UU BBA SEM 1 Managerial Economics Unit 5

UNIT - 5 OPTIMISATION OF FIRM
STRUCTURE
5.0 Learning Objectives
5.1 Introduction
5.2 Business Cycle & Inflation,
5.3 Measures of Economics stabilization,
5.4 Profit Measurement and Cost Minimization
5.5 Summary
5.6 Self-Assessment Questions
5.7 Suggested Readings
5.0 LEARNING OBJECTIVES

After studying this unit, you will be able to:
● Learn the working of the business cycle
● Understand the significance of firm optimization
● Analyse several measures undertaken to achieve economic

stabilization
● Discriminate difference between profit measurement and cost

minimisation.
5.1 INTRODUCTION
When someone mentions the term business
optimization, most imagine it refers to
business process optimization used to
improve various elements of a business. It's
an activity that often involves procuring
the services of a business consultant who
analyzes the business, identifies process
issues and recommends changes to
optimize the operation.
This procedure, if not carefully managed, often
results in minimal gain and less than
satisfactory results because of the difficulty
external consultants have in really
understanding a business.
This doesn't mean business optimization
doesn't work, nor that it isn't important.
Many organizations, especially
manufacturers, have adopted various
business optimization techniques such as
lean manufacturing, Six Sigma and the
Toyota Way with great success.
In fact, every business should be constantly
seeking ways to improve efficiencies,
Managerial Economics
reduce waste and optimize resources as

part of their ongoing business practices.
Business optimization works best when
driven internally and supported by decision
support software that helps executives
determine which of the many possible
business optimization strategies offers the
best return.
The dictionary definition of optimization
includes phrases such as:
 Make as perfect as possible
 Fully perfect
 Most effective
 The best alternative
Business optimization is the process of

identifying and implementing new methods
that make the business
EFFICIENT AND
more
COST EFFECTIVE.
Examples of business optimization include:
 Introducing new methods, practices and systems that reduce turnaround

time
 Reducing costs while improving performance
 Automation of repetitive tasks
 Machine-learning techniques that improve equipment operation
 Increasing sales through enhancing customer satisfaction
 Reducing all kinds of waste such as wasted time, scrap production and
repeat work.
Key elements of business optimization

include:
 Measurement of productivity, efficiency and performance
 Identifying areas for improvement
 Introducing new methods and processes

 Measuring and comparing results
 Repeating the cycle
Business Optimization Techniques
While the ultimate goal is to aim for

aPHILOSOPHY OF
CONTINUOUS
IMPROVEMENT as espoused
by the Kaizen Institute in Japan, the first
step is a business optimization project. As
part of that first step, the organization
needs to clearly determine objectives and
stipulate specific targets and goals. This is
a crucial step in
OPTIMIZATION
any
MODELING process.
Executive support is essential, as is the
appointment of a capable team to manage
the process. For many reasons, it's best to
appoint an internal team that understands
the business rather than relying on outside
consultants to perform the work. This does
not preclude the use of an external business
optimization analyst who can guide the
process and provide critical input.
It helps to have a business optimization
framework that outlines the program and
identifies specific goals, especially those
that affect employees. It's vital not to
neglect the potential impact on employees
and take steps to allay fears and create buy-
in.
Most optimization processes start with what's
termed low-hanging fruit, which are
changes that are easy to identify and
implement, as these early successes boost
confidence. Thereafter, deeper analysis is
required to identify and solve more
difficult optimization challenges.
Business Silos Impede Business Optimization
Most companies are organized around

functional capabilities, and it's almost
inevitable that there's a degree of internal
competition between different functions.
For example, production and maintenance
are often at loggerheads over machine
maintenance. Maintenance wants to take

machines offline for essential maintenance,
while production wants to continue
running to meet production targets.
Another example would be a production
manager who resists plans to move
production to other lines, even when there
are clear benefits.
Internal competition is the primary cause
ORGANIZATIONAL
of
SILOS where the goals of each silo
differ from each other and those of the
organization. The danger of this approach
is that as each silo attempts TO
IMPROVE
FUNCTIONAL
PERFORMANCE, it's
possible, and in fact probable, that steps to
optimize individual silos are incompatible
with other plans to improve overall
organizational performance. Focusing on
internal departmental efficiencies at the
expense of organizational agility can
severely disrupt business optimization
processes.
Benefits of Having One View of the Organization
While organizational silos are detrimental,

what's even worse are data silos. These
exist in any scenario where an organization
has separate software solutions for
different functions.
A common example is an organization that has
general ledger software for finance, a
payroll system for wages and a separate
procurement system for manufacturing.
Each package offers a different view of the
organization, and it's not unusual for
information to differ in context, timing and
detail. Although IT would almost certainly
have software interfaces that permit a
degree of data communication between
packages, these rarely run in real time, are
often one-way and don't resolve the
underlying problem of information being
held in separate and often incompatible
databases.
The problem with this is that data
SEPARATE LEGACY
in
SYSTEMS is not accessible to
everyone, nor is it transparent. Most
importantly, it's much harder to create a
coherent picture to support data-driven
decisions. What's really needed is a
solution such as enterprise-wide ERP that
offers one view of the organization. While
this is the ideal, it's not always immediately
feasible, and a viable interim alternative is
INTEGRATED
implementing an
BUSINESS PLANNING
SOLUTION that extracts
information from legacy systems to present
information in a commonly understood
format.
Business Optimization Processes Versus Decision-Making Tools
A key factor for success is a philosophy of

making data-driven decisions that measure
the financial benefits of proposed changes
compared to current practices. This
approach does away with guesswork and
natural human bias.
A major focus of optimization processes such
as continuous improvement and lean
management is continually evaluating
business processes. These may include
simple examples:
 Rearranging a work station so the operator doesn't have to walk across an

aisle to fetch parts
 Eliminating and consolidating unnecessary paperwork
 Automating repetitive tasks such as data capture or order entry
In these instances, the costs and benefits of

these changes are easy to measure. The
difficulty arises when evaluating complex
changes such as the best production line
for manufacturing a product or how to
optimize a product distribution network. In
this situation, analysis is complicated
because of multiple inter-related variables
and many possible outcomes. It's here that
decision support tools which

ADVANCED
use
ANALYTICS to determine
optimal solutions in complex scenarios are
powerful alternatives.
Finding the Right Business Optimization Answers

Even where an organization has enterprise-
wide software, transactional data held in its
databases is structured to optimize business
functions, and not for optimization
purposes. Despite this, these databases
contain a wealth of data that can help
organizations determine the best business
optimization strategies.
This can be achieved through modern data
analysis techniques that make use
ALGORITHMS TO
of
IDENTIFY PATTERNS in
unrelated and unstructured data sets to
support data-driven decision-making.
Some even leverage mathematical
capabilities like linear programming to
provide the absolute best-case scenario for
a business to be optimized. This form of
business optimization technique is known
PRESCRIPTIVE
as
ANALYTICS.
Thanks to the capabilities of advanced
modeling software, it's possible to prepare
a mathematical model of the business.
Once prepared, the model is validated
using historical data to verify its integrity.
Then, using structured and unstructured
data available to the company,
optimization solver software identifies the
best decisions and organizational changes
required to optimize the business. Because
the model has been validated, answers
have credibility and are free of personal
bias.
The Value of Business Optimization and Why You Need it
The direct benefits of business optimization

include:
 Improved productivity
 Less waste
 Lower costs
 Increased profitability
Added to this are less obvious benefits, such as

the development of a culture of excellence,
improved morale and the elimination of
organization silos that impede business
operations leading to greater organizational
focus.
The cumulative effects of business
optimization are such that the business
becomes more efficient. In this context, it's
wise to bear in mind the Kaizen philosophy
of continuous improvement, which means
business optimization isn't a one-off
project, but an ongoing process that
becomes part of the organization's culture.
In this way, the business will continue to
move forward, remain viable and outclass
competition.
5.2 BUSINESS CYCLE & INFLATION

Business Cycle, also known as the economic
cycle or trade cycle, is the fluctuations in
economic activities or rise and fall
movement of gross domestic product (GDP)
around its long-term growth trend.
No era can stay forever. The economy too does
not enjoy same periods all the time. Due to
its dynamic nature, it moves through
various phases.
The change in business activities due to
fluctuations in economic activities over a
period of time is known as a business
cycle. Business cycle are also called trade
cycle or economic cycle. Business
Cycle can also help you make better
financial decisions.
The economic activities of a country include
total output, income level, prices of
products and services, employment, and
rate of consumption. All these activities are
interrelated; if one activity changes, the rest
of them also change.
Business Cycle Definition

