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MANAGERIAL ECONOMICS (MB 105 )

CHAPTR - 1
MANAGERIAL ECONOMICS
Managerial Economics is Economics applied in decision making in a unit or a firm.
-A link between abstract theory and material practices.
-Economics is concerned with the problem of allocation of scarce resources.
-Provides a number of concept & analytical tools to understand & analysis a problem.
DIFFERENT SCHOLAR VIEWS
1 According to Mc nadir &Medium- Managerial Economics is the use of economic models of
thought to analyse business situation.
2 Spencer & Siegal man-Managerial Economics is integration of economic theory & business
practices for facilitating decision-making &forward planning by management.
3 Brigham & Pappas- Managerial Economics is the application of economic theory &
methodology to business administration practices.
COMMON FEATURES IN DIFFERENT VIEWS
1 Concerned with decision making of economic nature.
2 Deals with how decision should be made by the managers to achieve the organization goals.
3 Managerial Economics is pragmatic. It is concerned with those analytical tools, which are
useful in improving decision-making.
4 Managerial Economics is both conceptual & metrical (Quantitative Technique)
5 Provides a link between traditional economic & decision-making Sciences.
NATURE- Managerial Economics is concerned with the business firm and the economic
problems that every business management need to solve.
1 Macro Economic Conditions- Decisions of the firms are made in the broad economic
environment. It is known as macro economic conditions with regard to these conditions we
may stress 3 pointsA The economy in which business operates is a free enterprise economy using prices &
market.

B Present day economy is undergoing rapid technological & economic changes.


C Intervention of govt. has increased in economy.
2 Micro Economic Analysis- It helps in studding what is going on in a firm how best to use the
available scare resources between various activities of the firm, how to be technically as well
as economically efficient. Chief source of concepts and analytical tools is micro economic
theory also known as price theory.
Concepts-Elasticity of demand, marginal cost, short &long run economies &diseconomies of
scale, opportunity cost, present value, market structure.
Positive vs. Normative Approach
Positive- concerns with what is, was or will be ex. A govt. deficit will reduce unemployment
&cause an increase in prices.
Normative- concern with what ought to be ex. In setting policy, unemployment ought to matter
than inflation.
Managerial Economics is concerned with analysis, which is prescriptive or normative in nature.
Significance
-Become more competent
-Provides most of the concepts
-Help in decision-making
SCOPE
1 Micro Economics
2 Macro Economics
Both applied to business analysis & decision-making. Business issues to which economic
theories can be directly applied divided in two categories
A Operational or Internal issues
B Environmental or external issues
Micro Economics applied to Operational issues- all internal issues with in the purview & control
of management. Theory of demand, production, price profit, capital& investment.
Macroeconomics applied to business environment- Economic, Social, and Political
Atmosphere of the country.

Trends in Macro variables general trend in economy, investment climate, Trends in output
&employment, consumption pattern of society
B Trade relations with other countries export& import, fluctuation in international market,
Exchange rate.
C Govt. policies to control & regulate the economic activities.
MANAGERIAL ECONOMICS & OTHER DISCIPLINE
It has gained by interaction among by economics, mathematics statistics& has drowned upon
management theory & accounting concepts.
Managerial Economics is a part of normative economics as its focus is more on prescribing
choice & action. Managerial Economics draws on positive economics by utilizing the relevant
theories as a basis for prescribing choices, System of logic. Managerial Economics uses come
from economic theory.
Micro & Macro Economics
Micro Economics- theory of firm &the behavior &problems of individuals
Macro Economies- behavior of the economy as a whole & the theories about its operation.
Thus the study of the level determination of National Income, employment &prices &analysis of
agg. Consumption & balance of payment belong to Macro Economics.
Operational Research- after Second World War, in U.S. interdisciplinary research was
conducted to solve the complex operational problems of planning and resources allocation in
defence and key industries. Team developed models & tools, which has since grown as
operational research, linier programming, and inventory models. Economist focuses on
maximizing profit minimizing the cost while operational research focus on concept of
optimization.
Management Theory& Accounting- Maximisation of profit has been regarded as a central
concept in the theory of firm in Micro Economics, Organisation theories in recent years have
talked about satisfying as oppose to Maximizing as an objective of the enterprises.
Accounting data &statements constitute the language of business cost revenue information
their classification are influenced considerable by the accounting profession.
Mathematical Tools- Business man deals with concept that is essentially quantitative in
nature ex. Demand, price, cost, product, capital, wages, inventory. The use of mathematical
logic in the analysis of economic variables provides not only clarity of concepts but also a
systematic framework with in which quantitative relationships may be explored.

Statistics- these tools are a great aid in business decision-making. Statistical techniques are
used in collecting, processing & analysising data, testing the validity of economic issues with
the real economy phenomenon before they are applied to business analysis.
Basic Economic Concepts in Decision Making
These are the concepts of opportunity cost, marginal analysis and the principles of
discounting.
Concept of opportunity cost- When a person devote his entire time to his own business, he
hopes that he will earn at least as much as he can by working for someone else. In this case,
decision-making takes into account the cost of opportunities forgone. The opportunity cost of a
decision is therefore the cost of sacrificing the alternatives; it is necessary, that the cost of
sacrifices involved be measured. No, sacrifice no costs.
Concept of Marginal Analysis
A firm has following cost structure for its product and is considering whether to export or not.
Cost per unit of product
Labor
Materials

Rs.
10
15

Over heads (per unit of product)

20

Total cost per unit

45

Suppose the net export price the firm can earn Rs.35 per unit, should firm export?
The answer will depend on two questions
1 At what price can the firm sell in the domestic market?
2 Can it sell all its output in the home market?
If the net domestic price is Rs.50 firm will not export unless the state offer a large subsidy
enough to offset the domestic market. If 1/3 capacity is, idle after selling all in domestic market.
Then marginal reasoning would indicate that the extra cost per unit is no more than Rs.15
assuming labor &overheads to be fixed in the short run. Marginal revenue per unit will be
Rs.35 if the firm exports. In applying marginal analysis special attention to time horizon
relevant to the problem. In long term, we should take total cost rather than marginal cost.
Concept of Discount
The present value of Rs.1000 available at the end of two years is less than the present value
of Rs, 1000 available today. The mathematical technique for adjusting the time value of money

computing present values is called discounting .e.g. a sum of Rs. 100 is due after one year, Let
the rate of interest 10%:
Discounted value v1 = 100/ ( 1+I )

= 100/ 1.10

= Rs. 90.90

CHAPTER - II

DEMAND
Demand for a commodity implies
A- desire to acquire it
B- Willing to pay for it
C- ability to pay for it
Types of Demand
A- Demand for consumers goods & producers goods
B- Perishable goods &Durable goods
C- derived &Autonomous goods
D- Firm &Industry Demand
Consumers goods and Producers goods Demand
Consumers goods are goods used for final consumption e.g. food items, readymade cloths it
is also known as direct demand. Demand for producers goods is derived demand, for these
goods are demanded not for final consumption but for the production of other goods. E.g. steel
is used for kitchens utensils, Consumers demand depend upon consumer income, producers
goods demand depend upon demand of final product.
Perishable and Durable goods Demand
Both consumers and producers goods are further divided into perishable goods and durable
goods.
Perishable goods are those, which can be consumed only once, while durable goods are those
goods, which can be used more than once over a period. Bread, milk is perishable. Car, fridge
is durable. Perishable goods demand are current demand depends on market conditions.
Durable goods demands depend on replacement of old product and expansion of total stocks.

Derived and Autonomous Demands


When the demand for a product is tied to the purchase of some parent product, its demand is
called derived. E.g., cement for house. Autonomous is independent but such type good hard to
find. All goods depend on other goods and degree of dependence varies e.g. battery tightly
tied up with car sugar loosely with soft drinks. Thus, distinction is more of a degree than of a
kind.
Company and Industry Demands
Company demands denotes the demand for the products of a particular company while
industry demand means the demand for the product of a particular industry .e.g. TISCO
demand for steel is a company demand while all companies accumulated demand is known as
industry demand.
The important market structures are distinguished based on product differentiation and the
number of sellers:
Product differentiation

Number of sellers

One seller

Standardized products

Monopoly

Differentiated

---

A few sellers

Many sellers

Homogeneous

Perfect

Oligopoly

competition

Differentiated

Monopolistic

Oligopoly

competition

MONOPOLY- One seller and one product, no close substitute. E.g. Indian postal services
&Indian Air Lines.
HOMOGENEOUS OLIGOPOLY Few sellers & product are identical.Business is largely
transferable among rivals. Companys own demands is influenced by rival actions.e.g.steel,
aluminium & cement.
DIFFRENCIATED OLIGOPOLY- Few sellers&diffrenciated product. Demand varies on
tastese.g. car, scooter,fridge,radio,etc.

PERFECT COMPITITION- can sell on ruling price. Price determined at the point where
industry demand and industry supply are in equlibrium e.g. market of agriculture products.
MONOSPONY COMPETITION- Many sellers with diffrenciated products e.g. toothpaste,
textiles,soaps. Productsof rival firmsare advertised

like different products so we have

companydemand like monopoly.


DEMANDS BY TOTAL MARKET &BY MARKET SEGMENTS-Former refers to the total
demand for a product whereas the latter signifies demands arising from different segments of
the market.
DETERMINENTS- Demand analysis usually deals with the demand for cosumer goods. A
cosumers demand for a comodity or service depends on several factors the most important of
which are following:
A Consumers Income
B Price of the comodity or srevice
C Prices of related goods or services
D Cosumer tastes and preference
E Population and its distribution
F Cosumers Expectations for a cosumers goods
A CONSUMERS INCOME &DEMAND- Consumers income acts as a constraint variable in
demand functions. Income increase quantity increase.First quantitatively then quality. Thus
income increase-demand for good quality increase &demand for poor quality goods decrease.
Income ( I) Rs.

Demand

for

(Dx)
100

10

200

16

300

21

400

25
27
Demand
Curve

500

Income I Rs.

600

OWN PRICE&DEMAND (LAW OF

400

200

0
1

Demand for Good X

DEMAND)

If the price of comodity x falls, the demand for that comodity rises and vice versa when other
things remain constant. This is called law of demand. Two types of buyers:
1 Intra marginal buyers- Do not give up consumption but change level of consuption,
increase or decrease the consumption .
2 Maginal buyer- Give up consumption if price increase as price falls, other prices remain
constant, this comodity become cheaper relative to other comodities and so its demand
increase through the substitution effect. Quite the consumption, reverse will happen if price
increase. Thus the substitution effect is always negative. A fall in price increase purchasing
power of consumers. This in turn, increase consumers demand for superior goods and
decrease their demand for inferior goods. Since a change in price give rise to both substitution
& income effects. For superior goods both effects work in the same direction while for inferior
goods they work in opposite direction. Thus
A the price effect is always negative for superior goods.
B the price effect is negative for inferior goods if the negative substitution effect is greater than
the positive income effect.
C the price effect is positive for inferior goods if the negative substitution effect is smaller than
the positive income effect. An exception to the law of demand arises only when situation (c)
above is found to exit. The inferior goods whose demand varies directly with their prices are
called giffens goods. (on whom consumer spend a significant portion of their incomes.)
Price of goods x (Px) Rs.

Demand for comodity x (Dx )

8
7
6
5
4
3
2

50
55
60
70
80
90
100

Exception in law of demand may arise in following:


1 When the good is a luxury item Diamond
2When the good is out of fasion Radio
3 When price expectatios are of the kind found in stock markets.
C PRICES OF RELATED GOODS &DEMANDS Goods &services have two kind of
relationships:
Substitution goods & complementary goods e.g. tea ,coffee & bournvita. Tea and
coffee perhaps closer substitute than tea and bournvita similarly tea, suger and milk
are complememtary goods but tea and suger are closer compliments than milk and
suger.Price of a goods falls,substitute prices also falls but complementary goods
demand increase.

D TASTE & PREFERENCE- Child eat more sweets and take milk, as we grow older
consumption reduce.

E POPULATION & IT DISTRIBUTION & DEMAND- Number of cosumers and their


consumption habit e.g. large number elder people residing in a locality require
medicines and fruits.

F COSUMER EXPECTATION & DEMAND- Prices are going to fall within two or three
days, consumer wait for fall.
DEMAND FUNCTION- states the dependence relationship between the demand for a
commodity and the factors ( f ) affecting it.
Dx = f ( I,Px,Ps,Pc,T,U )
Dx Demand for x, I Consumers Income, Px- Price of x, Ps- Price of sustitute, Pc Price of
complements of x, T- measure of taste include advertisement, U any other factor
Q1 Discussion on income increase and substitution effect?
Q2 Why demand curve slope goes from left top to bottom right?
Q3 Can we create demand by the use of determinants ?
Q4 Draw a demand curve of diamonds?
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CHAPTER - III
ELASTICITY OF DEMAND
Elasticity measures the responsiveness of one variable to the variations in another variable.
Thus, the elaticity of x with respect to y, elasticity defined as
E =% change in x / % change in y
DEMAND ELASTICITIES- The contribution of the concept of elasticities lies in the fact that it
not only tells us that consumers demand responds to price changes but also the degree of
responsiveness of consumers to a price change.

Figure shows two Demand curves let Da be the demand for cheese in switzerland and Db be
the demand for cheese in England. At price $10 quantity demanded in both countries is 60.
When price falls $10 to $5 quantity demanded increased more in England than Switzerland.
We can say demand for cheese is more elastic in England than Switzerland. Elasticity of
demand is important as indicator of how total revenueTR changes when a change in P induced
changes in Q along the demand curve. The total revenue of the firm will equal the price

changed times the quantity sold (Total revenue = Price x Quantity ).Total revenue received by
the firms are equal to total spending by consumers. By simple multiplication, total revenue can
always be calculated for each point in a demand schedule.

CLASSIFICATION OF DEMAND CURVES ACCORDING TO THEIR ELATICITIES


Depending on how total revenue changes, when price changes we can clasify all demand
curve in five categories:
1 PERFECTLY INELASTIC DEMAND CURVES
2 INELSTIC DEMAND CURVES
3 UNITARY ELASTIC DEMAND CURVES
4 ELASTIC DEMAND CURVES
5 PERFECTLY ELASTIC DEMAND CURVES

Fig. A- PERFECTLT INELSTIC DEMAND CIRVES- Demand curve implies that when price
decrease the total revenue decrease and vice versa. All such demand curve are suppose to
have an elsticity coefficient Ed = 0. Elsticity coefficient is a number describing the elasticity of a

demand curve. E.g. life saving drugs.


Fig. C- PERFECTLY ELASTIC DEMAND CURVES- When prices falls the quantity demand
increases infinitely, on the other handwhen price rises the quantity demand falls to zero and
total revenue also falls to zero. Demand is infinitely responsive to price changes.When price
decrease total revenue increased and viceversa. Elsticity coefficient Ed = infinity.

Fig. B- represents mid point- when prices decrease total revenue remajns unaffected. Such
demand curve is said to be UNITARY ELASTIC. Price increase or decrease total revenue
remain constant. e.g. amount allcated for magzine. Ed = 1
Demand curves which have an elasticity coefficient between 0 and 1 are called inelstic or
relatively inelstic.

Da curve is an example of a relatively inelastic curve. When the price falls, the quantity
demand expands but total revenue still decreases.
Da curve is example of a relarively inelastic demand curve. Such curve have an elastic
coefficient between 1 and 150.
When price decrease total revenue increase and viceversa. Believe it or not, in the real world
99.99% of the demand curves are either relatively elstic or relatively inelastic.
NUMERICAL MEASUREMENT OF ELSTICITY
Elasticity coefficient (Ed ) = % change in quantity demanded / % change in price
Ed = Q1-Q0 / Q0 / P1-P0 / P0

P0 =original price, P1 =new price, Q0 =original quantity demanded, Q1 = new quantity


demanded
% gives us the nice property that the units in which the money or goods are measured do not
affect elsticity.Demand is elastic if a given % change in price results in a larger % change in
quantity demanded. E.g. 2% decline in price results in a large %4increase in demand then
called elastic. If 3% decline in price results 1% increase in demand then called inelastic. The
border line case of unitary elasticity whioch separate elasticity and inelasticity of demands
occurs where change % in price is equal to change % in demand.
COMPUTATION OF ELASTICITY COEFFICIENTS:
May use two measures of elasticity
A ARC &POINT ELASTICITY
We want to calculate elasticity when price changes from Rs.4 to Rs.3 per unit

Price of commodity Quantity


x (Rs.)
5
4
3
2
1

demanded

commodity x (kg.)
10
16
25
30
34

of

When price changes Rs.3 to Rs.4, P =Rs.3 Rs.4 = Rs.-1 (i.e. price changes is negative
since it is a price fall ). The change in quantity demanded is Q : 25 16 = 9 (quantity change
is positive )
E = Q / Q / P / P
= 9 / 16 / -1 / 4
= -2.25
Now if we calculate the elasticitywhen price increases from Rs.3 to Rs.4 we find that for the
same stretch of the demand curve, elasticity would be different.
E = Q / Q / P / P
= -9 / 25 / +1 / 3
= - 1.08
We got two answers for same strech. This is known as point elsticities. Two answers differ
because our initial quantity demanded and price have been different. To get rid of this
problemcreted by the choice of the initial situations, we take airthmatic mean of two quantities .
q and t he mean of two prices p. This gives us a arc elasticity
ARC. E = Q / Q0 +Q1 X P0 +P1 / P
Where Q0 & Q1 are the two quantities corresponding to the two points on the demand curve,
similarlyP0 & P1 are the two prices.
B MEASUREMENT OF ELSTICITY (GEOMETRICAL WAY)We have taken a non linier demand curve. Consider point P on demand curve Dx draw a
tangent line AB at point P
E = dQ / dp x p / Q

dQ / dp is the universe of the slop of demand curve. Hence is equal to MB / PM


Price is equal to OM
E = MB /PM / OM / PM
In other words, the price elasticity of demand is measure graphically by the ratio of the two
segments of the horizontal axis identified by the intersection of the

target to the point

cosidered, with the horizontal axis and by the perpendicular from that point to the same axis. If
we now cosider the similer triangles APN &BPM then AP /PM = PB / MB or MB / PN = PB / AP
Hence elsticity = MB / ON can be written as equal to PB / AP i.e. elasticity at Pis also equal to
PB / AP the ratio of the lower segment of demand curve to the upper segment. By simple
airthmatic we can calculate the elaticity.
TYPES OF ELASTICITIES
CROSS ( PRICE ) ELSTICITY OF DEMAND In order to evaluate the effect variations in the
price of product (tea ) on a quantity demanded of another product ( coffee ). We define cross
elaticity as follows:
Sign eij shows relationship between to goods
( i ) eij great than 0 then i & j are substitute goods. An increase in price of jth goods ( tea )
increase the quantity demandfor ith good (coffee ). Hence elasticity is positive .

