MANAGERIAL ECONOMICS

Unit –I
Economics

 Alfred Marshal: It is a study of mankind in the ordinary business of life , it examines that
part of individual and social action which is most closely related with the attainment and
use of material requisites of well being.

 Robbins : Economics is the science which studies human behaviour as a relationship

between ends and scarce means which have alternative uses.

Economics can broadly be classified into

 Micro Economics

 Macro Economics

Micro Economics : It is the study of economic actions of individuals and small groups of
individuals. It may also be an analysis of the behaviour of any particular decision making
unit such as an individual, a firm , an industry etc.

Macro Economics : It is the study of aggregates and averages of the entire economy ,such as
national income, output and employment. It is the study of how these aggregates and
averages are determined and what causes fluctuations in them

Managerial Economics

 Uses of Economic modes of thought to analyse business situations.

 Application of Economic theory to business management.

 The application of economic theory and the tools of decision science to examine how an
organization can achieve its aims or objectives most efficiently

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
Characteristics of ME

 It is concerned with decision making economic nature.

 It is micro economic in character
 It largely uses s body of economic concepts and principles called the “Theory of the
firm”
 It is goal oriented
 It is both conceptual and metrical
 It is applied Micro Economics

 The scope of ME refers to its area of study or application. ME is primarily concerned

with the application of economic principles and theories to various types of resource
decisions.

 ME focuses attention on the most profitable use of scarce resources and also provides
optimal solutions.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 1. The selection of product or service to be produced.

2. The choice of production method and resource combination.

3. The determination of the best price and quantity

4. The promotional strategy and activities

5. The selection of the location from which to produce and sells goods and services.

 Relationship between ME and other disciplines:

1. Economics: ME is related to Micro as well as macro Economics.

Micro Economics: ME is largely based on Micro Economics. It is applied Micro Economics. All
operational decisions are based on Micro Economics. ME uses several concepts of Micro
Economics , such as Demand, Marginal cost, theory of production, Pricing, Profit analysis etc

Macro Economics: ME uses concepts of Macro Economics , such as Analysis of National

Income , level of employment, general price level, consumption, investment, international trade,
public finance.

2. Management theory and accounting: Proper knowledge of accounting is very essential for
the success of the firm, since profit maximisation is the objective of every firm. This
requires proper knowledge of cost and revenue information and their classification.

3. ME and Statistics: Statistics helps in collection and analysis of data for decision making
process, demand estimation and forecasting involves statistical techniques like regression
and correlation, study of probability to reduce uncertainty and risk in decision making,
tests of significance etc.

Objectives of a Firm

 Profit Maximisation
 Value Maximisation
 Sales Revenue Maximisation
 Growth Maximisation
 Long Run Survival
 Management Utility Maximisation
 Satisfycing

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Profit Maximisation

Traditional theory of the firm says that the objective of a firm is to maximise short term
profits.

Business Versus Economic Profit

 Business (accounting) profit =

Revenues-explicit costs

 Economic profit=

Revenues-implicit costs

 Business (accounting) profit =

Revenues-explicit costs

Explicit costs: Which are evident (visible) or actually incurred from accounting point of
view.

Implicit Costs: Those costs which are not evident or actually incurred , they are only
implied e.g. Cost of own funds, owner’s time and effort, opportunity cost, depreciation etc

Business Profit: Total revenue minus the explicit or accounting costs of production.

Economic Profit: Total revenue minus the explicit and implicit costs of production.

Opportunity Cost: Implicit value of a resource in its best alternative use.

Profit is a signal that guides the allocation of society’s resources.

High profits in an industry are a signal that buyers want more of what the industry produces.

Low (or negative) profits in an industry are a signal that buyers want less of what the
industry produces.

 Value Maximisation

This concept takes into account long term profits . According to this concept firms try to
maximise long term profits. Value of a firm is defined as the present value of all future cash
flows. All future cash flows are discounted to determine the value of the firm.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Sales Revenue Maximisation
 Given by W J Baumol
 According to this theory firms seek a certain level of profit and within that
constraint aim at maximising sales.
 Reasons
 Financial Institutions consider sales as an indicator of performance and are willing to
finance firms with growing sales.
 Profits figures are available annually while
 sales figures are available at regular intervals.
 Managers’ remuneration are linked to sales.
 Growing sales indicate increasing market share and better competitive situation.
 Sales maximisation gives greater satisfaction to managers while profits go to the share
holder.
 Higher profits will become a standard, which may be difficult to achieve in the long run.

Growth Maximisation

By Robbin Marris
It is based on the assumption that managers try to maximise the firm’s balanced growth rate
,subject to some managerial and financial constraints.
Gr = Gd =Gc
Gr = Balanced growth rate of the firm
Gd = Growth rate of demand for the firm’s product
Gc = Growth rate of capital supply to the firm

Management Utility Maximisation

By O E Williamson

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 According to this theory , managers try to maximise their own interest and ignore the interest
of owners or shareholders, whenever there is a conflict of interest .

Management Utility= Salary, bonus, perks, authority etc.

Satisficing

 By Herbert Simon
 According to this concept firms do not maximise anything i.e. profits, sales etc , due to
conflict of interest.
 Firm try to achieve a satisfactory level of everything i.e. profits, sales , growth, salary etc,
so that all the stakeholders are satisfied.
 This goal is difficult to achieve
________________________________________________________________________

Unit-II

Demand

Quantity demanded is the amount of a good that buyers are willing and able to
purchase.

Law of Demand
By Alfred Marshal
The law of demand states that there is an inverse relationship between price and quantity
demanded. Demand increases with the decrease in price and decreases with the increase
in price, ceteris paribus
 Assumptions
1. There is no change in consumer’s tastes and preferences.
2. Income should remain constant
3. Prices of related goods i.e. substitutes and complimentary goods should not change.
4. People should not expect any change in the price of the commodity
5. Demand for the commodity should be continuous

Exceptions to the law of demand

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 1. Giffen’s Paradox: By Sir Robert Giffen It is based on a study of very poor people living
in Ireland. They consumed mainly two products meat and potatoes. When the price of
potatoes increased , they would consume less meat and use the money thus saved to buy
additional units of potatoes, leading to an increase in demand for potatoes.
2. Veblen’s Effect of Conspicuous Consumption. Rich people buy products , because of the
prestige value associated with the product. Hence if the price of the product decreases,
they will stop buying it, leading to a decrease in the demand for the product.
3. Ignorance: People judge the quality of a product by its price. Hence if the price falls,
people will assume that the quality is poor and will not buy it, leading to a decrease in
demand.
4. Speculation: If the price of a product increases, people may buy a greater quantity in the
anticipation that the price will rise further and they can sell the commodity for a profit.
5. Fear of shortage: If people fear a shortage
of a commodity they may buy more even if the price increases.
6. Necessities: If the commodity is a necessity people may not buy a lesser quantity if the
price increases.
7. Intoxicants: Demand may not decrease, even if the price increases, because people are
addicted to it.
8. Emergencies: In case of war, floods demand may increase even if price increases.

Types of Demand

 Industry Demand Versus Firm Demand

 The demand for the product of an industry e.g. automobiles, cosmetics .Demand
is subject to general economic conditions.
 Firm demand is the demand for the product of a specific company e.g. Maruti
Alto, Lux soap .It is determined by economic conditions and competition.
 Direct(Autonomous) Demand Versus Derived Demand
 Demand is the quantity customers are willing to buy under current market
conditions.
 Direct demand is demand for consumption, and is not dependent on the demand
for other products.
 Derived Demand
 Derived demand is input demand.
 Firms demand inputs that can be profitably employed. It is linked to the demand
for other goods e.g. textile machinery. Demand for textile machinery will depend
upon the demand for textile.
u Individual Versus Market demand refers to the sum of all individual demands for a
 particular good or service.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 u Graphically, individual demand curves are summed to obtain the market demand curve.
u Short Run and Long Run Demand
 Demand over a short period of time i.e. less than one year. It depends upon price of a
commodity, availability of substitutes etc.
 Long run demand varies over a long period of time 2-5 years and may depend upon
macro economic factors.
 Demand for Consumer goods and Producer goods
 Goods and services used for final consumption are known as consumer goods e.g.
bread, butter, cloth, car etc. It depends upon prices and household income.
 Goods used for production of other goods are known as producer goods e.g.
machinery. Demand for producer goods would depend upon the demand for
consumer goods.

