Master of Business Administration- MBA Semester 1 Reg No.

: 511011932

MB0026 / MB0042 – Managerial Economics - 3 Credits

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

1. Mention the demand function. What is elasticity of demand? Describe the
determinants of elasticity of demand.
A behavioral relationship between quantity consumed and a person's maximum willingness to
pay for incremental increases in quantity. It is usually an inverse relationship where at higher
(lower) prices, less (more) quantity is consumed. Other factors which influence willingness-to-
pay are income, tastes and preferences, and price of substitutes. Demand function specifies
what the consumer would buy in each price and wealth situation, assuming it perfectly solves
the utility maximization problem. The quantity demanded of a good usually is a storng function
of its price. Suppose an experiment is run to determine the quantity demanded of a particular
product at different price levels, holding everything else constant. Presenting the data in tabular
form would result in a demand schedule.
Elasticity of demand is the economist’s way of talking about how responsive consumers are to
price changes. For some goods, like salt, even a big increase in price will not cause consumers
to cut back very much on consumption. For other goods, like vanilla ice cream cones, even a
modest price increase will cause consumers to cut back a lot on consumption. Elasticity of
demand is an elasticity used to show the responsiveness of the quantity demanded of a good or
service to a change in its price. More precisely, it gives the percentage change in demand one
might expect after a one percent change in price. Elasticity is almost always negative, although
analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do
not conform to the law of demand, such as Veblen and Giffen goods, have a positive elasticity
demand. Goods with a small elasticity demand (less than one) are said to be inelastic: changes
in price do not significantly affect demand e.g. drinking water. Goods with large elasticity
demand’s (greater than one) are said to be elastic: even a slight change in price may cause a
dramatic change in demand. Revenue is maximised when price is set so as to create a ED of
exactly one; elasticity demand‘s can also be used to predict the incidence of tax. Various
research methods are used to calculate price elasticity, including test markets, analysis of
historical sales data and conjoint analysis. There is a neat way of classifying values of elasticity.
When the numerical value of elasticity is less than one, demand is said to be “inelastic”. When
the numerical value of elasticity is greater than one, demand is “elastic”. So “elastic” demand

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means that people are relatively responsive to price changes (remember the vanilla ice cream
cone). “Inelastic” demand means that people are relatively unresponsive to price changes
(remember salt). An important relationship exists between the elasticity of demand for a good
and the amount of money consumers want to spend on it at different prices. Spending is price
times quantity, p times Q. In general, a decrease in price leads to an increase in quantity, so if
price falls spending may either increase or decrease, depending on how much quantity
increases. If demand is elastic, then a drop in price will increase spending, because the percent
increase in quantity is larger than the percent decrease in price. On the other hand, if demand is
inelastic a drop in price will decrease spending because the percent increase in quantity is
smaller than the percent decrease in price.
The price elasticity of demand measures how responsive the quantity demanded of a good is to
a change in its price. The value illustrates if the good is relatively elastic (PED is greater than 1)
or relatively inelastic (PED is less than 1).
A good's PED is determined by numerous factors, these include;
Number of substitutes: the larger the number of close substitutes for the good then the easier
the household can shift to alternative goods if the price increases. Generally, the larger the
number of close substitutes, the more elastic the price elasticity of demand.
Degree of necessity: If the good is a necessity item then the demand is unlikely to change for a
given change in price. This implies that necessity goods have inelastic price elasticities of
demand.
Price of the good as a proportion of income: It can be argued that goods that account for a large
proportion of disposable income tend to be elastic. This is due to consumers being more aware
of small changes in price of expensive goods compared to small changes in the price of
inexpensive goods.
The following example illustrates how to determine the price elasticity of demand for a good.
The price elasticity of demand for supermarket own produced strawberry jam is likely to be
elastic. This is because there are a very large number of close substitutes (both in jams and
other preserves), and the good is not a necessity item. Therefore, consumers can and will easily
respond to a change in price.

