MBA-1st Sem.

Unit-4 Managerial Economics(M-103)

Lecture No-32

COST PLUS PRICING, INCREMENTAL / MARGINAL PRICING

What is cost-plus pricing?

Cost-plus pricing is a pricing strategy by which the selling price of a product is

determined by adding a specific fixed percentage (a "markup") to the product's unit
cost. Essentially, the markup percentage is a method of generating a particular desired
rate of return.

How to calculate cost-plus pricing

Before you can successfully implement a cost-plus pricing strategy, you need
to understand the cost plus pricing formula.

Cost plus pricing formula

Calculating cost-plus pricing is simple. Take your total fixed and variable costs (labor,
manufacturing, shipping, etc.), and then add your profit percentage. Here’s the formula:

Cost + Mark up = Price

Cost-plus pricing example

Say you’re starting a retail store and want to figure out pricing for a pair of jeans. The
cost of making the jeans includes:

 Material: $10
 Direct labor: $35
 Shipping: $5
 Marketing and overhead: $10
Cost-plus pricing involves adding a markup–let’s say 35%--to the total cost of making
your product:

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Cost ($60) x Markup (1.35) = Selling price ($81).

Advantages and disadvantages of a cost-plus pricing strategy:-

Cost plus pricing has its share of pros and cons. Let's look at the advantages and
disadvantages of this pricing strategy.

Advantages of cost-plus pricing: -

 Simple to figure out. You already track production costs and labor costs.
Setting the price is just a matter of adding a percentage for profit.
 Easy to justify. No price gouging here. The cost-plus pricing system is fair and
non-discriminatory. If you must apply a price increase, it’s only because the cost
of production and/or direct materials went up.
 Consistent rate of return. When costs stay the same, you can ensure that
every sale covers your costs. Revenue and profit can be estimated easily.
 Good to test the market. Cost-plus pricing is a great way to determine how
much a customer will pay for your product. When starting a retail business, you
don't have enough data to determine your pricing strategy. You can start with
cost-plus, get a feel for the market, and refine your pricing strategy from there.

Disadvantages of cost-plus pricing: -

 Dependent on costs. One drawback of cost-plus pricing is potential profit loss.

If you switch suppliers or get cheaper materials, your costs will get lower. Strictly
cost-plus pricing would require you to lower your selling price. If consumers are
willing to pay more for the product, you’d be missing out on revenue.
 Doesn’t take trends and external factors into account . If you sell a
trending product, you can charge more. If you're only considering cost, you're
limiting your revenue. For example, True Religion's Super T Jeans, a popular
upscale denim pant, cost $50 to make, and retail for around $260— a 520%
markup.
 Doesn’t take customer willingness to pay into account . If shoppers don’t
think your product is worth the set price, you won’t make sales. Cost-plus pricing
doesn’t respond to competitor prices or consumer demand.

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What Is Incremental Cost?-

Incremental cost is the total cost incurred due to an additional unit of product being
produced. Incremental cost is calculated by analyzing the additional expenses involved
in the production process, such as raw materials, for one additional unit of production.
Understanding incremental costs can help companies boost production efficiency and
profitability.

KEY TAKEAWAYS

 Incremental cost is the amount of money it would cost a company to make an

additional unit of product.
 Companies can use incremental cost analysis to help determine the profitability
of their business segments.
 A company can lose money if incremental cost exceeds incremental revenue.

Benefits of Incremental Cost Analysis: -

 Analyzing and understanding incremental cost enable companies to improve

production efficiency.
 Understanding incremental cost assists in decisions to manufacture a product or
simply buy it from other suppliers.
 It also helps in maximizing production output and increasing profitability.
 Knowing the incremental cost helps in determining the price of a product.
 Incremental cost analysis considers only relevant costs directly linked to a
business unit when evaluating the profitability of that business unit.
 Incremental cost analysis, together with the analysis of production volumes,
helps companies attain economies of scale by optimizing production. Economies
of scale occur when the average cost per unit declines as production increases.
 Fixed costs remain unchanged when incremental cost is introduced, which entails
that equipment costs do not vary with production volume.
 Incremental cost analysis is used in choosing between alternatives, such as
accepting or rejecting a one-off high-volume special order.
 Incremental cost analysis is used in short-term decision-making.

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References: -

 Brickley. Managerial Economics & Organizational Architecture. Tata McGraw-Hill.

 Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.

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Lecture No-33

Macro Economics measures: Introduction, Basic Concepts

What Is Macroeconomics?

