Managerial Economics

MANAGERIAL ECONOMICS

Q1. What is Managerial Economics? Explain the nature

and scope of Managerial Economics.

Answer:
Managerial Economics generally refers to the integration of economic theory with
business practice. While economics provides the tools which explain various concepts
such as Demand, Supply, Price, Competition etc. Managerial Economics applies these
tools to the management of business. Managerial Economics is also understood to refer
to business economics or applied economics.

“Managerial Economics lies on the border line of management & economics. It is a

hybrid of two disciplines and it is primarily an applied branch of knowledge.”

According to Prof. Spencer Sigelman,”Managerial Economics deals with integration

of economics theory with business practice for the purpose of facilitating decision
making and forward planning by management”.

According to Prof. Joel Dean,” The purpose of Managerial Economics is to show how
economic analysis can be used in formulating business policies”.

Nature of Managerial Economics:

It is true that managerial economics aims at providing help in decision-making by firms.

For this purpose, it draws heavily on the propositions of microeconomic theory. Note
that microeconomics studies the phenomenon at the individual’s level: behavior of
individual consumers, firms. The concepts of microeconomics used frequently in
managerial economics are: (i) elasticity of demand ii) marginal cost (iii) marginal
revenue (iv) market structures and their significance in pricing policies, etc. Some of
these concepts however provide only the logical base and have to be modified in
practice.

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Microeconomics assists firms in forecasting. Note that macroeconomic theory studies

the economy at the aggregative level and ignores the distinguishing features of
individual observations. For example, macroeconomics indicates the relationship
between (i) the magnitude of investment and the level of national income, (ii) the level
of national income and the level of employment (iii) the level of consumption and the
national income, etc. Therefore, the postulates of macroeconomics can be used to
identify the level of demand at some future point in time, based on the relationship
between the level of national income and the demand for a particular product. For
example, there is a relationship between the level of national income and demand for
electric motors. Also, the demand for durable goods such as refrigerators, air-
conditioners, and motorcars depends upon the level of national income.

Managerial Economics is decidedly applied branch of knowledge. Therefore, the

emphasis is laid on those propositions, which are likely to be useful to the management.
The precision of a scientist is not motivating factor in research activity. Improvement in
the quality of results is attempted provided the additional cost is not very high and the
decision maker can wait. For example it may be possible to have more accurate data on
the demand for the firm’s product by taking into consideration additional factors
(explanatory variables). But this may not be attempted because the decision has to be
made without delay. Besides, more accurate forecasts may not be justified on cost
considerations.

Managerial Economics is prescriptive in nature and character. It recommends that it

should be done under alternative conditions. For example, if the price of the synthetic
yarn falls by 50 %, it may be desirable to increase its use in producing different types of
textiles. Thus, managerial economics is one of the normative sciences and reflects upon
the desirability or otherwise of the propositions. For example if the analysis suggests
that the benefit-cost ratio of a large plant is less than that for a smaller plant and the
benefit-cost ratio is used as the criterion for project appraisal it is recommended that the
firm should not install a large plant. Contrast this with the positive sciences, which state

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the propositions without commenting upon what should be done. For example, if the
distribution of income has become more uneven, it is stated without indicating what
should be done to correct this phenomenon.

Managerial economics, to the extent that it uses economic thought, is a science, but it is
an applied science, Economic thought uses deductive logic (if X is true, then Y is true).
For example, if the triangles are congruent, their angles are equal. To have confidence
in the findings, the propositions deduced are subjected to empirical verification. For
example, empirical studies try to verify whether cost curves faced by a firm are really
U-shaped as suggested by the theory. Furthermore, there is an attempt to generalize the
propositions, which provide a predictive character. For example, empirical studies may
suggest that for every 1% rise in expenditure on advertising, the demand for the product
shall increase by 0.5%.

Scope of Managerial Economics:

The scope of Managerial Economics is so wide that it embraces almost all the problems
& areas of the manager and the firm. It deals with demand analysis and forecasting,
production function, cost analysis, inventory management advertising price system,
resource allocation, capital budgeting etc.

1. Demand analysis and forecasting:

It analyses carefully and systematically the various types of demand which enable the
manager to arrive at a reasonable estimate of demand for products of his company. He
takes into account such concepts as income elasticity and cross elasticity.

