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Chapters Contents of Unit I Pages
No. Nos.
1 Managerial Economics / Business Economics 3-32

2 Production Function 1-15

3 Cost Output Relation 1-38

4 Market Structure and Pricing Theories 1-33

5 Macro Economics 1-16

6 National Income Concepts 1-7

7 Business Environment 1-13

8 Capital Budgeting 1-13

Managerial Economics:
It essentially constitutes of economic theories and analytical tools that are widely applied to business
making. Therefore to understand the concept of managerial economics it is important to know “what is
“Economics is a social science which studies how people – individuals, household
households, firms and nations –
maximise their gains from their limited resources and opportunities i.e., maximising behaviour or optimizing
behaviour of the people”.
In other words, economics is a social science which studies human behaviour in relation to optimi
allocation of available resources to achieve the given ends.

Definition of Managerial Economics:

1. Mansfield:
“Managerial economics is governed with the application of economic concepts and economics to
the problems of formulating rational decision making”.

2. Spencer and Seigelman:

 “Managerial economics – it is the integration of economic theory with business practice for the purpose of
 facilitating decision making and forward planning by management”.
 In simple words, managerial economics can be broadly
broadly defined as the study of economic theories logic and
tools of economic analysis that are used in the process of business decision-making.
decision making. Economic theories and
techniques of economic analysis are applied to analyse business problems, evaluate business options and
opportunities with a view to arriving at an appropriate business decision.

Contribution of Economic Theories to Business Economics:

1. One of the most important things which the economic (theories) can contribute to the management science
is building
lding analytical models which help to recognise the structure of managerial problems, eliminate the
minor details that might obstruct decision-making,
decision making, and help to concentrate on the main issue.
2. Economic theory contributes to the business analysis a set of analytical methods’, which may not be applied
directly, to specific business problems, but they do enhance the analytical capabilities of the business
3. Economic theories offer clarity to the various concepts used in business analysis, which enabl
enables the
managers to avoid conceptual pitfalls.

Application of Economics to Business

1. It gives a clear understanding of various economic
concepts (eg., cost, price and demand, etc) used in
business analysis.
Eg. The concept of cost includes ‘total’,
‘average’, ‘marginal’, ‘fixed’, ‘variable’, ‘actual’ and
‘opportunity’. Economics classifies which cost
concepts are relevant and in what context.
2. It helps in ascertaining the relevant variables and
specifying the relevant data.
Eg. It helps in deciding what variables need to be
considered in estimating the demand for two
different sources of energy – petrol and electricity.
3. Economic theories state the general relationship
between two or more economic variables and also

Scope of Managerial Economics:
Economics has two major branches:
1. Microeconomics
2. Macroeconomics

Both these economics are applied to business analysis and decision making. The areas of business issues to
which economic theories can be directly applied may be broadly divided into two categories –
a) Microeconomics applied to operational or internal issues.
b) Macroeconomics applied to environmental or external issues.

Microeconomics Applied to Operational Issues:

Operational issues are of internal nature which includes:-
1. Choice of business and the nature of product i.e., what to produce.
2. Choice of size of the firm, ie..d, how much to produce
3. Choice of technology, i.e., choosing the factor- combination.
4. Choice of price – how to price the commodity.
5. How to promote sales.
6. How to face price competition
7. How to decide on new investments
8. How to manage profit and capital
9. How to manage an inventory, i.e., stock of finished goods and raw materials.

To study these questions following economic theories must be studied.

A. Theory of Demand:
Deals with consumer’s behaviour. The knowledge demand theory can, therefore be helpful in making the choice
of commodities, finding the optimum level of production and in determining the price of the product.

B. Theory of Production and Production Decisions:

It explains the relationship between inputs and output. It helps in determining the size of the firm, size of
the total output and the amount of capital and labour to be employed.

C. Analysis of Market-Structure and Pricing Theory:

Price theory explains how price is determined under different kinds of market conditions, when
price discrimination is desirable, feasible and profitable and to what extent advertising can be
helpful in expanding sales.

D. Profit Analysis and profit Management:

Profit making is the most common objective of all business undertakings, but an element of risk is always
there even if the most efficient techniques are used. The firms are therefore, supposed to safeguard their
interest and advert or minimise the possibilities of risk. Profit theory guides firm in the measurement and
management of profit, in making allowances for the risk premium, in calculating the pure return on
capital and pure profit and also for future profit planning.

E. Theory of Capital and Investment Decisions:

Capital like all other inputs is a scare and expensive factor. Its efficient allocation and management is one
of the most important tasks of managers and determinant of the success level of the firm. Therefore the
knowledge of capital theory can contribute a great deal in investment decision making. Choice of projects,
maintaining the capital, capital budgeting etc.

Macroeconomics Applied to Business Environment:

The major macroeconomic or environmental issues that figure in business decision-making,
particularly with regard to forward planning and formulated of the future strategy can be categorised as follows:

A. Issues Related to Macroeconomic Trends in the Economy:

Macroeconomic trends are indicated by the trends in macro variables, eg. The general trend in the
economic activities of the country, the level of GDP, investment climate, trends in national output and
employment as well as price trends. These factors determine the prospects of private business and also
greatly influence the functioning of individual firms.

B. Issues Related to Foreign Trade:
Since the managers of a firm are interested in knowing the trends in international trade, prices and
exchange rate and prospects in international market. This can be studied, obtained from international trade
and monetary mechanism branch of macroeconomics.

C. Issues Related to Government Policies:

 Government policies designed to control and regulate economic activities of the private business affect the
functioning of the private business undertaking. Besides, firms’ activities as producers and their attempt to
maximise their private gains or profits leads to considerable social costs like environment pollutio
pollution, traffic
congestion in the cities, creation of slums, etc. These social costs impose a social responsibility on the
firms. Government’s policies and its regulatory measures are designed by and large to minimise such social
 costs and conflicts.
 Economic Theories both micro and macro, have wide range of applications in the process of business business-
making and constitute the scope managerial economics but an overall study of economics and a
wider understanding of economic-behaviour
economic of the society, individuals,
duals, firms and state would always be
desirable and more helpful.

According to Marshall in his book “Principles of Economics”- “Economics is the study of mankind
in the ordinary business of life; it examines that part of individual and social
social action which is most closely
connected with the attainment and with the use of the material requisites of well –being”.