Macroeconomics is a branch of economics that studies how an overall economy—the

markets, businesses, consumers, and governments—behave. Macroeconomics
examines economy-wide phenomena such as inflation, price levels, rate of economic
growth, national income, gross domestic product (GDP), and changes in
unemployment.

KEY FEATURES: -

 Macroeconomics is the branch of economics that deals with the structure,

performance, behavior, and decision-making of the whole, or aggregate,
economy.
 The two main areas of macroeconomic research are long-term economic growth
and shorter-term business cycles.
 Macroeconomics in its modern form is often defined as starting with John
Maynard Keynes and his theories about market behavior and governmental
policies in the 1930s; several schools of thought have developed since.
 In contrast to macroeconomics, microeconomics is more focused on the
influences on and choices made by individual actors in the economy (people,
companies, industries, etc.).

Basic Concepts of Macroeconomics: -

Macroeconomics in itself studies decision-making, structure, performance, etc. of a

nation. Further, it accesses other quintessential aspects of microeconomics and
aggregate indicators that influence a country’s economy. It works through
macroeconomic models which Government and corporations use to formulate economic
strategies and policies.

1. Inflation and Deflation:– A significant factor of macroeconomics is the assessment

of inflation and deflation. Inflation denotes the rise in prices of goods and services, and
deflation means a decrease in the price of those.

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Economists evaluate inflation and deflation with the help of price indexes. Studying
these two aspects, the Government can take measures to curb them; as high inflation
rate leads to several consequences while deflation causes low economic output.

2. Unemployment: – Another crucial economic indicator is the unemployment rate. It

refers to the percentage of people without a job. Higher rate of unemployment of a
country means a lesser economic output. Economists have divided it into four classic
segments- classical, structural, frictional and cyclical employment.

3. Income and Outputs: – One of the most important macroeconomics concepts

includes income and output. The national output is calculated by a total number of
goods and services produced in a country over a specific period.

Macroeconomics Policies: -

Now and then the Government introduces several new policies to bring equilibrium in
an economy. Two of these policies are monetary policies and fiscal policies.

A. Monetary Policies - It is an essential factor which is implemented by a central

monetary authority like the Reserve Bank of India. The main objective of this change
is to stabilise GDP and narrow down the rate of unemployment.

A few instruments of monetary policies are CRR, SLR, Open Market Operations, Repo
and Reverse Repo Rate, Bank rate policy and various others. However, the primary goal
of this is to stabilise the economic condition of the country.

B. Fiscal Policies - It is a tool which makes use of Government’s expenditure and revenue
generation to control economic stability during a financial year. For example, if
production in an economy cannot match up to required output, Government may spend
on a few resources to reach up to estimated output. However, monetary policies are
preferred over fiscal policies by economists as the former ones are controlled by RBI,
which is an independent body. In contrast, fiscal policies are regulated by the
Government which can be altered by political intentions.

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Introduction to Macroeconomics - Key takeaways:-

 Macroeconomics is the study of how the entire economy behaves as a unit.

 Microeconomics studies individual prices, quantities, and markets, whereas

macroeconomics studies how the economy as a whole behaves.

 Macroeconomics consists of objectives and the tools or instruments to achieve

these objectives.

 The objectives of macroeconomics include output, employment, and stable

prices.

 The instruments of macroeconomics include monetary policy and fiscal policy.

References: -

 Brickley. Managerial Economics & Organizational Architecture. Tata McGraw-Hill.

 Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.

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Lecture No-34

Macroeconomic Ratios, Index Numbers

What is a Macroeconomic Factor?

A macroeconomic factor is a pattern, characteristic, or condition that emanates from, or

relates to, a larger aspect of an economy rather than to a particular population. The
characteristic may be a significant economic, environmental, or geopolitical event that
widely influences a regional or national economy.

Understanding Macroeconomics

Macroeconomics is a field of economics that studies broader economic trends, such as

inflation, economic growth rates, price levels, gross domestic product (GDP), national
income, and changes in levels of unemployment.

1. Inflation:- Inflation is a progressive increase in the average cost of goods and

services in the economy over time.
2. Economic Growth Rate:- The economic growth rate is the percent change in the
cost of the output of goods and services in a country across a specific period of time,
relative to a previous period.
3. Price Level:- A price level is the variation of existing prices for economically
produced goods and services. In broader terms, the level of prices refers to the costs
of a good, service, or security.
4. Gross Domestic Product (GDP):-The gross domestic product (GDP) is a
quantitative measure of the market value of all finished goods and services produced
over a given time period.
5. National Income:-National income is the aggregate amount of money generated
within a nation.
6. Unemployment Level:-The level or rate of unemployment is the unemployed
share of the labor force in a given country, calculated and stated as a percentage.