2. Production Function
Resources are scarce and also have alternative uses. Inputs play a vital role in the
economics of production. The factors of production, otherwise called inputs, may be
combined in a particular way to yield the maximum output. Alternatively, when the

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price of inputs shoot up, a firm is forced to work out a combination of inputs so as to
ensure that this combination becomes least cost combination.

3. Cost Analysis:
Determinants of cost. Methods of estimating costs, the relationship between cost &
output, the forecast of cost and profit-these are very vital to a firm.

4. Inventory Management:
An inventory refers to stock of raw materials, which a firm keeps. Now the problem is
how much of the inventory is ideal stock. If it is high, capital is unproductively feed up,
which might, if the stock of inventory is reduced, be used for other productive purposes.
On the other hand, if level of inventory is low, production will be hampered. Therefore,
managerial economics will use such methods as ABC analysis, a simple simulation
exercise and some mathematical models with a view to minimize the inventory cost.

5. Advertising
Advertising is an area which managerial economics embraces. While the copy,
illustration. Etc. of an advertisement are the responsibility of those who get it ready for
the press, the problems of cost, The methods of determining the total advertisement
costs and budge, the measuring of the economic effects of advertising-these are the
problems of the manager.

6. Price System
The central function of an enterprise is not only production but pricing as well. While
the cost of production has to be taken into account while pricing a commodity, a
complete knowledge of the price system is quite essential to determination of price.
Pricing is actually guided by considerations of cost plus pricing and the policies of
public enterprises.

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7. Resources Allocation:
Scarce resources obviously have alternate uses. The aim of course, is to achieve
optimization. For this purpose, some advanced tools, such as linear programming are
used to arrive at the best course of action for a specified end.

8. Capital Budgeting:
Capital is scarce and it costs something. Now, the problem is how to arrive at the cost
of capita: how to ensure that capital becomes rational: how to face Upto budgeting
problems, how to ensure that capital becomes rational; how to face Upto budgeting
problems, how to arrive at investment decisions under conditions of uncertainly; how to
effect a cost-benefit analysis etc. Any manager cannot ignore these areas.

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Q2. State and explain the law of demand. What are its

exceptions?

Answer:
The law may be stated:”Other things being equal, the higher the price of a commodity,
the smaller is the quantity demanded and lower the price, larger is the quantity
demanded”. In other works, the demand for a commodity expands as the price falls and
contracts as the price rises. Or briefly stated, the law of demand emphasizes that other
things remaining unchanged, demand varies inversely with price.
The conventional law of demand, however, relates to the much simplified demand
function:
D= f (P)
Where, D represents demand, P the price and f connotes a functional relationship. It,
however, assumes that other determinants of demand are constant and only price is the
variable and influencing factor. The relation between price and quantity of demand is
usually an inverse or negative relation, indicating a larger quantity demanded at a lower
price and a smaller quantity demanded at a higher price.

The law of demand is usually referred to the market demand. The law of demand can
be illustrated with the help of a market demand schedule, thus, as the price of
commodity decreases, the corresponding quantity demanded for that commodity
increases and vice-versa.
Price of Commodity X (in Rs.) per unit Quantity Demanded per week
5 10
4 20
3 30
2 40
1 50
______________________________________________________________________

This table represents hypothetical demand schedule for commodity X. With a fall in
priced at each stage, quantity demanded tends to rise. There is an inverse relationship
between price and quantity demanded. Usually, economists draw a demand curve to

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give a pictorial presentation of law of demand. When the data of table are plotted
graphically, a demand curve is drawn as shown in Fig.

Y Demand Curve

O X

Quantity Demanded of X

In this fig., DD is a downward sloping demand curve indicating an inverse relationship

between price and quantity demanded.
From the given market demand-curve once can easily locate the market demand for a
product at a given price. Further, the demand curve geometrically represents the
mathematical demand function: Dx = f (Px)

Assumption of the law of Demand

The law of demand is based upon the following assumptions:

1. Tastes & preferences of consumer remain unchanged:

It is assured that the tastes & habits of a consumer remain unchanged. The
demand curve is drawn on the basis of a particular level of tastes & preference. If it

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changes demand curve has to be redrawn. If the preference of a consumer changes he

may demand more or less of a given commodity. For instance when a commodity
becomes fashionable, consumption will increase, irrespective of price changes. In such
a case the law of demand will not hold true.