( ii ) eij = 0 if & only if i &j are independent goods. ( not related )


( iii ) eij less than 0 implying that i & j are complementary goods.
An increase in price jth goods (suger ) reduces the quantity demanded of the ith goods (tea ).
Hence relationship between variables is negative. Elasticity is negative. Greater the value of
eij, the more intense is the relationship existing between two goods.
INCOME ELASTICITY OF DEMAND- The responsiveness of demand to the changes in
income is known as imcome elasticity of demand. Income elasticity for a product say x ( i.e.)
mat be defined as
EI = XQ / XQ / I / I
XQ Quantity of X demanded, I

- disposable Income, XQ changes in quantity of X

demanded, I change in Income.


Income elasticity is always positive. Exception to this rule inferior goods, Income elasticity will
be negative because of inverse subsrirurion effect. The value of income elasticity tells about
the class of goods. When it is less than one, the goods are necessary. Luxury goods have
value greater than one & inferiors goods is negative. Income elasticities varies along a given
demand curve . It is a decreaseing function of income, it falls as the income rises. This is
because consumers modify their consumption pattern. The weighted sum of income elasticity
of demand various goods must add to one.

M1Q1 + M2Q2 = 1 where Q1&Q2are income elasticity of demands for goods 1& 2.

ELASTICITY OF DEMAND WITH RESPECT TO ADVERTISEMENT-

It is the ratio of %

change in the quantity demanded of a commodity ( Q ) to % in the advertisement outlay on the


commodity (A ). It is also called promotional elasticity. This is defined as % change in the level
of future prices ( Pt +1 ) expected as a result of a change in the level of current prices (P1 ).
E = dPt +1/dPt x Pt / Pt +1

CHAPTER - IV
DEMAND FORECASTING
A forecast is the prediction of a future situation. Aim of demand forecasting is to reduce risk
and in planning for firms long term growth.It start with macro economic forecast. Demand and
sales of most goods and services are strongly affected by business conditions e.g. sales of
automobiles, new houses etc.
TYPES OF DEMAND FORECASTING
PASSIVE-

based on assumption that firm doesnot change its course of action.

ACTIVE-

forecast is done under the conditions likely changes in future.

FORECASTING STEPS
A Identification of objective
B ditermining the nature of goods
C selecting a proper method of forecasting
D Interpretation of results
METHODS OF FORECASTING
Fundamentally two approaches

A SHORTRUN-

to obtain information about the intentions of consumers by means of

market research, survay, economic intelligence etc.

B LONGRUN- to use past exprience as a guide and by exploiting past trends, to estimate
the level of future demand.
NEW PRODUCT--- SURVEY METHOD used because no historical data is available.

EXPERT OPINION SURVEY METHOD


Obtaing information from group of experts regarding future technological stares.
Speedy and less costly.
DELPHI TECHNIQUE
Panel members are asked by letters to give their predictions. They got information throgh post
& sent outcome. Those who dissent are invited to give reasons or else modify their forecasts.
Process repeated and final range of outcome is regarded as probabilistic forecast.
CONSUMERS SURVEY METHOD
It is a direct approach. Three types
A COMPLETE ENUMERATION SURVEY
The probable demands of all the cosumers for the forecast period are summed up.
ADVANTAGE
Unbaised
Accurate

DISADVANTAGE
Cotact large number of persons
Tedious
Authenticity of data is doubtful
B SAMPLE SURVEY
Probable demand expressed by each selected unit is summed up. Then total sample demand
x by the ratio of number of consuming units in the population.Give good results for new
product.
ADVANTAGE
less tedious
less costly
less data errors
C END USE METHOD
Demand surveys of industries using this product as an intermediate product. Demand for the
final product is the end use demand. Intermediate product may have many end use. Domestic
and international market demand. The demands for final consumption and exports net of
imports are estimated through some other forecasting methods and its demanded for
intermediate use estimated through a survey of its users industries. Such a method is feasible
for national planning organisations and not for industry.
ADVANTAGES
Provides sectorwise demand forecasting
Does not require historical data
If numbers of end users is limited it will be convenient to use this method.
DISADVANTAGES
It required every industry to furnish its future plan,individual industry will have to rely on some
other method to estimate future demand, only intermediate demand can be predicted.

STATISTICAL METHOD
A TREND METHOD
Based on analysis of past sales pattern. These methods dispense with the need for costly
market research because necessary information is often already available.
Time series data- main 5 techniques as :
1 FITTING A TREMD LINE BY OBSERVATION
easy & quick
pattren trend
x
x
oct

xx actual bimonthly sale

oct

oct

oct

1980 1981 1982 1983


Time
TREND THROUGH LEAST SQUARE METHOD
Mathematical
Sales = a + b (year ) or
S = a + bt
Where a & b have been calculated from past data & t is the year number for which
forecast is to be made. e.g.
The sale record of company x reveal the following
Year
Sales in crores

1970 1972 1974 1976 1978


30

40

45

50

48

1980
57

Estimate sales for the year 1982 &1983.


SOLUTION
To find values of a & b we will have ti solve the normal equation

= Na + b T

ST = a
IN THE TABLE BELOW WE FIND
YEAR

YEAR NUMBER

T + b T 2

S, ST , T, T2
SALES (S)

SXT

1970

30

30

1972

40

120

1974

45

225

25

1976

50

350

49

1978

48

432

81

1980

11

57

627

121

36

270 1784 266

substituting
270 = 6a + 36 b
1784 =36a +266b
solving these equations for a & b we get a = 30.76 b = 2.34
Thus the trend equation becomes S = 30.76 + 2.34 t years 1982 &1983 take on the years
number 13 &14.
By substituting these values for t we get Rs. 61.18 & 63.52 crores.
Trend method is popular because it is simple and gives good forecasting more over it does not
require knowledge of economic theory and market.
MAIN DRAWBACK
Past rate of change in variables continue in future.not appropriate for short term, can not
explain turning point of business cycle.
C TIME SERIES ANALYSIS
This is an extension of linier regression which attempts to build seasonal and cyclical
variations into the estimating equation,
SALES = a (TREND) + b ( SEASON ) +c (CYCLE ) +d where a,b,c,d are constants
calculated from past data.Trend value is the year number. The value of season is given by

normal % difference from trend for the season being forecast. The value of cycle could be
found from baromatric indicators for the period of forecast.
D MOVING AVERAGE &ANNUAL DIFFERENCE METHOD
A moving average of order k is obtained by adding yearly demands for successive years of k
number of years and dividing it by k.Thus the moving average of order 5 at year t = 1/5 ( Dt-2
+ Dt 1 + Dt + Dt +1 + Dt +2 ) where Dt is demand in year t.
E EXPONENTIAL WEIGHTED MOVING AVERAGE METHOD
A progressively smaller weight is given to the more distance as compared to the more recent
past years.These weights will have to be chosen properly chosen. Once a smooth time series
is obtained the trend method can be applied to these series to generate demand forecasting.
BAROMATRIC TECHNIQUES
It is based on that the future can be predicted for certain events occuring in the present. It
involve statistical indicators. Time series provide indications of change in economy or specific
industry. These are termed as the barometer for market change.
( 1 ) Leading indicators consists of indicators which move up or down ahead of some series
e.g. ( I) index of net business ( capital ) formation ( ii) new orders of durable goods (iii) new
building permits ( reflect future market change ).
( 2 ) Coincidental indicators which coincide with or fall behind general economic activity or
market trends. e.g. number of employees in non agriculture sector.
(3) Lagging indicators-Those indicators which follow a change after sometime e.g. are
manufacturers stock level and cosumer credit outstanding.
The problem of choice may arise because some of the indicators appear in more than one
class.so it is advisable to rely on just one indicator.This lead to uses the diffusion index.
DIFFUSION INDEX- cops with problem of differing signals given by the indicators. A diffusion
index gives the % of rising indicators. In calculating a diffusion index for a group of indicators
scores alloted are1 to rising series, to constant series and zero to falling series. If 3 out of 6
indicators are moving up in lagging series the index shall be 50%. It is for short term forecast.
QS
1) What is delphi method? What is the use of this method?
2) How baromatric leadership is achieve discuss in light of perfect competition?
3) What are the indicators available in our economy?
Present in the class.
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REGRESSION METHOD
Regression anlysis denotes method by which the relationship between quantity demanded and
one or more independent variables (like income , price ,advertisement ) is estimated.
Simple regression analysis is used when the quantity demanded is estimated a function of a
single independent variable, such as price. Multiple regression analysis is used to estimate
demanded as a function of two or more variables simultaneously.
SIMPLE REGRESSION METHOD (SINGLE VARIABLE )
A single independent variable is used to estimate a statistical value of dependent variable
that is , the variables to be forecast.
QUARTERLY CONSUMPTION OF SUGER
Year

Population (millions)

Suger consumed 000 Tons

1985-86

10

40

1986-87

12

50

1987-88

15

60

1988-89

20

70

1989-90

25

80

1990-91

30

90

1991-92

40

100

suppose we have to forecast demand for suger for 1994-95 on tha basis of 7year data given in
table. This can be done by estimating a regression equation
Y = a + bX
Y is suger consumed, x is population ana a &b are constants.
Like trend fitting method above equation can be estimated by using least square method. The
parameter a and b can be estimated by solving the following two linier equations:

Y1 = na + bX1

--------------------- 1

XiYi = Xia + bXi ------------------------ 2

calculation of terms in linier equations


YEAR

POPULATION X

SUGER CONSUMED Y

X2

XY

1985-86

10

40

100

400

1986-87

12

15

144

600

1987-88

15

60

225

900

1988-89

20

70

400

1400

1989-90

25

80

625

2000

1990-91

30

90

900

2700

1991-92

40

100

n =7

x1 = 152

1600 4000
x 2 =3994 xy = 12,000

Y1 = 490

by substituting value in equation 1 and 2 we get


490 = 7a + 152 b

-------------------- 3

12,000 = 152a + 3994b ----------------- - 4


by solving equation 3 and 4 we get a = 27.42 b = 1.96
by substituting values for a and b in equation
Y = a + bx
Y = 27.44 = 1.96 X
Given the regression equation, the demand for suger for 1994-95 can be easily projected if
population for 1994-95 is known. Suppose population is projected 70 million, the demand for
suger in 1994-95 may be estimated as
Y = 27.44 + 1.96 (70)
=164,640tonnes.

MULTIVARIATE REGRESSION
Function of many variables
1 to specify the variables that are supposed to explain the variatios in the demand. The
explainatory variables are chosen from the determinants of demand.
2 to collect time series data on the independent variables.
3 to estimate the parametersin the chosen equatios with the help of statistical techniques.

MULTIPLICATIVE DEMAND FUNCTION


Qx = a Pbx Yc Pd
Qx = Quantity demanded for x, Px = price of commodity, y = cosumer income, A =
advertisement expences, a is constant, and bcd are parameters expressing the relationship
between demand and Px, y, Py, and A.
SIMULTANEOUSLY EQUATION METHOD
also known as complete systmatic approach. It involves simultaneously cosiderations of all
variables, as it is believed that every variable influences the other variable influences the other
variable in an economic decision environment, so here the set of equations equals the number
of variables.
Mathematical & statistical 1First step-Develop a complete model and specify the behavioural assumptions regarding the
variable included in this model. The variable included in models are called
a endogeneous variables
b exogeneous variables
Endogeneous variables that are determined with in the model as dependent variable
Exogeneous variable determined outside model e.g. Govt. tax rate
2 Data collection on both above variable which is hardly available
3 the model is solved for each endogeneous vriable in term of exogeneous variable into the
equations, the objective value is calculated and prediction made. e.g. consider a simple macro
economic model
Yt = Ct + It + Gt + Xt ----------------- 1
Yt Gross National Product,

Ct Total cosumption expenditure,

It = Gross Private

Investment, Gt = Govt. expenditure, Xt = Net Exports, (X M ) where M = Imorts and subscript

t represents a given time unit eq.1 is an identity , which can be explained with a system of
simultaneously equations. Suppose in eq. 1
Ct = a + b Yt -------------------- 2
It = 20 --------------------------- 3
Gt = 10 --------------------------- 4
Xt = 5-----------------------------5
In the above system of equations, Yt & Ct are endogeneous variables, It, Gt, Xt are
exogeneous variable. Eq2 is a regression equation that has to be eliminated. EQ 3 4 5 shows
the value of exogeneous variable determined outside model. Suppose we want to predict value
of Yt &Ct simultaneously. Suppose also we estimate the eq 2, we get
Ct = 100 + 0.75 Yt
Now using the equation system, we may determine the value of Yt as
Yt = Ct + 20 +10 +5
= Ct +35
since Ct = 100 + 0.75 Yt by substitution we get
Yt 0.75 Yt = 100 +35
0.25 Yt = 135
Yt = 135/ 0.25
= 540
now we can calculate Ct easily.
BOX JENKINS METHOD
For short term, only for stationary time series sales data, only monthly or seasonal variation,
date shows variation e.g. woolen cloth in winter, desert cooler in summer.
According to this approach any time series data can be analysed by the following three
methods:
1 Auto regression model
2 Moving average model
3 Auto regression and Moving average method
STEPS
1 to eliminate trend from time series data
2 to check seasonality in stationary time series
3 to pridict the sales in intended period

1 AUTO REGRESSION MODEL


The behavior of a variable in a period is linked to the behaviour of another variable in future
periods. The general form of model is :
Yt = a1 Yt-1 + a2 Yt2--------------+ anYt-n +e1
Value of Y in period t depends on the values of Y in period t-1, t-2,-------tn, e1 is random portion
of Yt. If value of coefficients a1,a2,---an are different from zero it revals seasonality in data.
2 MOVING AVERAGE MODEL
Model estimates Yt in relation to residuals e1 of the previous years.
The generl form of model is:
Yt = m +b1 et-1 + b2 et-2---------bp et-p + et
where M is mean of the stationary time series. et-1, et-2, et-p residuals, the random
components of Y in t-1, t-2, --------t-p periods.

3 AUTO REGRESSION ( MOVING AVERAGE MODEL )


After moving Average model is estimated, it is combined with auto regression model to form
the final form of the BOX JENKINS MODEL as below:
Y1 = a1 Yt-1 + a2 Y t-2 +------------ +an Yt-n + b1 et-1 +b2 et-2 +------ + bp et-p + e1
Sophisticated and complicated method require computer.
MOVING AVERAGE METHOD
This simple method assumed that demand in a future year equals the average of demand in
the past years as below:
Dt = 1/N (Xt-1 + Xt-2----------Xt-n)
Sales in previous years N = number of preceding year.
QS
1)You are given the following data:
X

10

13

13

13

14

10

12

12

14

14

20

Estimate the regression equation Y = a + b X

2) Why is demand forecasting essential? Is demand forecasting equally important for small
and big, and old and new business ventures? ( DISCUSS IN THE CLASS )

4) Demand forecasting is must for the bu


5)
6) siness?

CHAPTER - V

Cost concept
Need in all business decisions. The Kind of cost concept to be used in a particular
situation depends upon the type of business decision to be made.
Total cost, Average cost & Marginal cost: Total Cost includes all cash payments
made to hired factor of production & all the cash changes imputed for the use of the
owners factor of production in acquiring or producing a good or service . For e.g. A
shoe makers cost will include the amount he spent on lather, thread, rent of shop,
interest on borrowed capital, wages of employees etc & the amount charges for his
services & his own funds invested in business.
Average cost (AC) is the cost per unit of output
Ac = total cost/Total Quantity produced (X) if TC =100 & X= 10
AC = 10 Marginal cost (MC) is the extra cost of producing one additional unit.
After management is interested in incremental cost instead of MC e.g. TC of 101
hundred meter cost is Rs 101000 & that of producing 100 hundred meter lots is Rs
100000. The Mc is Rs 1000. The incremental cost per unit is the total incremental
cost divided by the increment in units produced. In the e.g., the incremental cost per
unit is Rs 10.
Total Cost concept is useful in break-even analysis & in finding out whether a firm is
making profit or not. The Average cost concept for calculating per unit profit. The
Marginal cost & Incremental Cost needed that whether firm needed to expand i.e.
production or not.
Fixed or Variable cost: FC defines as those, which remain the same at a given
capacity & do not carry with output. These costs will exist even if no out put is
produced e.g. Rent of factory. Variable cost varies directly as out put is produced e.g.
wages, cost of raw material. Some cost falls in between two extreme known as semi
variable e.g. electricity bill minimum charges. These cost used for forecasting the
effect of short run charges. These costs used for forecasting the effect of short run
charges in volume upon cost and profits.

