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Q.1 Income elasticity of demand has various applications. Explain each application with
the help of an example?

Ans: Income elasticity of demand may be defined as the ratio or proportionate change in the
quantity demanded of a commodity to a given proportion change in the income. In short, it
indicates the extent to which demand changes with a variation in consumer’s income. The
following formula helps to measure the income elasticity (Ey).

Or

Where

• Ey is income elasticity of demand

• D is change in demand

• D is original demand

• Y is change in income

• Y is original income

Example

Original demand=400 units Original income= 4000 units

New demand =700 units New income= 6000 units

Change in demand= 700-400= 300 units change in income=6000-4000=2000

Hence Ey=300/2000*4000/400=1.5

Generally speaking Ey is positive. This is because there is a direct relationship between income
and demand, i.e. higher the income; higher would be the demand and vice versa. On the basis of
the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal
to one, equal to zero and negative. The concept of ey helps us in classifying commodities in to
different categories.
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1. When Ey is positive, the commodity is normal (used in day-to-day life)

2. When Ey is negative, the commodity is inferior. ( for example jowar, beedi etc)

3. When Ey is positive and greater than one, the commodity is luxury.

4. When Ey is positive but less than one, the commodity is essential.

5. When Ey is zero, the commodity is neutral. E.g. salt, match box etc.

Practical application of income elasticity of demand

1. Helps in determining the rate of growth of the firm.

If the growth rate of the economy and income growth of the people is reasonable
forecasted, in that case it is possible predict expected increase in the sales of a firm and
vice versa.

2. Helps in the demand forecasting of a firm.

It can be in estimating future demand provided the rate of increase in income and Ey for
the products are known. Thus, it helps in demand forecasting activities of a firm.

3. Helps in production planning and marketing.

The knowledge of Ey is essential for production planning, formulating marketing
strategy, deciding advertising expenditures and nature of distribution channel etc in the
long run.

4. Helps in ensuring stability in production.

Proper estimation of different degrees of income elasticity of demand for different types
of product helps in avoiding over-production or under-production of a firm. One should
know whether rise or fall in income is permanent or temporary.

5. Helps in estimating construction of houses.

The rate of growth in incomes of people also helps in housing programs in a country.
Thus it helps a lot in managerial decisions of a firm.

Q.2 When is the opinion survey method used and what is the effectiveness of the method.

Ans: Survey of buyer’s intention or preference is one of the important methods of demand
forecasting. It is also called “Opinion Survey Method”.
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Under this method, consumer buyers are requested to indicate their preference and
willingness about a particular product. They are about to reveal their future purchase plans with
respect to specific items.

They are expected to give answer to question like what items they intends to buy, in what
quantity, why, where, what quality they expect, how much they are planning to spend etc.
Generally, the field surveys are conducted by the marketing research departments of the
company or hiring the services of outside research organization consisting of learned and highly
qualified professionals.

The heart of the survey is questionnaire. It is a comprehensive one covering almost all
questions either directly or indirectly in a most intelligent manner. It is prepared by an expert
body who are specialist in the field or marketing.

The questionnaire is distributed among the consumer either through mail or in person by
the company. Consumers are requested to furnish all relevant and correct information.

The next step is to collect the questionnaire from the consumers for the purpose of
evaluation. The materials collected will be classified, edited and analyzed. If any bias
prejudices, exaggerations, artificial or excess demand creation are found at the time of
answering they would be eliminated.

The information so collected will now be consolidated and reviewed by the top
executives with lot of experiences. It will be examined thoroughly. Inferences are drawn and
conclusions are arrived at. Finally a report is prepared and submitted to the management for
taking final decisions.

The success of the survey method depends on many factors:

1. The nature of the question asked.

2. The ability of the surveyed.

3. The representative of the sample

4. Nature of the product

5. Characteristics of the market

6. Consumer behavior

7. Techniques of analysis
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8. Conclusion drawn etc.

The management should not entirely depend on the result of survey reports t project future
demand. Consumer may not express their honest and real views and as such they may give only
the broad trends in the market. In order to arrive, at right conclusion, field surveys should be
regularly checked and supervised.