Demand for Perishable goods and durable goods

Perishable goods are those which become unusable within a very short period of time
e.g. food, milk , fruits etc.

Durable goods are those which can be used continuously over a period of time.

Production of perishable goods is done to meet current demand while production of

durable goods may be done to meet current, future or replacement demand.

Determinants of Demand

 Market price
 Consumer income
 Prices of related goods
 Tastes & Preferences

Elasticity of Demand.
 Elasticity

… is a measure of how much buyers and sellers respond to changes in market conditions
… allows us to analyze supply and demand with greater precision.

 Types of elasticities
 Price Elasticity
 Income Elasticity

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Cross Elasticity
 Advertising Elasticity

Price Elasticity of Demand

Price elasticity of demand is the percentage change in quantity demanded given a percent
change in the price

Percentage Change
in Quantity Demanded
Price Elasticity of Demand =
Percentage Change
in Price

Determinants of Price Elasticity of Demand

Nature of Commodity

Necessities versus Luxuries

Demand for Necessities is inelastic
Demand for Luxuries is elastic

Availability of Close Substitutes

Commodities for which substitutes are available , demand is elastic.

Commodities for which substitutes are not available demand is inelastic

u Variety of uses
If a commodity has variety of uses the demand will be elastic, since people will
forego unnecessary uses of the product.
u Time Horizon
Demand is inelastic in the short run and elastic in the long run
u Postponement of demand
If the demand for a commodity can be postponed the demand will be elastic
u Range of prices
At very high or very low prices demand may be inelastic

Uses of Price Elasticity of Demand

 Price Fixation: Sellers take into account the price elasticity of demand , while fixing
prices. If the demand is inelastic ,they may charge higher prices.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Production: Price elasticity enables producers to determine the level of production, since
production is based on demand.
 Distribution: The prices of various factors of production , depends upon the price
elasticity of demand for these factors e.g. Land, Labour, Capital, Entrepreneur.
 International Trade: Export and import of goods and their prices would depend upon the
price elasticity of demand for these products in foreign markets.
 Public Finance: Government’s decision to increase or decrease taxes, export /import
duties would depend upon price elasticity of demand for these products and their impact
on revenue.
 Public Finance: Government’s decision to Nationalise certain industries may depend

Marginal Revenue and Price Elasticity of Demand

 1 
MR  P 1  
 EP 

Income Elasticity

Cross-Price Elasticity of Demand

It refers to the quantity of commodity X purchased by consumers at various prices of Y,

where X and Y are related goods i.e. complementary or substitute goods
 Determinants of Cross Elasticity:
Nature of commodities
 Significance
1. To determine how the change in price of one commodity leads to a change in demand for
another commodity.
2. To identify substitutes and complimentary goods

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Advertising Elasticity
 It refers to a change in the quantity demanded with a change in advertising expenditure.

Demand Forecasting

 A Forecast is a prediction concerning the future and is required in all areas of business.

 Qualitative Methods
Consumer’s Interview Methods
a) Complete Enumeration: In this method all the consumers of a product are interviewed ,
based on which forecast is made. This method is unbiased because first hand information
is collected.
b) Sample Survey: In this method a sample of consumers is selected for interview. This
method is easy , less costly and useful. Method of sampling may be random or non
random
c) End Use Method: In this method the demand for the product from different sectors such
as industries, export , import etc is determined and the aggregate demand is the found out
by adding all o them

Qualitative Methods

Expert Opinion: Various people related to the product may be a source of information about the
product e.g. consumers, distributors, salesmen, managers etc. Opinion of all these people is
collected to arrive at an accurate estimate of demand. In this method forecasts can be made easily
and economically, however opinions may be subjective

Delphi Method: Under this method a panel of experts is selected to arrive at a consensus
regarding the level of demand. Both internal and external experts may be part of the panel. Panel
members are kept apart from each other and asked to express their views. A coordinator conducts
this process by sending questionnaires to all panel members. These questionnaires are then
collected and summarised. This summary is again sent back to panel members for their final
judgment.

Quantitative Methods

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
Time Series is based on the assumption that future events are a continuation of the past and,
therefore, historical data can be used to predict the future.

 The forecaster identifies the historical pattern of the variable and then projects or
forecasts that will continue moving along the path described by its past movement.

 The four major components of a Time Series are

1. Secular Trend

2. Cyclical Fluctuations

3. Seasonal Variation

4. Irregular or Random Influences

O=T+S+C+I (Additive Model)

O=TxSxCxI (Multiplicative Model)

 Method for determining the Trend Value

 (Method of Least Squares) This method will provide an equation of a straight line, which
best fits the graph

 Equation of a straight Line

 Y=a+bx

 ΣY=na+ bΣX

 ΣXY=a ΣX + bΣX2

Moving Average Forecasts

Forecast is the average of data from w periods prior to the forecast data point. A moving average
of order “w” is the arithmetic average of the most recent “w” observations.

The purpose of using moving average method is to calculate the average of recent observations.

A moving average is calculated by adding each period’s value over a length of time and then
dividing by the number of time periods.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 w
At  i
Ft  i 1 w

Exponential Smoothing Forecasts

Forecast is the weighted average of of the forecast and the actual value from the
prior period.

Ft 1  wAt  (1  w) Ft
Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 0  w 1
 The weights used to compute the forecast (moving average) are exponentially distributed.
 The forecast is the sum of the old forecast and a portion (a) of the forecast error (A t-1 - Ft-
1).
Ft = Ft-1 + a(A t-1 - Ft-1)
 . . . The weight has a value between 0 &1
 The forecast is the average of the actual market shares of 12 quarters=21
 Forecast for the period ‘t+1’ is a weighted average of the actual & forecasted values of
the time series in period ‘t’.
 The actual value of time series at period ‘t’ is assigned a weight ‘w’ (between 0 &1).
 The forecast for the period ‘t’ is assigned the weight (1-w)

Naïve method: The forecast for next period (period t+1) will be equal to this period's actual
demand (At).

 Y t+1= Y t

 naive approach looks at no data past the present

 forecast for the next period is the same for the last period

 best in the short run, not so good in the long run

 does not work with data that is trended or has a clear pattern assumes high volatility

Box Jenkins Method

 Developed by G E P Box and G M Jenkins

This approach seeks to identify patterns in historical values of a time series and then
extrapolate those patterns to a forecast period .

Box-Jenkins forecasting models are based on statistical concepts and principles and are
able to model a wide spectrum of time series behavior. It has a large class of models to
choose from and a systematic approach for identifying the correct model form
This method is also applicable if the data has at least 40-50 observations

 This method of forecasting is used only for short – term predictions. Besides, this method
is suitable for forecasting demand with only stationary time series sales data. Stationary
time series data is one, which does not reveal long term trend. In other words, Box-

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Jenkins technique can be used only on those cases in which time-series analysis depicts
monthly or seasonal variation recurring with some degree of regularity .
 Stationary data series means that the mean or variance should not change with time. Non-
stationary data, as a rule, are unpredictable and cannot be modeled or forecasted
 Step 1.
 The input data must be adjusted to form a stationary series, one whose values vary
more or less uniformly about a fixed level over time. Trends can be adjusted by having
the model apply a technique of "regular differencing," a process of computing the
difference between every two successive values.
 Differencing involves subtracting the observation in time t by the observation in time t-1
for all observations.
 Step 2.
 To determine whether the data series shows seasonality i.e. it varies over a fixed
period of time e.g. 3 months, 6 months, annually.
 Step 3.
To find a suitable model in which the data fits. In the model identification stage, the
forecaster must decide whether the time series is autoregressive, moving average, or both.
Models are AR, MA or ARIMA
Models are AR, MA or ARIMA
AR (autoregressive), MA (moving average)
ARIMA (Integrated AR & MA)
 The autoregressive model is one of a group of linear prediction formulas that attempt to
predict an output of a system based on the previous outputs and inputs, such as:
 Y(t) = b1 + b2Y(t-1) + b3X(t-1)….
 where X(t-1) is the actual value (inputs) and Y(t-1) is the forecast (outputs)
A model which depends only on the previous outputs of the system is called an
autoregressive model (AR), while a model which depends only on the inputs to the
system is called a moving average model (MA), and a model based on both inputs and
outputs is an autoregressive-moving-average model (ARMA or ARIMA )

Advantages
1. Several models are available which can be used.
2. Software is available for computing.
3. Method is objective
4. Forecast is accurate.
Limitations
1. Very complicated, and detailed knowledge of statistics is required.
2. Not suitable for small no. of observations i.e.<50
3. It does not give any idea about the causal factors i.e. factors which cause these changes.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
Barometric Techniques

 Barometric Techniques is based on the observation that there are relationships among
many economic time series. It is based on the assumption that future can be predicted on
the basis of certain events in the present. There are three types of statistical economic
indicators:

 Economic indicators help forecast the economy.