Arthur F. Burns and Wesley C. Mitchel defined
business cycle definition as
Business cycle are a type of fluctuation found in the aggregate

economic activity of nations that organize their work
mainly in business enterprises: a cycle consists of
expansions occurring at about the same time in many
economic activities, followed by similarly general
recessions, contractions, and revivals which merge into the
expansion phase of the next cycle; in duration, business
cycle vary from more than one year to ten or twelve years;
they are not divisible into shorter cycle of similar
characteristics with amplitudes approximating their own.
Arthur F. Burns & Wesley C. Mitchel

Phases of Business Cycle
4 Phases of Business Cycle are:
Phases of Business Cycle
EXPANSION
PEAK
CONTRACTION
TROUGH
LET US DISCUSS 4 PHASES OF BUSINESS
CYCLE IN DETAIL:
Expansion
Expansion is the first phase of a business cycle. It is often referred to as
the growth phase.
In the expansion phase, there is an increase in various economic factors,
such as production, employment, output, wages, profits, demand and
supply of products, and sales. During this phase, the focus of organisations
remains on increasing the demand for their products/services in the
market.
The expansion phase is characterised by:
Increase in demand
 Growth in income
 Rise in competition
 Rise in advertising
 Creation of new policies
 Development of brand loyalty
In this phase, debtors are generally in a good financial condition to repay
their debts; therefore, creditors lend money at higher interest rates. This
leads to an increase in the flow of money.
In the expansion phase, due to increase in investment opportunities, idle
funds of organisations or individuals are utilised for various investment
purposes. The expansion phase continues till economic conditions are
favourable.
Peak
Peak is the next phase after expansion. In this phase, a business reaches at
the highest level and the profits are stable. Moreover, organisations make
plans for further expansion.
Peak phase is marked by the following features:
High demand and supply
High revenue and market share
Reduced advertising
Strong brand image
In the peak phase, the economic factors, such as production, profit, sales,
and employment, are higher but do not increase further.
Contraction
An organisation after being at the peak for a period of time begins to
decline and enters the phase of contraction. This phase is also known as
a recession.
An organisation can be in this phase due to various reasons, such as a
change in government policies, rise in the level of competition,
unfavourable economic conditions, and labour problems. Due to these
problems, the organisation begins to experience a loss of market share.
The important features of the contraction phase are:
Reduced demand
Loss in sales and revenue
Reduced market share
Increased competition
Trough
In Trough phase, an organisation suffers heavy losses and falls at the
lowest point. At this stage, both profits and demand reduce. The
organisation also loses its competitive position.
The main features of this phase are:
Lowest income
Loss of customers
Adoption of measures for cost-cutting and reduction
Heavy fall in market share
In this phase, the growth rate of an economy becomes negative. In
addition, in trough phase, there is a rapid decline in national income and
expenditure.
After studying the business cycle, it is important to study the nature
of business cycle.
NATURE OF BUSINESS CYCLE
The nature of business cycle helps the organisation to be prepared for
facing uncertainties of the business environment.
CYCLICAL NATURE
GENERAL NATURE
Nature of Business Cycle
Let us discuss the nature of business cycle in detail.
Cyclical nature
This is the periodic nature of a business cycle. Periodicity signifies the
occurrence of business cycle at regular intervals of time. However, periods
of intervals are different for different business cycle. There is a general
consensus that a normal business cycle can take 7 to 10 years to complete.
General nature
The general nature of a business cycle states that any change in an
organisation affects all other organisations too in the industry. Thus,
general nature regards the business world as a single economic unit.
For example, depression moves from one organisation to the other and
spread throughout the industry. The general nature is also known as
synchronism.
TYPES OF BUSINESS CYCLE
Following the writings of Prof .James Arthur and Schumpeter, we can
classify business cycle into three types based on the underlying time
period of existence of the cycle as follows:
SHORT KITCHIN CYCLE
LONGER JUGLAR CYCLE
VERY LONG KONDRATIEFF WAVE
Short Kitchin Cycle (very short or minor period of the cycle,
approximately 40 months duration)
Longer Juglar cycle (major cycles, composed of three minor cycles and of
the duration of 10 years or so)
Very long Kondratieff Wave (very long waves of cycle, made up of six
major cycles and takes more than 60 years to run its course of duration)
BUSINESS CYCLE THEORY
A business cycle is a complex phenomenon which is common to every
economic system. Several theories of business cycle have been
propounded from time to time to explain the causes of business cycle.
BUSINESS CYCLE THEORY are:
HAWTREY MONETARY THEORY
INNOVATION THEORY
KEYNESIAN THEORY
HICKS THEORY
SAMUELSON THEORY
Business Cycle Theory
Hawtrey Monetary Theory
Hawtray was of opinion that in depression monetary factors play a critical
role. The main factor affecting the flow of money and money supply is the
credit position by the bank. He made the classical quantity theory of
money as the basis of his trade cycle theory.
According to him, both monetary and non-monetary factors also affect
trade. His theory is basically the product of the supply of money and
expansion of credit. This expansion of credit and other money supply
instrument create a cumulative process of expansion which in return
increase aggregate demand.
According to this theory the only cause of fluctuations in business is due
to instability of bank credit. So it can be concluded that Hawtray’s theory
of business cycle is basically depend upon the money supply, bank credits
and rate of interests.
CRITICISM OF THIS BUSINESS CYCLE
THEORY
 Hawtray neglected the role of non-monetary factors like prosperous
agriculture, inventions, rate of profit and stock of capital.
 It only concentrates on the supply of money.
 Increase in interest rates is not only due to economic prosperity but also
due to other factors.
 Over-emphasis on the role of wholesalers.
 Too much confidence in monetary policy. vi. Neglect the role of
expectations. vii. Incomplete theory of trade cycles.
Innovation Theory
The innovation theory of business cycle is invented by an American
Economist Joseph Schumpeter. According to this theory, the main causes
of business cycle are over-innovations.
He takes the meaning of innovation as the introduction and application of
such techniques which can help in increasing production by exploiting the
existing resources, not by discoveries or inventions. Innovations are
always inspired by profits. Whenever innovations are introduced it results
into profitability then shared by other producers and result in a decline in
profitability.
THEORY
Innovation fails to explain the period of boom and depression.
Innovation may be major factor of investment and economic activities but
not the complete process of trade cycle.
This theory is based on the assumption that every new innovation is
financed by the banks and other credit institutions but this cannot be taken
as granted because banks finance only short term loans and investments.
Keynesian Theory
The theory suggests that fluctuations in business cycle can be explained
by the perceptions on expected rate of profit of the investors. In other
words, the downswing in business cycle is caused by the collapse in the
marginal efficiency of capital, while revival of the economy is attributed

to the optimistic perceptions on the expected rate of profit.
Moreover, Keynesian multiplier theory establishes linkages between
change in investment and change in income and employment. However,
the theory fails to explain the cumulative character both in the upswing
and downswing phases of business cycle and cyclical fluctuations in
economic activity with the passage of time.
Hicks Theory
Hicks extended the earlier multiplier-accelerator interaction theory by
considering real world situation. In reality, income and output do not tend
to explode; rather they are located at a range specified by the upper ceiling
and lower floor determined by the autonomous investment.
In the theory, it is assumed that autonomous investment tends to grow at a
constant percentage rate over the long run, the acceleration co-efficient
and multiplier co-efficient remain constant throughout the different phases
of the trade cycle, saving and investment co-efficient are such that upward
movements take away from equilibrium.
The actual output fails to adjust with the equilibrium growth path
overtime. In fact it has a tendency to run above it and then below it, and
thereby, constitute cyclical fluctuations overtime. This basic intuition can
be shown with the help of the following figure.
THEORY
Wrong assumption of constant multiplier and acceleration co-efficient.
Highly mechanical and mathematical device.
Wrong assumption of no-excess capacity.
Full-employment ceiling is not independent
Samuelson theory
According to this theory process of multiplier starts working when
autonomous investment takes place in the economy. With the autonomous
investment income of the people rises and there is increase in the demand
of consumer goods. It directly affected the marginal propensity to
consume.
If there is no excess production capacity in the existing industry then
existing stock of capital would not be adequate to produce consumer goods
to meet the rising demand. Now in order to meet the consumer’s
requirements, producers will make new investment which is derived
investment and the process of acceleration principle comes into operation.
Then there is rise in income again which in the same manner continue the
process of income propagation. So in this way multiplier and acceleration
interact and make the income grow at faster rate than expected. After
reaching its peak, income comes down to bottom and again start rising.
Autonomous investment is incurred by the government with the objective
of social welfare. It is also called public investment. The autonomous
investment is the investment which is done for the sake of new inventions
in techniques of production.
Derived investment is the investment undertaken in capital equipment
which is induced by increase in consumption.
THEORY
 This model only concentrates on the impact of the multiplier and
acceleration and it ignored the role of producer’s expectations, changing
business requirements and consumers preferences etc.
 It is not practically possible to compute the fact of multiplier and

acceleration principle.
 It has wrong assumption of constant capital output ratio.

