UNIT 1 - Consumer Preferences

1 Draw the preferences of a consumer who cares only about two goods (x and
y). Prefers more of each good to less, and she has diminishing marginal rate of
Substitution.  Use the graph to show that her preferences are strictly convex.
2 What are the conditions for utility maximization?

 
With a single good, total utility is maximized when the marginal utility from the next
unit consumed is zero (that the budget or income of the consumer permits this point
to be attained.) When two or  more products are being chosen, the condition for
maximizing utility is that a consumer equalizes the marginal utility per rupee spent.
The condition for maximizing utility is: MUx/Pa = MUy/Pb where: MU is marginal
utility and P is price for product x and y
At the point of Maximum utility, the marginal utility becomes zero or It is the
point of equilibrium.,
Explanation with single product
With quantity of commodity on X-axis and marginal utility on the Y-axis the
Introduction and Consumer

Marginal utility curve is drawn. The marginal utility curve is a downward sloping.
Equilibrium curve which indicates that the marginal utility comes down for a
consumer as he purchases more and more units of that product. The market price
(op) is assumed to be constant for the theoretical explanation.
The figure shows that the consumer's marginal utility is KA when he  consumes 3
units of the given product at a price of "DA". He is happy at this point of consumption
as his marginal utility exceeds the price paid for the product, When he increases his
consumption of the given product by one more unit (i.e. to 4 units) his marginal utility
is "BL" and the price paid for the product(BL) equates his marginal utility, and it is the
point of" maximum satisfaction".
 
Explanation with two products (Also Answer for Question No.1)
"The law of equi-marginal utility states that the consumer will distribute his
money income between the goods in such a way that the utility derived from
the last rupee spent on each good is equal". In other words, consumer gets
equilibrium when his marginal utility of money expenditure on each good is
the same.
Mathematically,
MUx/Px= MUy/Py=MUex=MUey
Where
Mu refers to marginal utility of money expenditure
Mux= refers to marginal utility of product X
MUy =refers to marginal utility of product Y
MUex=Marginal Utility for Monet expenditure for Product X
MUey= Marginal Utility for Monet expenditure for Product Y
Px-price of product X=
Py-price of product y

Suppose a consumer purchases 2 goods X and Y for his consumption, then the
law states that "The consumer will allocate his income between the two
products in such a way that marginal utility of each product is proportional to
its price".
The customer has 72 Rs total for purchase.
Price for X=6 and Price for Y=9

MUe
Quantity MUx, MUy x MUey
1 60 72 10 8
2 54 63 9 7
3 48 54 8 6
4 42 45 7 5
5 36 36 6 4
6 30 27 5 3

Comparing marginal utility of X with marginal utility of Y

Marginal utility of money for consuming 3 units of X and 1 unit of
Y is equal (8 units). The cost of this consumption bundle is (3*Rs.6=Rs.18)
+ (1 *Rs.9=Rs.9) = Rs.27. after consuming this bundle, the consumer is left with
Rs.45 (Rs 72-27). Hence this cannot be the equilibrium point of consumption as the
consumer has not fully utilized the given budget constraint of Rs.72.

5 units of biscuits and 3 units of chips gives the consumer 6 units of marginal utility
of money expenditure. By selecting this bundle, the consumer expends (5*Rs 6=Rs
30) + (3*Rs 9=Rs27) = Rs 57) and thereby left with Rs 15..therefore this
consumption bundle cannot be offer equilibrium because the consumer has not
utilized the given budget allocation.

The third consumption bundle of 6 units of X and 4 units of Y  spends (6*Rs Rs 36)
+(4+Rs 9=Rs36) = Rs 72 the entire budget allocation and hence this consumption
bundle offer the equilibrium to the consumer.
We can note that the marginal utility of money expenditure for the above stated
consumption bundle keeps on diminishing as the consumer increases his
consumption of both biscuits and chips. What will happen to total satisfaction if the
consumer decreases X by 1 unit and increase Y by 1 unit?

In our example, the EQUILIBRIUM CONSUMPTION BUNDLE consists

of 6 units of X and 4 units of Y:
According to the new consumption bundle, the consumer wants to purchase 5 units
of X and 5 units of Y. This consumption bundle offers him 6 units of marginal utility of
money expenditure. That is X offer him MU, of 6 and Y offer him MU, of 4 which are
not equal From this we can conclude that once a consumer reaches the equilibrium
point, he normally does not change the
consumption bundle in order to keep his total satisfaction utility at the highest
possible
level.
The equilibrium condition for a consumption bundle that consist of more than two  
products/services is given by the equation;
MUx/Px= MUy/Py=MUn/Pn
MUn-Utility of nth Product
Pn-Price of nth Product
At equilibrium, or at the maximum utilization
QX*Px + Qy*Py=Total Income
We can understand from figure  that the consumer has different consumption bundles
consisting of products :X and" Y.The Customer is happy at any points on budget line. Among
them consumption Bundles, 3 bundles are plotted on the figure for the explanation purpose.
Let us take those 3(points) consumption bundles A.B and C. Consumption bundle A consist O
units of X 8 units of product Y: Bundle B consists of 6 units of product X and 0 units of
product Y and bundle C consists of 6 units of X and 4 units of Y. All these bundles have a
total expenditure 72 Rs.
QX*Px + Qy*Py=Total Income
Please note that the budget line is a downward sloping line and the slope of the line is 1.5 in
this example. Slope is calculated by dividing the vertical distance by the horizontal.
It is same at any point in Budget line
12/8 or 6/4 or 3/2 =1.5
The slope of the budget line is negative because of the concept of diminishing marginal
utility; the substitution rate is supposed to come down between these 2 products.
Also from the previous explanation it is clear that maximum utilization is obtained at
equilibrium point of B, where of 6 units of X and 4 units of Y are selected.
Here the substitution ratio remains at the same level when the consumer substitutes
more and more units of one product for the other. Normally, the substitution ratio
comes down when the consumer substitutes more and more units of one product for
the other due to the diminishing characteristics of customer, means his utility
decreases by purchasing the same item again and again, and that us why the
aquarium point is giving maximum satisfaction considering the utility theory and the
indifference curve becomes convex as shown. Or the marginal rate of substitution is
getting diminished. Marginal rate of substitution is the rate in which a consumer
substitution one product to the other product.
The tangent to the indifference curve is the budget line.
3 Compensated and Ordinary Demand functions

-Ordinary Demand Curve and Compensated Demand

Curve

A Compensated demand curve

 The income effect of a price change is not considered in Compensated demand

function curves.
 Substitution effect only is evaluated
 A compensated demand curve function is therefore always less elastic while
comparing to ordinary demand curves,

In compensated demand, the utility curve is fixed. Therefore, the only change in
compensated demand will be due to substitution effect. Substitution effect changes
compensated demand from A to B.

An ordinary demand function 

It gives the effect of price on demanded quantity. A variation in price makes a substitution
and also income effect.
 
 Substitution effect –Other goods become comparatively cheaper if the price of a
particular item higher,
 Income effect –with an increment in price means higher living cost, effectively it
decreases the disposable income and unable to buy much unlike before. 

 
 

In uncompensated demand, the utility curve is not fixed. Therefore, changes in

uncompensated demand will be due to substitution effect (A-B) and income effect (B--C).
 
 
Detailed comparison of Demand Function Curves
 
The Hicksian demand curve is the demand curve that represents the connection between
price and quantity demanded, subject to the consumer maintaining a specific level of utility
while allowing expenditure to vary.

Conversely, the Marshallian demand curve is the demand curve that represents the relation
between price and quantity demanded, subject to a budget constraint while allowing utility
to differ.
An individual's demand curve shows the relationship between item costs and demand. The
more the price, the less will purchase, that is why the demand function 
slopes negative.
 
This simple relationship is the Marshallian ordinary demand curve function - if you want to
predict how much consumers will purchase at a fixed price; this is the correct curve.
 
For some purposes, I need to recognize that 2 different things happen when the price of
something changes.
 
The first one - if something gets more expensive, less likely to buy it and more likely to buy
something else. 
Corresponding notion is that of the two demand curves:

The Uncompensated (Marshallian) demand curve functions deals with how demand variation occurs 

 Corresponding notion is that of the two demand curves:

The diagram given below depicts the t wo demand curves together. 

Derivation of Compensated curves and Non compensated Ordinary Curve

 The Marshallian Uncompensated Ordinary Demand Function Curve:

 

 
The Hicksian Compensated Demand Function Curve:
The Slutsky Compensated Demand Function Curve:

Difference Between Hicks Curve and Slutsky Curve

Unit-2-Management Firms
Questions.

An engineering fimm has applied for patents on two new products and has just
learned that only one application has been successful. Compare and contrast the
optimal pricing and promotional strategies for each of these new products. 

1.Examine the methods available for demand estimation, comparing and

contrasting the explanatory and extrapolator approaches

The following points highlight the top three techniques of demand forecasting. The
techniques include: 

1. Survey Methods 

2. Opinion Poll Methods 

3. Statistical Methods.

1. Survey Methods:
Under survey methods surveys are conducted about the consumers’ intentions,
opinions of experts, survey of managerial plans, or of markets. Data obtained
through these methods are analyzed, and forecasts on demand are made. These
methods are generally used to make short-run forecast of demand.

Consumers’ Survey:
Consumers’ survey method of demand forecasting involves direct interview of the
potential consumers. Consumers are simply contacted by the interviewer and asked
how much they would be willing to purchase of a given product at a number of
alternative product price levels.

Consumers’ survey may take any form as:

a. Complete Enumeration

b. Sample Survey, or

c. End-Use Method

a. Complete Enumeration Method:

In complete enumeration survey, all the consumers of the product are contacted and
asked to indicate their plans to purchasing the production in question for the forecast
period.

The demand forecast for the’ total census consumption is obtained

simply by adding the intended demand of all consumers as:
DF = Id  + ID  +……….. ID  
1 2 n

Where,
DF = demand forecast for all consumers

ID  = intended demand of consumer 1.

1

ID  = intended demand of consumer 2.

2

The probable demand of all the consumers are summed up to obtain the sales
forecast. This method facilitates the collection of firsthand information and is free
from bias. The method has its share of disadvantages too. This method can be
applied in case of those products only whose consumers are located in a certain
region. If the consumers of the product are widely dispersed, this method proves to
be costly and time consuming. Demand estimation through this method may not be
reliable because consumers have not thought out in advance what they would do in
these hypothetical situations.

b. Sample Survey Method:

Useful data for forecasting demand can also be obtained from surveys of consumer
plans. Unlike the complete enumeration method, under the sample survey method,
only a few potential consumers from the relevant market selected through an
appropriate sampling method, are interviewed. The survey may be conducted either
through direct-interview or mailed questionnaire to the sample consumers.

Then the probable demand expressed by each selected unit is summed up to get the
total demand for the forecast period. Total sample demand is then multiplied by the
ratio of number of consuming units in the population to the number of consuming
units in the sample. If the sample selected is adequately representative of the
population, the results of the sample are more likely to be similar with the results of
the population. This method is simpler, economical and time- saving as compared to
the complete enumeration survey.

Although surveys of consumer demand can provide useful data for forecasting, their
value is highly dependent on the skills of their originators. Meaningful surveys
require careful attention to each phase of the process. Questions must be precisely
worded to avoid ambiguity. The survey sample must be properly selected so that
responses will be representative of all customers. Finally, the methods of survey
administration should produce a high response rate and avoid biasing the answers of
those surveyed. Poorly phrased questions or a nonrandom sample may result in data
that are of little value.

Even the most carefully designed surveys do not always predict consumer demand
with great accuracy. In some cases, respondents do not have enough information to
determine if they would purchase a product. In other situations, those surveyed may
be pressed for time and be unwilling to devote much thought to their answers.

Sometimes the response may reflect a desire (either conscious or unconscious) to put
oneself in a favorable light or to gain approval from those conducting the survey.
Because of these limitations, forecasts seldom rely entirely on results of consumer
surveys. Rather, these data are considered supplemental sources of information for
decision- making.

c. End-Use Method:
The end-use method of demand forecasting has considerable amount of both
theoretical and practical values. This method involves a survey of firms in all
industries using the product and projects the sale of the product under consideration
based on demand survey of the industries using this product as an intermediate
product. Demand for the final product is the end-use demand of the intermediate
product used in the production of this final product.

Except in the case of intermediate products, demand forecasting through end-use

method is neither desirable nor feasible. Further, as the number of end-users of a
product increases it becomes more and more inconvenient to use this method. This
method is quite useful for industries that are largely producers’ goods, like
aluminium.

Making forecasts by this method requires building up a schedule of probable

aggregate demand for inputs in future by consuming industries and various sectors.
In this method, technological, structural and other changes, which might influence
the demand, are taken care of in the very process of estimation. This aspect of the
end- use approach is of particular importance.

2. Opinion Poll Methods:

The opinion poll methods make demand estimation by using opinions of those who
possess knowledge of the market, such as professional marketing experts and
consultants, sales representatives and executives. The collective judgment of
knowledgeable persons can be an important source of information.

In fact, some forecasts are made almost entirely on the basis of personal insights of
key decision makers. This process may involve managers conferring to develop
projections based on their assessment of economic conditions facing the firm. In
other circumstances, the company’s sales personnel may be asked to evaluate future
prospects. In still other cases, consultants may be employed to develop forecasts
based on their knowledge of the industry.

These methods include:

i. Experts’ Opinion:
The researcher identifies the experts on the commodity whose demand forecast is
being attempted, and probes with them on the likely demand for the product in the
forecast period. This method consists of securing views of the salesmen and/ or sales
management personnel. There are many variations.

The combined view of the sales force as to future sales expectations may be secured
by carefully scrutinizing at successive executive levels and future sales estimates
submitted by the salesmen individually. Another method would be to rely only on the
specialized knowledge of the company’s sales executives in preparing sales forecasts.

ii. Delphi Method:

The Delphi method is a facilitated process of gaining consensus within a group of
anonymous participants. The facilitator sends a forecast questionnaire to each
member of the Delphi group. Anonymity is critical in this method to prevent a few
group members from dominating the decision. When the questionnaire is returned,
the responses are statistically summarized and then sent back out to the group. Each
Delphi member has the choice to modify their previous responses based on the
responses of the group. This is a reiterative process that continues until a consensus
is obtained.

The Delphi method is used for new products or for very long-range forecasts.
However, it is a time-consuming process that is highly dependent on the quality of
the questionnaires. Further, participants may provide inadequate responses because
there is no accountability.

Under Delphi method opinions are collected from experts and efforts are made to
match them. This is done by bringing the experts together, arranging meetings and
arriving at some narrow range for the forecast under attempt to give the interval
forecast directly and for arriving at a point forecast by tampering it with the overall
assessment of the researcher or the coordinator of the forecasting exercise.

Generally, the forecast proceeds through the following stages:

(i) Request is made to all the experts of product to give their individual estimates for
the likely demand.

(ii) If the difference in forecasts is significant, the experts are invited for a conference
on the subject, present the problem with regard to differences in their estimates. By
arguing, convincing others and getting convinced, exchanging views with colleagues,
efforts are made to narrow the limits for likely demand.

(iii) If the range of variations is still large the exercise continues till the coordinator is
able to arrive at an acceptable range.

(iv) Declare the so arrived range as the interval demand forecast for the product for
the period for which it is done.

(v) Take a simple average of the lower and upper values of the forecast and declare
the point forecast for the variable under forecasting.

underestimated. Indeed, the insights of those closely connected with an industry can
be of great value in forecasting

iii. Surveys of Managerial Plans:

Surveys of managerial plans can be an important source of data for forecasting. The
rationale for conducting such surveys is that plans generally form the basis for future
actions. For example, capital expenditure budgets for large corporations are usually
planned well in advance. Thus a survey of investment plans by such corporations
should provide a reasonably accurate forecast of future demand for capital goods.

iv. Market Experiments:

Market experiments (actual or simulated) are performed to generate demand
forecasts. A potential problem with survey method is that survey responses may not
translate into actual consumer behavior. Consumers do not necessarily do what they
say they are going to do. This weakness can partially be overcome by use of market
experiments designed to generate data prior to the full-scale introduction of a
product or implementation of a policy.
Market experiment can be performed in two forms:
(a) Test Market:(b) Laboratory test
.

3. Statistical Methods:

We have discussed survey and experimental methods of demand forecasting. These

methods are more appropriate estimating demand for a product for the short term.

In this section statistical methods that depend upon time-series and cross-section
data and are appropriate for long term demand forecasting have been discussed:
The following are the main statistical methods:

i. Trend Projection Methods

ii. Barometric Methods, and

iii. Econometric Methods

i. Trend Projection Methods:

Trend projection is one of the most widely used techniques of demand forecasting.
This method requires a long and reliable time series data. This method assumes that
the factors responsible for the past trends in the variable to be projected will
continue to play their part in future in the same manner and to the same extent as
they did in the past in determining and magnitude and direction of the variable.
There can be linear or nonlinear trends in demand for 

a product.

Three important techniques of trend projection based on time-series are 

(i) Graphical, Inspection or Freehand Method:
Under this method a graph of historical data on the variable under forecasting is
drawn, it is then extrapolated visually up to the forecast period, and finally the value
of the variable in the forecast period is read out from the graph to yield the requisite
forecast.

 (ii) Trend Fitting or Least Square Method:

Under this method, extrapolation of historical data is attempted through estimation
of alternative trend equations.

A trend equation is one in which the variable under forecast is made

simply as a function of time:
This technique uses statistical formulae to find the trend line which ‘best fits’ the
available data.’ The trend line is the estimating equation which can be used for
forecasting demand by extrapolating the line for future and reading the
corresponding values of sales on the graph.

Linear Trend:
The estimating linear trend equation of sales is written as:
Sales = a + b (year number)

Or S = a + bT .… …(2.3)

where, a and b are calculated from past data and

T is the year number for which the forecast is required.

 (iii) Exponential Smoothing:

If the variable under forecast does not follow any specific trend, the trend method is
inappropriate. The smoothing method would be more useful. There are versions of
the smoothing method- simple smoothing (averaging) and weighted smoothing. One
characteristic of this method is that each observation has the equal weight.

ii. Barometric Forecasting:

Trend projection and exponential smoothing use time series data for forecasting the
future. In the absence of a clear pattern in a time series, the data are of no avail for
forecasting. An alternative approach is to find a second series of data that is
correlated with the first. A time-series that is correlated with another time-series is
called an indicator of the second series. As meteorologists use barometer to forecast
weather, economists use economic indicators as a barometer to forecast trends in
business activities.

Two techniques are discussed for barometric forecasting:

1. Leading Indicators, and

2. Composite and Diffusion Indices

1. Leading Indicators Method:

This method involves three steps:
i. Identification of the leading indicator for the variable under forecasting.

ii. Estimation of the relationship between the variable under forecasting and its
leading indicator.

iii. Derivation of forecasts

Three types of economic indicators are identified for constructing the

index:
a. Leading Indicators,

b. Co-Incidental Indicators

c. Lagging Indicators.

a. Leading Indicators:
If changes in one series consistently occur prior to changes in another series, a
leading indicator has been identified. The leading indicators move up or down ahead
of some other indicators. Leading indicators are of primary interest for the purposes
of forecasting.
As a meteorologist makes use of changes in barometric pressure for weather forecast,
leading indicators can be used to predict variations in general economic conditions. 

b. Co-Incidental Indicators:

If two data series increase or decrease at the same time, one series may be regarded
as a coincident indicator of the other series. In other words, the co-incidental
economic indicators move up or down simultaneously with the level of economic
activity.

Gross national product at constant prices, rate of employment, sales by different

sectors, the rates at which commercial banks accept deposits from and lend to the
private sector are more or less the coincident series with regard to the Bank rate, rate
of employment in non-agricultural sectors are the examples of co-incidental series.

c. Lagging Indicators:
The lagging indicators follow a change after some time lag. NBER identified some of
the lagging indices such as rate for short-term loans, outstanding loans, labour cost
per unit of manufactured output and the rate at which private money lenders accept
deposits and lend to individuals is lagging series with reference to both the Bank rate
and commercial banks’ deposit and lending rates.

2. Diffusion Indices:
The construction of an index improves the barometric forecasting. Such indices
represent a single time series made up of a number of individual leading indicators.
The purpose of combining the data is to smooth out the random fluctuations in each
individual series and the resulting index provides more accurate forecasts.

The index is a measure of the proportion of the individual times series that increase
from one month to the next. 

iii. Econometric Methods:

The most popular method of demand estimation among economists is perhaps the
regression method. 

This method involves four steps:

(a) Identification of the variables that influence the demand for the good whose
function is under estimation.

(b) Collection of historical/cross section data on all the relevant variables.

(c) Choosing an appropriate form for the function.

(d) Estimation of the function.

(i) Simple Linear Regression:

Simple regression analysis is used when the quantity demanded is estimated a
function of a single independent variable such as price. In case of linear trend in the
dependent variable, we can fit a straight line to the data, whose general form would
be, for example,
Sales = a + b. Price

(ii) Multivariate Regression:

Multiple linear regression generates a forecast by linking two or more independent
variables to the demand for a product. Estimation of the parameters of an equation
with more than one independent variable is called multiple regressions

Because most economic relationships involve more than a simple relationship

between a dependent and a single independent variable, multiple regression
techniques are widely used in economics. Thus, a simple regression equation
involving only quantity and price would be incomplete and probably would result in
an incorrect estimation of the relationship between quantity and price. This is
because the effects of other variables omitted from the equation are not taken into
account. Similarly, a regression equation that included only the rate of output as the
determinant of costs could generate inaccurate results because other factors, such as
input prices, also affect costs.

Simultaneous Equations:
The simultaneous equations method, also called the complete system approach to
forecasting, is the most sophisticated econometric method of forecasting. It involves
specification of a number of economic relations, one each for behavioral variable-
estimation and solution of which yield the forecasting equations 

One outstanding advantage of this method is that in this method we estimate the
future values only predetermined variables, unlike regression equation where the
value of both exogenous and endogenous variables have to be predicted. The method
suffers from the demerit of complexity.

2.Explain what is meant by a new product, carefully defining the concept of

'newness', and examine the cost and demand estimation problems surrounding new
product pricing. A

The determination of what constitutes a “new” product remains one of the most difficult
questions faced by the marketer. D
Perhaps the best way to approach this problem is to view it from two perspectives; that of the
consumer and that of the manufacturer.
The consumer’s viewpoint
There are a variety of ways that products can be classified as new from the perspective of the
consumer. Degree of consumption modification and task experience serve as two bases for
classification. Robertson provides an insightful model when he suggests that new products
may be classified according to how much behavioral change or new learning is required by
the consumer in order to use the product. (1)
The continuum proposed by Robertson depicts the three primary categories based on the
disrupting influence the use of the product has on established consumption patterns. It is
evident that most new products would be considered continuous innovations. Annual model
changes in automobiles, appliances, and sewing machines are examples. Portable hair dryers,
diet soda, and aerobic dance CDs reflect products in the middle category. True innovations
are rare.
Although conceptualizing new products in terms of how they modify consumer consumption
patterns is useful, there is another basis for classification. New task experience can also be a
criterion. For consumer the newness depends on his past experience. Using the model
proposed by Robertson, products can also be placed on a continuum according to degree of
task experience. Clearly, a product that has existed for a great many years, such as a
carpenter’s level, may be perceived as totally new by the person attempting to build a straight
wall. In this case, newness is in the eye of the beholder.
The obvious difficulty with this classification is that it tends to be person-specific. However,
it is conceivable that marketing research would show that for certain types of products, large
groups of people have very limited experience. Consequently, the marketing strategy for such
products might include very detailed instructions, extra educational materials, and sensitivity
on the part of the sales clerk to the ignorance of the customer.
Another possible facet of a new task experience is to be familiar with a particular product but
not familiar with all of its functions. 

Continuum for classifying new products.

The firm’s viewpoint
Classifying products in terms of their newness from the perspective of the manufacturer is
also important. There are several levels of possible newness that can be derived through
changes either in production, marketing, or some combination of both
Based on a schema developed by Eberhard, new products, from the perspective of the
business, can take the following forms: (2)

 Changing the marketing mix: one can argue that whenever some element of the
marketing mix (product planning, pricing, branding, channels of distribution,
advertising, etc.) is modified, a new product emerges.
 Modification: certain features (normally product design) of an existing product are
altered, and may include external changes, technological improvements, or new
areas of applicability.
 Differentiation: within one product line, variations of the existing products are
added.
  Diversification: the addition of new product lines for other applications.

A final consideration in defining “new” is the legal ruling provided by Government agencies.
Since the term is so prevalent in product promotion, government felt obliged to limit the use
of “new” to products that are entirely new or changed in a functionally significant or
substantial respect. Moreover, the term can be used for a fixed period of time. Given the
limited uniqueness of most new products, this ruling appears reasonable.
Strategies for acquiring new products
Most large and medium-sized firms are diversified, operating in different business fields. It
would be unrealistic to assume that the individual firm is either capable or willing to develop
all new products internally. In fact, most companies simultaneously employ both internal and
external sources for new products. Both are important to the success of a business.
Internal sources
Most major corporations conduct research and development (R&D) to some extent. However,
very few companies make exclusive use of their own internal R&D. On the contrary, many
companies make excellent use of specialists to supplement their own capabilities. Still, to
depend extensively upon outside agencies for success is to run a business on the blink of
peril. Ideally, divides R&D into three parts:

 Basic research: original investigations for the advancement of scientific knowledge

that do not have specific commercial objectives, although they may be in fields of
present or potential interest to the reporting company.
 Applied research: directed toward practical applications of knowledge, specific ends
concerning products and processes.
 Development: the systematic use of scientific knowledge directed toward the
production of useful materials, devices, systems, or methods, including design and
development of prototypes and processes

External sources
External approaches to new product development range from the acquisition of entire
businesses to the acquisition of a single component needed for the internal new product
development effort of the firm. The following external sources for new products are available
to most firms.
 

 Mergers and acquisitions: Acquiring another company already successful in a field a

company wishes to enter is an effective way of introducing products while still
diversifying. Research suggests that mergers and acquisitions can take place
between companies of various sizes and backgrounds and that first experiences with
this process tend to be less than satisfactory. Even large marketers such as General
Motors engage in acquisitions.
 Licenses and patents: A patent and the related license arise from legal efforts to
protect property rights of investors or of those who own inventions. A patent is
acquired from the US Patent Office and provides legal coverage for a period of
seventeen years, which means all other manufacturers are excluded from making or
marketing the product. However, there are no foolproof ways to prevent
competition. There are two main types of patents: those for products and those for
processes. The first covers only the product’s physical attributes while the latter
 covers only a phase of a production procedure, not the product. The patent holder
has the right to its assignment or license. An assignment is any outright sale, with the
transfer of all rights of ownership conveyed to the assignee. A license is a right to use
the patent for certain considerations in accordance with specific terms, but legal title
to the patent remains with the licensor.
 Joint ventures: When two or more companies create a third organization to conduct
a new business, a joint venture exists. This organization structure emerges, primarily,
when either the risk or capital requirements are too great for any single firm to bear.
Lack of technical expertise, limited distribution networks, and unfamiliarity with
certain markets are other possible reasons. Joint ventures are common in industries
such as oil and gas, real estate, and chemicals, or between foreign and domestic
partners. Joint ventures have obvious application to product development. For
example, small firms with technological resources are afforded an opportunity to
acquire capital or marketing expertise provided by a larger firm.

New Product Pricing – Price-Skimming vs. Market-Penetration Pricing

Steps and problem  in Pricing new product.
Maturity
Appropriate pricing over the cycle depends on the development of three different
aspects of maturity, which usually move in almost parallel time paths:
1. Technical maturity, indicated by declining rate of product development, increasing
standardization among brands, and increasing stability of manufacturing processes
and knowledge about them.
2. Market maturity, indicated by consumer acceptance of the basic service idea, by
widespread belief that the products of most manufacturers will perform
satisfactorily, and by enough familiarity and sophistication to permit consumers to
compare brands competently.
3. Competitive maturity, indicated by increasing stability of market shares and price
structures.
Pricing problems start when a company finds a product that is a radical departure
from existing ways of performing a service and that is temporarily protected from
competition by patents, secrets of production, control at the point of a scarce
resource, or by other barriers. The seller here has a wide range of pricing discretion 
To get a picture of how a manufacturer should go about setting a price in the pioneer
stage, let us describe the main steps of the process (of course the classification is
arbitrary and the steps are interrelated):
 (1) Estimate of demand, 
(2) Decision on market targets, 
(3) Design of promotional strategy, 
(4) Choice of distribution channels.
Estimate of Demand
The problem at the pioneer stage differs from that in a relatively stable monopoly
because the product is beyond the experience of buyers and because the perishability
of its distinctiveness must be reckoned with. How can demand for new products be
explored? How can we find out how much people will pay for a product that has
never before been seen or used? There are several levels of refinement to this
analysis.
The initial problem of estimating demand for a new product can be broken into
a series of subproblems: (1) whether the product will go at all (assuming price is in a
competitive range), (2) what range of price will make the product economically
attractive to buyers, (3) what sales volumes can be expected at various points in this
price range, and (4) what reaction will price produce in manufacturers and sellers of
displaced substitutes.
The first step is an exploration of the preferences and educability of
consumers, always, of course, in the light of the technical feasibility of the new
product. 
The second step is marking out this competitive range of price. Vicarious pricing
experience can be secured by interviewing selected distributors who have enough
comparative knowledge of customers’ alternatives and preferences to judge what
price range would make the new product “a good value.” Direct discussions with
representative experienced industrial users have produced reliable estimates of the
“practical” range of prices
The third step, a more definite inquiry into the probable sales from
several possible prices, starts with an investigation of the prices of substitutes.
Usually the buyer has a choice of existing ways of having the same service performed;
an analysis of the costs of these choices serves as a guide in setting the price for a new
way.
Comparisons are easy and significant for industrial customers who have a costing
system to tell them the exact value, say, of a forklift truck in terms of warehouse labor
saved. Indeed, chemical companies setting up a research project to displace an
existing material often know from the start the top price that can be charged for the
new substitute in terms of cost of the present material.
The fourth step in estimating demand is to consider the possibility of
retaliation by manufacturers of displaced substitutes in the form of price cutting.
This development may not occur at all if the new product displaces only a small
market segment. If old industries do fight it out, however, their incremental costs
provide a floor to the resulting price competition and should be brought into price
plans.
Decision on Market Targets
When the company has developed some idea of the range of demand and the range of
prices that are feasible for the new product, it is in a position to make some basic
strategic decisions on market targets and promotional plans. To decide on market
objectives requires answers to several questions: What ultimate market share is
wanted for the new product? How does it fit into the present product line? What
about production methods? What are the possible distribution channels?
Design of Promotional Strategy
Initial promotion outlays are an investment in the product that cannot be recovered
until some kind of market has been established. The innovator shoulders the burden
of creating a market—educating consumers to the existence and uses of the product.
Later imitators will never have to do this job; so if the innovator does not want to be
simply a benefactor to future competitors, he or she must make pricing plans to
recover initial outlays before his or her pricing discretion evaporates.
The innovator’s basic strategic problem is to find the right mixture of price and
promotion to maximize long-run profits. He or she can choose a relatively high price
in pioneering stages, together with extravagant advertising and dealer discounts, and
plan to recover promotion costs early; or he or she can use low prices and lean
margins from the very outset in order to discourage potential competition when the
barriers of patents, distribution channels, or production techniques become
inadequate. This question is discussed further later on.
Choice of Distribution Channels
Estimation of the costs of moving the new product through the channels of 
distribution to the final consumer must enter into the pricing procedure, since these
costs govern the factory price that will result in a specified consumer price and since
it is the consumer price that matters for volume. Distributive margins are partly pure
promotional costs and partly physical distribution costs. Margins must at least cover
the distributors’ costs of warehousing, handling, and order taking. These costs are
similar to factory production costs in being related to physical capacity and its
utilization, i.e., fluctuations in production or sales volume.
 
