximizesits profits. This is possible when:

1. The firm would produce that level of output at which MR = MC and MCcurve cuts MR curve from below. The firm adjusts its output and thescale of its plant so as to equate MC with market price.

Price = MC =MR

2. The firm in the long run must cover its full costs and should earnonly normal profits. This is possible when long run normal price isequal to long run average cost of production. Hence,

Price = AR =AC

3. When AR is greater than AC, there will be place for super normalprofits. This leads to entry of new firms – increase in total numberof firms – expansion in output – increase in supply – fall in price –fall in the ratio of profits. This process will continue tillsupernormal profits are reduced to zero. On the other hand, when AC isgreater than AR the industry will be incurring losses. This leads toexit of old firms, number of firms decrease, contraction in output,rise in price, and rise in the ratio of profits. Thus, losses areavoided by automatic adjustments. Such adjustments will continue tillthe firm reaches the position of equilibrium when AC becomes equal toAR. Thus losses and profits are incompatible with the position ofequilibrium. Hence,

Price = MR = MC = AR= AC

4. The firm is operating at its minimum AC making optimum use ofavailable resources.

In the case of the industry, E is the position of equilibrium at whichLRS = LRD, indicating OR as the equilibrium price and OQ as theequilibrium quantity demanded and supplied.

In case of the firm P indicates the position of equilibrium. At P, LMR= LMC and LMC curve cuts LMR curve from below. At the same point P theminimum point of LAC is tangent to LAR curve. Hence,

LAR =LAC

A competitive firm in the long run must operate at the minimum pointof the LAC curve. It cannot afford to operate at any other point onthe LAC curve. Otherwise, it cannot produce the optimum output or itwill incur losses.

Time will play an important role in determining the price of a productin the market. As the time under consideration is short, demand willhave a more decisive role than supply in the determination of price.Longer the time under consideration, supply becomes more importantthan demand in the determination of price.

The price determined in the long run is called as normal price and itremains stable.

Market price:

It refers to that price which is determined by the forces of demandand supply in the very short period where demand plays a major rolethan supply. Supply plays a passive role. Market price is unstable.

Normal price:

It is determined by demand and supply forces in the long period. Itincludes normal profits also. It is stable in nature.

2. Under what conditions is price discrimination possible?

Pre-Requisite conditions for Price Discrimination (when pricediscrimination is possible)

1. Existence of imperfect market:

Under perfect competition there is no scope for price discriminationbecause all the buyers and sellers will have perfect knowledge ofmarket. Under monopoly, there will be place for price discriminationas there are buyers with incomplete knowledge and information aboutthe market.

2. Existence of different degrees of elasticity of demand in differentmarkets:

A Monopolist will succeed in charging higher price in inelastic marketand lower price in the elastic market.

3. Existence of different markets for the same commodity:

This will facilitate price discrimination because buyers in one marketwill not be knowing the prices charged for the same commodity in othermarkets.

4. No contact among buyers:

If there is possibility of contact and communication among buyers,they will come to know that discriminatory practices are followed bybuyers.

5. No possibility of resale:

Monopoly product purchased by consumers in the low priced marketshould not be resold in the high priced market. Prevention of reexchange of goods is a must for price discrimination.

6. Legal sanction:

In some cases, price discrimination is legally allowed. For E.g., Theelectricity department will charge different rates per unit ofelectricity for different purposes. Similarly charges on trunk calls;book post, registered posts, insured parcel, and courier parcel aredifferent.

7. Buyers illusion:

When consumers have an irrational attitude that high priced goods areof high quality, a monopolist can resort to price-discrimination.

8. Ignorance and lethargy:

Due to laziness and lethargy consumers may not compare the price ofthe same product in different shops. Ignorance of consumers withregard to price variations would enable the monopolist to chargedifferent prices.

9. Preferences and Prejudices of buyers:

The monopolist may charge different prices for different varieties orbrands of the same product to different buyers. For e.g. low price forpopular edition of the book and high price for deluxe edition.

10. Non-transferability features:

In case of direct personal services like private tuitions, hair-cuts,beauty and medical treatments, a seller can conveniently chargedifferent prices.

11. Purpose of service:

The electricity department charges different rates per unit ofelectricity for different purposes like lighting, AEH, agriculture,industrial operations etc. railways charge different rates forcarrying perishable goods, durable goods, necessaries and luxuriesetc.

12. Geographical distance and tariff barriers:

When markets are separated by large distances and tariff barriers, themonopolist has to charge different prices due to high transport costand high rate of taxes etc.