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Types of Macroeconomic Factors

1. Positive

Positive macroeconomic factors are comprised of events that ultimately stimulate

economic stability and expansion within a country or a group of countries.

2. Negative

Negative macroeconomic factors include events that may threaten the national or global
economy.

Negative macroeconomic factors also include global pandemics (e.g., Covid-19) or

natural disasters, such as hurricanes, earthquakes, flooding, wildfires, etc.

3. Neutral

Some economic changes are neither positive nor negative. Instead, the exact
consequences are assessed based on the purpose of the action, such as the control of
trade across regional or national borders.

Index Numbers: -
Characteristics of Index Numbers

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An index number is a method of evaluating variations in a variable or group of variables

in regards to geographical location, time, and other features. The base value of the index
number is usually 100, which indicates price, date, level of production, and more.

Types of Index Numbers: -

Although there are different types of index numbers, most of their primary objective is
to simplify data to make comparison easier. One often uses this method in public and
private sectors to make well-informed decisions regarding policies, prices, and
investments. Let us look at some of the popular types of this statistical tool:

1. Quantity : It measures the changes in the volume or quantity of the products

produced, sold, and consumed over certain durations. Hence, they measure
the relative changes in the volume of a certain set of items between timeframes.
One can use it to measure construction, production, or employment. It has two
subtypes — weighted and unweighted.
2. Price : It computes the change in the price of a single or group of variables
between two time periods. A series of numbers organized to compare the values
of two durations make it up. One often uses this method to compare the price of
products from one timeframe to the base period. An example of this tool is
the Consumer Price Index or CPI.
3. Special Purpose : Its main purpose is not the same as the other types. Typically,
the primary objective of this tool is to track the changes in a unique variable
group, particular sector, or industry. Index numbers tracking the changes in the
securities market are an example of this type.

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4. Value : It measures the change in the aggregate value of a single or group of

variables compared to its value in the base period. One can use this statistical
measure to track the changes in sales, inventory, trade, etc.

Index Number Formula

Formula

There are multiple formulae for calculating index numbers. Two popular techniques are
as follows:

1. Simple Aggregative Method

The formula is as follows:

P01 = ΣP1 ÷ ΣP0 x 100

Where:

P01 is the index number.

ΣP1 is the sum of all prices in the year for which one has to compute the index number.

ΣP0 is the base year.

Importance of Index Numbers: -

Some uses of index numbers are as follows:

1. General Importance

Generally, this tool helps in many ways. Some of them are as follows:

 It helps one compare separate data sets concerning different durations or

different places.
 The tool simplifies complicated facts.
 It helps one make future predictions.

Moreover, this tool is useful for individuals engaging in practical or academic research.

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2. Measurement of Changes In Price Level

This tool measures the difference in the price levels or the value of money. Additionally,
it warns about inflationary tendencies, enabling a government to take effective anti-
inflationary measures.

3. This statistical measure provides information concerning the production trends of

different sectors in an economy. This helps one evaluate different industries’ conditions.

4 . Formation And Modification of Economic Policies

They help governments formulate and assess policies. A government can formulate new
policies or adjust the existing ones based on the changes occurring in the economic
conditions.

Besides these, the tools have specific uses in economics. They are as follows:

 They help analyze markets for particular commodities.

 In the stock market, they provide information regarding the price trends of
stocks.

Also, by using this tool, bank officials can get information regarding the changes in
deposits.

5. Highlights Variation in Cost of Living

This tool highlights the changes in a nation’s cost of living. It indicates if a country’s cost
of living is increasing or decreasing. As a result, the government can modify workers’
wages to minimize the impact of inflation on wage earners.

Limitations of Index Numbers: -

The statistical measure has the following limitations:

 It is never 100% accurate owing to the practical difficulties associated with the
calculation process. Moreover, it quantifies average change, thus indicating only
broad trends.
 One cannot use Index numbers prepared for a particular purpose for another
purpose.

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 The tool does not consider the items’ quality. A general increase in the index may
be possible because of a product’s quality improvement, not because of a price
increase.
 Different nations use different base years of the computation of index numbers.
Moreover, they include different items having different qualities. Hence, this
technique is not reliable for making international comparisons.