 Leading indicators, e.g., stock prices.

 Coincident indicators, e.g., production.
 Lagging indicators, e.g., unemployment
 Economic indicators help forecast the economy.

 Leading indicators: These are time series or factors that lead or precede changes
in the level of general economic activity e.g., stock prices.
 Coincident indicators: These are indicators which coincide with movements in
general economic activity. e.g., production.
 Lagging indicators : these are indicators which lag or follow movements in
general economic activity. e.g., production.e.g., unemployment
 Leading Indicators: Support price of whet announced by the govt is leading indicator
market price of wheat, Profitability for stock prices , new building permits for demand for
construction related goods, demand for consumer goods as leading indicator for the
demand for industrial goods.
 Coincident Indicators: Industrial production and unemployment rate, GNP & personal
Income.
 Lagging Indicators: Wages and WPI ,demand and unemployment rate, Inflation and rate
of interest, sales and inventory.

Simple Linear Regression

Linear regression analysis establishes a relationship between a dependent variable and one or
more independent variables.

In simple linear regression analysis there is only one independent variable.

If the data is a time series, the independent variable is the time period.

The dependent variable is whatever we wish to forecast.

l Regression Equation
Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 This model is of the form:

Y = a + bX

Y = dependent variable

X = independent variable

a = y-axis intercept

b = slope of regression line

Constants a and b

The constants a and b are computed using the following equations:

a=
 x  y- x xy
2

n x -( x)
2 2

n xy- x y
b=
n  x2 -( x)2

Multiple regression analysis is used when there are two or more independent variables.

An example of a multiple regression equation is:

Y = 50.0 + 0.05X1 + 0.10X2 – 0.03X3

where: Y = firm’s annual sales (Rs crores)

X1 = industry sales (Rs crores)

X2 = regional per capita income (Rs thousands)

X3 = regional per capita debt (Rs thousands)

Coefficient of Correlation (r)

The coefficient of correlation, r, explains the relative importance of the relationship between
x and y.

The sign of r shows the direction of the relationship.

The absolute value of r shows the strength of the relationship.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 The sign of r is always the same as the sign of b.

r can take on any value between –1 and +1.

n xy   x  y
r
n x 22  (  x )22  n y 22  (  y )22 

Criteria for Selecting a Forecasting Method

Cost
Accuracy
Data available
Time span
Nature of products and services

Forecasting Demand for new products

1. Evolutionary approach: In this method demand for a new product is projected on the
basis of the demand for an existing product. E,g, demand for DVD player may be based
on demand for VCD/VCR.

2. Growth Curve approach: On the basis of growth of demand for an established product,
the demand for a new product may be determined e.g. demand for a new model of a car ,
may be based on the demand for an old model.

3. Opinion poll approach: Demand is estimated by directly asking the consumer.

4. Sales Experience approach: Demand is estimated by supplying the new product in a

sample market e.g. If 40% of consumers buy the product that the demand can be
determined by assuming 40% of the entire population would buy the product.

5. Vicarious approach: By asking specialised dealers . These dealers and retailers are well
informed about consumer needs and preferences, hence they may be in a position to give
an estimate for the demand for a new product.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Unit-III

Supply

Quantity supplied is the amount of a good that sellers are willing and able to sell.

Determinants of Supply

 Market price
 Input prices
 Technology
 Expectations
 Number of producers

Law of Supply

 There is a direct and positive relationship between price of a commodity and its quantity
supplied.
 With an increase in price, the quantity supplied increases, other things remaining
constant.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Equilibrium Price
 The price that balances supply and demand. On a graph, it is the price at which the supply
and demand curves intersect.
o Equilibrium Quantity
 The quantity that balances supply and demand. On a graph it is the quantity at which the
supply and demand curves intersect.

 Price elasticity of supply is the percentage change in quantity supplied resulting from a
percent change in price.
 It is a measure of how much the quantity supplied of a good responds to a change in the
price of that good.

Production Functions

• Process of transforming inputs into outputs to create surplus value. Outputs may be
products or services. Inputs are resources like labour, machine, capital, land etc.

• Inputs may be Fixed or Variable

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 • Fixed Inputs are those which cannot be changed over a short period of time e.g. plant,
building

• Variable Inputs are those which can be changed over a short period of time e.g. raw
material, labour

• Production function is defined as any equation, table or graph showing the maximum
output of a commodity that a firm can produce per period of time with each set of inputs.
Both inputs and outputs are measured in physical units.

• Simplest production function is

• Q=f(L,K)

• The firm produces only one output, with two inputs i.e. land and labour.

• Assumptions underlying the concept of production functions

1. Production function is related to a particular period of time.

2. There is no change in technology because technology can change efficiency.

3. The producer is using the best technology available

4. The factors of production are completely divisible,

5. It is applicable to both short run and long run

• Uses of production functions

1. To obtain maximum output from a given set of inputs.

2. To get a given output by using minimum inputs

3. Whether additional employment of input will be profitable or not.
4. To determine least cost combination of inputs.
5. Short run and long run decisions regarding increasing/decreasing outputs.
6. Decisions regarding scale of operations i.e. plant capacity/ capacity utilisation.

Cobb Douglas Production Function. By Charles W Cobb and Paul H Douglas

Q=AKaL(1-a)
Q=Output
K=Capital=1/3
L=Labour=2/3
According to this function a 1% change in input will lead to 1% change in output.
Assumptions underlying Cobb Douglas Production Function.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Output is a function of only two inputs or factors i.e. labour and capital.
1. It is a linearly homogenous production function of 1st degree.
2. The function assumes that log of total output is a linear function of log of labour and
capital (log Q=alogK+(1-a) log L+logA)
3. There are constant returns to scale
4. All inputs are homogenous.
5. There is perfect competition
6. There is no change in technology.

Production Functions With One Variable Input

Law of variable proportions-By Baumol

As more and more of some input is employed, all other inputs being constant, eventually
a point will be reached , where additional quantities of input will yield diminishing marginal
contributions to the total product.

This law operates in the short run, where only one input is variable and the other inputs
remain constant.

Assumptions underlying the Law of variable proportions .

1. Technology remains constant

2. Some inputs remain constant

3. Inputs should not be required in rigidly fixed proportions

4. There is no scarcity of factors of production

5. There is only one variable input.

6. Variable factors are completely divisible.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Law of variable proportions-By Baumol

Stage –I The TP initially increases at an increasing rate. MP & AP also increase, but MP
increases at a faster rate. Up to point G, TP increases at an increasing rate and MP is
maximum. Beyond point G, TP increases at a decreasing rate and MP starts declining.

The reason is that initially the fixed factor is unutilised and also the firm is able to take
advantage of specialisation.

Law of variable proportions-By Baumol

Stage –II This stage starts when AP becomes max and at this point AP=MP. TP continues to
increase, but at a diminishing rate, until it reaches point J, when it starts declining. At this
point MP=0 and TP=Max.

This is the rational stage , where the firms must operate.

Law of variable proportions-By Baumol

Stage –III This stage starts beyond point J, when TP, starts declining and MP becomes
negative. Firms should not operate in this stage because output is decreasing.

This happens because the fixed factor like land , has been fully utilised and any additional
increase in input will lead to decrease in output. It may also happen due to increasing
problems of management and control.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Production With Two Variable Inputs

Isoquants show the locus of different combinations of two inputs that can produce the same
level of output.

Assumptions for Isoquants

1. There are only two factors of prodcution.
2. These factors are substitutes
3. The shape and slope of the isoquant depends upon the degree of substitutability
4. Technology is constant
5. The producer is rational

Properties of Isoquants

1. Isoquants are downward sloping and to the right. This indicates that in order to maintain
the same level of output , one input would have to be decreased and one increased. It
cannot have any other shape e.g. horizontal, vertical or upward sloping.

2. Higher isoquant represents higher level of output.

3. Two Isoquants cannot intersect each other.

4. Isoquants are convex to the origin. The Slope declines from left to right along the curve.
MRTS is negative and declines along the curve, as more of X is substituted for Y e.g.
initially 4 units of X for 1 unit of y, then 2 units of X for one unit of y ..

