MANAGERIAL ECONOMICS (MB 105 ) CHAPTR - 1 MANAGERIAL ECONOMICS Managerial Economics is Economics applied in decision making in a unit or a firm. -A link between abstract theory and material practices. -Economics is concerned with the problem of allocation of scarce resources. -Provides a number of concept & analytical tools to understand & analysis a problem. DIFFERENT SCHOLAR VIEWS 1 According to Mc nadir &Medium- Managerial Economics is the use of economic models of thought to analyse business situation. 2 Spencer & Siegal man-Managerial Economics is integration of economic theory & business practices for facilitating decision-making &forward planning by management. 3 Brigham & Pappas- Managerial Economics is the application of economic theory & methodology to business administration practices. COMMON FEATURES IN DIFFERENT VIEWS 1 Concerned with decision making of economic nature. 2 Deals with how decision should be made by the managers to achieve the organization goals. 3 Managerial Economics is pragmatic. It is concerned with those analytical tools, which are useful in improving decision-making.
Transcript
MANAGERIAL ECONOMICS (MB 105 )
CHAPTR - 1 MANAGERIAL ECONOMICS
Managerial Economics is Economics applied in decision making in a unit or a firm.
-A link between abstract theory and material practices.
-Economics is concerned with the problem of allocation of scarce resources.
-Provides a number of concept & analytical tools to understand & analysis a problem.
DIFFERENT SCHOLAR VIEWS
1 According to Mc nadir &Medium- Managerial Economics is the use of economic models of
thought to analyse business situation.
2 Spencer & Siegal man-Managerial Economics is integration of economic theory & business
practices for facilitating decision-making &forward planning by management.
3 Brigham & Pappas- Managerial Economics is the application of economic theory &
methodology to business administration practices.
COMMON FEATURES IN DIFFERENT VIEWS
1 Concerned with decision making of economic nature.
2 Deals with how decision should be made by the managers to achieve the organization goals.
3 Managerial Economics is pragmatic. It is concerned with those analytical tools, which are
useful in improving decision-making.
4 Managerial Economics is both conceptual & metrical (Quantitative Technique)
5 Provides a link between traditional economic & decision-making Sciences.
NATURE- Managerial Economics is concerned with the business firm and the economic
problems that every business management need to solve.
1 Macro Economic Conditions- Decisions of the firms are made in the broad economic
environment. It is known as macro economic conditions with regard to these conditions we
may stress 3 points-
A The economy in which business operates is a free enterprise economy using prices &
market.
B Present day economy is undergoing rapid technological & economic changes.
C Intervention of govt. has increased in economy.
2 Micro Economic Analysis- It helps in studding what is going on in a firm how best to use the
available scare resources between various activities of the firm, how to be technically as well
as economically efficient. Chief source of concepts and analytical tools is micro economic
theory also known as price theory.
Concepts-Elasticity of demand, marginal cost, short &long run economies &diseconomies of
% gives us the nice property that the units in which the money or goods are measured do not
affect elsticity.Demand is elastic if a given % change in price results in a larger % change in
quantity demanded. E.g. 2% decline in price results in a large %4increase in demand then
called elastic. If 3% decline in price results 1% increase in demand then called inelastic. The
border line case of unitary elasticity whioch separate elasticity and inelasticity of demands
occurs where change % in price is equal to change % in demand.
COMPUTATION OF ELASTICITY COEFFICIENTS:
May use two measures of elasticity
A ARC &POINT ELASTICITY
We want to calculate elasticity when price changes from Rs.4 to Rs.3 per unit
Price of commodity
x (Rs.)
Quantity demanded of
commodity x (kg.)
5 10
4 16
3 25
2 30
1 34
When price changes Rs.3 to Rs.4, P =Rs.3 –Rs.4 = Rs.-1 (i.e. price changes is negative
since it is a price fall ). The change in quantity demanded is Q : 25 –16 = 9 (quantity change
is positive )
E = Q / Q / P / P
= 9 / 16 / -1 / 4
= -2.25
Now if we calculate the elasticitywhen price increases from Rs.3 to Rs.4 we find that for the
same stretch of the demand curve, elasticity would be different.
