Master of Business Administration- MBA Semester 1

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MB0026 / MB0042 Managerial Economics - 3 Credits
Assignment Set- 1 (60 Marks)
Note: Each question carries 10 Marks. Answer all the questions.
Q.1 Price elasticity of demand depends on various factors. Explain each factor with the help of an
example.
Ans 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 economists 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 demands (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 demands 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
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.

Q.2 A company is selling a particular brand of tea and wishes to introduce a new flavor. How will
the company forecast demand for it
Ans - 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 retailers 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 technologicallydetermined 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.

Q.4 Show how producers equilibrium is achieved with isoquants and isocost curves
Ans - 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 great
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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
bearing
The farm has used some of its land to diversify into producing fresh vegetables for
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 see
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as being an integral part of the export earning capacity of the country.

Q.5 Discuss the full cost pricing and marginal cost pricing method. Explain how the two methods
differ from each other
Ans - 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.
SIKKIM MANIPAL UNIVERSITY DISTANCE EDUCATIO

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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.

Q.6 Discuss the price output determination using profit maximization under perfect competition
in the short run.

Ans - 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 ta
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collected by the business. Other revenue (a.k.a. non-operating revenue) is revenue from peripheral (noncore) 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 pric

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Master of Business Administration- MBA

Semester 1
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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

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 consumers
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.

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 consumers

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 on

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 noneconomists, is explained in the article "Recession? Depression? What's the difference?". Th
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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. AIERs 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 indicatorsM1 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.