3. Explain the average and marginal propensity to consume.

The Average Propensity to consume and the Marginal Propensity toConsume

1. The Average Propensity to consume

The relationship between income and consumption is measured by theaverage and marginal propensity to consume. The APC explains therelationship between total consumption and total income. At a certainperiod of time, it indicates the ratio of aggregate consumptionexpenditure to aggregate income. Thus, it is the ratio of consumptionto income and is expressed as C/Y.

Thus, APC =

Suppose the income of the community is Rs.10, 000 crore andconsumption expenditure is Rs. 8,000 crore, then the APC is8000/10,000 = 80% or 0.8. Thus, we can derive APC by dividingconsumption expenditure by the total income.

2. Marginal Propensity to consume

MPC may be defined as the incremental change in consumption as aresult of a given increment in income. It refers to the ratio of thechange in aggregate consumption to the change in the level ofaggregate income. It may be derived by dividing an increment inconsumption by an increment in income. Symbolically

MPC =

Suppose total income increases from Rs.10,000 crore to Rs. 20,000crore and total consumption increases from Rs8000 crore to Rs 15,000crore, then,

MPC = = 0.7 or 70%

Technical characteristics of MPC

1. The value of MPC is always positive but less than one

This means that when income increases, the whole income is not spenton consumption. Similarly, when income declines, consumptionexpenditure does not decline in the same proportion. Consumptionexpenditure never becomes zero.

2. MPC is greater than zero

It is always positive. This means that an increase in income will leadto an increase in consumption. MPC cannot be negative.

3. MPC goes down as income increases.

4. MPC may rise, fall or remain constant, depending on many factors,both subjective and objective.

5. MPC of the poor is greater than that of the rich.

6. In the short-run MPC is stable.

The concept of MPC throws light on the possible division of additionalincome between consumption and saving. It also tells us how the extraincome will be divided in the Keynesian system. Saving, in theultimate analysis is equal to investment. In our example, MPC is 70%and as such the MPS must be30%. The reason is that the income of acommunity is divided between saving and spending. The sum of MPC andMPS

Equals1.

Relationship between MPC and APC

The Table showing the Relationship between APC & MPC

Rs. In crores

Income Consumption APC MPC100 100 100 % –200 180 90 % 80 %300 240 80 % 60 %400 280 70 % 40 %

500 300 60 % 20 %

1. Generally speaking, when income increases, APC as well as MPCdeclines but the decline in MPC is greater than APC.

2. As income goes down, MPC falls and APC also falls but at a slowerrate.

3. If MPC is rising, the APC will also be rising although at a slowerrate.

4. When MPC is constant, APC may also remain constant.

5. APC, in some cases, may be equal to MPC. It is quite possible, if50% of increased income is consumed and the remaining 50% is saved.

6. MPC is generally high in poor countries when compared to richcountries. In rich countries the basic requirements are satisfied andtherefore, the MPC would be less and MPS would be high. But in poorcountries majority of the people have to satisfy their basic needs andhence as income increases the MPC also increases while MPS isgenerally low.

4. What is monetary policy? What are the objectives of such policy?

Meaning and definition:

Monetary Policy deals with the total money supply and its managementin an economy. It is essentially a program of action undertaken by themonetary authorities generally the central bank to control andregulate the supply of money with the public and the flow of creditwith a view to achieving economic stability and certain predeterminedmacroeconomic goals.

Monetary policy can be explained in two different ways. In a narrowsense, it is concerned with administering and controlling a country’smoney supply including currency notes and coins, credit money, levelof interest rates and managing the exchange rates. In a broader sense,monetary policy deals with all those monetary and non-monetarymeasures and decisions that affect the total money supply and itscirculation in an economy. It also includes several non-monetarymeasures like wages and price control, income policy, budgetaryoperations taken by the government which indirectly influence themonetary situations in an economy.

Different writers have defined monetary policy in different ways. Someof the important ones are as follows.

1. According to RP Kent, “Monetary policy is the management of theexpansion and contraction of the volume of money in circulation forthe explicit purpose of attaining a specific objective such as fullemployment”.

2. In the words of D.C.Rowan, “The monetary policy is defined asdiscretionary act undertaken by the authorities designed to influencethe supply of money, cost of money or interest rate and theavailability of money”.

Monetary policy basically deals with total supply of legal tendermoney, i.e., currency notes and coins, total amount of credit money,level of interest rates, exchange rate policy and general liquidityposition of the country.

Credit policy which is different from the monetary policy affectsallocation of bank credit according to the objective of monetarypolicy.

The government in consultation with the central bank formulatesmonetary policy and it is generally carried out and implemented by thecentral bank. It is evolved over a period of time on the basis of theexperience of a nation. It is structured and operated with in theinstitutional framework and money market of the country. Itsobjectives, scope and nature of working etc is collectivelyconditioned by the economic environment and philosophy of time.Monetary policy along with fiscal policy and debt management lumpedtogether form the financial policy of the country.