2. Income remains the same:

When income changes the consumer’s scale of preference or choice usually
becomes entirely different. With the increase in income, he may purchase more of a
commodity at the same price. If the commodity is of inferior quality, he may replace it
with a better variety at a higher price. Hence, stability of income through out the
demand schedule is necessary.

3. The prices of other goods remain the same:

A change in the prices of substitutes and complementary goods may cause
demand to shift. A consumer may shift from the consumption of present goods to its
complementary or substitute goods due to its fall in the price. Thus the demand for tea
will be affected by a fall in the price of coffee or sugar.

Exceptions to the Law of Demand

Generally, more of a commodity is demanded at a lower price & less of it is demanded

at a higher price. However, under certain conditions the law of demand does not hold
good. These are exceptions to the law of demand, which are as follows;

1) Conspicuous Consumption: There are certain commodities such as diamond

jewellery, antique collections the possession of which is a matter of prestige. More of
these commodities are purchased at a higher price & vice versa. While some goods are
such the constant use of which become necessity of life. For example, in spite of the
fact that the prices of television sets, refrigerator, washing machine etc. have been
continuously raising their demand does not show any tendency to fall. These are the
‘supper sector’ goods.

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2) Speculative markets: Households also act as speculators. In the speculative

markets a rise of prices is frequently followed by large purchases & a fall of price by
less purchases. Likewise, if price are expected to fall further, a reduced price may not
be a sufficient incentive to buy more. For example: in the share market, a rise in the
price of a specific share induces the speculators to buy large number of this share
because they expect a further rise in the price of that share. Consequently, the demand
for the share also rises. On the contrary, fall in the price of a specific share causes a fall
in its demand.

3) Giften goods: Giften goods are special type of cheaper goods. Sir Robert
Fifteen found that in the 19th century Ireland the people were so poor that they spent the
major part of their income on potatoes & a small part on meat. Potato was cheap but
meal was dear. When the price of potatoes rose, they had to economize on meat. To
maintain the earlier level of consumption or to fill the resulting gap in food supply more
potatoes had to be purchased. Thus, rise in the price of potatoes led to increased sales
of potatoes. This is known as Giften effect. This effect is usually found in the case of
cheap necessary foodstuffs. Bajra can also be considered as Giften good to which the
law of demand does not apply.

4) The income effect: The demand curve may be affected by the income effect. If
the income effect. If the income effect is positive we can expect a downward sloping
curve. But, on the other hand, if the income effect is negative, particularly in case of
inferior goods, the result may not be a downward sloping curve. If the total expenditure
of the commodity is small, the income effect will have less implication on the demand
curve & there will be an inverse relation between price and demand.

5) Emergencies: Emergencies like war, famine, floods etc. negate then operation
of the law of demand, In anticipation of scarcity of goods, consumers increase their
purchases & includes further price rise. Even at an increased price consumers are ready

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to buy more during such periods. On the other hand during depression no amount of
falling price is sufficient inducement for consumers to demand more.

6) Change in fashion: A change in fashion & tastes affects demand for a

commodity. When a narrow or thin metallic frame of spectacles replaces a broad
plastic frame, reduction in the price of latter is not sufficient to clear the stocks. On the
other hand, the demand for thin frame rises even at a higher price.

7) Ignorance: A consumer of one market may be ignorant about the prevailing

prices in the other market. Thus he can end up in buying a commodity at a higher price.
This is also true when the consumer is under impression that higher priced commodity
is better in quality than low priced commodity which is necessarily not true. The law of
demand also falls when an impulsive purchases is made without any calculation of price
and usefulness of the product.

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Q3. State and explain the Law of Variable Proportion.

Answer:
The law is about the production function (relationship between input and output) with
one factor variable keeping quantity of other factor fixed i.e. by bringing about the
changes in proportion between variable factor and the fixed factor. This law is very
important in the economics and it is supported by empirical evidence particularly in the
agricultural sector. The law of a\variable proportion is stated by various economists in
the following manner:
By F.Benham: “As the proportion of one factor in a combination of factors is
increased after a point, first the marginal and then the average product of that factor
will diminish.”
By G.J. Stigler: “As equal increments one input are added, the inputs of other
productive services being held constant, beyond a certain point the resulting increments
of product will decrease i.e. the marginal product will diminish”.

Thus, it is observed that the law refers to three aspects:

Behavior of output
Quantity of one factor is increased keeping quantity of other factors fixed
Marginal product and average product eventually declines.