 
The strategic decision in pricing a new product is the choice between (1) a policy of
high initial prices that skim the cream of demand and (2) a policy of low prices from
the outset serving as an active agent for market penetration. Although the actual
range of choice is much wider than this, a sharp dichotomy clarifies the issues for
consideration.
Skimming Price
The first new product pricing strategies is called price-skimming. It is also referred to
as market-skimming pricing. Price-skimming (or market-skimming) calls for setting a
high price for a new product to skim maximum revenues layer by layer from those
segments willing to pay the high price. This means that the company lowers the price
stepwise to skim maximum profit from each segment. As a result of this new product
pricing strategy, the company makes fewer but more profitable sales.
Many companies inventing new products set high initial prices in order to skim
revenues layer by layer from the market. An example for a company using this new
product pricing strategy is Apple. When it introduced the first iPhone, its initial price
was rather high for a phone. The phones were, consequently, only purchased by
customers who really wanted the new gadget and could afford to pay a high price for
it. After this segment had been skimmed for six months, Apple dropped the price
considerably to attract new buyers. Within a year, prices were dropped again. This
way, the company skimmed off the maximum amount of revenue from the various
segments of the market.
However, this new product pricing strategy does not work in all cases. Price-
skimming makes sense only under certain conditions. The product’s quality and
image must support the high initial price, and enough buyers must want the product
at that price. Also, the costs of producing smaller must not be so high that they
overshadow the advantage of charging more. And finally, competitors should not be
in sight – if they are able to enter the market easily and undercut the high price,
price-skimming does not work.

For products that represent a drastic departure from accepted ways of performing a
service, a policy of relatively high prices coupled with heavy promotional
expenditures in the early stages of market development (and lower prices at later
stages) has proved successful for many products. There are several reasons for the
success of this policy:
1. Demand is likely to be more inelastic with respect to price in the early stages than
it is when the product is full grown. This is particularly true for consumers’ goods.
Promotional elasticity is, on the other hand, quite high, particularly for products with
high unit prices such as television sets. Since it is difficult for customers to value the
service of the product in a way to price it intelligently, they are by default principally
interested in how well it will work.
2. Launching a new product with a high price is an efficient device for breaking the
market up into segments that differ in price elasticity of demand. The initial high
price serves to skim the cream of the market that is relatively insensitive to price.
Subsequent price reductions tap successively more elastic sectors of the market.
Example is the price of different editions of book.
3. This policy is safer, or at least appears so. Facing an unknown elasticity of demand,
a high initial price serves as a “refusal” price during the stage of exploration
4. Many companies are not in a position to finance the product flotation out of
distant future revenues. High cash outlays in the early stages result from heavy costs
of production and distributor organizing, in addition to the promotional investment
in the pioneer product. 
Penetration Price
The opposite new product pricing strategy of price skimming is market-penetration
pricing. Instead of setting a high initial price to skim off each segment, market-
penetration pricing refers to setting a low price for a new product to penetrate the
market quickly and deeply. Thereby, a large number of buyers and a large market
share are won, but at the expense of profitability. The high sales volume leads to
falling costs, which allows companies to cut their prices even further.
In order for this new product pricing strategy to work, several conditions must be
met. The market must be highly price sensitive so that a low price generates more
market growth and attracts a large number of buyers. Also, production and
distribution costs must decrease as sales volume increases. In other words,
economies of scale must be possible. And finally, the low price must ensure that
competition is kept out of the market, and the company using penetration pricing
must maintain its low-price position. Otherwise, the price advantage will only be of a
temporary
Quite a few products have been rescued from premature senescence by being priced
low enough to tap new markets. The reissues of important books as lower-priced
paperbacks illustrate this point particularly well. These have produced not only
commercial but intellectual renascence as well to many authors. The patterns of sales
growth of a product that had reached stability in a high-price market have undergone
sharp changes when it was suddenly priced low enough to tap new markets.
The following conditions may suggest for a penetration pricing policy.
 A high price-elasticity of demand in the short run, i.e., a high degree of
responsiveness of sales to reductions in price.
 Substantial savings in production costs as the result of greater volume—not a
necessary condition, however, since if elasticity of demand is high enough,
pricing for market expansion may be profitable without realizing production
economies.
 Product characteristics such that it will not seem bizarre when it is first fitted
into the consumers’ expenditure pattern.
 A strong threat of potential competition.
This threat of potential competition is a highly persuasive reason for penetration
pricing. One of the major objectives of most low-pricing policies in the pioneering
stages of market development is to raise entry barriers to prospective competitors.
This is appropriate when entrants must make large-scale investments to reach
minimum costs and they cannot slip into an established market by selling at
substantial discounts.
In many industries, however, the important potential competitor is a large, multiple-
product firm operating as well in other fields than that represented by the product in
question. For a firm, the most important consideration for entry is not existing
margins but the prospect of large and growing volume of sales. Present margins over
costs are not the dominant consideration because such firms are normally confident
that they can get their costs down as low as competitors’ costs if the volume of
production is large.
Therefore, when total industry sales are not expected to amount to much, a high-
margin policy can be followed because entry is improbable in view of the expectation
of low volume and because it does not matter too much to potential competitors if
the new product is introduced.
The fact remains that for products whose market potential appears big, a policy of
stayout pricing from the outset makes much more sense. When a leading soap
manufacturer developed an additive that whitened clothes and enhanced the
brilliance of colors, the company chose to take its gains in a larger share of the
market rather than in a temporary price premium. Such a decision was sound, since
the company’s competitors could be expected to match or better the product
improvement fairly promptly. Under these circumstances, the price premium would
have been short-lived, whereas the gains in market share were more likely to be
retained.
Of course, any decision to start out with lower prices must take into account the fact
that if the new product calls for capital recovery over a long period, the risk may be
great that later entrants will be able to exploit new production techniques which can
undercut the pioneer’s original cost structure. In such cases, the low-price pattern
should be adopted with a view to long-run rather than to short-run profits, with
recognition that it usually takes time to attain the volume potentialities of the
market.
It is sound to calculate profits in dollar terms rather than in percentage margins, and
to think in terms of percentage return on the investment required to produce and sell
the expanded volume rather than in terms of percentage markup. Profit calculation
should also recognize the contributions that market-development pricing can make
to the sale of other products and to the long-run future of the company. Often a
decision to use development pricing will turn on these considerations of long-term
impacts upon the firm’s total operation strategy rather than on the profits directly
attributable to the individual product.
Role of Cost
Cost should play a role in new product pricing quite different from that in traditional
ost-plus pricing. To use cost wisely requires answers to some questions of theory:
Whose cost? Which cost? What role?
As to whose cost, three persons are important: prospective buyers, existent and
potential competitors, and the producer of the new product. For each of the three,
cost should play a different role, and the concept of cost should differ accordingly.
The role of prospective buyers’ costs is to forecast their response to alternative prices
by determining what your product will do to the costs of your buyers. Rate-of-return
pricing of capital goods illustrates this buyer’s-cost approach, which is applicable in
principle to all new products.
Cost is usually the crucial estimate in appraising competitors’ capabilities. Two kinds
of competitor costs need to be forecasted. The first is for products already in the
marketplace. One purpose is to predict staying power; for this the cost concept is
competitors’ long-run incremental cost. Another purpose may be to guess the floor of
retaliation pricing; for this we need competitors’ short-run incremental cost.
The second kind is the cost of a competitive product that is unborn but that could
eventually displace yours. Time-spotted prediction of the performance
characteristics, the costs, and the probable prices of future new products is both
essential and possible. Such a prediction is essential because it determines the
economic life expectancy of your product and the shape of its competitiveness cycle.
This prediction is possible, first, because the pace of technical advance in product
design is persistent and can usually be determined by statistical study of past
progress. It is possible, second, because the rate at which competitors’ cost will slide
down the cost compression curve that results from cost-saving investments in
manufacturing equipment, methods, and worker learning is usually a logarithmic
function of cumulative output. Thus this rate can be ascertained and projected.
The producer’s cost should play several different roles in pricing a new product,
depending on the decision involved. The first decision concerns capital control. A
new product must be priced before any significant investment is made in research
and must be periodically repriced when more money is invested as its development
progresses toward market. The concept of cost that is relevant for this decision is the
predicted full cost, which should include imputed cost of capital on intangible
investment over the whole life cycle of the new product. Its profitability and
investment return are meaningless for any shorter period.
Segmentation Pricing
Particularly for new products, an important tactic is differential pricing for separated
market segments. To enhance profits, we split the market into sectors that differ in
price sensitivity, charging higher prices to those who are impervious and lower prices
to the more sensitive souls.
One requisite is the ability to identify and seal off groups of prospects who differ in
sensitivity of sales to price or differ in the effectiveness of competition (cross-
elasticity of demand). Another is that leakage from the low price segment must be
small and costs of segregation low enough to make it worthwhile.
One device is time segmentation: a skimming price strategy at the outset followed by
penetration pricing as the product matures. Another device is price-shaped
modification of a basic product to enhance traits for which one group of customers
will pay dearly (e.g., reliability for the military).
Cost Compression Curve
Cost forecasting for pricing new products should be based on the cost compression
curve, which relates real manufacturing cost per unit of value added to the
cumulative quantity produced. This cost function (sometimes labeled “learning
curve” or “experience curve”) is mainly the consequence of cost cutting investments
(largely intangible) to discover and achieve internal substitutions, automation,
worker learning, scale economies, and technological advances. Usually these move
together as a logarithmic function of accumulated output.
Cost compression curve pricing of technically advanced products (for example, a
microprocessor) epitomizes penetration pricing. It condenses the time span of the
process of cutting prices ahead of forecasted cost savings in order to beat
competitors to the bigger market and the resulting manufacturing economies that are
opened up because of creative pricing.
This cost compression curve pricing strategy, which took two decades for the Model
T’s life span, is condensed into a few months for the integrated circuit. But though
the speed and the sources of saving are different, the principle is the same: a steep
cost compression curve suggests penetration pricing of a new product. Such pricing
is most attractive when the product superiority over rivals is small and ephemeral 
1. Pricing a new product is an occasion for rethinking the overriding corporate goal.
2. The unit for making decisions and for measuring return on investment is the
entire economic life of the new product. 
3. Pricing of a new product should begin long before its birth, and repricing should
continue over its life cycle. 
4. A new product should be viewed through the eyes of the buyer. Rate of return on
customers’ investment should be the main consideration in pricing a pioneering
capital good.
5. Costs can supply useful guidance in new product pricing, but not by the
conventional wisdom of cost-plus pricing. Costs of three persons are pertinent: the
buyer, the competitor, and the producer. The role of cost differs among the three, as
does the concept of cost that is pertinent to that role: different costs for different
decisions.
6. A strategy of price skimming can be distinguished from a strategy of penetration
pricing. Skimming is appropriate at the outset for some pioneering products,
particularly when followed by penetration pricing 
7. Penetration and skimming pricing can be used at the same time in different sectors
of the market. Creating opportunities to split the market into segments that differ in
price sensitivity and in competitiveness, so as to simultaneously charge higher prices
in insensitive segments and price low to elastic sectors, can produce extra profits and
faster cost-compression for a new product. Devices are legion.

3.Opportunity cost is both subjective and speculative. As such the concept of

opportunity cost has no place in the scientific decision making process.'
Discuss

2- Opportunity Cost and Decision Making

Opportunity Cost Theory and decision making in resources allocation

 Opportunity cost theory has been defined as arising from a “foregone opportunity that has
been sacrificed” where the sacrifice of making a choice is called “opportunity cost”
(Samuelson 1967, p. 447). The notion of cost as an obstacle to decision making in the face of
multiple options is not new and there are researchers who have dealt with the theory of
opportunity cost more extensively (For example, see Solomons 1966; Becker 1968;
Buchanan 1969; Becker et al. 1974; Hoskin 1983; Northcraft and Wolf 1984; Horngren and
Foster 1987; March 1987; Zimmerman 1995; Vera-Munoz 1998). Drawing from these
streams of literature, Chenhall and Morris (1991) posit that opportunity cost is a concept
that is fundamental to choosing what 25 items should be included in the analysis of
resource allocation decision. Therefore, opportunity cost can be seen as arising from
alternative future uses of existing assets. From an accounting standpoint, opportunity cost is
defined as the maximum alternative earning that might have been obtained if a productive
good, service, or resource had been applied to some alternative use (Horngren 1972, p.
948). Balakrishman et al. (2004) argue that opportunity cost is central to a resource
allocation decision because it uncovers the next best alternative. Therefore, firms should
use cost allocations to attribute the cost of shared resources to decision alternatives. The
full spectrum of available options for consideration in any resource allocation decisions can
only be achieved when all the opportunity costs associated with each option are explicit

Opportunity Cost is a macroeconomic term that relates to scarcity of resources. Scarcity of resources – be
that time or money – means that we have to make decisions about how we use what we have. Because
we have to choose, we can only have the benefits of one option, and have to forego the benefits of the
other. The benefits of the foregone option are the Opportunity Cost.

“Opportunity cost is the cost of a foregone alternative. If you chose one alternative over another, then the
cost of choosing that alternative is an opportunity cost. Opportunity cost is the benefits you lose by
choosing one alternative over another one.”

Here are some of the benefits of knowing opportunity costs

           OPPORTUNITY COST = RESULT OF OPTION A – RESULT TO OPTION B

Where A is Lost Option and B is the Chosen Option

Classification of Opportunity Cost
4.Analyze the effects of an increase in both wage rates and labor productivity
on the costs of the firm.
Labor productivity
 is defined as real output per labor hour, and growth in labor productivity is measured as
the change in this ratio over time. Labor productivity growth is what enables workers to
produce more goods and services than they otherwise could for a given number of work
hours
 labor productivity equation: total output / total input.
Since the Labour productivity

Minimum wages 
have been defined as “the minimum amount of remuneration that an employer is
required to pay wage earners for the work performed during a given period, which
cannot be reduced by collective agreement or an individual contract”
Recent studies have shown that minimum wages not only help to reduce wage dispersion and to
channel productivity gains into higher wages, but they also can contribute to higher labor
productivity – both at the enterprise level and at the aggregate economy-wide level. At the
enterprise level, workers may be motivated to work harder. They may also stay longer with their
employer, gaining valuable experience and also encouraging employers and employee to engage in
productivity-enhancing training. At the aggregate level, minimum wages can result in more
productive firms replacing least productive ones – and surviving firms becoming more efficient.
These mechanisms can increase overall economy wide productivity.
(a)workers can be more motivated 
(b) there can be more productivity-
(c) Some firms can become more efficient 
. In economics an isocost line shows all combinations of inputs which cost the same total
amount.  Although similar to the budget constraint in consumer theory, the use of the isocost
[1][2]

line pertains to cost-minimization in production, as opposed to utility-maximization. For the two

production inputs labour and capital, with fixed unit costs of the inputs, the equation of the isocost
line is
C=rK+wL
Here the labor wages increases directly the Labor input
The Labor productivity means good services ,good machines,good envorinment
and good benefits means increasing the fixed cost or indirectly increasing the
capital(k) or Investment
Currently, the economy is functioning in a low-productivity state. One
explanation could be a decline in labor quality as highly skilled baby
boomers retire and are replaced by younger, less-experienced millennials.

 However, that explanation does not tell the entire story. Capital
deepening is an important component of productivity, and
 historically low growth of capital per hour is likely contributing
to the current low productivity state. Business and government can
increase labor productivity of workers by direct investing in or creating
incentives for increases in technology and human or physical capital.
 

 
 
where w represents the wage rate of labour, r represents the rental rate of capital, K is the
amount of capital used, L is the amount of labour used, and C is the total cost of acquiring
those quantities of the two inputs.
The absolute value of the slope of the isocost line, with capital plotted vertically and labour
plotted horizontally, equals the ratio of unit costs of labour and capital. The slope is:

 
                                      Labor Wages--🡪
 
The absolute value of the slope of the isocost line, with capital plotted vertically and labour
plotted horizontally, equals the ratio of unit costs of labour and capital. The slope is:
The isocost line is combined with the isoquant map to determine the optimal production point
at any given level of output. Specifically, the point of tangency between any isoquant and an
isocost line gives the lowest-cost combination of inputs that can produce the level of output
associated with that isoquant. Equivalently, it gives the maximum level of output that can be
produced for a given total cost of inputs. A line joining tangency points of isoquants and
isocosts (with input prices held constant) is called the expansion path.[3]

The cost-minimization problem[

The cost-minimization problem of the firm is to choose an input bundle (K,L) feasible for the
output level y that costs as little as possible. A cost-minimizing input bundle is a point on the
isoquant for the given y that is on the lowest possible isocost line. Put differently, a cost-
minimizing input bundle must satisfy two conditions:
 1. it is on the y-isoquant
2. no other point on the y-isoquant is on a lower isocost line.

The case of smooth isoquants convex to the origin

If the y-isoquant is smooth and convex to the origin and the cost-minimizing bundle involves
a positive amount of each input, then at a cost-minimizing input bundle an isocost line is
tangent to the y-isoquant. Now since the absolute value of the slope of the isocost line is the
input cost ratio , and the absolute value of the slope of an isoquant is the marginal rate of
technical substitution (MRTS), we reach the following conclusion: If the isoquants are smooth
and convex to the origin and the cost-minimizing input bundle involves a positive amount of
each input, then this bundle satisfies the following two conditions:

 It is on the y-isoquant (i.e. F(K, L) = y where F is the production function), and

 the MRTS at (K, L) equals w/r.
The condition that the MRTS be equal to w/r can be given the following intuitive
interpretation. We know that the MRTS is equal to the ratio of the marginal products of the
two inputs. So the condition that the MRTS be equal to the input cost ratio is equivalent to
the condition that the marginal product per dollar is equal for the two inputs. This condition
makes sense: at a particular input combination, if an extra dollar spent on input 1 yields more
output than an extra dollar spent on input 2, then more of input 1 should be used and less of
input 2, and so that input combination cannot be optimal. Only if a dollar spent on each input
is equally productive is the input bundle optimal.
An isocost line is a curve which shows various combinations of inputs that cost the same
total amount . For the two production inputs labour and capital, with fixed unit costs of the
inputs, the isocost curve is a straight line . The isocost line is always used to determine the
optimal production combined with the isoquant line .
if w represents the wage rate of labour, r represents the rental rate of capital, K is the amount
of capital used, L is the amount of labour used, and C is the total cost of the two inputs, than
the isocost line can be
C=rK+wL
In the figure, the point C / w on the horizontal axis represents that all the given costs are
used in labor, and the point C / r on the vertical axis represents that all the given costs are
used in capital . The line connecting these two points is the isocost line.
The slope is -w/r which represents the relative price. Any point within the isocost line
indicates that there are surplus after purchasing the combination of labor and capital at that
point. Any point outside the isocost line indicates that the combination of labor and capital is
not enough to be purchased at the given cost. Only the point in the isocost line shows the
combination that can be purchased exactly at the given cost .
If the prices of the t factors change, the isocost line will also change . Suppose w rises, so
that the maximum amount of labor that can be employed at the same cost will decrease, that
is, the intercept of the isocost line on the L axis will decrease; and because r remains
unchanged, the intercept of the isocost line on the K axis will remain unchanged.
 
 
1.An engineering firm has applied for patents on two new products and has just
learned that only one application has been successful. Compare and contrast the
optimal pricing and promotional strategies for each of these new products.
 
2. Examine the role and consequences of advertising,
contrasting the market expansion and re-distributional
implications of advertising.
3-Advertisement roles, Consequences, Market
Expansion and Redistribution

The different aspects of advertising are

1. General Roles of Advertising
2. Market Expansion, sales and Re-distributional effect of Advertisement
3. Consequence and Negative effects of Advertising
4. Tips to reduce negative effects.

General Roles of Advertising

 (1) New products Introduction in the market

 It is very difficult for an organization to make any proportional impact without
advertisement over the prospective of consumers. Immediate response and publicity is
generated by ads in Market.

(2) Educates
 Ads educate the people about new services or products –Ads on use and operation of new
products enables consumer to upgrade their idea and knowledge. It has helped them in
utilizing modern techniques of life and altering previous habits. It improved the standard of
living.

 (3) It sustains press and Media –

It gives a major source of revenue to the publishers of print media and visual media. The
circulation of publication increased and people will get them at low prices.

(4) Reputation of the advertiser 

 Advertising helps a business company to explain its gains and its efforts to satisfy the public.
Increased good will and reputation will help for completion in the field.

 (5). Reinforcement
By reinforcement people will get the feeling that they are better served and reassure
consumers that their decision is wise buying a product or service. 

(6). Reminder – 
It helps the firm to keep the brand name always fresh within human mind.

 (7) Supporting Salesmen:

For sales men the advertising reduces the effort to reach the customers efficiently.

(8) Motivating Distributors:

Distributors also get motivated by the advertisements since it is easy to reach the product to
customers.

(10) It Builds Customer Loyalty:

It generates demand and also retain the customers; They make the feeling that the
customer paying less than the original value.

 (11) Promotion Mix is the Strongest Component:

Product, promotion, place, and price mix are important. But promotion mix can do a lot. 

Market Expansion and Redistribution effects of Advertisement

The modern facilities and methods of advertisements completely changed the marketing
and redistribution of market. The market and sales becomes universal and any product can
be purchased from any more with same price. It activated completion and caparison of
quality of products.
Also some products or brands are kicked out from the market due to insufficient methods
employed in advertisement strategy. Also multinational companies with high budget for
advertisement pushed out small scale producers.
The following are the different aspects which are related to the same argument.
1.Social Media Marketing and Direct selling
Social media is the strongest way for advertisement now. The real contacts become low and
the social media connection becomes high. People may contact his friends through social
media only for business purposes or for selling their items at some times.

2. Helps in Future Growth of the Business:

It assists for future development of the business with new production units and strategies.
Advertising is a creative activity with research and development give way for understanding
the future demands of oscillating consumer characteristics. Thus whenever changes coming,
market target also expands, , redistribution  occurs. 
 
(3) Encourage and assists in mass production 
It encourages production of items on large scale basis since the enterprise knows that, with
advertising it will be able to supply the products to a large-scale market. Cost of production
reduces with huge production and market expansion.

 (4) R&D (Research and Development) is stimulated by Ads

 Research and development is must in modern scenario and it is applicable also in
advertisement. Every firm tries to overcome the competitive product of the other company.
It needs more quality and attraction. So R& D is must and no firm can be sustained in
modern market without new inventions.

(5 Increasing Sales Turnover, profit maximization

All companies allocate huge cost for ads since it helps to increase the demand and so profit
or the market expansion and redistribution occurs by advertisement.
The aim of any firm is maximize benefits.

(7) Cost Effective:
Advertisement is a selling tool. It communicates with masses within less time and directly
reduce the expenses of other activities.

(8). Persuasion 
 Persuasion is major tool for development and market expansion of product and firm. The
comparative advertising generates persuasion. A good advertising campaign assists in
getting the new customers both in the national and the international market by persuading
the consumer to purchase their products.

(9). Competitive weapon – it is powerful tool in competitive market

(9) Stimulating Primary Demand:

The advertisement for some products will encourage the use of row materials used for the
product and get good returns in that field and its demand increases.

Negative Effects of Advertising

1.On Society
Potential to create unrealistic expectation is on of negative aspect of adverting. It influences
our thoughts beyond our control and make wider cultural change of the society. work
holism, alcoholism, materialism, unhealthy lifestyle habits, unrealistic views and, political
mudslinging in advertisements negatively formulate our culture. Lies of omission are
common in advertisements
2.On Children
For children, it is difficult to identify the reality from the advertisement. They believe what
thy seeing in the advertisement., It may formulate bad thinking and bias in adult hood. The
unhealthy product is widely sold out creating false claims regarding health benefits.
3.Negative Campaign Ads
Campaign ads during elections and arguments in televisions also a part of personal or
political advertisement. The insulation and bad words are common
4.Drug Ads
Drug and medical advertisements helps to create awareness within the society but the
problem is the emphasis given. Only the good side is spread keeping silence about the side
effects. Even Medical practitioners are facing issues related to this aspect of ads.
5.Body Imaging Ads
Diet, weight loss, beauty and exercise ads create false and extreme negative aspect
regarding the size, shape and color of people and the ads cerate wrong standards for health,
life style and physical body part measurements. It also generates discrimination just based
on natural parameters of human beings.
6.Gender roles
Some ads assign certain tasks to female and some other tasks to men creating
discrimination based on sex.it reinforce stereo type classification like cleaning, beauty, diet
products by female while vehicle, tools and beer by male.
7.Inferior products sales
Some sellers promote inferior items by ads and selling with high price due to false claims.
8.Bad taste
Social decay is caused by certain ads which using objectionable pictures and Foul language.
Such ads hurts feelings and so are widely criticized by the people. Means its taste is bad.
Steps to avoid Negative effects of Advertising
1.Legal government laws to control the ads .
.2.Limiting the screen time
.3.Mute commercials ads
 4.Discussions about advertisements with their children
5.Proper training like neuro feedback and alpha waves activation to do correct decision
making

 
Determining an advertising budget
An advertising budget is the amount of money allocated for the advertisement of one
product or service.It can have sales and communication objectives.There are two
models with Sales-Advertising Budget Expenditure function. Concave and S-shaped
functions
 
The methods for determining advertisement budget are
1. The Percentage of Sales Approach 
2. The All-You-Can Afford Approach –The affordable method
3. The Return on Investment Approach 
4. The Objective and Task Approach
 5. The Competitive Parity Approach.
The Percentage of Sales Approach:
In this method, the sales value of the preceding year is first taken and then the
expected sales during the year in question are arrived at. Thereafter, some
percentage of the expected sales is considered..
This method was dominant in the past and even now it is widely used. It may be a
fixed percentage or a percentage that varies with conditions of sales. The method is
simple in calculation. In this method, a clear relationship exists between sales and
advertising expenses. By adopting this method advertisement war can be avoided.
In spite of these advantages, this method has little to justify it. This method does not
provide a logical basis for choosing the specific percentage except what has been
done in the past or what competitors are doing. It discourages experimenting with
countercyclical promotion or aggressive spending.
The aim of advertising is to increase the demand for the product and therefore it
should be viewed as the cause, not the result of sales. But this approach views
advertising on the results of sales. It leads to a budget set by the availability of funds
rather than by market opportunities.
The All-You-Can Afford Approach:
Under this approach, a company spends as much on advertising as it can afford. It
can spend for advertising as much as the funds permit. From the name itself, it is
clear that the affordable amount set aside for advertising is known as affordable
method. This approach appears to be more realistic, for all companies generally
spend that much amount on advertisements which they can afford, even though they
may not say so.
As advertising outlays are growing out of all proportions in the modern business, this
method seems to provide a basis for many firms with regard to advertising outlet.
Generally, a firm has to take into account the financial constraints while resorting to
advertisement schemes.
This approach to spending on advertising sometimes proves uneconomical. The
point up to which a firm can afford to spend is a limiting point. If the increase in sales
does not match the expenditure on advertising, it is evident that this is not a wise or
economical way of determining the budget.
This approach is helpful in the following ways in determining the advertising
budget:
(i) “It produces a fairly defensible cyclical timing of that part of advertising outlay that
has cumulative long-run efforts.”
 (ii) This method is more suitable to the marginal firms.
(iii) This method sets a reasonable limit to the expenditure to be incurred on
advertising.
However, the method has got some inherent weaknesses and they are the
following:
(i) It is difficult to plan long-term marketing development.
(ii) The opportunities of advertising may be overlooked.
The Return on Investment Approach:
This approach treats advertisement as a capital investment rather than as a more
current expenditure.
Advertising has a two-fold effect:
(i) It increases current sales.
(ii) It builds up future goodwill.
An increase in current sales involves such decisions as the selection of the optimum
rate of output in order to maximise short run profits. The building up of goodwill for
the future calls for a selection of the pattern of investment which is expected to
produce the best scale of production, leading to the maximum long run profits.
This method emphasizes the relation between advertisement and sales. Sales are
measured with advertising and without advertising. The rate of return provides a
basis for advertising budgeting, as the available funds will have to be distributed
among various kinds of internal investment on the basis of prospective rate of return.
The limitation to the return on investment approach is that one cannot accurately
judge the rate of return as advertising investment.
It involves the following problems and they are:
 (i) Problem of measuring the effect of advertisement accumulation as long run sales
volume.
(ii) Problem of estimating the evaporation of the cumulative effects of advertising,
and
(iii) Problem of distinguishing of investment advertising from outlays for immediate
effect.
The Objective and Task Approach:
This method is also known as the research objective method. This method became
prominent during the war time. This method calls upon marketers to develop their
promotion budgets by defining their specific objectives, determining the tasks that
must be performed to achieve these objectives and estimating the cost of performing
these tasks. The sum of these costs in the proposed budget.
This approach is an improvement over the percentage of sales approach. But the
fundamental relationship between the objectives and the advertising media again
depends upon the past experience of the firm. In reality, tasks to be determined
should be related to the objectives of the firm and to the past records of the firm.
This method has the following advantages:
(i) It requires management to spell out its assumption about the relationship between
amount spent, exposure level, trial rates and regular usage.
(ii) This method can be extended to highly promising experimental and marginal
approaches.
(iii) With the help of this method a clear advertisement programme can be drawn.
There are inherent defects in this approach. The important problem of the method is
to measure the value of such objectives and to determine whether they are worth the
cost of attaining them. 
The Competitive Parity Approach:
This approach is nothing but a variant of the percentage of sales approach. A firm
sets its budget solely depending upon the basis of competitors expenditure. The
advertising cost is decided on the basis of spending for advertising by the
competitors in the same industry.
Two arguments are advanced for this method. One is that the competitors’
expenditures represent the collective wisdom of the industry. The other is that it
maintains a competitive parity which helps to prevent promotion wars.
The defensive logic of large proportion of advertising outlay aims at checking the
inroads that might be made by competitors. The money which an individual firm
spends does not reveal how much it can afford to spend in order to equate its
marginal benefits with marginal costs. He finds that no correlation appears to exist
between the outlay and the size of the firm.
Another advantage of this method is that it safeguards against advertising wars. The
main advantages of the method are simplicity and security of its use. For this a firm
has to collect relevant data about competitors. If it is quite easy for the firm then it is
quite easy for it to follow its competitors.
The major problem in this method is that the firm has to identify itself with others in
the industry. Another problem is that it breeds complacency.
Pay out planning
.
. It is useful when introducing a new product.• The aim is to spend heavily to achieve
increased awareness and product acceptance..• It estimates the investment value of
advertising by linking it to other budgeting methods.The idea is to predict the amount
of revenue the product will generate and the costs it will incur over a period of time
The advertising budget is determined on the basis of rate of return desired.Preparing
a payout plan depends upon accuracy of sales forecast, factors affecting market,
estimated costs.Initially the advertising expenditures will be high and eventually will
reach a break-even point and then will show decline and increase in sales following
the S shaped Function.
Advantages
1. It is useful and logical planning tool
Disadvantages
• It cannot account for uncontrolled factors e.g. - competition, changes in government
Policies, new technology
Quantitative Models
• Advertisers use quantitative methods such as mathematical and statistical models
to allocate advertising budget .Multiple regression analysis is used to determine the
effect of advertising expenditure sales. Experimentation and formal analysis is
required to use this method.It is an expensive and time consuming method
The Experimental approach -
It is an alternative to quantitative models. The Advertising manager conducts tests or
experiments in one or more selected areas. The Advertising strategy is tested in
market areas with similar population of market share. Different advertising
expenditure levels are kept for each market. Brand awareness and sales levels are
measured before and after. Results are compared and variation of influence of
advertising expenditure studied. The feedback results determine the advertising
budget levels. Manager may decide a certain budget level according to the
advertising objectives
Disadvantages
It is expensive and time consuming
It ignores uncontrollable factors
It not universally accepted
 
4. Critically assess the methods used to generate empirical estimates of both
short-and long-run cost functions. Do the empirical difficulties encountered
rob the Resulting estimates of any general operational utility?
Here we will discuss three major aspects of Empirical cost functions, the sub
functions and the problems encountered in each models.