Acquition & opportunity cost: Acquiring cost means cash out flow committed to
acquire or produce a good or service. These costs are generally recorded in the
books of accounts. The included hiring land labor, Capital & management.
Opportunity costs are cash inflows prevented by taking one cause of action instead of
other e.g. student when deciding whether to go to college or not a student might
compete the amount his spent on fees, books etc with the movable increase in his
further earnings. He must add to these costs the earning he foregoes in the years he
spends in college. These earnings are opportunity cash
Out Of pocket and book cash: - Out of pocket cash refer to cost that involve
immediate payments to outsiders as opposed to book cost that do not required
current cash expenditure for ex. Usages to employees out of pocket salary to owner.
If not paid, is a book cash out of pocket also called explicit book costs implicit costs
both costs are actual cost of a firm.
Historical & Replacement cost: The historical cost of an asset is the actual cost
increased at the time that work was originally acquired. In contrast to this recost is the
cost, which will have to be incurred if that asset is purchased now.
Past and future costs: Past cost are actual costs incurred in the past & they are
always contained in the income statement. Future cost are likely to be increased in
future period & based on estimate.
Separable & common Cost: Cost of electricity is common cost; Raw material cost
can be separable cost.
Determinants of cost: out put level, prices of factor of production, productivity of
factor of production Technology.
Output & cost: Total cost varies directly with out put. The more output a firm
produces the higher will be its production cost & vice versa (Increase of raw material
& labor). If increase in substantial even fixed inputs have to increase.
Cost output relation ship: - In economics analysis the cost function usually refer to
the relationship between cost & rate of output alone & thus assumes that all of the
other independent variables are kept constant. Economist emphasis on this
relationship is reasonable because it is subjected to faster & more frequent changes.
Once the cost output function is determines, estimates of future costs of the
production at varies output levels can usually be obtained by adjusting the cost
function to reflect the effect of other forces such as wage rate, material prices &
productivity of labor. However cost output relationship is a partial relationship.
Variable cost varies with output positively. Fixed costs are constant in short term. In
long run all costs are variable.
Short run cost output Relationship: Refer to a particular scale of operation or to a
fixed plant. Thus the short run function relating cost to output variations is of following
type

Tc =F (x) + A
Tc = Total cost x = output A = total fixed cost. The fixed cost is for a given plant size,
for different plant sizes its value will differ F (x) denotes total variable cost short run
cost output relationship needs to be discussed in term of (a) fixed cost & output (b)
Variable cost & output (c) Total cost & output
Fixed cost & outputs: By definition fixed cost does not vary with output. Thus the
larger the quantity produced, the lower will be the fixed cost per unit & marginal fixed
cost will always be zero. In our e.g. the TFC Rs. 176 Irrespective of the units of
output & AFC decline Monotonically as output increases correspondingly TFC curve
is horizontal at RS. 176 & AFC curve is falling continuously in figure. The relationship
between fixed cost and output is the same for all type of business.

Cost output relationship:


Unit of Total
Total
output Fixed
Variable
cost
cost
(TFC)
TVC
0
176
0
1
176
75
2
176
130
3
176
175
4
176
209
5
176
230
6
176
265
7
176
289
8
176
312
9
176
320
10
176
344
11
176
367
12
176
400
13
176
448
14
176
510
15
176
600

Total
Cost
TC
176
251
306
351
385
414
441
465
488
504
520
543
576
624
688
776

Marginal Average
cost MC fixed
Cost
(AFC)

Average
Variable
Cost
AVC

Average
Total
cost
ATC

75
55
45
34
29
27
24
23
16
16
23
33
48
62
90

75
65
58
52
48
44
41
39
36
34
33
33
34
36
40

251
153
117
96
83
74
66
61
56
52
49
48
48
49
52

176
88
59
44
35
29
25
22
20
18
16
15
14
13
12

Variable cost & output: The total Variable Cost increased as output increases. The
cost may not increase by the same amount. For every unit increase in output. As
output increase TVC increase at a decreasing rate, then at a constant rate &
eventually at an increasing rate. Law of Diminishing return is in operation ex the
requirement of labor does not change linearly with quantity produced A Firm need
minimum number of labor for even one unit of its output & its way not need any extra
labor until it exceeds a given range of output if further expended needs more labors.

Total Cost & Out Put Relationship: As against this raw material cost Varies directly
with output. Other variables cost stationary, electrical bills etc. which very at different
level of outputs. If further increase variable factor input cost increase & they way have
to be paid higher price then before.
Another reason for a nonlinear Total Variable Cost & output relation is the operation
of the law of diminishing returns. It may be recall that according to this law as more &
more units of variables factors of production are used along with a factor of
production, the original products of that variables factors first increases, then remain
constant & finally stars diminishing. In this behavior of AVC function first fall as output

increases than remain constant for some output range, & eventually rise with every
increase in output. Marginal cost is also equals change in Total Variable Cost.
Variation in Average Variable Cost & Marginal Cost will be similar.
Total Cost & Output: Total cost increases as output increases Total Cost & Total
Variable Cost is parallel in above graphs.
The relationship among AVC, ATC & MC can briefly describe as -

All three cost measures fall than constant, then rise.


The rate of change in MC is greater than AVC & hence the minimum MC is at an output
lower than the output at which AVC is minimum.
The ATC falls for a longer range of output than the AVC & hence the minimum ATC is at
a larger output than the minimum AVC.
AVC= MC, when AVC is least.
ATC = MC, ATC is the least.

Long run cost output relationship: In the long run there is no fixed factor of
production & hence there is no fixed cost.
The Partial total cost function will be:
TC= f (x, k)
k- stands for the plant size. As k changes TC changes, thus the long run cost
function contains a family of short run cost functions one for each value of k.
Relationship is not unidirectional. If the output is small, small plant size will be less
than for a large plant size. Large plant size is good for large outputs. Thus, the family
of short run total cost curves are shown in graph. In short, run variations in output are
possible up to extent plant size permit. In long term plant size can change but no
employer will do it. Therefore, the concept of long term is only hypothetical

Economies and diseconomies of scale: These are concern with the behavior of
average cost as the plant size changes. There exist economies of scales if average
cost falls as plant size increases and the diseconomies of scale prevail if the opposite
is the case. For e.g. If the average cost at a given output with a plant size K= 1(say
100 unit capacity) is Rs. 8.00 and that with a plant size K= 2(say 200 unit capacity)
say Rs. 750, the there are economies of scale between plant size 1 and 2. If the
average cost prize is to say, Rs 8.00 for a plant size K=3(say 300 unit capacity) There
are diseconomies to scale between plant size 2 & 3.

Size of plant reflect the amount of investment made in the relatively fixed factor of
production. This Varies in long term only hence economics of scale are associated
with the long run average cost curve only. The long run average total cost curve is U
shaped. The point at which L arc is minimum is the point at which economy just equal
diseconomies of scale. Marshal classified economies and diseconomies of largescale production in two Internal & External. Internal are due to firms own

expansions. External are may arise due to expansion of the industries as a whole For
e.g.. Industries expansions may led to the construction of the railway line in certain
reign resulting in the reduction in transport cost for all the firms. External economies,
like internal economies may return into diseconomies beyond a certain output level.
QS

CHAPTER - VI
LAW OF SUPPLY
Supply of a commodity refers to the varies quantities of commodity which a seller is
able to sell at different prices in a given market, at a point of time, other things
remaining the same.
Determinants of supply: amount of a commodity supply depends upon a number of
factors. These can be stated in terms of a supply function.
Sx = f (Px, Py, Pz, Pf, O, T)
Sx = amount supplied of good x , Px- Price of good x
PyPz= Prices of other goods in the market
Pf= Prices of factor of production needed to produce good x
O = objectives of the producer T = state of technology used by the producer to
produce good x
Law of supply states that other things remaining constant more of a commodity is
supplied at a higher price & less of it is supplied at a lower price.
Firms supply schedule for scooter tyres
Price of Tyre

Quantity supplied

(Rs per tyre)


200
180
160
140

000 Nos
100
90
80
70

Shift in supply: increase or decrease in quantity supplied at the same price, same
quantity supplied at a higher, or a lower price.
Change in supply is in fact extension & contraction of supply when more goods are supplied at
a higher price it is call extension of supply. When less units of goods, are supplied at a lower
price it is called contraction of a supply.

SELLING COST
For determinig price and output under monopolistic competition and oligopoly. Firms often
compete through incurring selling cost on advertisement expenditure.
QS. How much selling on advertisement expenditure a firm should take to maximise its profit?

Salling cost distinguised from production costs - term selling cost broader than
advertisement expences.
Advertisement Expences include cost of production advertisement in news papers,
magazines on radio and tv.
SELLING COSTS - salary of the sales man,allowances of retailers for product displayed, other
type of promotional activities besides advertisement.
Chamberlin madedistinction between selling cost and production cost. According to him
production cost include all those expences which are incured to manufacture and provide a
product to consumer to meet his given demand. While selling costs are those which are
incured to change or creat or shifts in demand for a product.
SIMPLE CRITERIA -All the costs incured in the manufacurer and sale of a given product those
which do alter the demand curve for it are selling costs and those which donot are costs of
production. High rent of shop and trnsportation not comes in selling costs. It is difficult to say
attrractive packing is selling cost or production cost.

SELLING COSTS ROLE UNDER PERFECT COMPETITION, MONOPOLY AND IMPERFECT


COMPETITION
Perfect competition Product is homogeneous so industry can give a common
advertisement of all firms known as promotional advertising as comared to competitive
adversity.
Monopoly No close substitute of product so no competition hence advertisement is
informative and promotional.
Monopolistic and Oligopoly Product differerciation so advertisement and other selling
costs become important as a competitive weapon at the disposal of firms to increase its sales
at expence of others. Product close substitute so each firm try to convince the buyers that its
product is better than others. This is known as competitive advertisement. This shift demand
curve to right means at a given price, a greater quantity of product can be sold.

EFFECT OF SELLING COSTS ON DEMAND


The purpose and effect of sucessful advertisement is to increase there demand however these
selling costs are subject to varing returns. Equal increaments in advertising outlay first yield
increaseing returns then decreasing returns. Selling costs permits a firm to reapeat many times
its advertisement. Second reason for occurrence of increasing returns in beginning is the
economy of large scale. Diminishing return set in advetrtisement due to :
1 Initial advertisement attracts large number of buyers
2 From the increase in advertisement buyers may not increase their demands because
cosumers buy more a product its utility diminishes.

In diagramAssumptions All demand curves are parallel. Diminishing return in diagram is q0


q1, q1q2, q2q3.
THE CURVE OF AVERAGE SELLING COSTS
Two concepts
1 Average selling cost required to sell various amounts of output with varing advertisement
expences incured in a period the average selling costs per unit will depend upon the quantity
sold as a result of upword shift in demand curve brought about by a perticular amount of
selling costs. Selling costs is subject to varing returns.Firm will further plan out regarding
advertisement because selling cost per suit falls in beginning. After a point diminishing return
to selling costs set in and increase in advertisement outlay cause less than proportionate
increase in the amount demand of a product.

2. Curve of Average selling cost with a given amount of total selling costs means the average
selling cost per unit which is required to be undertake to seek various amounts of output. Once
selling cost fixed then greater level of output sold. This is because beyond a point no further
increase in selling cost can cause any expansion in amount demanded of a product.

OPTIMUM LEVEL OF ADVERTISING OUTLAY (SELLING COSTS ) WITH PRICE AND


PRODUCT DESIGN AS CONSTANT
How much selling cost a firm will take to maximise profits?
What is the optimum amount?
Above questions can be explained by average and marginal cost curves. In diagram ASC
Average selling cost , APC Average production cost
Average total cost = APC +ASC
Distance between AC and APC measures the average selling costs. We assume that OP is
fixed and constant further production is also unchanged and it is only advertisement expences
get changed. PL canbe viewed as MR curve. MC = MR at point E, OQ is quantity and OP is
price, total profit PERT.Average selling cost is equal to BR AND BR = QD So the total optimal
amountof advertisement QD X OQ quantity.

2 OPTIMAL LEVEL OF ADVERTISEMENT EXPENDITURE WITH PRICE AS A VARIABLE


Assume firms aims to maxmise profit. Aro is demand suppose these MC = MR curve equal to
Ono where Po is price and profit is PoLQH.

suppose firm spend Rs. 1000/ expences for advertisement. This expence will shift AR and cost
too will increase. The demand curve shift to AR1 and the new AC1 ( inclusive advertisement
expences ) equlibrium at ON1 price OP1 quantity ON1 and profit P1ETK here MR & MC equal
to ON1. Increased profit tempted to further advertisement Rs.2000/ with this demand curve
shift to AR2 equlibrium at ON2 and profit P2JSD. Lure to increase profit further advertisement
expences Rs. 3000/ revenue curve shift to AR3 equilibrium ON3 &AC3. New average cost
curve but less profit P3BWG so company will select P2 for profit maximisation.
EFFECT OF SELLING COST ON ELASTICITY OF DEMAND
Due to advertisement demand curve shift to right. Elsticity of demand at each price with
advertisement decline. Extent of decline is uncertain. Price and output both increase with
advertisement.
QS

CHAPTER VII
MEANING AND NATURE OF INDIFFRENCE CURVE
The locus of points, each representing a different combination of two substitute goods, which
yield the same utility or level of satisfaction to the consumer. Therefore, he is indifferent
between any two combinations of goods when it comes to making a choice between them.
Consumers consume a large number of commodities and services. One commodity may
substitute by another and combinations gave him same satisfaction when such combinations

plotted graphically the resulting curve is known as indifference curve also called iso utility
curve or equal utility curve. Let us suppose that a consumer makes fine combinations a to e.
All these combinations yield him the same level of satisfaction.
Combination
A
B
C
D
E

Units
of Units
commodity
commodity
y
X
25
5
15
7
10
12
6
20
4
30

25-

--A

15 -

-B

of Total utility
U
U
U
U
U

COMMODITY Y
654-e

- C-D
5 7 12

20

30

COMMODITY X
PROPERTIES OF INDIFFERENCE CURVE
1 Indifference curve have a negative slop that impliesa two commodities substituted for each other
b if quantity of one commodity decreases quantity of another commodity must increase
so
that consumer stays on same level of satisfaction.
2 Indifference curve are convex to origin impliesa two commodity are substitute to each other
b Marginal rate of substitution decreases
3 Indifference curve neither intersect nor be tangent to each other.

4 Upper indifference represent a higher level of satisfaction than the lower ones.

ISOQUANT CURVE
Isoquant curve means equal quantus means quantity. Therefore also known as equal product
curve or production indifference curve. An isoquant curve is locus of points representing

various combinations two inputs capital and labor yielding the same output. To illustrate curve
let us assume
7(I) There are only two factors of production labor L capital K to produce a commodity.
(ii) The two factors can substitute each other but at a diminishing rate.
(iii) The technology of production is given.
Given these conditions, it is always possible to produce a given quantity of
commodity x with various combinations of capital and labor. The factor combinations
are so formed that the substitution of one factor for the other leaves the output
unaffected. This technological fact is presented through an isoquant curve IQ = 100.
The curve IQ1 all along its length represent a fixed quantity 100 units of product x.
This quantity of output can be produced with a number of labor capital combinations
for e.g. point A,B,C,D on the isoquent iq1 show four different combinations of inputs
K.L.
CAPITAL LABOUR COMBINATIONS AND OUTPUT INPPUT COMBINATION
POINTS
CAPITAL +
LABOUR =
OUTPUT
A
OK4
OL1
100
B
OK3
OL2
100
C
OK2
OL3
100
D
OK2
OL4
100

K4
Capital

K
K3

K2

IQ2

K1

D
IQ1=100

L1 L2

L3

L4

Labor L
PROPERTIES OF ISOQUENT
(I) Isoquants have a negative slop.
(ii) Isoquants are converse to origin.
(iii) Isoquants cannot intersect or be tangent to each other.
(iv) Upper Isoquants represent higher level of output.

CHAPTER - VIII

Pricing
Price of a product or service is determined by the demand for it and greater demand
smaller supply, the greater will price and vice versa. There are five basic
determinants of the price of a commodity:
1 Demand
2 Cost function
3 Objectives of its producer
4 Nature of the competition in market
5 Government Policies
Let the demand facing a firm for its product be expressed as
Q = 25 0.5p
Q = Quantity demanded P = Price and the supply of this firm as
Q = 10 + 1.0 p
Q = Quantity supplied P = Price, in absence of any influence from the Government
the price is as
DEMAND = SUPPLY
25 0.5p = 10 + 1.0p
i.e. P = 10 and Q = 20 if Government imposes sales tax at Rs. 3 per unit, new supply
function would be:
Q = 10 + 1.0 (p 3)
So 25 0.5p = 10 + 1.0 (p 3)
i.e. p = 12 if substitute this in demand we get Q =19.

Pricing under different market structures


Markets

Imperfect Competition

Perfect
Competition

Monopoly

Monopolisti
c

Oligopoly

Pricing under perfect competition


In figure the firm demand curve is horizontal and the price determined in the industry
by the intersection of demand and supply. The demand curve is also the firms
average revenue curve.

Part B - Firm
D1
D

Part A Industry
S

MC ATC
E1

P
AR = MR
P1
PRICE
D1 AR =MR
P

D1
S

D1
G

E
F

O
Q Q
O
Q1 Q1
QUANTITY
D1D1 = AR = MR, ATC =Average total cost MC = Marginal cost. The firm reaches its
eqlibrium at E. When P = MC and MC curve intersect the MR curve from below.
Firms equilibrium output is OQ1. Profit area is D1EFG. In the short run, a firm can
make profit, loss or just breakeven depending upon its cost function and market
conditions? However, in long run no firms make profit or loss under perfect
competition. This follows from future of free entry and exit. If demand curve change
from DD to D1D1 the market price would be OP1 and industry output OQ1 and the
firms output OQ1, Es is economic profit. The supernormal profit lures other firms into
the industry. Consequently supply curve shift rightward causing a fall in price. Firms
occurring losses cannot survive in long run such firms quit the industry.