According to Robbins in his book “Nature and Significance of Economic Science” (1931)
Economics is the science which studies human behaviour as a relationship between ends and scarce
means which have alternative uses”.

The subject – matter of economics is so broad that that the study of economics has been divided into
two parts:
1. Micro Economics
2. Macro Economics
Micro Economics
Macro Economics
These terms were coined by Ragnar Frisch.

According to K.E. Boulding “Micro Economics is the study of particular firms, particular
households, individual prices, wages, incomes, national industries, particular commodities”.

“Macro Economics deals not with individual quantities as such but with aggregates or these
quantities not with individual incomes but with the national income; not with individual prices but with
the price levels; not with individual outputs but with the n
national output”.

Micro-Economic Theories
Product Pricing Factor Pricing Theory of Economic Welfare
(Theory of Distribution)

Theory of Theory of Wages Rent Interests Profits

Demand Production and cost


Chapter - 2
Production Function
Production is the transformation of physical inputs into physical outputs. It is creation or addition of
value. The theory of production provides a framework to help the managers to decide how to combine various
factors or inputs most efficiently to produce the desired output or service.
The relation between input and output of a firm has been called “The Production function”. Therefore,
the theory of production is the study of production functions. Production function can be of two types:-

1) Short-run production function

2) Long-run Production function

1) Short-Run Production Function:

The time period in which at least one factor or input is fixed and production is increased by varying
other factors is called short-run production function. In the short run output may be increase by using more of
the variable factor(s). While capital (and possibly other factors as well) are kept constant.

2) Long-Run Production Function:

The time period when all factors are variable is called long run. The length of the long run that is the
time period required for changes in all i9nputs depends on the industry.
Eg. For some industries such as making of wooden chairs or tables the long run may be few weeks or
months but for production of steel it may be many years as it takes several years to expand the capacity of
steel production.

Production function with one variable factor i.e.,

Short run Production function
Before studying long-run production function it is very necessary to understand short run production
function. In short-run production function we study the Production Function when the quantities of some inputs
are kept constant and quantity of one input are varied. This kind of input-output relationship forms the subject
matter of the law of diminishing marginal returns which is also called “law of variable proportions” and
describes return to a factor. This concept is relevant for the short run because in the short run some factors such
as capital equipment, machines, land remain fixed and factors such as labour, raw materials are increased to
expand output. Thus short run two factor production function can be written as
Q = f (L, K)

(Bar on K indicates that K is constant)

Where Q stands for output, (for labour and K for capital which is held constant.

The law of the variable proportions:

If one input is variable and all other inputs are fixed, the firm’s production function exhibits the law of
variable proportions. If the number of units of variable factor is increased, keeping other factors constant, now
output changes is the concern of the law.
Suppose land, plant and equipment are the fixed factors, and labour the variable factor. When the
number of labourers are increased successively to have larger output, the proportion between fixed factors and
variable factor is altered and the law of variable proportions set in.

The law of variable proportions states that as the quantity of a variable input is increased by equal
doses keeping the quantities of other output constant, total product will increase, but after a point at diminishing

In other words:
When more and more units of the variable factor are used, holding the quantities of fixed factors
constant, a point is reached beyond which the marginal product, then, the average and finally the total product
will diminish.

The Law of variable proportion is also known as the law of diminishing returns
To understand this law following concepts must be very clear.
1. Total product.
2. Marginal product
3. Average Product
4. Output elasticity of an input.

Labour TP MP Output Elasticity
L Q of labour (EL)
1 80 80 80 1
2 170 90 85 1.05
3 270 100 90 1.11
4 368 98 92 1.06
5 430 62 86 0.72
6 480 50 80 0.62
7 504 24 72 0.33
8 504 0 63 0
9 495 -9 55 -0.16
10 480 -15 48 -0.13
Labour – represent the number of workers
TP – Total Product
MP – Marginal product
AP - Average Product
EL - Output Elasticity of labour

1. Total Product:
The total product of a variable factor is the amount of total
output produced by a given quantity of the variable factor, keeping
the quantity of other factors such as capital, fixed., as the amount of
variable increases, the total output increases. But the rate of increase
in total output varies at different levels of employment of the
variable factor. It will be seen in the table that as more workers are
employed with a given quantity of capital, the total output of the
product (TP) increases.

In the diagram the total product initially increases at a

increasing rate and then at a diminishing rate.

2. Marginal Product:
 Marginal Product of a variable factor is the addition made tot eh
total production by the employment of an extra unit of a factor.
Eg. When two workers are employed to produce the product they
produce 170 units. Now, if instead of two workers, three workers
are employed and as a result total product increases to 270 i.e,
the third worker has added 100 meters to the total production.
Thus the marginal product of the third worker is 100 unit.

 In general, if employment of labour increases by units

yielding increases in totaloutput
total by units, the marginal
product of labour is given by MPL =

3. Average Product:
Average Product of a variable factor (labour) is the total output (Q) divided by the amount of
labour employed with a given quantity of capital (the fixed factor) used to produce commodity.


The law of variable proportions is presented diagrammatically in the figure. The TP curve first rises at
an increasing rate upto point B where its slope is the highest.
From point B upwards, see the total product increases at a diminishing rate till it reaches its highest
point C and then its starts falling. The maximum point on AP curve is E where it coincides with point B on the
TP curve from where the total product starts a gradual rise. When the TP curve reaches its maximum point C,
the MP curve becomes zero at point F.
Where TP curves starts declining the MP curves become negative. It is only when the total product
declines the marginal product becomes zero.
The rising, the falling and the negative phase of the total, marginal and average products are infact the
different stages of the law of variable proportions.

4. Output Elasticity of an Input:

It is an important elasticity of an input. Just as price elasticity of demand for a good is defined as
percentage change in quantity demanded of it that results from a given percentage change in, the output
elasticity of a variable input, say labour is the percentage change in output that is brought about by a given
percentage change in the quantity of variable input used, other factors such as capital remaining the same. That
EL =
EL =

= x = .

Since, represents MP of labour and represents average product of labour the equation can be
written as EL = .
The output elasticity of labour is the ratio of marginal product of labour to its average product.
When the elasticity of production of a variable input being less than one indicates diminishing returns
to that factor.
When the production elasticity is zero means that output does not change at all when a given
percentage change in a variable input. Keeping other factors constant, is used in the production process.
If or when elasticity of production is less than zero (that is, it is negative), this implies that output of the
commodity decreases as a result of a given percentage increase in the variable input.