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Isocost lines represent all combinations of two inputs that a firm can purchase with the same
total cost.

Optimal Combination of Inputs

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A.N.A College of Management Studies, Bareilly
 Returns to Scale

Production Function Q = f(L, K)

Q = f(hL, hK)
If  = h, then f has constant returns to scale.
If  > h, then f has increasing returns to scale.
If  < h, the f has decreasing returns to scale

 Law of Constant Returns to scale

If all factors i.e. inputs are changed in a given proportion and the output increases in the same
proportion.
Reasons

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 If all the factors of production are completely divisible then the production function must
show constant returns to scale.
If output is not proportional to input it may be due to indivisibility of certain factors.
It may also happen if there is a certain minimum proportion of inputs.

Law of Increasing Returns to scale

 If all factors i.e. inputs are changed in a given proportion and the output increases in a
greater proportion.
 Reasons
1. Indivisibility of certain factors : Certain factors are indivisible and can only utilised with
greater efficiency only at large levels of output.
2. Specialisation of Labour: Due to division of labour , as the no. of workers increases the
efficiency of workers would increase , since each worker has to do only a part of the job.
3. Dimensional Economies: If the volume of a container is doubled the cost of
manufacturing it increases by only 60%. This is known as 6/10 rule.

Law of Decreasing Returns to scale

 If all factors i.e. inputs are changed in a given proportion and the output increases in a
lesser proportion.
 Reasons
1. Increasing difficulties of management and control
2. Entrepreneur is fixed factor
3. Scarcity of factors of production

Economies and Diseconomies of Scale

 Economies and Diseconomies of Scale
 Economies of Scale
 Increase in output is greater than the increase in inputs.
 Diseconomies of Scale
 Increase in output is less than the increase in inputs.
 It indicates that large scale units are economical as compared to small
scale units.

 Factors/ Reasons for Economies and Diseconomies of Scale

 Economies of Scale
a) External Economies
b) Internal Economies

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A.N.A College of Management Studies, Bareilly
  Economies of Scale
a) External Economies : These are available to all the companies in an industry e.g. a new
technology has been developed , which will help all the automobile companies in
reducing costs, a railway line has been constructed , which will reduce the cost of
transportation for all the companies in the region. Economies also result from the increase
in the size of an industry when new companies join the industry.
a) Internal Economies : These are the economies or advantages which are available to a
particular firm in the industry, which gains an advantage over other firms in the industry.
These are more important from the point of view of a manager, because they can be
controlled by the manager.
Types if internal economies:
i. Labour Economies: If a firm expands its scale of output it , can reduce the labour cost per
unit by practicing division of labour. Economies of division of labour will arise because of
 Increase in skill, as a result of repetition
 Saving in time required from one operation to another.
ii. Technical Economies: Large machines and advanced technology can be used by large
organisations, with higher output, e.g. a large generator will be more efficient than a
small one. In small organisations, these machines will be under utilized , thereby leading
to higher cost.
iii. Managerial Economics: When the size of the firm increases, the efficiency of
management increases, because of greater specialisation. In large firms experts can be
appointed to look into specific functions.
iv. Marketing Economies: A large firm can secure economies in purchasing and sales. It can
purchase its requirements in bulk and get discounts, better services, concessions in
transportation etc. Marketing expenses like advertising per unit will be less.
v. Sergeant Florence and Economies of scale:
a) Principle of Bulk Transactions: The cost of dealing with a large batch may be lower than
dealing with a small batch e.g. 6/10 rule that the cost of a container of double the size
increases by only 60%, a machine of double the capacity does not cost double the amount
of money.
b) Principle of massed reserves: A laerge organisation with several departments can share
the cost of common services like photocopier, transport, fax etc.
c) Principle of multiples: By Charles Babbage: If manufacturing operation involves several
processes, each with different outputs, the total output should be a common multiple,
otherwise there will be unutilised capacity e.g. there are three different processes with
outputs of 30,40 and 1000. The final output should be at least 6000 units i.e. the LCM of
30, 40, and 1000.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 d) Economies of Vertical Integration: It includes backward and forward integration of
various stages of production. It results in cost savings as most of the costs become
controllable.
e) Financial; Economies: A large firm is able to get credit easily and at better terms and can
also have access to capital markets.
f) Economies of Risk Spreading: Large organisation can reduce its risk by diversification of
markets and diversification of products.
 Diseconomies of Scale
 Economies of scale cannot continue forever. After a certain limit, further expansion will
lead to decrease in output.
a) Internal Diseconomies : These are the disadvantages of a particular firm in the industry,
and are due to the human factor.
Types if internal diseconomies:
i. Limits of entrepreneur: Although all factors of production can be increased, but the
entrepreneur remains the same. He/ She will
not be able to devote sufficient time and effort , if business grows beyond a limit. Entrepreneurs
will not be able to monitor and control the performance of employees.
ii. Managerial Hierarchy: As the organisation grows, the number of levels of hierarchy will
increase, thereby making communication and difficult, which in turn will lead to
inefficiencies.
X-efficiency: There may be lack of motivation among employees, since they would try
tomaximise their utility, instead of productivity. Employees would also try to engage in routine
tasks, instead of new responsibilities.

iv. Increasing division of labour may lead to duplication of effort and over specialisaation.
v. Increasing problems of coordination and control of a large workforce.
External Diseconomies: Increasing concentration of industries in a region, will lead to
congestion, competition, increased demand for labour, problem of transportation.

--------------------------------------------------------------------------------------------------------------------
Cost Concepts
 Cost is defined as the price paid for anything or expenses incurred on anything.
 Costs may be classified on several basis:
1. Explicit and Implicit Costs

Explicit costs are cash expenses, which are actually incurred, clearly
identifiable and mentioned in books of account. Implicit costs are noncash
expenses, which may not have actually been incurred and do not involve
contractual payments (salaries, rent).

2. Opportunity cost is the cost associated with alternatives that are foregone
Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 3. Historical Versus Current Costs
Historical cost is the actual cash outlay.
Current cost is the present cost of previously acquired items.
4. Incremental Cost and Marginal Cost
Incremental cost is the change in cost due to a change in the nature or level of activity.
Incremental cost can involve multiple units of output.
Marginal cost involves a single unit of output. Marginal cost is the cost of one additional
unit.
5. Sunk Cost
Irreversible expenses incurred previously e.g. on plant , building, machinery.
An expenditure that has been made and cannot be recovered- Sunk costs are irrelevant to
present decisions, since the management cannot change them.
6. Short Run Versus Long Run
At least one input is fixed in the short run. Costs incurred in the short run on day to day
operating expenses.
7. Fixed costs do not change with changes in output
Variable costs increase as output increases
8. Direct and Indirect Costs:
Direct Costs are those which can be clearly identified and attributed to a cost
centre.
Indirect costs are those which cannot be clearly identified or attributed to a cost
centre.

Fixed cost FC
AFC = =
Quantity Q

Variable cost VC
AVC = =
Quantity Q

Total cost TC
ATC = =
Quantity Q

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A.N.A College of Management Studies, Bareilly
 (Change in total cost)
MC =
(Change in quantity)

= TC
Q

Short Run Cost Curves for a Firm

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Fixed Cost: The total fixed cost remains unchanged with the change in output.
 Average Fixed cost: It decreases with the increase in output.
 Average Variable Cost: It will first decrease and then increase. This happens because
efficiency of inputs first increases and then decreases e.g. as more labour is employed ,
their efficiency first increases due to division of labour and then decreases due to
problems of management and control
 Marginal Cost: It initially decreases and then starts increasing, reflecting Law of
diminishing returns or the property of diminishing marginal product. As long as marginal
cost is declining the AVC will be greater than marginal cost. When Marginal cost starts
increasing AVC will be less than marginal cost.
Average Total Cost :The average total-cost curve is U-shaped.
 At very low levels of output average total cost is high because fixed cost is spread over
only a few units.

 Average total cost declines as output increases.