Pricing under monopoly


Absolute power to produce and sell a product, which has no close substitute
A signal firm, exit in industry.
Causes and kind of monopolies
It prevent entry of other firms into the industry. Barriers are sources of power. The
measure sources of power are
1. Legal restrictions
2. Sole control over the supply of key raw materials
3. Efficiency and economies of scale
Pricing and output decision in short run- are based on revenue and cost.
A profit maximising monopoly firms chooses a price output combination at which
MR=MC i.e. point N to X-axis determines the profit maxmising output for the firm at
OQ. The output OQ can be sold per time unit at only one price i.e. PQ=OP1. Thus,
the determination of output simultaneously determines the price for monopoly firm.
Once price is fixed, the unit and total profits are also simultaneously determined.
Hence, the monopoly firm is in the state of equilibrium.
AR = Average revenue curve
MR = Marginal revenue curve
SAC = Short run Average cost curve

SMC = Short run marginal cost curve in the

SMC

Unit
Cost &
Revenu
e

P1

P2

SAC

N
PR=D
MR

X
OUTPUT

Monopoly pricing and output decisions in long run


The decision rules regarding optimum output and pricing the long run are the same
as in the short run. In the long run a monopolist gets an opportunity to get expand the
size of its firm with a view to enhance in long term profit. Expansion of plant is
subject to condition as
A Size of market
BExpected economic profit
CRisk of inviting legal restrictions
Let us assume that time being none of the above condition limits the expansions of monopoly
firm. The price and output determination in the long run.
AR CURVE = Market demand
MR CURVE = Marginal revenue
LAC and MAC show the long run cost conditions. LMC and MR intersect at point P
where output is OQ2. This is profit maxmising output. Given the AR curve, the price
at which the total output OQ2 can be sold is P2Q2. Thus, in the long run, the output

will be OQ2 and price P2Q2. This combination maximises the monopolists long run

profit LP2SM.

QS
1) What is the differnce between perfect compitition market and monopoly market? (class
verbal presentation )

Price Discrimination
selling the same or slightly differentiated product to different sections of consumers
at different prices. Consumer discriminated on the basis of their income or purchasing
power, geographical location, age, sex, marital status, quantity purchases, time of
purchase etc. When consumers are discriminated based on above factors in regard
to prices charged from them, it is called price discrimination. Another kind of
discrimination is that the same price is charged from the consumers of different areas
while cost of production in two different plants located differently is not the same ex.
Doctors, Lawyers, Consultants. Charges on the basis of ability to pay. Merchandise
sellers sell goods to relative and friends at lower price, Railway charge lower from
children and students.
Necessary conditions for price discrimination
1 Different market must be separate
2 Elasticity of demand must be different in different markets
3 there must be imperfect competition in the market
Degrees of price discrimination
First degree When seller knows that the price consumer is willing to pay so fixed
price accordingly. Once he has extracted the whole consumer surplus, he lowers the
price for extracting surpluses of second unit e.g.. Doctor.
Second degree Large market, monopolist-using block pricing method. Blocks
Rich highest price, Medium Low price, Poor Lowest price.
Third degree When a profit maxmising monopolist sets different prices in different
markets.

The firm marginal cost is shown but MC which intersects MR at point T. Optimum
level of output for this is determined at OQ at this level MR = MC. The whole quantity
cannot be sold in any one market at a profit maxmising price. So OQ out allocation
between the two markets in such proportion that profit maxmising is satisfied in both
the markets. This can be accomplished by drawing a line from point T parallel to xaxis through Mob and Mra intersecting at point S and R.

Pricing under monopolistic competition


Monopolistic competition has large number of sellers, free entry and free exit, perfect
factor mobility / substitute, complete dissemination of market information,
differentiated products e.g. T.V., Fridge, soap etc.

Short run pricing and output decisions


Monopolistic competition is close to perfect competition but about pricing and output
determination it is close to monopoly. Monopolistic competition faced a downward
sloping curve due to (1) a strong preference of a section of consumers for the product
( 2 ) the quasi monopoly of the seller own the supply. Strong preference of
consumers gives the sellers an opportunity to raise the price and yet retain some
customers and since each product is a substitute for the other, the firm can attracts
the consumers of other products by lowering the prices.

A FIRM MR intersect MC at point N. this points fulfills the necessary condition of profit
maxmising at output OQ. This output can be sold at price PQ. Therefore, price is
determined at PQ. Monopoly profit shown by P1PMP2. The economic profit Pm will
exit in the short run because of no possibility of new firms entering the industry but
profit level in monopolistic competition differ in different firms because of difference in
the elasticity of demand. Some firms may make losses for the same reason.

Long run price and output determination


It is similar to perfect competition. The existence of economic profits in the short run
attracts new firms to the industry. The entry of new firms reduces the share of
individual firms in total supply. This shifts the demand curve AR to left. Such shifts
continue so long as economic profit exits. At the stage where AR = LAC the individual
firms and also the industry attain the equilibrium level. In the long run, output is OQ.
At this stage, no new firm will enter in the industry or old firm quitting the industry.

Pricing under oligopoly


Oligopoly is a reduced form of monopolistic competition. It is a competition among
few sellers (big), each selling either differentiated or homogeneous products. Number
seller is too small that market share of each firm is so large that it influence the
market price. It also implies that each seller commands a sizable proportion of the
total market supply.
Classification on product basis
1 heterogeneous oligopoly ex. Automobile industry.
2 homogeneous / pure oligopoly ex. Gas, cement, and baby food.
Keen competition Action, reaction and counter action. In this market firms business
decisions become interdependent, since a major policy change by one firm is bound
to affect the interest of other firms. Consequently, strategic decisions regarding
pricing, marketing, advertisement etc. are based on explicit assumptions regarding
actions and reactions of rival firms.
Competition between oligopolists generally takes three forms:
1 Free competition: Price war against each other which ultimately takes the form of
non price competition as showed by kinked demand curve analysis.
2 when oligopoly is a competitions among unequal, the larger firm plays the role of
price maker and small ones become the price takers. This is known as price
leadership model.
3 Collusions between firms under cartel system or price agreement i.e. Collusive
module.
In a market setting characterised by a few monopolistic sellers, the demand curve
losses its significance because it is indeterminate. The demand curves keep shifting
back and forth from one position to another due to interdependent of firms decision.

Cornets model of oligopoly (Duopoly)


He assumed:
1 Two firms, each owing an artesian mineral water well.
2 both operate their wells at zero marginal cost.
3 both face a demand curve with constant negative slop.
4 each sellers acts on assumption that his competitor will not react to his decision to
change his output and price. Cornet has concluded that each seller ultimately
supplies one third of the market and charges the same price and one third of the
market remains unsupplied.

A is the only seller of mineral water in market. Following the profit maximising rule, he
sells quantity OQ where his MC = O = MR at price OP2. His total profit is OP2PQ. B
enters in the market. Market open is QM1/2 of total market. He assumed that A will
not change his price and quantity as he is earning maximum profit. Market available
to B is QM and demand PM. When he draws his MR curve PN is bisect QM at point
N where QN = NM. In order to maximise his revenue B sells QN = = 1/2/2 of the
market with entry B price falls to OP1, therefore As profit falls to OP, RQ. An attempt
to adjust his price and quantity to the changed situation. He assume that B will not
change his output QN and price OP1 AS He is making maximum profit. Assume that
B will continue to supply of market and he has of market available to him. To
maximise his profit, A supplies of (3/4) i.e. 3/8 of the market. It is noteworthy that
As market share as fallen from to 3/8. Now it is B turn to react. B assume that A
will continue to supply 3/8 of the market and market open to him equals 1-3/8 =5/8
.To maximise his profit under new conditions B supplies / 8/5 = 5/16 of the market.
Now its a turn to react. This action reaction continues until both reach at equilibrium
of equal market share 1/3 of each share. Any further attempt will produce same
result.
Period Seller A Seller B
1
(1) =
2
(1-1/4) = 3/8
3
(1-5/16) = 11/32
4
(1-21/64) = 43/128

() =
(1-3/8) = 5/16
(1-11/32) = 21/64
(1-43/128) = 85/256

Cournets equilibrium solution is stable.


Criticism 1 Firms continue to make wrong calculation about the competitors behavior.
2 Assumption of zero cost of production is unrealistic.

KINKED DEMAND CURVE ANALYSIS OF PRICE STABILITY: SWEEZYS MODEL


This model does not deal with price and output determination. Rather it seeks to
establish that once a price quantity combination is determined, an oligopoly firm will
not find it profitable to change its price in respond to a moderate change in cost of
production. Firms believe that if it reduces price of its product, rival firms would follow
and neutralise the expected gain from price reduction. However, if it raises its prices,
rival firms either would maintain their prices or may even cut their prices down. In
either case, the price raising firms stands or loose, at least a part of its share in the
market. All the firms in respect of others make these behavioral assumptions.

Suppose a firm raise its price rival firms may react in following way
1 follow the price change, both cut & hike
2 do not follow the price change
3 do not react to price hike but they follow the price cut.
Let us suppose market demand curve for a product is given by dd curve and that the
initial price is fixed at PQ. Now one firm change its price if rival firm react in manner
(I) they react with hike for hike and cut for cut the price changing firm will move along
the demand and if rival firm do not follow the price changes, then the price changing
firm will move along the demand curve DD. Note that the firm initiating the price
change faces two different demand curves conforming to two different kinds of
reactions (I) & (ii). The demand curve dd based on reaction (I) is less elastic than the
demand curve DD based on reaction (ii) Given the two demand curve dd and DD
let us now introduce reaction (iii) a more realistic one i.e. the rival firms follow the

price cut and do not follow the price hike. This asymmetrical behavior of the rival
firms makes only a part of the two demand curves relevant and produces a kinked
demand curve. If a firm increases, price and rival do not it losses a part of its market
to its rivals. The demand for its product decreases the firm is therefore forced down
from demand curve dP to DP. Now suppose alternatively that the firm decreases its
price. Then the rival firms also cut down their prices otherwise they would loose their
customers. This counter price move does not allow the firm to take full advantage of
DD curve. Therefore, its demand curve below point P rotates down. Let us now draw
MR curve. Recall that MR = AR AR/e. The MR curve drawn on the basis of
relationship takes a shape by a discontinuous curve DJKL. The DJ & KL segments of
MR curve correspond to DP &Pd. Suppose that original marginal cost curve
resembles the curve MC1 which intersecting MR at point K. Since at output OQ MR
= MC1 the firm makes maximum profit. Now even if MC curve shift upwards to MC2
any level between J & K firms profit would not affect. Therefore has no motivation to
increase or decrease price.
CRITICISM
1 It does not tell how initial price has been fixed at a certain level.
2 There is lack of price rigidity in the model in real world firms is reluctant to the price
hike.

Price Leadership model:


It may emerge spontaneously due to technical reasons or explicit agreement among
the firms to assign leadership role to one of them. Dominate firm takes lead in making
price change and smaller one follows. Price leadership exit only. Conditions are
1Numbers of firms is small.
2 Entry of firm is restricted.
3 Product are homogeneous.
4 Demand has low elasticity.
5 Firms have almost similar cost curve.
Price Leadership by low cost firms
Small firms face identical revenue curves as shown by MR and AR but they have
different cost curves as shown by AC1 and MC1 whereas all rival firms smaller in size
have their cost curves AC2 and MC2. This is so because larger firms has economies
of scale its cost of production is lower than the other firms.

Given the cost and revenue conditions, the low cost firm would find OP2=LQ2 most
profitable and sell quantity OQ2. At this level of output its MC=MR and hence profit is
maximum. High cost firm would maximize at OP3 and quantity OQ1 but if they keep
price high they would loose their customers to lower cost firm so they are forced to
accept OP2 level and recognize the price leadership of low cost firm. The low cost
firm can eliminate all firms by cutting the price to OP1 but he earns normal profit and
fear of anti monopoly laws.
Price Leadership by a dominant firm- Dominant firm fixes the price and other
follows.

Suppose the market demand curve is given by DDm in part (a). Supply curve of all
the firms including dominating is Ss. Both intersect at Equilibrium price level P3. The
total supply of small firms is P3E. Therefore at price OP3 the market left FC the
dominate firm is zero. When price is OP1 market demand is PB out of which PA is
supplied by the smaller firms. The market unsupplied by the smaller firm is AB thus at
price op1 the demand for dominant firms product equal PB - PA = AB. Similarly
when price is reduced to OP2 the demand for dominant firms product is CF. Following
this process, the market share of dominant firm at other prices can be easily
obtained. In graph P3DL as the demand curve for the dominant firm MC curve is MCL
its profit maximising output will be OQL and price PQL. Once the dominate firm sets
it price at OP the demand curve for small firms is the PB. They can sell as much as
they produce, but in order to maximise the joint profit small firms will produce PA.
Note the PB is the same as their MR=AR line and then supply curceP1SS intersects
AR=MR AT POINT A for small firms profit maximising joint output is PA.
Critical Appraisal1 Small firms faithfulness is doubtful.
2 Many cases of price leadership neither big nor low cost. (Political)
3 If leading firms losses the cost advantage new firm becomes leader.
4 It is assured those new firms are prevented by low cost but some enter through
diversification.
The Barometric Price Leadership-A firms initiated well-published changes in price
that are generally followed by rival firms in the industry. The barometric firm is
however supposed to have a better knowledge of prevailing market conditions and
has an ability to predict the market conditions more precisely than any of its
competitors. This qualification of the barometric firm should have been established in
the past. The firm having the qualifications of price leadership is regarded as a
barometer, which reflects changes in business conditions and environment of
industry. The price changes announced by the barometric firm serves as a barometer
of changes in demand and supply conditions in the market. It is evolved due to
following reasons:
1 Cut throat competition makes them unacceptable as a leader so a firm has better
predictive ability emerge as price leader.
2 No firms want to make calculation continuously so they find it advantageous to
accept the price changes made by a firm.
3 Price leadership often develops as a reaction to long warfare in which all firms are
looser.
Collusion model: The Cartel It is an association of business firms formed by an
explicit agreement between them. The firms jointly establish a cartel organization to
make price and output decisions, to establish production quotas for each firm and to
supervise the market activities of firm in the industry. Cartel type of collusions is
formed with a view to (1) eliminating uncertainty (2) restrain competition and theyre
by ensuring monopoly gains to the cartel group. The cartel works through a board of
control. One of the functions of the board is to determine market share of each firm.
For this purpose, the board calculates the MC and MR of the industry. MC is
summation of MCs of individual firms. One the basis of MC and MR the total output

of industry is determined. The total output then allotted between the member firms on
the basis of their MC.

The industry out put is determined at OQ and price at PQ. The share of each firm in
the industry out put OQ is determined at the level of their own out put, which equates
their individual MC with the industry MC. The industrys marginal cost CQ is
determined by the intersection of industries MC and MR at point C. The market share
of each firm can be obtained by drawing a line from point C to parallel to x axis
through MC2 and MC1 to the y axis. The point of intersections C1and C2 determines
the level of out put for firm And B. The share of each firm two A&B is determined at
oq1 +oq2 = OQ. Their total profit can be computed as (price ac) x firms out put.
This shows the stability of price and out put under collusive oligopoly.

COST PLUS PRICING OR MARKS UP PRICING- also known as Average cost


pricing or Full Cost Pricing. It is the most common method of pricing a product by the
manufacturing firms. General practice under this method is to add a fair % of profit
margin to the average variable cost (AVC). The price is set as
P = AVC +AVC (m)
where m is markup %.AVC (m) = gross profit margin (GPM)
The markup % (m) is fixed to cover average fixed cost (AFC)& a net profit margin (NPM). Thus
AVC (m) = AFC + NPM
The procedure for arriving at AVC & price fixation may be summarised as follows:
First step is to estimate the average variable cost. For this, the firm has to ascertain
the volume of its output for a given period of, time usually one accounting year. To
ascertain the out put, the firm uses its figure of planed budgeted out put or takes into
account its normal level of production. The next step is to compute the total variable
cost (TVC) of the standard out put. The TVC includes direct cost i.e. cost of labor and
raw materials and other variable costs. This cost added together give the total
variable cost. The average variable cost AVC is then obtained by dividing the total

variable cost TVC by the standard out put QS i.e. AVC = TVC/QS. After AVC is
obtained a mark so some % of AVC is added to, it for profit and the price is fixed.
Limitations 1 it assumes that firms resources are optimally allotted and the
standard cost of production is comparable with the average of the industry. In reality it
is not so.
2 historical cost is used rather than current cost data it led under pricing.
3 Variable cost fluctuates frequently and significantly.
4 It ignores demand side of the market.
MULTI PRODUCT PRICING Price theory is based on assumption that a firm
produces a single homogeneous product. In actual, all firms have more than one
product. Even most specialisd firms produce a commodity in multiple models. Ex.
Radio, TV. , Car, fridge. Models produced by the same company may be treated as
different products for at least pricing purpose. Each model or product has different AR
& MR curves and that one firm compete against the firm. The pricing under these
conditions is known as multi product pricing or product line pricing.
Each product has separate demand curve and they have one
inseparable marginal cost curve. Therefore, marginal rule of pricing cannot apply. The
solution is third degree price discrimination. As a discriminating monopoly tries to
maximise its revenue in all its markets so does a multiproduct firm from each of its
product.
MAJOR PROBLEM

Suppose A firms has four different products A, B, C, D in its line of production. The AR
= MR curves for the four goods are shown in four segments. The marginal cost for all
the products taken together is shown by MC curve. Let us suppose that when the
MRs for individual producers is horizontally summed up, the aggregate MR (not given
in figure) passes through point C on MC curve. If a line parallel to x axis is drawn
from point C to Y axis through the MRs, the intersecting points will show the points
where MC &MR are equal for each product as shown by line EMR, the equal
marginal revenue line

CHAPTER - IX
PRICING IN LIFE CYCLE OF A PRODUCT
Life cycle five stages
1 Introduction or initial stage
2 Growth
3 Maturity
4 Saturation
5 Decline

1 Introduction to the customer through advertisement. Trial of the product. Sale


constant.
2 Growth After successful trial. Product gain popularity. Sale increasing at
increasing rate. Result of cumulative advertisement.
3 Maturity sale continue to increase at lower rate and eventually become constant.
4 Saturation- sales do not saturate nor increase nor decrease becomes constant.
After the saturation decline stage comes.
5 Decline A decline trend for such reasons as (I) increase in the availability of
substitutes (ii) the loss of distinctiveness of the product.
PRICING OF A NEW PRODUCT A new product be either simply another brand
have added to the existing once or an altogether new product. Pricing a new product
for which many substitutes exist in the market is not a big problem as pricing a new
product for which close substitute is not available. We confine here pricing strategy
for new product. Two kinds of strategies 1 Skimming price policy 2 Penetration price
policy.
1 SKIMMING PRICE POLICY- it is intended to skim the cream of market i.e.
Consumers surplus, by setting a high initial price; three or four times the ex. Factory
price and subsequent lowering of price in series of reduction. Initial high price would
be accompanied by heavy sales promoting expenditure. This policy succeeds for the
following reasons:

1 Demand is relative inelastic because of consumers desire for distinctiveness by the


consumption of a new product.
2 cross elasticity is very low for lack of a closer substitute
3 Step by step price cuts help skimming consumers surplus available at lower segments of
demand curve
4 Initial advertisement elasticity is considerably high
5 High initial prices help in recouping the developmental cost.
Post skimming strategy Appropriate occasion for price reduction is the time of saturation of
the top-level demand or when a strong competition is apprehended.
2 PENETRATION PRICE POLICY: is adopted generally in case of new products for
which substitute are available. Fixes a lower initial price designed to penetrate the
market as quickly as possible and is intended to maximise profit in the long run. The
success of policy requires the existence of following conditions:
1 Short runs demand for the product has an elasticity greater than unity. It helps in
capturing the market at lower prices.
2 Economies of large scale of firm production available.
3 Potential market for the products large and has a good deals of future products
4 Product should have high cost elasticity in relation to rival products.
5 the product by nature should be such that it can be easily accepted and adopted
but the consumers.
PRICING IN MATURITY PERIOD: Second stage in life cycle of a product, It is
between growth period and decline period .It may be define as the period of decline
in growth rate of sales and the period of zero growth rate. The concept of maturity
period is useful to the extent it gives out signals for taking precautions in regard to
price policy. First step reduce price second product improvement and market
segment.
PRICING A PRODUCT IN DECLINE- In this stage, the total sale of the product starts
declining. First step reduce price. The total should be reformulated and remodeled
to suit consumers preference. Advertisement expenditure may be reduced or
withdrawn completely and rely on residual market.
PRICING IN RELATION TO ESTABLISH PRODUCTS- new products are not very
frequent. Most producers enter in the market with a new brand of commodity for with
a number of substitute available. They face the problem of pricing his product
because of strong competition with established products. In pricing a product in
relation to its well-established substitutes, generally three types of pricing strategies
are adopted.