ASSUMPTIONS
1. The state of technology remains unchanged. If there is an any improvement in
technology, then marginal and average product may rise instead of diminishing.
2. Alteration or variation in various factor proportion is done by varying some inputs
i.e. some inputs must be kept fixed. This law does not apply when all factors are varied.
3. The law is also based on the assumption that there is a possibility of varying the
proportions in which the various factors can be combined to produce a product. If

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factors were used in fixed proportion then the increase in one factor would not lead to
any increase in the output that means the marginal product of a factor is zero.
There are three stages of law of variable proportion namely”
Stage of increasing returns where marginal productivity increases
Stage of decreasing returns where marginal productivity decreases
Stage of negative returns where marginal productivity becomes negative.

THREE STAES OF LAW OF VARIABLE PROPORTION

As shown in figure, X-axis is measured the quantity of the variable factor and on the Y-
axis are measured the total product, average product and the marginal product. As the
variable factor is increases, we can see its effect on the total, average and marginal
productivity of a product changes. The behavior of these total, average and marginal
products of the variable factor consequent on the increase in its amount can be seen
through three stages which are as follows;

Stage-I
Increasing returns:
In this stage, total product to a point increases at an increasing rate. In the fig. From the
origin to the point F, slope of the total TP is increasing. I.e. Upto point F total product

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curve increases at an increasing rate. The point F where the total product stops
increasing at an increasing rate and starts increasing at a diminishing rate is called as the
point of inflexion where corresponding vertically to this point of inflexion marginal
productivity is maximum. Upto the point F marginal product MP rises. The average
product curve rises through out the first stage Upto the point S. It is notable that the
marginal product in this stage increases but in later part it starts declining but remains
greater than the average product so that the average product continues to rise.

Stage-2
Stage of diminishing returns:
In this stage, the total product increases but at a stage both the marginal product and the
average product of the variable factor are diminishing but are positive. At point M
marginal product of the variable factor is zero, which is corresponding to the highest
point H of the total product curve TP.

Stage-3
Stage of negative returns:
In this stage, the total product declines and therefore the TP curve slopes downward.
As a result, marginal product of a variable factor is negative and the marginal product
curve MP goes below X-axis. Average product curve therefore declines. The stage is
called the stage of negative returns. Since the marginal product of the variable factor is
negative during this stage.

EXPLANATION OF THE VARIOUS STAGES:

Increasing returns: As more and more units of variable factors are added to constant
quantity of fixed quantity of fixed factor then fixed factor gets more intensively &
effectively utilized and production increases at a rapid rate.
The variable factor i.e. no. Of workers increase as a firm expands its product. A worker
contributes three pairs of whose per day to the firm’s output. The total product reaches

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seven pairs of shoes per day when the second worker contributes to the production.
Fuller utilization of machine is possible due to the addition of a variable factor. One
worker cannot take full advantage of the capabilities of machinery. When the second
worker joint it is possible to use the full potential of the machinery. More over
increasing returns can also be attributed to the principle of division of labor or
specialization of work.

Diminishing returns: The peculiar features of this stage are that the marginal product
falls through out the stage and finally touches to zero. Corresponding vertically is the
point H, which is the highest point of the TP curve. Where stage two ends.

The third stage is set in by hiring 3rd worker who adds only 3 pairs of shoes per day as
compared to 4v pairs per day added by the 2nd worker. Total product increases but the
gain from third worker is not as great as gain from second worker. Once the point is
reached at which variable factor is sufficient to ensure full utilization of fixed factor,
then further increase in variable factor will cause MP as well as AP to fall because fixed
factor has not become inadequate relative to the quantity of variable factors. In stage
two-fixed factor is scarce as compared to variable factor. According to Joe Robinson
famous economist, the factors of production are imperfect substitutes for on another, the
stage of diminishing returns occurs. Fixed factor is scarce and variable factor is in
abundance. If some factors are available that are perfect substitutes of fixed factor then
fixed factor would not have remained scarce. The paucity of fixed could have been
made up by such perfect substitutes. If one of the variable factors added to the fixed
factor were perfect substitute deficiency of fixed could have been made up but elasticity
of substitute between factors is not infinite, substitution is not possible and diminishing
returns occur.