E = Q / Q / P / P
= -9 / 25 / +1 / 3
= - 1.08
We got two answers for same strech. This is known as point elsticities. Two answers differ
because our initial quantity demanded and price have been different. To get rid of this
problemcreted by the choice of the initial situations, we take airthmatic mean of two quantities .
q and t he mean of two prices p. This gives us a arc elasticity
ARC. E = Q / Q0 +Q1 X P0 +P1 / P
Where Q0 & Q1 are the two quantities corresponding to the two points on the demand curve,
similarlyP0 & P1 are the two prices.
B MEASUREMENT OF ELSTICITY (GEOMETRICAL WAY)-
We have taken a non linier demand curve. Consider point P on demand curve Dx draw a
tangent line AB at point P
E = dQ / dp x p / Q
dQ / dp is the universe of the slop of demand curve. Hence is equal to MB / PM
Price is equal to OM
E = MB /PM / OM / PM
In other words, the price elasticity of demand is measure graphically by the ratio of the two
segments of the horizontal axis identified by the intersection of the target to the point
cosidered, with the horizontal axis and by the perpendicular from that point to the same axis. If
we now cosider the similer triangles APN &BPM then AP /PM = PB / MB or MB / PN = PB /
AP Hence elsticity = MB / ON can be written as equal to PB / AP i.e. elasticity at Pis also equal
to PB / AP the ratio of the lower segment of demand curve to the upper segment. By simple
airthmatic we can calculate the elaticity.
TYPES OF ELASTICITIES
CROSS ( PRICE ) ELSTICITY OF DEMAND – In order to evaluate the effect variations in the
price of product (tea ) on a quantity demanded of another product ( coffee ). We define cross
elaticity as follows:
Sign eij shows relationship between to goods
( i ) eij great than 0 then i & j are substitute goods. An increase in price of jth goods ( tea )
increase the quantity demandfor ith good (coffee ). Hence elasticity is positive .
( ii ) eij = 0 if & only if i &j are independent goods. ( not related )
( iii ) eij less than 0 implying that i & j are complementary goods.
An increase in price jth goods (suger ) reduces the quantity demanded of the ith goods (tea ).
Hence relationship between variables is negative. Elasticity is negative. Greater the value of
eij, the more intense is the relationship existing between two goods.
INCOME ELASTICITY OF DEMAND- The responsiveness of demand to the changes in
income is known as imcome elasticity of demand. Income elasticity for a product say x ( i.e.)
mat be defined as
EI = XQ / XQ / I / I
XQ – Quantity of X demanded, I - disposable Income, XQ – changes in quantity of X
demanded, I – change in Income.
Income elasticity is always positive. Exception to this rule inferior goods, Income elasticity will
be negative because of inverse subsrirurion effect. The value of income elasticity tells about
the class of goods. When it is less than one, the goods are necessary. Luxury goods have
value greater than one & inferiors goods is negative. Income elasticities varies along a given
demand curve . It is a decreaseing function of income, it falls as the income rises. This is
because consumers modify their consumption pattern. The weighted sum of income elasticity
of demand various goods must add to one.
M1Q1 + M2Q2 = 1 where Q1&Q2are income elasticity of demands for goods 1& 2.
ELASTICITY OF DEMAND WITH RESPECT TO ADVERTISEMENT- It is the ratio of %
change in the quantity demanded of a commodity ( Q ) to % in the advertisement outlay on the
commodity (A ). It is also called promotional elasticity. This is defined as % change in the level
of future prices ( Pt +1 ) expected as a result of a change in the level of current prices (P1 ).
E = dPt +1/dPt x Pt / Pt +1
CHAPTER - IV
DEMAND FORECASTING
A forecast is the prediction of a future situation. Aim of demand forecasting is to reduce risk
and in planning for firm’s long term growth.It start with macro economic forecast. Demand and
sales of most goods and services are strongly affected by business conditions e.g. sales of
automobiles, new houses etc.
TYPES OF DEMAND FORECASTING
PASSIVE- based on assumption that firm doesnot change it’s course of action.