Monetary policy is passive when the central bank decides to abstaindeliberately from applying monetary measures. It is active when thecentral bank makes use of certain instruments to achieve the desiredobjectives. It may be positive or negative. It is positive when itpromotes economic activities and it is negative when it restricts orcurbs economic activities. Similarly, it is liberal when there isexpansion in credit money and it is restrictive when it leads tocontraction in money supply. Again, a cheap money policy may befollowed by cutting down the interest rates or a dear money policy byraising the rate of interest.

The Scope and effectiveness of monetary policy depends on themonetization of the economy and the development of the money market.

Parameters of monetary policy:

Broadly speaking there are three parameters of monetary policy of acountry. It is through these parameters, the monetary policy has tooperate. They are

1. Total money supply available in a country.

2. Cost of borrowings or the level of interest rates.

3. The nature of credit control measures.

All the three put together determine the nature of working of monetarypolicy.

Objectives of Monetary Policy

Objectives of monetary policy must be regarded as a part of overalleconomic objectives of the government. It should be designed anddirected to achieve different macroeconomic goals. The objectives maybe manifold in relation to the general economic policy of a nation.The various objectives may be inter related, inter dependent and

mutually complementary to each other. They may also be mutuallyinconsistent and clash with each other. Hence, very often the monetaryauthorities are concerned with a careful choice between alternativeends. The priorities of the objectives depend on the nature ofeconomic problems, its magnitude and economic policy of a nation. Thevarious objectives also change over a time period.

Economists have conflicting and divergent views with regard to theobjectives of monetary policy in a developed and developing economy.There are certain general objectives for which there is common consentand certain other objectives are laid down to suit to the specialconditions of a developing economy. The main objective in a developedeconomy is to ensure economic stability and help in maintainingequilibrium in different sectors of the economy where as in adeveloping economy it has to give a big push to a slowly developingeconomy and accelerate the rate of economic growth.

General objectives of monetary policy.

1. Neutral money policy:

Prof. Wicksteed, Hayak, Robertson and others have advocated thispolicy. This objective was in vogue during the days of gold standard.According to this policy, money is only a technical devise having noother role to play. It should be a passive factor having only onefunction, namely to facilitate exchange. It should not inject anydisturbances. It should be neutral in its effects on prices, income,output, and employment. They considered that changes in total moneysupply are the root cause for all kinds of economic fluctuations andas such if money supply is stabilized and money becomes neutral, theprice level will vary inversely with the productive power of theeconomy. If productivity increases, cost per unit of output declinesand prices fall and vice-versa. According to this policy, money supplyis not rigidly fixed. It will change whenever there are changes inproductivity, population, improvements in technology etc to neutralizefundamental changes in the economy. Under these conditions, increaseor decrease in money supply is allowed to result in either fall orraise in general price level. In a dynamic economy, this policy cannotbe continued and it is highly impracticable in the present dayeconomy.

2. Price stability:

With the suspension of the gold standard, maintenance of domesticprice level has become an important aim of monetary policy all over

the world. The bitter experience of 1920’s and 1930’s has made allmost all economies to go for price stability. Both inflation anddeflation are dangerous and detrimental to smooth economic growth.They distort and disturb the working of the economic system and createchaos. Both of them are bad as they bring unnecessary loss to somegroups where as undue advantage to some others. They have potentialpower to create economic inequality, political upheavals and socialunrest in any economy. In view of this, price stability is consideredas one of the main objectives of monetary policy in recent years. Itis to be remembered that price stability does not mean that prices ofall commodities are kept constant or fixed over a period of time. Itrefers to the absence of sharp variations or fluctuations in theaverage price level in the country. A hundred percent price stabilityis neither possible nor desirable in any economy. It simply impliesrelative price stability. A policy of price stability checks cyclicalfluctuations and smoothen production and distribution, keeps the valueof money stable, prevent artificial scarcity or prosperity, makeseconomic calculations possible, introduces an element of certainty,eliminate socio-economic disturbances, ensure equitable distributionof income and wealth, secure social justice and promote economicwelfare. On account of all these benefits, monetary authorities haveto take concrete steps to check price oscillations. Price stability isconsidered as one of the prerequisite condition for economicdevelopment and it contributes positively to the attainment of asteady rate of growth in an economy. This is because price stabilitywill build up public morale and instill confidence in the minds ofpeople, boost up business activity, expand various kinds of economicactivities and ensure distributive justice in the country. Prof Basurightly observes, “A monetary policy which can maintain a reasonabledegree of price stability and keep employment reasonably full, setsthe stage of economic development”.

