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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.
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
20
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.
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
Demand
for
(Dx)
100
10
200
16
300
21
400
25
27
Demand
Curve
500
Income I Rs.
600
400
200
0
1
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.
8
7
6
5
4
3
2
50
55
60
70
80
90
100
D TASTE & PREFERENCE- Child eat more sweets and take milk, as we grow older
consumption reduce.
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?
-------------------------------------------------------------------------------------------------------------------------------
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.
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
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
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
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 .
M1Q1 + M2Q2 = 1 where Q1&Q2are income elasticity of demands for goods 1& 2.
It is the ratio of %
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-
ACTIVE-
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-
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.
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
oct
oct
oct
40
45
50
48
1980
57
= 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
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.
------------------------------------------------------------------------------------------------------------------------------
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)
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
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
-------------------- 3
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.
It = Gross Private
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
10
13
13
13
14
10
12
12
14
14
20
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 )
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.
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 -
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
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.
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.
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.
Imperfect Competition
Perfect
Competition
Monopoly
Monopolisti
c
Oligopoly
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.
SMC
Unit
Cost &
Revenu
e
P1
P2
SAC
N
PR=D
MR
X
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.
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.
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
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.
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.
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 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.
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)
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.
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.
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.
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
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.
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.
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.
W1
W
W2
N1 N N2
Employment
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
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
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.
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
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.
CS
Proportional
E2
E1
Non- Proportional
E3
E0
E4
Y3
Y4 Y0
Income
Y2
Y1
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
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
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
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.
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.
(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
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
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.
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.
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.
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.
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.
Shapiro Demand Pull Inflation the general price level rises because the demand for goods
and services exceeds the supply available at existing prices.
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.