No:1 Short-Run Cost  functions and Estimation

a)Simple Extrapolation; b) Gradient Analysis:(c) Time-Series Regression Analysis; d)
The Engineering Technique:
 
No:2. Long Run Cost functions and Estimation:
a) Cross-Section Method; b) The Survival Principle; c) The Engineering Technique:
No 3. Cost Forecasting
No:1 Short-Run Cost  functions and Estimation
a)Simple Extrapolation:
The term ‘extrapolation’ refers to the assignment of value to a sequence of results,
beyond the range of these actually given or determined. Unless we have a known
functional relation between the results, any process of extrapolation assumes “that a
relation is maintained beyond the range and domain for which it is actually
established.”
The simplest method of short-run cost estimation is “probably to ascertain the
present level of marginal or average variable costs and extrapolate this backward or
forward to other output levels.” Most business managers believe that both marginal
and average variable costs of their plants are constant over a range of output levels
surrounding the current output level.
This implies that constant returns to the variable factors occur over this range of
output. If this constant efficiency situation actually exists in the short-run production
process, then the simple extrapolation method of cost estimation gives accurate
results.
Difficulty Encountered
In reality, the short run production function exhibits diminishing returns to variable
factor, i.e., marginal costs rise after a certain stage of the production process.
Therefore, if marginal costs are simply believed to remain constant, when, in fact,
they are increasing with every additional unit of output; the simple extrapolation
method may give erroneous results and thus cause poor decisions to be made.
b) Gradient Analysis:
Gradient is the measure of the steepness of a slope, expressed in the Cartesian
plane as the ratio between differences of ordinates and abscissae. Then the gradient
of the line PQ joining P(x , y ) to Q(x ,y ) is given by y -y /x – x .
1 1 2 2 2 1 2 1

It is then equal to tan 8, where 6 is the angle of slope 

Since output of a business firm does fluctuate from period to period, it is possible to
find two or more cost/output observations, in which case one can conduct gradient
analysis. It may be noted that the gradient of each cost category is the rate at which
that cost category changes with changes in the level of output.
If we exclude those cost changes which are not the result of changes in the output
level, we can estimate the marginal cost (per unit) over range of output under
observation on the basis of the sum of the gradients.
In fact, three or more observations permit gradient analysis to accurately estimate
the change in marginal costs with changes in output levels. If we have various
cost/output observations, we can make use of the technique of regression analysis
for short-run cost estimation.
(c) Time-Series Regression Analysis:
If we have a set of cost-output observations, we can apply regression analysis to
estimate the functional dependence of costs upon the volume of output and thus
arrive at an estimate of the marginal cost. If our object is to estimate the cost function
for a particular firm, we must make use of time- series data from the firm.
Difficulty encountered
If over the observation period, some factors have changed, the results of regression
analysis will be less reliable. Changes in factor prices, for instance, due to inflation or
market forces and/or factor productivities due to technological change and
improvement in efficiency of labor may make regression analysis irrelevant.
To eliminate these problems to the maximum possible extent the cost data should be
appropriately deflated by the price index and time should be included as an
independent variable in the regression equation. 
One major drawback of this method is that it is subject to problems of measurement
error. The cost/output observations should be the result of considerable fluctuations
of output over a short period of time with no cost/output matching problems.
Moreover, the choice of the functional form of the regression equation has major
implications for the estimate of the marginal cost curve which will be indicated by the
regression analysis
If the short-run cost function is linear, i.e., if we specify that total variable cost is a
linear function of output such as TVC = a + bQ, the marginal cost estimation
generated by the regression analysis will be the parameter b. It is because marginal
cost is the total variable cost function with respect to output changes.
For a given set of data (based on various observations), the consequent average
variable cost and marginal cost curves that would be generated by regression
analysis in this case. In this case, the AVC will decline to approach the MC curve
asymptotically.

Linier Variable Cost function

 
Alternatively, for the same set of data, we can use a quadratic cost function such as
TVC = a + bQ + cQ . In this case, the marginal cost will rise as a constant function of
2

output. The below hypothesized quadratic relationship is superimposed upon the

same data observations, with the resultant AVC and MC curves illustrated in the
bottom half of the diagram.
 

Quadratic variable Cost function

 
Finally, if we specify the functional form to be cubic, such as TVC = a -bQ- cQ  + dQ ,
2 3

the estimate of MC generated by regression analysis will be curvilinear and will

increase as the sequence of the output level. We can alternatively specify the
functional relationship to be a power function. 

Cubic variable Cost function

 
 
The choice of the functional form depends upon the degree of accuracy to be
achieved. It may be possible to ascertain that one of the above three functional
forms best represents the apparent relationship existing between the two variables
and piece of information may be used for decision-making.
d) The Engineering Technique:
An alternative method of cost estimation is known as the engineering technique. It
simply consists of developing the relation that exists between the inputs and the
output (on the basis of the physical production function) and attaching cost values to
the inputs in order to obtain a TVC figure for each level of output.
We then have to calculate, or test for each level of output, the amount of each of the
variable factors necessary to produce that level of output. By attaching costs to these
variable factors, it is possible subsequently to calculate (estimate) the TVC for each
level of output and the corresponding AVC and MC.
The average and marginal cost curves on the basis of actual data are shown below.
Interpolating through these observations it is possible to estimate marginal and
average costs by using the engineering technique.
Moreover, it is also possible to determine incremental costs associated with any
decision to increase or decrease output levels on the basis of the variable costs as
calculated by one or a combination of the above methods, after making an allowance
for any opportunity costs that are involved and any incremental fixed costs that may
be necessitated.
It is necessary to calculate incremental fixed costs on the basis of the knowledge of
the production capacity of the fixed factors involved. This, in its turn, may require an
engineering-type investigation of the output capacities of particular fixed facilities.
Studies of Short-run Cost Behavior:
Numerous empirical estimates of short-run cost have led to the conclusion that
marginal cost tends to be constant in the operating range of the firms studied.
Hence, it follows that AVC is constant at the same level (or is asymptotically
approaching that level) and declining due to the influence of declining AFC. ATC will
also decline. In other words, in most cases, a linear TVC function provides the best
fit to the data observations.
No:2. Long Run Cost Estimation:
a) Cross-Section Method; b) The Survival Principle; c) The Engineering
Technique:
a) Cross-Section Method:
The long-run cost function can be estimated using either time-series cost-output data
collected on a plant (or firm) whose size has been variable over time, or cross-
sectional cost-output data collected on a sample of plants (firms) of different sizes at
a particular point in time.
We cannot use time-series cost-output data dueto the usual problems of holding
constant all other factors (except output) that affect costs. Due to technological
change and development of new products in the product line, the long-run cost curve
may shift over time. If it is not possible to hold the effects of such changes constant..
Moreover, using time-series requires that costs be deflated to reflect changes in
prices over long periods of time.
The above reason justifies the use of the cross- sectional data in estimating long run
cost functions. Data observations from various plants at a fixed time period may be
analyzed using the technique of regression analysis. Thus the researcher should
collect pairs of data observations relating the output level, to the total cost of
obtaining the output level in each plant, for a very short period of time.
Measures should be taken in such as a way as to avoid errors of measurement
relating either to the actual level or rate of output in that period, or to the actual level
of costs that should be associated with the level of output in each plant observed.
There is also need to specify the functional form of the equation and the problem
here is the same as in the case of short-run cost estimation. We have to choose the
functional form that best fits the data observations subject to each variable
determining cost being significant at an acceptable level.
The behavior of long run average cost largely depends on economies and
diseconomies of scale. Therefore, the cubic function which is consistent with
economies and diseconomies of plant size would be most appropriate. If, however, a
linear function best fits the data, we may be driven to the conclusion that increasing
returns to plant size prevail over the range of data observations.
Finally, if a power function best fits the data, the numerical value of the exponent to
the output variable will indicate whether returns to plant size are increasing (if it is
less than one), or constant (if equal to one), or decreasing (if it is greater than one).
Problem Encountered
In addition to this problem which arises in a short-run cost analysis, further difficulties
of a conceptual nature are also encountered in estimating the long-run cost-output
relationship by statistical methods.
One major problem with cross-section data is that the observations collected may
not be points on the long-run average cost curve at all. This is shown in Figure. It
depicts the five short run average cost curves (SAC , SAC etc.) of a firm. Each curve
1 2 

corresponds to a specific plant. The estimated output/cost values are shown by the
point on each short run cost curve marked by an asterisk.
 

Estimation of LAC from cross section

This small piece of information suggests that the above analysis has over-estimated
the presence of economies and diseconomies of plant size in this particular case. It
is because of the fact that the observation points for each plant were not points of
tangency with the actual long-run cost curve.
The second problem that may arise with cross- section data is that various plants
may be operating in different areas or under different economic and non-economic
environments.
As a result, there may be differences in factor prices and factory productivities
among the plants. If this problem exists, there may be cost differences among plants
due to the two above factors and regression analysis may fail to give accurate
results.
b) The Survival Principle:
If there are economies of scale that a firm fails to exploit, long run average cost of
production will be higher than of competing firms; the firm will be too small for
efficient operation and must either grow or perish.
Many people believe that production by larger firms will be less costly on average
than by small firms. Even if a firm has to be large enough to exploit the economies of
scale that are available, bigger plants may encounter diseconomies of scale and be
forced to reduce the scope of their operations or sink.
If firms (production facilities) of a particular size tend to exist in an industry, this is
considered to be a good evidence of the requisites size that is most efficient. This is
known as the survival principle put forward by G. Stigler in 1958. Some economists
have used this principle to determine the most efficient scale of operations for a
particular industry.
Stigler has devised a test for the presence or absence of economies or
diseconomies of plant size in specific industries which is based upon the survival
principle stated above. The implication is that the most efficient firms will be able to
survive in the long run and even increase their market share, while the less efficient
ones will tend to become less important in that industry with the passage of time.
The survival principle is a method of determining the optimum size (or range of
sizes) of firms within an industry. Stigler’s procedure was to classify the firms in an
industry by size and calculating the share of industry output coming from each size
class over time.
If the share of industry output of a given class tends to decline over time, then this
size class is presumed to be relatively inefficient and to have higher LACs. On the
contrary, an increasing share of industry output over time indicates that the size
class is relatively efficient and has lower LACs.
The rationale of this approach is that the forces of competition will tend to eliminate
relatively inefficient firms, leaving only efficient (low-cost) firms to survive in the long
run.
Difficulties encountered
However, this method has two major limitations as well. Firstly, it does not utilize
actual cost data in the analysis. Thus, it is not possible to assess the magnitude of
the cost differentials among firms of differing size and efficiency. Secondly, due to
legal factors, the LAC curve derived by this technique may be distorted and may fail
to measure the cost curve postulated in traditional economics.
c) The Engineering Technique:
The engineering technique used in short-run cost functions may also be applied to
several plants of different sizes, at the same point in time, to arrive at an estimate of
the long-run cost function.
This approach needs a knowledge of production facilities and technology (such as
speed of machines, labour productivity and physical input-output transformation
relationships) to determine the most efficient (lowest average cost) combination of
resources (capital, labour, materials, etc.) to produce various levels of output.
It may be recalled that in the context of short- run cost estimation, the engineering
technique was used to find the cost curves of a particular firm at’ a fixed point of
time. If the same exercise is carried out with other plants that are available, one
would be able to trace out a series of short-run cost curves that are available to the
firm at a definite time period.
Diagram shows a hypothetical situation in which five different sizes of plants have
been observed and the SAC curve of each has been derived by the engineering
technique. The envelope of the SAC curves is the LAC curve.
One can infer that initially there are economies of plant size as one move from the
first plant to the second plant. This stage is followed by relatively constant returns to
plant size as one progress to the third and fourth plant, and decreasing returns to
plant size with the largest plant available.

Engineering Technique of Long Run Cost Estimation

The engineering method has three major advantages over statistical methods.
Firstly, it is generally much easier with the engineering method to hold constant such
factors as prices of factors, product mix and production efficiency (technological
progress).This enables us to isolate the effects of changes in output on costs.
Secondly, the long-run cost function obtained by the engineering method is based on
current technology whereas the function obtained by the statistical method is based
on a mix of old and current technology. Finally, the engineering methods make it
possible to avoid some of the accounting problems normally encountered when
using the statistical approach.
Problem Encountered
The major disadvantage of the method is that it deals only with the technical aspects
of the production process or plant. It completely ignores various other aspects
affecting cost behavior such as “the management and entrepreneurial aspects, such
as recruiting and training workers, marketing the product(s), financing the operation
and administering the organization.
 General Managerial uses of Empirical Cost Functions:
Various important managerial decisions are based on estimates of cost curves such
as short- run choices of rates of output and prices, and long- run decisions about
numbers, sizes and locations of plants.
Pricing and output decisions are perhaps the most important for a profit-maximising
firm. Such decisions must be based on reliable estimates of short-run cost functions.
Capital investment decisions such as plant construction or expansion are long-term
decisions and are usually based on estimates of long-run cost functions. Long-run
cost functions enable progressive organizations to determine whether or not to make
the investment, and what should be optimum size of the plant under the present
conditions. Decisions on plant size are largely based on an accurate estimate of
demand.
General Limitations of Empirical Cost Functions
Investment decision is most complex because demand can shift over time.
Moreover, the structure of factors affecting cost may also be expected to shift. These
factors make it advisable to build or expand plants in substantial increments of
capacity.
It is important to note that past production and cost relationships may not always be
relevant to decisions about future investments in plant and equipment.
Empirical (statistical) estimates may require adjustments to reflect changes in future
prices, input combinations, nature of the product, product mix, scale of output, scale
of plant, the nature of the conversion process (i.e., conversion of inputs into output)
and so forth; all these are expected to effect future costs. Costs of future periods
may not behave in the same way as that in the past.
NO 3. Cost Forecasting:
Cost forecasting, is an important topic in managerial economics. It must be
emphasized at the very outset that cost forecasting has to be differentiated from
what is known as cost estimation.
The short and long run cost functions can be statistically estimated. It is this process
of statistical determination of the cost-output relationship that is referred to as cost
estimation. Both short and long-run cost functions refer to the cost of production of
the company at various levels of output.
The only difference between these two cost functions is that, in the short- run
function, the plant size is taken to be fixed while in the long-run function, it is
considered to be variable. It is to be specifically noted that the long-run cost function
does not refer to cost of production in the future.
It tells us what the cost of production at alternative levels of output would be today if
each level of output could be produced at an optimal plant size. Cost forecasting, on
the other hand, refers explicitly to the future. The question here is: what would be the
cost of production (of, say, a specified level of output) in the future?
A company must know its cost function before it can hope to take optimal decisions
regarding the level of output to be produced and the size of the plant to be built.
Problem Encountered
If the production function and the prices of inputs remain unchanged, the cost
function will be totally unchanged. It will be exactly the same as it is today. The
problem of cost forecasting arises because neither the production function nor the
prices of the inputs would necessarily remain unchanged in the future.
The production function is a technological relationship between output and inputs. If
productivity of the inputs changes (i.e., if from the same amounts of inputs we can
extract a different level of output) the production function will change.
The prices of inputs used by the company, on the other hand, would change in pace
with the general level of factor prices (or, more generally, with the process of inflation
or deflation) in the economy. 
 
5."Profit is the maximum value a company can distribute during the year and still
expect to be worth as much at the end of the year as it was at the beginning.
Discuss this statement, and comment on its value in measuring profit for decision-
Making.
 
Profits value the company as they increase the overall share prices and thus market
capitalization and subsequently the enterprise value can change dramatically.

Measuring profits helps management decide on dividend payments and total free operating
cash flows and mutually decide on employee stock options.
Nowadays, the very actual and important problem in the management of enterprises is the
issue of recognized profit quantification and its correct distribution. The problem is that
enterprises use accrual accounting with a recognized profit, but with cash flows not allowing
them to continue to do business and pay out the shares smoothly. This means the enterprise
needs to indebt itself to be able to provide assets recovery and pay out the shares, which leads
to the expensive and uneconomic equity capital. The greater distribution of profits, as is the
amount of the real level of the enterprise's distributable reserves profit of the business causes
reduction of business property and in future reduction in the production ability of the
enterprise to the extent causing an involuntary closing of business activities. The analysis of
the business property's changing trends of the entity should be one of the most important
tasks of the financial analysis for the assessment of the financial situation of the enterprise.
So it very important to measure the actual profit, its quantification for any decision making
on its allocation. A thorough analysis of the reported accounting profit must be the starting
point for the allocation of profit, which does not compromise the further existence of the
enterprise.
 Accounting is always the starting point for determining the economic result of a business,
whether profit or loss. It is the only accounting tool that needs to be considered, given the
summaries of the company's revenues and expenses for the accounting period, the difference
of which represents the achieved economic result. The adjustment of bookkeeping and
financial statements is always dependent on the business environment law in the country in
which the enterprise operates. Several countries currently draw on International Financial
Reporting Standards (IFRS) when drawing up their financial statements. According to IASB,
around 140 countries have adopted the IFRS to some extent. Leuz and Wysocki (2008)
highlight the influence of political, legal, cultural and social environment on the economic
institutions, as well as capital market, financial reporting, ownership structures, their
dividend policy, protection of creditors and investors. The development of IFRS (IAS)
was bound to the requirements of the professional institutions regarding unification of the
financial reporting in line with the need to satisfy investors' needs on capital markets to have
timely and relevant information and evaluates consequences of their adoption in both,
positive and negative aspects. To reach a society-wide advantage resulting from the
international harmonization of financial reporting, some specific prerequisites must be met,
as it is not possible to regulate centrally the application of any unified rules. The basic
prerequisites are incentives for companies when applying standards, as well as a functional
way of their enforcement. However, mere meeting these prerequisites and using standards
cannot guarantee the very quality of accounting and making true and accurate picture on a
given accounting unit in financial reporting. The quality of accounting is achieved based on
the function of internal regulations of the given accounting unit, and by its way of financial
reporting standards application. The quality of accounting can be neither increased nor
decreased by merely changing the accounting standards. Mandatory or voluntary adoption of
the international framework of the financial reporting within the countries must be set for the
special conditions of a given country otherwise their application is ineffective and more
problematic then effective. Therefore, the mandatory or voluntary adoption of these special
conditions for the financial reporting standards application in selected accounting units and
countries must be secured, so the internationally harmonised accounting can be used.
Influence of such institutional impacts and frameworks on information reporting in the
statements of finances, reporting and quality of income trading, protection of investors,. IFRS
clearly does not solve the issue of profit-sharing and management decisions aimed at
preserving business property and production ability in the future. Rather, it is about
adjusting financial reporting to the correct reporting of past events of the enterprise in
financial terms. In the context of a critical analysis of profit quantification and its
distributionin Selection of the appropriate concept of capital maintenance should be based
on the principle that profit should not be reported until the enterprise during an accounting
period maintains the amount of its net assets in both financial and physical terms 
2. BUSINESS PROPERTY AND BUSINESS DEVELOPMENT   
Business property is the most important indicator to identify and assign a portion of the
accounting profit, corresponding to the non-realised profit and fictitious profit to continued
decision-making of managers, associates and shareholders. To ensure a good future in doing
business, enterprises should orient to sustainable business property. The decision on the way
of division of the reported profit, any undertaking received in the present is therefore a
strategic one, especially in relation to the future of the business. The strategy determines the
long-term objectives, procedures for activity realization and distribution of resources., 
strategic management is in the responsibility of its owners, top management and department
of strategic management. When creating the strategy, it is necessary to analyse external
environment and internal environment and select the appropriate strategy based on the
results. External factors are “accepted” by an entity and must be adapted to the new
conditions. Organizing the movement of capital, cash, receivables and payables is the content
of the entity`s financial strategy for enterprise development. The movement of the parameters
quantifies the benefits of all business activities therefore financial strategy is an important
part of entity's management. 
2.1 Understanding the business property   
The understanding of the business property must always be a criterion for correct determining
of the accounting unit's economic result, as well as its distributable part. This issue is closely
connected with the used methods of valuations admitted by financial accountancy laws and
applied by an accounting unit. A detailed analysis of the development of the business capital
as a future production and performance ability of the property and capital development as a
source of coverage for this capital should be one of the basic tasks of the financial
analysis .This analysis should not only be made once in few years, but at least periodically to
the date of statement of finances, because usually there is no linear growth or decline of the
accounting unit's business property, but periods of growth and decline change in irregular
intervals. Too long interval between these individual analyses can lead to the situation when
an accounting unit does not recognize the threat of a business property decline on time and
does not adopt measures to reverse an adverse situation in a good time. The basic source of
information provision for the financial analysis; for the correct assessment of the accounting
unit's financial situation, development of a change in a business property and capital invested
by owners in an enterprise should by accounting, and predominantly statements of
finances .The decline of the accounting unit's business property may be caused by the
reported loss or by higher profit distribution in comparison with the sum of actually achieved
distributable profit.   The basic division of the understanding of the business property to
capital, proprietary and performance of the business property may be further divided
according to the way of quantification into absolute and relative 
 Absolute capital understanding of the business property is quantified in an absolute sum of
financial means invested by owners. 
 Relative capital understanding of the business property is quantified as a share of invested
financial means by owners in the total sum of capital – own and borrowed. 
 
 Absolute understanding of the business property according to the proprietary is
quantified as total netto sum of a property in financial units. 
 Relative understanding of the business property according to the proprietary is
quantified as shares of individual proprietary on a total property in percentage. In the
sum it is 100%. 
 Absolute expression of business property performance is quantified as a sum of a
performance – overall production of an enterprise in measurement units of
performance (e.g. in pieces) a year. 
 Relative expression of business property performance is quantified as shares of
property components on achieved total production of a performance in percentage.
In the sum it is 100%.

5. DECISION-MAKING BASED ON THE CONSTRUCTIVE CRITICAL ANALYSIS

OF PROFIT CREATION AND QUANTIFICATION   
In decision-making processes of the enterprise, the management must constantly
use the information provided by an accounting, should it be information from the past
(financial accounting), or future predictions (managerial accounting). Quantification
of the distributable profit and the correct justification of an investor's proposal for the
profit distribution is one of the most important decisions the management must make
every year because the share of own and borrowed sources in the enterprise
operations financing is one of the most important things, as regards the future
development of the enterprise
. 
 CONSTRUCTIVE CRITICAL ANALYSIS OF PROFIT  

Commercial Code only states in its provisions regulating creation and use of
legitimate reserve fund and indivisible fund in commercial corporations, minimal
mandatory profit allowances to the funds, having only a partial “bad times”
cumulative and safeguarding effect for the enterprises. Commercial Code does not
state how to divide the profit beyond these mandatory allowances to the funds, e.g.
regarding the preservation of assets. A thorough analysis of reported business profit
must be the base for the profit division, in a way the further existence of the
enterprises would be preserved .It is important to be able to identify and earmark
from the business profit a part that would correspond to the non-realised profit and
virtual profit, as a potential release of those outside the enterprises would threaten
their future performance. These parts of reported profit do not correspond to the real
produced, realized and real performance, which is a necessary precondition to
achieve a real profit. A realised profit is a profit arising from the comparison of
revenues and costs of a respective property type sale, or associated to the service
provided outside the enterprise. The non-realised profit, arising from the result-based
revaluation of property to its increased real value, or from declaring exchange rate
profits when recalculating assets and liabilities in a foreign currency as of the date of
financial statements, shall be, until it is realised, a fictitious profit, that does not have
to be realised in the future and until that happens the very basis of the enterprise
erodes and its ability to fully perform its activities, being a precondition of revenue
generation is jeopardized, as it is not able to reproduce its property.
Quantification of real profit
So the distribution of the achieved financial result, especially profit, is important in order to preserve
the property in the business entity, thus ensuring that the enterprise operates in the future. The
analysis of the business property's changing trends of the entity should be one of the most
important tasks of the financial analysis for the assessment of the financial situation of the
enterprise. The decrease of the business property can cause a future reduction in the production
ability of the enterprise to the extent causing an involuntary closing of business activities. The
reduction of business property is usually caused not only by the reported loss, but also by the
greater distribution of profits, as is the amount of the real level of the enterprise's distributable
reserves profit of the business. A thorough analysis of the reported accounting profit must be the
starting point for the allocation of profit, which does not compromise the further existence of the
enterprise. It is important to be able to identify and assign a portion of the accounting profit,
corresponding to the non-realised profit and fictitious profit, where eventual release outside the
enterprise threatens the future performance of the enterprise. These portions of the reported profit
do not correspond to the actually made, realised and real production, which is a necessary condition
to achieve a real profit. The division of real profit to the investors is the only thing that will not cause
a threat to the existing abilities of an enterprise, neither in the short nor the long term. The decision
on the way of division of the reported profit, any undertaking received in the present is therefore a
strategic, especially in relation to the future of the business. For sustainable business development it
is a relevant tool retention of the proceeds in enterprise by sustainable and growing business
property in financial (monetary) understanding and physical (material) understanding as well. Since
the main of entity's internal resources is produced profit, constructive critical analysis of profit
creation and its quantification is important for every decision-making on its allocation with a goal to
maintain the enterprise's health. Items that need to be carefully analysed for proper assessment of
their essence and impact on generated profits are mainly revenues. In particular, it is a matter of
assessing whether the revenues are realised, or that they are as a result only from a change in
valuation or a change in the method of measurement, book keeping and reporting. In the case of
underestimated costs, then the calculated profit is overestimated and must also be analysed to
avoid the production capacity of the enterprise being compromised in the event of an
overestimation outside the enterprise. A realised profit is a profit arising from the comparison of
revenues and costs of a respective property type sale, or associated to the service provided outside
the enterprises. The non-realised profit, arising from the result-based revaluation of property to its
increased real value, or from declaring exchange rate profits when recalculating assets and liabilities
in a foreign currency as of the date of financial statements, shall be, until it is realised, a fictitious
profit, that does not have to be realised in the future and until that happens the very basis of the
enterprise erodes and its ability to fully perform its activities, being a precondition of revenue
generation is jeopardised, as it is not able to reproduce its property. In case of the realised profit, the
risk of inception and division of the fictitious profit is lower and associated with a change in realised
(sold) property price in time. Real (true) profit is the part of the realised profit from realised
performance, corresponding to the comparison of incomes and associated costs, both in current
(real) prices. Divisive profit is the part of business profit which, in case of its division outside the
enterprise (by owner, associate, shareholder, co-op member) does not jeopardise the performance
of the enterprise, i.e. production ability (assets in all ways of its understanding) stays preserved.
In case of the realised profit, the risk of inception and division of the fictitious profit is lower and
associated with a change in realised (sold) property price in time. In this case, the fictitious profit
represents the part of the realised profit corresponding to the difference between costs associated
with realised performance and valuated in current prices, and their valuation in historic prices used
when business profit is quantified. Real (true) profit is the part of the realised profit from realised
performance, corresponding to the comparison of incomes and associated costs, both in current (fair
value, real) prices. Divisive profit is the part of business profit which, in case of its division outside
the enterprise (by owner, associate, shareholder, co-op member) does not jeopardise the
performance of the enterprise, i.e. production ability (assets in all ways of its understanding) stays
preserved. For the correct identification of the divisive profit, it is thus important to quantify the real
profit from the business profit (Figure), so we can consider the lower one divisive after their mutual
comparison.   

UNIT 4 - Macroeconomics
1 Analyze the effects of an increase in interest rates on the investment
activity of a profit Maximizing firm. Does it matter if inflation increases in
proportion to the increase in Interest rates?

The analysis of the relationship between the rates of interest and profit deals with how to integrate
the theory of money with that of value and distribution. In this analysis the notion of 'money' or
'market' interest rate is distinguished from that of 'average' or 'natural' a real interest rate. The level
of the latter is determined either by the same factors affecting the rate of profit or by other factors,
including monetary ones. Its movements are related to those of the rate of profit through the
operation of competitive market forces. The daily variations of the 'money' or 'market' interest rate,
instead, are not systematically related to those of the rate of profit. The analysis of the relationship
between the rates of interest and profit thus considers the following questions which functional
relations describe the operation of the competitive market forces linking the 'average' or 'natural
interest rate and the rate of profit, which are the factors affecting the two rates and which of the
two is independently determined In the history of economic thought different views have been
proposed on this issue. The dominant view is that the 'average' or 'natural' or 'real' interest rate is
independent of monetary factors and depends on the same forces determining the rate of return on
the capital invested in the process of production. The alternative view states that monetary factors
are relevant, both temporarily and permanently, in determining the equilibrum level of economic
variables, including the interest rate For Smith and Ricardo the natural' interest rate is a portion of
the rate of profit. The difference between these two rates represents the remuneration of the
entrepreneur for the greater nsk and trouble of investing in the production sector, rather than in
financial assets.

The rate of profit is determined on the basis of the surplus' theory, by taking as given the social
product, the available technology and the real wage rate. The 'natural' interest rate is thus
determined by the rate of profit, and no direct influence of monetary factors on the former rate is
allowed. In the second half of the 1820s, Tooke and JS Mill argued, in opposition to Ricardo, that the
'average interest rate too can be influenced by monetary factors. Their position was stimulated by
the observations of the long-lasting rise in the interest rate which occurred duning and after the
Napoleonic wars and which was the result, according to them, of the eam at least the general rate of
profit on the capitals and wages anticipated to carry on its activity Changes in the interest rates
affect the revenues (interest received on ank loans and financial assets) and the cost (which include
payments for wages, interest on deposits and the rate of profit on the capital advanced) of the
banking firms. This produces adjustment processes tending to restore the conditions of equilibrium
between revenues and costs, which are influenced by the movements of the rates of interest and
profit.