3. Exchange rate stability:

Maintenance of stable or fixed exchange rate was one of the majorobjects of monetary policy for a long time under the gold standard.The stability of national output and internal price level wasconsidered secondary and subservient to the former. It was throughfree and automatic imports and exports of gold that the country wasable to remove the disequilibrium in the balance of payments andensure stability of exchange rates with other countries. Thegovernment followed the policy of expanding currency and credit withthe inflow of gold and contracting currency and credit with theoutflow of gold. In view of suspension of gold standard and IMF

mechanism, this object has lost its significance. However, in order tohave smooth and unhindered international trade and free flow offoreign capital in to a country, it becomes imperative for a county tomaintain exchange rate stability. Changes in domestic prices wouldaffect exchange rates and as such there is great need for stabilizingboth internal price level and exchange rates. Frequent changes inexchange rates would adversely affect imports, exports, inflow offoreign capital etc. Hence, it should be controlled properly.

4. Control of trade cycles:

Operation of trade cycles has become very common in modern economies.A very high degree of fluctuations in overall economic activities isdetrimental to the smooth growth of any economy. Economic instabilityin the form of inflation, deflation or stagflation etc would serve asgreat obstacles to the normal functioning of an economy. Basically,changes in total supply of money are the root cause for businesscycles and its dampening effects on the entire economy. Hence, it hasbecome one of the major objectives of monetary authorities to controlthe operation of trade cycles and ensure economic stability byregulating total money supply effectively. During the period ofinflation, a policy of contraction in money supply and during theperiod of deflation, a policy of expansion in money supply has to beadopted. This would create the necessary economic stability for rapideconomic development.

5. Full employment:

In recent years it has become another major goal of monetary policyall over the world especially with the publication of general theoryby Lord Keynes. Many well-known economists like Crowther, Halm.Gardner Ackley, William, Beveridge and Lord Keynes have stronglyadvocated this objective in the context of present day situations inmost of the countries. Advanced countries normally work at near fullemployment conditions. Their major problem is to maintain this highlevel of employment situation through various economic policies. Thisobject has become much more important and crucial in developingcountries as there is unemployment and under employment of most of theresources. Deliberate efforts are to be made by the monetaryauthorities to ensure adequate supply of financial resources toexploit and utilize resources in the best possible manner so as toraise the level of aggregate effective demand in the economy. Itshould also help to maintain balance between aggregate savings andaggregate investments. This would ensure optimum utilization of allkinds of resources, higher national output, income and higher livingstandards to the common man.

6. Equilibrium in the balance of payments:

This objective has assumed greater importance in the context ofexpanding international trade and globalization. Today most of thecountries of the world are experiencing adverse balance of payments onaccount of various reasons. It is a situation where in the import

payments are in excess of export earnings. Most of the countries whichhave embarked on the road to economic development cannot do away withimports on a large scale. Imports of several items have becomeindispensable and without these imports their development process willbe halted. Hence, monetary authorities have to take appropriatemonetary measures like deflation, exchange depreciation, devaluation,exchange control, current account and capital account convertibility,regulate credit facilities and interest rate structures and exchangerates etc. In order to achieve a higher rate of economic growth,balance of payments equilibrium is very much required and as suchmonetary authorities have to take suitable action in this direction.

7. Rapid economic growth:

This is comparatively a recent objective of monetary policy. Achievinga higher rate of per capita output and income over a long period oftime has become one of the supreme goals of monetary policy in recentyears. A higher rate of economic growth would ensure full employmentcondition, higher output, income and better living standards to thepeople. Consequently, monetary authorities have to take the necessarysteps to raise the productive capacity of the economy, increase thelevel of effective demand for various kinds of goods and services andensure balance between demand for and supply of goods and services inthe economy. Also they should take measures to increase the rate ofsavings, capital formation, step up the volume of investment, directcredit money into desired directions, regulate interest ratestructure, minimize economic and business fluctuations by balancingdemand for money and supply of money, ensure price and overalleconomic stability, better and full utilization of resources, removeimperfections in money and capital markets, maintain exchange ratestability, allow the inflow of foreign capital into the country,maintain the growth of money supply in consistent with the rate ofgrowth of output minimize adversity in balance of payments condition,etc. Depending upon the conditions of the economy money supply has tobe changed from time to time. A flexible policy of monetary expansionor contraction has to be adopted to meet a particular situation. Thus,a growth-friendly monetary policy has to be pursued by monetaryauthorities in order to stimulate economic growth.

It is to be noted that the above-mentioned objectives are interrelated, inter dependent and inter connected with each other. Each oneof the objectives would affect the other and in its turn is influencedby the others. Many objectives would come in clash with others undercertain circumstances. A proper balance between different objectivesbecomes imperative. Monetary authorities have to determine thepriorities depending upon the economic environment in a country. Thus,there is great need for compromise between different objectives

Objectives of monetary policy in developing countries:

As the development problems of developing countries are different fromthat of developed countries, the objectives of monetary policy alsochanges. The following objectives may be considered in the context ofdeveloping countries.