2. How is demand forecasting useful for managers?

Demand forecasting is the activity of estimating the quantity of a product or service that
consumers will purchase. Demand forecasting involves techniques including both informal

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methods, such as educated guesses, and quantitative methods, such as the use of historical
sales data or current data from test markets. Demand forecasting may be used in making
pricing decisions, in assessing future capacity requirements, or in making decisions on whether
to enter a new market. Often forecasting demand is confused with forecasting sales. But, failing
to forecast demand ignores two important phenomena[1]. There is a lot of debate in demand-
planning literature about how to measure and represent historical demand, since the historical
demand forms the basis of forecasting. The main question is whether we should use the history
of outbound shipments or customer orders or a combination of the two as proxy for the demand.
Stock effects
The effects that inventory levels have on sales. In the extreme case of stock-outs, demand
coming into your store is not converted to sales due to a lack of availability. Demand is also
untapped when sales for an item are decreased due to a poor display location, or because the
desired sizes are no longer available. For example, when a consumer electronics retailer does
not display a particular flat-screen TV, sales for that model are typically lower than the sales for
models on display. And in fashion retailing, once the stock level of a particular sweater falls to
the point where standard sizes are no longer available, sales of that item are diminished.
Market response effect
The effect of market events that are within and beyond a retailer’s control. Demand for an item
will likely rise if a competitor increases the price or if you promote the item in your weekly
circular. The resulting sales increase reflects a change in demand as a result of consumers
responding to stimuli that potentially drive additional sales. Regardless of the stimuli, these
forces need to be factored into planning and managed within the demand forecast.
In this case demand forecasting uses techniques in causal modeling. Demand forecast
modeling considers the size of the market and the dynamics of market share versus competitors
and its effect on firm demand over a period of time. In the manufacturer to retailer model,
promotional events are an important causal factor in influencing demand. These promotions can
be modeled with intervention models or use a consensus to aggregate intelligence using
internal collaboration with the Sales and Marketing functions.

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

A production function is a function that specifies the output of a firm, an industry, or an entire
economy for all combinations of inputs. Almost of all macroeconomic theories, like
macroeconomic theory, real business cycle theory, neoclassical growth theory (classical and

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new) presuppose (aggregate) production function. Heckscher-Ohlin-Samuelson theory in

international trade theory also presupposes production function. In this sense, production
function is one of the key concepts of necoclassical macroeconomic theories. It is also important
to know that there is a subversive criticism on the very concept of production function.
A production function is a function that specifies the output of a firm, an industry, or an entire
economy for all combinations of inputs. A meta-production function (sometimes metaproduction
function) compares the practice of the existing entities converting inputs X into output y to
determine the most efficient practice production function of the existing entities, whether the
most efficient feasible practice production or the most efficient actual practice production.[1] In
either case, the maximum output of a technologically-determined production process is a
mathematical function of input factors of production. Put another way, given the set of all
technically feasible combinations of output and inputs, only the combinations encompassing a
maximum output for a specified set of inputs would constitute the production function.
Alternatively, a production function can be defined as the specification of the minimum input
requirements needed to produce designated quantities of output, given available technology. It
is usually presumed that unique production functions can be constructed for every production
technology.
By assuming that the maximum output technologically possible from a given set of inputs is
achieved, economists using a production function in analysis are abstracting away from the
engineering and managerial problems inherently associated with a particular production
process. The engineering and managerial problems of technical efficiency are assumed to be
solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed
to be making allocative choices concerning how much of each input factor to use, given the
price of the factor and the technological determinants represented by the production function. A
decision frame, in which one or more inputs are held constant, may be used; for example,
capital may be assumed to be fixed or constant in the short run, and only labour variable, while
in the long run, both capital and labour factors are variable, but the production function itself
remains fixed, while in the very long run, the firm may face even a choice of technologies,
represented by various, possible production functions.
The relationship of output to inputs is non-monetary, that is, a production function relates
physical inputs to physical outputs, and prices and costs are not considered. But, the production
function is not a full model of the production process: it deliberately abstracts away from
essential and inherent aspects of physical production processes, including error, entropy or
waste. Moreover, production functions do not ordinarily model the business processes, either,

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ignoring the role of management, of sunk cost investments and the relation of fixed overhead to
variable costs. (For a primer on the fundamental elements of microeconomic production theory,
see production theory basics).
The primary purpose of the production function is to address allocative efficiency in the use of
factor inputs in production and the resulting distribution of income to those factors. Under certain
assumptions, the production function can be used to derive a marginal product for each factor,
which implies an ideal division of the income generated from output into an income due to each
input factor of production.