What is Inflation?
Inflation can be defined as the eventual loss of buying power of a particular
currency. A quantitative measure of the pace at which buying power
declines can be expressed in the growth in an economy’s average price
level of a basket of selected goods and services over time. An increase in
the overall level of prices, generally represented as a percentage, indicates
that a unit of money buys less than it did previously. Inflation is
distinguished from deflation, which happens when the buying power of
money rises but prices fall.
What is Inflation and What Causes It?
Inflation is caused by a rise in the quantity of money, which can occur
through many causes in the economy. The monetary authorities can
increase the money supply by printing and distributing more money to
individuals, legally devaluing (decreasing the value of) the legal tender
currency, or more commonly (and most commonly) by lending new
money into existence as reserve account credits through the banking
system by purchasing government bonds from banks on the secondary
market.
In all instances where the money supply is increased, the money loses
buying power. There are three sorts of processes that cause inflation:
demand-pull inflation, cost-push inflation, and built-in inflation.
DEMAND-PULL EFFECT
Demand-pull Inflation happens when an increase in the availability of
money and credit causes an economy’s total demand for goods and
services to rise faster than the economy’s production capability. This raises
demand and, as a result, prices.
With more money accessible to individuals, a better consumer mood leads
to more expenditure, which drives up prices. It causes a demand-supply
imbalance, with more demand and less flexible supply, resulting in higher
prices.
COST-PUSH EFFECT
Cost-push inflation occurs as a result of price increases in manufacturing
process inputs. Costs for all types of intermediate products rise when
increases in the supply of money and credit are funneled into a commodity
or other asset markets, especially when this is accompanied by a negative
economic shock to the supply of essential commodities.
These advances raise the cost of the final product or service, which in turn
raises consumer pricing. For example, when the money supply expands
and causes a speculative boom in oil prices, the cost of energy for all
purposes might rise, contributing to rising consumer prices, which is
reflected in various measures of inflation.
BUILT-IN INFLATION
Built-in inflation is linked to adaptive expectations or the belief that

present inflation rates will persist in the future. Workers and others learn
to assume that when the price of products and services grows, they will
continue to climb at a similar rate in the future and demand higher
expenses or salaries to maintain their level of living. Their greater earnings
raise the cost of products and services, and the wage-price spiral continues
as one component induces the other and vice versa.
Inflation Rate Meaning and Formula
The inflation rate is the percentage rise or reduction in prices over a given
time period, which is often a month or a year. The percentage indicates
how rapidly prices increased during the period.
FORMULA:
The difference between the initial and final CPIs divided by the starting
CPI is the inflation rate formula. The value is then multiplied by 100 to
calculate the inflation rate.
Rate of Inflation = (Initial CPI – Final CPI/ Initial CPI)*100
CPI= Consumer Price Index
CALCULATION INFLATION:
The Consumer Price Index is used to calculate inflation (CPI). By
following these procedures, you may determine inflation for any product.
Determine the product’s rate at a previous time.
Determine the product’s current rate.
In order to get the inflation rate, multiply (Initial CPI – Final CPI/Initial
CPI)*100. In this case, CPI is the product’s rate.
This provides the % increase/decrease in the product’s price. This may be
used to compare the inflation rate throughout time.
HOW DOES INFLATION IMPACT
Also Read:
THE STOCK MARKET
Effects of Rising Inflation Rate
A rise in the inflation rate can result in more than just a loss of purchasing
power.
Inflation may lead to economic growth since it is an indication of growing
demand.
Inflation might lead to more cost increases as workers demand salary
increases to keep up with inflation. This might lead to an increase in
unemployment if businesses are forced to lay off people in order to meet
the expenditures.
Domestic products may become less competitive if the country’s inflation
rate rises. It has the potential to depreciate the country’s currency.
Types of Inflation
ON THE BASE OF CAUSE
(I) CURRENCY INFLATION:
The production of currency notes causes this sort of inflation.
(II) CREDIT INFLATION:
Commercial banks, being profit-making organizations, provide more
loans and advances to the public than the economy requires. Price levels
grow as a result of such credit expansion.
(III) DEFICIT-INDUCED INFLATION:
When government expenditure surpasses revenue, the budget is in deficit.
To close the deficit, the government may request that the central bank issue
more money. Because more money must be pumped into the economy to
cover the budget deficit, any price increase may be referred to as deficit-
induced inflation.
(IV) DEMAND-PULL INFLATION:
A rise in the price level results from an increase in aggregate demand over
available output. This type of inflation is known as demand-pull inflation
(henceforth DPI).
(V) COST-PUSH INFLATION:
Inflation in an economy can occur as a result of an increase in the overall
cost of manufacturing. Cost-push inflation is the name given to this form
of inflation (henceforth CPI). The cost of production may rise when the
price of raw materials, salaries, and so on rises.
ON THE BASE OF INTENSITY
(I) CREEPING OR MILD INFLATION:
If the rate of price rise is gradual yet significant, we get creeping inflation.
Economists have not indicated what rate of yearly price growth is a
creeping one. Some define creeping or moderate inflation as yearly price
increases ranging between 2% and 3%. If the pace of price growth remains
at this level, it is thought to be beneficial to economic progress. Others
believe that if yearly price increases are little more than 3%, there is no
concern.
(II) WALKING INFLATION:
Walking inflation occurs when the yearly rate of price growth falls
between 3 and 4%. Walking inflation develops when modest inflation is
allowed to fan out. These two forms of inflation are referred to as
“moderate inflation.”
(III) GALLOPING AND HYPERINFLATION:
Running inflation may be converted from walking inflation. Running
inflation is risky. If it is not managed, it may eventually lead to galloping
or hyperinflation. When an economy is shattered, it results in an extreme
type of inflation.
(IV) GOVERNMENT’S REACTION TO
INFLATION:
The inflationary condition might be open or closed. Because of the
government’s anti-inflationary efforts, inflation may not be an
embarrassing one.
Inflation and Business Cycles
Inflation
The word “inflation” means different things to different people. One
popular conception of inflation focuses on prices — all prices, actually. For
these people, including some economists, “inflation” means a rise in the
general price level, i.e., the goods and services we buy have higher price
tags.
The other conception of inflation focuses on the money supply. Economists
with this focus think of inflation as an increase in the amount of money in
the economy. We’ll see that viewing inflation as a rise in prices can be
misleading and ambiguous especially compared to viewing inflation as an
increase in the money supply.
FIRST OF ALL, PRICES CAN RISE FOR MANY