Cost of Production:
When the input are multiplied by their respective prices and added together, they give the money value
of the inputs, i.e., the cost of production.
Cost of production is an important factor in almost all business analysis and business decision-making.

Cost Concepts:
The cost concepts are divided into two parts –
1. Accounting cost concept
2. Analytical cost concept.

Accounting Cost Concepts

1. Opportunity cost and actual cost:
 The opportunity cost may be defined as the expected returns from the second best use of the resources that
 are foregone due to the scarcity of resources. The opportunity cost is also called alternative cost.
 Had the resources available to a person, a firm or a society been unlimited, there would be no opportunity

2. Business Costs and Full Costs:

 Business costs include all the expenses that are incurred to carry out a business. It includes all the payments
and contractual obligations made by the firm together with the book cost of depreciation or plant and
 equipment”.
 Full cost includes business cost, opportunity cost and normal profit.
3. Actual or Explicit
it Costs and Implicit or Imputed Costs:
 The actual or explicit cost are those which are actually incurred by the firm in payment for labour, material
 plant, building machinery, equipment, travelling and transport, advertisement, etc.
 Implicit or imputed costs are not those which do not take the form of cash outlays nor do they appear in the
 accounting system.
 Opportunity costs are known as implicit or imputed costs. Implicit costs are not taken into account while
calculating the loss or gains of the business, but they form an important consideration in deciding whether
 or not to retain a factor in its present use.
 The explicit and implicit costs together make the economic cost.

4. Out-of Pocket-and
and Book Costs:
 The items of expenditure that involve cash payments or cash transfers, both recurring and non non-recurring are
known as out-of-pocket
pocket costs. All the explicit costs (eg. wages, rent, interest, cost of materials and
 maintenance, transport expenditure, electricity and telephone expenses, etc) fall iinn this category.
 Book costs are those costs which do not involve cash payments, but a provision is therefore made in the
books of account and they are taken into account while finalizing the profit and loss accounts.

Analytical Cost
1. Fixed and Variable Costs:
Fixed costs are those that are fixed in volume for a certain quantity of output. It does not vary with
variation in the output between zero and a certain level of output.
It includes:
a) Costs of managerial and administrative staff.
b) Depreciation
ation of machinery, building and other fixed assets.
c) Maintenance of land etc.
The concept of fixed cost is associated with the short
Variable cost are those costs which vary with the variation in the total output. Variable costs include cost of
raw material,
aterial, running cost of fixed capital such as fuel, repairs.

2. Total, Average and Marginal Costs:
Total cost is the total actual cost incurred on the production of goods and service. It refers to the total
outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level
of output. It includes both fixed costs and variable costs.
Average cost is of statistical nature. It is obtained by dividing the total cost (TC) by the total output (Q) i.e.,
AC =
Marginal cost is defined as the addition to the total costs on account of producing one additional unit of the
product. It is the cost of the marginal unit produced. It is calculated as TCn – TCn-1 where n is the number
of units produced.
MC =

3. Short-Run and Long Run:

 Short run costs are those that have a short-run implication in the process of production. Such costs are made
once eg. payment of wages, cost of raw materials, etc. Short run cost vary with the variation in output, the
 size of the firm remaining the same.
 Long run costs are those that have long – run implications in the process of production, i.e., they are used
over a long range of output. The costs which are incurred on the fixed factors like plant, building,
machinery etc. are known as long-run costs.

4. Incremental Costs and Sunk Costs:

 Incremental cost refers to the total additional cost associated with the decisions to expand the output or to
add a new variety of product, etc. The concept of incremental cost is based on the fact that in the real world,
it is not practicable to employ factors for each unit of output separately. Besides in the long run, when firms
expand their production, they hire more of men, materials, machinery and equipments. The expenditure of
 this nature are incremental costs.
 Sunk costs are those which are made once and for all and cannot be altered, increased or decreased, by
varying the rate of output, nor can they be recovered.

5. Historical and Replacement Costs:

 Historical cost refers to the cost incurred in past on the acquisition of productive assets, eg. land, building,
 machinery, etc.
 Replacement cost refers to the outlay that has to make for replacing an old asset. The
 Replacement cost figures in business decisions regarding the renovation of the firm.

6. Private and Social Costs:

 Private costs are related to the working of the firm and are used in the cost-benefit analysis of business
 decisions.
 Social costs are termed as external costs from the firm’s point of view and social costs from the
 society’s point of view.
 Private costs are those which are actually incurred or provided for by an individual or a firm on the
purchase of goods and services from the market. For a firm, all the actual costs, both explicit and
implicit are private costs. Private costs are internalized costs that are incorporated in the firm’s total
 cost of production.
 Social cost refers to the total cost borne by the society due to production of a commodity. Social costs
include both private cost and the external cost. Social cost includes a) the cost of resources for which
the firm is not required to pay a price, i.e., atmosphere, rivers, lakes etc, and also for the use of public
utility services like roadways etc.

Theory of Cost-The Cost-Output Relations:

The theory of cost deals with the behaviour of cost in relation to a change in output i.e., the cost theory
deals with cost-output relations. The basic principle of the cost behaviour is that the total cost increases with
increase in output. The general form of the cost function is written as
TC = f(Q)

Short-Run Cost-Output Relations
The basic analytical cost concepts used in the analysis of cost behaviour are total, average and marginal
Total Cost
The total cost (TC) is defined as the actual cost that must be incurred to produce a given quantity of output. The
short-run TC is composed of major two elements:
i. Total fixed cost (TFC)
ii. Total Variable cost (TVC)
TFC (i.e., the cost of plant, building, etc) remains fixed in the short-run, whereas, TVC varies with the
variation in the output.
For a given quantity of output (Q), the average cost, (AC), average fixed cost (AFC) and average
variable cost (AVC) can be defined as follows:
AC = =
= += AFC + AVC
AFC = and AVC =
Marginal cost (MC) is defined as the change in the total cost divided by the change in the total output,
MC =
In fact,
MC is the first derivative of cost function ie.,
It may be added here that since = and in the short-run therefore,
. Furthermore, under the marginality concept, where MC = .