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

Economies of scale external to the firm (or industry wide scale economies) are only considered
examples of network externalities if they are driven by demand side economies. In many
industries, the production of goods and services and the development of new products requires
the use of specialized equipment or support services. An individual company does not provide a
large enough market for these services to keep the suppliers in business. A localized industrial
cluster can solve this problem by bringing together many firms that provide a large enough
market to support specialized suppliers. This phenomenon has been extensively documented in
the semiconductor industry located in Silicon Valley.
Labor Market Pooling
A cluster of firms can create a pooled market for workers with highly specialized skills.
It is an advantage for:
Producers
They are less likely to suffer from labor shortages.
Workers
They are less likely to become unemployed.
Knowledge Spillovers
Knowledge is one of the important input factors in highly innovative industries.
The specialized knowledge that is crucial to success in innovative industries comes from:
Research and development efforts
Reverse engineering
Informal exchange of information and ideas
As firms become larger and their scale of operations increase they are able to experience
reductions in their average costs of production. The firm is said to be experiencing increasing
returns to scale. Increasing returns to scale results in the firm's output increasing at a greater

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proportion than its inputs and hence its total costs. As a consequence its average costs fall.
Thus initially the firm's long run average cost curve slopes downward as the scale of the
enterprise expands. The firm enjoys benefits called internal economies of scale. These are cost
reductions accruing to the firm as a result of the growth of the firm itself. (An external economy
of scale is a benefit that the firms experience as a result of the growth of the industry.)
After the firm has reached its optimum scale of output, where the long run average cost curves
are at their lowest point, continued expansion means that its average costs may start to rise as
the firm now experiences decreasing returns to scale. The long run average cost curve
therefore starts to curve upwards. This occurs because the firm is now experiencing internal
diseconomies of scale.

Types of internal economies of scale

Types of internal economies of scale

Financial The farm has been able to gain loans and assistance at preferential interest rates
from the EIB, World Bank and the EU
Marketing It has managed to dedicate resources to its strategy of niche marketing
Technical The access to finance has allowed it to invest in sophisticated Israeli irrigation
technology
Managerial It large size enables it to employ specialised personnel such as estate managers
Risk The farm has used some of its land to diversify into producing fresh vegetables for
bearing export as well as continue producing maize.

These large scale farms are attracting a considerable amount of overseas development aid
funding from organisations such as the World Bank and the European Union as they are seen

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as being an integral part of the export earning capacity of the country.

5. Discuss the profit maximization model.

The profit maximization principle stresses on the fact that the motive of business firms to
maximize profit is solely justified as being a method of maximizing the income of their
shareholders.
Firms may maximize profit by maximizing sales, stock price, market share or cash flow. In order
to achieve maximum profit the firm needs to find out the point where the difference between
total revenue and total cost is the highest.
The rules that apply for profit maximization are:
i. increase output as long as marginal profit increases
ii. profit will increase as long as marginal revenue (MR) > marginal cost (MC)
iii. profit will decline if MR < MC
iv. summing up (ii) and (iii), profit is maximized when MR = MC
Profit Maximization model means a scenario where the busniess is runned by the motive of
profit making and keep the cost low.
The business firm is the productive unit in an exchange economy. In order to survive, a firm
must deal with three constraints: the demand for its product, the production function, and the
supply of its inputs. When the firm successfully deals with these constraints, it makes a profit.

These readings explore the assumption that firms maximize profits, pointing out some of the
ambiguities of this assumption. It then explores how the rules of maximization apply to the firm.
It considers two ways in which the maximization principle can be used: to determine the proper
levels of inputs or to determine the proper level of output. The first leads to the rule that
marginal resource cost should equal marginal revenue product, and the second to the rule that
marginal cost should equal marginal revenue. The readings show that these two rules are
equivalent and simply represented different ways of using the information from the three
constraints that a firm faces. Much of this material is quite technical, but it is at the core of
microeconomics.
Profit is maximized where MR = MC.
Profit maximization rule: Produce until the point where the change in revenue from producing 1
more unit equals the change in cost from producing 1 more unit.
Why?
Suppose MR > MC. If I produce 1 more unit, my revenues increase by more than my costs.

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Therefore, if MR > MC, producing more will increase my profit. If I can increase my profit by
changing how much I produce, then when producing where MR > MC can't be profit-
maximizing.
Suppose MR < MC. If I produce 1 less unit, my revenues decrease by less than my costs
decrease. Therefor, if MR < MC, I can increase profit by decreasing output. If I can increase
profit when MR < MC, then choosing q such that MR < MC can not be profit-maximizing.
So, in order to maximize profit, I must choose a quantity q such that MR = MC.
MR = MC is an equilibrium in the sense that it is the only place where there is no incentive to
change the production level.
This rule, the profit maximization rule, is just an application of the marginal principle (MB = MC).
Why? This MB of producing an extra unit is the extra revenue you get. MR is the MB. So the 2
statements are equivalent. The marginal principle is more general, and the profit maximization
rule is specific to the firm production decision.