References: -

 Brickley. Managerial Economics & Organizational Architecture. Tata McGraw-Hill.

 Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.

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Lecture No-35

National Income Deflators; Consumption Function

What Is the Gross National Product (GNP) Deflator?

The gross national product deflator is an economic metric that accounts for the effects
of inflation in the current year's gross national product (GNP) by converting its output
to a level relative to a base period.

The GNP deflator can be confused with the more commonly used gross domestic
product (GDP) deflator. The GDP deflator uses the same equation as the GNP deflator,
but with nominal and real GDP rather than GNP.

KEY TAKEAWAYS

 The gross national product (GNP) deflator is an economic metric that accounts
for the effects of inflation in the current year's GNP.
 The GNP deflator provides an alternative to the Consumer Price Index (CPI) and
can be used in conjunction with it to analyze some changes in trade flows and
the effects on the welfare of people within a relatively open market country.
 The higher the GNP deflator, the higher the rate of inflation for the period.

Understanding the Gross National Product (GNP) Deflator:-

The GNP deflator is simply the adjustment for inflation that is made to nominal GNP to
produce real GNP. The GNP deflator provides an alternative to the Consumer Price
Index (CPI) and can be used in conjunction with it to analyze some changes in trade
flows and the effects on the welfare of people within a relatively open market country.

Calculating the Gross National Product (GNP) Deflator

The GNP deflator is calculated with the following formula:

GNP Deflator = (Nominal GNP/Real GNP) ×100

The result is expressed as a percentage, usually with three decimal places.

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What Is the GDP Price Deflator?-

The GDP (gross domestic product) price deflator, also known as the GDP deflator or the
implicit price deflator, measures the changes in prices for all the goods and services
produced in an economy.

KEY TAKEAWAYS

 The GDP price deflator measures the changes in prices for all the goods and
services produced in an economy.
 Using the GDP price deflator helps economists compare the levels of real
economic activity from one year to another.
 The GDP price deflator is a more comprehensive inflation measure than the
Consumer Price Index (CPI) index because it isn't based on a fixed basket of
goods.

Consumption Function:-

What is the Consumption Function?

The consumption function is an economic formula that directly connects total

consumption and gross national income. The process introduced by the British
economist John Maynard Keynes indicates the relationship between income and
expenditure and the proportion of income spent on goods.

Key Takeaways

 The consumption function is an economic formula directly associated with the

total consumption and gross national income.
 It was introduced by the British economist John Maynard Keynes to show the
correlation between income and expenditure and the income proportion spent
on goods.
 It is related to income and wealth. It is a direct income function of income.
Therefore, its functional relationship to consumption varies as income differs.
 The consumption function theory explains that low consumption results in high
economic savings. The saving amount increases with income as only the
consumption function increases.

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Consumption Function Formula

Below is the equation of the consumption function.

C = c + bY
C – Total Consumption

c – Autonomous Consumption (minimum consumption for survival when income is

zero).

 Autonomous consumption is not influenced by income – We must understand

that consumption can never be zero. If the earnings become zero, minimum
consumption is never nullified. Such consumption is called autonomous
consumption. If income is low, there is a minimum level of expenditure that is
higher than the income. In such a case, consumption has to be maintained
irrespective of income. The minimum level of consumption is said to
be autonomous consumption.
 Induced consumption (bY) (influenced by income) – bY; b is the marginal
propensity to consume (which means the consumption level increases for every
rupee increase in the revenue). Induced consumption is influenced by
income. Y indicates, i.e., income.
 Break-even point – When consumption expenditure reaches the income, it is
called the break-even point stage if there is no concept of saving.

References: -

 Brickley. Managerial Economics & Organizational Architecture. Tata McGraw-Hill.

 Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.

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Lecture No-36

Investment Function, Marginal efficiency of capital and business

expectations

Investment Function:-

What is Investment Function?

A strategy or concept of economics that helps in identifying the connection between

shifts in the investment patterns of people and other variable factors affecting
investment in an economy is known as Investment Function.
The expenditure incurred to create new capital assets is known as Investment. These
capital assets include buildings, machinery, raw material, equipment, etc. The
expenditure on these assets results in an increase in the economy’s productive
capacity. The investment expenditure can be classified under the heads:
 Induced Investment
 Autonomous Investment

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1. Induced Investment:- The investment which depends upon the profit

expectations and has a direct influence of income level on it is known as Induced
Investment. Induced Investment is income elastic. It means that the induced
investment increases when income increases and vice-versa.