Short-Run Cost Functions and Cost Curves:

The cost out-put relations are determined by the cost function and are exhibited through cost curves. The
shape of the cost curves depends on the nature of the cost function. Cost functions are derived from actual cost
curves depends on the nature of the cost function. Cost functions are derived from actual cost data of the firms.
Given the cost data, cost function may take variety of forms, eg., linear quadratic or cubic, yielding different
kinds of cost curves.

1. Linear Cost Function:

A linear cost function takes the following form.
TC = q + bQ -1

Where TC = total cost, Q = quantity produced, a = TFC and b = change in TVC due to change in Q.
Given the cost function in equation 1, AC and MC can be obtained as follows:
AC = = = + b and MC =
Since, ‘b’ is a constant, MC remains constant throughout in case of a linear cost function.
Eg. to illustrate a linear cost function, let us suppose that an actual cost is given as
TC = 60 + 10Q - Eq. 2
Given, the above cost function, one can easily work out TC, TFC, TVC, MC and AC for different
levels of output.

Depending on the number of sellers and degree of competition, the market structure is
broadly classified as follows:

Types of Market Structures

No. of firms and
degree of Nature of
Control over Method of
Market Structure product Industry where
price Marketing
differentiation prevalent
Large number of
firms with Financial markets
1. Perfect Market exchange
homogenous and some farm None
Competition or auction
products products

2. Imperfect competition
Many firms with Manufacturing
real or perceived Competitive
a) Monopolistic tea, toothpastes,
product Some Advertising,
competition TV sets, shoes
differentiation refrigerators, etc. Quality Rivalry

Little or no. of Aluminium, steel Competitive

b) Oligopoly product cars, passenger Some advertising quality
differentiation cars etc. rivalry
A single products Public utilities, Promotional
Considerable but
c) Monopoly without close telephones, advertising if
usually regulated
substitute electricity etc. supply is large
The market structure determines a firm’s power to fix the price of its product a great deal. The
degree of competition determines a firm’s degree of freedom in determining the price of its product.
The higher the degree of competitions the lower the firm’s degree of freedom in pricing decision and
control over the price of its own product and vice-versa.

Perfect Competition:
In this type of market structure a large number of firms compete against each other for selling
their product. Therefore the degree of competition under this is close to one i.e., market is highly
competitive firm’s discretion in determining the price of its product is close to none. In fact, the price
is determined by market forces i.e, demand and supply.

Monopolistic competition:
Degree of competition is high but less than one, i.e., the firm’s have some discretion in setting
the price of their products. The degree of freedom in monopolistic competition depends largely on the
number of firms and the level of product differentiation.

The control over the pricing discretion increases under oligopoly where degree of competition
is quite low, lower than that under monopolistic competition.

The degree of competition is close to nil. Monopoly firm has full control over the price of its
product. It is free to fix any price for its product, of course under certain constraints, viz. i) the
objective of the firm and ii). Demand conditions.

Price Determination Under Perfect Competition

1) A large number of sellers and buyers,
2) Homogeneous product
3) Perfect mobility of factors of production
4) Free entry and free exit of firms
5) Perfect knowledge
6) Absence of collusion or artificial restraint
7) No government intervention.

Perfect Competition vs. Pure Competition

Perfect competition, is an uncommon phenomenon. The actual markets that approximate to
the conditions of perfectly competitive model include share markets, securities and bond markets, etc.
Sometimes a distinction is made between perfect competition and pure competition.

Price and Output:

Market price in a perfectly competitive market is determined by the market forces – market
demand and supply. Market demand refers to the demand for the industry as a whole; it is the sum of
the quantity demanded by each individual consumer or uses at different prices. Similarly market and
supply is the sum of quantity supplied by the individual firms in the industry. The market price is
therefore determined for the industry and is given for each individual firm and for each buyer. Thus, a
seller in a perfectly competitive market is a “price-taker” not a price-maker.
In a perfectly competitive market, therefore, the main problem for a profit maximising firm is
not to determine the price of its product but to adjust its output to the market-price, so that profit is
Price determination under perfect competition is analysed under three conditions:
1) Market period or very short run
2) Short run and
3) Long-run

Price Determination in Market Period

In the market period the total output of a product is fixed. Each firm has a stock of commodity
to be sold. The stock of goods with all the firms makes the total supply. Since the stock is fixed, the
supply curve is perfectly inelastic. In this situation price is determined solely by the demand
condition. Supply remains an inactive factor.

Similarly, given the demand for a product, if its supply decreases suddenly for such reasons
as droughts, floods etc price of the products will shoot up as shows in the figure.

Price – Determination In the Short-Run:
A short-run is, by definition a period in which firms can, neither change their scale of
production pr quit, not can new firms enter the industry. While in the market period supply is
absolutely fixed; in the short-run, it is possible to increase (or decrease) the supply by increasing (or
decreasing) the variable inputs.

The determination of market price in the short-run is explained in the diagram (a) and
adjustment of output by firms to the market price and firm’s equilibrium are shows in figure (b).

Given the price P1Q in figure (a) firms are required to adjust their output to the price PQ so
that they maximise their profit.
The process of firm’s output determination is shown in figure (b). since price is fixed at PQ,
firm’s AR = PQ. If AR is constant, MR = AR. The firm’s MR is shown by AR = MR line. Firms
upward sloping MC curve intersect AR = MR at E. at point E, MR = MC. Point E is therefore firm’s
equilibrium. Therefore the profit – maximising output is OM.

The total maximum Profit has been shown by the area P1TNE.
Profit = (AR – AC).Q
Q = OM
Substituting these values we get
Profit = (EM – NM).OM
= EN x OM
= P1TNE.
P1TNE is maximum supernormal profit or economic profit given the price and cost curves, in
short run.
Firms may make losses in the short-run.
While firms may make supernormal profit, there may be conditions under which firms make
losses in the short-run this may happen if market price decreases to P’Q’ due to downward shift in the
demand curve from DD to D’D’ (a). This will force a process of output adjustments till firms reach a
new equilibrium at point E’. Here again firm’s AR’ = MR’ = MC.
But in Figure (b) AR <AC. Therefore firms incur loss. But the firms will survive in the short-
run so long as they cover their MC.