REASONS. If the demand for something increases relative to its
supply, or if the supply of something decreases relative to the demand for
it, the price will increase.
The fundamental reason for this is called diminishing marginal utility —
increasing our stock of some good means that it will go toward the
satisfaction of a lower-ranked end. If the next “marginal unit” goes toward
a lower-ranked end, then the most we are willing to pay for the next unit
must be less than the previous unit. You might be willing to pay $600 for
one Apple Watch, but the most you would be willing to pay for another
might be $100, maybe as gift for somebody else or so that you could have
one on both of your wrists!
Even though this sounds pretty limiting in terms of the reasons prices can
rise, these two concepts — supply and demand — can and do channel all
sorts of changes in the market.
Preferences can change, goods can go in and out of fashion, accidents can
happen that reduce our supply of a certain good, we can think of new and
more efficient ways of producing goods, services that at one time could
only be done with human labor can be replaced or complemented with new
tools and machines, and so on.
The list of things that affect supply and demand is infinite, depending on
how specific you get, but the important thing to remember is that all of
these sorts of changes are integrated into and channeled through our
preferences and ideas and therefore supply and demand.
SECONDLY, THERE IS REALLY NO GOOD
WAY TO MEASURE A GENERAL RISE IN THE
PRICE LEVEL. You maybe familiar with indexes like the
Consumer Price Index, which are calculated and compiled based on survey
data and technical mathematical methods, but by their very nature they
cannot appropriately capture the price level. They cannot do so because
these sorts of indexes are one number.
They try to boil the trillions of pieces of data on the prices of all goods and
services in the economy down to just one piece of data. Market prices,
which are a complicated phenomenon on their own, fluctuate not only year
to year, but month to month, day by day, and even second to second. Also,
there is no central repository of price information.
Even in one country, prices emerge in a very scattered, decentralized way,
from the halls of Washington D.C. to the dark, back alleys of downtown
Chicago; from the lots of car dealers with neon paint to hand-to-hand-to-
pocket tips for bellhops and restaurant servers; from fleeting ones and
zeroes soaring at light speed across the internet to long-term contracts for
land use or film production.
One number couldn’t even begin to describe the magnitude and dynamic
nature of something like the “price level”. It would be like driving out West
for a camping trip and going to the remotest location at night to view the
stars and a meteor shower and then the next month, when you return to
civilization and cell service you text your parents what the view was like
and type, “Cool.”
Price index information is delayed, incomplete, and by its very nature
incapable of describing the astronomical picture of market prices. And we
haven’t even mentioned the well-cited issues with surveys, government
data, and the more specific issues with the particular measurements.
A THIRD ISSUE WITH VIEWING INFLATION
ONLY AS A RISE IN THE PRICE LEVEL IS
THAT IT STOPS SHORT OF EXPLAINING THE
FULL CONSEQUENCES OF MONETARY
INFLATION. Many people correctly understand the relationship
between the price level and the money supply — more money means higher
prices — and they also understand that this relationship is bad for the
average Joe.
Now, Dr. Salerno is not average by any measure, but we can say that if he
is one of the later receivers of new money, he has to pay higher prices
before his own salary increases due to inflation, however you define it.
In this way, inflation is not harmless — it represents a wealth transfer to
the first users of the new money from the later users of new money as it
ripples through the economy.
Even though most people know and understand this consequence of
increasing the money supply, it stops short of explaining the full
consequences of monetary inflation, which will be discussed in just a
moment.
But to summarize, viewing inflation as a rise in the price level has at least
three main problems:
It is ambiguous because almost anything can change prices;
It is impractical because it can’t be appropriately measured;
And it is incomplete because it doesn't tell the whole story of increases in
the money supply.
Inflation is more appropriately viewed as an increase in the money supply,
and this conception of inflation does not suffer the same problems as the
other. Monetary inflation has a simple, well-defined cause, unlike price
inflation. Monetary inflation is measureable because money is its own unit
of account and can be counted up, unlike price inflation, which is not
directly measureable. Monetary inflation is also the starting point for the
business cycle story, instead of a stopping point for many, like price
inflation.
The business cycle
Before we can discuss the ups and downs of the business cycle, we have to
gain an understanding of two connected concepts: the interest rate and
production.
The interest rate is a price, like any other price, but for present money. It
seems weird that you can buy money, but if you just reverse your
perspective of any regular transaction, “buying money” becomes an
obvious and ubiquitous part of our day-to-day lives.
When you buy an Apple Watch (or two) you exchange money for the
device. From Apple’s perspective though, they are not only selling the
watch, but buying your money. The price of your $600 is one Apple Watch.
THE INTEREST RATE IS A PRICE FOR
PRESENT MONEY, IN TERMS OF FUTURE
MONEY. When you take out a loan, you are buying present money in
exchange for the promise of a future payment. The relative difference
between these two sums is the interest rate. And, just like any other good,
the lower the price, the more people will want to buy. At lower interest
rates, more people are willing to borrow.
In modern times, we've outsourced a lot of the lending to banks, which act
as financial intermediaries. Banks use our savings to lend to prospective
borrowers, and so the supply of loanable present money depends on how
much people save — said another way, it depends on how much people
consume, since saving is the opposite of consumption.
The indirectness of borrowing and lending through banks does not
complicate things too much; in fact it makes it easier for us to conceive of
the supply of loans simply as savings.
Entrepreneurs are some of the primary borrowers of present money.
Entrepreneurs buy factors of production like land, labor, and capital to
produce goods and services. They will only engage in production, though,
if they expect to profit, that is, if their revenues exceed their costs.
IF THEY BORROW MONEY TO PAY FOR THE
FACTORS OF PRODUCTION, THEN THE
PROFIT WOULD ALSO HAVE TO EXCEED THE
INTEREST THEY PROMISE TO PAY FOR THE
BORROWED FUNDS. For this reason, the interest rate is a vital
piece of information for entrepreneurs. If interest rates are high, then only
high-revenue lines of production will be undertaken. If interest rates are
low, then more lines of production become profitable.
In an unhampered market, interest rates are determined by supply and
demand. If people become more willing to part with their present money,
or save, then the supply of loanable funds will increase relative to demand,
and the interest rate will fall. At the lower interest rate, more lines of
production will become profitable because now entrepreneurs can borrow
more cheaply to purchase factors of production. Since this scenario started
with people becoming more willing to save, it’s also clear that the
entrepreneurs will be able to purchase the real resources required for
production. Consumers have shown that they are willing to consume less
so now, more resources can be used by producers for production.
Let’s walk through a specific example of how this works:
Suppose Tim Cook has an idea for how to produce one million Apple
Watches and expects revenues from his sales to exceed his costs by 10%.
He doesn’t have the money to pay for the machines and the laborers and
the factories required to produce the watches, so he needs to borrow. The
current interest rate is 15%, unfortunately for Tim Cook, so he just holds
on to his idea for the time being.
However, a couple months later, due to the increased willingness for people
to save and invest, the interest rate falls a whopping 10%, down to just 5%.
Tim Cook reevaluates his plan and his expectations of profitability and
decides to go for it. He borrows the money necessary to pay for laborers,
machines, and factories and starts producing Apple Watches.
He sells his product and gets revenue that exceeds his cost by 12% — a
little more than he was expecting! He pays back his creditors the amount
he promised, 5%, which left him with 7% all to himself for taking the risks
and producing something consumers like.
The lower interest rate in this example encouraged the entrepreneur to
produce and also signaled to the entrepreneur that resources have been
freed up in the economy for use in production. Now let’s see what happens
when entrepreneurs get a false signal from credit markets via monetary
inflation.
WHEN A CENTRAL BANK DECIDES TO
INCREASE THE MONEY SUPPLY, THE NEW
MONEY ENTERS THE ECONOMY THROUGH
THE SAME MARKETS THAT PEOPLE
BORROW AND LEND. The new money increases the supply of
present money available for lending, which, as we all know, will decrease
the price, or the interest rate in this case.
To be clear, this time, the lower interest rate does not reflect people’s
willingness to save or invest, but only reflects the central bankers’
intervention. This artificially low interest rate sends all of the same signals
to entrepreneurs and lenders that a normal interest rate does, but is not
based on people’s real preferences.
When the central bank increases the money supply and interest rates fall, it
induces more borrowing and less saving. Entrepreneurs are more than
happy to take out the loans at the lower interest rate, but everybody else is
less willing to save at the lower interest rate. The newly printed money
makes up the difference.
Less saving means more consumption, and since the interest rate is so low,
consumers may even borrow to finance even more consumption.
Entrepreneurs take their funds and purchase factors of production, and at
the new, lower interest rate, the lines of production they undertake are the
ones that weren’t as profitable before. EVERYBODY IS
HAPPY AS THEY CONSUME, INVEST, EARN
HIGHER WAGES, START NEW PROJECTS,
AND ENJOY THE RIDE TO THE TOP.
THIS HIGH CANNOT LAST FOREVER,
THOUGH. Even though spending is climbing on all fronts, no new
resources have been created, just new green slips of paper. The economy
has not allocated real resources away from consumption and toward
production, it has just stretched the existing resources thin. The signals
entrepreneurs rely on were falsified and based on the whims of a few
powerful people, not the collective, voluntary interactions of individuals
everywhere.
The boom peaks and falls into a bust when some combination of these
events unfolds:
When the increasingly scarce factors of production become too expensive;
When the monetary spigot gets turned off and so consumption and
investment run dry;
And when people start to realize the damage that has been done.
The bust is characterized by under- and unemployment, falling prices, and
a readjustment of capital throughout the economy. The bust is painful, but
necessary and healthy.
Capital and laborers have been misallocated, funds malinvested, and lines
of production that appeared to be profitable are revealed to be unprofitable
in hindsight. The correction happens during the bust. IN FACT,
THE BUST IS THE CORRECTION. Resources need to go
where they are most highly valued, and the only system capable of such a
daunting task is the unhampered market economy.
In the past and up to today, the necessary correction hasn't been allowed to
run its course before central banks reinflate and restart the cycle. So, it’s
unfortunate that we have to call it the boom-bust “cycle”, instead of the

boom-bust “event”. If it were a one-time thing, we might forgive the ones
responsible and say, “Ok, that was an interesting experiment. We didn't
really think it was going to work, but now everybody knows.” Like the
George Clooney/Arnold Schwarzenegger Batman movie.
But as the term “business cycle” suggests, the artificial booms and the
painful busts continue because some people, especially the government,
stand to benefit at the expense of others and because of a general lack of
understanding of even the fundamental mechanisms at work.
WE CAN AVOID THE MESS. People are getting into and
developing currencies that are not tied to our fractional reserve and central
banking system. Newer technologies are being adopted for loans to be
processed at rates less affected by central bank manipulation.
Many people are realizing the disastrous record of central banking and
expansionary monetary policy. The same people are learning the way to
real economic growth via real savings and economically sustainable uses
of our resources.
5.4 MEASURES OF ECONOMICS