ACTIVE- forecast is done under the conditions likely changes in future.
FORECASTING STEPS
A Identification of objective
B ditermining the nature of goods
C selecting a proper method of forecasting
D Interpretation of results
METHODS OF FORECASTING
Fundamentally two approaches
A SHORTRUN- to obtain information about the intentions of consumers by means of
market research, survay, economic intelligence etc.
B LONGRUN- to use past exprience as a guide and by exploiting past trends, to estimate
the level of future demand.
NEW PRODUCT--- SURVEY METHOD used because no historical data is available.
EXPERT OPINION SURVEY METHOD
Obtaing information from group of experts regarding future technological stares.
Speedy and less costly.
DELPHI TECHNIQUE
Panel members are asked by letters to give their predictions. They got information throgh post
& sent outcome. Those who dissent are invited to give reasons or else modify their forecasts.
Process repeated and final range of outcome is regarded as probabilistic forecast.
CONSUMERS SURVEY METHOD
It is a direct approach. Three types
A COMPLETE ENUMERATION SURVEY
The probable demands of all the cosumers for the forecast period are summed up.
ADVANTAGE
Unbaised
Accurate
DISADVANTAGE
Cotact large number of persons
Tedious
Authenticity of data is doubtful
B SAMPLE SURVEY
Probable demand expressed by each selected unit is summed up. Then total sample demand
x by the ratio of number of consuming units in the population.Give good results for new
product.
ADVANTAGE
less tedious
less costly
less data errors
C END USE METHOD
Demand surveys of industries using this product as an intermediate product. Demand for the
final product is the end use demand. Intermediate product may have many end use. Domestic
and international market demand. The demands for final consumption and exports net of
imports are estimated through some other forecasting methods and it’s demanded for
intermediate use estimated through a survey of it’s users industries. Such a method is feasible
for national planning organisations and not for industry.
ADVANTAGES
Provides sectorwise demand forecasting
Does not require historical data
If numbers of end users is limited it will be convenient to use this method.
DISADVANTAGES
It required every industry to furnish it’s future plan,individual industry will have to rely on some
other method to estimate future demand, only intermediate demand can be predicted.
STATISTICAL METHOD
A TREND METHOD
Based on analysis of past sales pattern. These methods dispense with the need for costly
market research because necessary information is often already available.
Time series data- main 5 techniques as :
1 FITTING A TREMD LINE BY OBSERVATION
easy & quick
pattren trend
x
x xx – actual bimonthly sale
oct oct oct oct
1980 1981 1982 1983
Time
TREND THROUGH LEAST SQUARE METHOD
Mathematical
Sales = a + b (year ) or
S = a + bt
Where a & b have been calculated from past data & t is the year number for which
forecast is to be made. e.g.
The sale record of company x reveal the following
Year 1970 1972 1974 1976 1978 1980
Sales in crores 30 40 45 50 48 57
Estimate sales for the year 1982 &1983.
SOLUTION
To find values of a & b we will have ti solve the normal equation
∑S = Na + b ∑ T
∑ ST = a ∑ T + b∑ T 2
IN THE TABLE BELOW WE FIND ∑ S, ∑ ST ,∑ T, ∑T2
YEAR YEAR NUMBER SALES (S) S X T T 2
1970 1 30 30 1
1972 3 40 120 9
1974 5 45 225 25
1976 7 50 350 49
1978 9 48 432 81
1980 11 57 627 121
∑ 36 ∑ 270 ∑ 1784 ∑ 266
substituting
270 = 6a + 36 b
1784 =36a +266b
solving these equations for a & b we get a = 30.76 b = 2.34
Thus the trend equation becomes S = 30.76 + 2.34 t years 1982 &1983 take on the years
number 13 &14.
By substituting these values for t we get Rs. 61.18 & 63.52 crores.
Trend method is popular because it is simple and gives good forecasting more over it does not
require knowledge of economic theory and market.
MAIN DRAWBACK
Past rate of change in variables continue in future.not appropriate for short term, can not
explain turning point of business cycle.