 Average total cost starts rising because average variable cost rises substantially.
 The bottom of the U-shape occurs at the quantity that minimizes average total cost. This
quantity is sometimes called the efficient scale of the firm and represents the least cost
level of output.
 The marginal-cost curve crosses the average-total-cost curve at the minimum of average
total cost

Long Run Cost Curves for a Firm

u In the long run all costs become variable, including those that are fixed in the short run.
 Long-Run Total Cost = LTC = f(Q)
 Long-Run Average Cost = LAC = LTC/Q
 Long-Run Marginal Cost = LMC = LTC/Q

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Characteristics of LAC curves
1. It is tangential to the SAC curves i.e. it envelopes the SAC curves, hence it is also called
“Envelope Curve”.
2. The LAC curve is U shaped, implying, that initially the cost decreases economies of scale
and then it increases (diseconomies of scale).
3. The LAC can never cut a SAC i.e. LAC can never be higher than SAC. This is because,
whatever economies are available in the short run are also available in the long run
4. The optimum scale of production of the LAC will be its least cost point.
5. LAC will touch the SACs on the left of its least cost point at the left of their (SACs) least
cost points.
6. LAC will touch the SACs on the right of its least cost point at the right of their (SACs)
least cost points.
This happens because the slope of the LAC is negative on the left of the least cost
point, hence the slope of SAC should also be negative, because at this point slope of
LAC= slope of SAC

Estimating and Predicting Cost

 Estimates of future costs can be obtained from a cost function, which relates the cost of
production to the level of output and other variables that the firm can control.
 It may be linear, quadratic or cubic cost function
 Linear cost function Y= a+b X (Y=Total Cost, a= fixed cost, X represents quantity, b
=variable cost)

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Quadratic Cost function=Y=a+bX-CX2
 Cubic Cost function=Y=a+bX-cX2+dX3

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Unit IV
Market Structure

Perfect Competition
 Many buyers and sellers
 Buyers and sellers are price takers
 Product is homogeneous
 Perfect mobility of resources
 Economic agents have perfect knowledge
 Example: Stock Market

Monopolistic Competition

 Many sellers and buyers

 Differentiated product
 Perfect mobility of resources

Oligopoly
 Few sellers and many buyers
 Product may be homogeneous or differentiated
 Barriers to resource mobility
 Example: Automobile manufacturers

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A.N.A College of Management Studies, Bareilly
 Monopoly

 Single seller and many buyers

 No close substitutes for product
 Significant barriers to resource mobility
 Control of an essential input
 Patents or copyrights
 Economies of scale: Natural monopoly
 Government franchise: Post office

Profit maximization occurs at the quantity where marginal revenue equals marginal cost

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Firms will enter or exit the market until profit is driven to zero.
 In the long run, price equals the minimum of average total cost.
 The long-run market supply curve is horizontal at this price

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
Monopoly

• A firm is considered a monopoly if . . .

 it is the sole seller of its product.

 its product does not have close substitutes.

The monopolist will receive economic profits as long as price is greater than average total cost.
In the long run a firm under monopoly earns profits which are known as “Abnormal profits”.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
In the long run also price and output are determined by the point at which MR=LMC. The
marginal cost curves and average total cost curves are long run curves.

Price discrimination

Price discrimination is the practice of selling the same good at different prices to different
customers, even though the costs for producing for the two customers are the same

First-Degree Price Discrimination

• Each unit is sold at the highest possible price

• Firm extracts all of the consumers’ surplus
• Firm maximizes total revenue and profit from any quantity sold

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Second-Degree Price Discrimination

• Charging a uniform price per unit for a specific quantity, a lower price per unit for an
additional quantity, and so on
• Firm extracts part, but not all, of the consumers’ surplus

Third-Degree Price Discrimination

• Charging different prices for the same product sold in different markets
• Firm maximizes profits by selling a quantity on each market such that the marginal
revenue on each market is equal to the marginal cost of production
• E.g. Railway tickets for senior citizens, Wheat for BPL families, student’s concessions

Monopolistic Competition
Many firms selling products that are similar but not identical.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
Short-run economic profits encourage new firms to enter the market. This:
 Increases the number of products offered.
 Reduces demand faced by firms already in the market.
 The firms’ demand curves shift to the left.
 Demand for the firms’ products fall, and their profits decline.
Short-run economic losses encourage firms to exit the market. This:
 Decreases the number of products offered.
 Increases demand faced by the remaining firms.
 Shifts the remaining firms’ demand curves to the right.

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A.N.A College of Management Studies, Bareilly
Increases the remaining firms’ profits
Firms will enter and exit until the firms are making exactly zero economic profits.

Oligopoly

Only a few sellers, each offering a similar or identical product to the others.

A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly

 The duopolists /Oligopolists may agree on a monopoly outcome.

o Collusion :The two firms may agree on the quantity to produce and the price to
charge.
o Cartel :The two firms may join together and act in unison

Oligopoly Models
 Kinked Demand Curve Model
 Cartels

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A.N.A College of Management Studies, Bareilly
  Price leadership

Kinked Demand Curve Model

Proposed by Paul Sweezy

 If an Oligopolist raises price, other firms will not follow, so demand will be elastic
 If an Oligopolist lowers price, other firms will follow, and there will be no substantial
change in demand, so demand will be inelastic
 Implication is that demand curve will be kinked, MR will have a discontinuity, and
Oligopolists will not change price when marginal cost changes
 The optimum quantity would be determined by the point at which MR=MC, at the point
of the kink in demand curve. This qty does not change even if the MC curve shifts up or
down.

Limitations of Kinked Demand Curve Model

1. There are other explanations for price rigidity i.e. fear of price war.
2. The model does not explain , as to how does the firm arrive at the kink i.e. at what point
does the firm decide to lower prices.
3. The assumption that price increases , will not be matched by competitors , may not
always be true.

Cartels
Cartel is a formal agreement between producers/ sellers

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A.N.A College of Management Studies, Bareilly
 Collusion is an informal agreement (illegal)
 Cooperation among firms to restrict competition in order to increase profits
 Market-Sharing Cartel
 Collusion to divide up markets
 Centralized Cartel
 Formal agreement among member firms to set a monopoly price and restrict
output
 Cartel acts a monopoly.

Conditions for Cartel Formation

1. No. of firms should be small
2. Price changes by rival firms is easily noticed
3. All sellers have similar costs (use similar technology)
4. Demand is inelastic
5. Entry into the market is difficult
6. Price stability/ rigidity

Price output under cartel formation:

The cartel establishes the MC curve for the cartel as a whole. The output is determined by the
point at which MR=MC i.e. 50. The price at which the cartel will sell is determined by the
demand curve i.e. Rs 8. Hence the cartel acts as a monopoly and charges a monopoly price.
The sales may also be divided amongst the firms.

Price Leadership

 Price Leader: Largest, dominant, or lowest cost firm in the industry. It is in a position to
eliminate small firms, but due to govt restrictions on creation of monopolies, it lets some
small firms survive.
 Followers: Take market price as given and behave as perfect competitors

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A.N.A College of Management Studies, Bareilly
  Barometric Price Leadership: Well publicised price changes, which other firms follow
e.g. DTH prices Rs 999

1. It is assumed that the dominant firm has knowledge of the MC curves of smaller firms
2. At each price the larger firm will be able to supply that part of the total demand , which is
not supplied by smaller firms i.e. at each price the demand for the market leader will be
the difference between total D and S (DD & SS)
3. At price P1 the demand for the leader’s product is 0, because the total qty is supplied by
smaller firms.
4. As the price falls below P1 the demand for the leader’s product increases.
5. At P2, the total demand is PD2. The part P2A is supplied by the smaller firms and the
remaining AD2 by the leader.
6. At P3 the total qty is supplied by the leader.
7. The leader will decide the price and output , based on his MR=MC i.e. Qty =OQ and
price=OP
8. At price ‘P’ the total demand is PC and the part PB is supplied by the smaller firms and
BC by the leader

9. The leader is able to maximise his profits, while the smaller firms are not able to do it.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Pricing
 Price: The amount of money charged for a product or service, or the sum of the
values that consumers exchange for the benefits of having or using the product or
service.
• New Product Pricing Strategies
• Market-Skimming Pricing
• Setting a high price for a new product to skim maximum revenues layer by layer from
segments willing to pay the high price. The Firm makes few but profitable sales. The
product’s image must support the high price. The competitors should not be in a position
to enter the market.
• Market-Penetration Pricing
• Setting a low price for a new product in order to attract a large number of buyers and a
large market share.
This approach should be used under the following conditions
1). The market must be highly price-sensitive so that a low price produces more market
growth.
2). Production and distribution costs must fall as sales volume increases.
3). The low price must help keep out competition, and the penetration price must maintain
its low-price position--otherwise, the price advantage may be only temporary.
• When the product is part of a product mix, the product mix pricing strategies often need
to be evaluated.
• Product Line Pricing
It involves setting the price steps between various products in a product line based on cost
differences between the products, customer evaluations of different features, and
competitors’ prices.
1). In many industries, sellers use well-established price points for products in their line
e.g. Mobiles
• Optional-Product Pricing
Pricing optional or accessory products sold with the main product e.g. cars, computers
• Captive-Product Pricing
It involves setting a price for products that must be used along with a main product.
Examples of captive products are razor blades, printer cartridges, video games, and computer
software.
1). Producers of the main product offer them at low prices and set high markups on the
supplies.
• By-Product Pricing
It involves setting a price for by-products in order to make the main product’s price more
competitive
Pricing bundles of products sold together