1. Development role:

It has to promote economic development by creating, mobilizing andproviding adequate credit to different sectors of the economy. Supplyof sufficient financial resources, its proper direction, canalizationand utilization, control of inflation and deflation etc would createproper background for laying a solid foundation for rapid economicdevelopment.

2. Effective central banking:

In order to achieve various objectives of monetary policy and to meetthe ever-growing development requirements of the economy, the centralbank of the country has to operate effectively. It has to control thevolume of credit money and its distribution through the use of variousquantitative and qualitative credit instruments. Central bank of thecountry should act as an effective leader to control the activities ofall other financial institutions in the country. It should command therespect of other institutions.

3. Inducement to savings:

It has to encourage the saving habits of the common man by providingall kinds of monetary incentives. It has to take the necessary stepsto expand the banking facilities in the country and mobilize savingsmade by them. Special steps are to be taken to mobilize rural smallsavings.

4. Investment of savings:

It should help in converting savings into productive investments. Forthis purpose, it has to create an institutional base and investmentclimate in the country. People should have variety of opportunities toinvest their hard earned money and earn adequate retunes on them.

5. Developing banking habits:

Monetary authorities have to take effective and imaginary steps topopularize the use of various credit instruments by the common man.Banking transactions should become the part of their day-to-day life.

6. Magnetization of the economy:

The monetary authorities have to take different measures to convertnon-monetized sector or barter sector into monetized sector and makepeople use credit money extensively in their day-to-day life. Increase

in total money supply should be in accordance with the degree ofmonetization of the economy.

7. Monetary equilibrium:

It is the responsibility of the monetary authorities to maintain aproper balance between demand for money and supply of money and ensureadequate liquidity position in the economy so that neither there willbe excess supply of money nor shortage in the circulation of money.

8. Maintaining equilibrium in the balance of payments:

It is the job of the monetary authorities to employ suitable monetarymeasures to set right disequilibrium in the balance of payments of acountry.

9. Creation and expansion of financial institutions:

Monetary authorities of the country have to take effective steps toimprove the existing currency and credit system. They should help indeveloping banking industry, credit institutions, cooperativesocieties, development banks and other types of financialinstitutions, to mobilize more savings and direct them to productiveactivities.

10. Integration of organized and unorganized money markets:

The money markets are under developed, undeveloped, highly unorganizedand they are not functioning on any well laid down principles. Infact, there is no proper integration between organized and unorganizedmoney markets. This has come in the way of well-developed moneymarkets in these countries. Hence, money markets are to be broughtunder the purview of the central bank of the country.

11. Integrated interest rate structure:

The monetary authorities have to minimize the existence of differentinterest rates in different segments of the money market and ensure anintegrated interest rate structure.

12. Debt management:

Monetary authorities have to decide the total volume of internal aswell as external borrowings, timing of the issue of bonds, stabilizingtheir prices, the interest rates to be paid for them, nature of debtservicing, time and methods of debt redemption, the number of

installments, time of repayment etc. The primary aim of the debtmanagement policy is to create conditions in which public borrowing isincreased from year to year on a big scale without giving any jolt tothe system and this must be at cheap rates to keep the burden of thedebt as low as possible. Thus, debt management of the country is to besuccessfully organized by the monetary authorities.

13. Long term loan for industrial development:

The monetary policy should be framed in such a way as to promote rapidindustrial development in a country by providing adequate finance forthem.

14. Reforming rural credit system:

The existing rural credit system is defective and as such it has to bereformed to assist the rural masses.

15. To create a broad and continuous market for government securities:

It is the responsibility of the monetary authorities of the country todevelop a well-organized securities market so that funds are easilyavailable for the needy people.

Thus, the objectives of monetary policy are manifold in nature indeveloping countries and a proper balance between them is requiredvery much to achieve desired goals of the government.

5. Explain briefly the phases of business cycle. Through what phase did the worldpass in 2009-10.

Basically, a business cycle has only two parts- expansion andcontraction or prosperity and depression. Burns and Mitchell observethat peaks and troughs are the two main mark-off points of a businesscycle. The expansion phase starts from revival and includes prosperityand boom. Contraction phase includes recession, depression and trough.In between these two main parts, we come across a few otherinterrelated transitional phases. In its broader perspective, abusiness cycle has five phases. They are as follows.

1. Depression, contraction or downswing

It is the first phase of a trade cycle. It is a protracted period in which business activity is far below the normal level and is extremelylow. According to Prof. Haberler depression is a “state of affairs in which the real income consumed or volume of production per head and the rate of employment are falling and are sub-normal in the sense that there are idle resources and unused capacity, especially unused labor”.