The above graph shows that the induced investment curve II has an upward slope from
left to right. It indicates that as the income increases from OY to OY 1, the investment
also increases from OM to OM 1.

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2. Autonomous Investment:-The investment on which the change in income level

does not have any effect and is induced only by profit motive is known as Autonomous
Investment. Autonomous Investment is income inelastic. It means that if there is a
change in income (increase/decrease), the autonomous investment will remain the
same. In general, autonomous investments are made by the Government in
infrastructural activities. However, a country’s level of autonomous investment
depends upon its social, economic, and political conditions. Therefore, the investment
can change when there is a change in technology, or there is a discovery of new
resources, etc.

The above graph shows that the amount of investment remains the same, i.e., OI, no
matter whether the income level in the economy is OY or OY 1.

Difference between Induced Investment and Autonomous Investment

Basis Induced Investment Autonomous Investment

Meaning It is the investment that It is the investment on which the
depends upon the profit change in income level does not have
expectations and has a any effect and is induced only by profit
direct influence on income motive.
level on it.
Motive The motive behind induced The motive behind autonomous
investment is profit. It investment is social welfare.
means that it depends on

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profit expectations.
Income Induced Investment is Autonomous Investment is income
Elasticity income elastic. It means inelastic. It means that if there is a
that the induced investment change in income (increase/decrease),
increases when income the autonomous investment will
increases and vice-versa. remain the same.
Investment As induced investment is As autonomous investment is income
Curve income elastic, its curve inelastic, its curve is parallel to X-axis.
slopes upwards.
Sector In general, induced In general, autonomous investment is
investment is done by the done by the government sector.
private sector.
Relation with Induced Investment is Autonomous Investment is unrelated
National positively related to to national income.
Income national income.

Factor Determinants of Investment

As per Keynes, the decision to invest in a new project or private investment depends
upon two factors; i.e., Marginal Efficiency of Investment and Rate of Interest.

1. Marginal Efficiency of Investment (MEI):

MEI is the expected rate of return from an additional investment. The following two
factors are required to determine MEI:
 Supply Price: It is the production cost of a new asset of that kind. Simply
put, the supply price is the price at which one can supply or replace the new
capital asset. For example, if old equipment is replaced by equipment of
₹20,000, then ₹20,000 is the supply price.
 Prospective Yield: It is the net return or net of all costs, which is expected
from the capital asset over its lifetime. For example, if the equipment of
₹20,000 in the previous example is expected to yield receipts of ₹2,500 and
the running expenses will be ₹500, then the prospective yield will be ₹2,500
– ₹500 = ₹2,000.
The Marginal Efficiency of Investment (MEI) of the given equipment will be:

2. Rate of Interest (ROI):-

It is the cost of borrowing money for financing investment. There is an inverse

relationship between ROI and the volume of investment. If the Rate of Interest is high,

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then the investment spending will be less and if the Rate of Interest is low, then the
investment spending will be more.

Comparison between MEI and ROI:-

To know about the profitability of an investment, a comparison between MEI and ROI
is done. If the Marginal Efficiency of Investment is more than the Rate of Interest, then
the investment is profitable, and if the Marginal Efficiency of Investment is less than
the Rate of Interest, then the investment is not profitable. For example, if a
businessman has to pay 10% rate of interest on the loan and the MEI or expected rate
of profit is 15%, then the businessman will surely invest and will continue to make the
investment till the Marginal Efficiency of Investment becomes equal to Rate of
Interest.

Marginal efficiency of capital and business expectations: -

What Is the Marginal Efficiency of Capital?

The marginal efficiency of capital (MEC) refers to the expected rate of return on an
additional unit of capital investment in the production process. It measures the ability of
an investment to generate additional income, taking into account all relevant factors,
such as market conditions, competition, and technological advancements.

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The concept of the “marginal efficiency of capital” was introduced by John Maynard
Keynes in his book “The General Theory of Employment, Interest, and Money,”
published in 1936. He saw MEC as a crucial factor in determining the level of
aggregate investment in the economy and its impact on economic growth and
employment.

Key Features of marginal efficiency of capital (MEC): -

 The marginal efficiency of investment refers to the expected rate of return on an

additional unit of investment made within certain parameters and over a given
time frame.
 The rate of return is calculated as the expected additional return from an
investment project for a given unit of investment.
 Several short- and long-term factors influence MEI. Therefore, forecasting these
values helps greatly in efficiently planning and deploying funds for investment.