C TIME SERIES ANALYSIS
This is an extension of linier regression which attempts to build seasonal and cyclical
variations into the estimating equation,
SALES = a (TREND) + b ( SEASON ) +c (CYCLE ) +d where a,b,c,d are constants
calculated from past data.Trend value is the year number. The value of season is given by
normal % difference from trend for the season being forecast. The value of cycle could be
found from baromatric indicators for the period of forecast.
D MOVING AVERAGE &ANNUAL DIFFERENCE METHOD
A moving average of order k is obtained by adding yearly demands for successive years of k
number of years and dividing it by k.Thus the moving average of order 5 at year t = 1/5 ( Dt-2
+ Dt –1 + Dt + Dt +1 + Dt +2 ) where Dt is demand in year t.
E EXPONENTIAL WEIGHTED MOVING AVERAGE METHOD
A progressively smaller weight is given to the more distance as compared to the more recent
past years.These weights will have to be chosen properly chosen. Once a smooth time series
is obtained the trend method can be applied to these series to generate demand forecasting.
BAROMATRIC TECHNIQUES
It is based on that the future can be predicted for certain events occuring in the present. It
involve statistical indicators. Time series provide indications of change in economy or specific
industry. These are termed as the barometer for market change.
( 1 ) Leading indicators – consists of indicators which move up or down ahead of some series
e.g. ( I) index of net business ( capital ) formation ( ii) new orders of durable goods (iii) new
building permits ( reflect future market change ).
( 2 ) Coincidental indicators – which coincide with or fall behind general economic activity or
market trends. e.g. number of employees in non agriculture sector.
(3) Lagging indicators-Those indicators which follow a change after sometime e.g. are
manufacturers stock level and cosumer credit outstanding.
The problem of choice may arise because some of the indicators appear in more than one
class.so it is advisable to rely on just one indicator.This lead to uses the diffusion index.
DIFFUSION INDEX- cops with problem of differing signals given by the indicators. A diffusion
index gives the % of rising indicators. In calculating a diffusion index for a group of indicators
scores alloted are1 to rising series, ½ to constant series and zero to falling series. If 3 out of 6
indicators are moving up in lagging series the index shall be 50%. It is for short term forecast.
QS
1) What is delphi method? What is the use of this method?2) How baromatric leadership is achieve discuss in light of perfect competition?3) What are the indicators available in our economy?Present in the class.
Sophisticated and complicated method require computer.
MOVING AVERAGE METHOD
This simple method assumed that demand in a future year equals the average of demand in
the past years as below:
Dt = 1/N (Xt-1 + Xt-2----------Xt-n)
Sales in previous years N = number of preceding year.
QS
1)You are given the following data:
X 3 6 8 10 13 13 13 14
Y 8 6 10 12 12 14 14 20
Estimate the regression equation Y = a + b X
2) Why is demand forecasting essential? Is demand forecasting equally important for small
and big, and old and new business ventures? ( DISCUSS IN THE CLASS )
4) Demand forecasting is must for the bu
5)
6) siness?
CHAPTER - V Cost concept Need in all business decisions. The Kind of cost concept to be used in a particular situation depends upon the type of business decision to be made. Total cost, Average cost & Marginal cost: Total Cost includes all cash payments made to hired factor of production & all the cash changes imputed for the use of the owner’s factor of production in acquiring or producing a good or service. For e.g. A shoe maker’s cost will include the amount he spent on lather, thread, rent of shop, interest on borrowed capital, wages of employee’s etc & the amount charges for his services & his own funds invested in business.
Average cost (AC) is the cost per unit of output
Ac = total cost/Total Quantity produced (X) if TC =100 & X= 10 AC = 10 Marginal cost (MC) is the extra cost of producing one additional unit.After management is interested in incremental cost instead of MC e.g. TC of 101 hundred meter cost is Rs 101000 & that of producing 100 hundred meter lots is Rs 100000. The Mc is Rs 1000. The incremental cost per unit is the total incremental cost divided by the increment in unit’s produced. In the e.g., the incremental cost per unit is Rs 10.Total Cost concept is useful in break-even analysis & in finding out whether a firm is making profit or not. The Average cost concept for calculating per unit profit. The Marginal cost & Incremental Cost needed that whether firm needed to expand i.e. production or not.