STABILIZATION
Economic stabilisation is one of the main remedies to effectively control
or eliminate the periodic trade cycles which plague capitalist economy.
Economic stabilisation, it should be noted, is not merely confined to a
single individual sector of an economy but embraces all its facts. In order
to ensure economic stability, a number of economic measures have to be
devised and implemented.
In modem times, a programme of economic stabilisation is usually
directed towards the attainment of three objectives: (i) controlling or
moderating cyclical fluctuations; (ii) encouraging and sustaining
economic growth at full employment level; and (iii) maintaining the value
of money through price stabilisation. Thus, the goal of economic stability
can be easily resolved into the twin objectives of sustained full
employment and the achievement of a degree of price stability.
THE FOLLOWING INSTRUMENTS ARE USED
TO ATTAIN THE OBJECTIVES OF ECONOMIC
STABILISATION, PARTICULARLY CONTROL
OF TRADE CYCLES, RELATIVE PRICE
STABILITY AND ATTAINMENT OF
ECONOMIC GROWTH:
(1) Monetary policy
(2) Fiscal policy; and
(3) Direct controls.
1. Monetary Policy:
The most commonly advocated policy of solving the problem of
fluctuations is monetary policy. Monetary policy pertains to banking and
credit, availability of loans to firms and households, interest rates, public
debt and its management, and monetary management.
However, the fundamental problem of monetary policy in relation to trade
cycles is to control and regulate the volume of credit in such a way as to
attain economic stability. During a depression, credit must be expanded
and during an inflationary boom, its flow must be checked.
Monetary management is the function of the commercial banking system,
and through it, its effects are primarily exerted the economy as a whole.
Monetary management directly affects the volume of cash reserves of
banks, regulates the supply of money and credit in the economy, thereby
influencing the structure of interest rates and availability of credit.
Both these factors affect the components of aggregate demand
(consumption plus investment) and the flow of expenditures in the
economy. It is obvious that an expansion in bank credit causes an
increasing flow of expenditure (in terms of money) and contraction in bank
credit reduces it.
In the armoury of the central bank, there are quantitative as well as
qualitative weapons to control the credit- creating activity of the banking
system. They are bank rate, open market operations and reserve ratios.
These are interrelated to tools which operate on the reserves of member
banks which influence the ability and willingness of the banks to expand
credit. Selective credit controls are applied to regulate the extension of
credit for particular purposes.
We shall now briefly discuss the implications of these weapons.
Bank Rate Policy:
Due to various reasons, the bank rate policy is relatively an ineffective
weapon of credit control. However, from the viewpoint of contracyclical
monetary policy, bank rate policy is usually interpreted as an evidence of
monetary authority’s judgement regarding the contribution of the current
flow of money and bank credit to general economic stability.
That is to say, a rise in the bank rate indicates that the central bank
considers that liquidity in the banking system possesses an inflationary
potential. It implies that the flow of money and credit is very much in
excess of the actual productive capacity of the economy and therefore, a
restraint on the expansion of money supply through dear money policy is
desirable.
On the other hand, a reduction in the bank rate is generally interpreted as
an evidence of a shift in the direction of monetary policy towards a cheap
and expansive money policy. A reduction in bank rate then is more
significant as a symbol of an easy money policy than anything else.
However, the bank rate is most effective as an instrument of restraint.
Effectiveness of Bank Rate Policy in Expansion:
ACCORDING TO ESTEY, THE FOLLOWING
DIFFICULTIES USUALLY ARISE IN THE WAY
OF AN EFFECTIVE DISCOUNT POLICY IN
EXPANSION:
1. During high prosperity, the demand for credit by businessmen may be
interest-inelastic.
2. The rising of bank rate and a consequent rise in the market rates of
interest may attract loanable funds from the financial intermediaries in the
money market and assist in counteracting undesired effects.
3. Though the quantity of money may be controlled by the banking system,
the velocity of its circulation is not directly under the influence of banks.
Banking policy may determine how much credit there should be but it is
the trade which decides how much and how fast it will be used. Thus, if
the velocity of the movement is contrary to the volume of credit, banking
policy will be rendered ineffective.
4. There is also the difficulty of proper timing in the application of banking

policy. Brakes must be applied at the right time and in the right quarter. If
they are applied too soon, they must bring expansion to an end with factors
of production not fully employed. And when applied too late, there might
be a runaway monetary expansion and inflation, completely out of control.
Open Market Operations:
The technique of open market operations refers to the purchase and sale of
securities by the central bank. A selling operation reduces commercial
banks’ reserves and their lending power.
However, because of the need to maintain the government securities
market, the central bank is completely free to sell government securities
when and in what amounts it wishes in order to influence commercial
banks’ reserve position. Thus, when a large public debt is outstanding, by
expanding the securities market, monetary policy and management of the
public debt become inseparably intertwined.
Reserve Ratios:
The monetary authorities have at their disposal another most effective way
of influencing reserves and activities of commercial banks and that
weapon is a change in cash reserve ratios. Changes in the reserve ratios
become effective at a pre-announced date.
Their immediate effect is to alter the liquidity position in the banking
system. When the cash reserve ratio is raised commercial banks find their
existing level of cash reserves inadequate to cover deposits and have to
raise funds by disposing liquid assets in the monetary market. The reverse
will be the case when the reserve ratio is lowered. Thus, changes in the
reserve ratios can influence directly the cash volume and the lending
capacity of the banks.
It appears that the bank rate policy, open market operations and changes
in reserve ratios exert their influence on the cost, volume and availability
of bank reserves through reserves, on the money supply.
Selective Controls:
Selective controls or qualitative credit control is used to divert the flow of
credit into and out of particular segments of the credit market. Selective
controls aim at influencing the purpose of borrowing. They regulate the
extension of credit for particular purposes. The rationale for the use of
selective controls is that credit may be deemed excessive in some sectors
at a time when a general credit control would be contrary to the
maintenance of economic stability.
It goes without saying that these various means of credit controls are to be
co-ordinated to achieve the goal of economic stability.
Effectiveness of Monetary Control:
Monetary policy is much more effective in curbing a boom than in helping
to bring the economy out of a depressionary state. It has long been
recognised that monetary management can always contract the money
supply sufficiently to end any boom, but it has little capacity to end a
contraction.
This is because the actions of monetary management do not directly enter
the income-expenditure stream as the most effective contra-cyclical
weapon, for their first impact is on the asset structure of financial
institutions, and in this process of altering the assets structure, rate of
interest, volume of credit and the income-expenditure flow may be altered.
All these operate more significantly in restraining the income stream
during expansion than in inducing an increase during contraction.
However, the greatest advantage of monetary policy is its flexibility.
Monetary management makes decisions about the rate of change in the
money supplies that are consistent with economic stability and growth on
a judgement of given quantitative and qualitative evidences.
But, whether this point of monetary policy will prove its effectiveness or
not depends on its exact timing. Manipulation of bank rate and open
market dealings by the central bank should be reasonably effective if
applied quickly and continuously in preventing booms from developing
and consequently, into a depression.
To sum up, monetary policy is a necessary part of the stabilisation
programme but it alone is not sufficient to achieve the desired goal.
Monetary policy, if used as a tool of economic stabilisation, in many ways,
serves as a complement of fiscal policy.
It is strong, whereas fiscal policy is weak. It is flexible and capable of
quick alternations to suit the measure of pressures of the time and needs.
However, it is to be co-ordinated with fiscal policy. A wrong monetary
policy may seriously endanger and even destroy the effectiveness of fiscal
policy. Thus, monetary policy and fiscal policy, each reinforcing and
supplementing the other, are the essential elements in devising an
economic stabilisation programme.
2. Fiscal Policy:
Today, foremost among the techniques of stabilisation is fiscal policy.
Fiscal policy as a tool of economic stability, however, has received its due
importance under the influence of Keynesian economies only since the
depression years of the 1930s.
The term ‘‘fiscal policy” embraces the tax and expenditure policies of the
government. Thus, fiscal policy operates through the control of
government expenditures and tax receipts. It encompasses two separate
but related decisions: public expenditures and level and structure of taxes.
The amount of public outlay, the inducement and effects of taxation and
the relation between expenditure and revenue exert a significant impact
upon the free enterprise economy.
Broadly speaking, the taxation policy of the government relates to the
programme of curbing private spending. The expenditure policy, on the
other hand, deals with the channels by which government spending on new
goods and services directly add to aggregate demand and indirectly
income through the secondary spending which takes place on account of
the multiplier effect.
Taxation, on the other hand, operates to reduce the level of private
spending (on both consumption and investment) by reducing the
disposable income and the resulting savings in the community. Hence,
under the budgetary phenomenon, public expenditure and revenue can be
combined in various ways to achieve the desired stimulating or
deflationary effect on aggregate demand.
Thus, fiscal policy has quantitative as well as qualitative aspect changes in
tax rates, the structure of taxation and its incidence influence the volume
and direction or private spending in economy. Similarly, changes in
government’s expenditures and its structure of allocations will also have
quantitative and redistributive effects on time, consumption and aggregate
demand of the community.
As a matter of fact, all government spending is an inducement to increase
the aggregate demand (both volume and components) and has an
inflationary bias in the sense that it releases funds for the private economy
which are then available for use in trade and business.
Similarly, a reduction in government spending has a deflationary bias and