6. Examine the relationship between revenue concepts and price elasticity of demand.
There is a predictable relationship between revenue and elasticity. Depending on PED, one may
raise revenue either by increasing prices and sacrificing quantity or by reducing them and
outputting more. revenues or revenue is income that a company receives from its normal
business activities, usually from the sale of goods and services to customers. In many countries,
such as the United Kingdom, revenue is referred to as turnover. Some companies receive
revenue from interest, dividends or royalties paid to them by other companies. In general usage,
revenue is income received by an organization in the form of cash or cash equivalents. Sales
revenue or revenues is income received from selling goods or services over a period of time.
Tax revenue is income that a government receives from taxpayers. In more formal usage,
revenue is a calculation or estimation of periodic income based on a particular standard
accounting practice or the rules established by a government or government agency. Two
common accounting methods, cash basis accounting and accrual basis accounting, do not use
the same process for measuring revenue. Corporations that offer shares for sale to the public
are usually required by law to report revenue based on generally accepted accounting principles
or International Financial Reporting Standards. Revenues from a business's primary activities
are reported as sales, sales revenue or net sales. This excludes product returns and discounts
for early payment of invoices. Most businesses also have revenue that is incidental to the
business's primary activities, such as interest earned on deposits in a demand account. This is
included in revenue but not included in net sales. Sales revenue does not include sales tax

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collected by the business. Other revenue (a.k.a. non-operating revenue) is revenue from
peripheral (non-core) operations. For example, a company that manufactures and sells
automobiles would record the revenue from the sale of an automobile as "regular" revenue. If
that same company also rented a portion of one of its buildings, it would record that revenue as
“other revenue” and disclose it separately on its income statement to show that it is from
something other than its core operations. A firm considering a price change must know what
effect the change in price will have on total revenue. Generally any change in price will have two
effects: the price effect: an increase in unit price will tend to increase revenue, while a decrease
in price will tend to decrease revenue. The quantity effect: an increase in unit price will tend to
lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold.
Because of the inverse nature of the price-demand relationship the two effects offset each
other; in determining whether to increase or decrease prices a firm needs to know what the net
effect will be. Elasticity provides the answer. In short, the percentage change in revenue is
equal to the change in quantity demanded plus the percentage change in price. In this way, the
relationship between PED and revenue can be described for any particular good:
When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the
price do not affect the quantity demanded for the good; raising prices will cause revenue to
increase.
When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in
quantity demanded is smaller than that in price. Hence, when the price is raised, the total
revenue of producers rises, and vice versa.
When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the
percentage change in quantity is equal to that in price and a change in price will not affect
revenue.
When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in
quantity demanded is greater than that in price. Hence, when the price is raised, the total
revenue of producers falls, and vice versa.
When the price elasticity of demand for a good is perfectly elastic (Ed is infinite i.e. undefined),
any increase in the price, no matter how small, will cause demand for the good to drop to zero.
Hence, when the price is raised, the total revenue of producers falls to zero.
Hence, to maximise revenue, a firm ought to operate close to its unit-elasticity price.

MB0026 / MB0042 – Managerial Economics - 3 Credits

Assignment Set- 2 (60 Marks)

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Note: Each question carries 10 Marks. Answer all the questions.

1. Under perfect competition how is equilibrium price determined in the short and long
run?
In economics, perfect competition occurs in markets in which no participant has market power.
Because the conditions for perfect competition are strict, there are few if any perfectly
competitive markets. Nonetheless, the concept of perfect competition can serve as a useful
benchmark against which to measure real life, imperfectly competitive markets.
Generally, a perfectly competitive market exists when every participant is a "price taker," and no
participant influences the price of the product it buys or sells. Specific characteristics may
include:
Infinite Buyers/Infinite Sellers – Infinite consumers with the willingness and ability to buy the
product at a certain price, Infinite producers with the willingness and ability to supply the product
at a certain price.
Zero Entry/Exit Barriers – It is relatively easy to enter or exit as a business in a perfectly
competitive market.
Perfect Information - Prices and quality of products are assumed to be known to all consumers
and producers.
Transactions are Costless - Buyers and sellers incur no costs in making an exchange
Firms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal revenue,
where they generate the most profit.
Homogeneous Products – The characteristics of any given market good or service do not vary
across suppliers.
Some subset of these conditions is presented in most textbooks as defining perfect competition.
More advanced textbooks try to reconcile these conditions with the definition of perfect
competition as equilibrium price taking; that is whether or not firms treat price as a parameter or
a choice variable. It should be noted that a general rigorous proof that the above conditions
indeed suffice to guarantee price taking is still lacking.
In the short term, perfectly-competitive markets are productively inefficient as output will not
occur where marginal cost is equal to average cost, but allocatively efficient, as output will
always occur where marginal cost is equal to marginal revenue, and therefore where marginal
cost equals average revenue. In the long term, such markets are both allocatively and