Fixed or Variable cost: FC defines as those, which remain the same at a given capacity & do not carry with output. These costs will exist even if no out put is produced e.g. Rent of factory. Variable cost varies directly as out put is produced e.g. wages, cost of raw material. Some cost falls in between two extreme known as semi variable e.g. electricity bill minimum charges. These cost used for forecasting the effect of short run charges. These costs used for forecasting the effect of short run charges in volume upon cost and profits.
Acquition & opportunity cost: Acquiring cost means cash out flow committed to acquire or produce a good or service. These costs are generally recorded in the books of accounts. The included hiring land labor, Capital & management. Opportunity costs are cash inflows prevented by taking one cause of action instead of other e.g. student when deciding whether to go to college or not a student might compete the amount his spent on fees, books etc with the movable increase in his further earnings. He must add to these costs the earning he foregoes in the years he spends in college. These earnings are opportunity cash
Out Of pocket and book cash: - Out of pocket cash refer to cost that involve immediate payments to outsiders as opposed to book cost that do not required current cash expenditure for ex. Usages to employees out of pocket salary to owner. If not paid, is a book cash out of pocket also called explicit book costs implicit costs both costs are actual cost of a firm.
Historical & Replacement cost: The historical cost of an asset is the actual cost increased at the time that work was originally acquired. In contrast to this recost is the cost, which will have to be incurred if that asset is purchased now.
Past and future costs: Past cost are actual costs incurred in the past & they are always contained in the income statement. Future cost are likely to be increased in future period & based on estimate.
Separable & common Cost: Cost of electricity is common cost; Raw material cost can be separable cost.
Determinants of cost: out put level, prices of factor of production, productivity of factor of production Technology.
Output & cost: Total cost varies directly with out put. The more output a firm produces the higher will be its production cost & vice versa (Increase of raw material & labor). If increase in substantial even fixed inputs have to increase.
Cost output relation ship: - In economics analysis the cost function usually refer to the relationship between cost & rate of output alone & thus assumes that all of the other independent variables are kept constant. Economist emphasis on this relationship is reasonable because it is subjected to faster & more frequent changes. Once the cost output function is determines, estimates of future costs of the production at varies output levels can usually be obtained by adjusting the cost function to reflect the effect of other forces such as wage rate, material prices & productivity of labor. However cost output relationship is a partial relationship.Variable cost varies with output positively. Fixed costs are constant in short term. In long run all costs are variable.
Short run cost output Relationship: Refer to a particular scale of operation or to a fixed plant. Thus the short run function relating cost to output variations is of following type
Tc =F (x) + A
Tc = Total cost x = output A = total fixed cost. The fixed cost is for a given plant size, for different plant sizes its value will differ F (x) denotes total variable cost short run cost output relationship needs to be discussed in term of (a) fixed cost & output (b) Variable cost & output (c) Total cost & output
Fixed cost & outputs: By definition fixed cost does not vary with output. Thus the larger the quantity produced, the lower will be the fixed cost per unit & marginal fixed cost will always be zero. In our e.g. the TFC – Rs. 176 Irrespective of the units of output & AFC decline Monotonically as output increases correspondingly TFC curve is horizontal at RS. 176 & AFC curve is falling continuously in figure. The relationship between fixed cost and output is the same for all type of business.
Variable cost & output: The total Variable Cost increased as output increases. The cost may not increase by the same amount. For every unit increase in output. As output increase TVC increase at a decreasing rate, then at a constant rate & eventually at an increasing rate. Law of Diminishing return is in operation ex the requirement of labor does not change linearly with quantity produced A Firm need minimum number of labor for even one unit of its output & its way not need any extra labor until it exceeds a given range of output if further expended needs more labors.