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 • It involves combining several products and offering the bundle at a reduced price
Companies usually adjust their basic prices to account for various customer differences
and changing situations

Cost-Based Pricing: Cost-Plus Pricing

• Adding a standard markup to cost
• Ignores demand and competition
• Popular pricing technique because:
• It simplifies the pricing process
• Price competition may be minimized
• It is perceived as more fair to both buyers and sellers

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 UNIT V
National Income
• Labour and capital of a country acting on its natural resources, produce annually a certain
net aggregate of commodities, material and immaterial , including services of all kinds-by
Alfred Marshal
• Aggregate factor incomes (i.e. earning from labour, capital etc) which arise from the
current production of goods and services by the Nation’s economy.
• National Income : Money value of the end result of all economic activities e.g. farming ,
production , banking etc.
• Non Economic activities : Religious, social, political etc.
• It is that part of the objective income of a community which can be measured in terms of
money.

• National Income represents total receipts as well as total expenditure since every receipt
is also an expenditure e.g. salary is an expenditure for a firm and a receipt for the
individual.
• There are three measures of National Income:

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A.N.A College of Management Studies, Bareilly
 1. Sum of all incomes , in cash and kind accruing to factors of production in a given time
period i.e. total income flows.
2. Sum of net outputs arising in several sectors of
the nation’s production.
3. The sum of consumer’s expenditure , govt expenditure etc on capital goods.
The sum of all i.e. 1,2 & 3 will be the same.
National Income can be measured by measurement of :
a) Sum of all incomes of all individuals
b) Production of all sectors
c) Sum of all expenditures made on goods and services.

Y= C+ S
Y= National Income
C= Consumption
S= Savings
Y= C+ I
I=Investments
Investments and consumption are determinants of National Income

GDP (Gross Domestic Product): Market value of all final goods and services produced in
the domestic economy during a period of time . It includes income earned locally by
foreigners and excludes income earned abroad by Indians.
It includes exports and excludes imports.
GNP (Gross National Product): Total value of final goods and services produced by the
residents of a country during a given time period including net income from abroad.
It includes income earned abroad by Indians and excludes income earned locally by
foreigners.
GDP= GNP-Net Income from abroad
Net National Income =GNP- Depreciation.
GNP does not include:
a) Services rendered free of charge
b) Transfer payments – pension
c) Capital gains and losses
d) Income from illegal activities.

Importance of National Income Analysis:

1. It indicates growth of the economy
2. It helps policymakers.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 3. It is useful in economic planning
4. It helps in analysis of distribution of income.

Methods of measurement of National Income

1. Net Output or Value added method: National Income can be computed by the
following:
a) Gross value of domestic output from various sectors of the economy e.g. production,
farming etc
b) Estimating cost of material & services used and also depreciation of physical assets.
c) a)-b)
2. Factor Income Method: Adding income from various factors of production
National Income=Rent + wages + interest+ profits
3. Expenditure Method : All expenditures are added:
i. Private consumption expenditure of individuals
ii. Direct tax payments i.e. income tax
iii. Donations and payments to charities.
iv. Savings and Investments
v. Private business expenditure on replacement renewals and new investments
vi. Exports- Imports
vii. All the methods should be used , so that they can be cross checked.

Difficulties in measurement of National Income

I. Treatment of non- monetary transactions and services (excluded)
II. Government expenditure on services like defence, justice, and administration are counted
by way of salaries and wages paid to government employees. Capital expenditure by
government is treated like capital exp by private companies.
Treatment of income arising out of activities of foreign firms. Production by foreign
firms is ascribed to the territory in which production takes place, while income earned by
branches and subsidiaries of foreign firms are credited to the parent company.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Determination of National Income
Aggregate Demand α Income
Aggregate Demand = Consumption Demand+ Investment Demand
With the increase in income , consumption demand will increase . (Propensity to
consume may remain stable , but overall consumption will increase)
Curve ‘C’ represents consumption demand, which increases with the increase in income.
The line ‘Y’ represents (i) Supply (ii) Income
Y=C+S
Y= National Income C= Consumption S= Savings
Equilibrium occurs at point ‘E’ when
Aggregate Supply= Aggregate Demand
“OY” represents National Income
If Aggregate Demand> Aggregate Supply, hence output will be increased and National
Income will increase.
If Aggregate Demand< Aggregate Supply, hence output will be decreased and National
Income will decrease.
The distance between National Income(Y) and “C” represents “Savings”

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Inflation

• In refers to a process of rising prices. A situation is described as inflationary when either

prices or supply of money are rising.
• According to Keynes: True inflation begins when the elasticity of supply of output in
response to increase in money supply becomes ‘zero’, or when output is unresponsive to
changes in money supply.
• Inflationary Gap: Gap between money income of the community and the available supply
of goods and services.
• Characteristics of Inflation:
• It is a process of rising prices
• It is initiated by some change which makes it impossible to satisfy the whole demand
• It is propagated by reactions of buyers to an initial price rise so that further price rise is
induced
• Deflation: Negative Inflation
• Stagflation: Stagnant + Inflation

Causes of Inflation:

i. Increase in demand

ii. No corresponding increase in supply of goods/services.

Causes of Inflation:

i. Increase in demand: It may be due to:

a) Increase in money supply
b) Increase in disposable income
c) Increase in aggregate spending on consumption goods and investment goods
d) Excessive speculation
e) Increase in foreign demand (Exports)
f) Increase in salaries and wages
g) Increase in population
ii. No corresponding increase in supply of goods/services.

a) Deficiency of capital equipment

b) Scarcity of other factors of production
c) Increase in exports for earning foreign exchange

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 d) Decrease/ restrictions on imports
e) Speculative hoardings
f) Droughts/ Famines
g) Prolonged industrial unrest-strikes.
Effect of Inflation:

1. Effect on distribution of income & wealth: Inflation leads to inequalities in the

distribution of wealth. People who have fixed incomes i.e. middle and lower classes will
suffer , since their real income decreases. People with higher incomes, such as
industrialists and traders may earn more on account of higher profits, prices and
speculation. Impact on different classes of people:

(i) Salaried People: There is a negative impact , since their real income decreases. They
may have to cut down consumption

(ii) Wage Earners: The impact is similar to that of salaried people, however sometimes
labour unions may bargain for higher wages , based on the rate of inflation or WPI. If unions
enter into contractual agreements wages may not increase.

(iii) Businessmen: Industrialists , traders etc generally gain, since the value of their
inventories may rise and also because prices may indicate higher profit. They may gain on
account of speculation and also because their costs do not rise immediately .

(iv)Investors: Investors in equity shares gain during inflation because during inflation
business activities also increase , thereby leading to increase in profits and hence dividends.
Investors in fixed interest bearing securities like FDs may lose , since the value of their
money declines.

• Theories of inflation

1. Market Power theory of inflation

2. Demand Pull theory of inflation
3. Mark Up Theory
4. Bottleneck Theory
5. Demand Composition Theory

1. Market Power theory of inflation (Cost push theory): When a seller or a group of
sellers in the market combine to establish a price, different from a competitive level, it is
called the “market power price”. This group can raise the price to any level they feel
comfortable. Irrespective of the suffering of consumers. This occurs in an Oligopolistic
Economy, thereby allowing Oligopolists to raise prices, even when there is no increase in

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 demand. It may also happen because Trade Unions keep bargaining for higher wages
and these higher wages are passed on to consumers by way of increase process.

Implications:

 Monetary & Fiscal policies are ineffective in controlling inflation, because they rely on
controlling demand, whereas this type of inflation is caused by increase in cost.
 Credit curbs are ineffective because Oligopolists are large firms and have access to
capital markets.
 This type of inflation is called “seller’s inflation” and is followed by depression.
 Govt should keep a check over administered prices.
 Govt tries to control inflation by controlling aggregate demand i.e. raising taxes, interest
rate
2. Demand Pull Inflation theory: according to this theory inflation is the result of excess
of aggregate demand over aggregate supply. This generally happens when the economy is
operating at full employment level and it is not possible to increase supply.