This period is characterized by:

a. A sharp reduction in the volume of output, trade and other transactions.

b. An increase in the level of unemployment.

c. A sharp reduction in the aggregate income of the community especially wages and profits. In a few cases, profits turns out to be negative.

d. A drop in prices of most of the products and fall in interest rates.

e. A steep decline in consumption expenditure and fall in the level of aggregative effective demand.

f. A decline in marginal efficiency of capital and hence the volume of investment.

g. Absence of incentives for production as the market has become dull.

h. A low demand for Loanable funds, surplus cash balances with banks leading to a contraction in the creation of bank credit.

i. A high rate of business failures.

j. An increasing difficulty in returning old debts by the debtors. This forces them to sell their inventories in the marketwhere prices are already falling. This deepens depression further.

k. A decline in the level of investment in stocks as it becomesless attractive and less profitable. This reduces the deposits with the banks and other financial institutions leading to a contraction in bank credit.

l. A lot of excess capacity exists in capital and consumer goods industries which work much below their capacity due to lackof demand.

During depression, all construction activities come to a more or lesshalting stage. Capital goods industries suffer more than consumergoods industries. Since costs are ‘sticky’ and do not fall as rapidlyas prices, the producers suffer heavy losses. Prices of agriculturalgoods fall rapidly than industrial goods. During this periodpurchasing power of money is very high but the general purchasingpower of the community is very low. Thus, the aggregate level ofeconomic activity reaches its rock bottom position. It is the stage oftrough. The economy enters the phase of depression, as the process ofdepression is complete. It is also called, the period of slump.

During this period, there is disorder, demoralization, dislocation anddisturbances in the normal working of the economic system.Consequently, one can notice all-round pessimism, frustration anddespair. The entire atmosphere is gloomy and hopes are less. It is aperiod of great suffering and hardship to the people. Thus, it is theworst and most fearful phase of the business cycle. USA experienceddepression two times, between 1873- 1879 and 1929 – 1933.

2. Recovery or revival

Depression cannot last long, forever. After a period of depression, recovery starts. It is a period where in, economic activities receive stimulus and recover from the shocks. This is the lower turning point from depression to revival towards upswing. Depression carries with itself the seeds of its own recovery. After sometime, the rays of hopeappear on the business horizon. Pessimism is slowly replaced by optimism. Recovery helps to restore the confidence of the business people and create a favorable climate for business ventures.

The recovery may be initiated by the following factors:

a. Increase in government expenditure so as to increase purchasing power in the hands of consumers.

b. Changes in production techniques and business strategies.

c. Diversification in investments or Investment in new regions.

d. Explorations and exploitation of new sources of energy etc.

e. New innovations- developing new products or services, new marketingstrategy etc.

As a result of these factors, business people take more risks andinvest more. Low wages and low interest rates, low production costs,recovery in marginal efficiency of capital etc induce the businesspeople to take up new ventures. In the early phase of the revival,there is considerable excess capacity in the economy so, the outputincreases without a proportionate increase in total costs. Repairs,renewals and replacement of plants take place. Increase in governmentexpenditure stimulates the demand for consumption goods, which in itsturn pushes up the demand for capital goods. Construction activityreceives an impetus. As a result, the level of output, income,employment, wages, prices, profits, start rising. Rise in dividendsinduce the producers to float fresh investment proposals in the stockmarket. Recovery in stock market begins. Share prices go up.Optimistic expectations generate a favorable climate for newinvestment. Attracted by the profits, banks lend more money leading toa high level of investment. The upward trends in business give a sortof fillip to economic activity. Through multiplier and accelerationeffects, the economy moves upward rapidly. It is to be noted thatrevival may be slow or fast, weak or strong; the wave of recovery onceinitiated begins to feed upon itself. Generally, the process ofrecovery once started takes the economy to the peak of prosperity.

3. Prosperity or Full-employment

The recovery once started gathers momentum. The cumulative process ofrecovery continues till the economy reaches full employment. Fullemployment may be defined as a situation where in all availableresources are fully employed at the current wage rate. Hence,achieving full employment has become the most important objective ofall most all economies. Now, there is all round stability in output,

wages, prices, income, etc. According to Prof. Haberler “Prosperity isa state of affair in which the real income consumed, produced and thelevel of employment are high or rising and there are no idle resourcesor unemployed workers or very few of either.” During the period ofprosperity an economy experiences-

a. A high level of output, income, employment and trade.

b. A high level of purchasing power, consumption expenditureand effective demand.

c. A high level of Marginal Efficiency of Capital and volume ofinvestment.

d. A period of mild inflation sets in leading to a feeling ofoptimism among businessmen and industrialists.

e. An increase in the level of inventories of both inputs andoutputs.

f. A rise in Interest Rate.

g. A large expansion in bank credit and financial institutionslend more money to business men.

h. Firms operate almost at full capacity along with itsproduction possibility frontier.

i. Share markets give handsome gains to investors as dividendsand share prices go up. Consequently, idle funds find their wayto productive investments.

j. A state of exuberance and enthusiasm exists in businesscommunity.

k. Industrial and commercial activity, both speculative andnon-speculative show remarkable expansion.

l. There is all round expansion, development, growth andprosperity in the economy. Everyone seems to be happy during thisperiod.