Factors influenced marginal efficiency of capital (MEC): -

The marginal efficiency of capital (MEC) is influenced by several factors, including:

 Technological progress: New technologies can increase the productivity

of capital, leading to an increase in MEC.
 Competition: Competition among firms can lead to a reduction in the rate of
return on investment, reducing MEC.
 Expectations: The expectations of investors about future market conditions can
impact MEC. If investors expect high profits, MEC will be high, and investment
will increase.
 Interest rates: Higher interest rates increase the cost of borrowing, lowering
MEC.
 Time preference: The time preference of investors, i.e., their preference for
current consumption over future consumption, can impact MEC.
 Risk: The perceived risk of an investment can influences MEC, as investors will
require a higher rate of return to compensate for the risk.
 Availability of investment opportunities : If investment opportunities are
abundant, MEC will be high, and investment will increase.

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These factors interact and can affect MEC fluctuations, impacting investment and
economic growth.

Formula

Here,

Sp: Supply price or the cost of the capital asset

R1,R2… Rn: Series of expected annual returns from the capital asset in the years
1,2…….n

i: Rate of discount

Calculation Example

The lifetime of a capital asset (n) is two years.

The supply price (Sp) is $10,000

The expected yield at the end of a year (R1) is $5,500

The expected yield at the end of 2 years (R2) is $6,050

The commodity worth $10,000 is predicted to provide an annual yield of $1,000. Then,
10% will be the marginal efficiency of capital:

(1000/10,000) X (100/1) = 10%

Here, the rate of discount “i” or MEC equals the two sides of the equation. For example,
a new capital asset with a supply price of $ 10,000 and a two-year life is anticipated to
generate $5,500 in the first year and $6,050 in the second. Therefore, the marginal
efficiency of capital (MEC), or the rate of discount that balances the expected future
returns of the asset with its cost price, is 10%. It is demonstrated as follows:

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MBA-1st Sem. Unit-4 Managerial Economics(M-103)

References: -

 Brickley. Managerial Economics & Organizational Architecture. Tata McGraw-Hill.

 Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.

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Lecture No-37

Multiplier, Accelerator

Multiplier and Accelerator: -

The multiplier and the accelerator are not rivals: they are parallel concepts. While
multiplier shows the effect of changes in investment on changes in income (and
employment), the accelerator shows the effect of a change in consumption on
private investment.

Oftentimes, people confuse multiplier with accelerator, both economic concepts differ.
Multiplier reflects how a change in investment affect income and employment while
accelerator reflects how a change in production and consumption affect investment.
Both economic concepts seek to show the connection or interaction between
investments and production/consumption. For multiplier, consumption is dependent
upon investment, while accelerator maintains that investment is dependent upon
consumption.

Concept of Multiplier: -

The concept of multiplier is an integral part of Keynes’ theory of employment. It is an

important tool of income propagation and business cycle analysis. Keynes believed that
an initial increment in investment increases the final income by many times. To this
relationship between an initial increase in investment and the final increase in total
income, Keynes gave the name of ‘investment multiplier,’ which is also known as
‘income multiplier’ or simply ‘multiplier’.

Assumptions of Multiplier:-

The working of multiplier is based on a number of assumptions. As these assumptions

are not fulfilled in the actual world, they limit the operation of multiplier.
Main assumptions are as follows:-

(i) There is no induced investment. Multiplier specially applies to autonomous

investment which is free from profit motive.
(ii) Marginal propensity to consume remains constant during the adjustment process.
(iii) Consumption is a function of current income.
(iv) The output of consumer goods is responsive to effective demand for them.

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(v) There is surplus capacity in the consumer goods industries to meet the increased
demand for these goods as a result of a rise in income following the increased
investment.
(vi) Other factors and resources of production are easily available in the economy.

(vii) The new higher level of investment is maintained for the completion of the
adjustment process.
(viii) There is net increase in investment. In order words, increase in investment in one
sector is not offset by a decline in investment in some other sector.
(ix) There are no time lags involved in the multiplier process. An increase in investment
instantaneously leads to a multiple increase in income.
(x) There is a closed economy implying the absence of international trade.
(xi) Multiplier process operates in the industrialized economy.
(xii) There is no change in the prices of commodities and raw materials, etc.
(xiii) The situation of less-than-full employment prevails in the economy.