Total Cost & Out Put Relationship: As against this raw material cost Varies directly with output. Other variables cost stationary, electrical bills etc. which very at different level of outputs. If further increase variable factor input cost increase & they way have to be paid higher price then before.Another reason for a nonlinear Total Variable Cost & output relation is the operation of the law of diminishing returns. It may be recall that according to this law as more & more units of variables factors of production are used along with a factor of production, the original products of that variables factors first increases, then remain constant & finally stars diminishing. In this behavior of AVC function first fall as output
increases than remain constant for some output range, & eventually rise with every increase in output. Marginal cost is also equals change in Total Variable Cost. Variation in Average Variable Cost & Marginal Cost will be similar.
Total Cost & Output: Total cost increases as output increases Total Cost & Total Variable Cost is parallel in above graphs.
The relationship among AVC, ATC & MC can briefly describe as -
All three cost measures fall than constant, then rise.
The rate of change in MC is greater than AVC & hence the minimum MC is at an output lower than the output at which AVC is minimum.
The ATC falls for a longer range of output than the AVC & hence the minimum ATC is at a larger output than the minimum AVC.
AVC= MC, when AVC is least. ATC = MC, ATC is the least.
Long run cost output relationship: In the long run there is no fixed factor of production & hence there is no fixed cost.The Partial total cost function will be: TC= f (x, k) k- stands for the plant size. As k changes TC changes, thus the long run cost function contains a family of short run cost functions one for each value of k.Relationship is not unidirectional. If the output is small, small plant size will be less than for a large plant size. Large plant size is good for large outputs. Thus, the family of short run total cost curves are shown in graph. In short, run variations in output are possible up to extent plant size permit. In long term plant size can change but no employer will do it. Therefore, the concept of long term is only hypothetical
Economies and diseconomies of scale: These are concern with the behavior of average cost as the plant size changes. There exist economies of scales if average cost falls as plant size increases and the diseconomies of scale prevail if the opposite is the case. For e.g. If the average cost at a given output with a plant size K= 1(say 100 unit capacity) is Rs. 8.00 and that with a plant size K= 2(say 200 unit capacity) say Rs. 750, the there are economies of scale between plant size 1 and 2. If the average cost prize is to say, Rs 8.00 for a plant size K=3(say 300 unit capacity) There are diseconomies to scale between plant size 2 & 3.
Size of plant reflect the amount of investment made in the relatively fixed factor of production. This Varies in long term only hence economics of scale are associated with the long run average cost curve only. The long run average total cost curve is U shaped. The point at which L arc is minimum is the point at which economy just equal diseconomies of scale. Marshal classified economies and diseconomies of large-scale production in two – Internal & External. Internal are due to firms own
expansions. External are may arise due to expansion of the industries as a whole For e.g.. Industries expansions may led to the construction of the railway line in certain reign resulting in the reduction in transport cost for all the firms. External economies, like internal economies may return into diseconomies beyond a certain output level.QS
CHAPTER - VI LAW OF SUPPLYSupply of a commodity refers to the varies quantities of commodity which a seller is able to sell at different prices in a given market, at a point of time, other things remaining the same.Determinants of supply: amount of a commodity supply depends upon a number of factors. These can be stated in terms of a supply function. Sx = f (Px, Py, Pz, Pf, O, T) Sx = amount supplied of good x , Px- Price of good xPyPz= Prices of other goods in the marketPf= Prices of factor of production needed to produce good xO = objectives of the producer T = state of technology used by the producer to produce good x Law of supply states that other things remaining constant more of a commodity is supplied at a higher price & less of it is supplied at a lower price.
Firms supply schedule for scooter tyres
Price of Tyre Quantity supplied
(Rs per tyre) 000 Nos 200 100
180 90 160 80
140 70
Shift in supply: increase or decrease in quantity supplied at the same price, same quantity supplied at a higher, or a lower price.Change in supply is in fact extension & contraction of supply when more goods are supplied at
a higher price it is call extension of supply. When less units of goods, are supplied at a lower
price it is called contraction of a supply.
SELLING COST
For determinig price and output under monopolistic competition and oligopoly. Firms often
compete through incurring selling cost on advertisement expenditure.
QS. How much selling on advertisement expenditure a firm should take to maximise it’s profit?
Salling cost distinguised from production costs - term selling cost broader than
advertisement expences.
Advertisement Expences include – cost of production advertisement in news papers,
magazines on radio and tv.