Macro Economics emerged as a separate branch in 1936 with the publication of’ John Maynard
Keynes’ book, “The General Theory of Employment, Interest and Money, generally referred to as The General

P.A. Samuelson defined “Macro economics is the study of the behaviour of the economy as a whole.
It examines the overall level of a nation’s output,
outpu employment, prices and foreign trade”.

Kenneth E Boulding defined “Macroeconomics is the study of the nature, relationship and behaviour
of aggregates of economic quantities. Macroeconomics deals not with individual quantities as such, but with
aggregates of these quantities – not with individual incomes, but with the national income, not with individual
prices, but with price levels, not with individual output, but with the national output”.

Thus, from the above definitions we can say that Macroeconomics

Macroeconomics is a study of economic system as a
whole. It deals with aggregate national income, total consumption of goods and services, total savings and
investment, unemployment, inflation etc, in the economy. It concentrates on the equilibrium of the entientire
economy. It is also known as the theory of income and employment. It is concerned with the problems of
unemployment, economic fluctuations, inflation, deflation, instability, stagnation, international trade and
economic growth. It is the study of the causes
causes of unemployment, and the various determinants of employment.

In the field of business cycles, it concerns itself with the effect of investment on total output, total
income, and aggregate employment. In the monetary sphere, it studies the effect of thethe total quantity of money
on the general price level.

In international trade, the problems of balance of payments and foreign aid fall within the purview of
economic analysis above all, macroeconomic theory discusses the problems of determination of o the total
income of a country and causes of its fluctuations. Finally, it studies the factors that retard growth and those
which bring the economy on the path of economic development.

Macro-Economic Theories

Theory of income General price and Theory of Growth Macroeconomic

and employment Theory of inflation and Development Theory of

Theory of Consumption function Theory of Investment function


Origin and Growth of Macroeconomics

The foundation of macroeconomics, as a separate branch of economics, was laid down by a British
economist. John Maynard Keynes (1883-1946)
(1883 in his revolutionary book “The General Theory of
Employment, Interest and Money (1936). But the economist of the pre-Keynesian
Keynesian era had also given
important contribution in the macro--economic problems of the economy.

Hence, the growth of macroeconomics can be studied under three sub-sections.


i. Classical Macroeconomics
ii. Keynesian Revolution
iii. Post-Keynesian Developments
The Classical Macroeconomics (16 century and later era)
The school of economic thoughts that dominated the economic world before the ‘Keynesian Revolution’ is
called the ‘Classical School’. Their macroeconomic thoughts were in the form of certain ‘postulates’ which are
as follows:
1. There should be ‘laissez – faire doctrine’ i.e., the market forces of demand and supply should be
allowed to work freely i.e., there should be no government intervention.
2. There will always be full employment in the long-run and unemployment, if any, will be a short run
3. There will be neither over production nor under-production at the aggregate level;
4. The economy will always be in the equilibrium in the long run.

The great Depression of 1930s, however, proved all the classical postulates wrong. It exposed the
inadequacy of the theoretical foundations of the classical laissez-faire doctrine’. The classical economics could
offer neither an explanation nor a solution to the economic problem created by the Great Depression. Therefore,
this necessitated a fresh look at the working of the economic system. Hence the emergence of the Keynesian
Macroeconomics took place.

The Keynesian Revolution (1930s – 1960s)

The collective policy measures against the Classical’s Approach was given by J.M. Keynes in his
General Theory. Keynesian macroeconomics was born out of the Keynes’s attempt to find solution to economic
problem associated with Great Depression.
Keynesian macroeconomic theories are associated mainly with
a) Employment
b) Growth
c) Stability

The central postulates of the Keynesian Macroeconomics can be stated as under:

1) The level of output and employment in an economy is determined by the aggregate demand given the
2) The unemployment in any country is caused by lack of aggregate demand and economic fluctuations
are caused by demand deficiency.
3) The demand deficiency can be removed through compensatory government spending.
4) Keynesian economists favoured the influence of government spending (specially the role of demand
management by the government).

The dominance of the Keynesian postulates banished the classical view for some time, at least. The
period between the late 1930s and Mid 1960s is called the period of “Keynesian Revolution”. During this
period most economists and governments had adopted Keynesian policies.

The Post-Keynesian Developments (1970s onwards)

The Keynesian economics showed the sign of failures in early 1970s, as it failed to provide solution to
economic problems of low growth, high unemployment and high rate of inflation faced by most developed
countries especially U.S. This led to the growth of a new school of macro-economic thoughts called
“monetarists” followed by other schools of macroeconomic thoughts.
Post Keynesian developments in macroeconomics include following macroeconomic thoughts.
i) Monetarism: A counter-revolution
ii) Neo-classical Macroeconomics
iii) Supply side economics
iv) Neo-Keynesianism
(i) Monetarism – a counter revolution (1970s)
 A group of economists called “monetarists”, led by Milton Friedman came out with a new
revolutionary thought. According to them, the role of money is central to the growth and stability of

national output, not the role of aggregate demand for real output as Keynesian’s believed. According to
monetarists money supply is the main determinant of output and employment in the short run and price
level in the long run.
 The monetarists added a new dimension to both macroeconomic theory and policy. At theoretical level,
the emphasis shifted from the analysis of the role of aggregate demand fro real output to the aggregate
demand for and supply of money and at policy level, the emphasis shifted from demand management
 to monetary management.
 The monetarists view led to a prolonged debate between the monetarists and Keynesians about –“what
determines the aggregate demand”.

(ii) Neo Classical’s Macroeconomics (Radicalists) 1980s.
  1980s Keynesian economists was attacked by another group of economists called “Radicalists” and
their macroeconomic propositions are called “neo-classical macroeconomics”. Neo-classical economics
 was created by economists Robert E.Lucas, the Nobel Laureate of 1995.
 The neo-classical school emphasises the role of individual’s rational expectations about future
economic events, specially on the supply side of economy and expectations about future government
 policies.
 The core of radicalist thought is that people’s rational expectations about government’ monetary and
fiscal policies determine the behaviour of aggregate supply and aggregate demand curves in such a way
that real output remains unaffected, though prices and wages go up.

(iii) Supply-Side Economics:
 The “supply-side economists” led by Arthur Laffer emphasised the role of factors operating on the
supply side of the market. While Keynesian’s emphasised the role of shift in aggregate demand in
 changing employment and output, supply siders stress the role of shift in aggregate supply curves.
 Arthur Laffer widely known for “Laffer Curve” argued that a cut in tax rate shifts aggregate supply
 curve rightward and leads to a rise in output and employment.
 An important point is to be noted that both Keynesian’s and supply-sider’s consider fiscal policy as the
main instrument of economic management.