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productively efficient. Under perfect competition, any profit-maximizing producer faces a market
price equal to its marginal cost. This implies that a factor's price equals the factor's marginal
revenue product. This allows for derivation of the supply curve on which the neoclassical
approach is based. The abandonment of price taking creates considerable difficulties to the
demonstration of existence of a general equilibrium except under other, very specific conditions
such as that of monopolistic competition.
Perfect competition is used as a yardstick to compare with other market structure (such
monopoly and oligopoly) because it displays high levels of economic efficiency. In both the short
and long run, price is equal to marginal cost (P=MC) and therefore allocative efficientcy is
achieved - the price that consumers are paying in the markwet reflects the factor cost of
resouces used up in producing/providing the good or service. Productive efficiency occurs when
price is equal to average cost at its minimum point. This is not achieved int eh short run-firms
can be operating at any point on their short run average total cost curve, but productive
efficiency is attained in the long run because the profit maximixing ouput is achieved at a level
where average revenue is tagential to the average total cost curve. The long run of perfect
competition, therefore, exhibits levels of static economic efficiency. There is of course another
form of economic efficiency - dynamic efficiency - which relates to aspects of market
competition such as the rate of innovation in a market, the quality of output provided over time.

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2. Under what conditions is price discrimination possible?

Price discrimination or yield management occurs when a firm charges a different price to
different groups of consumers for an identical good or service, for reasons not associated with
costs. It is important to stress that charging different prices for similar goods is not pure price
discrimination. Differences in price elasticity of demand between markets: There must be a
different price elasticity of demand from each group of consumers. The firm is then able to
charge a higher price to the group with a more price inelastic demand and a relatively lower
price to the group with a more elastic demand. By adopting such a strategy, the firm can
increase its total revenue and profits (i.e. achieve a higher level of producer surplus). To profit
maximise, the firm will seek to set marginal revenue = to marginal cost in each separate
(segmented) market. Barriers to prevent consumers switching from one supplier to another: The
firm must be able to prevent “market seepage” or “consumer switching” – defined as a process
whereby consumers who have purchased a good or service at a lower price are able to re-sell it
to those consumers who would have normally paid the expensive price. This can be done in a
number of ways, – and is probably easier to achieve with the provision of a unique service such
as a haircut rather than with the exchange of tangible goods. Seepage might be prevented by
selling a product to consumers at unique and different points in time – for example with the use
of time specific airline tickets that cannot be resold under any circumstances.
Examples of price discrimination
Price discrimination is an extremely common type of pricing strategy operated by virtually every
business with some discretionary pricing power. It is a classic part of price competition between
firms seeking a market advantage or to protect an established market position.
(a) Perfect Price Discrimination – charging whatever the market will bear
Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the
whole market into each individual consumer and charges them the price they are willing and
able to pay. If successful, the firm can extract all consumer surplus that lies beneath the
demand curve and turn it into extra producer revenue (or producer surplus). This is impossible
to achieve unless the firm knows every consumer’s preferences and, as a result, is unlikely to
occur in the real world. The transactions costs involved in finding out through market research
what each buyer is prepared to pay is the main block or barrier to a businesses engaging in this
form of price discrimination.
If the monopolist is able to perfectly segment the market, then the average revenue curve
effectively becomes the marginal revenue curve for the firm. The monopolist will continue to see
extra units as long as the extra revenue exceeds the marginal cost of production.