The USA experienced the longest period of prosperity between 1923 &29.

4. Boom or Over full Employment or Inflation

The prosperity phase does not stop at full employment. It gives way tothe emergence of a boom. It is a phase where in there will be anartificial and temporary prosperity in an economy. Business optimismstimulates further investment leading to rapid expansion in allspheres of business activities during the stage of full employment,unutilized capacity gradually disappears. Idle resources are fullyemployed. Hence, rise in investment can only mean increased pressurefor the available men and materials. Factor inputs become scarcecommanding higher remuneration. This leads to a rise in wages andprices. Production costs go up. Consequently, higher output isobtained only at a higher cost of production.

Once full employment is reached, a further increase in the demand for factor inputs will lead to an increase in prices rather than an increase in output and income. Demand for Loanable funds increases leading to a rise in interest rates. Now there will be hectic economicactivity. Soon a situation develops in which the number of jobs exceedthe number of workers available in the market. Such a situation is known as overfull employment or hyper-employment. During this phase:

a. Prices, wages, interest, incomes, profits etc. move in the upward direction.

b. MEC raises leading to business expansion.

c. Business people borrow more and invest. This adds fuel tothe fire. The tempo of boom reaches new heights.

d. There is higher output, income and employment. Livingstandards of the people also increases.

e. There is higher purchasing power and the level of effectivedemand will reach new heights.

f. There is an atmosphere of “over optimism” all round, whichresults in over investment. Cost of living increases at a raterelatively higher than the increase in household incomes.

e. It is a symptom of the end of prosperity phase and thebeginning of recession.

The boom carries with it the gems of its own destruction. Theprosperity phase comes to an end when the forces favoring expansionbecomes progressively weak. Bottlenecks begin to appear. Scarcity offactor inputs and rise in their prices disturb the cost calculations

of the entrepreneurs. Now the entrepreneurs realize that they haveover stepped the mark and become over cautious and their over-optimismpaves the way for their pessimism. Thus, prosperity digs its owngrave. Generally the failure of a company or a bank bursts the boomand ushers in a recession. USA experienced prosperity between 1923 and1929.

5. Recession – A turn from prosperity to Depression

The period of recession begins when the phase of prosperity ends. Itis a period of time where in the aggregate level of economic activitystarts declining. There is contraction or slowing down of businessactivities. After reaching the peak point, demand for goods decline.Over investment and production creates imbalance between supply anddemand. Inventories of finished goods pile up. Future investment plansare given up. Orders placed for new equipments and raw materials andother inputs are cancelled. Replacement of worn out capital ispostponed. The cancellation of orders for the inputs by the producersof consumer goods creates a chain reaction in the input market.Incomes of the factor inputs decline this creates demand recession. Inorder to get rid of their high inventories, and to clear off theirbank obligations, producers reduce market prices. In anticipation offurther fall in prices, consumers postpone their purchases. Productionschedules by firms are curtailed and workers are laid-off. Bankscurtail credit. Share prices decline and there will be slackness instock and financial market. Consequently, there will be a decline ininvestment, employment, income and consumption. Liquidity preferencesuddenly develops. Multiplier and accelerator work in the reversedirection. Unemployment sets in the capital goods industries and withthe passage of time, it spreads to other industries also. The processof recession is complete. The wave of pessimism gets transmitted toother sectors of the economy. The whole economic system thereby runsin to a crisis.

Failure of some business creates panic among businessmen and theirconfidence is shaken. Business pessimism during this period ischaracterized by a feeling of hesitation, nervousness, doubt and fear.Prof. M. W. Lee remarks, “A recession, once started, tends to buildupon itself much as forest fire. Once under way, it tends to createits own drafts and find internal impetus to its destructive ability”.Once the recession starts, it becomes almost difficult to stop therot. It goes on gathering momentum and finally converts itself in to afull- fledged depression, which is the period of utmost suffering forbusinessmen. Thus, now we have a full description about a business

cycle. The USA experienced one of the severe recessions during 1957-58.