With the rise to dominance of the marginalist theory of value and distnbution after the 1870s, the
analysis of the relationship between the rates of interest and profit took a new form. In the perfectly
competitive equilibrium propose… stresses the histoncal, conventional character of this rate by
claiming that any level of interest which is accepted with sufficient conviction as likely to be durable,
will be durable (Keynes, 1936, p. 203). He pointed out that the policy of the monetary authority is a
major determinant of the common opinion' as to the future value of the interest rate. But he also
added that other elements of an economic and institutional character can affect this common
opinion', for instance by persuading the public that the monetary authority will not be able to
maintain its present policy The analysis of liquidity preference, which examines how an agent
chooses the allocation of his wealth, also allowed Keynes to deal with the competitive forces relating
the movements of the rates of interest and profit. The analysis referred to a single interest rate. Yet,
in Chapter 17 of the General Theory, he tried to describe the effects of a wide portfolio allocation on
the relationship between the rates of interest and profit. At the time, some other attempts to
analyse the structure of the interest rates and the effects of a large portfolio allocation on the
economy were cared out by Hicks (1935) and Kaldor (1939). The latter explicitly described his work
as an attempt to Keynes's analysis to the case of several interest rates. Some years later, Markowitz
(1952) and Tobin (1958) gave formal precision to this analysis Thus, both on the analysis of the
factors determining the 'average' interest rate and on that of the competitive market forces linking
the movements of the rates of interest and profit,Keynes opened the way to important
developments. Taken together, these contributions can provide a basis to argue for a monetary
determination of the rate of profit, 1.e. for a theory of distribution where monetary factors can be
directly allowed in the determination of the rate of profit, while the real wage rate is determined as
a residuum

Sraffa's rehabilitation of the surplus theory of value and distribution seems to move along these
lines. Taking probably advantage of his direct partecipation in the debate on the

General Theory before and after its making, Sraffa (1960, p. 33) suggested that to analyse

contemporary market economies, it is preferable to consider the rate of profit as an

independent variable (determined by the level of the money interest rates), instead of

following the classical political economists of the last century who took the real wage rate as

independently determined

Sraffa's suggestion has been carried forward by subsequent work (see Panico, 1980, 1985,

1988, Pivetti, 1985, 1991), which has proposed a 'monetary theory of distribution. This has

developed, on the one side, Marx's and Keynes' idea of a 'conventional determination of the

Formation of the expectations of financial operators

On the other side, it has introduced within a Sraffian price system, the analysis of the competitive
market forces linking the movements of the rates of interest and profit, such as these set in motion
by portfolio choice and by the tendency towards equilibrium betuten costs and revenues of the
banking sector The emphasis on monetary policy has raised the problem of the role of other
Government policies in the theory of distribution. This problem hae been neglected by the recent
development of Sraffa's suggestion. It was considered by Kaldor (1958, 137-9), having in mind the
theory of distribution he had proposed in 1955-56, which the literature bas considered alternative to
the monetary theory of distribution. Kaldor did not provide a formal treatment of the role of the
Government sector within his theory of distribution, although he had esplicitly referred to the need
to do it. A recent debate on this theme (see Panico, 1993) has, however, shoun the possibility to
reconcile the tuo Post Keynesian vieus on income distribution, considered alternative by the
literature. By following Kaldor's suggestions on how monetary and fiscal policies contribute to
maintaining steady growth conditions, the debate has shown that distributive variables can depend
both on the rate of accumulation, as pointed out by Kaldor, and on the money rate of interest, as
suggested by Sraffa. In the presence of a Government sector, the equilibrium condition in the
commodities market. which establishes a functional relation between the rate of profit and the rate
of accumulation, also includes as a variable the Government deficit net of interest payment. This
constraint can be associated with that describing the relationship beturen the rates of interest and
profit on the basis of portfolio choice to define the rate of profit and the Government deficit net of
interest payments compatible with steady growth, when the rate of accumulation is taken a given
and the money interest rate is exogenously determined along the lines suggested by Keynes in the
General Theory.

The recent debate on the role of the Government sector in the Post Keynesian theory of distribution
thus strengthens what has been defined the alternative view on the relationship between the rates
of interest and profit, since it clarifies the influence on these rates of the

How does inflation affect firms?

Firms generally prefer inflation to be low and stable. If inflation rises above 3 or 4%, firms may see a
rise in costs and uncertainty. Inflation can also cause firms problems of rising costs, falling
profitability, and a decline in international competitiveness.

However, inflation is not necessarily damaging for a firm – especially, if they can increase prices to
consumers more than their costs of production rises.

Some of the costs of inflation for firms

  Menu costs. These are the costs of changing price lists. If inflation is high, then firms will
have to update prices more regularly. There are costs involved in this. For firms like Pound /
Dollar shops, this high inflation could be particularly damaging because it becomes harder to
find goods which can be sold for a Pound.
 However modern technology makes changing prices much easier than before. These
days, you don’t need to change prices manually but can update barcodes and this is less
time-consuming.
 Wage Inflation. Unexpected inflation may lead to the necessity of renegotiating wage deals
with workers. However, these wage rises may be expensive for the firm because they cannot
afford them.
 Uncertainty and confusion. If inflation is higher than expected, then the costs of investing
will be changing frequently. This makes firms less willing to invest because they are
uncertain over future costs, wages and future demand This is particularly a problem with
unexpected cost-push inflation raising the price of raw material costs. This is perhaps the
biggest cost of inflation for firms – high inflation creates uncertainty and can lead to lower
growth.
 International Competitiveness. If UK inflation is higher than other countries, then this will
make UK firms less competitive than international competitors; this is important for
exporters.
 A higher inflation rate than our competitors will also lead to a depreciation in the
exchange rate; this will help to restore competitiveness but at the expense of more
expensive imports and a decline in living standards.
Unexpected inflation
These costs of inflation will be worse if the inflation is unexpected. For example, if firms expect
inflation of 2%, but, it proves to be 5%, this is worse than if they had expected inflation of 5%.

Stagflation
One of the most problematic types of inflation for firms is cost-push inflation. This is inflation due to
a rise in the cost of raw materials – but at the same time demand falls. Therefore, firms have both
rising costs, but also lower demand. Therefore, firms are usually pushed into reducing profit margins
and absorb the price increases.
Benefits of inflation for firms
Inflation can be beneficial in some circumstances.

 Reduces the value of debt. If firms have debt, then inflation may help reduce the real value
of debt. This is because, under inflation, nominal revenue will be rising – making it easier to
pay off old loans. In this case, inflation is more desirable than deflation, where the real value
of debt will be increasing.
 Though it also depends on interest rates. If high inflation leads to high-interest rates,
then firms with debt will see rising interest rate costs.
 Strong economic growth usually results in at least a moderate inflation rate. For example,
suppose inflation is very low 0.5% – this is probably associated with low economic growth. A
stimulus to demand will see higher inflation and higher economic growth. In this case, rising
inflation can lead to an increase in profitability for firms.
 Moderate inflation makes it easier to change relative prices and relative wages. For example,
if you have inflation of 0%, it is hard to cut nominal wages for unproductive workers. But, if
inflation is 2%, it is easier to have pay freezes and effective real wage cuts for unproductive
workers.
How does inflation affect the profits of a firm?
There is no definitive answer.

In a period of demand-pull inflation, with rising economic growth, the firm will see rising demand
and it is able to increase prices. In this case, it may be able to increase profits, at least in the short
term. Though – if the inflationary growth leads to a boom and bust – it may be followed by a
recession where demand and profits fall.

In a period of cost-push inflation, it depends whether firms are able to pass their rising costs of
production onto consumers. If markets are very competitive and demand weak, firms may face
pressure to absorb cost rises by reducing profit margins.

In the long-term, a low inflationary environment may facilitate higher investment and growing
demand, which improves profits.

Example of Cost-push inflation from depreciation

In 2016, the UK saw a 15% depreciation in the value of the Pound due to
Brexit vote. This depreciation led to a rise in import prices. Firms saw in input
prices rise.
However, despite higher inflation, firms were able to keep wage growth low. Real wages actually fell.
Therefore, the cost of inflation was felt more by workers than firms.

There is a time delay for firms to pass on the higher costs onto consumers. But, also firms may try to
avoid increasing prices.

How firms can try respond to inflation

In this period of rising import prices, Tesco threatened to stop stocking products if manufacturers try
to pass on higher prices. (See: Tesco boss tells food producers not to pass on depreciation to
consumers)
In other words, Tesco (which has a degree of monopsony buying power) is trying to make food
manufacturers absorb the input price rises and reduce their profit margins.

It is a move that will be popular with consumers (and perhaps good advertising for Tesco), but will
producers be able to keep absorbing all the input price increases themselves?

Inflation Adjustment of Nominal Interest Rate

The Fisher Effect describes the relationship between inflation and nominal or real interest rate
through the equation below:

(1 + i) = (1 + R) (1 + h)

 Where:

 i – Nominal interest rate

 R – Real interest rate
  h – Expected inflation rate

Means effective or total increase in interest rate is dependent on inflation. So if total interest is
accounted t inflation is already included. If only nominal interest is considered the inflation has to be
considered separately to find out the effect on investment.

2 A firm faces a uniform annual demand of 100 000 units. The purchase cost
of stock is £10 per unit, whilst the cost of ordering stock is £20, and the cost
of holding stock is 14% of the average stock value. Find the Economic Order
Quantity and the Minimum Acquisition Cost.
D=10000

S=20

H=14%of unit price of stock=0.14*10=1.4

2DS/H=2*100000*20/1.4=28.57*100000=285.7*10000

The Economic Order Quantity ,EOQ=Sqrt(2DS/H)=16.9*100=1690.31

Minimum Acquisition Cost=Total purchase Cost +Order Cost+ Holding Cost

At Q=1690.31

Annual Total Cost or Total Cost, D*P+ (D * S) / Q + (Q * H) / 2

Or

Annual Total Cost or Total Cost(order cost Holding Cost) =

(D * S) / Q + (Q * H) / 2
At EOQ,Q=1690

100000*20/1690.31 + 1690.31*1.4/2

1183.21+1183.21=2366.43

Total Annual Cost including total purchase at EOQ = PC + OC + HC =

  (P x D) + ( (D x S) / Q) + ( (H x Q) / 2).

10*100000+2366.43=1002366.43

3-Critically assess the view that an understanding of the principles of

'scientific Decision-making is fundamental to the success of a modem
economy
Scientific decision-making concept: Every business decision comes with some uncertainty. However,
businesses and managers want to apply logic to their decisions with the support of relevant data to
mitigate uncertainty and risk. Scientific decision-making involves a cognitive process in which each
step follows the previous step in a logical order.

Scientific decision-making ncludes the use of:

 Software logic to analyze scenarios and application of predictive models.

 Data mining and big data to procure relevant data to inform decision making.
 Forecasting to consider the possible effects of business decisions.

3. Scientific decision making contributes to the success of the modern economy. Modern
economics relies heavily on multiple scientific decision-making methods. Making a scientific
decision means considering alternatives. In this case, we not only have to determine as many of
these alternatives as possible, but also choose one.

 The probability of success or effectiveness is the highest.

 It is more suitable for our goals, desires, lifestyles, values, etc..
 Decision-making involves comparing pros and cons between alternative approaches based
on business logic.
 Provide a clear sense of direction.
 There can be more than one person involved in this process, thus reducing the prejudice
process and facilitating decision-making in economic sectors.
 Scientific decision-making ensures that decisions are continuously monitored and reviewed.
 One of the great advantages of the scientific method is its flexibility.
 Policies made on the basis of good planning with other managers are easier to defend.

Criticisms of scientific decision making:

 It is only suitable for small organizations.

 Workers can be prevented from being motivated. It affects the oppressive feeling
of workers.
 Administrative decisions are often accompanied by managerial rigor and stress due to the
need to take full control of the workplace and its employees.
 Therefore, scientific decision-making has some drawbacks, but there are still many in
improving the modern economy.
 What is Scientific Decision Making?

All business decisions involve some uncertainty. However businesses and managers increasingly
want to reduce that uncertainty and risk by applying logic to decision-making, supported by relevant
data.

Scientific decision-making involves the use of:

 Data mining and big data to source relevant data to inform decisions
 Application of software logic and predictive models to analyses scenarios
 Forecasts to consider the possible implications of business decisions

Quite a few of the models you explore as a business student can be linked to scientific decision-
making (although they also involve some qualitative judgments), including:

 Decision trees
 Investment appraisal
 Sales forecasting
 Sensitivity analysis
 Network analysis

Reasons Why Scientific Decision Making is Becoming More Popular

 More widespread availability of data

 Greater sophistication of data analytics & skills / experience of data analysts
 Management expectation that data will be used wherever possible, particularly where a decision is
significant to the business

4.The market allocates resources to the firms that best meet the needs of
consumers. ‘Discuss.

4-Firm Resource Allocation, Market and Consumer

In market economics, markets make mutually beneficial exchange between manufactures

and customers, to solve the economic issues. Through the interaction of free and self-
directed market forces resource are allocated. What to produce is decided by consumers,
how to produce is determined by manufactures, and the purchasing power of customer
decides the end user.
Price is used as a Signal to allocate resources to the highest valued consumers. They are
ready to pay bigger amount for their highly valued products and services. The companies
and manufactures will allocate more resources for the production and supply of these
services and commodities that have a huge price keeping all other things same. The
employees have to work more hours and gets higher salaries.
This is applicable to both product markets and resource markets. Two important role of
household are (a) Supply resources (b) Demand service and commodities. Business does the
opposite (a) Supply Commodities and Services (b) Demand Resources

An inefficient allocation of resources occurs because of this price factor and the effective
highest values customer friendly allocation of the resources and services. It critically reduces
the well-being of the society
n.
●Societies face the fundamental economic problem of scarcity.

● in a free-market economy there eeds to be a mechanism that coordinates the allocation

of resources.

 ● Prices play a key role in this process.

● If market forces are to allocate resources effectively, consumers need to be able to

express their preferences for goods and services in such a way that producers can respond.

 ● Consumers express their preferences through prices, as prices will adjust to equilibrium
levels following a change in consumer demand.

 ● Consumer surplus represents the benefit t that consumers gain from consuming a
product over and above the price they pay for that product.

● Producer surplus represents the benefit gained by firms over and above the price at which
they would have been prepared to supply a product.

 ● Producers have an incentive to respond to changes in prices. In the short run this occurs
through output adjustments of existing firms (movements along the supply curve), but in
the long run firms will enter the market (or exit from it) until there are no further incentives
for entry or exit.

. “Within the “Market system” resource allocation is heavily dependent on the variations
of the price of the resources themselves. Price acts as an indicator to both the consumers
and the sellers within the market.” (Price Signals as Guides for Resource Allocation,
Anon, n.d.)
To be explicit given accurate price information the sellers will use costly scare raw materials,
or resources to produce goods of high value. Likewise, only those consumers who see
benefit in consuming those higher valued goods will demand them therefore achieving
balance within the system. If the price of an easily accessible resource is low it will be given
by the resource users for use to produced goods in a lower valued tier and consumer
behavior will also react accordingly.
To summarize, the change in the price of privately owned resources within a free market
results from the change in the demand and supply of the resource i.e. labor, capital, raw
material. This is supposed to create an efficient resource allocation by the resource
managers through:

The productivity and efficiency are facilitated, encouraged by a better investment situation
in order to increase investment capital and profit. (Investment Climate, Anon, n.d.). 
The market system itself motivates manufactures to efficiently allocate all available
resources confirming that they are put to use without any wastage at the market price. So
the market system plays effectively and efficiently within the business environment
achieving full utilization of labor, investment capital, machine and land. By this market
system facilitates, encourages a positive investment scenario.
So a market allocation system is one that relies on consumers to allocate resources.
Consumers “write” the economic plan by deciding what will be produced by whom. The
market system is an economic democracy–citizens have the right to vote with their
pocketbooks for the goods of their choice. The role of the state in a market economy is to
promote competition and ensure consumer protection.
 In a competitive market, consumers and producers determine market price. The interaction
of supply and demand decides on resource allocation, which is defined as “the manner by
which society manages and rations its resources”. For example, if a resource/product rises
in price, buyers will use it less frequently in order to ration their income and get the most of
all of their consumption choices, and producers will try to produce more of it because the
rise in price shows scarcity in that market. Thus, in a free market economy, the price
information gained from consumers and producers determine resource allocation – people
make decisions based on what is most important and worth producing.

COMMAND ALLOCATION
State has its own power in a command allocation system depending on the people's
interest. What product to made, what standards to be implemented and hoe to make them
rare strictly specified by governments. The consumer can choose the item what he need but
decision of availability of product is determined by state.
 
MIXED SYSTEM
Actually in reality the only available market system is mixed with command allocation and
Free market allocation. The government has control in areas but there is acceptable
fluctuation in-law.

Customer Portfolio Theory and Resources Allocation

Leveraging on the concepts of portfolio theory, Fiocca (1982) explores a new industrial
marketing strategy that has the customer as the core of the analysis and considers some of
the important elements of industrial marketing, such as demand and buyer/seller
relationships. Following the lead of Henderson (1979), Fiocca postulates that customer
portfolio analysis consists of two-dimensional planes with the customer’s business
attractiveness on one axis and the buyer/seller relationship on the other. Fiocca proposes a
two-step customer portfolio analysis.
First step was done at a general level where the complete portfolio of customers of the
supplier company is considered. This step facilitates the identification of key customers that
may need special attention and therefore require more in-depth analysis. 
The second step focuses on an in-depth analysis of the customers identified in the first step.
At this level of analysis, the two variables are considered, which form the dimensions of a
nine-cell matrix. These variables are the customer's business attractiveness (high, medium,
low), and the relative stage of the present buyer/seller relationship (strong, medium, weak).
This same principle was extended to analyzing business strength against industry
attractiveness, which is popularly known as the GE-McKinsey matrix. Figure 5 shows an
example of the GE-McKinsey Nine-Cell Matrix. 
The purpose of the analysis is to formulate appropriate marketing strategies for different
customers or groups of customers; and thus allocate the necessary resources for
implementing them. Similarly, Campbell and Cunningham (1983) extend the product
portfolio matrix (Henderson 1979), the product-positioning matrix (Hofer and Schendel
1978), 36 and the product/performance matrix (Wind 1982) by conducting customer
analysis for strategy development in industrial markets. Using customer portfolio concepts,
they suggest that companies should develop their strategy from an analysis of existing
customers. Based on their findings, they recommend that customer analysis should focus on
the current allocation of resources to different customers and customer groups and identify
the company's position with key customers relative to competition in different market
segments.
 The purpose of the analysis is to improve the allocation of scarce technical and marketing
resources between different customers to achieve the supplier's strategic objectives. In
contrast to Porter (1980), who lays stress on the need to counteract buyers' bargaining
power, their recommendation emphasizes the scope of developing relationships of mutual
interdependent and shared objectives. This study also resulted in a nine-cell matrix similar
as in Fiocca (1982). Other researchers have built on this concept. For example, Yorke (1986)
also applies the theory and suggests that customer portfolio theory is more appropriate and
useful where the product purchase is of low technology; continuously supplied the 37
perceived risk is relatively low, and the data available on customers and competitors is more
complete. 

5- The force of competition, the desires of managers and

the needs of shareholders combine to ensure that firms
maximize profit' Discuss.
Competition

In order to maximize profits in a perfectly competitive market, firms set marginal revenue equal to
marginal cost (MR=MC). MR is the slope of the revenue curve, which is also equal to the demand
curve (D) and price (P). In the short-term, it is possible for economic profits to be positive, zero, or
negative. When price is greater than average total cost, the firm is making a profit. When price is less
than average total cost, the firm is making a loss in the market.
Perfect Competition in the Short Run: In the short run, it is possible for an individual firm to make
an economic profit. This scenario is shown in this diagram, as the price or average revenue, denoted
by P, is above the average cost denoted by C.

Over the long-run, if firms in a perfectly competitive market are earning positive economic profits,
more firms will enter the market, which will shift the supply curve to the right. As the supply curve
shifts to the right, the equilibrium price will go down. As the price goes down, economic profits will
decrease until they become zero.

When price is less than average total cost, firms are making a loss. Over the long-run, if firms in a
perfectly competitive market are earning negative economic profits, more firms will leave the
market, which will shift the supply curve left. As the supply curve shifts left, the price will go up. As
the price goes up, economic profits will increase until they become zero.

In sum, in the long-run, companies that are engaged in a perfectly competitive market earn zero
economic profits. The long-run equilibrium point for a perfectly competitive market occurs where
the demand curve (price) intersects the marginal cost (MC) curve and the minimum point of the
average cost (AC) curve.

Perfect Competition in the Long Run: In the long-run, economic profit cannot be sustained. The
arrival of new firms in the market causes the demand curve of each individual firm to shift
downward, bringing down the price, the average revenue and marginal revenue curve. In the long-
run, the firm will make zero economic profit. Its horizontal demand curve will touch its average total
cost curve at its lowest point.
The Demand Curve in Perfect Competition

A perfectly competitive firm faces a demand curve is a horizontal line equal to the

Key Points

 In a perfectly competitive market individual firms are price takers. The price is determined by
the intersection of the market supply and demand curves.
 The demand curve for an individual firm is different from a market demand curve. The market
demand curve slopes downward, while the firm’s demand curve is a horizontal line.
 The firm’s horizontal demand curve indicates a price elasticity of demand that is perfectly
elastic.

Key Terms

 Perfectly elastic: Describes a situation when any increase in the price, no matter how small,
will cause demand for a good to drop to zero.

In a perfectly competitive market the market demand curve is a downward sloping line, reflecting
the fact that as the price of an ordinary good increases, the quantity demanded of that good
decreases. Price is determined by the intersection of market demand and market supply; individual
firms do not have any influence on the market price in perfect competition. Once the market price
has been determined by market supply and demand forces, individual firms become price takers.
Individual firms are forced to charge the equilibrium price of the market or consumers will purchase
the product from the numerous other firms in the market charging a lower price (keep in mind the
key conditions of perfect competition). The demand curve for an individual firm is thus equal to the
equilibrium price of the market.

Demand Curve for a Firm in a Perfectly Competitive Market: The demand curve for an individual
firm is equal to the equilibrium price of the market. The market demand curve is downward-sloping.

The demand curve for a firm in a perfectly competitive market varies significantly from that of the
entire market. The market demand curve slopes downward, while the perfectly competitive firm’s
demand curve is a horizontal line equal to the equilibrium price of the entire market. The horizontal
demand curve indicates that the elasticity of demand for the good is perfectly elastic. This means
that if any individual firm charged a price slightly above market price, it would not sell any products.

A strategy often used to increase market share is to offer a firm’s product at a lower price than the
competitors. In a perfectly competitive market, firms cannot decrease their product price without
making a negative profit. Instead, assuming that the firm is a profit-maximize, it will sell its goods at
the market price.

MAnager roles

1. Assess and Reduce Operating Costs

Operating expenses, commonly referred to as OPEX, are the costs associated with running a
business. Operating expenses include rent; utilities; equipment and inventory; marketing and
advertising; research & development (R&D); selling, general and administrative (SG&A); and payroll.

OPEX does not include costs directly associated with product production—these are accounted for in
cost of goods sold (COGS) or, for big-ticket items like buildings or machinery, capital expenditures.

When companies need to cut costs, OPEX is often the first place they look because these expenses
are not directly related to production. However, if done preemptively or unwisely, OPEX cuts can
have long-term negative effects on the business. Executives must review all reductions and
understand how a decrease in, for example, advertising and marketing will impact sales in six, 12 and
18 months. Likewise, slash R&D today and you may end up with no new products to release 12 or 24
months from now.

2. Adjust Pricing/Cost of Goods Sold (COGS)

Cost of goods sold (COGS) are the direct costs associated with making a product or delivering a
service—mainly raw materials and labor. It’s critical that COGS is calculated accurately and kept as
consistent as possible so that products or services may be priced correctly.

To achieve this, companies must define, track and price the time and material resources needed to
complete each build. By standardizing the manufacturing process, you should be able to accurately
anticipate true costs and avoid large discrepancies from one build to the next—thus standardizing
COGS.
Although COGS may be decreased immediately by decreasing labor or substituting less-expensive
components or raw materials, again, as with OPEX, consider the long-term implications: Will your
production speed or product quality suffer?

3. Review Your Product Portfolio and Pricing

Related to both of the above items, it’s important to understand the true unit margins for each
product in your portfolio and update that data frequently.

A good rule of thumb: Before adding a new offering, review your current portfolio. Are products
underperforming? Do you have difficult-to-produce items that are eating away at your margins, time
and money? Would a price decrease of your highest-margin products increase sales? At the same
time, don’t be afraid to discontinue products with the lowest margins, or raise their prices.

4. Up-sell, Cross-sell, Resell

It’s expensive to acquire new customers. Instead, smart companies know that one of the best ways
to increase sales is by introducing current customers to additional products, via upselling, cross-
selling and reselling.

Make sure all sales reps are trained in upselling techniques and know how to approach the
conversation without being pushy and turning the customer off from the purchase altogether. Use
an informative/educational approach and explain how premium features add benefits that could
help the customer. Clear comparisons, perhaps in a grid or informative graphic, are helpful for
educating consumers on the features and benefits of various available models.

Cross-selling is also an easy way to increase a current customer’s consumption of products. Consider
promotions to introduce customers to additional products, especially new ones—think a free bottle
of shampoo with the hairspray they’ve come in to buy. Cross-selling can also be successful without a
special promotion, or discount, simply with a recommendation from the sales rep that items pair
well together, as in: “I brought this top for you to try with those pants.” Finally, consider cross-selling
by automatically promoting personalized options based on items in a customer’s online cart.

Finally, reselling is one way many companies are generating additional revenue from existing
products. By offering a resell program, customers can donate (or sell back) merchandise they no
longer want but that is still in good condition. With some minor refurbishing and cleaning, this
merchandise can often be resold, increasing your profitability and decreasing waste of unwanted
items.

5. Increase Customer Lifetime Value

Aka: Never underestimate the power of happy clients. Understanding your customers and delivering
consistently excellent experiences is perhaps the most cost-effective way to increase loyalty and
acquire new customers via referrals.

You can show appreciation for your existing customers, increase their lifetime value, deliver new
leads and boost your profits. How? Consider:

Incentives:
Offer personalized promotions of products a current customer has expressed interest in, plus a code
to share with friends or family.

Encourage referrals:
Launch a referral program that rewards customers for recommending your product or service.

Recommendations and reviews:

Incentivize customers to talk up their favorite products on social platforms. After all, the best
advertising is free advertising.

Customer retention:
Today, experiences are paramount to consumers. Interactions with a company  can trigger an
immediate and lingering effect on their sense of trust and loyalty. Value, reliable service and quality
products will always be important, but experience and connection are what set a company apart in
highly competitive markets.  

6. Lower Your Overhead

That’s retail. How can profitability be improved in manufacturing? Often, the fastest way to higher
margins here is negotiating better terms with suppliers to lower COGS. If you’re using more than one
supplier to deliver the same component, consider economies of scale: If you increase your order
incrementally with one provider while decreasing incrementally with the others, could you capitalize
on a price break?
For example, say you purchase 21,000 bottle tops every month, and you have three suppliers. To
ensure a resilient supply chain, you place an order for 7,000 from each. But supplier A offers 20% off
if you purchase 10,000 or more units. By increasing your order to supplier A by 3,000 and decreasing
by 1,500 from B and C, you’ve saved 10%.

Likewise, look across your portfolio: Have you started purchasing additional products from an
incumbent supplier? If so, have you renegotiated at each step and asked for discounts?

7. Refine Demand Forecasts

If you have more componentry or raw material inventory than demand, you’ll end up spending to
store it, or worse, have it expire and need to be replaced. But if you don’t have enough, you’ll pay
for rush orders and expedited shipping—both of which increase COGS.

And, did you know that in 2019, U.S. shoppers returned merchandise worth more than $300 billion,
with a significant chunk of those items ending up back in the hands of distributors? Make sure you
have a plan to extract maximum revenue for returned items.

The ability to accurately predict required inventory based on historical demand, seasonality or sales
forecasts helps mitigate both problems.

8. Sell Off Old Inventory

In a related problem, say you make a promotional or seasonal product, it doesn’t sell as expected,
and you’re left with obsolete inventory. Each day, this inventory sits in your warehouse, taking up
space that could be used to store goods that are high movers and yield a tidy profit.

First, try to sell that obsolete inventory. Options include third-party retailers, such as Amazon or
eBay, discounting or outlets and reverse-logistics vendors. Barring that, consider donating items for
a tax write-off. Deciding which path to take depends on factors including the costs of transportation,
inspection and restocking.

Then, figure out where things went wrong and how to avoid over-producing in the future.

9. Engage/Motivate Employees

Depending on your industry, one innovative way to engage workers is to enlist their help in reducing
waste. This is a way to ease into a corporate social responsibility project while saving money.
Your employees are the experts on the most efficient ways to use materials, such as cut plans for
fabrics. By collecting their insights and incorporating these ideas into the build process, you minimize
waste, ensure the proper componentry is used such that the finished product is completed correctly
and passes quality inspection and provide a way to give back to the environment and help with
customer satisfaction.

Products that must be disassembled and fixed, or worse thrown out, increases labor costs and
waste. The more specific you can be about which components to use, such as specifying the bin in
which each is located or having the bin light up when staff is picking componentry, the more
accurate your builds will be—and the greener your industry.

10. Increase Order Efficiency

Ensuring the correct product is sent to the customer the first time ensures
satisfaction and maximizes your profit. If an incorrect item is delivered, you will need to send the
correct item, incur a second shipping charge—or a third for the original item if you want it returned
—and spend on labor to receive the returned item, inspect it and either repackage it to be put back
on the shelf or eat the cost and dispose of it.

Aside from being a hassle, the costs from incorrectly shipped items are 100% avoidable. When
collecting those employee efficiency ideas, ask about how to get it right, every time.

11. Add Recurring Revenue

Recurring revenue is a great way to add consistency to sales. There are two main routes to increase
monthly recurring revenue (MRR) or annual recurring revenue (ARR).

Added services to products

Think routine cleaning and maintenance for an additional fee—increase customer satisfaction by
removing the burden of making sure upkeep is done on time, effortlessly.

Product subscriptions
Also simplify the customer experience through automatic fulfillment of routinely purchased items.
Consider offering discounts on automatic replenishments of your most commonly purchased
products
12. Use KPIs and Benchmark Regularly

Establishing benchmarks is key to evaluating your performance and enables continuous

improvement. Reviewing KPIs regularly and addressing any outliers ensures problems are caught,
and remedied, before major issues, and costs, arise.

Profit maximization of firm or Share Holder

profit, as an accounting term, is the excess of income generated by sales over the expenses incurred
from the overall operation of a business. Any business is said to be in a loss if the expenses are
consistently more than the income. And it is said to be profitable if the income is more than the
expenses. Therefore, in the context of economics, the goal of a firm should be to maximize profits,
or to say in simple terms, to realize a large amount of profit.

Profit maximization can be achieved in two ways: enhance revenue and minimize costs. Therefore,
to maximize profits, many firms minimize their costs and boost their revenue. The problem,
however, with such a goal is that it is short-term in nature and banks on extreme measures to
reduce costs, like cutting down and paring advertisement budgets, employee training, development
expenses, research and development expenditure, customer care budget, employee salary, or
bonuses.