3. Mark up theory: by Gardner Ackley :according to this theory inflation is caused by both
demand pull and cost push factors. Demand pull inflation is caused by excess demand for
goods and services so that their prices increase. Increase in prices stimulates production
(because of increase in profits) and causes increase in demand for factors of production
(labour, capital). As a result cost of production increases and producers will increase
prices to cover increased costs.

4. Bottle Neck theory: By Otto Eckstein: according to this theory inflation leads to increase
in prices of most of commodities, including industrial goods. Prices of the commodities
of certain industries increases very sharply, as compared to others. These industries are
called “Bottle Neck” industries e.g. Petroleum, steel, cement etc. Inflation is primarily
due to the increase in demand for the product of these “Bottle Neck” industries.
5. Demand Composition Theory: By Charles Schulz: according to this theory prices and
wages are comparatively less sensitive to decrease in demand and more sensitive to
increase in demand. If demand decreases prices and wages do not decline immediately,
but if demand increases prices and wages will increase immediately. Hence inflation is a
result of change in composition of demand , even though there may not be any change in
aggregate demand.

Change in composition of demand means that there is increase in the demand for the
product of a few industries and decrease in the demand for the product of other industries.
Hence aggregate demand remains the same. Prices of those industries will not change
much, where demand has decreased, but prices of those industries will increase where
demand has increased.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Selective credit controls are useful for controlling this type of inflation.

Business Cycle

• In refers to the fluctuations in economic activity, occurring regularly in capitalist

economies.

• These are wave like fluctuations in the interlinked economic variables like aggregate
employment, income, prices, output etc.

A trade cycle is composed of periods of good trade characterised by rising prices & low
unemployment alternating with periods of bad trade characterised by falling prices and high
unemployment

• Characteristics

1. Business Cycles are wave like fluctuations in economic activity, as reflected in economic
variables like income, employment etc.

2. These fluctuations are cyclical in nature:

a) Secular Trend: Long run changes in business activity which occur slowly over a period of
several years, due to changes in population, technology etc.

b) Random Fluctuations: Unpredictable changes which occur suddenly due to floods,

earthquakes etc. Effects are short term and irregular.

c) Seasonal Changes: Short run fluctuations which occur with regularity and variations are
repeated every year.

d) Cyclical fluctuations: These changes occur over a long period of time, due to business
cycles.

3.The changes in business cycle occur frequently and in a similar pattern.

4.The periodicity between cycles may not be similar e.g. every cycle may not occur after
every 5 years.

5.Business cycles are types of fluctuations in aggregate economic activity and not restricted
to a single firm or industry.

6.There are minor cycles of duration 3-4 years and major cycles of duration 6-12 years.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Phases of Business Cycle

1. Recovery or revival of economic activity

2. Prosperity or expansion of economic activity

3. Recession or downturn of economic activity

4. Depression or contraction of economic activity

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 .
Theories of Business Cycle

 Climatic Theory: Business cycles occur due to changes in the climate. In some years
there is a favourable climate and sometimes unfavourable climate.
 Under Consumption Theory: Inequality of wealth and concentration of wealth are the
main causes of Business Cycles. Rich people save more and invest it in producing goods
and services. There is an increase in supply of goods ,but people do not have the money
to buy these goods, leading to a recession.
 Keynes Theory:
1 Level of output or employment are determined by the level of aggregate effective
demand.
2 Aggregate Effective Demand= Demand for consumption goods+ Demand for investment
goods.
3 If AED is large the entrepreneur will be able to sell a large quantity , hence they will
produce more.
4 In order to produce more they will employ more labour and capital.
5 Hence higher level of AED will lead to higher employment , income etc and vice versa.
6 Fluctuations in economic activities are due to fluctuations in AED
7 AED depends upon total expenditure by consumers on consumption goods and by
entrepreneurs on investment goods.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 8 Marginal Propensity to consume remains stable ,hence AED mainly depends upon
fluctuations in investment demand.
9 Investment demand depends upon rate of interest and marginal efficiency of capital.
10 During a boom increase in demand for capital goods , results in higher prices of land,
labour .
11 Higher prices raise the cost of investment, thereby leading to decrease in Marginal
Efficiency of capital (Expected rate of return on investment).
12 Demand for money also increases thereby leading to an increase in interest rates.
13 Increase in interest rates and decreasing MEC will cause a decrease in investment
demand.
14 This will lead to decline in AED and hence income, employment etc.

 Hicks Theory

1. Multiplier Effect: When investment increases income also increases and hence
consumption also increases.
2. Kahn’s Employment Multiplier :When Govt undertakes public works programmes
like building roads , people get employment. This is initial or primary employment.
The income of people increases and they use it to buy goods and services, thereby
leading to an increase in demand.
3. This will lead to increase in output of these industries, which will employ more
people. These people will spend their incomes leading to further increase in demand,
leading to further increase in output and employment. The total employment thus
generated is far greater than the initial increase in employment.
4. Keyne’s Income Multiplier: A given increase in investment ultimately creates total
income which is many times the initial increase in income.
5. Suppose an new investment is made. Employees are paid wages, which they will
spend on buying goods . Producers of these goods will produce more goods and
employ more people, thereby further increasing employment and income.
6. If an initial investment of Rs 1000 cr is made. This money will be used for paying
wages. The people who receive these wages will spend some money and save the
rest. Suppose Marginal Propensity to save is 0.25 and propensity to consume is 0.75
7. 1000+0.75x1000+0.75x0.75x1000+0.75x0.75x0.75x1000……..
8. The sum of an infinite GP is =a/(1-r)
9. 1000/(1-0.75)=4000
10. Hence an initial investment of Rs 1000 cr will lead to increase in income to Rs 4000
cr.
11. This principle works in reverse also.
12. Accelerator Effect: There is an increase in investment as a result of increase in
income. When income increases people will spend more, leading to an increase in
Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 demand for goods. In order to meet this demand, investment must increase . Initially
this increase in demand will be met by using existing facilities. This will lead to
increase in profits, inducing the Entrepreneur to invest more. Thus rise in income
leads to increase in investment.
13. Hick’s Theory is based on the combination of these multiplier and accelerator
effects.

 The line AA represents autonomous investment. Autonomous Investment grows annually

at a rate represented by the slope of the line AA.
 Autonomous investment may be due to innovation, govt policy etc.
 As a result of increase in investment employment and income will increase due to the
multiplier effect. This will determine the equilibrium level LL
 Since the National income is growing there would be some induced investment due to
accelerator effect.
 EE shows the level of National Income due to combined effects of multiplier and
accelerator.
 FF represents the maximum limit for National Income, due to full employment.
 Suppose initially the economy is at point P0. There is some external event, which leads to
increase in autonomous investment.
 Due to the combined effects of multiplier and
 accelerator , the economic indicators jump to P1.At this point there is full employment
and hence income cannot increase any further.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  For a brief period the economic indicators will remain constant i.e. from P1 to P2.
 When National income stops growing the induced income will start decreasing.
 Decrease in induced investment leads to decrease in income.
 Multiplier and accelerator principles now start working in the reverse, leading to further
fall in economic indicators like income.
 At Q the minimum point has been reached and the economic indicators grow due to
induced investment.
 The cycle repeats.

Controlling Business Cycles

Business Cycles can be controlled by :

1. Fiscal Policy
2. Monetary Policy
3. Physical (Non- Monetary measures)

1. Fiscal Policy : It may be of two types :

(a)Discretionary (b) Non Discretionary

(a)Discretionary : Deliberate changes by the government to influence national output and prices.

(i) At the time of recession the government increases its expenditure on building roads etc or
reduces taxes or both.Increasing expenditure on building roads, bridges creates employment
leading to increase in income and demand due to multiplier and accelerator effects.

However this may lead to a Budget Deficit. This deficit may be financed by borrowing money
from the public (This may lead to reduction in money supply) or by printing new currency.

(ii) At the time of recession govt may also reduce taxes. This increases the disposable income in
the hands of society, leading to increase in consumption and hence demand.

(iii) Fiscal Policy for Controlling Inflation:

• The Govt may increase taxes, thereby reducing the disposable income, and hence
consumption and demand.