3. Negative returns: Under this stage, marginal product falls below “X” axis i.e.
negative because total product starts falling. In this example this is set in by hiring 6 th
worker. The total product falls from 13 pairs of shoes per week to 12 pairs of shoes per
week. The large number of variable factors impairs the efficiency of the fixed factor.

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The excessive variable factor as compared to less fixed factor results in a fall of total
output. In such a situation, a reduction in the units of the variable factor will increase
the total output.

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Q4. Define ‘Business Cycle’. Explain various phases of

business cycle.

Answer
Definition of A Business or Trade Cycle

The term “trade cycle” in economies refers to the wave-like fluctuations in the
aggregate economic activity. Particularly in employment, output and income. In other
words, trade cycles are ups and downs in economic activity. A trade cycle is defined in
various ways by different economists. For instance, Mitchell defined trade cycle as a
fluctuation in aggregate economic activity. According to Heberler, ‘The business cycle
in the general sense may be defined as on alternation of periods of prosperity and
depression, of good and bad trade.’

Keynes, points out that ‘A trade cycle is composed of periods of good trade
characterized by rising prices and low unemployment percentages, altering with periods
of bad trade characterized by tolling prices and high unemployment percentages.’
Keynes, thus, stresses two indices namely, prices and unemployment, for measuring the
upswing and downswing of the business cycles.

PHASES OF BUSINESS CYCLES

The ups and downs in the economy are reflected by the fluctuations in aggregate
economic magnitudes, such as. Production, investment, employment, prices, wages,
bank credits. etc. The upward and downward movements in these magnitudes show
different phases of a business cycle. Basically there are only two phases in a cycle, viz.,
prosperity and depression. But considering the intermediate stages between prosperity
and depression, the various phases of trade cycle may be enumerated as follows: -
1) Expansion
2) Peak
3) Recession

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4) Trough
5) Recovery and expansion.

The five phases of a business cycle have been presented in the figure below.

The figure showing phases of Business Cycle

1) Prosperity Expansion and Peak

The prosperity phase is characterized by rise in the national output, rise in consumer
and capital expenditure rise in the level of employment. Inventories of both input and
output increase. Debtors find it more and more convenient to pay off their debts. Bank
advances grow rapidly even thought bank rate increases. There is general expansion of
credit. Idle funds find their way to productive investment since stock prices increase due
to increase in profitability and dividend. Purchasing power continues to flow in and out
of all kinds of economic activities. So long as the conditions permit, the expansion
continues, following the multiplier process.

In he later stages of prosperity, however inputs start falling short of their demand.
Additional workers are hard to find. Hence additional workers can be obtained by
bidding a wage rate higher than the prevailing rates. Labor market becomes seller’s
market. A similar situation appears also in other input markets. Consequently, input
prices increase rapidly leading to increase in cost at production. As a result. Prices
increase and overtake the increase in output and employment. Cost of living increases at

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a rate relatively higher than the increase in household income. Hence consumers,
particularly the wage earners and fixed income class. Review their consumption.
Consumer’s resistance gets momentum. Actual demand stagnates or even decreases.
The first and most pronounced impact falls on the demand for new houses, flats and
apartments. Following this, demand for cement, iron and steel, construction-labor tends
to halt, this trend subsequently appears in other durable goods industries like
automobiles. refrigerators, furniture, etc. This marks reaching the Peak.

2) Turning- Point and Recession

Once the economy reaches the peak, increase in demand is halted. It even starts
decreasing in some sectors, for the reason stated above. Producers, on the other band,
unaware of this fact continue to maintain their existing levels of production and
investment. As a result, a discrepancy between output supply and demand arises. The
growth of discrepancy. Between supply and demand is so slow that it goes unnoticed
for some time. But producers suddenly realize that their inventories are piling up. This
situation might appear in a few industries at the first instance. But later it spreads to
other industries also, initially, it might be taken as a problem arisen out of minor
maladjustment. But, the persistence of the problem makes the producers believe that
they have indulged in ‘over-investment’. Consequently, future investment plans are
given up; orders placed for new equipments, raw materials and other inputs are
cancelled. Replacement of worn-out capital is postponed. Demand for labor ceases to
increase; rather. Temporary and casual workers are removed in a bid to bring demand
and supply in balance. The cancellation of orders for the inputs by the producers of
consumer goods creates a chain -reaction in the input market, Producers of capital
goods and raw materials cancel their orders for their input. This is the turning point and
the beginning of recession.