This method is simple and useful to the producers who produce goods in bulk. Here the
burden of forecasting is put on the customers.

However this method is not much useful in estimating the future demand of the
household as they run in a large numbers and also do not freely express their future demand
requirements. It is expensive and so difficult. Preparation of questionnaire is not an easy task.
At best it can be used for short term forecasting.

Q.3 Show how price is determined by the forces of demand and supply, by using forces of
equilibrium.

Ans: The word equilibrium is derived from the Latin word “aequilibrium” which
means equal balance. It means a state of even balance in which opposing forces or tendencies
neutralize each other. It is a position of rest characterized by absence of change. It is a state
where there is complete agreement of the economic plans of the various market
participants so that no one has a tendency to revise or alter his decision. In the words of
professor Mehta: “Equilibrium denotes in economics absence of change in movement.”

Market Equilibrium

There are two approaches to market equilibrium viz., partial equilibrium approach
and the general equilibrium approach. The partial equilibrium approach to pricing
explains price determination of a single commodity keeping the prices of other
commodities constant. On the other hand, the general equilibrium approach explains the
mutual and simultaneous determination of the prices of all goods and factors. Thus it explains
a multi market equilibrium position.

Earlier to Marshall, there was a dispute among economists on whether the force of
demand or the force of supply is more important in determining price. Marshall gave
equal importance to both demand and supply in the determination of value or price. He
compared supply and demand to a pair of scissors – “ We might as reasonably dispute whether
it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether
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value is governed by utility or cost of production. ” Thus neither the upper blade nor the
lower blade taken separately can cut the paper; both have their importance in the process
of cutting. Likewise neither supply alone, nor
demand alone can determine the price of a commodity, both are equally important in
the determination of price. But the relative importance of the two may vary depending
upon the time under consideration. Thus, the demand of all consumers and the supply
of all firms together determine the price of a commodity in the market.

Equilibrium between demand and supply price:

Equilibrium between demand and supply price is obtained by the interaction of these two
forces. Price is an independent variable. Demand and supply are dependent variables. They
depend on price. Demand varies inversely with price, a rise in price causes a fall in demand and
a fall in price causes a rise in demand. Thus the demand curve will have a downward slope
indicating the expansion of demand with a fall in price and contraction of demand with a
rise in price. On the other hand supply varies directly with the changes in price, a rise in price
causes a rise in supply and a fall in price causes a fall in supply. Thus the supply curve will
have an upward slope.
At a point where these two curves intersect with each other the equilibrium price is
established. At this price quantity demanded is equal to the quantity demanded. This we can
explain with the help of a table and a diagram.

Price in Rs Demand in units Supply in units State of market Pressure on price
30 5 25 D<S P
25 10 20 D<S P
20 15 15 D=S Neutral
10 20 10 D>S P
5 30 5 D>S P

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In the table at Rs.20 the quantity demanded is equal to the quantity supplied. Since the price is
agreeable to both the buyer and sellers, there will be no tendency for it to change; this is called
equilibrium price. Suppose the price falls to Rs.5 the buyer will demand 30 units while the
seller will supply only 5 units. Excess of demand over supply pushes the price upward until it
reaches the equilibrium position supply is equal to the demand. On the other hand if the price
rises to Rs.30 the buyer will demand only 5 units while the sellers are ready to supply 25 units.
Sellers compete with each other to sell more units of the commodity. Excess of supply over
demand pushes the price downward until it reaches the equilibrium. This process will continue
till the equilibrium price of Rs.20 is reached. Thus the interactions of demand and supply forces
acting upon each other restore the equilibrium position in the market.

In the diagram DD is the demand curve, SS is the supply curve. Demand and supply are
in equilibrium at point E where the two curves intersect each other. OQ is the equilibrium
output. OP is the equilibrium price. Suppose the price OP2 is higher than the equilibrium price
OP. at this point price quantity demanded is P2D2. Thus D2S2 is the excess supply which the
seller wants to push into the market, competition among the sellers will bring down the price to
the equilibrium level where the supply is equal to the demand. At price OP1, the buyers will
demand P1D1 quantity while the sellers are ready to sell P1S1. Demand exceeds supply. Excess
demand for goods pushes up the price; this process will go until equilibrium is reached where
supply becomes equal to demand.