• Reducing Govt expenditure on building roads, bridges etc. This would reduce
employment, income and demand.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 These measure may however create a budget surplus. This surplus may be reduced by
retiring or reducing public debt, but it would lead to increase in money supply and inflation.

Hence the govt undertakes impounding of public debt i.e. funds are kept idle.

(b): Non-Discretionary Policy measures: The tax structure and govt expenditure are so designed
that they vary automatically when changes in National Income occur.

• Personal Income Tax: Tax structure has progressive rates i.e. higher taxes are charged
from higher income groups. During a recession income decreases, so the individual has to
pay lower taxes. During a period of inflation, income increases, hence individuals have to
pay higher taxes, thus reducing disposable income.

• Corporate Income tax: Tax structure has progressive rates i.e. higher taxes are charged
from firms with higher incomes. During a recession the income of the firm decreases, so
the firm has to pay lower taxes. During a period of inflation, income increases, hence
firms have to pay higher taxes.

• Transfer payments: During a recession govt expenditure on unemployment benefits

increases, because there is greater level of unemployment. During a period of inflation or
boom, the level of unemployment is low , so govt exp on unemployment benefits is
reduced.

• Corporate Dividend: Companies follow a pattern of constant dividends, during a boom or

recession, hence money supply remains stable.

• Companies may also pay higher dividends during recession because they do not need
funds for expansion during recession, thereby increasing the money supply.

• During a period of inflation companies may pay lower dividends because they need funds
for expansion, thereby reducing money supply.

2. Monetary Policy : These measures are aimed at controlling money supply. These are of
the following types:

a) Open market Operations

b) Changing Bank Rate
c) Changing CRR
d) Selective Credit Control

a) Open Market Operations: This involves purchase and sale of govt securities by the the
Central Bank i.e. RBI. During a recession the govt repurchases govt securities thereby

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 increasing the money supply. During a period of inflation govt sells securities, thereby
reducing the money supply.

b) Changing Bank Rate: Bank rate is the rate of interest at which the RBI lends money to
commercial banks. During a recession the RBI reduces the bank rate , hence the
commercial banks would reduce the interest rate at which they lend money to firms. This
would encourage firms to take loans and make investments, which would increase
employment and income.

c) During a period of inflation the RBI increases the bank rate, thereby discouraging firms
from taking loans , and hence leading to a reduction in investment, employment and
income.

d) Changing CRR: Cash Reserve Ratio is the % of deposits which banks have to maintain
as cash reserves . During a period of recession the RBI will reduce the CRR, thereby
allowing banks to lend more money and hence increasing the money supply. During a
period of inflation the RBI increases the CRR, thereby allowing banks to lend less money
and hence reducing the money supply.

e) Selective Credit Control : The govt regulates the credit flow, by specifying the flow of
credit for certain sectors i.e. priority sector e.g. agriculture, education etc. During a period
of inflation, the govt may discourage banks to lend money to non priority sector. This can
be done by fixing a minimum credit limit for priority sector loans or a maximum credit
limit for non-priority sector.

3. Physical (Non- Monetary measures)

a) Increasing output: During a recession the govt may encourage PSU to increase output .
During a period of inflation it may encourage imports and discourage exports.

b) Controlling Wages: The govt may control wages , in order to prevent cost push
inflation.

c) Price Control: The govt may control prices of essential commodities during inflation, by
selling them at controlled prices through ration shops.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Profit

Profit is the reward for the entrepreneurial functions. Profit differs from the return on other
factors on account of the following:

1. Profit is a residual income and not contractual or certain income.

2. There may be much greater fluctuations in profits than the rewards from other factors.

3. Profits may be negative, whereas rent, wages and interest cannot be negative.

From the total receipts of business , what has to be paid out for various factors of production i.e.
rent, wages , interest must be taken out. Profit includes the following:

• Interest on the entrepreneur’s own capital: The entrepreneur could have earned interest by
lending this capital (Opportunity Cost)

• Rent of land owned by the entrepreneur: The opportunity cost of rent , which the
entrepreneur could have earned by giving it on rent.

• Entrepreneur’s wages for management and supervision: The opportunity cost of the work
done by the entrepreneur, if he had worked for another firm

• Reward of the entrepreneur as a risk taker, for those risks which cannot be insured.

• Gains as a superior bargainer: The entrepreneur bargains with workers, suppliers,

landlords, consumers etc. The gains will depend upon his bargaining skills.

Theories of Profit

 Dynamic Surplus theory,

 Risk bearing theory

 Uncertainty bearing theory

 Innovation theory.

 Dynamic Surplus theory by J B Clark. According to this theory in a static world, where the
population, capital, human wants, method of production, technical knowledge remain constant,
there will be no profits, due to perfect competition.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 Profits represent the difference between the selling price and cost. It is the surplus above costs.
Whenever there is a surplus, there will be an increase in production , leading to decrease in price
and hence the surplus will disappear.

 In a dynamic world, changes take place continuously and hence firms earn profits. The
successful entrepreneur is able to foresee the changes occurring in the dynamic world and is able
to take advantage of the same.

 The world is dynamic due to two sets of factors i.e. Internal and external.

 Internal factors are which are brought about by the entrepreneur, such as innovation

 External factors are of two kinds i.e.(a) regular changes like business cycles and irregular
changes like fire, war, earthquake.

 hence profits occur due to changes, which cannot be foreseen and cannot be insured.

Risk bearing theory by F B Hawley: According to this theory, profit is the reward for taking
risk. Higher the risk, which the entrepreneur takes, higher will be the profit. Since people are not
willing to take risks, the supply of entrepreneurs is less.

 There are Four types of risks:

1. Replacement Risk: Depreciation . It can be calculated and is counted as a cost

2. Risk Proper: Risk of marketability of the product i.e. whether the product will be
accepted by the market.

Risk of Uncertainty: Uncertainty related to business, such as changes in prices, competitors,

fluctuations in demand etc.

4. Risk of Obsolescence: The product may be become obsolete e.g. land line , PCOs,
pagers.

Those risks which can be insured such as fire , theft etc , are costs and therefore not
included in risk of business. Some economists say that it is not the ability to take risk, but the
ability to reduce it , which leads to profits.

Uncertainty bearing theory By Knight: According to this theory , it is the ability to bear
uncertainty which leads to profits and not the ability to bear risk.

 Risks such as fire ,theft etc can be insured and are included in the cost. These risks are
taken by the insurance company and not the entrepreneur. Risk refers to those dangers
which can be predicted.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
  Uncertainty refers to those changes which cannot be predicted, such as marketability of
the product, changes in demand etc. Hence profit is a reward for bearing uncertainties and
not risks.

According to this theory uncertainty bearing is also like a factor of production. Hence
uncertainty bearing also has a supply price i.e. unless the price is high the entrepreneur will not
undertake uncertainty. Uncertainty bearing will also depend upon the temperament of the
entrepreneur. Some entrepreneurs may be willing to undertake greater uncertainty, depending
upon their resources, but only if the possibility of profit is high.

Limitations of the theory:

1. Supply of entrepreneurs may depend upon other factors, such as availability of capital,
opportunities etc.

2. Uncertainty bearing is not the only function of the entrepreneur e.g. ability to manage.

3. Uncertainty bearing cannot be called a factor of production.

Innovation theory by Schumpeter

According to this theory firms earn profits due to innovation of new products, production
techniques, marketing strategies etc. These innovations are costly , so profit is seen as a reward
for innovation. Innovation is introduced by an entrepreneur who innovates to earn extra profits.
Others follow and copy this entrepreneur, leading to increased competition and declining profits ,
till another innovation occurs.

According to Schumpeter ‘Innovation’ is the main function of entrepreneurs.

Innovation may be defined as discovery of a new material, technique of production

resulting in lower costs, improving the quality of a product, any new policy etc.

Innovations may be of two types:

a) Those which change the production function and reduce the cost of the product e.g. new
machinery, improved production process, new raw material etc.

b) Those innovations which stimulate demand for the product e.g. new product, new variety
of old product, new form of advertisements, discovery of new markets, new channel of
distribution (internet) etc.

c) Profits increase because either the cost of production is lower or because the new product
allows the firm to charge a higher price.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly
 d) Successful entrepreneurs are those who continue to make innovations.

e) Profits are both the cause and effect for innovations.

f) Limitations of the theory

g) It ignores the risk bearing and uncertainty bearing role of entrepreneurs.

Dr Abhijit Das
A.N.A College of Management Studies, Bareilly