Leakages of Multiplier: -

In actual practice, the operation of multiplier is affected by a number of factors. Given

the MPC, the whole of the increment of income in each period may not be spent on
consumption. This is because there are several leakages from the income stream as a
result of which the process of income propagation is slowed down.
According to Peterson, “Income that is not spent for currently produced consumption
goods and services may be regarded as having leaked out of income stream.” Or, in
other words, leakages of multiplier constitute that portion of prior income which has
been lost to the income stream.

Important leakages are described below: -

I. Saving:
Saving constitutes an important leakage to the process of income propagation. Since
marginal propensity to consume is less than one (MPC < 1), the whole of the increment
of income is not spent on consumption. A part of it is saved and peters out of the
income stream, thereby limiting the value of multiplier.
The whole of saving forms a leakage and the size of multiplier is inversely related to the
marginal propensity to save (MPS). According to the formula of multiplier (i.e., K =
1/MPS = 1/Leakage), the higher the MPS, the greater the leakage and the lower the
value of multiplier.

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MBA-1st Sem. Unit-4 Managerial Economics(M-103)

II. Debt Cancellation:

If some of the income received by the people is used for paying off old debts, that part
peters out of the income stream and becomes leakage.
III. Imports:
Net imports form another leakage in the domestic income stream. If there is an excess
of imports over exports, a part of the increased domestic income as a result of increased
investment will flow out to foreign countries.
IV. Price Inflation:
Price inflation is another important leakage from the income stream of an economy.
When there is a rise in prices of consumption goods, a major part of the increased
income is dissipated on higher prices, instead of promoting consumption, income and
employment.
V. Hoarding:
If people have a tendency to hoard the increased income in the form of idle cash
balances, they will reduce the expenditure on consumption in the economy. This will
constitute another leakage, restricting the value of the multiplier.
VI. Purchase of Old Shares and Securities:
If people purchase old stocks and securities with the newly earned income, this type of
financial investment will reduce consumption and restrict the value of multiplier.
VII. Taxation:
Taxes reduce the disposable income of the tax payers, discourage consumption
expenditure and lower the size of the multiplier.
VIII. Undistributed Profits:
If a part of profits of the company is not distributed to the shareholders in the form of
dividends and is kept in reserve fund, it forms a leakage from the multiplier process.

Effect of Leakages:-

The leakages interfere with the smooth flow of income stream and thereby lead to the
slowing down of the pace of multiplier. Had the entire higher income been spent and
none saved, the process of income generation will go on endlessly.

Importance of Multiplier:
Despite the various qualifications, limitations and weaknesses, the concept of
multiplier continues to be of great theoretical and practical importance:-

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i. Importance of Investment:
The concept of multiplier highlights the importance of investment as the major dynamic
element in the process of income generation in the economy.
ii. Income Generation Process:
The theory of multiplier not only indicates the direct creation of income and
employment, it also reveals that income is generated in the economy like a stone
causing ripples in the lake.
iii. Trade Cycle:
The knowledge of the process of multiplier is of vital importance for understanding
different phases of trade cycle and for its accurate forecasting and control.
iv. Economic Policy:
Multiplier is a useful tool in the hands of the policy-makers for formulating suitable
economic policies for the achievement of full employment and for the control of
business fluctuations.
v. Saving-Investment Equality:
The multiplier process helps to understand how equality between saving and investment
is brought about. An increase in investment leads to increase in income. As a result of
increase in income, saving also increases and becomes equal to investment.
vi. Deficit Financing:
The theory of multiplier emphasises the importance of deficit financing. Increases in
public expenditure by creating deficit budget help in creating income and employment
multiple times the initial increase in expenditure.
vii. Public Investment:
The concept of multiplier highlights the special significance of public investment (in the
form of government expenditure in public works, and other public welfare activities) in
achieving and maintaining full employment.

Working of Acceleration Principle:-

The working of acceleration principle can be explained with the help of an example given
in Table.

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MBA-1st Sem. Unit-4 Managerial Economics(M-103)

Table: - Working of Acceleration Principle: V=2

(i) Column (1) indicates a series of time periods.