1 PRICING BELOW THE MARKET PRICE- is generally preferred in two conditions. First if a
firm wants to expend its product mix with a view to utilize its unused capacity in face of tough
competition with the established brand. Brand loyalty should be over weight by some incentive.
Secondly, this technique has been found to be more successful in case of innovative products.
2 PRICING AT MARKET PRICE To be most reasonable pricing strategy. Product can be sold
in any quantity at the existing market rate. This strategy is adopted also when the seller is not
a price leader but a price taker.
3 PRICING ABOVE THE EXISTING MARKET PRICE This strategy is adopted when a seller
intends to achieve a prestigious position among the sellers in the locality. Prestigious goods.
Consumers of such goods prefer shopping in a gorgeous shop of a posh locality of the city.
This is known as Veblen effect. After the seller achieves the distinction of selling high quality
products, though at a high price, they may sell even the ordinary goods at a price much higher
than the market price.

Transfer Pricing - The parent division buys the product of its subsidiaries such firms face
the problem of determining an appropriate price for the product transferred from one division to
other. This problem becomes more difficult when each division has a separate profit function to
maximise. Pricing of intra, firm transfer product is referred to as transfer pricing.
TECHNIQUE OF TRANSFER PRICING Let us suppose that a refrigeration company
established a decade ago used to produce and sell refrigerators fitted with compressors
bought from a compressor manufacturing company. Now the refrigeration company decided to
set up it is subsidiary to manufacture compressors. Let us also assume ( I ) both parent and
subsidiary companies have their own profit functions to maximise ( 2 ) refrigeration company
sells its product in a competitive market and its demand is given by a straight horizontal line.
& ( iii ) the refrigeration company uses all the copressors produced by its subsidiary. In
addition, we assume that there is no external market for compressors.
TRANSFER PRICING WITHOUT EXTERNAL MARKET
MCt & MCb combined vertically gives common MCt for e.g. at out OQ,
TQ+MQ = PQ.
The MCt intersect line Arr = MRr at point P, An ordinate draw from P to Q determines most
profitable out put of both refrigerator body & compressors each at OQ.

For price of compressors we have to assess MC & MR. The MC for the compressor is MCc.
Therefore firm has to obtain marginal revenue MRc that can be obtained by subtracting noncompressor mc of the final goods from MRr. Thus
MRc = MRr (MCt MCc)
For e.g. at out put OQ, Mrt = PQ1
Mct = PQ by substituting these values in equation
MRc = PQ- (PQ-MQ)
= MQ since in figure. OQ-MQ =PM &PM = TQ therefore
MRc = PQ TQ = PT and PT = MQ at point P, MRc = MCc thus the
price of compressor is determined at PQ.
TRANSFER PRICING WITH EXTERNAL CMPETITIVE MARKET
Now assume that there is external market for compressors and market is competitive.
Therefore, demand curve is P2D. Note that in absence of external market, the transfer price of
compressor would have been fixed at OP1 =PQ2 but compressor sold in competitive market
the market price of compressor i.e. OP2 instead of OP1 where MRc = MCc besides the price
OP2 is also the potential MR for the compressor division. Therefore, in maximise the profit
compressor price will be set at point P where MRc is greater than MCc. Thus, price will be
fixed at PQ1 and the Refrigerator Company would buy OQ1. The total output is determined at
a level where MCc intersects the demand line D at point R so Q1Q3 sold in external market.

TRANSFER PRICING UNDER IMPERFECT EXTERNAL MARKET:


Let us suppose
(I) Average and marginal revenue curves for the compressors are given by Arx & MRx
(ii) That the marginal net revenue from the internal use of compressors are represented by
MRc & MCc with a view to maximising over all profits the refrigeration company will determine
the out put of compressors where MCc = MRc + Mrx i.e. MCc intersects MRt at point P which
determines output OQ3. Copressor division can maximise it s profit by dividing its out put
between the refrigeration company and the external market so as to equalise its MC & MR in
both the markets. Draw a line PP1 determine shares, parent body share OQ1 and external
market OQ2. Not that OQ1 + OQ2 = OQ3. Transfer price is set OP1.

QS
1) What are the main problems come in fixing a price of an established product?
2) What is the problem in transfer pricing? (class discussion)

COMPETITIVE BIDDING OR CONTRACT PRICING


A kind of price in which a firm is required to quote its price under uncertain cost and price
conditions with a view to winning a contract or tender. The foremost problem is to quote a
supply price, which can win the contract without unduly reducing the profit margin. Price should
be lower than rivals should.
PEAK LOAD PRICING
Electricity & Telephone, demand varies in day & night, consumption of electricity reaches its
peak in daytime, Peak load time. In night peak off time and reduce consumption. Unique and
technical features of such product are that it cannot be stored. Production has to increase in
peak load time and reduce in peak off time. Besides, given the installed capacity, their
production can be increased but at an increasing marginal cost.

PROBLEMS IN PRICING
Pricing of goods as if electricity is problematic. Short run setting in fig. DP peak load demand
curve DL off load demand curve, short run marginal cost curve is SMC. P3 Peak load price
change. It is unfair consumer will be charged for what they do not consume. Govt. will face
public opposition. P1 off load if charged production will fall to OQ2 and there will be acute
shortage of power. If P2 is charged it will have demerits of both peak load and off load and
extent of AB excess production will go waste, during peak load shortage to extent BC which
can be produced only at an extra marginal cost of CD.
DOUBLE PRICING SYSTEM
For the above reason generally a double pricing, system is adopted. A higher price P3 during
peak load and P1 during off load. Production also gets increase and decrease.
ADVANTAGES
Peak load pricing has two advantages1-Day business pay higher rates

2 Billing system is greatest problem; consumer has to install two meters, which increase theft.

CHAPTER - X
BREAKEVEN ANALYSIS
Break Even Analysis also known as profit contribution analysis important analytical
techniques used to study the relationship between total cost, total revenue & total
profit & losses own the whole range of stipulated output.
Breakeven point - Linear cost & revenue functions
E.g. Let us assume Fixed cost = Rs. 100 and its variable cost varies at a constant
rate of Rs. 10 per unit in response to increase output. We assume a short run linier
cost function of the form
TC = 100 + 10 Q
Let us also assume that price for the firms product is given in market at Rs. 15 i.e. we assume
a linier revenue function of the form
TR = 15 Q
The firm now needs for breakeven analysis of its business operations is to make a chart of its
total fixed cost, total variable cost, total cost, and the total revenue and graph them to find out
breakeven point B. Line TR shows the total revenue Q X P. Line TR intersect the TC at B
where output Q = 20. Below B TC is higher than TR i.e. loss ahead TC is lower than TR i.e.
profit. Algebraically calculation: We know that at breakeven point TR = TC That is, in terms of
TR & TC function
15Q = 100 + 10 Q
5Q = 100
Q = 20

LIMITATIONS
Under the condition of linear cost and revenue function, Tc & TR are straight lines and
intersect each other only at a point dividing whole range of out put in two parts profitable and
non profitable. It may not be true due to changing price and cost conditions. In reality, the cost
and revenues functions may be nonlinear so that AVC and price vary with variation in the
output. As a result, the total cost may increase at increasing rate while the total revenue
increases at a decreasing rate. Therefore, at some stage of output TC may exceed TR Thus
there might be two breakeven points. This may limit the profitable range of output and
determine the lower and upper limits of profitable output, so analyst should therefore pretest
and verify the validity of cost and revenue functions.

BREAKEVEN POINT: NON-LINIEAR COST AND REVENUE FUNCTIONS

TFC line shows the fixed cost at OF and the distance between TC AND TFC measures the
total variable cost (TVC). TR curve shows the total sales proceeds or total revenue at different
level of output and price. The vertical distance between TR & TC measures the profit or loss
for various levels of output. In graph TR & TC intersects at two points B1 & BBBBB2 where TR
= TC. These are lower and upper breakeven points. It implies that a firm producing more than
OQ1 and less than OQ2 unit will make profit.

PROFIT VOLUME ANALYSIS CHART

The profit line is graphed by computing the profit or loss consisting of the difference between
sales revenue and the total cost at each volume. The point where profit line intersects the
horizontal axis is the break-even point. This has been shown in graph.

USE OF BREAKEVEN ANALYSIS


(I) Sales volume can be determined to earn a given amount of return on capital.
(ii) Profit can be forecast if estimates of revenue and cost are available.
(iii) Effect of change in volume of sales, sales price, cost of production can be appraised
(iv) Choice of products can be made from the alternatives available
(v) Impact of increase or decrease in fixed and variable costs can be high lighted.
(vi) Effects of high fixed costs and low variable cost to the total cost can be studied.
(vii) Inter firms comparisons of profitability can be made.
(viii) It emphasizes the importance of capacity utilization for achieving economy

LIMITATIONS
1 It can be applied to single product system. In joint cost operations, it become difficult, to
segregate product wise cost.
2 It cannot be useful where cost and price data cannot be ascertain.

CHAPTER - XI

National Income
According to Marshall the labor and capital of a country acting on its natural
resources produce annually a net aggregate of commodities, material and immaterial
including services of all kinds.
According to Pigou, National dividend is that part of the objective income of the community
including of course income derived from abroad which can be mwasured in money.
According to Fisher National income consists solely of services as received by ultimate
consumers whether from their material or human environment.
Keyness approach to national income- Earlier definitions do not throw light on the
factors which determine the level of income and employment at a particular time in an
economy. According to him, aggregate income of an economic system lies
somewhere between the value of gross national and the net national product . Gross
national product refers to the money value of final goods and services at a particular
time. Keynes take into account depreciation and obsolesce changes to arrive at
national income.
Net Income= A-U-V A- Gross National Income U- User costdepreciation of machines
V-Supplementry cost other type of depreciation

Modern definitions- According to Simon Kuznets It is the net output of


commodities and services flowing during the year from the countrys production
system in the hands of the ultimate consumers.
National Income Commission of India- National Income estimate measures the value of
commodities and services turned out during a given period counted without depreciation.
Different Concepts of National Income1. Gross National Product (GNP)- refers to total value of final goods and services
produced in the country during the given.

Main FeaturesA- does not take into account the depreciation of goods and services
B- excludes maternity benefit unemployment, free scholarships, pensions etc.
C- includes only those goods and services brought in market for sale and purchase
D-capital gains are excluded ex. Scooter Rs. 20,000 sold at Rs.22, 000 difference will not
be included.
E- Intermediate goods, which are used for making another goods, are not included.
F- measured in monetary terms.
2- Net National Product- NNP = GNP- Depreciation
3-Net National Product at Market Price- Gross National Product at Market Price - Capital
Consumption Allowances (depreciation charges for renewal of plant wearing out and
obsolescence of capital equipment) net money value.
MeritsA - It stresses the long-term significance of maintaining the productive capacity of the
economy
B- Extremely useful in the economic growth
C- it clarifies the long run improvement in physical productivity of capital
D- Useful in analysis the net increase in total product.
4- Net National Product at Factor Cost - It is the sum total of income payments made to
the factors of production. The sum total of goods and services produced with the
cooperation of factors of production at factor cost during one year in a country.

Constituents12345-

Wages salaries and supplementary earnings of employees for their productive services.
Net rent of all individuals including imputed rent
Net interest paid to all individuals
Net profit of all kinds minus
Transfer payment (pension, maternity benefit etc.)

NNP at Factor Cost = NNP at market price Indirect taxes (sales, excise) or NNP at factor
cost = NNP at market price + subsidy Indirect taxes.
5- Personal Income- Income received by individuals of a country in a year from all
sources.
Personal Income = Net National Income + Transfer payments Undivided corporate profit
corporate income tax social security contribution.
6- Disposable Income Actual income that can be spent on consumption by individuals
and families. Income after tax deductions, Person does not spent full income but save a
part so,
Disposable income = consumption expenditure + savings
7- Corporate income- Income and profits of companies or public corporation. We deduct
the income tax and profit tax, we get corporate income.
8- Percapita Income- Average earning of an individual in a particular year.
Percapita Income = National Income of a country/ population of a country.
9- Private Income obtained by private individuals from any source whether productive or
nonproductive. Private Income = NNP at factor cost + Transfer payments +Interest on
public debts social securities profits and surpluses of public undertakings.
10-Real Income - is the National income expressed in terms of level of prices of a
particular year as base year when the general price level is neither too high nor too low
and the price level for that year is assumed to be 100.
11- Domestic Income or Product- refers to the income generated by the factors of
production within the country from its own resources. It includes wages, salaries, rent,
interest, dividend, and undistributed direct taxes.

Relationship between different concepts of National Income 1- Gross Domestic Product at Market Prices = Consumption of household + Govt.
consumption + Investment Expenditure.
2- Net Domestic Product at factor cost = N.D.P. at Mkt prices Indirect taxes.
3- Net Domestic Product at Market Prices = G.D.P. at Mkt. Prices Depreciation
4- National Income = Net National Product at factor cost.

Methods of Measuring National Income

1- Income method- Adding together net income payments received by the citizens of a
country in a particular year. In other words net income that accrue to the factors of
production by way of net interest, net profit and net wages etc. are all added together
but income received by way of transfer payment are excluded from it.
2- Product Method or Inventory Method Commodity Service Method. N.I. is the sum
total value of all the final goods and services produced during a given period in an
economy.
3- Expenditure Method known as consumption and investment method. In this, we add
up personal consumption expenditure, Govt. purchases of goods and services, Net
domestic investment and net foreign investment.
NATIONAL INCOME ANALYSIS: techniques of social accounting (S.A.)
In the words of Peacock and Cooper, Social Accounting is concerned with the statistical
classification of the activities of human beings and human institutions in ways, which help
us to understand the operation of the economy as a whole. The field of studies summed up
by words Social Accounting embraces, however not only the classification of economic
activity, but also the application of the information thus assembled to the investigation of the
operation of the economic system.
System presents a detailed factual record of the performance of various sectors and sub
sectors of the economy during a specific period. All the transactions, big or small, that take
place in the economy are duly recorded in this comprehensive system of accounts. It is a
method to study the structure of economic system in its entirety.
In the s.a. system adopted by the N.I. committee in India, the entire economy has been
classified in 3 main sectors 1 Enterprise 2 Households 3 Govt. Each sector further sub
divided in 4 heads 1 Production 2 Consumption 3 Addition to wealth 4 External accounts.
Entire framework of accounting has 12 accounts. Collection of statistical data on
expenditure, saving, investment, capital information and depreciation. Private sector not
interested in giving data and statistical dept. has own limitations. Manipulate facts and
figures. This causes serious imbalances in sectors. U.S.-Dept. of commerce has followed a
sect oral classification. Entire economy divided in 5 sectors-1 Personal or household 2
Business sector 3 Govt.4 Rest of the world or International 5 Saving and investment.
Balance sheet of each sector.
(I) Personal or Household sector: individual, family, non-profit institutions, charitable
organizations and voluntary associations operating on non-profit basis. Balance sheet has
two columns- 1 Expenditures and 2 Receipts. The most prominent item of expenditures
sector accounts is the consumer purchases of goods and services 70% approx which can
be determined by commodity flow method - Producers sell goods to wholesaler- Retailers is
in producer prices + margined of wholesaler and retailers + Transportation + storage + local
tax. It is possible to determine the value of commodity purchased by the consumer.

(ii) Business sector- In U.S. constituted by corporate and non-corporate business


concerns including enterprises owned by Govt. All type of producing units is included in it.
This account includes the receipts and expenditure of all businesses units in a country.
(iii) Government sector- is composed of all govt. bodies and their sub divisions, federal,
state and local. The main source of receipts is taxes and social security contributions. The
govt. expenditure is incurred on the purchases of commodities and services and for making
transfer payments. There may be a surplus or deficit on current account, which must also
taken in consideration. Expenditure includes salary and wages.
(iv) Rest of the world sector- National income account must include the International
transactions related to commodities and factor payments net foreign investment is receipts
from transactions. It value may be calculated by net export from the country plus the
services rendered to the foreigners and money received by them. From it, value of imports
and services hired and money paid are to be deducted.
(v) The savings and Investment sector- Account of the gross saving and invest. is of
great strategy importance in an economy.