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The reality is that, although optimal pricing can and does take place in the real world, most
suppliers and consumers prefer to work with price lists and price menus from which trade can
take place rather than having to negotiate a price for each unit of a product bought and sold.
Second Degree Price Discrimination
This type of price discrimination involves businesses selling off packages of a product deemed
to be surplus capacity at lower prices than the previously published/advertised price.
Examples of this can often be found in the hotel and airline industries where spare rooms and
seats are sold on a last minute standby basis. In these types of industry, the fixed costs of
production are high. At the same time the marginal or variable costs are small and predictable. If
there are unsold airline tickets or hotel rooms, it is often in the businesses best interest to
offload any spare capacity at a discount prices, always providing that the cheaper price that
adds to revenue at least covers the marginal cost of each unit.
There is nearly always some supplementary profit to be made from this strategy. And, it can
also be an effective way of securing additional market share within an oligopoly as the main
suppliers’ battle for market dominance. Firms may be quite happy to accept a smaller profit
margin if it means that they manage to steal an advantage on their rival firms.
The expansion of e-commerce by both well established businesses and new entrants to online
retailing has seen a further growth in second degree price discrimination.
Early-bird discounts – extra cash-flow
The low cost airlines follow a different pricing strategy to the one outlined above. Customers
booking early with carriers such as EasyJet will normally find lower prices if they are prepared to
commit themselves to a flight by booking early. This gives the airline the advantage of knowing
how full their flights are likely to be and a source of cash-flow in the weeks and months prior to
the service being provided. Closer to the date and time of the scheduled service, the price rises,
on the simple justification that consumer’s demand for a flight becomes more inelastic the
nearer to the time of the service. People who book late often regard travel to their intended
destination as a necessity and they are therefore likely to be willing and able to pay a much
higher price very close to departure.
The internet and price discrimination
A number of recent research papers have argued that the rapid expansion of e-commerce using
the internet is giving manufacturers unprecedented opportunities to experiment with different
forms of price discrimination. Consumers on the net often provide suppliers with a huge amount
of information about themselves and their buying habits that then give sellers scope for
discriminatory pricing. For example Dell Computer charges different prices for the same

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computer on its web pages, depending on whether the buyer is a state or local government, or a
small business.
Two Part Pricing Tariffs
Another pricing policy common to industries with pricing power is to set a two-part tariff for
consumers. A fixed fee is charged (often with the justification of it contributing to the fixed costs
of supply) and then a supplementary “variable” charge based on the number of units consumed.
There are plenty of examples of this including taxi fares, amusement park entrance charges and
the fixed charges set by the utilities (gas, water and electricity). Price discrimination can come
from varying the fixed charge to different segments of the market and in varying the charges on
marginal units consumed (e.g. discrimination by time).
Peak time pricing – a common feature of many local transport markets
Product-line pricing
Product line pricing is also becoming an increasingly common feature of many markets,
particularly manufactured products where there are many closely connected complementary
products that consumers may be enticed to buy. It is frequently observed that a producer may
manufacture many related products. They may choose to charge one low price for the core
product (accepting a lower mark-up or profit on cost) as a means of attracting customers to the
components / accessories that have a much higher mark-up or profit margin.

3. Explain the average and marginal propensity to consume.

In economics, the marginal propensity to consume (MPC) is an empirical metric that quantifies
induced consumption, the concept that the increase in personal consumer spending
(consumption) that occurs with an increase in disposable income (income after taxes and
transfers). For example, if a household earns one extra dollar of disposable income, and the
marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents
and save 35 cents.
Mathematically, the marginal propensity to consume (MPC) function is expressed as the
derivative of the consumption (C) function with respect to disposable income (Y).
For example, suppose you receive a bonus with your paycheck, and it's $500 on top of your
normal annual earnings. You suddenly have $500 more in income than you did before. If you
decide to spend $400 of this marginal increase in income on a new business suit, your marginal
propensity to consume will be 0.8 ($400 / $500).
The marginal propensity to consume is measured as the ratio of the change in consumption to
the change in income, thus giving us a figure between 0 and 1. The MPC can be more than one

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if the subject borrowed money to finance expenditures higher than their income. One minus the
MPC equals the marginal propensity to save (in a two sector closed economy), both of which
are crucial to Keynesian economics and are key variables in determining the value of the
multiplier.
The MPC relies heavily upon the real (inflation-adjusted) rate of interest. A high rate of interest
causes spending in the future to become increasingly attractive due to the intertemporal
substitution effect on consumption. Because a rate increase primarily decreases the present
value of lifetime wealth, the consumer relies on becoming a lender to offset this effect. In a two
period model, as S(1+r) increases with the interest rate, so does future income[C= -(1+r)c
+we(1+r)]. Therefore, every dollar of current income spent by the consumer is 1(1+r) dollars the
consumer will not be able to spend in the second period.
Economists often distinguish between the marginal propensity to consume out of permanent
income, and the marginal propensity to consume out of temporary income, because if a
consumer expects a change in income to be permanent, then they have a greater incentive to
increase their consumption (Barro and Grilli, p. 417-8). This implies that the Keynesian multiplier
should be smaller in response to permanent changes in income than it is in response to
temporary changes in income (though the earliest Keynesian analyses ignored these
subtleties). However, the distinction between permanent and temporary changes in income is
often subtle in practice, and it is often quite difficult to designate a particular change in income
as being permanent or temporary. What is more, the marginal propensity to consume should
also be affected by factors such as the prevailing interest rate and the general level of consumer
surplus that can be derived from purchasing.