In some cases, firms, in an attempt to maximize profit, may also neglect the safety, welfare, benefits
of the environment, and their different stakeholders. These knee-jerk reactions are short-term in
nature and can be efficient for the near future but in the longrun, these measures slow down the
sales, which in turn diminish the profits and dwindles the overall value of the firm. Therefore, the
objective of profit maximization has a myopic outlook towards the long-term growth of the firm.

Over the years, when financial management became independent from economics and became a
branch on its own, the objective of the firm witnessed a steady shift from profit maximization to
shareholders' wealth maximization. This is a comprehensive approach focusing on the long-term
growth, profitability, and the value of the firm. This goal focuses on wider objectives and includes
the welfare of employees, communities, and society at large. It is a fact that wealth or value is a
long-term concept and for the firms, it is reflected in the market price of its shares that in turn
depends on the success and expectations of the future success of a firm. Firms with higher
performance receive a higher valuation from investors which is reflected in the increase in the share
prices as compared to the initial listed value. Therefore, the value of a firm is a dynamic function of
the overall performance of the firm and the rationality of the firm's investment, financing, and
dividend decisions.

In a way, shareholders' wealth maximization is also associated with intangible assets like goodwill,
branding, good customer relations, a significant and loyal customer base, committed employees, and
intellectual property rights. This concept also overarches and includes community and social welfare.
Therefore, firms are moving away from the goal of profit maximization that has a short-term
approach, ignores any risk or uncertainty, and overlooks the timing of returns. In comparison, a long-
term vision acknowledges risks and uncertainty and considers the overall shareholders' wealth and
not just profits.

This concept of shareholders' wealth maximization is mainly applicable to large firms where there
are a large number of shareholders, including promoters, financial institutions like banks and mutual
funds, foreign investors, and retail investors. The managers' actions should enhancethe value of the
firm to benefit all shareholders. But does this concept apply to small businesses, where the owners
are the managers and there are no diverse set of shareholders, excepts family members or partners?

The situation for small businesses is also different as they are not listed on the stock markets. In the
absence of external shareholders, the objective of profit maximization appears to be the correct
approach. For small businesses, the availability of funding or capital is difficult, which is not a
constraint for many large firms and they can invest in other stakeholders and efficient business
processes. This improves the overall value of the firm and increases the wealth of the shareholders.
Since surviving is the main goal of small businesses, they are more inclined towards profit
maximization by reducing costs or enhancing revenue. As and when these small businesses start to
grow and achieve a sizable expansion, the concept of shareholders' wealth maximization should be
the way to go forward.

Unit-5-Indian Economy
1. How much amount does India plans spend on its infrastructure in the next
5 years to achieve the goal of USD 5 trillion economy by 2024.

As part of its goal to become a USD 5 trillion economy by 2024, India plans to spend USD 1.4 trillion
on its infrastructure in the next five years,
"As we envisage becoming a five trillion-dollar economy by 2024-25, our focus on creating world-
class infrastructure has become even more resolute. If we spent USD 1.1 trillion on infrastructure in
the last 10 years (2008-17), we now are going to invest about USD 1.4 trillion in the next five years,"
she said.

India, she said, has taken various steps to enhance infrastructure investment by launching innovative
financial vehicles such as Infrastructure Debt Funds (IDFs), Real Estate Investment Trusts (REITs),
Infrastructure Investment Trusts (InvITs) and laying down a framework for municipal bonds.

"We are already applying Public Private Partnership (PPP) models in the country. We have adopted
the Asset Recycling model to modernize existing infrastructure, like highways, while providing
gover ..

2. According to the 2019 World Economic Outlook report, India's GDP growth
rate for the fiscal year 2020-21 had been lowered. Discuss the impact of
Covid-19 on the Indian Economy while keeping in mind value drivers of 2019
World Economic Outlook Report.

121

Recording its worst ever performance in over four decades, India clocked a negative growth of 7.3
per cent for 2020-21 while the fourth quarter of the fiscal showed a meagre rise of 1.6 per cent. The
GDP numbers released by the National Statistical Office (NSO) on Monday, reflect the delicate state
of the nation's economy and is all the more glaring since the Centre had begun the 'Unlock' process
from July 2020 onwards after imposing a nation-wide lockdown in March 2020, which had lasted till
June 2020.

The fourth quarter numbers are all the more poor as during the January-March period, all sectors
had been completely opened and the situation was near normal, yet a 1.6 per cent growth during
the fourth quarter of FY21 shows all is not well with the fiscal health of the nation.

"Real GDP or Gross Domestic Product (GDP) at Constant (2011-12) Prices in the year 2020-21 is now
estimated to attain a level of ₹ 135.13 lakh crore, as against the First Revised Estimate of GDP for the
year 2019-20 of ₹ 145.69 lakh crore, released on 29th January 2021. The growth in GDP during 2020-
21 is estimated at -7.3 percent as compared to 4.0 percent in 2019-20," Ministry of Statistics &
Programme Implementation said in a press release.

In 2019-20, the GDP had shown a poor growth of four per cent, an 11-year low, mainly due to
contraction in secondary sectors like manufacturing and construction.

During the first quarter of 2020-21, India's GDP had shrunk by 24.38 per cent, hit mainly by the
Covid-19 pandemic.

The Central Statistics Office (CSO) released the GDP numbers for January-March quarter and
financial year 2020-21 on Monday evening.

Hit by the pandemic and the nationwide lockdown imposed to curb the spread of infections last
year, India's economy had contracted during the first half of FY21, before returning to positive
territory in October-December quarter with a growth of 0.4 per cent. In April-June, the economy had
shrunk by 24.38 per cent, which improved to 7.5 per cent contraction in July-September.

The CSO had projected 8 per cent GDP contraction in FY21, implying a contraction of 1.1 per cent in
March quarter. Meanwhile, the Reserve Bank of India had projected a 7.5 per cent contraction for
FY21. However, most of the analysts had expected the economy to bounce back at a better-than-
expected pace in March quarter, and predicted that the FY21 contraction would be less than CSO's
projection of 8 per cent.

According to a SBI research report, India's GDP was likely to expand by 1.3 per cent in January-March
quarter, thus leading to a less-than-expected 7.3 per cent contraction during FY21

3 Lok Sabha has passed National Bank for financing Infrastructure

and Development Bill 2021.List out purposes and unique features.
 The National Bank for Financing Infrastructure and Development Bill, 2021 was introduced in
Lok Sabha on March 22, 2021.  The Bill seeks to establish the National Bank for Financing
Infrastructure and Development (NBFID) as the principal development financial institution
(DFIs) for infrastructure financing.  DFIs are set up for providing long-term finance for such
segments of the economy where the risks involved are beyond the acceptable limits of
commercial banks and other ordinary financial institutions.  Unlike banks, DFIs do not accept
deposits from people.  They source funds from the market, government, as well as multi-
lateral institutions, and are often supported through government guarantees.  
 
 NBFID: NBFID will be set up as a corporate body with authorised share capital of one lakh
crore rupees.  Shares of NBFID may be held by: (i) central government, (ii) multilateral
institutions, (iii) sovereign wealth funds, (iv) pension funds, (v) insurers, (vi) financial
institutions, (vii) banks, and (viii) any other institution prescribed by the central government.
Initially, the central government will own 100% shares of the institution which may
subsequently be reduced up to 26%.
 
 Functions of NBFID: NBFID will have both financial as well as developmental objectives.
Financial objectives will be to directly or indirectly lend, invest, or attract investments for
infrastructure projects located entirely or partly in India.  Central government will prescribe
the sectors to be covered under the infrastructure domain.  Developmental objectives
include facilitating the development of the market for bonds, loans, and derivatives for
infrastructure financing.  Functions of NBFID include: (i) extending loans and advances for
infrastructure projects, (ii) taking over or refinancing such existing loans, (iii) attracting
investment from private sector investors and institutional investors for infrastructure
projects, (iv) organising and facilitating foreign participation in infrastructure projects, (v)
facilitating negotiations with various government authorities for dispute resolution in the
field of infrastructure financing, and (vi) providing consultancy services in infrastructure
financing.  
 
 Source of funds: NBFID may raise money in the form of loans or otherwise both in Indian
rupees and foreign currencies, or secure money by the issue and sale of various financial
instruments including bonds and debentures.  NBFID may borrow money from: (i) central
government, (ii) Reserve Bank of India (RBI), (iii) scheduled commercial banks, (iii) mutual
funds, and (iv) multilateral institutions such as World Bank and Asian Development Bank.
 
 Management of NBFID:  NBFID will be governed by a Board of Directors.  The members of
the Board include: (i) the Chairperson appointed by the central government in consultation
with RBI, (ii) a Managing Director, (iii) up to three Deputy Managing Directors, (iv) two
directors nominated by the central government, (v) up to three directors elected by
shareholders, and (vi) a few independent directors (as specified).  A body constituted by the
central government will recommend candidates for the post of the Managing Director and
Deputy Managing Directors.  The Board will appoint independent directors based on the
recommendation of an internal committee.
 
 Support from the central government: The central government will provide grants worth Rs
5,000 crore to NBFID by the end of the first financial year.  The government will also provide
guarantee at a concessional rate of up to 0.1% for borrowing from multilateral institutions,
sovereign wealth funds, and other foreign funds.  Costs towards insulation from fluctuations
in foreign exchange (in connection with borrowing in foreign currency) may be reimbursed
by the government in part or full.  Upon request by NBFID, the government may guarantee
the bonds, debentures, and loans issued by NBFID.
 
 Prior sanction for investigation and prosecution: No investigation can be initiated against
employees of NBFID without the prior sanction of: (i) the central government in case of the
chairperson or other directors, and (ii) the managing director in case of other employees.
Courts will also require prior sanction for taking cognisance of offences in matters involving
employees of NBFID.
 
  Other DFIs: The Bill also provides for any person to set up a DFI by applying to RBI.   RBI may
grant a licence for DFI in consultation with the central government.  RBI will also prescribe
regulations for these DFIs.

 4. Government of India has recently lifts restriction on private banks to engage in government-
related business. List out the reasons for earlier ban and impact on banking sector after lifting of
ban

The Centre has lifted the restrictions on the grant of government businesses to private
banks, Finance Minister Nirmala Sitharaman announced on Wednesday. All private sector banks now
will be allowed to conduct government-related banking transactions, such as tax and pension
payments.

Sitharaman in a tweet said that private banks can now be equal partners in the development of the
Indian economy, furthering government social sector initiatives, and enhancing customer
convenience.

“Embargo lifted on grant of government business to private banks. All banks can now participate,”
she tweeted.

By lifting the embargo, this move will spur competition and promote greater efficiency in the
standards of customer services, the Department of Financial Services said in a statement.

In a statement, the finance ministry said the government has conveyed its decision to the Reserve
Bank of India (RBI). “With the lifting of the embargo, there is now no bar on the RBI for authorisation
of private banks for government business, including government agency business,” the statement
added.

Government-related banking transactions include taxes and other revenue payments, pension
payments, and small savings schemes.

In 2012, the finance ministry had not allowed private banks, barring some, to undertake government
business for three years.

In 2015, the government had continued with the embargo, and allowed the private sector with
existing government agency business to continue without any fresh authorisation to private banks.

For undertaking government agency business, the RBI pays a commission to banks. The central bank
carries out the general banking business of the central and state governments through agency banks
appointed under Section 45 of the RBI Act, 1934. The government transactions eligible to
commission are revenue receipts, payments on behalf of the central and state governments, pension
payments, and any other item specified by the RBI. The current directive relates to the central
government’s business.

“Private banks will get a level playing field, and get more room for government business,” said
Prashant Kumar, managing director and chief executive officer, YES Bank.
This will also benefit customers in specific instances like businesses and firms maintaining accounts
with public sector banks (PSBs) for paying tax, added Kumar. Now, this can be done through private
banks as well, he added.

The social sector programmes of the government can be conducted through private banks as well,
said Kumar. When private banks get government business, they will be obliged to perform, he
added. “Private banks are competent to handle mandates for public benefit with a robust digital
backbone.”

Hopefully, state governments will take a cue from this shift in approach and become open to engage
closely with private banks, he added.

The development underscores the importance of private banks and their technological prowess, said
Prakash Agrawal, head-financial institutions at India Ratings and Research. This will improve the flow
of current account savings account, along with pension accounts, improving both their funding and
fee income, said Agrawal.

However, PSBs will get impacted by the move, as this is a very large business for them, said a former
public sector banker. There is a strong chance that a good chunk of this business will move to private
banks over a period of time.

But private banks will not look at transaction-related business, given not much money is involved in
that, said the banker. Business that pertains to the deployment of funds through various
government ministries will be more lucrative, he added.

R K Thakkar, former chairman of UCO Bank, said the size and scale of the business is growing every
year and there is space for all. “This will be good for competition and enhance customer
convenience,” he said.
To give an estimate on the size of the government funds routed through agency banks, Thakkar said
taxes worth Rs 2-2.5 trillion are routed through agency banks every month.

Calling it a “good” decision, former banking secretary D K Mittal said the RBI will now have to work
out the modalities for allowing more banks to undertake government business. This will negatively
impact banks that are currently allowed to do business due to intense competition, he added.

5 List down key highlights of Economic Survey 2020-21 of Indian Economy.

5-Economic Survey 2020-21- Indian Economy

 
Strategy to face the Covid pandemic:
Response came from the humane principle that Human lives lost never be returned
back.  Gross Domestic Product (GDP) growth will recover from the temporary shock
caused by the Covid-19 pandemic. India’s policy response also derived from extensive
research on epidemiology.
One of the key insights was that pandemic spreads faster in higher and denser
population and intensity of lockdown matters most at the beginning of the pandemic.

Four Pillar Strategy:

India applied a unique four-pillar strategy having, financial, and long-term structural
reforms, containment and fiscal. India adopted a calibrated approach best suited for a
resilient recovery of its economy from COVID-19 pandemic impact, in contrast with a
front-loaded large stimulus package adopted by many countries

Covid pandemic affected both demand and supply:

The Rs. 1.46-lakh crore Production Linked Incentive (PLI) scheme is expected to make
India an integral part of the global supply chain and create huge employment
opportunities. Demand-side measures have been announced in a calibrated manner. 
Economic Recovery:
V-shaped Economic Recovery after Lockdown:

Starting July 2020, a resilient V-shaped recovery is underway.

Reasons:
It is supported by the initiation of a mega vaccination drive with   opens of a robust
recovery in the services sector and prospects for robust growth in consumption and
investment-shaped recovery is due to resurgence in high frequency indicators such
as power demand, rail freight, E-Way bills, Goods and Services Tax (GST) collection,
steel consumption, etc. The fundamentals of the economy remain strong as
gradual scaling back of lockdowns along with the support of Aatmanirbhar Bharat
Mission have placed the economy firmly on the path of revival.
Significance:
This path would entail a growth in real Gross Domestic Product (GDP) by 2.4% over
the absolute level of 2019-20 - implying that the economy would take two years to
reach and go past the pre-pandemic level.

Fiscal Developments
External Sector

GDP’s Estimation
India’s real 11.0% growth in FY2021-22 and nominal GDP recorded by 15.4%. These
projections are in line with International Monetary Fund estimates. India’s GDP is estimated
to contract by 7.7% in the Financial Year (FY) 2020-21, composed of a sharp 15.7% decline in
the first half and a modest 0.1% fall in the second half. 
ices, manufacturing, construction were hit hardest, and have been recovering steadily.
The external sector provided an effective cushion to growth with India recording a Current
Account Surplus of 3.1% of GDP in the first half of FY 2020-21.

Monetary Management and Financial Intermediation

Regulatory Forbearance:
Regulatory forbearance for banks after the Global Financial Crisis involved relaxing the
norms for restructuring assets, where restructured assets were no longer required to
be classified as Non-Performing Assets (NPAs henceforth) and therefore did not require
the levels of provisioning that NPAs attract. However, the survey points out that
regulatory forbearance is an emergency medicine, not staple diet and suggests: Instead
of continuing regulatory forbearance for years, policymakers should lay out thresholds
of economic recovery at which such measures will be withdrawn. An Asset Quality
Review exercise must be conducted by banks immediately after the forbearance is
withdrawn. Legal infrastructure for the recovery of loans needs to be strengthened.
To promote judgment amidst uncertainty, ex-post inquests must recognize the role of
hindsight bias and not equate unfavorable outcomes to bad judgment.

Foreign Investment:
Net Foreign Direct Investment (FDI) inflows of USD 27.5 billion during April-October,
2020 - 14.8% higher as compared to the first seven months of FY 2019-20.Net Foreign
Portfolio Investment (FPI) .

Debt Sustainability and Growth:

Growth leads to debt sustainability in the Indian context but not necessarily vice-versa.
Debt sustainability depends on the ‘Interest Rate Growth Rate Differential’ (IRGD), i.e.,
the difference between the interest rate and the growth rate.

Service Sector
Negative IRGD in India 
Not due to lower interest rates but much higher growth rates – prompts a debate on
fiscal policy, especially during growth slowdowns and economic crises. Fiscal policy that
provides an impetus to growth will lead to lower debt-to-GDP ratio. Given India’s growth
potential, debt sustainability is unlikely to be a problem even in the worst scenarios.
Desirable to use counter-cyclical fiscal
policy to enable growth during economic downturns.

Process Reforms:
The survey highlighted excessive regulation in the country. India over-regulates the
economy resulting in regulations being ineffective even with relatively good compliance
with process. The root cause of the problem of overregulation is an approach that
attempts to account for every possible outcome. Increase in complexity of regulations,
intended to reduce discretion, results in even more non-transparent discretion. The
solution is to simplify regulations and invest in greater supervision which, by definition,
implies greater discretion.

India and Sovereign Credit Ratings:

India's sovereign credit ratings do not reflect the economy's fundamentals and the global
agencies should become more transparent and less subjective in their ratings.

Defense Sector:
The allocated capital budget for defense has been fully utilized since 2016-17, reversing
the previous trends of surrender of funds.

Bare Necessities Index (BNI):

Bare Necessities Index (BNI) based on the large annual household survey data can
be constructed using suitable indicators and methodology at district level for
all/targeted districts to assess the progress on access to bare necessities. The BNI
summarizes 26 indicators on five dimensions viz., water, sanitation, housing, micro-
environment, and other facilities.
Improvement in Bare Necessities:

Bare necessities have improved across all States in the country in 2018 as compared to
2012.Increase in equity is noteworthy as the rich can access private options for public
goods.

 Agriculture and Food Processing

Healthcare:
Pradhan Mantri Jan Arogya Yojana (PM-JAY):
PM-JAY contributed to improvement in many health outcomes in States that
implemented the ambitious programme the Centre had launched more than two years
ago to provide healthcare access to most vulnerable sections.
National Health Mission (NHM):
NHM provided the regulations and vaccination strategy during Covid-19 emergency
crisis.
Government Spending:
An increase in government spending on the healthcare sector – from the current 1% to
2.5-3% of GDP – as envisaged in the National Health Policy 2017 could reduce out-of-
pocket expenditures.

Education:
Literacy:
India has attained a literacy level of almost 96% at the elementary school level. As
per National Sample Survey (NSS), the literacy rate of persons of age 7 years and above
at the All India level stood at 77.7% but the differences in literacy rate attainment
among social-religious groups, as well as gender still persists. Female literacy remained
below the national average among social groups of SC, ST, OBC, including religious
groups of Hinduism and Islam.
Rural Enrolment:
The percentage of enrolled children from government and private schools owning a
smartphone increased enormously from 36.5% in 2018 to 61.8% in 2020 in rural India.
PM eVIDYA:
PM eVIDYA is a comprehensive initiative to unify all efforts related to digital/online/on-
air education to enable multi-mode and equitable access to education for students and
teachers. Around 92 courses have started and 1.5 crore students are enrolled
under Swayam Massive Open Online Courses (MOOCs) which are online courses
relating to the National Institute of Open Schooling.
PRAGYATA:
PRAGYATA guidelines on digital education have been developed with a focus on
online/blended/digital education for students who are presently at home due to
closure of schools.
MANODARPAN:
The MANODARPAN initiative for psychological support has been included in
Atmanirbhar Bharat Abhiyan.

Vocational Courses and Skill Development:

Vocational courses will be introduced phase-wise in schools for classes 9 to 12 to
expose students to skill development avenues, as part of the Centre's flagship skilling
scheme Pradhan Mantri Kaushal Vikas Yojana 3.0.Merely 2.4% of India's workforce in
the age group of 15-59 years have received formal vocational or technical training,
while another 8.9% obtained training through informal sources. Out of the 8.9%
workforce who received non-formal training, the largest chunk is contributed by on-
the-job training (3.3%), followed by self-learning (2.5%) and hereditary sources
(2.1%) and other sources (1%).Among those who received formal training, the most
opted training course is IT-ITeS among both males and females. The Unified Skill
Regulator- National Council for Vocational Education and Training (NCVET) was
operationalized recently.

Sustainable Development and Climate Change:

Social Infrastructure, Employment and Human Development:

Inequality and Growth:

 Both inequality and per-capita income (growth) have similar relationships with socio-
economic indicators in India, unlike in advanced economies. Economic growth has a
greater impact on poverty alleviation than inequality. India must continue to focus on
economic growth to lift the poor out of poverty. Redistribution in a developing economy
is feasible only if the size of the economic pie grows.

            What are the 3 Major Concerns of Macroeconomics?

Three major macroeconomic concerns are the unemployment level,
inflation, and economic growth.

 1. Employment and Unemployment:

 ISSUE # 2. Inflation:

 ISSUE # 3. The Trade Cycle:

 ISSUE # 4. Stagflation:

 ISSUE # 5. Economic Growth:

 ISSUE # 6. The Exchange Rate and the Balance of Payments:

Price elascity

P1

a) Differentiate between Micro economics and Macroeconomics.

What is Microeconomics?
Microeconomics is the study of decisions made by people and businesses regarding the
allocation of resources and prices of goods and services. The government decides the regulation
for taxes. Microeconomics focuses on the supply that determines the price level of the economy.
It uses the bottom-up strategy to analyse the economy. In other words, microeconomics tries to
understand human’s choices and allocation of resources. It does not decide what are the
changes taking place in the market, instead, it explains why there are changes happening in the
market.
 The key role of microeconomics is to examine how a company could maximise its production and
capacity, so that it could lower the prices and compete in its industry. A lot of microeconomics
information can be obtained from the financial statements.
The key factors of microeconomics are as follows:

 Demand, supply, and equilibrium

 Production theory
 Costs of production
 Labour economics
Examples: Individual demand, and price of a product.

What is Macroeconomics?
Macroeconomics is a branch of economics that depicts a substantial picture. It scrutinises itself
with the economy at a massive scale, and several issues of an economy are considered. The
issues confronted by an economy and the headway that it makes are measured and
apprehended as a part and parcel of macroeconomics.
Macroeconomics studies the association between various countries regarding how the policies of
one nation have an upshot on the other. It circumscribes within its scope, analysing the success
and failure of the government strategies.
In macroeconomics, we normally survey the association of the nation’s total manufacture and the
degree of employment with certain features like cost prices, wage rates, rates of interest, profits,
etc., by concentrating on a single imaginary good and what happens to it.
The important concepts covered under macroeconomics are as follows:

1. Capitalist nation
2. Investment expenditure
3. Revenue

Examples: Aggregate demand, and national income.

b)

Microeconomics Macroeconomics

                                                                             Meaning

Microeconomics is the branch of Economics Macroeconomics is the branch of Economics that

that is related to the study of individual, deals with the study of the behaviour and
household and firm’s behaviour in decision performance of the economy in total. The most
making and allocation of the resources. It important factors studied in macroeconomics
comprises markets of goods and services and involve gross domestic product (GDP),
deals with economic issues. unemployment, inflation and growth rate etc.

                                                                         Area of study

Microeconomics studies the particular market Macroeconomics studies the whole economy,
segment of the economy that covers several market segments
                                                                              Deals with

Microeconomics deals with various issues like

Macroeconomics deals with various issues like
demand, supply, factor pricing, product
national income, distribution, employment,
pricing, economic welfare, production,
general price level, money, and more.
consumption, and more.

                                                          Business Application

It is applied to internal issues. It is applied to environmental and external issues.

                                                                                 Scope

It covers several issues like demand, supply, It covers several issues like distribution, national
factor pricing, product pricing, economic income, employment, money, general price level,
welfare, production, consumption, and more. and more.

                                                                              Significance

It is useful in regulating the prices of a product It perpetuates firmness in the broad price level,
alongside the prices of factors of production and solves the major issues of the economy like
(labour, land, entrepreneur, capital, and more) deflation, inflation, rising prices (reflation),
within the economy. unemployment, and poverty as a whole.

                                                                             Limitations

It has been scrutinised that the misconception of

It is based on impractical presuppositions, i.e.,
composition’ incorporates, which sometimes fails
in microeconomics, it is presumed that there is
to prove accurate because it is feasible that what is
full employment in the community, which is
true for aggregate (comprehensive) may not be
not at all feasible.
true for individuals as well.

(b)   What is price elasticity of demand? How it

can be measured?

What is price elasticity?

Both demand and supply curves show the relationship between price and
the number of units demanded or supplied. Price elasticity is the ratio
between the percentage change in the quantity demanded, \text{Q}_dQd
start text, Q, end text, start subscript, d, end subscript, or supplied, \
text{Q}_sQsstart text, Q, end text, start subscript, s, end subscript, and the
corresponding percent change in price.

The price elasticity of demand is the percentage change in the quantity

demanded of a good or service divided by the percentage change in the
price. The price elasticity of supply is the percentage change in quantity
supplied divided by the percentage change in price.

Elasticities can be usefully divided into five broad categories: perfectly

elastic, elastic, perfectly inelastic, inelastic, and unitary. An elastic
demand or elastic supply is one in which the elasticity is greater than one,
indicating a high responsiveness to changes in price. An inelastic
demand or inelastic supply is one in which elasticity is less than one,
indicating low responsiveness to price changes. Unitary
elasticities indicate proportional responsiveness of either demand or
supply.

Perfectly elastic and perfectly inelastic refer to the two extremes of

elasticity. Perfectly elastic means the response to price is complete and
infinite: a change in price results in the quantity falling to zero. Perfectly
inelastic means that there is no change in quantity at all when price
changes.
Using the midpoint method to calculate elasticity
To calculate elasticity, instead of using simple percentage changes in
quantity and price, economists sometimes use the average percent change
in both quantity and price. This is called the Midpoint Method for
Elasticity:

Th
e advantage of the midpoint method is that we get the same elasticity
between two price points whether there is a price increase or decrease.
 This is because the formula uses the same base for both cases. The
midpoint method is referred to as the arc elasticity in some textbooks.

Using the point elasticity of demand to calculate

elasticity
A drawback of the midpoint method is that as the two points get farther
apart, the elasticity value loses its meaning. For this reason, some
economists prefer to use the point elasticity method. In this method, you
need to know what values represent the initial values and what values
represent the new values.

Calculating the price elasticity of supply

Now let's try calculating the price elasticity of supply. We use the same
formula as we did for price elasticity of demand:

(c)    What is opportunity cost?

(e)    What are selling costs? Why selling costs are important in monopolistic competition?
(f)    What are the steps involved in estimating national income by income method?
(g)   What do you mean by static multiplier?
(h)   Explain the phases of Recession and Depression in a trade cycle.
(i)     What are the various instruments of monetary policy?
(j)     Define Hyperinflation?

What is Managerial Economics? Discuss its scope.

Definition of Managerial Economics

 
Managerial economics is defined as the branch of economics which deals
with the application of various concepts, theories, methodologies of
economics to solve practical problems in business management. It is also
reckoned as the amalgamation of economic theories and business
practices to ease the process of decision making. Managerial economics is
also said to cover the gap between the problems of logic and problems of
policy. 
 
Managerial economics is used to find a rational solution to problems faced
by firms. These problems include issues around demand, cost, production,
marketing, and it is used also for future planning. The best thing about
managerial economics is that it has a logical solution to almost every
problem that may arise during business management and that too by
sticking to the microeconomic policies of the firm. 
 
When we talk of managerial economics as a subject, it is a branch of
management studies that emphasizes solving business problems using
theories of micro and macroeconomics

Nature of Managerial Economics 

 We will now look at the characteristics of managerial economics in brief. 
 
 1. Art and Science
 
Managerial Economics requires a lot of creativity and logical thinking
to come up with a solution. A managerial economist should possess
the art of utilizing his capabilities, knowledge, and skills to achieve the
organizational objective. Managerial Economics is also considered as
a stream of science as it involves the application of different
economic principles, techniques, and methods, to solve business
problems.
 
 
2. Microeconomics
 
In managerial economics, problems of a particular organization are
looked upon rather than focusing on the whole economy. Therefore it
is termed as a part of microeconomics. 
 
 
3. Uses Macroeconomics
 
Any organization operates in a market that is a part of the whole
economy, so external environments affect the decisions within the
organization. Managerial Economics uses the concepts of
macroeconomics to solve problems. Managers analyze the
macroeconomic factors like market conditions, economic reforms,
government policies to understand their impact on the organization. 
 
 
4. Multi-disciplinary
  
Managerial Economics uses different tools and principles from
different disciplines like accounting, finance, statistics, mathematics,
production, operation research, human resource, marketing, etc. This
helps in coming up with a perfect solution. 
 
 
5. Management oriented and pragmatic
 
Managerial economics is a tool in the hands of managers that aids
them in finding appropriate solutions to business-related problems
and uncertainties. As mentioned above, managerial economics also
helps in goal establishment, policy formation, and effective decision
making. It is a practical approach to find solutions. 

We know about managerial economics like what it is and how different

people define it. Managerial Economics is an essential scholastic field. It
can be termed as a science in the sense that it fulfills the criteria of being a
science. 
 
 We all know science as a systematic body of knowledge and it is based on
methodological observations. Similarly, Managerial Economics is also a
science of making decisions and finding alternatives, keeping the scarce of
resources in mind. 
 In science, we arrive at any conclusion after continuous experimentation.
Similarly, in managerial economics policies are formed after constant
testing and trailing. 
 In science, principles are universally acceptable and in managerial
economics, policies are universally applicable at least partially if not fully. 
Q3.      Discuss the cost output relationship in long
run.

Q4.      Explain various pricing methods.

1. Penetration pricing
It’s difficult for a business to enter a new market and immediately capture
market share, but penetration pricing can help. The penetration pricing
strategy consists of setting a much lower price than competitors to earn
initial sales. These low prices can draw in new customers and divert
revenue from competitors.
This strategy is meant to jumpstart sales and won’t be effective for your
long-term growth. You’ll likely take a monetary loss at first in exchange for
higher sales volume and brand recognition. As you eventually raise prices
to be more in line with the market, prepare for some customers to drop off
as they continue to look for the cheapest option. You can combat customer
churn up front with strategies that turn those new buyers into loyal
customers.
Pro: Market penetration is much easier than entering with an average
price, and you can quickly earn new customers.
Con: It’s not sustainable in the long run and should only be a short-
term pricing strategy.
Example: A new cafe opens up in town and offers coffee that is 30%
cheaper than any other cafe in the area. They also focus on excellent
customer service and implement a loyalty program that offers every tenth
coffee for free. When customer demand has built up, the cafe slowly starts
increasing the coffee price to a more profitable level. This gives customers
a chance to build a taste for the coffee and other products and enjoy the
great service as they work towards their free tenth coffee. Many of them will
keep coming back as the price rises.
2. Skimming pricing
Businesses that charge maximum prices for new products and gradually
reduce the price over time follow a price skimming strategy. In this type
of pricing strategy, prices drop as products end their life cycle and become
less relevant. Businesses that sell high-tech or novelty products typically
use price skimming.
Pro: You can maximize profits of new products and make up for production
costs.
Con: Customers may become frustrated that they purchased at a higher
price and watch as the price gradually declines.
Example: A home entertainment store starts selling the latest, most
advanced television well above market price. Prices then gradually
decrease over the year as newer products come to market.
3. High-low pricing
High-low pricing is similar to skimming, except the price drops at a different
rate. With the high-low pricing method, the price of a product drops
significantly all at once rather than at a gradual pace. Retail businesses
that sell seasonal products typically use a high-low strategy, often using a
promotion to clear stock they won’t be able to sell for much longer.
Pro: You can clear your inventory of out-of-date products by discounting
them and putting them on clearance.
Con: Customers may wait for impending sales rather than purchasing at
full price.
Example: A boutique clothing store sells women’s sundresses at a high
price during the summer and then puts them on clearance once autumn
arrives.