it reduces the aggregate demand (its volume and relative components in
which the expenditure is curtailed). Thus, the composition of public
expenditures and public revenue not only help to mould the economic
structure of the country but also exert certain effects on the economy.
For maximum effectiveness, fiscal policy should be planned on both long-
run and short-run basis. Long- run fiscal policy obviously is concerned
with the long- run trends in government income and spendings. Within the
framework of such a long-range plan of fiscal operations, the budget can
be made to vary cyclically in order to moderate the short-run economic
fluctuations.
Basically two sets of techniques can be employed for planning the desired
flexibility in the relation between tax revenue and expenditure: (1) built-
in flexibility or automatic stabilisers, and (2) discretionary action.
Built -in Flexibility: The operation of a fiscal policy is always confronted
with the problem of timing and forecast. A fiscal policy administrator has
always to face the question: When to do what? But it is a very difficult and
complex question to answer. Thus, in order to minimise the difficulties
that arise from uncertainties of forecasting and timing of fiscal operations,
an automatic stabiliser programme is often advocated.
Automatic stabiliser programme implies that in a given framework of
expenditure and revenue relation in a budgetary policy, there exist factors
which provide automatically corrective influences on movements in
national income, employment, etc. This is what is called built-in
flexibility. It refers to a passive budgetary policy.
The essence of built-in flexibility is that (i) with a given set of tax rates tax
yields will vary directly with national income, and (ii) there are certain
lines of government expenditures which tend to vary inversely with
movements in national income.
Thus, when the national income rises, the existing structure of taxes and
expenditures tend to automatically increase public revenue relative to
expenditure, and to increase expenditures relative to revenue when the
national income falls. These changes tend to mitigate or offset inflation or
depression at least partially. Thus, a progressive tax structure seems to be
the best automatic stabiliser.
Likewise, certain kinds of government expenditure schemes like
unemployment compensation programmes, government subsidies or
price-support programmes also offset changes in income by varying
inversely with movements in national income.
However, automatic stabilisers are not a panacea for economic
fluctuations, since they operate only as a partial offset to changes in
national income, but provide a force to reverse the direction of the change
in the income.
They slow down the rate of decline in aggregate income but contain no
provision for restoring income to its former level. Thus, they should be
recognised as a very useful device of fiscal operations but not the only
device. Simultaneously, there should be scope for discretionary policies as
the circumstances will call for.
Discretionary Action:
Quite often, it becomes absolutely necessary to have fiscal operations with
a tool kit of discretionary policies consisting of measures for putting into
effect with a minimum delay, the changes in government expenditures.
This calls for a skeleton of public works projects providing for
administrative discretion to employ them and the funds to put them into
effect.
It calls for a budgetary manipulation an active budget policy constituting
flexible tax rates and expenditures. There can be three ways of
discretionary changes in tax rates and expenditures: changing expenditure
with constant tax rates; changing tax rates and constant expenditure; and a
combination of changing tax rates and changing expenditures.
In general, the first method is probably superior to the second during a
depression. That is to say, to increase expenditures with the level of taxes
remaining unchanged is useful in pushing up the aggregate spending and
effective demand in the economy. However, the second method will prove
to be superior to the first during inflation.
That is to say, inflation could be checked effectively by increasing the tax
rates with a given expenditure programme. But it is easy to see that the
third method is much more effective during inflation as well as deflation
than the other two.
Inflation would, of course, be more effectively curbed when taxes are
enhanced and public expenditure is also simultaneously reduced.
Similarly, during a depression, the spending rate of private economy will
be quickly lifted up if taxes are reduced simultaneously with the increasing
public expenditure.
However, the main difficulty with most discretionary policies is their
proper timing. Delay in discretion and implementation will aggravate the
problem and the programme may not prove to be effective in solving the
problems.
Thus, many economists fear that discretionary government actions are
likely to do more harm than good, owing to the uncertainty of government
actions and the political pressures to favour vested interests. That is why
reliance on built-in stabilisers, as far as possible, has been advocated.
3. Direct Controls:
Broadly speaking, direct controls are imposed by government which
expressly forbid or restricts certain kinds of investment or economic
activity. Sometimes, direct government controls over prices and wages as
a measure against inflation have been advocated and implemented.
During World War II, price-wage controls were employed in conjunction
with consumer rationing and materials allocation to curb generalised total
excess demand and to direct productive resources into channels desired by
the government. Monetary-fiscal controls may be used to curb excess
demand in general but direct controls can be more useful when they are
applied to specific scarcity areas.
DIRECT CONTROLS HAVE THE FOLLOWING
ADVANTAGES:
1. They can be introduced or changed quickly and easily: hence the effects
of these can be rapid.
2. Direct controls can be more discriminatory than monetary and fiscal
controls.
3. There can be variation in the intensity of the operations of controls from
time to time in different sectors.
IN A PEACE-TIME ECONOMY, HOWEVER,
THERE ARE SERIOUS PHILOSOPHICAL AND
POLITICAL OBJECTIONS TO DIRECT
ECONOMIC CONTROLS AS A STABILISATION
DEVICE OBJECTIONS HAVE BEEN RAISED

TO SUCH CONTROLS ON THE FOLLOWING
COUNTS:
1. Direct controls suppress individual initiative and enterprise.
2. They tend to inhibit innovations, such as new techniques of production,
new products etc.
3. Direct controls may breed or induce speculation which may have
destabilising effects. For instance, if it is expected that a commodity X,
say steel, is to be rationed because of scarcity, people may try to hoard
large stocks of it, which aggravates its shortage. It, thus, encourages the
creation of artificial scarcity through large-scale hoarding;.
4. Direct controls need a cumbersome, honest and efficient administrative
organisation if they are to work effectively.
5. Gross disturbances reappear as soon as controls are removed.
In short, direct controls are to be used only in extraordinary circumstances
like emergencies, but not in a peace-time economy.
5.5 Profit Measurement and Cost Minimization

Today’s business word of the day is “profitable.” According to the
unabridged Merriam-Webster English Dictionary, the definition of
profitable is, “affording profits: yielding advantageous returns or results.”
Thesaurus.com provides some related words, including “beneficial,”
“cost-effective,” and “fruitful.” Other relevant words include “gainful”
and “money-making.” Antonyms include “fruitless” and “valueless.”
Most business owners understand profitability from a fundamental
standpoint. If the revenue from sales covers your expenses, you’re turning
a profit. Profits mean positive cash flow. Positive cash flow helps keep
your business in operation. Profitableness tends to be one of the primary
goals of business owners. They seek to have a profitable experience and
capitalize on material gain.
However, business owners should look beyond a simple profit dollar
amount. The basic dollar amount doesn’t indicate why the business is
profitable. Analyzing key metrics can help business owners determine
whether their company is healthy, and profitability is sustainable. By
calculating and comparing metrics, owners can identify the areas of the
business that are working well — and those that need improvement.
Broadly speaking, there are three primary ways to determine whether
you’re a profitable business: margin or profitability ratios, break-even
analyses, and return on asset assessments.
In this article, we’ll provide you with a breakdown of everything you need
to know to run a financial profitability analysis. The financial ratios and
figures that we’ve included will not only provide you with an accurate
measure of profitability but help predict future profitability as well.
MARGIN OR PROFITABILITY RATIOS