(iv) Neo-Keynesians:
 Keynesian economics remains the focal point of reference for all the schools of macroeconomists either
for attack or for its reconstruction. In the process, an another school of thought emerged which was known
 as “Neo-Keynesians”.
 Neo-Keynesians argue that market does not clear always, in spite of individuals (household, firms and
labour) working for their own interest. They give reason that information, problem and cost of changing
prices lead to some price rigidities which cause fluctuations in output and employment.




National Income Measures:
Different kinds of national income measures are used in national income analysis and in income policy
1. Gross Domestic Product (GDP):
The gross Domestic Product (GDO) can be defined as the sum of market value of all final goods
and services produced in a country during a specific period of time, generally one year. It is
important to note here that in estimating GDP, the income earned by the foreigners in the country
are included and the income by the residents abroad and remitted to the home country are
GDP = Market value of final goods and services + incomes earned by the national resident in
foreign countries – incomes earned locally but accruing to foreigners.

The market value of domestic product is obtained at both constant and current prices. Accordingly,
Accordingly, GDP is
known as ‘GDP at constant prices’ and ‘GDP’ at current prices”, respectively.

GDP can also be defined and measured as the sum of all factor payments (wages, interest, rent, profit and
depreciation). It is then called ‘GDP
GDP at factor cost’.

2. Gross National Product (GNP):

The concept of GNP includes the income of the resident nationals which they receive abroad, and excludes
the incomes generated locally but accruing to the non-nationals.
GNP = Market value of goods and services produced by the residents in the country + incomes earned in
the country by the foreigners – incomes received by residents of a country from abroad.

3. Net National Product (NNP):

NNP is net of depreciation. It is obtained by subtracting depreciation from GNP., that is
NNP = GNP – Depreciation or Capital Consumption
The NNP is the measure of national income which is available for consumption and net net-investment to
the society. The NNP is, in fact, the actual measure of national income. The NNP divided by the po population of
the country gives the per capita income.

4. Personal Income (PI):

Personal Income can be defined as the sum of all kinds of incomes received by the individuals from all sources
of incomes. It includes wages and salaries, fees and commission, bonus,
bonus, dividends etc., it also includes transfer
payments like pensions, family allowances etc. it also includes the incomes earned through, illegal means, eg.
Bribe, smuggling.
PI = NNP – (Undistributed company profits + Surplus of Public Undertakings + Rentals
Rentals of Public Property)

5. Disposable Income:
Disposable Income refers to personal income of the income earners against which they do not have any legally
enforceable payment obligations eg. income tax, fine and penalties etc.
Disposable – Personal Income – (income tax + fees + fines)

6. Private Income:
Broadly speaking, all personal incomes are private incomes. However, the term private income is used in
contrast to public income for the purpose of national income accounting, NNP is generally divided into two
1. Private income, and
2. Public income. Public income is that part of NNP which accrues to the public sector, including
administrative units of the government and the government commercial undertakings. Thus, income
accruing to the public sector is called public income. In contrast, incomes accruing to the individuals,

including private sector earnings, transfer payments and undistributed profit of private companies are called
personal income.

otal Private Income = Net Domestic Product – Public Income

Some Accounting Relationships

1. GNP at factor cost +Net Indirect taxes – Depreciation = GNP at market prices
2. GNP at market price – depreciation = NNP at market price
3. NNP at market price – Indirect taxes + subsidies = NNP at factor cost
4. NNP at factor cost + /- domestic income accruing to non-residents
non = NDP at factor cost
5. Personal Income – Direct taxes, fees, fines, etc = Disposable Income
6. NDP at factor cost – surplus of public undertakings – rentals / profits of = Personal income
statutory corporations – profit tax – income accruing to non residents +
interest on national debt + transfer payments

Nominal and Real GNP:

The GNP, and also GDP, are estimated at both current and constant prices. The GNP estimated at current prices
is called nominal GNP and GNP estimated at constant price in a chosen year (called ‘base year’) is called real
income. Similarly, GDP estimated at current prices and constant prices is called nominal GDP and real GDP

GNP Deflator and Its Application:

The GNP deflator is essentially an adjustment factor used to convert nominal GNP into real GNP.

The GNP deflator is the ratio of price index number (PIN) of a chosen year to the price index
number(PIN) of the base year. The PIN of the base year = 100. The chosen year is the year who real GNP is to
be estimated.

The method of working out GNP deflator is as follows:

GNP Deflator=

The formula for converting nominal GDP of a year into real GNP may be written as follows.
Real GNP =

Real GNP=
(where PINcy is the price index number of the chosen year.

GNP Implicit Deflator

Another variant of GNP Deflator is GNP implicit deflator, also called implicit price deflator. It is the ratio of
nominal GNP to real GNP i.e,

GNP Implicit Deflator=

The GNP implicit deflator can be used for the following purposes:-
i) To construct price index number, and
ii) To measure the rate of change in prices, i.e, to measure the rate of inflation
inflation or deflation.

Methods of Measuring National Income
The economists have, devised different methods of estimating national income. The basic approach in
measuring national income is to measure the two kinds of flows generated by the economic activities of the
residents of the country. The circular flows of income the income generating process creates two kinds of flows:

a) Product flows.
b) Money flows
The money flows can be looked upon from two angles
a) The money flows as factor payments.
b) Money flows as payments for goods and services.
Given the product flows and two ways of money flows, the economists have devised three methods of
measuring national income.

(i) Net Product Method or the Value Added Method

(ii) Factor Income Method, and
(iii) Expenditure Method.


Business is an economic activity performed by business firms or organisations often with the
objectives of maximising profit. This objective is supplemented by other objectives such as sales
maximisation, growth maximisation, maximisation of market share, maximisation of own benefits by
the managers, building up an image, and social responsibility. The economic activities performed by
business organisations include production (transformation of inputs into outputs), distribution (supply
of output in a marketplace) and sales (exchange of products with buyers for money).

Profit Maximisation:
Profit maximisation which is one of the main objectives of business organisations, requires
maximisation of revenue. However, resources in the hands of business organisations are limited.
Therefore, firms face the challenge of allocating
allocating existing resources among alternative uses in such
process of allocation and profit maximisation.