Q.4 Distinguish between fixed cost and variable cost using an example?
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Ans: Fixed cost: These costs are incurred on fixed factors like land, building, equipments,
plants, superior types of labour, top management etc. fixed costs in the short run remains
constant because the firm does not change the size of plant and the amount of the fixed factors
employed. Fixed costs do not vary with either expansion or contraction in output. These cost are
to be incurred by a firm even output is zero. Even if the firm close down its operation for some
time temporarily in the short run, but remains in business, these cost have to be borne by it.
Hence, these costs are independent of output and are referred to as unavoidable contractual cost.

Prof. Marshall called fixed cost as supplementary costs. They include such items as
contractual rent payments, interest on capital borrowed, insurance premium, depreciation and
maintenance allowance, administrative expenses like manager’s salary or salary of the
permanent staff, property and business taxes, license fees, etc. They are called as over- head
costs because these costs are to incurred whether there is production or not. These costs are to
be distributed on each units of output produced by a firm. Hence, they are called as indirect
costs.

Variable Costs: The costs corresponding to variable factors are described as variable
costs. These costs are incurred on raw materials, ordinary labour, transport, power, fuel, water
etc, which directly vary in the short runs.

Variable costs are directly and proportionately increases or decreases with the level of
output. If a firm shut down for some times in the short run; then it will not use the variable
factors of production and will not therefore incurs any variable costs. Variable costs are
incurred only when some amount of output is produced. Total variable cost increases with the
level of increase in the level of production and vice-versa. Prof. Marshall called variable costs
as prime costs or direct costs because the volume of output produced by a firm depends directly
upon them.

It is clear from the above description that a production cost consists of both fixed as well
as variable costs. The difference between the two is meaningful and relevant only in the short
run. In the long run all costs become variable because all factors of production become
adjustable and variable in the long run.

However, the distinction between the fixed and variable costs is very important in the
short because it influences the average costs behavior of the firm. In the short run, even if a firm
wants to close down its operation but wants to remain in the business, it will have to incur fixed
costs but it must cover at least its variable costs.

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Q.5 Discuss Marris Growth Maximization model and show how it is different from the
Sales maximization model?

Ans: Profit maximization is traditional objective of a firm. Sales maximization objective is
explained by Prof. Boumal. On similar lines, Prof. Marris has developed another alternative
growth maximization model in recent years. It is a common factor to observe that each firm
aims at maximizing its growth rate as this goal would answer many of the objectives of a firm.
Marris points out that a firm has to maximize its balanced growth rate over a period of time.

Marris assumes that the ownership and control of the firm is in the hands of two groups
of people, i.e. owner and managers. He further points out that both of them have two distinctive
goals. Managers have a utility function in which the amount of salary, status, position, power,
prestige and security of job etc are the most import variable where as in case of are more
concerned about the size of output, volume of profits, market shares and sales maximization.

Utility function of the manager and that the owner are expressed in the following manner-

Uo= f [size of output, market share, volume of profit, capital, public esteem etc.]

Um= f [salaries, power, status, prestige, job security etc.]

In view of Marris the realization of these two functions would depend on the size of the firm.
Larger the firm, greater would be the realization of these functions and vice-versa. Size of the
firm according to Marris depends on the amount of corporate capital which includes total
volume of the asset, inventory level, cash reserve etc. He further points out that the managers
always aim at maximizing the rate of growth of the firm rather than growth in absolute size of
the firms. Generally managers like to stay in a grouping firm. Higher growth rate of the firm
satisfy the promotional opportunity of managers and also the share holders as they get more
dividends.

Boumal’s Sales Maximization model:

Sales maximization model is an alternative for profit maximization model. This model is
developed by Prof. W.J. Boumal, an American economist. This alternative goal has assumed
greater significance in the context of the growth of the oligopolistic firms. The model highlights
that the primary objective of the firm is to maximize its sales rather than profit maximization. It
states that the goal of the firm is maximization of sales revenue subject to a minimum profit
constraint. The minimum profit constraint is determined by the expectation of the shareholders.
This is because no company can displease the shareholders. It is to be noted here that

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maximization of sales does not mean maximization of physical sales but maximization of total
sales revenue. Hence, the managers are more interested in increasing sales rather than profit.
The basic philosophy is that when sales are maximized automatically profits of the company
would also go up. Hence, attention is diverted to increase the sales of the company in recent
years in the context of highly competitive market.