Morgan has mentioned two important reason for this account


1. It is important for measuring productivity, maximum total output and for determining the
rate of purchase of new buildings, machines and inventories.
2 .Its significance rests in the importance of the flow of savings and of investment for
analyzing the inflationary or deflationary tendencies in a system

CHAPTER - XII
CLASSICAL THEORY OF EMPLOYMENT
Classical economists used the term full employment to signify a situation in which only all
those people who are willing to work at the prevailing wage rate get work. Full employment
means absence of involuntary unemployment. Involuntary unemployment means a worker
is ready to work at exiting rate but does not get work.
According to classical economist, following kinds of unemployment could be possible1. Voluntary unemployment Existing level of wages unacceptable to labor.
2. .Frictional unemployment Due to shortage of raw material/ special skilled job.
3. Seasonal unemployment Ice business in winter.
4. Structural unemployment changes in countrys export trade.
5. Technical unemployment change in technique of production.
Assumptions
1. Full employment

2. Perfect competition
3. Laissez faire (no interference of Govt. in economy)
4. Closed economy (no effect of foreign trade on economy
5. Techniques of production remain unchanged in short period)
6. Money medium of exchange (limited role of money)
7. Rationality (man is rational)
8. Efficiency (use of resources, no wastage)
9. Equality between savings and investment
10. Production is subject to law of diminishing marginal returns.
Determination of output and employment - Classical economists opined that in an
economy output and employment are determined by production function and the
equilibrium of demand and supply.
Production function expresses the financial relation between input and output.
Q = F (N, L, K, T,)
In the short period capital (K), land (L), Technique of production (T), Therefore volume of
production (Q), depends on the level of employment L i.e. = F (L). F- Factor
Y
O
U
T
P
U
T

P2
P1
P

O
L L1 L2

Level of employment
In diagram curve so is output curve. It denotes the relation between employment and
output. It is obvious from this curve that as the level of employment increases output too is
increases. Dig. Shows that increase in the proportion of output is less than the increase in
the proportion of employment.
In an economy, level of employment is determined by the equilibrium of demand and supply
of labor. IN the classical system the demand for labor (ND) is assumed to be a function of
the real wage i.e. the purchasing power of a given money wage (W/P) as: ND = F (W/P)
like demand for labor, supply of labor (NS) is also a function of real wage rate. Supply has
positive relationship with real wages as NS = F (W/P) if supply of labor and price rise
proportionately; It indicates no relation to money wages.
S
Determination of output
and employment
according to classical theory :
D
W

D
L

Out Put

K
S

Wages

Employment

OS curve denotes production function. In B diag. ss is the supply curve of labor and DD
is demand curve. Both cut each other at E equilibrium. In equilibrium OL get employment at
OW wage rate. Thus, there will be no involuntary unemployment. If some labor is still
unemployed, they will be called voluntary unemployed and are not ready to work at existing
wage rate. Therefore, classical economist held the views that equilibrium position would
always be in full employment situation. According to classical economist if a situation of
disequilibria arises in the economy, then wage rate, prices and rate of interest would
change in such a way that equilibrium situation is reestablished.

Flexibility of wages: At equilibrium E wage rate is w and employment is N, If wage


increase w1 than less number of labors ON1 and rate of supply is ON2. Labor will agree to
work on fewer wages so this force to come down on W at equilibrium. If wage falls OW2
then supply of labor will be ON1 and its demand will be ON2.
Real wage = Money wage/price
D
Wages

W1
W
W2

N1 N N2
Employment

Flexibility of Rate of interest At equilibrium E rate of interest is R at this saving =


investment. If the rate of interest increase to OR1 than supply will be more and demand,
will less. It will decrease the rate of interest. If rate of interest decrease OR2 then demand
of capital is more and supply is less.
D
Rate Of Interest

R1
R
R2

I>S
=
Saving/Investment
Flexibility of price level- Aggregate demand (MV) = Aggregate supply (PT) M - supply of
money P Price level V Velocity of circulation of money T - goods traded, if V and T
remain constant then there will be direct relation between price level & supply of money as
P =F (M)
This equation is called quantity theory of money. Money market equilibrium at
MV=PT
If unemployment is there in an economy money wage rate will fall. Result more
employment, Production & supply. Price falls is less than money waging therefore real
wage to fall.
Criticism of Classical Theory of Employment According to Keynes the classical theory
of employment is perfectly logical and proves its points provided the assumptions are
strictly adhere to but in reality the assumptions are perfectly unrealistic in practical working
of economy. Hence, the criticism is levied against the basic assumptions as below
1. Full employment According to Keynes some unemployment always exit in an
economy. Full employment equilibrium as exceptions. He says under employment situation
is normal.
2. Rejection of says law- Supply creates it is own demand. Keynes says there is always a
disequlibrium (constant) between demand and supply.
3. Wages cut and unemployment Keynes says that unemployment is due to wage
rigidity and that flexible wage rates will lead to full employment.
4. Emphasis on macro economic study Classical says that unemployment is
temporary phenomenon. Keynes says that it is serious problem and it is too risky to call it

temporary. He emphasized to look at macro level & evolve a forceful policy of the trade
cycles to solve this problem.
5. Money acts as a store value Classical says money plays no role. Keynes says
money as an active factor, which acts as a store of value.
6. Classical Economics ignores short period problems They focus long run
equilibrium, Keynes stress on short period problems. He says in long run all shall die.
7. Savings & investments are interest inelastic: Keynes pointed out that savings are
income elastic. According to Keynes, equality between saving and investment is brought
about through the changes in level of incomes.
8. Necessity of state of intervention Keynes did not agree with the classical that
interventions are a stumbling block in the working of the economy. Keynes suggests that
Govt. intervention is must to tackle the problems of depression and inflation in the
economy.
9. No Automatic Adjustment Classical says that economy has its inherent power to
bring a state of full employment. Keynes says system need out side intervention for
achieving a state of full employment.
10. Lacks Empirical facts Capitalist economies are ordinarily subjects to the problem of
inflation, unemployment, Trade cycles etc.
QS
1) How full employment can be achieved in our country from classical economists point of
view?
2) What factor you would like to suggest in our economy for employment generation?

CHAPTER - XIII
KEYNES THEORY OF EMPLOMENT
Great depression of 1930s leads to high unemployment. It was only Keynes who
concluded that main cause of this unemployment was the shortage of aggregate demand
and suggested that if aggregate demand is increased, unemployment absolutely can
removed. Aggregate demand is of two types the demand for consumption goods and
demand for investment goods in the short period consumption remain constant and the
aggregate demand can be increased by increasing investment. Keynes was also in favor of
Govt. intervention, which can remove unemployment.

ASSUMPTIONS
1. Short Period Everything remains unchanged.
2. Closed Economy Export import donot affect aggregate demand.
3.Perfect Competition Prices get affected by demand and supply only.
4. Diminishing Marginal Productivity of factors It diminishes as quantity increased.
Keynes also assumed that under perfect competition marginal productivity of labor are
always equals to its wage rate.
5. Money IlLusion Workers are under impression tar real wages will increase in same
ratio as the increase in money wages.
6. Money acts as a store of value Since money can be stored, it is essential that people
will spend the whole for their money income.
7. Labor acts as a variable factor Keynes assumed that the only size of labor affects
the size of production in short run.
8. Under employment equilibrium Keynes assumed that capitalist economics is subject
to boom and depression under laissez-fair policy so there always exists some
unemployment. Full employment a special case.
9. Saving and Investment functions Keynes assumed that savings are income elastic
and investment is interest elastic.
10. Limited role of Govt. Keynes principles is based on the assumption that aggregate
demand is affected by consumption expenditure and investment expenditure has hardly an
effect of Govt. influence of it.
11. Role of Interest A monetary phenomenon, Keynes believed that rate of interest is
determined by the monetary factors. Demand for money is revealed in liquidity preference
and the liquidity preference is for transactions, precautionary and speculative motives.
12. Current consumption: depends upon current income with out any time leg.
KEYNES THEORY according to Keynes theory of employment, in the short run the
total production and National income of a capitalistic economy depends on the level of
employment. The level of employment depends on effective demand. Effective demand is
that level of aggregate demand at which it is equal to aggregate supply . So effective
demand is essence of Keynes theory. According to his theory, the level of employment is
determined by the aggregate demand and aggregate supply. The level of employment
increases as effective demand increases and vice versa.
Keynesian theory of employment,

Total output = National Income and National Income depends on the level of employment.
Y = F (N)
Employment depends on effective demand
N = F (ED)
Effective demand depends on aggregate demand and aggregate supply.
EFFECTIVE DEMAND

Further, aggregate demand depends on consumption and investment.


AD = C + I
As the consumption increases, total income also increases. It depend on following two
1. Propensity to consume It refers to the proportion of consumption expenditure on
different level of incomes.
Average propensity to consume APC = C/Y
C = consumption Y = National Income,
Marginal propensity to consume MPC = change in consumption/ change in National
Income
2. Size of National Income According to Keynes C= F (Y) as the income increases,
consumption also increases, but less than income as a result National Income increases.
Investment It refers to that expenditure which leads to addition in the total stock of
capital assists. It is important constitution of aggregate demand. Investment depends on
two factors 1 rate of interest 2 marginal efficiency of capital.

1. Rate of Interest According to Keynes; investment increases with fall in rate of interest
and decrease with rise of rate of interests. Rate of interest is determined by demand for
and supply of money. Demand for money is as above chart.
2. Marginal efficiency of capital means rate of profit. MEC is the addition made to the
total profit by applying one more unit of capital assets. MEC depends on (a) Prospective
yield the amount of profit expected per unit of capital per aunum is called prospective
yield.
(b) Supply price Supply price refers to that price of a machine, which is paid for a similar
new machine. An entrepreneur compares rate of interest with MEC, if MEC is more than
the rate of interest he will invest to earn more profit.

Determination of Employment
Table
Employment
(laces)

Aggregate
supply

Aggregate
demand (crors)

Trend
Employment

0
10
20
30
40
50
60
70
80
90
100

(Crows)
0
100
200
300
400
500
600
700
800
900
1000

120
200
280
360
440
520
600
680
760
840
920

Increase
- Do - Do - Do - Do - do Equilibrium
Full
-do -do -do -

AS
F

AD

600
E

600

in

Table Explain That


1. When the level of employment is zero then AD. Is 120 cr, AS =0
2. Employment increases unto 50 lac there is increase in AD. And AS. ,AD. is greater than
AS. Producer will continue to produce more.
3. When 60 laces persons get employed AD = AS. Equilibrium point level of employment
determined.
4. After 60 laces persons as more and more persons are employed. AD fall short than AS.
ACHIEVEMENT OF FULL EMPLOYMENT It is clear from analysis that in an economy
equilibrium possible with the existence of unemployment. It is termed as under
employment. If in short, run investment increase AD. Curve will shift upward and cross
supply curve at point F. know as full employment. Further investment push AD above F.
knows as over full employment.
DETERMINATION OF INCOME AND OUTPUT - According to Keynes Income and out put
depends on the level of employment. Income & out put depends on the level of
employment . Income and output can be determined with the help of following equation:
Y= C+ I
Y=Income C = Consumption I= Investment
C=Co +By
Co = Autonomous Consumption b= Marginal propensity to consume
I= I
= Autonomous Investment
Y=Co +By +I

TABLE
Income

Consumption Saving

Investment

Y
0
100
175
300
350
400

C
25
100
156
250
287.5
325

I
75
75
75
75
75
75

S=Y-C
-25
0
19
50
62.5
75

Aggregate
demand
C+I
100
175
231
325
362.5
400

450
500

362.5
400

87.5
100

75
75

437.5
475

Y
AS
E

AD
C

M
I

S
F

C
O

X
Q

Income

When income is zero still consumption is there at point F saving = investment, Equilibrium
point is E where AS =AD. Equilibrium income is Q.

Criticism of Keynes Theory


1 Ignored the importance of long run
2 static in character
3 lack generality
4 closed economy
5 perfect competitions is not a reality
6 wage unit, as a measure of employment is unscientific
7 lacks practicability
8 ignores cost push inflation
9 ignores acceleration effect
10 depression economics
11 over aggregate and less analytical economics

QS
1) What are the applications of Keynes theory in our economy? Present your views in
class.
2) How mpc can be increased in our country? Present your views.

CHAPTER - XIV
RELATIVE INCOME HYPOTHESIS (J.Duesenberry)
He states that
1) Every individual consumption behavior is not independent but interdependent of the
behavior of every other individual and
2) That consumption relations are irreversible and not reversible in time.
Consumers has the tendency is to strive constantly toward a higher consumption level and
to emulate the consumption pattern of ones rich neighbors and associates. Thus,
consumer preferences are independent. A rich person has lower APC (consumption income

ratio) because he spends a lower portion of income to maintain but a poor have higher APC
because he is to keep up standard of neighbour. This provides constancy of long run APC
because lower and higher APC would balance out in aggregate. If absolute size of incomes
in a country increases, the APC for economy as a whole at the higher level of income would
be constant.
The second part is Past peak of Income states that during a period of prosperity
consumption will increase and attain gradually a level or standard is attained. People
become accustomed to this standard they will not reduce their consumption in recession.
Dussenbery combined his two hypothesis related in the following form:
Ct/ Yt = a-b Yt/ Yo
C - consumption Y income t - current period o - previous peak period a is constant
relating to positive autonomous consumption b - consumption function CL long run
consumption function Cs & Cs2 short run consumption function.
CL
Consumption

C2

E2

CS2
CS1

C1
E1
E0
Y0

Y1

Y2

Income
Suppose peak level income is OY1 where E1Y1 is consumption. Now income falls to Oyo
they will not reduce to Oyo but slight reduction and less savings, they will maintainC1Yo
level of consumption. Period of recovery starts. Consumers will reach on E1Y1 and restore
their previous level of saving. If income increase up to Y2 level. Consumer will move
upward with CL and reaching at E2. If income falls back from E2 to E1 to C2. This is known
as ratchet effect.

CRITICISM

1. Proportional increase in income and consumption hypothesis is wrong they differ.


2. This hypothesis assumes relation between consumption and income to be direct but this
has not been born out experience. Recessions do not always lead to decline in
consumption, as was the case during the recessions of 1948-49 & 1974-75.

3. Theory based on assumption that the distribution of income remains unchanged with the
change in the aggregate level of income. If with increase in income, a redistribution occurs
towards greater equality, between rich and poor then consumption function will not shift to
Cs1 to Cs2.
4. Consumers behavior change over a time and slowly reversible.
5. Theory is related to previous peak income. Neglect other factors e.g. Age, urbanization,
asset holdings etc.
6. Poor copy rich neighbors, it is not always true.

PERMANENT INCOME HYPOTHESIS (FRIEDMAN)


He rejects the use of current income as the determinant of consumption expenditure and
instead divides both consumption and income into permanent and transitory components
so that
Y=Yp + Yt, P= permanent and t = transitory Y = Income c - consumption
Permanent income is defined as the amount a consumer unit could consume while
maintaining its wealth intact. Y income will depend directly on Yt Transitory Income. If
wind fall gain in Yt then y > Yp if loss due to theft y <Yp.
Permanent consumption is defined as the value of the services that it is planned to
consume during the period in question. Measured consumption divided in Cp & Ct.
So measured consumption directly depends on Ct i.e. positive, negative or zero.
ASSUMPTIONS1. There is no correlation between Yp & Yt.
2. There is no correlation between Cp & Ct.
2. No relation between Ct & Yt.

4. Only differences in permanent income affect consumption systematically.


CL
C2
C0
C3

CS

Proportional

E2

E1
Non- Proportional

E3

E0
E4

Y3

Y4 Y0
Income

Y2

Y1

In diag. CL is long run consumption function. Cs is non-proportional short run consumption


function. At Oyo CS =CL at Eo changes in permanent income and measured income are
identical. Here transitory factors are non-existent andPy=1. If we move E3 from Eo then
measured income declines to OY3 due to heavy losses, since permanent income is OY4 is
higher than OY3, permanent consumption will remain at OC3 (=Y4E4). It moves Eo toE1
on Cs income is OY1and consumption is OC2. Permanent consumption level will be
maintained at E2 at income level Y2. OY1 is windfall due to profit.
CRITICISM
Friedsman assumption of no correlation between transitory consumption and income is
wrong.
1.

2. Consumption income ratio (APC) is same for rich and poor in long run is wrong.
3. Used of permanent, transitory and measured create confusion.
4. Permanent incomes do not make difference between human and non-human wealth.

CHAPTER - XV

CHANGE IN AGGREGATE DEMAND AND MULTIPLIER


Aggregate Demand may increase in either aggregate demand for consuming goods(C) or
(I) aggregate demand for capital goods or both. Let us assume the agg. Demand

Increase due to increase in capital goods (I). The increase in investment I may be result
by a firm and Govt. Let us suppose that the aggregate demand increased from C+ I to
C+I+ I,
When agg. Demand increase, National Income increase in some multiple of I due to
multiplier. The numerical value of a multiple is known as multiplier. Thus multiplier is a
number which multiplied by the addition investment I gives the additional increase in
national income. If m is multiplier then
Y = I x m and m = Y/I.
The multiple increases in National Income as a result of I depend on the mpc. When I
take place, it generates income Y will lead to increase in consumption C depending on
mpc. If mpc = b then C = bY. Those who supply goods & services to the tune of C,
earn an income equal to bY in the second period. They would consume b times bY their
consumption = b2 Y. this process continues until Y = .0 in this process a series of new
incomes are generated leading to increase in National Income. The whole series of new
incomes Ys over n period may be summarized as follows:
Y = Y +bY+b2Y +b3Y----------+b n-1Y
= Y (1/ 1-B)
Once change y calculated multiplier could be obtained as
M = Y/I
The whole process is known as dynamic multiplier.
ASSUMPTIONS
1 I am one injection investment.
2 It remains constant.
3 Economic systems is closed one.
4 There is autonomous investment in economy.
5 There is excess capacity in economy and out put is responsive to changes in aggregate
demand.
6 There is no time lag between receipt of income and its disposal in form of consumption.
Given an investment multiplier 6, invest worth Rs.50 cores will raise income by Rs.300
cores without any time lag between investment and income.
Y = M X I
= 6 X 50
= 300 cores
The investment multiplier m can be derived from Keynes psychological law of consumption.
The basic proposition of this law is that marginal propensity to consume is less than unity.