Business Environment and Its Components

The term Business environment refers to all those factors that are external to a business unit,
but impact business
usiness decisions. The business environment is surrounded by the two components of
environment, viz. micro business environment and macro business environment.

Types of Environment:
1. Micro Environment:
 The micro business environment, also known as task environment,, refers to the immediate
surroundings of the business. It not only affects the operations of the firm but also gets
 influenced by its decisions and actions.
 “The micro environment consists of the actors in the company’s immediate environment tha
affects the performance of the company. These include the suppliers, marketing
intermediaries, competitors, customers and the public’s.”

1. Public:
It consists of all those parts of society which can directly or indirectly influence an organisation’s
ability to achieve its objectives. Public opinion is important for a company as it can either
strengthen or weaken its brand image. For example, satisfied customers are a public that spread
good image about the products through word of mouth. On the contrary, activist, consumer
forums, non-government
government agencies and even media protesting against the environmental damage
done by a company is a public that can tarnish the image of a company,
company, and weaken its brand
image. Thus, managing public opinion is a crucial task for any company.

2. Suppliers:
They are the agents who supply inputs, such as raw materials and intermediate goods to an
organisation. They play an important role in operational
operational efficiency. A delay in the supply of
inputs can delay all the subsequent operations and the firm may fail in timely delivery of its
products to customers, resulting in consumer dissatisfaction and even losing them forever.
Therefore, managers need to assess
assess the ability of suppliers for their ability to supply inputs in the
required quantities in a given time frame.

3. Bankers and Financial Institutions:

Financial Intermediaries include bank insurance companies and credit agencies that help
companies raisee finance as well as insure against various types of risks involved in production and
other business operations.

4. Competitors:
Competitors are rivals who compete with an organisation in the market place. Except monopoly
market structure, firms in all other market structures have one or more competitors for their
products. As the number of competitors increases the competition becomes intense. Competitors
not only compete for customers but also for talented staff. To prevent customers and employees
from shifting to the competitors, a company needs to continuously assess consumer taste and
preferences, and design the products accordingly. It also needs to design retention strategies so
that the talented staff can be retained for a longer time.

5. Market Intermediaries:
Marketing Intermediaries consists of service agencies and financial intermediaries. Service
agencies include marketing research and consultancy firms, advertising agencies and media firms.
These agencies help consumers identify the target population and market products in most
efficient and influential manner.

6. Consumers:
Consumers comprise individuals and households that buy goods and services for personal
consumption. Consumers are the most important constituents of the micro business environment
as they are the demand side of the market. Without them companies cannot do their business?
Identifying customer needs, retaining customers, and extending products and services to them
throughout their lives are important challenges for business organisations.

2. Macro Environment:
 Macro business environment refers to the general environment. It though influences
business decisions, is not affected by the functioning of a business unit, making it an
 uncontrollable factor.
 The macro environment consists larger societal forces that affect all the actors in the
company’s micro environment – namely, the demographic, economic, natural, technical,
political and cultural forces.”

Social and Cultural Environment:

a. Social and cultural factors in various countries of the globe affect the international business.
These factors include attitude of the people to work, attitude to wealth, family, marriage, religion,
education, ethics, human relations, social responsibilities etc.

b. Culture:
 Derived mostly from the climatic conditions of the geographical region and economic conditions
of the country.
 A set of traditional beliefs and values which are transmitted and shared in a given society
 A total way of life and thinking patterns that are passed from generation to generation.
 Norms, customs, art, values etc.

Technological Environment:
 A given set of technologies available for the conduct of business determines the technological
environment of business. Technology is the application of science, art and other fields of
knowledge in various activities such as designing tools and equipments, producing goods and
 supplying services, communicating information and enhancing productivity.
 Technological advancements are driving force behind the global developments for centuries, but
they are much more rapid in the present era, making the global environment highly dynamic and

Economic Environment:
Economic environment of a country is affected by the economic system, planning process,
economic structure, business fluctuations, and trends in macroeconomic variables, economic policies
and international economic environment. These various constituents of economic environment are
detailed as follows:
a. Economic System:
 It is a set of institutions, principles and mechanisms created by a society to facilitate economic
units to address their basic economic problems of allocation of scarce resources and perform
their basic economic activities. Every organised society follows some or the other economic
 system.
 On the basis of ownership of resources, economic systems are classified into capitalism,
socialism and mixed economies. Whereas on the basis of market mechanism, the systems are
classified as market economies, planned economies and mixed economies.

b. Planning Process:
Planning is needed for an efficient allocation of resources, which are limited in supply, among
alternative uses. The planning process is an integral part of communist and socialist states.
However, retaining their basic free market structure, even capitalist economies use planning to
some extent. At present, all countries have mixed economic systems and follow planning, to a
smaller or greater extent, to stimulate the level of investment, encourage technological
innovations, use the resources as per national priorities and evolving economic situation, and
reconcile the process of economic growth with the overall socioeconomic development of the

c. Economic Structure:
Economic System defines the institutional framework, whereas economic structure defines the
physical framework under which an economy and business units operate. The economic structure
is determined by the factors such as total population size, per capita income, demographic profile,
factor endowment, technological advancement, and is reflected in the sectoral composition of
output and employment, fiscal, financial and trade structure, and population structure.

d. Business Fluctuations and Cycles:

Countries, world over, face wide cyclical fluctuations in output, prices, employment, and other
macroeconomic variables due to the fluctuations in various components of aggregate demand and
supply. Business fluctuations are recurrent; occur around a long-term growth and of short
duration, but without a fixed periodicity. There are broadly three approaches – conventional
business cycles, growth cycles and growth rate cycles that are used for measuring these

Legal Environment / Political Environment:

The functioning of a company impacts its internal stakeholders such as shareholders,
managers and workers as well as external stakeholders such as suppliers, consumers and the
community at large. Different stakeholders have different interest in the working of an organisation.
At times, these interests may conflict with each other. For example, textile industry, trying to
maximize its profit, may not internalize the cost of pollution of the nearby water bodies where it’s
used chemicals are discharged. Such discharges may affect the livelihood of those who are dependent
on marine life for their earnings. Hence, world over, the governments enact laws to resolve conflicting
interests and minimise the harmful impacts of the functioning of companies.