Perhaps the best way to determine whether you run a profitable business
is by running margin ratios, also referred to commonly as profitability
ratios. To run these figures, you’ll first need to calculate three things from
your income statement:
Gross Profit = Net Sales – Cost of Goods Sold
Operating Profit = Gross Profit – (Operating Costs, Including Selling and
Administrative Expenses)
Net Profit = (Operating Profit + Any Other Income) – (Additional
Expenses) – (Taxes)
All three of these figures provide you with a way to express profit from a
dollar perspective. We can take this a step further by turning these figures
into ratios. Doing so is beneficial because it allows you to analyze your
company more accurately. Ratios help you measure efficiency much better
than straight dollar amounts.
For instance, in Q1, you may have a
GROSS
higher PROFIT
MARGIN than in Q4, even though
you earned more money (from a dollar
amount perspective) in Q4. Additionally,
ratios allow you to compare your company
to others in your industry.
Just because a company earns more profit
doesn’t mean it’s financially healthy.
Margin ratios are a far better predictor of
health and long-term growth than mere
dollar figures.
Below, we’ll look at how you can turn things
like gross and net profit into ratios so that
you can better analyze your company’s
financial health. One ratio is not better than
the other. All three will help give you an
accurate look at the inner-workings of your
business.
Gross profit margin ratio

If you sell physical products, gross margin
allows you to hone in on your product
profitability. Your total gross profit is sales
revenue minus your cost of goods sold. Cost
of goods sold represents how much your
company paid to sell products during a
given period.
In other words, it’s profit after deducting direct
materials, direct labor, inventory, and
product overhead. It does not consider your
general business expenses. The formula to
calculate the gross profit margin ratio is:
GROSS PROFIT MARGIN
RATIO = (GROSS PROFIT ÷
SALES) × 100
If the gross profit margin is high, it means that
you get to keep a lot of profit relative to the
cost of your product. One of the primary
things you want to concern yourself with is
the stability of this ratio.
Your gross margins shouldn’t fluctuate
drastically from one period to the other. The
only thing that should cause a severe
fluctuation would be if the industry that
you’re part of experiences a widespread
change that directly impacts your pricing
policies or cost of goods sold.
Operating profit margin ratio

The operating margin provides you with a good
look at your current earning power. Unlike
gross profit, which you would prefer to be
stable, an increase in the operating profit
margin illustrates a healthy company. The
formula to calculate the operating margin is:
OPERATING PROFIT
MARGIN RATIO =
(OPERATING INCOME ÷
SALES) × 100
The operating margin gives you a good look at
how efficient you are. If you’re looking to
compare your returns to others in the
industry, this is the best ratio to do so, as it
shows your ability to turn sales into pre-tax
profits. Many individuals in corporate
finance find this to be a much more
objective evaluation tool than the net profit
margin ratio.
One of the things that can keep this ratio
stagnant is an increase in operating
expenses. If you suspect that some
operating costs are creeping up, you should
perform a comparative analysis of your
operating expenses.
A comparative analysis is a side-by-side
percentage comparison of two or more years
of data. It’s a little more time-consuming
than a basic ratio calculation, but it’s not too
bad if you can export the data from
ACCOUNTING
your
SOFTWARE.
After you plug in the numbers, scan your
comparative analysis for the biggest
percentage changes over time. Doing so will
allow you to identify the reason for the
expense increase and determine if it’s worth
being concerned about.
Net profit margin ratio

Net profit margin, sometimes referred to as just
“profit margin,” is the big-picture view of
your profitability. Some industries — like
financial services, pharmaceuticals,
medical, and real estate — have sky-high
profit margins, while others are more
INDUSTRY
conservative. Use
STANDARDS as a benchmark,
and perform an internal year-over-year
comparison to assess your performance.
The formula to calculate the net profit
margin ratio is:
NET PROFIT MARGIN RATIO
= (NET INCOME ÷ SALES) ×
100
Net profit margin is similar to operating profit
margin, except it accounts for earnings after
taxes. It demonstrates how much profit you
can extract from your total sales.
Break-even analysis
Your break-even point is the point at which
expenses and revenues are the same. You’re
not making money at your break-even point,
but you’re not losing money either. You
should take time to measure your break-
even point to determine how much
“breathing room” you have in case things
turn south.
As a business owner, you need to plan for the
unexpected. Perhaps you lose access to raw
materials because of a natural disaster. Or
one of your manufacturers suffers a
warehouse fire and can no longer provide
you with the goods you need. Whatever the
case, knowing the break-even point will let
you know how much you can afford to lose
before you are no longer a profitable
company.
You can calculate the break-even point for
various components of the business. For
instance, you can measure the break-even
point as a figure of sales. The formula to do
so is:
BREAK-EVEN POINT SALES
= FIXED EXPENSES +
VARIABLE EXPENSES
You could also measure your break-even point
against units sold. The method to do so is:
BREAK-EVEN POINT FOR
UNITS SOLD = FIXED
EXPENSES ÷ (UNIT SALES
PRICE – UNIT VARIABLE
EXPENSES)
Running these figures allows you to determine

how profitable you’ll remain in the future
were something to happen to your company.
Return on assets and return on investments

The last two measures of profitability that you
can get from your financial statements are
return on assets (ROA) and return on
investments (ROI). ROA shows total
revenue compared to total assets used. You
can use this figure as a comparison tool
from period to period within your company
and with other firms in your industry. The
higher the ROA, the more efficiently you
operate. The formula to calculate ROA is:
RETURN ON ASSETS = (NET
INCOME BEFORE TAXES ÷
TOTAL ASSETS) × 100
ROI shows how much you’re earning compared
to the investments that you make.
Measuring profitable investments allow you
to ensure that you’re putting your money in
the right places.
You want to make sure that your ROI is at least
as high as what you’d be earning in a risk-
free investment, like a high-yield savings
account or CD. If it’s not, you’d be better
off putting your money into one of these
accounts, as they would yield higher
earnings. ROI is basically a measure of
whether “this is all worth it.”
The formula to calculate ROI is:
RETURN ON INVESTMENT =
NET PROFIT BEFORE
TAXES ÷ NET WORTH
Also consider profit by segment
A lot of small businesses are subject to the
80/20 rule: Eighty percent of revenue comes
from 20 percent of customers. Segment
your business by product or service lines to
find out which areas of your business have
the REVENUE AND
best
NET INCOME.
There are two ways to calculate profit by
segment. One option is to identify the
specific revenue and costs associated with
the segment. If you do this, you’ll ignore
overhead expenses like business insurance,
rent, utilities, and executive salaries.
Alternatively, you can use a cost allocation plan
to allocate overhead costs to each segment
or service line. For example, if your salary
comprises a big chunk of overhead, you
would allocate that salary based on how
much time you spend on each segment.
What Is Cost Minimization?

Cost minimization is a basic rule used by
producers to determine what mix of labor
and capital produces output at the lowest
cost. In other words, what the most cost-
effective method of delivering goods and
services would be while maintaining a
desired level of quality.
An essential financial strategy it is important to understand why cost
minimization is important and how it works.
THE FLEXIBILITY OF THE PRODUCTION FUNCTION
In theLONG RUN , a producer has the flexibility over all aspects

of production—how many workers to hire, how big of a factory to have,
what technology to use, and so on. In more specific economic terms, a
producer can vary both the amount of capital and the amount of labor it
uses in the long run.
Therefore, the long-run PRODUCTION
FUNCTION has 2 inputs: capital (K) and labor (L). In the table
provided here, q represents the quantity of output that is created.
CHOICES OF PRODUCTION PROCESS
In many businesses, there are a number of ways in which a particular

quantity of output can get created. If your business is making sweaters, for
example, you could produce sweaters either by hiring people and buying
knitting needles or by buying or renting some automated knitting
machinery.
In economic terms, the first process uses a small quantity of capital and a
large quantity of labor (i.e., is "labor intensive"), whereas the second
process uses a large quantity of capital and a small quantity of labor (i.e.,
is "capital intensive"). You could even choose a process that is in between
these 2 extremes.
Given that there are often a number of different ways to produce a given
quantity of output, how can a company decide what mix of capital and
labor to use? Not surprisingly, companies are generally going to want to
choose the combination that produces a given quantity of output at the
lowest cost.
DECIDING THE CHEAPEST PRODUCTION