Lord Over stone describes the course of business cycle in thefollowing words – “A state of quiescence (inert or silent) – nextimprovement – growing confidence – prosperity – excitement –overtrading – convulsion – pressure – distress – ending – again inquiescence”

A detailed study of the various phases of a business cycle is ofparamount importance to the management. It helps the management toformulate various anti-cyclical measures to be taken up to check theadverse effects of a trade cycle and create the necessary conditionsfor ensuring stability in business.

6. What are the causes of inflation? What were the causes that affected inflation in Indiaduring the last quarter of 2009.

Causes of Inflation

Demand side

Increase in aggregative effective demand is responsible for inflation.In this case, aggregate demand exceeds aggregate supply of goods andservices. Demand rises much faster than the supply. We can enumeratethe following reasons for increase in effective demand.

1. Increase in money supply: Supply of money in circulation increaseson account of the following reasons – deficit financing by thegovernment, expansion in public expenditure, expansion in bank creditand repayment of past debt by the government to the people, increasein legal tender money and public borrowing.

2. Increase in disposable income: Aggregate effective demand riseswhen disposable income of the people increases. Disposable incomerises on account of the following reasons – reduction in the rates oftaxes, increase in national income while tax level remains constantand decline in the level of savings.

3. Increase in private consumption expenditure and investmentexpenditure: An increase in private expenditure both on consumptionand on investment leads to emergence of excess demand in an economy.When business is prosperous, business expectations are optimistic andprices are rising, more investment is made by private entrepreneurs

causing an increase in factor prices. When the incomes of the factorsrise, there is more expenditure on consumer goods.

4. Increase in Exports: An increase in the foreign demand for acountry’s exports reduces the stock of goods available for homeconsumption. This creates shortages in the country leading to rise inprice level.

5. Existence of Black Money: The existence of black money in a countrydue to corruption, tax evasion, black-marketing etc, increases theaggregate demand. People spend such unaccounted money extravagantlythereby creating un-necessary demand for goods and services causinginflation.

6. Increase in Foreign Exchange Reserves: It may increase on accountof the inflow of foreign money in to the country. Foreign DirectInvestment may increase and non-resident deposits may also increasedue to the policy of the government.

7. Increase in population growth creates increase in demand foreverything in a country.

8. High rates of indirect taxes would lead to rise in prices.

9. Reduction in the rates of direct taxes would leave more cash in thehands of people inducing them to buy more goods and services leadingto an increase in prices.

10. Reduction in the level of savings creates more demand for goodsand services.

II. Supply side

Generally, the supply of goods and services do not keep pace with theever-increasing demand for goods and services. Thus, supply does notmatch with the demand. Supply falls short of demand. Increase insupply of goods and services may be limited because of the followingreasons.

1. Shortage in the supply of factors of production

When there is shortage in the supply of factors of production like rawmaterials, labor, capital equipments etc. there will be a rise intheir prices. Thus, when supply falls short of demand, a situation ofexcess demand emerges creating inflationary pressures in an economy.

2. Operation of law of diminishing returns

When the law of diminishing returns operate, increase in production ispossible only at a higher cost which de motivates the producers toinvest in large amounts. Thus production will not increaseproportionately to meet the increase in demand. Hence, supply fallsshort of demand.

3. Hoardings by Traders and speculators

During the period of shortage and rise in prices, hoarding ofessential commodities by traders and speculators with the object ofearning extra profits in future creates artificial scarcity ofcommodities. This creates a situation of excess demand paving the wayfor further inflation.

4. Hoarding by Consumers

Consumers may also hoard essential goods to avoid payment of higherprices in future. This leads to increase in current demand, which inturn stimulate prices.

5. Role of Trade unions

Trade union activities leading to industrial unrest in the form ofstrikes and lockouts also reduce production. This will lead tocreation of excess demand that eventually brings a rise in the pricelevel.

6. Role of natural Calamities

Natural calamities such as earthquake, floods and drought conditionsalso affect adversely the supplies of agricultural products and createshortage of food grains and raw materials, which in turn createsinflationary conditions.

7. War: During the period of war, shortage of essential goods createrise in prices.

8. International factors also would cause either shortage of goods andservices or rise in the prices of factor inputs leading to inflation.E.g., High prices of imports.

9. Increase in prices of inputs with in the country.

III Role of Expectations

Expectations also play a significant role in accentuating inflation.The following points are worth mentioning:

1. If people expect further rise in price, the current aggregatedemand increases which in its turn causes a raise in the prices.

2. Expectations about higher wages and salaries affect very much theprices of related goods.

3. Expectations of wage increase often induce some business houses toincrease prices even before upward wage revisions are actually made.

Thus, many factors are responsible for escalation of prices.

In India the main reason for inflation in last quarter of 2009 wasshortage of food grains due to bad monsoons and hoarding by traders.