(ii) Column (2) gives the assumed level of income and output in each period.
(iii) Assuming a constant capital-output ratio or the value of accelerator, v = 2, the
required stock of capital in each period is two times the corresponding output of that
period, as shown in Column (3).
(iv) The replacement investment in each period is assumed to be equal to 10% of the
capital stock in period zero. Thus, it is 20 in each period, (i.e., 10% of 200= 20) as shown
in Column (4).
(v) Net investment in any period as shown in Column (5) equals v times the change in
output between that period and the preceding period. For example, net investment in
period 3= v (Yt3 – Yt2) = 2(115-105) = 20. This means that given the accelerator v = 2, an
increase in the demand for final output of 10 leads to an increase of capital goods of 20.
(vi) Total demand for capital goods {Column (6)} is equal to the net investment plus
replacement investment { (i.e.. Column (4) + Column (5) } in each period. For example,
total investment in period 3 = 20+ 20 = 40.
(vii) Thus it is clear that, given the value of accelerator, total demand for capital goods
depends upon the change in the total output. As long as the demand for final goods rises
{i.e., Y increases upto period 6 in Column (2)}, net investment is positive {(i.e., upto
period 6 in Column (5)}. After period 6, demand for final goods [Column (2)] falls and the
net investment [Column (5)] is negative.
(viii) Total output [(Column (2)] increases at an increasing rate from period 1 to period 4
and net investment increases {Column (5)}. Then output increases at a decreasing rate
from period 5 to 6 and the net investment declines. From period 7 to 9, total output
falls, and the net investment becomes negative.

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MBA-1st Sem. Unit-4 Managerial Economics(M-103)

(ix) The behaviour of gross investment is similar to the net investment. The only
difference is that the gross investment is not negative and once it becomes zero in
period 8, it starts rising. The reason for this is that despite the net investment becoming
negative, the replacement investment continues at the constant rate.
Assumptions and Limitations of Acceleration Principle:
The acceleration principle is based on a number of assumptions which are difficult to be
found in the actual world.
The important assumptions and limitations of the principle of acceleration are as
follows:-

i. Constant Capital-Output Ratio:

The acceleration principle is based on the assumption of constant capital-output ratio. It
means that the units of capital required to produce one unit of output remain constant.
In the dynamic world, the capital-output ratio changes and therefore the acceleration
effect also varies.
ii. No Excess Capacity:
The acceleration principle assumes that there should be no excess capacity in the capital
goods industries. If excess capacity exists, an increase in the demand for consumer
goods will not lead to any induced investment because the increased demand will be
met from the existing capital and machinery.
iii. Permanent Change in Consumption Demand:
The principle of acceleration will operate it the increase in consumption demand is
permanent. A purely temporary change in consumption demand will not induce the
entrepreneurs to invest in the production of additional capital goods.
iv. Availability of Resources:
The acceleration principle assumes the availability of resources. The supply of resources
should be elastic so that the investment in capital goods industries can be increased
easily. If tire economy is at the full employment, the capital goods industries will fail to
expand because of non-availability of required reserves.
v. Elastic Supply of Funds:
The acceleration principle assumes elastic supply of cheap credit so that sufficient funds
for induced investment are available. If there is shortage of credit, the rate of interest
will be high and the investment in capital goods will be low.
vi. Absence of Time Lags:
The acceleration principle assumes that increased output leads to a simultaneous rise in
investment. But, in reality, a rise in demand takes a long time to produce its impact on
investment level.

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MBA-1st Sem. Unit-4 Managerial Economics(M-103)

vii. Neglect of Expectations:

The acceleration principle neglects the role of expectations on the decision-making
behaviour of entrepreneur. Inducement to invest is not influenced by demand alone. It
is also affected by future anticipations about stock market changes, political changes,
international events, etc.
viii. Neglect of Technological Changes:
The acceleration principle also ignores the role of technological changes on investment.
Some technological changes may take the form of capital-saving (or labour-saving) and
thus may reduce (or increase) the volume of investment.
Importance of Acceleration Principle:
In spite of certain limitations, the principle of acceleration occupies a significant place in
the macro-economic analysis.

The main points of importance are given below:-

(i) The principle of acceleration, along with the principle of multiplier, helps to
understand the process of income generation more clearly and comprehensively. The
concept of multiplier provides only a partial explanation of the income generation
process.
(ii) The principle of acceleration explains why the fluctuations in income and
employment occur so violently.
(iii) It demonstrates that capital goods industries fluctuate more than the consumer
goods industries.
(iv) It is more useful in explaining the upper turning point of the business cycle because
what is responsible for a fall in the induced investment is not any absolute fall in the
demand for consumer goods but only a decline in its rate of increase.
(v) Harrod has used the coefficient of acceleration in the growth model to show that the
economic growth in an economy depends upon the size of accelerator; higher the size of
accelerator, higher the growth rate and vice versa.

References: -

 Brickley. Managerial Economics & Organizational Architecture. Tata McGraw-Hill.

 Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.

Dr. Pramod Gupta, MBA Department-MITRC(Alwar-Raj.) 159