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4. Premium pricing
Premium pricing occurs when prices are set higher than the rest of the
market to create perceived value, quality, or luxury. If your company has
a positive brand perception and a loyal customer base, you can often
charge a premium price for your high-quality, branded products. 
This type of pricing strategy works especially well if your target
audience includes early adopters who like to be ahead of the pack.
Companies that sell luxury, high-tech, or exclusive products—especially
within the fashion or tech industry—often use a premium pricing strategy. 
Pro: Profit margins are higher since you can charge much more than your
production costs.
Con: This type of pricing strategy only works if customers perceive your
product as premium.
Example: A beauty salon builds up credibility within its market (such as
via word of mouth or online reviews) and offers its services for 30% higher
than its competitors.
5. Psychological pricing
Psychological pricing strategies play on the psychology of consumers by
slightly altering price, product placement, or product packaging.
Some psychological pricing techniques include offering a “buy two, get one
half off” deal or setting the price to $9.99 rather than $10 (“well, it’s cheaper
than $10, isn’t it?”). Some businesses also use artificial time constraints to
speed customers into stores, such as one-day or limited-time sales.
Nearly any type of business can use this strategy, but retail and restaurant
businesses most commonly employ this method as it creates the
perception of getting a bargain.
Pro: You can sell more products by slightly tweaking your sales tactics
without losing profits.
Con: Some customers may perceive it as being tricky or salesy, which
could potentially tarnish your reputation or lead to missed sales.
Example: A restaurant sets a gourmet hamburger’s price at $12.95 to lure
customers into purchasing at a perceived lower price compared to $13.
6. Bundle pricing
Bundle pricing is a type of promotional pricing where two or more similar
products or services are sold together for one price. Bundling is an effective
way to upsell additional products to customers or add value to their
purchases. Restaurants, beauty salons, and retail stores are among the
many businesses that apply this type of pricing strategy.
Pro: Customers discover new products they weren’t initially planning to buy
and may end up purchasing them again.
Con: Products that are sold within a bundle will be bought less often
individually since consumers are saving money on a bundled purchase.
Example: A taco cantina sells tacos, tortilla chips, and salsa individually
but offers a discounted price if customers buy an entire meal with all of
these items.
7. Competitive pricing
The competitive pricing strategy sets the price of your products or services
at the current market rate. Your pricing is determined by all other products
in your industry, which helps you stay competitive if your business is in a
saturated industry. You can also decide to price your products above or
below the market rate, as long as it’s still within the range of prices set by
all competitors in your industry. 
With the advent of e-commerce, it‘s now easy to compare prices before
purchasing—and 96% of consumers do. This gives you an opportunity to
win over customers with a price slightly below the market average.
Pro: You can maintain market share in a competitive market and attract
customers who are interested in paying slightly less than your competitors’
rates.
Con: You need to diligently watch average market prices to maintain
a competitive advantage for price-conscious consumers.
Example:  A landscaping company compares its prices to local
competitors. It then sets the price for its most popular service, a lawn
maintenance package, below the market average to attract price-sensitive
customers.
8. Cost-plus pricing
Cost-plus pricing involves taking the amount it cost you to make the
product and increasing that amount by a set percentage to determine the
final price. You can work backwards to determine your markup percentage
by first figuring out how much you want to profit from each product sold.
Pro: Profits are more predictable since you’re setting your markup price to
a fixed percentage.
Con: Since this type of pricing strategy doesn’t account for external factors,
like your competitors’ pricing, or market demand, you may miss out on
sales if you set your markup percentage too high.
Example: A pizza shop adds up the cost of its ingredients and labor, then
sets the pizza price to receive a 20% profit margin.
9. Dynamic pricing
Dynamic pricing matches the current market demand for a product. Also
known as demand pricing, this pricing strategy most often occurs when the
product at hand fluctuates on a daily or even hourly basis. Industries like
hotels, airlines, and event venues set different prices daily and apply this
strategy to maximize profits.
Pro: You can increase overall revenues by raising prices when demand is
on the rise.
Con: Dynamic pricing requires complex algorithms that small businesses
may not have the ability to manage.
Example: A boutique hotel raises its room rates for one weekend because
there is a popular summer festival in town.
10. Economy pricing
Economy pricing consistently undercuts competitors with the goal of
making a profit through high sales volumes. This type of pricing
strategy usually goes hand-in-hand with low production costs. It works well
in the commodity goods sector and is used by companies like Walmart and
Costco.
Pro: You‘re likely to sell a large volume of products.
Con: You won’t be making much on each item, so you’ll need to sell more
goods than usual. Also, if you don‘t manage your pricing carefully, you
might create the perception of a low-value product or business.
Example: A superstore sells a generic brand of tea for 10% less than its
local grocery store competitors.
11. Freemium pricing
Freemium pricing offers a basic product or service for free, then
encourages customers to upgrade to the paid, premium version to access
more features or choices. Potential customers get a taste of what the
product or service can do for them and gain insight into your company. This
is a popular strategy for software businesses and membership-based
organizations.
Pro: You‘re building trust and educating potential customers about your
product. You also get their contact details so you can stay in touch
through email marketing.
Con: You don’t make money from every customer immediately and many
users may choose not to upgrade.
Example: A software company offers basic virus protection for free with the
option to upgrade to several other tiers of progressively higher levels of
online security.
12. Loss-leader pricing
Loss-leader pricing brings customers to your store to buy a highly
discounted product (the loss leader). While they’re there, they might buy
other full-price items they didn’t plan on—which should more than make up
for the loss of the original product.
Pro: This type of pricing strategy attracts customers who might not
otherwise visit your store and exposes them to your full range of products.
Con: Some customers will only buy the loss leader product (and possibly
many of them), so you need to watch your profit and stock levels closely.
Example: A supermarket offers bread at a very low price on Fridays,
attracting people who might then do all their shopping for the week.

Q6.      Describe the main causes of trade cycles in

an economy.-business cycle.
A business cycle is the fluctuations of Gross Domestic Products (GDP). It is a
series of cycles of economic expansions and contractions, therefore, it is also
called an economic cycle or a trade cycle. In this article, students will learn
about the causes and the effects of the business cycle.

Internal Causes
The factors that are built within the economic system and influence the
business cycle are called the internal causes of the business cycle. The major
causes that affect the business cycle are as follows:
 Change in Demand: A change in the demand of a good or service will
lead to changes in production and supply of the concerned goods and
services, thus, affecting output in an economy. This kind of change can
also cause inflation in an economy if there is excessive demand. A
decrease in demand will lead to lower output, lower employment
affecting the income of the public eventually leading to a trough in the
economy. If the situation is not resolved, it will lead to depression in the
economy.
 Investment Fluctuations: Changes in investments made will lead to
differences in output in an economy much like what happens in changes
in demand. So it naturally follows that an increase in investments will
lead to expansion of the economy while a decrease will lead to trough
or depression. There are a few factors affecting the investment
decisions: expectation of profits, entrepreneurial and current rate of
interests, and income generation.
 Macroeconomic Policies: The monetary and other related policies set
up by a government are the macroeconomic policies that immensely
affect the business cycle. If the policies benefit businesses and
 investors, the economy will see an expansion or boom leading to
economic growth, whereas, policies that will not benefit such
businesses but discourage investment instead such as an increase in
tax rates or removing subsidies will create recession in the economy.
 Supply of Money: It is obvious that more supply of money will make
people spend more which will, in turn, lead to growth or expansion in
the economy and vice-versa. But excessive money in the economy will
lead to inflation that will hurt the spending habits of the citizens whose
income did not increase at the same rate as inflation.

External Causes
The factors or changes that arise outside of an economy but still affect it are
called external causes of the business cycle. These are exogenous causes
that affect economies in other countries as well.
 Wars: During wars, economic resources and available capital are used
for manufacturing weapons and providing for the army which increases
the need for basic amenities among the general citizens as the focus
shifts to the battlefield and other places of the economy are ignored.
This slows down the economy and is one of the main causes of the
Great Depression of the 1930s.
 Technology: Changes and development of technology is an essential
cause of changes in the demands and supply of different goods and
services. It is also an influencing factor of employment opportunities and
progress in different fields of the economy.
 Natural Causes: Natural disasters like drought, famine or flooding
greatly affect several factors of input in the economy such as
transportation, employment, agriculture which results in an increase in
existing prices of related products. Such natural calamities may cause
depression.
 Population Expansion: Excessive expansion in population puts
pressure on the demands of an economy thereby affecting the supply
and prices of products. There is a strict need to control the population
through various policies in order to keep the economy in check.

Q7.      What are the various measures to control

inflation?
What is Inflation? In economics, inflation (or less frequently,
price inflation) is a general rise in the price level of an economy
over a period of time. When the general price level rises, each
unit of currency buys fewer goods and services; consequently,
inflation reflects a reduction in the purchasing power per unit of
money – a loss of real value in the medium of exchange and
unit of account within the economy.
As per RBI, an inflation target of 4 per cent with a +/-2 per cent
tolerance band, is appropriate for the next five years (2021-
2025).

Types of Inflation
The different types of inflation in an economy can be explained
as follows:

Demand-Pull Inflation
This type of inflation is caused due to an increase in aggregate
demand in the economy.
Causes of Demand-Pull Inflation:

 A growing economy or increase in the supply of money –

When consumers feel confident, they spend more and
take on more debt. This leads to a steady increase in
demand, which means higher prices.
 Asset inflation or Increase in Forex reserves– A sudden
rise in exports forces a depreciation of the currencies
involved.
 Government spending or Deficit financing by the
government – When the government spends more freely,
prices go up.
 Due to fiscal stimulus.
  Increased borrowing.
 Depreciation of rupee.
 Low unemployment rate.
Effects of Demand-Pull Inflation:

 Shortage in supply
 Increase in the prices of the goods (inflation).
 The overall increase in the cost of living.

Cost-Push Inflation
This type of inflation is caused due to various reasons such as:

 Increase in price of inputs

 Hoarding and Speculation of commodities
 Defective Supply chain
 Increase in indirect taxes
 Depreciation of Currency
 Crude oil price fluctuation
 Defective food supply chain
 Low growth of Agricultural sector
 Food Inflation
 Interest rates increased by RBI
Cost pull inflation is considered bad among the two types of
inflation. Because the National Income is reduced along with
the reduction in supply in the Cost-push type of inflation.

Built-in Inflation
This type of inflation involves a high demand for wages by the
workers which the firms address by increasing the cost of
goods and services for the customers.
Also, read about Inflation Targeting in the linked article.

Remedies to Inflation
The different remedies to solve issues related to inflation can
be stated as:

 Monetary Policy (Contractionary policy)

The monetary policy of the Reserve Bank of India is aimed at
managing the quantity of money in order to meet the
requirements of different sectors of the economy and to boost
economic growth.
This contractionary policy is manifested by decreasing bond
prices and increasing interest rates. This helps in reducing
expenses during inflation which ultimately helps halt economic
growth and, in turn, the rate of inflation.

 Fiscal Policy

  Monetary policy is often seen separate from fiscal

policy which deals with taxation, spending by
government and borrowing. Monetary policy is either
contractionary or expansionary.
 When the total money supply is increased rapidly
than normal, it is called an expansionary policy while
a slower increase or even a decrease of the same
refers to a contractionary policy.
 It deals with the Revenue and Expenditure policy of
the government.
Tools of fiscal policy

1. Direct Taxes and Indirect taxes – Direct taxes should be

increased and indirect taxes should be reduced.
 2. Public Expenditure should be decreased (should borrow
less from RBI and more from other financial institutions)

To know more about the Fiscal policy in India, refer to the

linked article.

 Supply Management measures

 Import commodities that are in short supply

 Decrease exports
 Govt may put a check on hoarding and speculation
 Distribution through Public Distribution System
(PDS).

Measurement of Inflation

1. Wholesale Price Index (WPI) – It is estimated by the

Ministry of Commerce & Industry and measured on a
monthly basis.
2. Consumer Price Index (CPI) – It is calculated by taking
price changes for each item in the predetermined lot of
goods and averaging them.
3. Producer Price Index – It is a measure of the average
change in the selling prices over time received by
domestic producers for their output.
4. Commodity Price Indices – It is a fixed-weight index or
(weighted) average of selected commodity prices, which
may be based on spot or futures price
5. Core Price Index – It measures the prices paid by
consumers for goods and services without the volatility
caused by movements in food and energy prices. It is a
way to measure the underlying inflation trends.
6. GDP deflator – It is a measure of general price inflation.
Know more about the Cash reserve ratio in this article.

Effect of Inflation on the Economy

The effect of inflation on the economy can be stated as:

  The effect of inflation is not distributed evenly in the

economy. There are chances of hidden costs for different
goods and services in the economy.
 Sudden or unpredictable inflation rates are harmful to an
overall economy. They lead to market instability and
thereby make it difficult for companies to plan a budget
for the long-term.
 Inflation can act as a drag on productivity as companies
are forced to mobilize resources away from products and
services to handle the situations of profit and losses from
inflation.
 Moderate inflation enables labour markets to reach
equilibrium at a faster pace
3. Effects on Income and Employment:
Inflation tends to increase the aggregate money income (i.e.,
national income) of the community as a whole on account of larger
spending and greater production. Similarly, the volume of
employment increases under the impact of increased production.
But the real income of the people fails to increase proportionately
due to a fall in the purchasing power of money.

4. Effects on Business and Trade:

ADVERTISEMENTS:

The aggregate volume of internal trade tends to increase during

inflation due to higher incomes, greater production and larger
spending. But the export trade is likely to suffer on account of a rise
in the prices of domestic goods. However, the business firms
expand their businesses to make larger profits.
During most inflation since costs do not rise as fast as prices profits
soar. But wages do not increase proportionate with prices, causing
hardships to workers and making more and more inequality. As the
old saying goes, during inflation prices move in escalator and wages
in stairs.

5. Effects on the Government Finance:

During inflation, the government revenue increases as it gets more
revenue from income tax, sales tax, excise duties, etc. Similarly,
public expenditure increases as the government is required to spend
more and more for administrative and other purposes. But the
rising prices reduce the real burden of public debt because a fix sum
has to be paid in instalment per period.

6. Effects on Growth:
A mild inflation promotes economic growth, but a runaway inflation
obstructs economic growth as it raises cost of development projects.
Although a mild dose of inflation is inevitable and desirable in a
developing economy, a high rate of inflation tends to lower the
growth rate by slowing down the rate of capital formation and
creating uncertainty.

3.What are the functions of business managers ?

4. How does economics helps business
managers in performing their functions?
(12Yz) What are the major macroeconomic
issues related directly to business decision-
making?
What is their significance in business
decisions ?
 5. What is indifference curve ? What are the
properties of indifference curves?

Indifference Curve
What is an Indifference Curve?

An indifference curve is a contour line where utility remains constant across

all points on the line. In economics, an indifference curve is a line drawn
between different consumption bundles, on a graph charting the quantity
of good A consumed versus the quantity of good B consumed. At each of
the consumption bundles, the individual is said to be indifferent.

Summary

 An indifference curve is a contour line where utility remains constant across

all points on the line.
 The four properties of indifference curves are: (1) indifference curves can
never cross, (2) the farther out an indifference curve lies, the higher the
utility it indicates, (3) indifference curves always slope downwards, and (4)
indifference curves are convex.
 The optimal consumption bundle is the tangency condition between the
indifference curve and the budget line.
What is Utility?

When an individual consumes goods and services, the satisfaction gained

or lost from consumption is called utility. Consumer preferences are defined
by the consumption bundles that consumers face. A collection bundle is a
bundle that maximizes the consumer’s total utility, given the consumer’s
budget constraints. One unit of utility is known as a util.
The Principle of Diminishing Marginal Utility

Marginal utility refers to the utility gained from the consumption of an

additional unit of a good or service.

The principle of diminishing marginal utility is illustrated here as the total

utility increases at a diminishing rate with additional consumption. It is
evidenced by figures D, E, and F having decreased marginal utility.
Therefore, the principle of diminishing marginal utility indicates that each
additional unit of consumption adds less to the cumulative utility than the
previous unit.
What Does an Indifference Curve Look Like?

An indifference curve is a contour line where utility remains constant across

all points on the line. Each point on an indifference curve represents a
consumption bundle, and the consumer is indifferent among all
consumption bundles on the indifference curve. In our example, the
consumer yields 250 utils.

An entire utility function can be graphically represented by an indifference

curve map, where several indifference curves correspond to different levels
of utility. In the graph below, there are three different indifference curves,
labeled A, B, and C. The farther from the origin, the greater utility is
generated across all consumption bundles on the curve.
Properties of Indifference Curves

If a good satisfies all four properties of indifference curves, the goods are
referred to as ordinary goods. They can be summarized as the consumer
requires more of one good to compensate for less consumption of another
good, and the consumer experiences a diminishing marginal rate of
substitution when deciding between two goods.

4. Indifference curves never cross. If they could cross, it would create

large amounts of ambiguity as to what the true utility is.
5. The farther out an indifference curve lies, the farther it is from the
origin, and the higher the level of utility it indicates. As illustrated
above on the indifference curve map, the farther out from the origin,
the more utility the individual generates while consuming.
6. Indifference curves slope downwards. The only way an individual can
increase consumption in one good without gaining utility is to
consume another good and generate the same amount of utility.
Therefore, the slope is downwards sloping.
 7. Indifference curves assume a convex shape. As illustrated above in
the indifference curve map, the curve gets flatter as you move down
the curve to the right. It illustrates that all individuals experience
diminishing marginal utility, where additional consumption of
another good will generate a lesser amount of utility than the prior.
What Defines the Convexity of Indifference Curves?

As you go down the curve of an indifference curve, the curve becomes

flatter as one good is substituted for the other. It is the
individual’s marginal rate of substitution, which is defined as the more an
individual consumes good A in proportion to good B, the less of good B
the individual will substitute for another unit of good A.

The Optimal Consumption Bundle

In the graph below, point A illustrates the tangency condition the utility
curve has with the budget line constraint.
The tangency condition between the indifference curve and the budget line
indicates the optimal consumption bundle when indifference curves exhibit
typical convexity.

Slope of the Budget Line

The slope of the budget line is the relative price of good A in terms of good
B, equal to the price of good A as a ratio of the market price of good B.
Moreover, the slope of the budget line subtracted by relative price
represents the opportunity cost of consumption. There is an opportunity
cost because of the consumer’s limited budget. The budget line is shifted
outwards by the price of goods becoming proportionally cheaper.

Slope of the Indifference Curve

The slope of the indifference curve at any point is the negative marginal
utility of good A as a proportion of the marginal utility of good B. It
indicates that the optimal consumption bundle – the marginal rate of
substitution between goods A and B – is the ratio of their prices.

6.What are the sources of monopoly of a firm ?

Di~i~uish'~ between a franchise monopoly
and natural'''tnonopoLy:·

Monopoly Power: Meaning,

Sources, and Effects
You are here: Home / Economics / Microeconomics / Monopoly Power: Meaning, Sources, and
Effects
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What’s it: Monopoly power refers to a firm’s ability to influence market

prices. It is weak when the market is made up of many players, and
products are relatively homogeneous. Market power is higher when firms
operate under an oligopoly, where the market consists of only a few firms.
And, the firm has absolute market power if it is the only producer in the
market (monopoly).

Monopoly power is synonymous with market power and is often used

interchangeably in some literature.

The relationship between monopoly power

and market structure
Monopoly power is often contrasted with a price taker. When a company is
a price taker, it has no control over their products’ selling price, let alone
influence the market price. It only takes the market price as the selling price
of its products. Price takers work in a perfectly competitive market.

In a monopolistic competitive market, firms have some power to set prices.

They do this by differentiating the offer. One way is to differentiate product
features or branding through advertising. Differentiation allows the
company to set a selling price that is higher than the market price.

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Furthermore, monopoly power is getting more significant in the oligopoly

market. Because the market comprises a few firms, firms have more
market power than monopolistic competitive markets. The fewer players,
the higher the power over the selling price.

Under an oligopoly market, competition has a more intriguing dimension. I

mean, in designing strategy, companies are likely to observe strategic
decisions made by their opponents. Or, they may collude or form cartels.

Finally, the power over market prices is absolute in a monopoly market.

The monopolist determines supply, product quality, and selling price
because it is the sole supplier.

The monopolist has neither direct competitors nor threats from substitute
products. Barriers to entry are also very high, allowing the company to
maintain its power. Furthermore, the customer doesn’t have the option to
switch to another product because there is no substitute product.
 What affects monopoly power
The significance of monopoly power depends on:

 Market entry barriers. The higher the entry barriers, the higher the
company’s chance to gain and maintain monopoly power. New entrants
bring new capacities to the market and add choices for consumers.
Suppose the current firm charges a higher price than the equilibrium price.
In that case, the new entrant may offer at the equilibrium price,
encouraging more purchases.
 The number of rivals. The fewer players, the greater the monopoly power.
As I explained earlier, market power in perfect competition is zero. It will
increase when the market leads to monopoly. Moreover, if the market
consists of a few players, it was easy for them to collude in setting prices.
 Product differentiation. Differentiation increases a firm’s ability to set a
selling price. Conversely, when producing a homogeneous product (mass
product), the power over the selling price decreases. Once the company
charges a higher price than other players, consumers will switch to cheaper
products. Long story short, differentiation increases consumer switching
costs.

Sources of monopoly power

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Market power comes from a variety of sources, including:

 Economies of scale
 Resource control
 Demand elasticity
 Legal barriers

Economies of scale
Economies of scale affect a firm’s cost structure. Take, for example, a
market (industry) which has the characteristics of a significant proportion
of fixed costs.

To achieve economies of scale and lower costs, it requires a few players.

In fact, the market might require only one company to produce cheap
output.
Such situations will eventually lead to monopoly, which we often refer to as
a natural monopoly. The most common examples are in the electrical
industry.

Resource control
Firms also have influence over market prices if they have control over
resources essential to production. Companies can limit competitors to
obtain the same resources. Competitors may have to pay more to access
resources.

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So, indirectly, the resource authority will influence the cost structure in the
market, which impacts the price in the market.

Demand elasticity
The company is better positioned to charge prices higher than its marginal
cost if demand elasticity is low (demand is relatively inelastic). Conversely,
if the elasticity of demand is high (demand is relatively elastic), the firm has
less market power.

Economists use the Lerner Index to measure market strength. This index

basically measures the price markup on marginal cost.

 Lerner’s index (L) = (P – MC) / P = 1 / | E |

Where P is price, MC is marginal cost and E is the elasticity of demand.

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When Lerner’s index is positive (L≥0), the firm has monopoly power. They
can charge more than their marginal cost—the greater the index value, the
greater the monopoly power.

Furthermore, in perfect competition, Lerner’s Index is equal to zero (L = 0).

The firm does not have the power to influence market prices and charge
the selling price at a marginal cost level—the closer to 0, the closer to
perfect competition.

Regulatory barriers
Monopoly power also arises because of regulatory support. The
government may only permit one company to operate in the market.
Usually, it is for strategic industries such as utilities and the weapons
industry.

Not only that, but the granting of patents, copyrights, licenses, protection of
other intellectual property rights also contributes to market power. Such
protection prevents others from copying or selling an innovation. Only the
owner can monetize it.

The effects of monopoly power on market

failure
Market failures arise when market mechanisms don’t work. The selling
price doesn’t reflect the equilibrium price. Producers will take advantage by
setting a price higher than the equilibrium price. As a result, the consumer
surplus decreases.

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An extreme case is perfect price discrimination in a monopoly market. The

monopolist sets the selling price at the consumer reservation price level.
The reservation price is the highest price a consumer is willing to pay.

Because each consumer has a different reservation price, the monopolist

will set a different price for each customer, according to the reservation
price. In this way, the monopolist can maximize profits and convert the total
consumer surplus into producer surplus.

How to reduce monopoly power

Monopoly power isn’t always detrimental, as long as the product’s price
matches consumers’ satisfaction. Despite paying higher prices, consumers
get a higher quality product.

Moreover, in natural monopoly, the market would be more beneficial if it

consisted of only one player. That way, the average cost drops, and the
selling price is more affordable.

But, in more and more cases, monopoly power hurts consumers. They pay
higher prices for unqualified products. There are various ways to reduce
monopoly power, including:
 Deregulation – The government may issue several regulations for several
industries. But, if the industry continues to be inefficient and innovative, it
can release regulations to open up more competition. For example,
increasing the limits on foreign ownership in specific industries.
 Privatization – This is to reduce the state monopoly in the economic
sector. In this case, the government sold state-owned companies to the
private sector.
 Competition rules – for example, antitrust laws. Such regulation prevents
unfair competition practices that lead to increased monopoly power.

Related

 A franchised monopoly refers to a company, or individual, that

is sheltered from competition by virtue of an exclusive license or
patent granted by the government.
 Government-issued franchised monopolies are typically established
because they are believed to be the best option for supplying a good
or service from the perspective of both the producers and the
consumers of that good or service.
 Governments typically regulate the price of the products offered by a
franchised monopoly to prevent them from selling at high prices.
 Franchised monopolies can be found in essential sectors such as
transportation, water supply, and power.
 Critics of franchised monopolies believe they don't lead to efficiency,
innovation, and can be subject to favoritism.

 A natural monopoly is a type of monopoly that arises due to unique
circumstances where high start-up costs and significant economies
of scale lead to only one firm being able to efficiently provide the
service in a certain territory.
 A company with a natural monopoly might be the only provider or
product or service in an industry or geographic location.
 Natural monopolies are allowed when a single company can supply
a product or service at a lower cost than any potential competitor but
are often heavily regulated to protect consumers.

Q-25-Define Oligopoly. What is the basic

difference between #, oligopoly and
 monopolistic competition? In which of the
two kinds of markets price and output are
intermediate ?
Monopoly
A monopoly exists in areas where one company is the only or dominant
force to sell a product or service in an industry. This gives the company
enough power to keep competitors away from the marketplace. This could
be due to high barriers to entry such as technology,
steep capital requirements, government regulation, patents or high
distribution costs.

Once a monopoly is established, lack of competition can lead the seller to

charge high prices. Monopolies are price makers. This means they
determine the cost at which their products are sold. These prices can be
changed at any time. A monopoly also reduces available choices for
buyers. The monopoly becomes a pure monopoly when there is absolutely
no other substitute available.

Monopolies are allowed to exist when they benefit the consumer. In some
cases, governments may step in and create the monopoly to provide
specific services such as a railway, public transport or postal services. For
example, the United States Postal Service enjoys a monopoly on first class
mail and advertising mail, along with monopoly access to mailboxes.2

 
The United States Postal Service enjoys a monopoly on letter carrying and
access to mailboxes that is protected by the Constitution.2

Oligopoly
In an oligopoly, a group of companies (usually two or more) controls the
market. However, no single company can keep the others from wielding
significant influence over the industry, and they each may sell products
that are slightly different.

Prices in this market are moderate because of the presence of

competition. When one company sets a price, others will respond in
fashion to remain competitive. For example, if one company cuts prices,
other players typically follow suit. Prices are usually higher in an oligopoly
than they would be in perfect competition.

Because there is no dominant force in the industry, companies may be

tempted to collude with one another rather than compete, which keeps
non-established players from entering the market. This cooperation makes
them operate as though they were a single company.

In 2012, the U.S. Department of Justice alleged that Apple (AAPL) and five
book publishers had engaged in collusion and price fixing for e-books. The
department alleged that Apple and the publishers conspired to raise the
price for e-book downloads from $9.99 to $14.99.3 A U.S. District Court
sided with the government, a decision which was upheld on appeal.4

In a free market, price fixing—even without judicial intervention—is

unsustainable. If one company undermines its competition, others are
forced to quickly follow. Companies that lower prices to the point where
they are not profitable are unable to remain in business for long. Because
of this, members of oligopolies tend to compete in terms of image and
quality rather than price.

Legalities of Monopolies vs. Oligopolies

Oligopolies and monopolies can operate unencumbered in the United
States unless they violate anti-trust laws. These laws cover unreasonable
restraint of trade; plainly harmful acts such as price fixing, dividing markets
and bid rigging; and mergers and acquisitions (M&A) that substantially
lessen competition.1

Without competition, companies have the power to fix prices and create
product scarcity, which can lead to inferior products and services and
higher costs for buyers. Anti-trust laws are in place to ensure a level
playing field.

In 2017, the U.S. Department of Justice filed a civil antitrust suit to block
AT&T's merger with Time Warner, arguing the acquisition would
substantially lessen competition and lead to higher prices for television
programming.5 However, a U.S. District Court judge disagreed with the
government's argument and approved the merger, a decision that was
upheld on appeal.6

The government has several tools to fight monopolistic behavior. This

includes the Sherman Antitrust Act, which prohibits unreasonable restraint
of trade, and the Clayton Antitrust Act, which prohibits mergers that lessen
competition and requires large companies that plan to merge to seek
approval in advance.1 Anti-trust laws do not sanction companies that
achieve monopoly status via offering a better product or service, or though
uncontrollable developments such as a key competitor leaving the market.
Examples of Monopolies and Oligopolies
A company with a new or innovative product or service enjoys a monopoly
until competitors emerge. Sometimes these new products are protected by
law. For example, pharmaceutical companies in the U.S. are granted 20
years of exclusivity on new drugs.7 This is necessary due to the time and
capital required to develop and bring new drugs to market. Without this
protected status, firms would not be able to realize a return on
their investment, and potentially beneficial research would be stifled.

Gas and electric utilities are also granted monopolies. However, these
utilities are heavily regulated by state public utility commissions. Rates are
often controlled, along with any rate increases the company may pass onto
consumers.

Oligopolies exist throughout the business world. A handful of companies

control the market for mass media and entertainment. Some of the big
names include The Walt Disney Company (DIS), ViacomCBS (VIAC) and
Comcast (CMCSA). In the music business, Universal Music Group and
Warner Music Group have a tight grip on the market.

From an economic perspective, a market comprises buyers and sellers.