USES OF MULTIPLIER
It is an important tool of analyzing growth, planning and projecting the investment
requirement of an economy given the growth objective.

LIMITATIONS
1) Formula m= 1/ 1 (1-MPC) implies that higher the mpc the higher is multiplier. It means
that the less developed countries with higher mpc would grow at a much higher rate than
the developed countries having low mpc but this is not true. It means actual multiplier does
not depend on mpc alone but other factor also.
2) A chain of investment through consumption is not true. People may purchase assets, pay
loan back, purchase shares. These are called leakages in consumption flow, which reduce
the rate of multiplier. The money thus keeps circulating but does not generate the demand
for new consumers. In this case multiplier will be 1. Other leakages holding idle cash,
deposits in foreign bank etc.
3) Assumption that goods and services are available may not be true.
4) Under the condition of full employment, the theory of multiplier does not work because
goods and services cannot be produced in excess of their full employment level.
THE BALANCED BUDGET MULTIPLIER
When Govt. expenditure G = T taxes, both are simultaneously change, the Govt.
budget is said to be balance. The effect of balanced budget on the national income is
analysed by balanced budget theorem states that the balanced budget multiplier is always
equal to one. That is why the balanced budget theorem is also called unit multiple theorem.
The proof the theorem can be provided as followsY = 1/1-b (a Bt + I + G)----------------- (1)
B = mpc a = constant T = Tax I = Investment G = Govt. Expenditure, by incorporating G
and T (while both equal) and resulting combined change in income Y can be expressed
as
Y + Y = 1/ 1-b [a-b (T +T) + I + G + G]--------------- (2)
By subtracting equation (1) from equation (2) we get
Y = 1/ 1-B (-b T + G)
Since T = G we can write as
Y = 1/1-b (- b G +G)
By multiplying both side by 1-b we get
T (1-B) = -b G + G OR
Y (1-b) = G (1-b) OR
Y = G
We can obtain balanced budget multiplier ( Bm ) by dividing both sides of equation by G
that is
Bm = y/g
= G/G
=1
Operation of Acceleration :
Due to operation of multiplier, increase in income leads to increase in demand. If there is
lack of surplus production capacity in economy, then investment will have to be increased
to meet the increase in demand caused by rise in income. Increase in investment will

depend on the technique of production. Technique of production will determine capital


output ratio or accelerator. Therefore, accelerator analysis shows a change in net
investment or capital due to change in income. It depends on technological factors.
Symbolically
W = K/ Y = 1/Y
W accelerator, K change in capital stock or net investment ( I ), Y changes in
income. Accelerator is related to induced investment. Above account reveals that
K
I

W
Y

K
C

Y.

Super multiplier
Multiplier and Accelerator influenced each other and help in the increase in income. Their
mixed influence can be understood with the help of the following formula:
Given Y = C + I
Y = C + I -------------------- (1 )
C = Ca + c y ---------------- ( 2 )
I = Ia + d Y ---------------- ( 3 )
putting value of ( 2 ) & ( 3 ) in ( 1 ) we get
Y = Ca + c y + Ia + d Y
y c y d Y = Ca + Ia
y ( I-C-D ) = Ca + Ia
or Y = 1/ I-C-D ( Ca + Ia )
or Y/ Ca + Ia = 1/ I-C-D - SUPER MULTIPLIER
Y = change in income, C = change in consumption, I = change in investment, c =
marginal propensity to consume, d = marginal propensity to invest, Ia = autonomous
investment, Ca = autonomous consumption. Thus it is clear from above that when change
in income due to change in investment and change in investment due to change in income
take place in the economy the multiplier that comes into being due to mixed effect of
multiplier and accelerator, is called super multiplier by Hicks. Its value will be more than
that of an ordinary multiplier.

In diagram, OS is aggregate supply curve and MD is aggregate demand curve. Both curve
intersects each other at point E. so oy is the equilibrium income. If induced investment
increases aggregate demand curve MD shifts to MN and this curve is also start from M and
gap widens in both demand curve. It indicates that with increase in income demand is
increasing. Consequently new equilibrium is achieved at E1 and equilibrium income OY2.
This increase in income due to super multiplier. Contrary to this if autonomous investment
increased only, the new demand curve would have started from point P to become PR and
equilibrium at a and new income oy1, income due to multiplier alone will beYY1 and with
mixed effect of accelerator YY2 which is high.

CHAPTER - XVI
PHASES OF ECONOMIC CYCLE
Periodic booms and slumps in economic activity
Ups and downs in economy reflected by fluctuations in production, investment,
employment, prices, wages, bank credits etc.
Upward and downward movement in these magnitudes shows different phases of business
cycles. Basically only two phases Prosperity and Depression.
VARIOUS PHASES OF A TRADE CYCLE

1 Expansion of economic activities


2 Prosperity or peak of boom
3 Recession the downtrend
4 Trough, the bottom of depression
5 Recovery and expansion
Prosperity
Expansion or peak

Rise in National income, consumer and capital expenditures in the prices of raw materials
and finished goods, and rise in level of employment. Inventories of both input and output
grow. Debtors find it more convenient to pay off their debts. Bank advances grow rapidly
even though bank rate increases. Idle funds find productive investment. Stock prices

increases due to increase in profitability and dividend. So long condition permit. Expansion
continues following multiplier process.
In later stage of prosperity- inputs falls short- labor shortage- wage high- high cost of
production-price increase and over take increase in output and employment. Cost of living
increased at a rate relatively higher than the increase in households incomes. Consumers
and wage people review their consumption pattern. Consumers resistance gets
momentum. Actual demand stagnant or decrease. First impact falls for demand for new
houses .Subsequently demand falls for cement, iron, construction labor, consequently
appear in other durable goods. This marks reaching the peak.
TURNING POINT AND RECESSION
At peak demand halt than decrease in some sector. On the other hand businessman
continue to invest and production. Supply increase and demand decrease by unnoticed.
Producers sudden relies that their inventories are piling up. Realise over investment and
over production. Cancel all investment and orders of input for production reduction. Start
decline chain known as turning point and beginning of recession. Since demand for input
decrease leads decrease in income and interest. Earners demand recess. Producers
reduce price to get rid of inventories. Consumers wait for further cut. Result discrepancy
between demand and supply continues to grow. Reduce further in income and consumption
which reversible multiplier effect. Process is exactly reverse of expansion. Investment
curtailed. Production and employment decline. Decline further in demand of consumer
goods and capital goods. Borrowing for investment decrease, bank credit shrinks, share
prices decrease, unemployment increase. At this stage, the process of recession is
completed and economy enters in period of depression.
DEPRESSION AND TROUGH
Economic activities slide down their normal level. Growth rate become negative. Decline in
National income and expenditure, Prices of consumer and capital goods, unemployment
increase. Debtors find difficult to pay off their debts. Bank credit becomes low increase in
cash. Investment in stock becomes least profitable. At the depth of depression all economic
activities touch the bottom and the phase of trough is reached. Even the expenditure on
maintenance is defer. Weaker firms eliminate from industries. At this point the process of
depression is complete. Price decrease halt.

How is the process is reversed


Price decrease halt. Producers become optimistic offer job to unemployed labor at lower job
wages. Consumer also resumes that old consumption pattern which was postponed for
reduction in price. Hence, demand pickup gradually. Producers note that prices of inputs
decline greater than prices of finished goods. So they also investor cautiously and slowly to
generate stocks. Due to increase in income and consumption the process of multiplier further
accelerate and phase of recovery gets underway.
THE RECOVERY
Get momentum firms plans additional investment, some undertake renovation programmes
and some undertake both. These activities generate construction activities. Individual also
observe least construction cost start their plan for construction. Leads to increase in
employment. Wage rate also start increasing consumption also increase. At this business

start expansions for higher profit. A number of related developments begin to take place.
Economy enters in phase of expansion and prosperity. Cycle gets completed.

1)The pure monetary theory


The main cause of business fluctuations is the unstable monetary and credit system.
Fluctuations in supply of money and bank credit are the basic casual factor at work in
cyclical process. Hawtrey state that main proponent of business cycle is successive phases
of inflation and deflation. All changes in the levels of Economic activity are only reflections
of changes of money flows. money supply expands price rise, profit increase, and total
output increase. Money supply falls prices decrease, profit decrease, production falls. The
principal factor affecting the money supply is the credit mechanism.
2) THE MONETORY OVER INVESTMENT THEORY
focus the role of imbalance between the desired and actual investment in economic
fluctuations. Hayek stated that to keep economy in equilibrium, investment pattern must
correspond to the pattern of consumption and for economic equilibrium, it is necessary that
voluntary savings are equal to actual investment. Total investment so distributed among
industries that each industry supplies equal to demand of consumer. Economic stability
gets upset due to supply of money and saving investment relations. Investment may
increase due to marginal efficiency, low rate of interest , optimism of Businessman for
future prospects.
Critical Evaluation :
a) Theory presumes that when market rate of interest is lower than the natural rate, the
new bank credit flows to the capital good industries. This would be true only under the
condition of full employment but business cycles have taken place even when resources
were not fully employed.
b) It focuses on rate of interest only. It ignores businessman own expectations.
c) Theory lays undue emphasis on imbalance between the investment in capital goods
and consumer goods industries. In modern economy such imbalances are selfcorrecting and do not create depressions.
3) Schumpeters theory of Innovation- emphasiss innovations in business as the main
cause of increase in investment and business fluctuations. Model has two stages(1) First approximation- Model starts with economic system in equilibrium in which no
involuntary employment. Each firm has mc=mr and price = average cost. In addition, there is
no incentive for additional investment nor disincentive to reduce it. In this condition, firm
introduces innovation. Addition finance will be given by bank. Firm will go on bidding higher
prices for other inputs with a view to withdraw them from consumers. Due to increase spending
in economy, prices begin to rise. This process further accelerated when other firm copies.
Innovate and Invest. Product comes in market but firms cannot increase after a point. Prices
start decrease and firms start pay back loans. This start flow of money leads to contraction in
money supply. Prices start decrease. The process of recession begins and continuous until
equilibrium is once again restored.

(2) Second Approximation- Model analyses the secondary waves that are created by way of
first approximation. Main element is speculation. When primary wave expansion begin
investors in capital goods expect that upswing is permanent. They borrow heavily. Even
consumers anticipating higher price in further go to debt to acquire goods. This heavy indebt
ness causes problem, when prices began to fall. Debtors both investors and consumers find it
difficult to meet their obligations. This situation lead to depression. The lower turning point
comes when the necessary liquidation has been completed, the debt structure has been
brought to order and uneconomic firms are eliminated.
Critical Evaluation
A.W.Lee states that this theory is based on sociological rather than economic factors. Difficult
to test. This theory differ from investment theory in a way that is variation in investment when
economy is in equilibrium. This theory leaves many other factors of fluctuations.
4) Multiplier Accelerator interaction Theory- Samuelsons model is regarded as the first
step in integrating theory of multiplier and principal of acceleration. His model show how both
interact with each other to generate income, to increase consumption and investment
demands more than expected and how this cause economic fluctuations.
To understand model first distinguish between autonomous and derived investment.
Autonomous Investment- undertaken due to exogenous factors such as new inventions in
technique of production, production process and of new market.
Derived Investment- in capital equipments, which is undertaken due to increase in
consumption necessitating new inventions.
Interaction Process- when autonomous investment takes place, income rises and process of
multiplier begins. Increase in income leads to increase in demand for consumer goods
depending on the mpc. If there is no excess production capacity, producers takes new
investment. Thus, increase in consumption creates demand for investment (derived
investment). This marks begin acceleration process. Derived Investment takes place leads to
rise in income. Same manner Autonomous investment. This is now multiplier and accelerator
interact and make the income grow at a rate much faster then expected.
Exogenous factors Autonomous Investment Multiplier Effect Derived Investment +
Acceleration of Investment. Derived Investment multiplier effect leading to accelerator. This
is called multiplier acceleration interaction.
In his analysis of interaction process, Samuelson assumes:
(1) No excess production capacity
(2) One year lag in consumption
(3) One year lag in increase in consumption and investment demand
(4) No Govt. activities and no foreign trade.
Samuelsons model and his conditions for economic fluctuations mat be briefly presented
as below: given the assumption 4 the economy will be in equilibrium when
Yt = Ct + It ----------------- (1)
Yt = National Income Ct = total consumption expenditure It = Investment expenditure all in
period t.
Given the assumption2 the consumption function may be as
Ct = a Y t-1 --------------------- (2)
Yt-1 is income in period t-1i.e. Income in preceding year and a is mpc. Or C/Y
(Determine multiplier)

Investment function with one-year lag is expressed asIt = b (Ct Ct -1) -------------------- (3)
Where b represents capital / output ratio. Parameter b determines the acceleration here. By
substituting equation (2) & (3) in (1) equilibrium can be rewritten as
Yt = aYt-1 +b (Ct - Ct-1)------------- (4)
Note that Ct = a Yt-1 and Ct-1 = a Yt-2 by substitution in equation (4)
Yt = a Yt-1 +b (aYt-1 aYt-2)--------(5)
By solving equation (5) we get
Yt = a (1+b) y t-1 ab Yt-2 ----------(6)
This form of equation is used to derive the necessary information for analyzing the
business cycle. Equation reveals that if values of a & b and incomes of two preceding two
years are known, income for any past or future year can be determined.
Samuelson has also shown various kinds of cycles that would be generated by different
combination of a & b.

Areas marked by ABCD each having different pattern of cycle. Natures of cycles may be
described as below
Area A All combinations make the incomes move upward or downward at decreasing
rates asymptotically reaching a new equilibrium. In this area rise or fall in one way.
Area B All combinations produce cycles of amplitude growing smaller and smaller until
the cycle disappears and economy stabilizes. That is the case of damped cycle.
Area C All combination produce a series of cycle with larger and larger amplitude. This
area is of explosive cycles.
Area D - all combination makes income increase (or decrease) at an exponential rate until
the ceiling (or bottom) is hit. This is a case of one-way explosion.
Point E shows a special case in which cycles are of equal amplitude and continue forever.
Critical Evaluation

(1) Highly simplifying assumptions


(2) Focus on interaction and leaving many factors untouched like businessman
expectations, changing business psychology, changing consumer preferences.
(3) Major short coming- assume constancy of capital / output ratio.
(4) Shapiros pointed out many cycle patterns suggested by the model do not conform to
the world experience.
(5) HICKS THEORY OF TRADE CYCLE
Hicks uses
(i)
Keynesian concept of saving investment relation and multiplier
(ii)
Clarks acceleration principal
(iii)
Samuelsons interaction of multiplier and accelerator
(iv)
Growth model of Harrods Domar.
ASSUMPTIONS
Hicks assumes an equilibrium rate of growth in the model economy in which realized
growth rate (Gr) equals the natural growth rate (Gn). The autonomous investment (AI)
increases at a constant rate, which always equals the rate of increases in voluntary
savings. The equilibrium growth rate is determine by the rate of Autonomous Investment
and savings. Hicks also assume a Samuelson type of consumption function i. e. Ct = aYt-1
(with one year lag in consumption). The reasons he gives for lagged consumption function
are: (1) lag of expenditure behind income (ii) lag in non-wage income behind the change in
GNP. The saving function naturally become the function of past years income. Hicks
multiplier becomes a mathematical truism with the lagged relations between income and
saving investment; the multiplier process has a dampening effect on the fluctuations. The
lagged multiplier acts as a depressant on upswing and a counterforce on the down swing .
Hicks assumes that autonomous investment is a function of current out put, and is
undertaken to replace the worn out capital. The induced investment in his model is a
function of change in out put. The change in out put generates induced investment, which
bring the accelerator principal in action. It may be noted here that this acceleration inter
acts with multiplier effect upon income and consumption.
Finally, Hicks prescribe ceilings and bottom for the upswing and downswing. Upward
ceiling is due to scarcity of employable resources. As regard downswing he says there is no
such direct limit on contraction but an indirect limit is imposed by the mechanism of
accelerator of the downswing.
GRAPHICAL PRESENTATION OF HICKS THEORY

IN DIAGRAM
Vertical axis logarithm of out put and employment, horizontal axis by semi logarithm
measures time.
F-Full employment ceiling
E- Equilibrium path of out put which a constant multiple of autonomous investment
L- Equilibrium path during the period of slump assuming that out put level will never go
below this level
A- Autonomous investment increasing at a constant rate
Let us suppose economy is progressing on dynamic path and revealed point Po. Suppose
autonomous investment takes place due to some invention. Consequently out put
increases and the economy leaves the path EE. After a certain lag begins the multiplier
process caused by autonomous investment. As a result out put and employment increase.
Increase in out put leads to induced investment, which in turn bring acceleration in action.
The inter action between both multiplier and accelerator causes expansion in economy
which than movesPoP1. The expansion beyond P1 will not possible due to full employment
constraint. The most it can do to creep along FF. but it cannot do for long. For the initial
burst of autonomous investment was supposed to short lived. Thus on the upper path PoP1
has been mainly on account of induced investment during the preceding periods. But when
ceiling is hit, the expansion sustained by the induced investment along FF is bound to end
and a down swing becomes inevitable. For, increase in out put along FF is not high enough
to induce investment and hence it ceases to take place. The down swing may be prolonged
if out put investment (induced ) relation has a 3 or 4 year lag, but the down fall inevitable.
Once down fall started, it must continue to hit EE line. Since there is nothing to stop it at EE
line, down fall will continue further. The rate of fall should be lower since the disinvestments
are limited to the rate of depreciation, which goes on decreasing . Following the decrease
in out put. That is the reverse accelerator does not work as fast as it does during the up
swing: There is a marked lack of symmetry. Even though the process of decline in out put

may be slower, a situation characterized by slump does takes place in due course. Here
the autonomous investment is reduced a little below the normal level, while induced
investment is zero. The course of slump is shown by Q1Q2. The absolute magnitude of out
put decreases along the curve Q1Q2 towards the slump equilibrium line LL. This line is
geared by the (autonomous investment ) AA and rises with it. Thus at any stage out put will
again have started to rise. This increase in out put should bring the accelerator back into
action . This marks beginning of recovery. Once the autonomous investment starts coming
in the process of multiplier, later accelerator makes the economy to grow on the path of
expansion towards equilibrium path EE. This completes cycle.
CRITICAL EVALUATION
1- This theory does not provide sufficient reasons for linier consumption function and a
constant multiplier.
2- Assumption regarding constancy of multiplier under the dynamic conditions is looked
upon with skepticism.
3- Regarded as a highly abstract formulation, which seems incapable of explaining the
phenomenon of fluctuations in real life.