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

Monetary policy is the process a government, central bank, or monetary authority of a country
uses to control (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of
interest to attain a set of objectives oriented towards the growth and stability of the economy.[1]
Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a contractionary policy,
where an expansionary policy increases the total supply of money in the economy, and a
contractionary policy decreases the total money supply. Expansionary policy is traditionally used
to combat unemployment in a recession by lowering interest rates, while contractionary policy
involves raising interest rates to combat inflation. Monetary policy is contrasted with fiscal policy,
which refers to government borrowing, spending and taxation

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The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding
importance to price stability. The Treaty makes clear that ensuring price stability is the most
important contribution that monetary policy can make to achieve a favourable economic
environment and a high level of employment.
These Treaty provisions reflect the broad consensus that the benefits of price stability are
substantial (see benefits of price stability). Maintaining stable prices on a sustained basis is a
crucial pre-condition for increasing economic welfare and the growth potential of an economy.
The natural role of monetary policy in the economy is to maintain price stability (see scope of
monetary policy). Monetary policy can affect real activity only in the shorter term (see the
transmission mechanism). But ultimately it can only influence the price level in the economy.
The Treaty provisions also imply that, in the actual implementation of monetary policy decisions
aimed at maintaining price stability, the Eurosystem should also take into account the broader
economic goals of the Community. In particular, given that monetary policy can affect real
activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in
output and employment if this is in line with the pursuit of its primary objective.

5. Explain briefly the phases of business cycle. Through what phase did the world pass
in 2009-09.
The business cycle is the periodic but irregular up-and-down movements in economic activity,
measured by fluctuations in real GDP and other macroeconomic variables.
If you're looking for information on how various economic indicators and their relationship to the
business cycle, please see A Beginner's Guide to Economic Indicators.
A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the
pendulum of a clock. Its timing is random and, to a large degress, unpredictable. A business
cycle is identified as a sequence of four phases:
Contraction (A slowdown in the pace of economic activity)
Trough (The lower turning point of a business cycle, where a contraction turns into an
expansion)
Expansion (A speedup in the pace of economic activity)
Peak (The upper turning of a business cycle)
A recession occurs if a contraction is severe enough... A deep trough is called a slump or a
depression.
The difference between a recession and a depression, which is not well-understood by non-
economists, is explained in the article "Recession? Depression? What's the difference?". The

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following articles are also useful for understanding the business cycle, and why recessions
happen:
Why Don't Prices Decline During A Recession?
Do Changes in Stock Prices Cause Recessions?
Are Recessions Good For the Economy?
A Beginner's Guide to Economic Indicators
Business cycle phase 2009 is slow or negative economic growth and perhaps falling prices. As
the slowdown or recession progresses, credit demand surges as businesses run low on cash.
Consumers pay down their debts and businesses get rid of workers and reduce inventories to
bring production into line with demand.
Raw material prices fall sharply and after a lag, consumer prices slow their ascent. Finally, when
the pain of recession grows too severe for the government to tolerate, the Fed eases credit and
of course the cycle begins all over again.
Some business cycles are more severe and therefore more distinct than others. But regardless,
there are certain types of investments that are best in each stage of the business cycle. For
instance, in phase one, at the bottom of a recession, common stocks are the best place to be
while bonds, real estate and commodities are okay but gold and collectibles should be avoided.
In phase two when the economy accelerates and prices begin to climb, all commodities,
including gold, are the best investments; stocks are good and bonds are fair. During phase
three of the cycle with rising interest rates and a coming recession, equities start to weaken and
bonds begin to move up.
Finally, in phase four the slowdown or recession is progressing full steam ahead. This is when
fixed income instruments, like bonds provide great returns. Late in this phase, stocks start
looking good again. Commodities and real estate should be avoided during this phase.
In January, the economy entered the second year of its recession. The magnitude of the
downturn is not unprecedented by any means. Several of the past recessions brought larger
decreases in gross domestic product and higher levels of unemployment. But the speed of the
current deterioration is daunting. The bulk of it took place in the last quarter of 2008. AIER’s
statistical indicators of business-cycle conditions continue to point to further contraction. It
seems unlikely that the recession has reached its trough.
The percentage of primary leading indicators appraised as expanding fell to 17 from 20 last
month. Only two primary leading indicators—M1 money supply and the yield curve index— are
appraised as expanding, but they reflect only the expansionary monetary policy. Employment
situation remains grim and production continues to contract. As a response to a slowdown, both

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consumer and producer prices began to fall.