The buyer purchases products or services from the seller, and in turn, the
seller tries to promote his products.
In a situation where there are many sellers and there is no interference
from the government, it gives rise to strict competition. In a market,
there are two types of competitions that exist, namely perfect and
imperfect competitions.
A perfect competition is a situation where the price of a commodity is
not under the control of the individual sellers and buyers. An imperfect
competition is a situation where either the buyer or the seller exercises
control over the price of a commodity. There are three types of imperfect
competitions, namely monopoly, oligopoly, and monopolistic
competition.
What is a Monopoly?
A monopoly is a type of imperfect competition in which a company and
its product dominate the sector or industry. This situation arises when
there is no competitor in the market for the same product.
Monopolies enjoy a significant market share due to the absence of any
competitors. They can control the price of the product by knowing that
the product will sell.
Competitors are unable to enter the market due to the high barrier of
entry. The organisation can change the prices at their will due to the
resources at their disposal, and in this way, kill the competition from
small scale manufacturers.
Also Check: Features of Monopoly Market

What is a Monopolistic Competition?

A monopolistic competition is a type of imperfect competition where
there are many sellers in the market who are competing against each
other in the same industry. They position their products, which are near
substitutes of the original product.
In a monopolistic competition, the barriers of entrance and exit are
comparatively low. The companies try to differentiate their products by
offering price cuts for their goods and services. The examples of such
industries are hotels, e-commerce stores, retail stores, and salons.
The following table will help students grasp the most critical points of
difference between monopoly and monopolistic competition.

Monopoly Monopolistic Competition

 What does it mean?

A monopoly is the type of imperfect A monopolistic competition is a type of

competition where a seller or producer imperfect competition where many
captures the majority of the market share sellers try to capture the market share by
due to the lack of substitutes or competitors. differentiating their products.
 Number of players

One Many

Degree of competition

No competition exists, as only one seller is A very high competition exists, as there
present in the market. are many sellers.

Barriers to entry

High barriers to entry Low barriers to entry

Demand curve

Steep Flat

6. What is inflation? How does it affect

economic growth and employment?
Q40Examine critically profit maximization
as the objective of business firms. Explain
the first and second order conditions of
profit maximization.

Q10.Elaborate the concept demand elasticities.

Examine the role played by demand elasticity in
managerial decision making.
Elasticity of Demand
“Elasticity of demand is the responsiveness of the quantity
demanded of a commodity to changes in one of the variables on
which demand depends. In other words, it is the percentage change in
quantity demanded divided by the percentage in one of the variables
on which demand depends.”

The variables on which demand can depend on are:

 Price of the commodity

 Prices of related commodities
 Consumer’s income, etc.

Let’s look at some examples:

a. The price of a radio falls from Rs. 500 to Rs. 400 per unit. As a

result, the demand increases from 100 to 150 units.
b. Due to government subsidy, the price of wheat falls from Rs.
10/kg to Rs. 9/kg. Due to this, the demand increases from 500
kilograms to 520 kilograms.
In both cases above, you can notice that as the price decreases, the
demand increases. Hence, the demand for radios and wheat responds
to price changes.

Types of Elasticity of Demand

Based on the variable that affects the demand, the elasticity of
demand is of the following types. One point to note is that unless
otherwise mentioned, whenever the elasticity of demand is
mentioned, it implies price elasticity.
Price Elasticity
The price elasticity of demand is the response of the quantity
demanded to change in the price of a commodity. It is assumed that
the consumer’s income, tastes, and prices of all other goods are
steady. It is measured as a percentage change in the quantity
demanded divided by the percentage change in price. Therefore,

$$\text{Price Elasticity} = E_p =  \frac{\text{Percentage change in

quantity demanded}}{\text{Percentage change in price}}$$

Or,

Ep=Change in Quantity×100Original QuantityChange in Price×100Original Price

=Change in QuantityOriginal Quantity×Original
PriceChange in Price
Income Elasticity
The income elasticity of demand is the degree of responsiveness of
the quantity demanded to a change in the consumer’s income.
Symbolically,

EI=Percentage change in quantity demandedPercentage

change in income
Cross Elasticity
The cross elasticity of demand of a commodity X for another
commodity Y, is the change in demand of commodity X due to a
change in the price of commodity Y. Symbolically,

Ec=ΔqxΔpy×pyqx
Where,
 Ec
 is the cross elasticity,

Δqx
 is the original demand of commodity X,

Δqx
 is the change in demand of X,

Δpy
 is the original price of commodity Y, and

Δpy
 is the change in price of Y.

Q11. What do you mean by perfect competition? How

price output decisions are undertaken under it?
efinition: Perfect competition describes a market structure where
competition is at its greatest possible level. To make it more clear,
a market which exhibits the following characteristics in its structure
is said to show perfect competition:

1. Large number of buyers and sellers

2. Homogenous product is produced by every firm

3. Free entry and exit of firms

4. Zero advertising cost

5. Consumers have perfect knowledge about the market and are

well aware of any changes in the market. Consumers indulge in
rational decision making.

6. All the factors of production, viz. labour, capital, etc, have perfect
mobility in the market and are not hindered by any market factors
or market forces.

7. No government intervention

8. No transportation costs
 9. Each firm earns normal profits and no firms can earn super-
normal profits.

10. Every firm is a price taker. It takes the price as decided by the
forces of demand and supply. No firm can influence the price of the
product.

How is the principle of Perfect Competition Used?

Perfect competition refers to a standard that enables the comparison of

different market models. In theoretical language, it is totally the antonym of
a monopoly where there is only one firm selling a product or service. Being
the sole supplier and because of no competition, the firm becomes the
price maker and has the ability to set any price for their products. They
know that customers will buy their product no matter how high they set the
prices. However, in perfect competition, there are lots of buyers and sellers
for homogenous products, and this regulates the market demand and
supply. Firms manage to stay in a profitable position so as to keep their
business going. Because of no barrier to entry, new firms can enter the
market at any time, and affect the profitability of the existing firms. A market
that is perfectly competitive has the following features:

 All companies sell homogenous products.

 All companies are price takers and not price makers.
 All companies enjoy lesser market share.
 Buyers already have knowledge about the type of product being sold followed by its
prices.
 The firms can enter or exit the industry any time they want.

Q12. What do you mean by product differentiation in

monopolistic competition? Discuss pricing output decision
in this form of competition.
Monopolistic Competition
Product Differentiation
Product differentiation is the process of distinguishing a product or service from others
to make it more attractive to a target market.

 Differentiation occurs because buyers perceive a difference between products.

Causes of differentiation include functional aspects of the product or service, how it
is distributed and marketed, and who buys it.
 Differentiation affects performance primarily by reducing direct competition. As the
product becomes more different, categorization becomes more difficult, and the
product draws fewer comparisons with its competition.
 There are three types of product differentiation: simple, horizontal, and vertical.

Key Terms

 product differentiation: Perceived differences between the product of one firm

and that of its rivals so that some customers value it more.

One of the defining traits of a monopolistically competitive market is that there is a

significant amount of non- price competition. This means that product differentiation is
key for any monopolistically competitive firm. Product differentiation is the process of
distinguishing a product or service from others to make it more attractive to a target
market.

Although research in a niche market may result in changing a product in order to

improve differentiation, the changes themselves are not differentiation. Marketing or
product differentiation is the process of describing the differences between products or
services, or the resulting list of differences; differentiation is not the process of creating
the differences between the products. Product differentiation is done in order to
demonstrate the unique aspects of a firm's product and to create a sense of value.

In economics, successful product differentiation is inconsistent with the conditions of

perfect competition, which require products of competing firms to be perfect substitutes.

Consumers do not need to know everything about the product for differentiation to
work. So long as the consumers perceive that there is a difference in the products, they
do not need to know how or why one product might be of higher quality than another.
For example, a generic brand of cereal might be exactly the same as a brand name in
terms of quality. However, consumers might be willing to pay more for the brand name
despite the fact that they cannot identify why the more expensive cereal is of higher
"quality".
There are three types of product differentiation:

 Simple: the products are differentiated based on a variety of characteristics;

 Horizontal: the products are differentiated based on a single characteristic, but
consumers are not clear on which product is of higher quality; and
 Vertical: the products are differentiated based on a single characteristic and
consumers are clear on which product is of higher quality.

Differentiation occurs because buyers perceive a difference. Drivers of differentiation

include functional aspects of the product or service, how it is distributed and marketed,
and who buys it. The major sources of product differentiation are as follows:

 Differences in quality, which are usually accompanied by differences in price;

 Differences in functional features or design;
 Ignorance of buyers regarding the essential characteristics and qualities of goods
they are purchasing;
 Sales promotion activities of sellers, particularly advertising; and
 Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as

unique. Differentiation affects performance primarily by reducing direct competition. As
the product becomes more different, categorization becomes more difficult, and the
product draws fewer comparisons with its competition. A successful product
differentiation strategy will move the product from competing on price to competing on
non-price factors.

13. How is national income measured? Discuss

the conceptual framework of triple identity.
What is National Income?
The total value of final goods and services produced by the normal
residents during an accounting year, after adjusting depreciation.

 It is Net National Product (NNP) at Factor Cost (FC)

 It does not include taxes, depreciation and non-factor inputs (raw
materials)
Domestic Income – Total value of final goods and services produced
within a domestic territory during an accounting year, after adjusting
depreciation.

 It is NDP at FC
 Both NNP and NDP can be measured at constant prices (real
income) or market prices (nominal income)
 Domestic Income + NFIA = National Income

Measurement of National Income

There are three methods to measure national income:

Methods to Measure National Income

S.No Measurement Method

1. Income Method

2. Production (Value-Added) Method

3. Expenditure Method

Measurement of National Income – Income Method

Estimated by adding all the factors of production (rent, wages, interest,
profit) and the mixed-income of self-employed.

1. In India, one-third of people are self-employed.

2. This is the ‘domestic’ income, related to the production within the
borders of the country

Measurement of National Income – Production Method

Estimated by adding the value added by all the firms.
Value-added = Value of Output – Value of (non-factor) inputs
 1. This gives GDP at Market Price (MP) – because it includes
depreciation (therefore ‘gross’) and taxes (therefore ‘market price’)
2. To reach National Income (that is, NNP at FC)

 Add Net Factor Income from Abroad: GNP at MP = GDP at

MP + NFIA
 Subtract Depreciation: NNP at MP = GNP at MP – Dep
 Subtract Net Indirect Taxes: NNP at FC = NNP at MP – NIT

Measurement of National Income – Expenditure Method

The expenditure method to measure national income can be understood
by the equation given below:
Y = C + I + G + (X-M),
where Y = GDP at MP, C = Private Sector’s Expenditure on final consumer
goods, G = Govt’s expenditure on final consumer goods, I = Investment
or Capital Formation, X = Exports, I = Imports, X-M = Net Exports
Any of these methods can be used in any of the sectors – the choice of
the method depends on the convenience of using that method in a
particular sector

Quick Facts about National Income for UPSC Prelims

The table mentioned below gives the list of items that are included in
national income and of those which are not included:

National Income

Items Included in Items not included in National Income

National Income

Goods produced for self- Intermediate goods

consumption

Estimated rent of the self- Transfer payments (unilateral payments made without
occupied property expectations of return; like gifts, unemployment allowance,
 donations, etc)

– Sale and purchase of old goods and existing services (shares

are not included unless they are through an IPO)

– Windfall gains (lottery income)

– Black money (cannot be estimated)

– Work done by housewives

1. A first rough estimate of National Income was done by Dadabhai

Naoroji for 1867-68; published in his book Poverty and Unbritish
rule in India (famous for its Drain of Wealth theory)
2. The first scientific estimate made by Prof V K R V Rao (1931-32)
3. The Indian government estimated the National Income for the first
time in 1948-49 through the Ministry of Commerce
4. National Income Committee was set up in 1949 (Chairman – Dr. P
C Mahalanobis)

 P C Mahalanobis was also the chairman of Indian Statistical

Institute
5. Currently, the National Statistical Office (NSO) estimates National
Income
 It publishes National Accounts Statistics annually

 Under the Ministry of Statistics and Programme

Implementation
 Now, CSO has been merged with the National Sample Survey
Organization to form the National Statistical Organization

Q11.What do you mean by demand?

What are the determinants of demand?
What is demand?
Demand simply means a consumer’s desire to buy goods and
services without any hesitation and pay the price for it. In
simple words, demand is the number of goods that the
customers are ready and willing to buy at several prices during
a given time frame. Preferences and choices are the basics of
demand, and can be described in terms of the cost, benefits,
profit, and other variables.
The amount of goods that the customers pick, modestly relies
on the cost of the commodity, the cost of other commodities,
the customer’s earnings, and his or her tastes and proclivity.
The amount of a commodity that a customer is ready to
purchase, is able to manage and afford at provided prices of
goods, and customer’s tastes and preferences are known as
demand for the commodity.
Suggested reading: Elasticity of Demand
The demand curve is a graphical depiction of the association
between the price of a commodity or the service and the
number demanded for a given time frame. In a typical
depiction, the cost will appear on the left vertical axis. The
number (quantity) demanded on the horizontal axis is known as
a demand curve.

Determinants of Demand
There are many determinants of demand, but the top five
determinants of demand are as follows: 
Product cost: Demand of the product changes as per the
change in the price of the commodity. People deciding to buy a
product remain constant only if all the factors related to it
remain unchanged.
The income of the consumers: When the income increases, the
number of goods demanded also increases. Likewise, if the
income decreases, the demand also decreases.
Costs of related goods and services: For a complimentary
product, an increase in the cost of one commodity will
decrease the demand for a complimentary product. Example:
An increase in the rate of bread will decrease the demand for
butter. Similarly, an increase in the rate of one commodity will
generate the demand for a substitute product to increase.
Example: Increase in the cost of tea will raise the demand for
coffee and therefore, decrease the demand for tea.
Consumer expectation: High expectation of income or
expectation in the increase in price of a good also leads to an
increase in demand. Similarly, low expectation of income or low
pricing of goods will decrease the demand.
Buyers in the market: If the number of buyers for a commodity
are more or less, then there will be a shift in demand.
You may also want to know: What are the Shifts in the Demand
Curve?

Types of Demand
Few important different types of demand are as follows:

1. Price demand: It refers to various types of quantities of

goods or services that a customer will buy at a quoted
price and given time, considering the other things remain
constant.
2. Income demand: It refers to various types of quantities of
goods or services that a customer will buy at different
stages of income, considering the other things remain
constant.
 3. Cross demand: This means that the product’s demand
does not depend on its own cost but depends on the cost
of the other related commodities.
4. Direct demand: When goods or services satisfy an
individual’s wants directly, it is known as direct demand.
5. Derived demand or Indirect demand: The goods or
services demanded or needed for manufacturing the
goods and satisfying the consumer indirectly is known as
derived demand.
6. Joint demand: To produce a product there are many
things that are related to each other, for example, to
produce bread, we need services like an oven, fuel, flour
mill, and more. So, the demand for other additional things
to produce a product is known as joint demand.
7. Composite demand: A composite demand can be
described when goods and services are utilised for more
than one cause. Example: Coal

The Law of Demand

The law of demand is interpreted as ‘the quantity demanded of
a product comes down if the price of the product goes up,
keeping other factors constant.’ In other words, if the cost of
the product increases, then the aggregate quantity demanded
decreases. This is because the opportunity cost of the
customers increases that leads the customers to go for any
other substitute or they may not purchase it. The law of
demand and its exceptions are really inquisitive concepts.
Consumer proclivity theory assists us in comprehending the
combination of two commodities that a customer will purchase
based on the market prices of the commodities and subject to
a customer’s budget restriction. The amount of a commodity
that a customer actually purchases is the interesting part. This
is best elucidated in microeconomics utilising the demand
function.

Q14.. Explain the Law of Variable Proportion.

The law of proportions states that if we go on using more and

more units of a variable factor(labour) with a fixed factor
(land), the total physical product increases at an increasing
rate in the beginning, then increases at a diminishing rate after
a level of output and ultimately it falls. In accordance with
law, the marginal physical product increases in the beginning,
then it starts falling but remains positive and ultimately it
contains to fall but also becomes negative. The following
schedule and diagram illustrate the law:

The schedule and diagram show that there are three

phases of the law of variable proportions.
In the phase I, TPP increasesat an increasing rate and
MPP rises. In phase II, TPP increases at decreasing rate
and MPP falls but remains positive. In phase III, TPP
starts falling and MPP becomes negative. Phase I is
upto point M and phase II is from point M to point T.
Phase III is after T.

Q12. Explain the relationship between

Cost and Production Function.
Production Function: It shows the relationship between the input used
and the output produced. It is used for measuring the efficiency of the
factors that are used in the production process.
Cost Function: It shows the relationship between the price of inputs and
quantity produced. It includes total cost, total fixed cost, the total variable
cost, average total cost, average fixed cost, and average variable cost.
The connection between the production function and the cost function is
that cost function is derived from the production function.
The cost and production function could be related through the curves of
total production and total cost. Initially, the total cost is higher compared
to the total product because of the higher fixed cost. In the long run, the
increase in output surpasses an increase in cost. However, when the
production enters into a stage of diminishing returns to scale, the total
variable cost increases more than the increase in production of output.
 In the above graph, you can see that as the total product
increases, the total variable cost increases at a diminishing rate.
 When the total product reaches the maximum, the average
variable cost is at the minimum point.
 When the marginal product is at maximum, the marginal cost is
minimum.
  At point A', the MP interest the average product curve at its
maximum point. At the same point, the marginal cost curve
intersects the average variable cost curve. The average variable
cost is minimum at this point.
 When the TP enters into stage III(diminishing returns to scale), the
average variable starts increasing.

13. Explain Price Leadership model of Oligopoly.

In certain situations, organizations under oligopoly are not involved
in collusion.

There are a number of oligopolistic organizations in the market, but

one of them is dominant organization, which is called price leader.

ADVERTISEMENTS:

Price leadership takes place when there is only one dominant

organization in the industry, which sets the price and others follow
it.

Sometimes, an agreement may be developed among organizations

to assign a leadership role to one of them. The dominant
organization is treated as price leader because of various reasons,
such as large size of the organization, large economies of scale, and
advanced technology. According to the agreement, there is no
formal restriction that other organizations should follow the price
set by the leading organization. However, sometimes agreement is
formal in nature.

Price leadership is assumed to stabilize the price and maintain price

discipline.

This also helps in attaining effective price leadership,

which works under the following conditions:
ADVERTISEMENTS:

i. When the number of organizations is small

ii. Entry to the industry is restricted

iii. Products are homogeneous

iv. Demand is inelastic or less elastic

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v. Organizations have similar cost curves

Types of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price
discipline. There are three major types of price leadership, which
are present in industries over a passage of time.

These three types of price leadership are explained as

follows:
i. Dominant Price Leadership:
Refers to a type of leadership in which only one organization
dominates the entire industry. Under dominant price leadership,
other organizations in the industry cannot influence prices. The
dominant organization uses its power of monopoly to maximize its
profits and other organizations have to adjust their output with the
set price.

The interests of other organizations are ignored by the dominant

organization. Therefore, dominant price leadership is sometimes
termed-as partial monopoly. Price leadership by the leading
organization is most commonly seen in the industry.

ii. Barometric Price Leadership:

ADVERTISEMENTS:

Refers to a leadership in which one organization declares the

change in prices at first and assumes that other organizations would
accept it. The organization does not dominate others and need not
to be the leader in the industry. Such type of organization is known
as barometer.

This barometric organization only initiates a reaction to changing

market situation, which other organizations may follow it if they
find the decision in their interest. On the contrary, the leading
organization has to be accurate while forecasting demand and cost
conditions, so that the suggested price is accepted by other
organizations.

Barometric price leadership takes place due to the

following reasons:
a. Lack of capacity and desire of organizations to estimate
appropriate supply and demand conditions. This influences
organizations to follow price changes made by the barometric
organization, which has a proven ability to make correct forecasts.

ADVERTISEMENTS:

b. Rivalry among the organizations may make a leader, which can

be unacceptable by other organizations. Thus, most of the
organizations prefer barometric price leadership.

iii. Aggressive Price Leadership:

Implies a leadership in which one organization establishes its
supremacy by threatening the organizations to follow its leadership.
In other words, a dominant organization establishes leadership by
following aggressive price policies and forces other/organizations to
follow the prices set by it.

Price-Output Determination under Price Leadership:

ADVERTISEMENTS:

Price leadership takes place when there is only one dominant

organization in the industry, which sets the price and others follow
it. Different economists have developed different models for
determining price and output in price leadership.

Here, we would discuss a simple model for determining

price and output in price leadership, which is shown in
Figure-4:

Suppose there are two organizations, A and B producing identical

products where organization A has a lower cost of the production
than organization B. Therefore, consumers are indifferent between
these two organizations due to identical products. This implies that
both the organizations would face same demand curve, which
further represents equal market share.

In Figure-4, DD is the demand curve of both the organizations and

MR is their marginal revenue. MCa and MCb are the marginal cost
curves of organization A and B respectively. As stated earlier, the
cost of production of organization A is less than B, thus, MC a is
drawn below MCb.
Let us first start the discussion of price leadership with the case of
organization A. The profits of organization A would be maximized at
a point where MR intersects MCa. At this point, the output of
organization A would be OQ with the price level OP. On the other
hand, the profits of organization B would be maximized at a point
where MR intersects MCb with output OQ1 and price OP1.
ADVERTISEMENTS:

In such a case, the price of organization B is more as compared to

organization A. However, both the organizations have to charge the
same price as products are homogeneous. In this case, organization
A is the price leader and organization B is the follower.

Thus, organization A will dictate the price to organization B. Both

the organizations will follow the same output, OQ and price OP.
However, the profits earned by organization B are less than A, as it
has to produce at price OP which is less than its profit maximizing
price, OP1. In addition, the organization B also has high costs of
production that leads to lower profits at price OP 1.
Drawbacks of Price Leadership:
The price leadership suffers from various drawbacks.

These are discussed as follows:

i. Makes it difficult for the price leader to assess the reactions of
followers.

ii. Leads to malpractices, such as charging lower prices by rival

organizations in the form of rebates, money back guarantees, after
delivery free services, and easy installment facility. The prices
charged by rival organizations are comparatively less than the prices
set by the price leader.
iii. Leads to non-price competition by rival organizations in the
form of aggressive promotion strategies.

iv. Influences new organizations to enter into the industry because

of price rise. These new organizations may not follow the leader of
the industry.

v. Poses problems if there are differences in cost of price leaders and

price followers. In case, if cost of production of price leader is less,
then he/she would fix lower prices. This will lead to a loss for a price
follower if his/her cost of production is more than the price leader.

14. Explain different pricing practices in India. UNIT-IV

Q15. What are various motives for

holding money?
Cash: Nature and Motives for
Holding It | Working Capital
Let us make an in-depth study of the nature and motives
for holding cash.
Nature of Cash:
For some persons, cash means only money in the form of currency
(cash in hand). For other persons, cash means both cash in hand
and cash at bank. Some even include near cash assets in it. They
take marketable securities too as part of cash.

These are the securities which can easily be converted into cash.
These viewpoints reflect the degree of freedom of the persons using
the cash. Whether a person’s wants to use it immediately or can
wait for a time to use it depends upon the needs of the concerned
person.

Cash itself does not produce goods or services. It is used as a

medium to acquire other assets. It is the other assets which are used
in manufacturing goods or providing services. The idle cash can be
deposited in bank to earn interest.

A business has to keep required cash for meeting various needs. The
assets acquired by cash again help the business in producing cash.
The goods manufactured or services produced are sold to acquire
cash. A firm will have to maintain a critical level of cash. If at a time
it does not have sufficient cash with it, it will have to borrow from
the market for reaching the required level.

There remains a gap between cash inflows and cash outflows.

Sometimes cash receipts are more than the payments or it may be
vice-versa at another time. A financial manager tries to synchronize
the cash inflows and cash outflows. But this situation is seldom
found in the real world. Perfect synchronization of receipts and
payments of cash is only an ideal situation.

Motives for Holding Cash:

The firm’s needs for cash may be attributed to the following needs:
Transactions motive, Precautionary motive and Speculative motive.
Some people are of the view that a business requires cash only for
the first two motives while others feel that speculative motive also
remains.

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These motives are discussed as follows:
1. Transaction Motive:
A firm needs cash for making transactions in the day to day
operations. The cash is needed to make purchases, pay expenses,
taxes, dividend, etc. The cash needs arise due to the fact that there is
no complete synchronization between cash receipts and payments.
Sometimes cash receipts exceed cash payments or vice-versa.

The transaction needs of cash can be anticipated because the

expected payments in near future can be estimated. The receipts in
future may also be anticipated but the things do not happen as
desired. If more cash is needed for payments than receipts, it may
be raised through bank overdraft.

On the other hand if there are more cash receipts than payments, it
may be spent on marketable securities. The maturity of securities
may be adjusted to the payments in future such as interest payment,
dividend payment, etc.

2. Precautionary Motive:
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A firm is required to keep cash for meeting various contingencies.

Though cash inflows and cash outflows are anticipated but there
may be variations in these estimates. For example, a debtor who
was to pay after 7 days may inform of his inability to pay; on the
other hand a supplier who used to give credit for 15 days may not
have the stock to supply or he may not be in a position to give credit
at present.
In these situations cash receipts will be less than expected and cash
payments will be more as purchases may have to be made for cash
instead of credit. Such contingencies often arise in a business. A
firm should keep some cash for such contingencies or it should be in
a position to raise finances at a short period.

The cash maintained for contingency needs is not productive or it

remains ideal. However, such cash may be invested in short-period
or low-risk marketable securities which may provide cash as and
when necessary.

3. Speculative Motive:
The speculative motive relates to holding of cash for investing in
profitable opportunities as and when they arise. Such opportunities
do not come in a regular manner. These opportunities cannot be
scientifically predicted but only conjectures can be made about their
occurrence.

Q9. Elaborate the concept and use of law of

demand. Examine the role played by demand
function in managerial decision making.

What is 'Law of Demand'

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Definition: The law of demand states that other factors being constant
(cetris peribus), price and quantity demand of any good and service are
inversely related to each other. When the price of a product increases, the
demand for the same product will fall.
Description: Law of demand explains consumer choice behavior when
the price changes. In the market, assuming other factors affecting
demand being constant, when the price of a good rises, it leads to a fall in
the demand of that good. This is the natural consumer choice behavior.
This happens because a consumer hesitates to spend more for the good
with the fear of going out of cash.

The above diagram shows the demand curve which is downward sloping.
Clearly when the price of the commodity increases from price p3 to p2,
then its quantity demand comes down from Q3 to Q2 and then to Q3 and
vice versa.

Importance of Demand Analysis

1. Sales Forecasting
2. Pricing Decisions
3. Marketing Decisions
4. Production Decisions
5. Financial Decisions
6. Demand Policy

1. Sales Forecasting
The demand is a basis of the sales of the product of a firm Hence, sales
forecasting can be made on the basis of demand.

For example, if demand is high, sales will be high and if demand is low
sales will be low. The firms can make different arrangements to increase or
reduce production or push up sales on the basis of sale forecast.
2. Pricing Decisions
The analysis of demand is the basis of pricing decisions of a firm. If the
demand for the product is high, the firm can charge high price, other things
remaining the same. On the contrary, if the demand is low, the firm cannot
charge high price.

The demand analysis also helps the firm in profit budgeting. If demand is
high price can be charged high and profit will be high. Hence, the profit or
sales, in part, depend on the demand for a commodity.

3. Marketing Decisions
The analysis of demand helps a firm to formulate marketing decisions. The
demand analysis analyses and measures the forces determine demand.

The demand can be influenced by manipulating the factors on which

consumers base their demands, example, consumers may base their
demand on attractiveness. So good packaging may lead to an increase in
demand.

4. Production Decisions
How much a firm can produce depends on its capacity, but ho could
produce depends on demand. Production is not re is no demand. But
continuous production schedule salary if the necessary if the de s than the
quantity of production, new y means of promotional activities such as
demand is less demand for the product is relatively stable.

If the demand is expected to be high in future, the firm should hold more
inventories. Similarly, the personnel manager must set up recruitment and
training programs to ensure availability of different work force to produce
and sell the products.

5. Financial Decisions
The demand condition in the market for firm's product affects the financial
decisions as well. If the demand for firm's product is strong and growing,
the need for additional finance will be greater.

Hence, the financial manager should make necessary arrangement to

finance the growing need of the capital.

6. Investment Policy
Demand analysis helps firm adopt appropriate investment policy. Based on
the nature of demand for a particular product in a particular market, firms
can make their investment decisions.
 Why long run average cost curve is
Q11.

known as envelope curve? Elaborate.

Q12. What do you mean by market
structure? Discuss cost leadership in
oligopoly.
Meaning of a Market:
A market can be characterised as where a couple of
parties can meet, which will expedite the trading of
products and services. The parties involved in the
market activities are the sellers and the buyers. A
market is an actual structure like a retail outlet, where
the dealers and purchasers can meet eye to eye, or in a
virtual structure like an internet-based market, where
there is the truancy of direct, actual contact between the
purchasers and vendors.

Types of the market:

Monopoly:
A monopolistic market is a market formation with the
qualities of a pure market. A pure monopoly can only
exist when one provider gives a specific service or a
product to numerous customers. In a monopolistic
market, the imposing business organisation, or the
controlling organisation, has the overall control of the
entire market, so it sets the supply and price of its goods
and services. For example, the Indian Railway, Google,
Microsoft, and Facebook.

Oligopoly:
An oligopoly is a market form with a few firms, none of
which can hold the others back from having a critical
impact. The fixation or concentration proportion
estimates the piece of the market share of the biggest
firms. For example, commercial air travel, auto
industries, cable television, etc.

Perfect competition:
Perfect competition is an absolute sort of market form
wherein all end consumers and producers have
complete and balanced data and no exchange costs.
There is an enormous number of makers and customers
rivalling each other in this sort of environment. For
example, agricultural products like carrots, potatoes,
and various grain products, the securities market,
foreign exchange markets, and even online shopping
websites, etc.

Monopolistic competition:
Monopolistic competition portrays an industry where
many firms offer their services and products that are
comparative (however somewhat flawed) substitutes.
Obstructions or barriers to exit and entry in monopolistic
competitive industries are low, and the choices made of
any firm don’t explicitly influence those of its rivals. The
monopolistic competition is firmly identified with the
business technique of brand separation and
differentiation. For example, hairdressers, restaurant
businesses, hotels, and pubs.

Monopsony:
A monopsony is a market situation wherein there is just
a single purchaser, the monopsonist. Just like a
monopoly, a monopsony additionally has an imperfect
market condition. The contrast between a monopsony
and a monopoly is basically in the distinction between
the controlling business elements. A solitary purchaser
overwhelms a monopsonist market while a singular
dealer controls a monopolised market. Monopsonists
are normal to regions where they supply most of the
locale’s positions in the regional jobs. For example, a
company that collects the entire labour of a town. Like a
sugar factory that recruits labourers from the entire
town to extract sugar from sugarcane.

Oligopsony:
An oligopsony is a business opportunity for services and
products that is influenced by a couple of huge
purchasers. The centralisation of market demand is in
only a couple of parties that gives each a generous
control of its vendors and can adequately hold costs
down. For example, the supermarket industry is arising
as an oligopsony with a worldwide reach.
Natural monopoly:
A natural monopoly is a kind of a monopoly that can
exist normally because of the great start-up costs or
incredible economies of scale of directing a business in
a particular industry which can bring about huge barriers
to exit and entry for possible contenders. An
organisation with a natural monopoly may be the main
supplier of a service or a product in an industry or
geographic area. Normally, natural monopolies can
emerge in businesses that require the latest technology,
raw materials, or similar factors to work. For example,
the utility service industry is a natural monopoly. It
consists of supplying water, electricity, sewer services,
and distribution of energy to towns and cities across the
country.