Capital Budgeting
Capital Budgeting or investment appraisal is the planning process used to determine whether
an organisation’s long- term investment such as new machinery, replacement machinery, new plants,
new products and research development projects, are worth the funding of cash through the firm’s
capitalisation structure (debt, equity or retained earnings). It is the process of allocat
allocating resources for
major capital or investment, expenditures. One of the primary goals of capital budgeting investments
is to increase the value of the firm to the shareholders.

It is an activity of spending resources (money, labour and time) on creating assets that can
generate income over a long period of time or which enhances the returns on the existing assets.

Capital budgeting is essentially a process of conceiving, analysing, evaluating and selecting the most
profitable project for investment. Capital budget is of great significance due to two reasons:
1. Capital expenditure is generally irreversible
2. The very survival of the firm depends on how well planned is its capital expenditure.

Requisites of Capital Budgeting
1. Defining Capital
al Expenditure
2. Deciding Planning Period
3. Choice of Decision Rules: The criteria and decision rules are normally chosen on the basis of
the objective of the firm, such as profit maximisation, asset-building,
asset building, a regular cash flow or
maximisation of short or long-term gains.

First step: To clearly define the objective of investment

Second step: To select the criteria for evaluating the projects. Three important criteria for evaluating
investment projects are
a) Pay-back
back period
b) Discounted cash flow (present value criterion)
c) Internal rate of return.
Third Step: to decide on the approach for the final selection of projects.

a) Accept – Reject Approach:

The Accept-Reject
Reject Approach is adopted generally where limited funds are available and
thee firm has to select one or a few from a number of mutually exclusive and alternative projects.

The ranking approach is adopted generally when a firm has a large amount of funds to
invest in several projects at the same time. The projects are ranked in order
order of their preferability
on the basis of the chosen objective.

1. Data Collection:
An important aspect of capital budgeting is to collect relevant, reliable and adequate data on
the following aspects of investment.

(i) alternative avenues of investment,

(ii) cost of investment projects,

(iii) the expected returns from the projects,
(iv) period of maturity, fruition and the productive life of the projects,
(v) the market rate of interest and
(vi) availability of internal and external finances.

Collection of required data on these aspects is necessary to determine where to invest and
how much to invest.

Investment Decisions under Certainty:

In this section, we will discuss investment decision under the condition of certainty. The
condition of certainty refers to a state of perfect knowledge. It implies that investors have complete
knowledge about the market conditions, especially the investment opportunities, cost of capital and
the expected returns on the investment. Of the several criteria proposed for evaluating the profitability
of the various kinds of projects, the three most commonly used criteria under certainty are :
(i) Pay-back (or pay-out) period;
(ii) Net discounted present value and
(iii) Internal rate of return or marginal efficiency of capital

These criteria are equally applicable to a variety of investment decisions regarding new
investments and those pertaining to replacement, scrapping and widening or deeping capital.
Incidentally, from analysis point of view, there is no structural difference between decision on new
investment and those on replacement.

Let us now briefly describe the three criteria mentioned above and look into their
applicability. We will discuss these criteria under the condition of certainty. As mentioned above,
investment decisions under the condition of risk and uncertainly will be discussed in the next chapter.

The pay-back period is also known as 'pay-out' and 'pay-off' period. The pay-back period
method is the simplest and one of the most widely used methods of project evaluation. The pay-back
period is defined as the time required to recover the total investment outlay from the gross earnings,
i.e., gross of capital wastage or depreciation. If a project is expected to generate a constant flow of
income over its life-time, the pay-back period may be calculated as given below.

For example, if a project costs Rs. 40,000 million and is expected to yield an annual income
of Rs. 8,000 million, then its pay-off period is computed as follows :

In case of projects which yield cash in varying amounts, the pay-back period may be obtained
through the cumulative total of annual returns until the total equals the investment outlay. The sum of
cash inflows gives the pay-back period. For example, suppose that the cost of a project is Rs. 10,000
million which yields cash flows over 5 years as given in Col. 3 of Table 1. The table provides
necessary information for the calculation of pay-back period.

Table 1 : Calculation of Pay-back period

Year Total fixed outlay Annual Cash-flows Cumulative Total of
(Rs. in million) (Rs. in million) Col. (3)
(Rs. in million)
(1) (2) (3) (4)
1st 10,000 4,000 4,000

2nd -- 3,500 7,500

3rd -- 2,500 10,000
4th -- 1,500 11,500
5th -- 1,000 12,500

As the table shows, the cumulative total of annual cash flows breaks-even with the total
outlay of the project ( . 10,000 million) at the end of the 3 year. Thus, the pay-back period of the
project is 3 years.

In case of projects with different investments yielding different annual returns, the project
evaluation procedure can be described as follows. After pay-back period of each project is calculated,
projects are ranked in increasing order of their pay-back period. Let us suppose, for example, that a
firm has to select one out of four riskless projects, viz., A, B, C and D. The total cost of each project
and their respective annual yields are given in columns (2) and (3), respectively in Table-2. The
calculation of their respective pay-back period given in column (4) of the table. Project B ranks 1
nd rd th
and projects C, D and A rank 2 ,3 and 4 , respectively. The firm will invest in this project in the
same order, if it adopts the pay-back period criterion for project evaluation.
In case projects A, B, C and D yield cash flows at different rates in the subsequent years, the
cumulative total method can be adopted to calculate their pay-back periods as shown in Table-1 and
projects ranked accordingly. After projects are ranked, they are selected in order of their ranking
depending on the availability of funds.

All other things being the same, a project with a shorter pay-off period is preferred to those
with longer pay-off period. This method or ranking projects or project selection is considered to be
simple, realistic and safe. Its simplicity is obvious in the calculation of the pay-off period. It is
realistic in the sense that businessmen want their money back as quickly as possible and this method
serves their purpose. It is safe since it avoids incalculable risk in the long run.

Table 2: Ranking of Projects

Project Total outlay Annual return Pay-back period Rank
( in millions) ( . in millions) (Years)
(1) (2) (3) (4) (5)
A 36,000 6,000 36,000÷6,000 = 6 4
B 24,000 8,000 24,000÷8,000 = 3 1
C 20,000 5,000 20,000÷5,000 = 4 2
D 15,000 3,000 15,000÷3,000 = 5 3