The cyclical score, which is based on a separate purely mathematical analysis of the leaders,
decreased to 28 from 33 last month. Both the cyclical score and the percentage of leaders
expanding continue to signal that further contraction is likely.
The primary roughly coincident indicators strongly confirm that the economy is in recession.
None of the indicators is appraised as expanding. The cyclical score for the coinsiders fell to 23
from 36 last month, reinforcing the view that the economy is in recession.

6. What are the causes of inflation? What were the causes that affected inflation in India
during the last quarter of 2009?
A sustained rise in the prices of commodities that leads to a fall in the purchasing power of a
nation is called inflation. Although inflation is part of the normal economic phenomena of any
country, any increase in inflation above a predetermined level is a cause of concern.
High levels of inflation distort economic performance, making it mandatory to identify the
causing factors. Several internal and external factors, such as the printing of more money by the
government, a rise in production and labor costs, high lending levels, a drop in the exchange
rate, increased taxes or wars, can cause inflation.
Different schools of thought provide different views on what actually causes inflation. However,
there is a general agreement amongst economists that economic inflation may be caused by
either an increase in the money supply or a decrease in the quantity of goods being supplied.
The proponents of the Demand Pull theory attribute a rise in prices to an increase in demand in
excess of the supplies available. An increase in the quantity of money in circulation relative to
the ability of the economy to supply leads to increased demand, thereby fuelling prices. The
case is of too much money chasing too few goods. An increase in demand could also be a
result of declining interest rates, a cut in tax rates or increased consumer confidence.
The Cost Push theory, on the other hand, states that inflation occurs when the cost of producing
rises and the increase is passed on to consumers. The cost of production can rise because of
rising labor costs or when the producing firm is a monopoly or oligopoly and raises prices, cost
of imported raw material rises due to exchange rate changes, and external factors, such as
natural calamities or an increase in the economic power of a certain country.
An increase in indirect taxes can also lead to increased production costs. A classic example of
cost-push or supply-shock inflation is the oil crisis that occurred in the 1970s, after the OPEC
raised oil prices. The US saw double digit inflation levels during this period. Since oil is used in
every industry, a sharp rise in the price of oil leads to an increase in the prices of all

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commodities. However, the central bank indicated that, in the wake of an expected improvement
in agricultural production as well as low international commodity prices, inflationary pressures
are expected to remain at a low level through the greater part of the 2009-10. According to the
report, global crude oil prices are expected to remain stable during the current financial year, at
the current level of $50 per barrel.
"If global economic recovery begins earlier and is stronger, there is an upside risk of even
higher oil prices from the current level. Assuming that there are no major crude oil supply
disruptions, average WTI (West Texas Intermediate) prices are expected to be $52.6 per barrel
in 2009, which is 47 per cent lower than the average price for the year 2008 ($99.6 per barrel).
In view of the relatively tight demand supply-balance over the long run, the long-term outlook for
oil, however, remains highly uncertain," the apex bank said.
Price-rise down due to base effect
Driven by the reduction in the administered prices of petroleum products and electricity, as well
as the decline in prices of freely priced minerals, oil items, iron & steel, oilseeds, edible oils, oil
cakes and raw cotton, year-on-year (y-o-y) headline inflation in the country showed a sharp
correction from a historic peak of 12.90 per cent on August 2, 2008 to 0.3 per cent as on March
28, 2009.
"A significant part of the end year reduction in WPI inflation could also be attributed to the base
effect reflecting the rapid increase in inflation recorded during the last quarter of 2007-08," the
report said.
With the decline in prices of sugar, edible oils/oil cakes, textiles, chemicals, iron & steel and
machinery & machine tools, manufactured products' inflation fell to 1.4 per cent on March 28,
2009 compared with 7.3 per cent a year ago.
While money growth is considered to be a principal long-term determinant of inflation, non-
monetary sources, such as an increase in commodity prices, have played a key role in
triggering inflation in the past four decades.
Inflation has become a major concern worldwide in 2008, with global prices rises in oil, food,
steel and other commodities being the culprit.

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