14. Elaborate the concept of multiplier.

Q-15 “Managerial economics is the integration of

Economic theory with Managerial practice for the
purpose of facilitating decision making.” Explain.
Managerial Economics has developed due to the close
interrelationship between management and economics. Usually
the managerial decisions are economic in nature as the firms
management is faced with the problems of choice in simple
words various alternatives. The management has to look out
for the best possible alternative available with them based on
the economic theory and analysis of the activities involved. And
as the resources are scarce in nature thereby it becomes the
management’s responsibility to see that the resources are
allocated appropriately.

Since the economic environment in which the firms operate is

volatile and changes rapidly, this makes it important for the
firms to facilitate appropriate and rational decision-making and
forward planning skills in its managers. As the firms are
responsible for providing goods and services to the individuals,
the economic environment they function in also affects them.
Therefore, managerial economic provides for the study of
allocation of resources available with firm vis-a-vis its activities,
keeping in mind the best possible alternative available to the
firm.

The manager is therefore responsible for taking rational

decisions and future planning with regards to the economic
concepts and problem analysis. As it needs to ensure that
scarce resources are utilized to the utmost efficiency and that
best results are achieved.
The resource allocation decision may include taking decisions
pertaining to production and transportation process. Whereby
the manager is responsible for deciding the amount of factors
of production to be allocated to a particular activity and the
transportation process and cost involved in transferring these
factors of production to the activity.
 Source: pixabay.com
Apart from resource allocation the managers are also faced
with inventory issues, which involve taking decisions pertaining
to holding the appropriate levels of stock of raw materials and
finished goods for a period of time. For which it is important to
understand the demand and supply conditions in the market, as
it would have a bearing on the prices of its products.

The decision-nicking process also involves an important

decision relating to fixing the prices of the products. For which
various methods may be adopted keeping in mind that the price
is neither too high nor too low. As, if the price is high, it will be
out of reach for various individuals and if the price is too low
then people may tend to have second thoughts about its
quality. As the firms operate for profits thus accurate price
decisions play a vital role in the growth of the organization as a
whole.

And also that decision-making by the management involves

making a choice from various available alternatives, which
makes it all the more economic in nature. As the best decision
can only be reached by making the appropriate choice keeping
in mind the objectives as well as the obstacles on the path. In
other words, the optimal decision-making process is achieved
with a combination of traditional economic concepts along with
tools and techniques of analysis in order to reach the best
solution to the business problem.
The managers are also faced with taking decisions regarding
future i.e. forward planning. It relates to taking various
investment decisions. As appropriate decisions have to be
taken while planning to install new machinery or hiring extra
labor, as the cost factor and the further repercussions have to
be kept in mind while planning and taking decisions thereon.

Therefore, it is a true fact that economics and management

goes hand in hand with the help from various concepts, tools
and methodologies. It also enhances the role and function of a
manager as it helps the manager to take rational decisions and
to appropriately plan for the future based on the analysis of the
information available with him.

Q 8. State and explain the principle of Equi-

Marginal Principle
Same Marginal utility priniciple
Or
The equimarginal principle is an important idea in the economic
subfield of managerial economics. It is otherwise known as the “equal
marginal principle” or the “principle of maximum satisfaction.” The
equimarginal principle states that consumers choose combinations of
various goods in order to achieve maximum total utility.

In other words, consumers will allocate spending their incomes across

goods/services so that the marginal utility per dollar of expenditure
on the final unit of each good purchased will be equal to all other
goods purchased. It explains the way in which each consumer will
spend portions of their income across a variety of different goods in
such a way as to maximize their overall satisfaction.

The Equation for the Equal Marginal

Principle

The equation for the equimarginal principle is as follows:

Marginal Utility of A       Marginal Utility of B

—————————————  =  —————————————

Price of A                           Price of B

According to the equimarginal principle, when a consumer is making

purchasing decisions, they will consider both the marginal utility (MU)
of goods along with the price of goods. Taking both of these into
consideration, they will make a decision that balances both. This
means, in effect, evaluating the good’s MU/price—the marginal utility
of expenditure on each unit of a good.

Equimarginal Principle Example

Let’s apply the equimarginal principle to a very simple case, with just
two goods (socks and mittens). The price of each pair of socks, as well
as each pair of mittens, is just $1. This means that the ideal quantity of
goods to maximize utility would be 4. With a quantity of 4, 16/$1 is
equal to 16/$1. See the table below for a representation of this
example:
 Pairs of gloves/socks Marginal utility of socks Marginal utility of mittens

1 40 22

2 32 20

3 24 18

4 16 16

5 8 14

Assumptions Underlying Marginal Utility

Theory

Marginal utility theory rests on the assumption that consumers are

always rational (a common assumption in the field of economics more
generally), and that both the idea of utility and goods themselves can
be quantified as specific units. It also assumes constant incomes and
constant prices. In reality, things are a bit more complicated.

Limitations of the Equimarginal Principle and Marginal

Utility Theory

Here are a few of the limitations of the equimarginal principle and of

marginal utility theory as they operate in the real world:
1. Consumers are not always rational

Consumers will sometimes make economically irrational choices based

on other reasons besides those that are quantifiable. Common
influences outside of rationality include habits (people tend to repeat
their purchasing habits once they’re satisfied with a good or service)
as well as emotional impulses (which things like advertising or
personal experience can influence).

2. Consumers do not typically quantify utility

In the real world, the concept of “utility” is likewise complex and

difficult to quantify for most people. So when the average consumer is
making purchasing decisions, they might have a general sense of the
utility they will derive from a good, but are unlikely to quantify that
level of utility. Assessing this can be even more difficult in light of how
many products consumers have access to and the fluctuation of their
income levels.

3. Many goods cannot be split into units

The equimarginal principle quantifies goods as units, but many goods

cannot be divided into smaller units, and can only function as a whole.

4. The utility of some goods depends on other goods

When you buy a lamp, it has no real utility until you have also
purchased light bulbs for it. That means that the utility of a lamp rests
on having functional light bulbs and does not exist independently.
Q9. “The amount demanded increases with a fall in price
and diminishes with a rise in the price.” Discuss.
Previous answer of law of deand
12. Discuss the principles of economics which help in
effective managerial decision making.
 Q7.What are the major areas of business
decision making. How does managerial
economics contribute to managerial decisions?

These are the four main aspects of decision

making that help managers plan ahead for their
team: –
1.Resource Allocation: – Resources always are
the top concern for managers. It is often that
most of them feel that their team has too little
manpower to complete the task at hand. It is also
 one of the principles that allow the best use of
the resources to complete the task.
2.Inventory: – Inventory allocation is another one
of the major challenges. But, they must be on top
of these aspects by analyzing the demand and
supply models. Managers can get a better hold of
management and transport of inventories by
queuing products.
3.Pricing: – Fixing prices for the products in any
firm is a crucial part of the decision making
process. Pricing problems involve decisions
about various methods of pricing that firms need
to adopt.
4.Investment: – Managers must be aware of the
future of their firms. In this manner, they can
have oversight of falling prey to negative market
forces. Thus, investment planning is of the
pillars.

Economics and Decision Making

Managerial economics provides a link between
economic theory and the decision sciences in the
analysis of managerial decision making. You need
to make decision irrespective of the work you are
doing. What if you go to the movies and shop at
the very same time? It is impossible to do two
things simultaneously. You must choose what to
do first and then what to do next. As a result,
 decision making can be described as selecting
the best choice from a set of options. To make a
decision is to make a choice. Decision making
involves deciding whether to do this or that.
Definition of decision making: – Decision
Making can be described as the process of
choosing the best course of action from a variety
of options. Most significant aim of business
manager is decision making. Managerial
Economics’ main goal is to help people make
better decisions. When a number of options are
open, the issue of decision making occurs. For
example: –
 What would the price of the product be?

 What should the plant’s size be when it’s installed?

 How many employees should be hired?

 What kind of education do they receive?

 What is the ideal level of finished goods, raw

materials, spare parts, and other inventory?

As a result, we can assume that the issue of
decision making occurs as a result of resource
scarcity. We have an infinite number of desires
and a finite number of ways to fulfill them; when
one desire is satisfied, another emerges, posing a
decision making challenge. When doing his job,
the manager must make several choices in order
to achieve the firm’s objectives. The majority of
decisions are made in the face of uncertainty and
include risks.
 The key causes of instability and risk are the following
market forces’ unpredictable behavior are as follows: –
 The demand and supply

 Changing business environment

 Government policies

 External influence on the domestic market

 Changes in society and politics

What is economic problem?

Meaning of Economic problem: – An economic
method can be expressed as a problem
involving unlimited wants and limited resources.
The issue occurs solely as a result of these
unrestricted desires. Since assets used to fulfill
one need cannot be used to satisfy another, every
man addresses the challenge of economizing his
wealth. The meaning of the term “economic
problem” is “a problem that affects the economy”.

To understand what an economic issue is, we must

combine the four characteristics, as follows: –
 Human desires are limitless.

 The strength of human desires varies.

 The assets and means available are small.
 There are other ways to put the scarce resources to

good use.
In the face of limitless desires, the economic
dilemma is how to use the comparatively restricted
resources with alternative uses. Every person
should make every effort to put his or her limited
resources to possible alternatives in order to get
the most satisfaction from his or her constrained
capacity. Everyone seeks to fulfill the most urgent
or extreme desires first, then those that are
marginally lesser urgent, and so on, compromising
the fulfillment of desires that are lower on the scale
of choice and for which he does not have money.
This is known as the economic problem; how to get
the most out of limited resources.
The causes of the economic problem: – We have a
finite amount of resources, and we also have a
finite number of ways to fulfill certain resources.
The society’s reserves include not only free gifts
from nature, such as soil, trees, and minerals, but
also individual physically and psychologically
ability, as well as all kinds of man-made aids
further to development, such as machines,
machinery, and construction.
Q20."Managerial Economics follow an Inter-
disciplinary• approach". Comment in the light
of nature of managerial economics.
What is Managerial Economics?
Managerial economics is a stream of management studies that emphasizes primarily
on solving business problems and decision-making by applying the theories and
principles of microeconomics and macroeconomics. It is a specialized stream
dealing with an organization’s internal issues using various economic tools.
Economics is an indispensable part of any business. This single concept derives all
the business assumptions, forecasting, and investments.

Nature of Managerial Economics

You need to know about the various characteristics of managerial economics to get
more knowledge about it. Let’s read about the nature of managerial economics.

• Art and Science: Management theory requires a lot of critical and logical thinking
and analytical skills to make decisions or solve problems. Many economists also find
it a source of research, saying it includes applying different economic concepts,
techniques, and methods to solve business problems.

• Microeconomics: Managers typically deal with the problems relevant to a single

entity rather than the economy as a whole. It is therefore considered an integral part
of microeconomics.

• Uses of Macro Economics: A corporation works in an external world, i.e., it

serves the consumer, which is an important part of the economy. For this purpose,
managers must evaluate the various macroeconomic factors such as market
dynamics, economic changes, government policies, etc., and their effect on the
company.

• Multidisciplinary: Managerial economics uses many tools and principles that

belong to different disciplines, such as accounting, finance, statistics, mathematics,
production, operational research, human resources, marketing, etc.

• Prescriptive or Normative Discipline: By introducing corrective steps managerial

economics aims at achieving the objective and solves specific issues or problems.

• Management Oriented: This serves as an instrument in managers’ hands to deal

effectively with business-related problems and uncertainties. This also allows for
setting priorities, formulating policies, and making successful decisions.

• Pragmatic: The solution to day-to-day business challenges is realistic and rational.

Different individuals take different views of the principles of managerial economics.

Others may concentrate more on customer service, while others may prioritize
efficient production.
 Q30.What do you mean by Marginal rate of
substitution? Discuss consumer's
equilibrium with indifference curve.

Marginal Rate of Substitution (MRS): Definition

What is marginal rate of substitution? The marginal rate of substitution
(MRS) is the rate at which a consumer is willing to substitute one good for
some amount of another good, given that the new good brings the same level of
satisfaction. The marginal rate of substitution is always negative because it is
measuring the rate at which someone is willing to give up some amount of one
good in exchange for gaining some amount of another good. Since the equation
contains the amount that is willing to be given up (negative) in the numerator
and the amount to be gained (positive) in the denominator, the result is always
negative.
The marginal rate of substitution will always illustrate how much of one item
we are willing to give up for one unit of another item. For example, if the MRS
is -3, then we are willing to give up 3 units of one item in exchange for 1 unit of
another item. The MRS in this case can also be written as 3:1.

Slope of Indifference Curve: MRS

An indifference curve shows multiple combinations of two goods that result in

the same satisfaction for the consumer, hence making them indifferent about
any of the possible combinations on the curve. The marginal rate of substitution
is equal to the slope of the indifference curve. It is important to note that the
indifference curve is actually a curve, so the slope and the MRS are constantly
changing along the curve. The indifference curve is used to explain consumer
preferences within the limits of budget constraints. For example, say someone
has a budget of $10, and they can buy any combination of hot dogs and fries.
Hot dogs cost $1 and bring 10 units of satisfaction while fries cost $0.50 and
bring 5 units of satisfaction. The combinations that would fall on the
indifference curve are where the level of satisfaction is equal. If they decide to
get 10 hot dogs for $10, they gain 100 units of satisfaction; the same applies to
purchasing 5 hot dogs and 10 fries for $10, which also brings 100 units of
satisfaction. In this case, they are willing to give up 5 hot dogs in exchange for
10 fries because either amount of each respective good brings the same amount
of satisfaction. This makes the marginal substitution rate for hot dogs at this
point on the curve -0.5 since they will give up 5 hot dogs to gain 10 fries (-5 /
10). One way to interpret this is that 0.5 units of a hot dog brings the same
satisfaction as 1 unit of fries.
This is the theoretical application of this concept, and in theory, the same
satisfaction from either combination of the two goods would be received.
However, the law of diminishing marginal utility plays its part and can vary the
amount of satisfaction gained from each additional unit consumed. The law of
diminishing marginal utility states that as each additional unit of a good or
service is consumed, the marginal utility gained from each additional unit
decreases. For example, the first hot dog consumed might bring 10 units of
satisfaction, but the second hot dog might bring only 7 units. However, for the
purpose of learning about this concept, we will pretend that the marginal utility
for each unit of the same good is constant.

Marginal Rate of Substitution Formula

The marginal rate of substitution formula is the change in good X (dx)
divided by the change in good Y (dy). The amount of the good being
given up will be good X since it will always be negative. The amount
gained in exchange is always good Y. The negative value always goes
in the numerator, and the positive value always goes in the denominator.
 Are you a student or a teacher?
 I am a student  I am a teacher
Take this indifference curve, for example. The
coordinates for Point A are (10 units, 20 units). To find
the marginal rate of substitution, first determine which
good is being given up and which good is being gained.
It can work either way depending on what is being
looked for. For example, say we are giving up 20 units of
Good A to gain 10 units of Good B. The equation is -
20/10 and results in an MRS of -2 for Good A at this
point on the curve. The way to interpret this result is that
we are willing to give up 2 units of Good A to gain 1 unit
of Good B. But what if we are giving up Good B to gain
Good A? In this case, we give up 10 units of Good B to
gain 20 units of Good A. The resulting MRS is -0.5 for
Good B at this point on the curve (-10 Good B / 20 Good
A).
Q50. What is short run Production Function?
Explain Law of Production when only one factor of
production is variable.

The Production Function

Meaning of Production Function: – Production function is

the equation that expresses the relationship between the
quantities of productive factors (such as labour and
capital) used and the amount of product obtained. It states
the amount of product that can be obtained from every
combination of factors, assuming that the most efficient
available methods of production are used.

Production is the result of four factors of production

i.e., land, labor, capital and organization support. This is
evident from the fact that no single commodity can be
produced without the help of one of these four factors of
production.
Therefore, the manufacturer combines all four factors of
production to technical ratios. Profit maximization is the only
aim of the producer. For this, he decides to maximize
production at the lowest cost through the best combination of
factors of production.
The manufacturer achieves the best combination by applying
the principles of same-marginal return and substitution.
According to the principle of equilateral returns, the
maximum output of any product can be achieved, when the
marginal return of all the means of production is equal to each
other.
What is the relationship between Input and Output?
In simple terms, the production function refers to
the functional relationship between the quantity of a good
produced (production) and the factors of production
(input).
Thus, the production function shows how much production
we can expect if we have too much labor and so much capital
as well as labor. In other words, we can say that the
production function is an indicator of the physical relationship
between the two inputs and outputs of a firm.
Mathematically, such a basic relationship between input and
output can be expressed as: –
Q = f(L, C, N)
Where ‘Q’ = quantity of output
‘L’ = labor
‘C’ = capital
‘N’ = land.

Therefore, the level of output (Q) depends on the amount of

different inputs (L, C, N) available to the firm. In the simplest
case, where there are only two inputs, labor (L) and capital
(C) and one output (Q), becomes a production function.
 Q = F (L, C)
Definition of production function by different professors
Prof. Koutsoyiannis: – Defined as, “The production function
is purely a technical relation which connects factor inputs and
output.”
Prof. Watson: – Defined production function as “The relation
between a firm’s physical production (output) and the material
factors of production (inputs).”
Prof. L.R. Klein: – “The production function is a technical or
engineering relation between input and output. As long as the
natural laws of technology remain unchanged, the production
function remains unchanged.”
Prof. George J. Stigler: – “Production function is the
relationship between inputs of productive services per unit of
time and outputs of product per unit of time.”
Prof. Richard J. Lipsey: – “The relationship between inputs
and outputs is summarized in what is called the production
function. This is a technological relation showing for a given
state of technological knowledge how much can be produced
with given amounts of inputs.”
Thus, from the above definitions, we can conclude that the
production function reflects the relationship between the
physical quantity of inputs and outputs obtained over a period
of time, for a certain state of technical knowledge.
What are the features of Production Function?
The main features of production function are as follows: –
1. Substitutability: – Thus the quantity of any output can vary
with changes in the quantity of even one input while
keeping other factors constant.
2. Complementary: – Therefore, a producer can produce the
output by mixing the factor inputs together. If the quantity
of any input is zero, the output cannot be produced.
3. Specificity: – For example, raw materials, specialized labor,
machines, and equipment can be used for the production of
the specific product. However, all these factors of
production are not completely specialised as they can also
be used in the production of other products.
4. Production Time: – Production of any type of product
requires time. Production can only be possible in the long
run. In the production function, the variation in total output
is due to the variation in input quantity. The quantity of a
single input may be possible in a short period of time.
What are the characteristics of Production Function?
The characteristics of Production Function are as follows:
–
1. A production function is a representation of the functional
relationship between the amount of input employed and the
amount of output produced.
2. This shows the technical relationship between inputs and
outputs which are in physical form.
3. It also denotes the flow of input that will produce the flow
of output over a specific period of time.
4. The state of technology affects production. A change in the
state of technology will also change the production
function. Improvement in the level of technology will
increase the output level, even if the amount of input
remains the same.
5. A production function has no monetary significance; It only
shows the physical relationship.
What are the types of production functions?
There are two types of production operations; they
are short run and long runs: –
1. Short Run Production Function: –
A.In short time period, the factors of production are fixed
and variable.
 B.In short run, it is not possible to change factors of
production because of very less time.
C.A manufacturer cannot change the amount of capital such
as machines, tools, equipment, factory houses, etc.
D.The manufacturer may change variable factors of
production such as units of labor.
E. Factors of production that are given in quantity in the
short term are known fixed factors of production.
F. Factors of production whose quantity can be changed are
called variable factors of production.
G.Short-run refers to a period of time that is too short to
allow a manufacturer to change its plant capacity, yet it is
sufficient to change the level at which the fixed plant is
used.
H.The short-term production function is written as: – Q = f
(L) where, ‘Q’= Quantity of output and ‘L’= Labour
I. For example, an agricultural firm has 10 units of labor
and 6 acres of land. Here, land is the constant factor and
labor is the variable factor. The firm initially uses only
one unit of labor (variable factor) on its land (constant
factor). Hence the land-labor ratio is 6: 1. If the firm uses
2 units of labor, the land-labor ratio becomes 6: 2 or 3: 1.
2. Long Run Production Function: –
A.In long-term production, all functions, factors of
production are variable.
B.In a long-run output, all inputs are variable in a single
output.
C.When long term is used to explain, it is called the law of
returns on the scale.
D.In long run we measure that by how much proportion the
output changes if we change the proportion of input.
E. From the point of view of existing firms, the long term
refers to the period that is sufficient to allow these firms
 to change the quantities of all resources which are
employed in the production, including plant capacity.
F. The producer can convert all inputs and establish the
necessary plant capacity to maximize profit.
G.Long run production can be written as: – Q=
f(L,C) Where, ‘Q’= Quantity of output, ‘L’= Labour and
‘C’= Capital
H.All production resources or inputs are variable over the
long term.
I. For example, the builder can build a new building or
expand an existing building, buy more new machines and
equipment, open more branches of a production unit, buy
more land to expand the firm’s size, can hire more and
skilled workers, change production and managerial
technology, etc

6. Compare and contrast Monopoly

equilibrium with equilibrium under
Perfect Competition in short run.
Differentiate between monopolistic competition and perfect competition

Key Takeaways
Key Points

 Perfectly competitive markets have no barriers of entry or exit. Monopolistically

competitive markets have a few barriers of entry and exit.
 The two markets are similar in terms of elasticity of demand, a firm's ability to make
profits in the long-run, and how to determine a firm's profit maximizing quantity
condition.
 In a perfectly competitive market, all goods are substitutes. In a monopolistically
competitive market, there is a high degree of product differentiation.
Key Terms

 perfect competition: A type of market with many consumers and producers, all of
whom are price takers

Perfect competition and monopolistic competition are two types of economic markets.

Similarities
One of the key similarities that perfectly competitive and monopolistically competitive
markets share is elasticity of demand in the long-run. In both circumstances, the
consumers are sensitive to price; if price goes up, demand for that product decreases.
The two only differ in degree. Firm's individual demand curves in perfectly competitive
markets are perfectly elastic, which means that an incremental increase in price will cause
demand for a product to vanish). Demand curves in monopolistic competition are not
perfectly elastic: due to the market power that firms have, they are able to raise prices
without losing all of their customers.

Demand curve in a perfectly competitive market: This is the demand curve in a

perfectly competitive market. Note how any increase in price would wipe out demand.
Also, in both sets of circumstances the suppliers cannot make a profit in the long-run.
Ultimately, firms in both markets will only be able to break even by selling their goods
and services.

Both markets are composed of firms seeking to maximize their profits. In both of these
markets, profit maximization occurs when a firm produces goods to such a level so that
its marginal costs of production equals its marginal revenues.

Differences
One key difference between these two set of economic circumstances is efficiency. A
perfectly competitive market is perfectly efficient. This means that the price is Pareto
optimal, which means that any shift in the price would benefit one party at the expense
of the other. The overall economic surplus, which is the sum of the producer and
consumer surpluses, is maximized. The suppliers cannot influence the price of the good
or service in question; the market dictates the price. The price of the good or service in a
perfectly competitive market is equal to the marginal costs of manufacturing that good
or service.

In a monopolistically competitive market the price is higher than the marginal cost of
producing the good or service and the suppliers can influence the price, granting them
market power. This decreases the consumer surplus, and by extension the market's
economic surplus, and creates deadweight loss.

Another key difference between the two is product differentiation. In a perfectly

competitive market products are perfect substitutes for each other. But in
monopolistically competitive markets the products are highly differentiated. In fact, firms
work hard to emphasize the non-price related differences between their products and
their competitors'.

A final difference involves barriers to entry and exit. Perfectly competitive markets have
no barriers to entry and exit; a firm can freely enter or leave an industry based on its
perception of the market's profitability. In a monopolistic competitive market there are
few barriers to entry and exit, but still more than in a perfectly competitive market.
Q7. Discuss with diagrams firm and industry
equilibrium under monopolistic competition in short
run and long run.

Short Run Equilibrium:

Equilibrium of a firm under monopolistic competition is often
couched in terms of short period and long period. In the short run,
Chamberlin’s model of monopolistic competition comes closer to
monopoly.

That is to say, there is virtually no difference between monopolistic

competition and monopoly in the short run. Thus, Chamberlin’s
firm may earn supernormal profit, normal profit, or incur loss in the
short run—since entry and exit are not allowed during this time
period.

ADVERTISEMENTS:

In Fig. 5.15, the short run marginal cost curve, SMC, is equal to MR
at point E. Thus E is the equilibrium point. Corresponding to this
equilibrium point, the firm produces OQ output and sells it at a
price OP. Thus, the firm earns pure profit to the extent of PARB
since total revenue (OPAQ) exceeds total cost of production
(OBRQ).

A firm, in the short run, may earn only normal profit if MC = MR <
AR = AC occurs. A loss may result in the short run if MC = MR < AR
< AC happens

Long Run Equilibrium:

In the long run, monopolistic competition comes closer to perfect
competition because the freedom of entry and exit allows firms to
enjoy only normal profit.

ADVERTISEMENTS:

Whenever some firms earn pure profit in the long run some other
firms may be attracted to join this product group, thereby shifting
the demand curve or AR curve downward and to the left. Thus,
entry of new firms would cause decline in market share by reducing
the demand for its product.
Consequently, excess profit will be reduced to zero. Further, if the
existing firm experiences losses then the exit of firms will bring
about an opposite effect and the process will continue until normal
profit is earned driving excess profit to zero. Seeing losses for a long
time, losing firms may be induced to leave the product group
thereby eliminating losses. Thus all firms in the long run earn only
normal profit.

Long run equilibrium is achieved at point E where LMC equals MR

(Fig. 5.16). The equilibrium output thus determined is OQM. At this
output, AR equals AC. The firm gets normal profit by selling
OQM output at the price OPM. Note that a monopolistically
competitive firm always operates somewhere to the left of the
minimum point of its AC curve.

In other words, as the demand curve is not perfectly elastic, or, as

the demand curve is negative sloping, the AR curve becomes
tangent to the left of the lowest point of the AC curve (say, point N).
Each firm thus produces at a cost higher than the minimum and
gets only normal profit.

ADVERTISEMENTS:

Under perfect competition, long run equilibrium is achieved at that

point where MC = MR = AR = AC. Because of the perfectly elastic
AR curve, a tangency occurs between AR and AC at the latter’s
lowest point. In Fig. 5.16 the dotted AR = MR curve is the demand
curve faced by a competitive firm.
Equilibrium is attained at point R where LMC = MR = AR = lowest
point of LAC. The competitive output thus determined is OQ P which
will be sold at the price OPP. So, we can conclude that
monopolistically competitive output (OPM) is less than the perfectly
competitive output (OQP), and monopolistically competitive price
(OPM) is larger than competitive price (OPP).
Thus, the difference in output — QMQP— measures excess capacity or
unused capacity faced by monopolistically competitive firms.
Production at a higher cost implies wastage of resources or
underutilization of resources.
Since production takes place at the lowest point of AC curve under
perfect competition, there does not occur any wastage of resources.
Hence a perfectly competitive market is ‘efficient’ in the sense that
resources are allocated efficiently. Society gets larger output and
consumers get output at a low price. Thus, as perfect competition
maximizes social welfare, it is an ideal market.
But as the monopolistically competitive firm operates to the left of
the minimum point of its AC curve, this market is considered as
an ‘inefficient’ one. As a result, social welfare is not maximized
under monopolistic competition since society gets lower output
compared to perfectly competitive output and buyers buy the
differentiated products at a high price.
Dominick Salvatore argues:
“Excess capacity permits more firms to exit (i.e., it leads to
overcrowding) in monopolistically competitive markets as
compared with perfect competition. Consumers, however,
seem to prefer that firms selling some services operate
with same unused capacity (i.e., they are willing to pay a
slightly higher price…) so as to avoid waiting in long
lines.”
However, Chamberlin’s notion of excess capacity does not fall with
the arguments advanced here.

Q19. 12. Explain diagrammatically the relationship

between AVC and AC.
Relationship between AC and AVC:
The relationship between AC and AVC can be discussed with the
help of Fig. 6.11.

1. AC is greater than AVC by the amount of AFC.

2. The vertical distance between AC and AVC curves continues to

fall with increase in output because the gap between them is AFC,
which continues to decline with rise in output.

3. AC and AVC curves never intersect each other as AFC can never
be zero.

4. Both AC and AVC curves are U-shaped due to the Law of Variable
Proportions.

5. MC curve cuts AVC and AC curves at their minimum points.

6. The minimum point of AC curve (point A) lie always to the right

of the minimum point of AVC curve (point B).
13. Distinguish between GNP and GDP.
What are the components of GNP?

National income is a macroeconomic variable that helps in

determining the economic stability of a nation. It represents the
total income accrued to a country from all the economic
activities in a year.
The most preferred way of calculating the national
income involves two concepts, namely GDP and GNP. GDP is
known as gross domestic product and GNP is known as gross
national product.

What is GDP?
GDP refers to the gross domestic product and is a widely used
measure to determine the size of the economy of a nation. It
represents the total amount of goods and services produced in
a country within a financial year.
The GDP takes the purchases of newly produced goods and
services for a particular period into account. In calculating the
GDP, the focus is on the total value of goods and services
produced within the country borders, irrespective of whether
the value addition is due to the residents or non-residents of the
country.
Also read about GDP and Welfare
There are two methods of calculating GDP. They are:

1. Expenditure approach
2. Income approach

The expenditure approach takes into account adding up all the

amount spent on goods and services during the period.
GDP = C + I + G + (X – M)
Where,
C = Consumption spending
I = Business investments (Capital equipments, inventories)
G = Government purchases
X = Exports
M = Imports
Income approach: Under the income approach, the GDP is
calculated by adding up three factors.
GDP = National income + Statistical discrepancy + Capital
consumption allowance
Also check: MCQ on GDP Deflator

What is GNP?
GNP is known as gross national product and represents the
total value of goods and services produced by the residents of
a country during a financial year.
It takes the income earned by the citizens of the country
present within or outside the country into consideration. It
excludes the income generated by the foreign nationals who
are residing in the country. It can be calculated as:
GNP = GDP + NR – NP
Where,
GDP = Gross domestic product
NR = Net income receipts
NP = Net outflow to foreign assets
Let us go through the most crucial differences between GDP
and GNP in the following table:
 

GDP GNP

Definition
The value of goods and services The value of goods and services
produced within the geographical produced by the citizens of a nation
boundaries of a nation in a irrespective of the geographical limits in
financial year is termed as GDP. a financial year is known as GNP.

What Does It Measure?

It measures only the domestic It measures only the national
production. production.

Emphasis
It emphasises on the production It emphasises on the production that is
that is obtained domestically. achieved by the citizens living in
different nations.

Highlights
It highlights the strength of the It highlights the contribution of the
country’s economy. residents to the development of the
economy

Scale of Operations
Local scale International scale

Excludes
The goods and services that are The goods and services that are
being produced outside the produced by the foreigners living in the
economy are excluded. country are excluded.