How Profit Maximization model differs from Sales Maximization model:

The sale maximization model differs on the following grounds:

• Emphasis is given on maximizing sales rather than profit.

• Increase the competitive and operational ability of the company.

• The amount of slack earning and salaries of the top managers are directly linked to it.

• It helps in enhancing the prestige and reputation of top management, distributes more
dividends to share holders and increases the wage of the workers and keeps them
happy.

• The financial and other lending institutions always keep a watch on the sales revenue of
a firm as it is an indication of financial health of the firm.

Q.6 Explain how fiscal policy is used to achieve economic stability?

Ans: In order to achieve a stable economic condition, fiscal policy has to play a positive and
constructive role both in developed and developing nations. The specific role to be played by
fiscal policy can be discussed as follows:

• To act as optimum allocator of resources: As most of the resources are scarce in their
supply, careful planning is needed in its allocation so as to achieve the set targets.
Rational allocation would ensure fulfillment of various objectives.

• To act as a saver:

1. It should follow a rational consumption policy reduces the MPC and raises the
MPS.

2. Taxation policy has to be modified to raise the rates of old taxes, introduces new
additional taxes, and extends the tax-nets.

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3. Profit earning capacity of public sector units are to be raise substantially to mop-up
financial resources.

4. The government should borrow more money both in the country and outside the
country.

5. Higher the rate of interest are to be offered for government bonds and security.

• To act as an investor: Mere mobilization of financial resources is not an end in itself. It
should result in the creation of real resources which are more important in accelerating
the growth process. Rapid economic growth depends upon the volume of investment.
Hence, fiscal policies have to be ensuring higher volume of investment in both private
and public sectors.

• To act as price stabilizer: price stability is of paramount of importance in an economy.
Extreme levels of both inflation and deflation would disrupt and disturb the normal and
regular working of an economic system. This would come in the way of stable and
persistent growth. Hence all measures are to be taken to check these two dangerous
situations so as to create necessary congenial atmosphere to prepare the background for
rapid economic growth.

• To act as an economic stabilizer: Price stability would create the necessary background
for over all economics stability. Upswing and downswing in the level of economic
activities are to be avoided. If an economy is subject to frequent fluctuation in the form of
trade cycle, certainly, it would undermine and disturb the growth process. Instability
would come in the way of persistent and consistent growth in a country. Hence all
measure to be taken to ensure economic stability.

• To act as an employment generator: Fiscal policy should help in mobilizing more
financial resources, convert them in to investment and create more employment
opportunity to absorb the huge unemployed man power.

• To act as balancer: There must be proper balance between aggregate saving and
aggregate investment, demand and supply, income and output and expenditure, economic
overhead capital and social overhead capital etc. Any sort of imbalance would result in
either surpluses or scarcity in different sectors of the economy leading to fast growth in
some sectors followed by lagging of some other sectors.

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• To act as growth promoter: The basic objective of any economic policy is to ensure
higher economic growth rates. This is possible when there is higher national savings,
investment, production, employment and income. Hence, fiscal policy is to be designed
in such a manner so as to promote higher growth in an economy.

• To act as in come redistribute: Fiscal policy has to minimize inequalities and ensure
distributive justice in an economy. This is possible when a rational taxation and public
expenditure policy is adopted. More money is collected from richer section of the society
through various imaginative taxation policies and a larger amount of money is to be spent
in favor of poorer sections of the society. Thus, inequality is to be reduced to the
minimum.

• To act as stimulator of living standards of people: the final objective is to raise the
level of living standards of the people. This is possible when there is higher output,
income and employment leading to higher purchasing power in the hands of common
man. Hence, fiscal policy should help in creating more wealth in the economy. If there is
economic prosperity, then it is possible to have a satisfactory, contended and peaceful
life.

Thus, fiscal policy has to play a major role in promoting economic growth in a country.

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