Since demand for inputs has decreased, input prices. E.g. wages, interest etc. show a
gradual decline leading to a simultaneous decrease in the incomes of wage and interest
earners, This ultimately causes demand recession, Oil the other band, producers lower
down the price in order to get rid of their inventories and also to meet their obligations.

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Consumers in their turn expect a further decrease in price and hence postpone their
purchases. As a result the discrepancy between demand and supply continues to grow.
When this process gathers speed, it takes the form of irreversible recession. Investments
start declining, the decline in investment leads to decline in Income and consumption.
The process of reverse of (of negative) multiplier gets underway. (The process is
exactly reverse of expansion). When investments are curtailed, production and
employment decline resulting in further decline in demand for both consumer and
capital goods. Borrowings for investment decreases; bank credit shrinks: share prices
decrease; unemployment gets generated along with a fall in wage rates. At this stage,
the process of recession is complete and the economy enters the phase of depression.

3) Depression and Trough

During the phase of depression, economic activities slide down their normal level, the
growth rate becomes negative. The level of national income and expenditure declines
rapidly. Prices of consumer and capital goods decline steadily. Workers lose their jobs.
Debtors find it difficult to pay off their debts. Demand for bank credit reaches its low
ebb and banks experience mounting of their cash balances. Investment in stock becomes
less profitable and least attractive. At the depth of depression, all economic activities
touch the bottom and the phase of trough is reached. Even the expenditure on
maintenance is deferred in view of excess production capacity. Weaker firms are
eliminated form the industries. At this point the process of depression is complete.

How is the process reversed? The factors reverse the downswing varies from cycle to
cycle like factors responsible for business cycle vary form cycle to cycle. Generally, the
process begins in the labor market. Because of widespread unemployment: workers
offer to work at wages less than the prevailing rates. The producers anticipating better
future try to maintain their capital stock and offer jobs to some workers here and there.
They do so also because they feel encouraged by the halt in decrease in price in the
trough phase. Consumers on their part expecting no further decline in price begin to
spend on there postponed consumption and hence demand picks up, though gradually.

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Besides, there is a self - correcting process within the price mechanism. When prices
fall during recession the prices of raw materials and that of other inputs fall faster than
the prices of finished products. Therefore, some profitability always remains there,
which tends to increase after the trough. Hence the optimism generated in the stock
market gets strengthened in the commodity market. Producers start replacing the worn -
out capital and making - up the depleted capital stock, though cautiously and slowly.
Consequently. Investment picks up and employment gradually increases, following this
recovery in production and income, demand for both consumer and capital goods start
increasing. Since banks have accumulated excess cash reserves, bank credit becomes
easily available and at a lower rate. Speculative increase in prices gives indication of
continued rise in levee. For all these reason the economic activities get accelerated. Due
to increase in income and consumption. The process of multiplier gives further impetus
to the economic activities, and the phase of recovery gets underway. The phase of
depression comes to an end over time depending on the speed of recovery.

4) The Recovery
As the recovery gathers momentum, some firms plan additional investment, some
undertake renovation programmes, some undertake both. These activities generate
construction activities in both consumer and capital good sectors. Individuals who had
postponed their plans to construct houses undertake it now, lest cost of construction
mounts up. As a result, more and more reemployment is generated in the construction
sector, as employment increases despite wage rates moving upward the total wage
income increase at a rate higher than employment rate. Wage income rises, so does the
consumption expenditure. Businessmen realize quick turn over and an increase in
profitability. Hence, they speed up the production machinery.

Over a period, as the factors of production become more fully employed wages and
other input prices move upward rapidly. Investors therefore, become discriminatory
between alternative investments. As prices, wages and other factor - prices increase, a
number of related developments begin to take place. Businessmen start increasing their
inventories, consumers start buying more and more of durable goods and variety items.

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With this process catching up. The economy enters the phase of expansion and
prosperity. The cycle is thus complete.

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Q5. Write notes on.

E. Fiscal Policy
Answer:
The ‘fiscal policy’ refers to the variations in taxation and public expenditure
programmes by the government to achieve the predetermined objectives. Taxation is a
measure of transferring funds from the private purses to the public coffers: it amounts to
withdrawal of funds from the private use. Public expenditure, on the other hand,
increases the flow of funds into the private economy. Thus, taxation reduces private
disposable income and thereby the private expenditure, end public expenditure
increases private incomes and thereby the private expenditure. Since tax-revenue and
public expenditure form the two sides of the government budget, the taxation and public
expenditure policies are also jointly called as ‘budgetary policy.’