CHAPTER - XVII

Economic stabilization policies


Violent fluctuations are harmful to business and bring misery to human beings by
unemployment and poverty. In 1930-great depression, came and orthodox belief was that
invisible market forces would automatically maintain balance in economy. Recently Govt.
realized through trade cycles that need for stabilization. Keynes assigned a big role to Govt.
Govt. in free enterprise economy not only entered in production of commodity and services but
also adopt a number of fiscal and monetary measures to control and regulate violent economic
fluctuations. In developing countries like India, Govt. is the key player in economic growth
With, employment and stabilization. Communist has regimented economy. Problems of trade
cycles are similar in developed and developing economies. Advanced countries faced
depression during 1980 with growth rate 2% - 3%; developing countries faced double inflation,
in addition to unemployment, balance of payment crises. The major stabilization problem in
developing economies is to control prices while in developed economies preventing growth
rate from sliding further down. The stabilization issue is quite important today.

CONCEPT AND OBJECTIVES OF STABILISATION


Preventive extreme up and downs, stabilization should permit a reasonable degree of flexibility
for self-adjusting forces of the economy.

MAJOR OBJECTIVES OF STABILISATION POLICY


1 Prevent excessive fluctuations, making allowance for fluctuations for a long term, sustained
economic growth.
2 Efficient utilisation of labor and other productive resources.
3 Encouraging free competitive enterprises with minimum interference with the functioning of
marketing economy.
4 Avoiding, as far as possible, the conflict between the internal external interests of economy.
Two important widely used economic policies to achieve economic stability are
1 Fiscal policy
2 Monetary policy
In dire need away from above two policies, Govt. adopts direct controls to supplement above
two policies.
FISCAL POLICY refers to Govt. policy of changing its taxes and public expenditure
programmes intended to achieve certain predetermined objectives.

Taxation is a measure of transferring funds from individual purse to public coffers. It amount to
withdraw of fund from the private use.
Public expenditure increase the flow of funds in economy it increase private income and
private expenditure. Tax revenue and public expenditure form the two sides of Govt. budget.
Taxation and public expenditure policies are also jointly called as budgetary policy / fiscal
policy.
Fiscal policy is regarded as powerful instrument of economy stablisation. It rest on the fact that
Govt. activities in modern economy are greatly enlarged and Govt. tax revenue and
expenditure account for a considerable portion of GNP ranging from 10 25 % so Govt. may
affect private economic activities to the same extent through variation in tax and expenses.
Fiscal policy directly affect the private decisions while monetary indirectly. If fiscal policy is so
formulated that it generates additional purchase power during depression and it contracts
during the period of expansion known as counter cycle fiscal policy . The counter cycle fiscal
policy is based on relation of public expenditure and taxes to the National income, the GNP as
below
PUBLIC EXPENDITURE AND GNP An increase in public expenditure raises the level of
GNP. The size in increase in GNP because of additional public expenditure is determined by
the multiplier. Public expenditure increase households incomes, wage, interest, rent and
business profit in turn increase Govt. tax. Process continues and GNP increases by the rate of
multiplier.
TAXATION AND GNP
All taxes, especially direct tax has deflationary impact on the economy. Increase in the
taxation through increase in the rates of exiting taxes and imposition of new taxes reduces
GNP. The size of decrease in GNP because of increase in taxation depends on the tax
multiplier. It should be noted here that the negative multiplier would not be as high as in case
of public expenditure because the payment of taxes at the first instance does not reduce the
GNP, as it is only a transfer of income.
COUNTER CYCLE FISCAL POLICY: Automatic and discretionary changes.
Increased in public expenditure and reduction in taxation to fight depression
Deficit
budget
Decrease in public expenditure and increase in taxation to control inflation
Surplus
budget
Some of the budgetary changes are automatic and some are discretionary. Automatic
adjustment takes place only when fiscal policy has built in flexibility. The automatic budget
changes should follow the change in GNP. Built in flexibility implies that as GNP falls, both
income and consumption decline. Consequently, the revenue from both direct and indirect
taxes decline. Govt. establishment and committed expenditure remaining the same, public
expenditure exceeds its revenue and the budget automatically runs into deficit. When GNP
increases, tax base expends and tax revenue increases. Expenditure level remain same, the
budget automatically show surpluses.
THE DISCRETIONARY CHANGES: in the budget refer to the changes in the tax structure and
in the level and pattern of public expenditures by the Govt. on its own discretion. Discretionary

changes include changes in tax rate structure, abolition of existing taxes, imposition of new
taxes, increase and decrease public expenditure, changing the patter of public expenditure etc.

PROBLEMS IN FORMULATING COUNTER CYCLE FISCAL POLICY


Eckstein pointed
1 All expenditures do not have the same multiplier effect.
2 Not all taxes have same multiplier effect.
3 Deficit financing through public borrowing may reduce private investment.
4 Practical difficulties in assessment of time lags and accuracy of forecasts.

MONETARY POLICY Refers to the central banks programme of changing monetary


variables viz- total supply of money, interest rates, and credit rationing to achieve certain
predetermined objectives. Monetary policy main object is to achieve economic stability. The
following are the traditional monetary instruments through which a bank carries out monetary
policy1 Open market operations
2 changes in bank rate (or discount rate)
3 changes in statutory reserve ratios.
(I) Open market operation by the central bank is the sale and purchase of Govt bonds,
treasury bills, securities etc.
(ii) Bank rate is the rate at which central bank discounts the commercial banks bills of
exchanges or first class bill.
(iii) Statutory reserve / liquidity ratio (SLR) is the proportion of commercial banks time and
demand deposits which they are required to deposit with the central bank.
All these instruments when operated by the central bank reduce (or enhance) directly or
indirectly the credit creation capacity of the commercial banks and thereby reduce (or
increase) the flow of funds from the banks to public. Often these instruments of monetary
control, the open market operation is considered the most effective weapon available to central
bank, especially in less developed countries having under developed money market.
This instrument is flexible and easily adjustable to the changing conditions.
SELECTIVE CREDIT COTROLS to control flow from undesired to desired sector.
Moral sustain banks ask to work in interest of nation.

MONETARY POLICY
Instruments are two types
1 QUANTITATIVE, GENERAL, OR INDIRECT
2 QUALITATIVE, SELECTIVE OR DIRECT

The affect of level of aggregate demand through the supply of money cost of money and
availability of credit.

1 BANK RATE POLICY


The bank rate is the minimum-lending rate of the central bank at which it rediscounts first class
bills of exchange and Govt. securities held by the commercial banks. In inflation it increase,
borrowing becomes costly. In depression it lower, borrowing becomes cheap.
2 OPEN MARKET OPERATIONS
IT refers to sale and purchase of securities in the money market by the central bank. When
price rises, bank sells securities. The reserves of commercial banks are reduced and they are
not in position to lend. Investment get discouraged price check. When recession starts central
bank, buy securities. Reserves of commercial banks raised. Lend more, investment, output,
employment, income and demand rise and fall in price check.

CHANGES IN RESERVE RATIO


This weapon was suggested by Keynes. Every bank is required by law to keep a certain % of
its total deposits in the form of a reserve fund in its vaults and a certain % with the central
bank. Price rise central bank raise the ratio. Price falls central bank decrease the ratio.
4 SELECTIVE CREDIT COTROLS
Selective credit controls are used to influence specific types of credit for particular purposes.
They usually take the form of changing margin requirements to control speculative activities in
economy. E.g. raising margin to 60 % means pledger of securities of Rs. 1000 will get Rs. 400.
In case of recession, in particular sector central bank encourages borrowing by lowering
marginal requirements.
For an effective analytical monetary policy all four should be adopted simultaneously but all
economists has agreed that
1 The success of monetary policy is nil in a depression when business confidence is at its
lowest ebb.
2 It is successful against inflation.
In inflation, scope is very limited to control it. Limitations are
1 Increase in the velocity of residual public money
2 Private sector makes new methods to make better use of available money supply.
3 Discrimination Restricted monetary policy affect poor traders rather than rich because rich
do not depend on credit
4 Threat to credit market Investor may postpone investment to have profit of increasing rate
of interest. Credit fund may dry.
5 After expectations of borrowers and lenders.
6 Time lags Its recognition and operation in due time.

RATE OF MONETARY POLICY IN A DEVELOPING ECONOMY

1 To control inflationary pressures


2 To achieve price stability
3 To bridge balance of payment deficit
4Interest rate policy and savings
5 To create banking and financial institutions
6 Debt management

LIMITATIONS IN UNDER DEVELOP COUNTRIES


1 Large non-magnetized sector (barter system in rural)
2 Undeveloped money and capital markets (lack bill)
3 High liquidity of commercial banks
4 Foreign banks
5 Small bank money (share is small)
6 Money not deposited with banks

FISCAL POLOICY IN DEVELOPING ECONOMY


1 To increase rate of investment
2 To encourage socially optimal investment (sector development)
3 To increase employment opportunities
4 To promote economic stability in the face of international instability
5 To counteract inflation
6 To increase and redistribute national income.

CHAPTER - XVIII

INFLATION
A sizable and a rapid increase in general price level, which results in decline in the purchasing
power of money. Prof. H.G. Johnson had divided definitions in two categories
1 casual definitions
2 definitions in term of price rise.

CASUAL DEFINITIONS
(I) A.C.Pigeon explains Inflation exit when money income is expending more than in
proportion to income earning activities.
(2) In the words of E.James Inflation is a self perpetuating and irreversible upward movement
of prices caused by an excess of demand over capacity to supply.
(3) Keynes Inflation is the result of the excess of aggregate demand over the available
supply and true inflation starts only after full employment.

DEFINITIONS IN TERM OF PRICE RISE


(1) P.J.Curian An economy regarded as suffering from inflation if it is undergoing period of
continuously rising process.
( 2 ) L.B.Thomas Inflation as persistent rise in level of prices.
( 3 ) Golden Weiser Inflation occurs when the volume of money actively bidding for goods
and services increases faster than the available supply of goods.

KEYNSIAN VIEW OF INFLATION


Inflation is based on the concept of full employment. According to him, inflation is the result of
the excess aggregate demand over the available aggregate supply and true inflation starts
after full employment.

Keynes mentioned prices may rise even before full employment, mainly due to the existence of
certain bottlenecks in the expansion of but he termed such a rise in prices as semi inflation i.e.
in diagram.

MODERN VIEW
Two types
1 demand-pull
2 cost-push
1 In demand pull, inflation and falling unemployment are supposed to go together while in
cost push, inflation and rising unemployment are suppose to occur simultaneously.
2 A.W.Phillips less inflation meant more unemployment.

3 During late 1960s monetarists held view that the trade of between inflation and
unemployment existed only in short run and not in long run. In the long run inflation and
unemployment will simultaneously increase.
4 Fried man combined demand-pull and cost-push inflation as one integrated completely.

CHARACTERISTICS
Rise in prices, economic phenomenon, and condition of economic diseqlibrium, caused by
demand-pull or cost-push or by both. First mild than instant get momentum.

TYPES OF INFLATION
1 CRITERION OF NATURE
A Wage induced inflation It occurs because of an increase of money wages without an
equal increase in productivity. Trade union pressure. This rise in wages leads to increase in the
cost of production.
B Deficit induced inflation caused by adoption of deficit financing or by the Govt. spending
excess of revenue receipts. In order to meet increasing expenditure Govt. Prints more
currency notes thus supply of money increase.
C Profit induced inflation Higher profit margin leads to rise in prices.
D Scarcity induced inflation Supply of goods not increase due to natural calamities. Thus
prices tend to rise.
E Currency induced inflation Supply of money exceeds the available output of goods and
services.
F Credit induced investment Due to expansion of credit without raising quantity of money.
G Foreign trade induced inflation Sudden rise in demand for it exports against inelastic
supply of exports in domestic market.
2 Criterion of scope
A Comprehensive inflation When the prices of goods and services increase throughout
economy. This leads to increase in price index.
B Sporadic inflation It affects few sectors of economy therefore prices of some goods
increase.

3 CRITERION OF EMPLOYMENT
A Partial inflation Rising prices level that prevails before full employment. Keynes says this
lead to more employment know as desired inflation.
B Full inflation It occurs after full employment.

4 CRITERION OF TIME INFLATION

A Wartime inflation Govt. want to win the war so increase utilisation of resource by
more expenses, prints more currency.
B Post war inflation due to reconstruction and continuous decline of output.
C Peace inflation due to planned economic developments in under developed countries
deficit financing leads to greater expenditure with no correspondence with increase in
production.

5 CRITERION OF SPEED INFLATION


A Creeping inflation mildest form, for economic growth.
B Walking inflation rise in prices become more marked. Danger signal ahead.
C Running inflation rise in prices starts running. Difficult to measure.
D Hyperinflation starts after full employment reached, caused by issue too currency by
Govt. prices increase many times.
6 CRITERION OF GOVT.REACTION INFLATION
A Open inflation no interference of govt.
B Suppressed inflation - price control by monetary and fiscal policy.
C Potential inflation wartime forced savings. In future may turn in expenses.

7 CRTERION OF GENERAL INFLATION


A Ratchet inflation when prices in certain sectors are not allowed to fall through there is
every
reason for the fall. Not decline due to resistance of industrialists and trade unions.
B Stagflation due to simultaneously existence of high rate of inflation and high
unemployment in economy. Observed in 1960s in developing countries who pursued
stabilisation policies to achieve full employment.
THEORIES OF INFLATION:
A DEMAND PULL INFLATION ( TRADITIONAL THEORY )
B COST PUSH INFLATION ( MODERN THEORY )
A DEMAND PULL INFLATION
Peterson Demand pull inflation theory holds that inflation is caused by an excess of demand
( spending ) relative to the available supply of goods and services exceeds the supply
available at existing prices.

Shapiro Demand Pull Inflation the general price level rises because the demand for goods
and services exceeds the supply available at existing prices.

THREE APPROACHES TO DEMAND PULL INFLATION

1 TRADITIONAL QUANTITATIVE THEORY OF MONEY


After full employment level , there is direct and proportional relationship between supply of
money and price level. If money supply is doubled prices will be doubled. If money supply is
halved price will be halved, if other things remain equal.
2 KEYNES THEORY
When aggregate demand is more than aggregate supply there is increase in prices.
AD = C + I + G
So when ever increase in consumption , investment or Govt. expenditure.

3 MODERN QUANTITY THEORY


Prof.Millton Friedman Increase in money lead to inflation. The theory does not assume full
employment or velocity of money. According to this theory demand function in real term is
stable. Given the demand function of money the change in money supply determine the rates
therefore rise in wages in industries having organised labor sooner or later spread from one
industry to another without increase in productivity the resultant upward shift in the aggregate
supply will lead to cost push inflation.
Profit push inflation occurs in imperfectly competitive markets where prices rise faster than
costs. This lead to greater profits. All sellers lead. Shortage of supply also leads.
3 Increase in the price of Imported inputs: pushed the cost of production, result increase in
price of final goods in the economy.
4 Heavy taxation- Govt. imposes heavy taxes, sellers push it to customers in form of price rise
leads to cost push inflation.

In fig. Real income is on ox axis and


price level oy ss is the only supply
curve and DD is original demand
curve. Equilibrium E point oy
income and op is price. This is also
the point of full employment. If cost
of production increases due to
increase in wages. Profit supply
curve shifts upwards1s, equilibrium
shifts to E1 and out put reduce oy to
oy1 and price increase to op1
further push to E2 oy2 price higher
op2. We can conclude price level
rises while out put and employment
falls.
Interaction of Demand-pull and cost-push inflation: Great controversy between demandpulls and cost-push.
In free economy demand and supply fix the price. When weightage given to demand then
demand-pull, when weightage given to supply then cost-push. Cost and incomes are basic
factors of the flow of money. One factor is from angle of buyers and others from angle of
sellers. Once process starts both merge with each other and difficult to separate both merge to
intensify the pressure of inflation.

In diagram ss original supply curve DD is the original demand curve, E is equilibrium OY


income OP is price. E to E1 is due to demand-pull but E1 to E2 is cost-push.
CONTROL OF INFLATION
A Monetary Policy
B Fiscal Policy
C Direct Measures

A- Monetary Policy
1 control over money
2 control above credit
(a) increasing bank rate
(b) higher cash reserve ratio
(c) open market operations
(d) selective credit control
(I)
higher margin requirements
(ii)
regulated consumer credit
B Fiscal Policy
(I ) reduction in public expenditure
( II) increase in taxes
(iii) control of deficit financing
( iv) public borrowings
(v) debt management
(vi) over valuation ( discourage exports)
C Direct Measures
(I)
(II)
(III)
(IV)
(V)
(VI)

Income policy
price control
Rationing
increase in saving
more imports less exports
increase production.