How can a company decide what combination is the cheapest?
One option would be to map out all of the combinations of labor and
capital that would yield the desired quantity of output, calculate
the COST of each of these options, and then choose the option with
the lowest cost. Unfortunately, this can get pretty tedious and is in some
cases not even feasible.
Luckily, there is a simple condition that companies can use to determine
whether their mix of capital and labor is cost minimizing.
THE COST-MINIMIZATION RULE
Cost is minimized at the levels of capital and labor such that

MARGINAL
the PRODUCT OF
LABOR divided by the wage (w) is equal to the marginal product of
capital divided by the rental price of capital (r).
More intuitively, you can think of cost being minimized and, by extension,
production being most efficient when the additional output per dollar spent
on each of the inputs is the same. In less formal terms, you get the same
"bang for your buck" from each input. This formula can even be extended
to apply to production processes that have more than 2 inputs.
To understand why this rule works, let's consider a situation that is not cost
minimizing and think about why this is the case.
WHEN INPUTS ARE NOT IN BALANCE
Let's consider a production scenario, as shown here, where the marginal

product of labor divided by the wage is greater than the marginal product
of capital divided by the rental price of capital.
In this situation, each dollar spent on labor creates more output than each
dollar spent on capital. If you were this company, wouldn't you want to
shift resources away from capital and towards labor? This would allow
you to produce more output for the same cost, or, equivalently, produce
the same quantity of output at a lower cost.
Of course, the concept of diminishing marginal product implies that it's
generally not worthwhile to keep shifting from capital to labor forever,
since increasing the quantity of labor used will decrease the marginal
product of labor, and decreasing the quantity of capital used will increase
the marginal product of capital. This phenomenon implies that shifting
towards the input with more marginal product per dollar will eventually
bring the inputs into cost-minimization balance.
It's worth noting that input doesn't have to have a higher marginal product
to have a higher marginal product per dollar, and it may be the case that it
could be worthwhile to shift to less productive inputs to production if those
inputs are significantly cheaper.
5.6 SUMMARY
 Forecasting consumer price inflation requires knowledge of
pricing behaviour and cost pressures in particular. Unit wage costs
are an apparent underlying source of inflation . Spare capacity
depresses this, as embodied by the Phillips curve .Capacity
constraints cannot be directly recorded. However, statistical
techniques can be used to back out the most likely level of effective
spare capacity consistent with observed data.
 There are some signs of a flattening of the Phillips curve , meaning
spare capacity has less effect on inflation . Some of this may be
because large amounts of slack have less impact amid aversion to
below zero real and especially nominal pay growth.
 With contemporary policymakers preventing significant capacity
constraints, inflation expectations have not been encouraged to
spiral higher, which would be an effective outward shift in the
Phillips curve that also appears like a very steep portion of it.
 The potential level of GDP consistent with non-excessive inflation

can be backed out from estimates of spare capacity or summed up
from estimates and assumptions about the underlying factors of
production. The latter is less flexible and cannot catch structural
changes in anything approaching a useful timeframe.
 In reality, the structure of the economy is constantly evolving. As
resources move, they can become underemployed or obsolete, with
this creating breaks in productivity trends. Where resources end up
determines their new return. Such dynamics are of a metastable
equilibrium , not the standard steady state one.When spare capacity
is being used up, the monetary policy setting is stimulative, with
rates below their neutral setting. Structurally, saving and
investment determine that neutral rate, which in turn reflects the
natural expected return on investment and time preferences.
5.7 SELF-ASSESSMENT QUESTIONS

A. Descriptive Questions:
1. Define business cycle.
2. Explain in detail the four phases of the business cycles
3. Describe the characteristics and types of business cycle
4. Explain in depth-business cycle theories
5. What are the causes/ reasons of inflation
6. Discuss the types of inflation found in an economy
B. Practical/Scenario based Questions

1. Show the relationship between inflation and the business cycle with the
help of an example
2. Discuss Monetary policy
3. Debate on effectiveness of Bank rate policy
4. Mention advantages of the direct control method of economic
stabilization
5. Define cost minimization and explain its rules
6. Present the list of formulas used for measurement of profit
C. Multiple Choice Questions

1. The major government policies that can be used to pursue its
macroeconomic goals are
(A) fiscal policy and debt policy
(B) fiscal policy and monetary policy
(C) fiscal policy, debt policy and monetary policy
(D) fiscal policy, monetary policy and subsidies
2. Monetary policy of a country is managed by

(A) central bank
(B) finance ministry
(C) commercial banks
(D) board of revenue
3. High inflation levels in the economy leads to _______ in the supply of

money.
A. Increase
B. Decrease
C. No change
D. None of the above
1. Which of the following concepts is the opposite of inflation?
A. Deflation
B. Stagflation
C. Recession
D. None of the above

2. The term business cycle refers to –
(a) fluctuations in aggregate economic activity over time.
(b) ups and down in the production of goods
(c) increasing unemployment
(d) declining savings
3. Expansion phase all but one of the following characteristics.

(a) Increase in national output
(b) Increase in consumer spending
(c) Excess production capacity of industries
(d) Expansion of bank credit
4. Which one of the following is not the characteristic of business cycle?

(a) They are recurrent
(b) They are not at regular intervals
(c) They have uniform causes
(d) All the above
5. The turning points of the business cycle are

(a) Expansion and Peak
(b) Peak and Contraction
(c) Contraction and Trough
(d) Peak and Trough
6. ____ refers to the top or the highest point of business cycle.

(a) Expansion
(b) Peak
(c) Expansion and Peak
(d) None of the above
7. Involuntary unemployment is almost zero in the _____ phase of

business cycle.
(a) Expansion
(b) Contraction
(c) Trough
(d) Depression
Answers:
1-b, 2-a, 3-a,4-a, 5-a, 6-c, 7-c, 8-d, 9-b, 10-a
5.8 SUGGESTED READINGS

Textbook References
● Paul G Keat, K.Y. Young. January 2013. Managerial Economics.
Prentice Hall Publications
● Ahuja HL. January 2017. Managerial Economics. S. Chand & Co.

Delhi
● M. L. Seth. January 2009. Micro Economics. Lakshmi Narain Agarwal
Websites
● www.econlib.org
● www.wikipedia.org
● www.corporatefinanceinstitute.com

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UNIT - 5 OPTIMISATION OF FIRM

5.0 LEARNING OBJECTIVES

● Understand the significance of firm optimization

● Analyse several measures undertaken to achieve economic

● Discriminate difference between profit measurement and cost

reduce waste and optimize resources as

 Make as perfect as possible

 The best alternative

Business optimization is the process of

 Introducing new methods, practices and systems that reduce turnaround

 Reducing costs while improving performance

 Automation of repetitive tasks

 Machine-learning techniques that improve equipment operation

 Increasing sales through enhancing customer satisfaction

Key elements of business optimization

 Measurement of productivity, efficiency and performance

 Identifying areas for improvement

 Introducing new methods and processes

 Repeating the cycle

Business Optimization Techniques

While the ultimate goal is to aim for

Business Silos Impede Business Optimization

Most companies are organized around

maintenance. Maintenance wants to take

Benefits of Having One View of the Organization

While organizational silos are detrimental,

Business Optimization Processes Versus Decision-Making Tools

A key factor for success is a philosophy of

 Rearranging a work station so the operator doesn't have to walk across an

 Eliminating and consolidating unnecessary paperwork

 Automating repetitive tasks such as data capture or order entry

In these instances, the costs and benefits of

decision support tools which

Finding the Right Business Optimization Answers

The Value of Business Optimization and Why You Need it

The direct benefits of business optimization

Added to this are less obvious benefits, such as

5.2 BUSINESS CYCLE & INFLATION

Business Cycle Definition

Business cycle are a type of fluctuation found in the aggregate

Arthur F. Burns & Wesley C. Mitchel

marginal efficiency of capital, while revival of the economy is attributed

 It is not practically possible to compute the fact of multiplier and

 It has wrong assumption of constant capital output ratio.

Built-in inflation is linked to adaptive expectations or the belief that

FIRST OF ALL, PRICES CAN RISE FOR MANY

unfortunate that we have to call it the boom-bust “cycle”, instead of the

5.4 MEASURES OF ECONOMICS

4. There is also the difficulty of proper timing in the application of banking

Similarly, a reduction in government spending has a deflationary bias and

DEVICE OBJECTIONS HAVE BEEN RAISED

5.5 Profit Measurement and Cost Minimization

MARGIN OR PROFITABILITY RATIOS

Gross profit margin ratio

Operating profit margin ratio

Net profit margin ratio

Running these figures allows you to determine

Return on assets and return on investments

What Is Cost Minimization?

In theLONG RUN , a producer has the flexibility over all aspects