Fiscal or budgetary policy is regarded as a powerful instrument of economic

stabilization. The importance of fiscal policy as an instrument of economic stabilization.
The importance of fiscal policy as an instrument of economic stabilization rests on the
fact tat government activities in modern economies are greatly enlarged, and
government tax-revenue and expenditure account for a considerable proportion of GNP,
ranging from 10-25 per cent. Therefore, the government may affect the private
economic activities to the same extent through variations in taxation and public
expenditure. Besides, fiscal policy is considered to be more effective than monetary
policy because the former directly affects the private decisions while the Latter does so
indirectly. If fiscal policy of the government is so formulated that it during the period of
expansion, it is known as ‘counter - cyclical fiscal policy’.

F. Monetary Policy
Answer:
Monetary policy refers to the programme of The Central Bank’s variations, in the total
supply of money and cost of money to achieve certain predetermined objectives. One of

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the primary objectives of monetary policy is to achieve economic stability. The

traditional instruments through which Central Bank carries out the monetary policies
are: -

Quantitative Credit Control Measures such as open market operations, changes in bank
rate and changes in statutory reserve ratios. Briefly speaking, open market operation
by the Central Bank is the sale and purchase of government bonds, treasure bills,
securities, etc, to and form the public. Bank rate is the rate at which Central Bank
discounts the commercial banks’ bills of exchange or first class bill. The statutory
reserve ratio is the proportion of commercial banks’ time and demand deposits, which
they are required to deposit with the Central Bank or keep cash in- vault. All these
instruments when operated by the Central Bank reduce (or enhance) directly and
indirectly the credit creation capacity of the commercial banks and thereby reduce (or
increase) the flow of funds from the banks to the public.

In addition these instruments, Central Banks use also various selective credit control
measures and morel suasion. The selective credit controls are indented to control the
credit flows to particular sectors without affecting the total credit, and also to change
the composition of credit from undesirable to desirable pattern. Moral suasion is a
persuasive method to convince the commercial banks to behave in accordance with the
demand of the time and in the interest of the nation.

N. Distinction between Shares and Debentures

Answer:
Following are the points of differences between shares and debentures
Shares are part of the capital of the company. Debentures constitute loan to the
company.
Shareholders are owners of the company, whereas debenture-holders are creditors of the
company. Shareholders enjoy the rights like right to vote, right to attend general
meetings etc. Usually these rights are not available to a debenture-holder.

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As regards return of principal amount, the debenture-holders will have prior claim over
shareholders, in the event of liquidation of a company.
Shareholders get dividend depending on the profitability of the company as a reward for
their investment. In the event of no loss, the company may not declare dividend. In
respect of debentures a fixed rate of interest is paid, irrespective of the profitability of
the company. Payment of interest is mandatory.
Debentures are generally secured by creating a change on the assets of the company.
Share capital being the risk capital, no security is offered to the shareholders.
Normally, debentures are issued for a limited period. That means debentures are
redeemed during the life of the company. The share capital is the permanent source, is
generally not returned to the shareholders during the lifetime of the company. This is
subject to exception of redeemable preference shares or buy back of shares, which has
been allowed by the companies act recently.

Limitation of cost-benefit analysis

Answer:
Cost - benefit analysis suffers from following limitations. : -

Critics have pointed out that this analysis is applicable in a partial equilibrium
framework. However economists like AC. Harberger have shown that it can be applied
to the general equilibrium analysis as well
The exactness and usefulness of this analysis is limited by the fact that it is based on the
assumption that maximization of net wealth can ensure maximization of social welfare.
The cost benefit analysis is applied on another assumption that the existing pattern of
distribution of income, distribution is given and has to be kept as it is. In fact, a change
in income distribution does lead to a change in net wealth and further in social welfare.
Another limitation of the analysis is that it ignores the effect of diminishing marginal
utility of additional wealth or income with every incremental dose of income or wealth
being added to the existing total.

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By assuming the positive correlation between wealth and welfare, the analysis assumes
away all difficulties involved in the calculation of present and future cost as well as
private and social cost.
Whatever applies to costs also applies to benefits i.e., calculation of present and future
benefits as well as private and social benefits involves similar difficulties.

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