SELLING COSTS - salary of the sales man,allowances of retailers for product displayed, other
type of promotional activities besides advertisement.
Chamberlin madedistinction between selling cost and production cost. According to him
production cost include all those expences which are incured to manufacture and provide a
product to consumer to meet his given demand. While selling costs are those which are
incured to change or creat or shifts in demand for a product.
SIMPLE CRITERIA -All the costs incured in the manufacurer and sale of a given product those
which do alter the demand curve for it are selling costs and those which donot are costs of
production. High rent of shop and trnsportation not comes in selling costs. It is difficult to say
attrractive packing is selling cost or production cost.
SELLING COSTS ROLE UNDER PERFECT COMPETITION, MONOPOLY AND IMPERFECT
COMPETITION
Perfect competition – Product is homogeneous so industry can give a common
advertisement of all firms known as promotional advertising as comared to competitive
adversity.
Monopoly – No close substitute of product so no competition hence advertisement is
informative and promotional.
Monopolistic and Oligopoly – Product differerciation so advertisement and other selling
costs become important as a competitive weapon at the disposal of firms to increase its sales
at expence of others. Product close substitute so each firm try to convince the buyers that its
product is better than others. This is known as competitive advertisement. This shift demand
curve to right means at a given price, a greater quantity of product can be sold.
EFFECT OF SELLING COSTS ON DEMAND
The purpose and effect of sucessful advertisement is to increase there demand however these
selling costs are subject to varing returns. Equal increaments in advertising outlay first yield
increaseing returns then decreasing returns. Selling costs permits a firm to reapeat many times
its advertisement. Second reason for occurrence of increasing returns in beginning is the
economy of large scale. Diminishing return set in advetrtisement due to :
1 Initial advertisement attracts large number of buyers
2 From the increase in advertisement buyers may not increase their demands because
cosumers buy more a product its utility diminishes.
In diagramAssumptions – All demand curves are parallel. Diminishing return in diagram is q0
q1, q1q2, q2q3.
THE CURVE OF AVERAGE SELLING COSTS
Two concepts
1 Average selling cost required to sell various amounts of output with varing advertisement
expences incured in a period the average selling costs per unit will depend upon the quantity
sold as a result of upword shift in demand curve brought about by a perticular amount of
selling costs. Selling costs is subject to varing returns.Firm will further plan out regarding
advertisement because selling cost per suit falls in beginning. After a point diminishing return
to selling costs set in and increase in advertisement outlay cause less than proportionate
increase in the amount demand of a product.
2. Curve of Average selling cost with a given amount of total selling costs means the average
selling cost per unit which is required to be undertake to seek various amounts of output. Once
selling cost fixed then greater level of output sold. This is because beyond a point no further
increase in selling cost can cause any expansion in amount demanded of a product.
OPTIMUM LEVEL OF ADVERTISING OUTLAY (SELLING COSTS ) WITH PRICE AND
PRODUCT DESIGN AS CONSTANT
How much selling cost a firm will take to maximise profits?
What is the optimum amount?
Above questions can be explained by average and marginal cost curves. In diagram ASC –
Average selling cost , APC –Average production cost
Average total cost = APC +ASC
Distance between AC and APC measures the average selling costs. We assume that OP is
fixed and constant further production is also unchanged and it is only advertisement expences
get changed. PL canbe viewed as MR curve. MC = MR at point E, OQ is quantity and OP is
price, total profit PERT.Average selling cost is equal to BR AND BR = QD So the total optimal
amountof advertisement QD X OQ quantity.
2 OPTIMAL LEVEL OF ADVERTISEMENT EXPENDITURE WITH PRICE AS A VARIABLE
Assume firms aims to maxmise profit. Aro is demand suppose these MC = MR curve equal to
Ono where Po is price and profit is PoLQH.
suppose firm spend Rs. 1000/ expences for advertisement. This expence will shift AR and cost
too will increase. The demand curve shift to AR1 and the new AC1 ( inclusive advertisement
expences ) equlibrium at ON1 price OP1 quantity ON1 and profit P1ETK here MR & MC equal
to ON1. Increased profit tempted to further advertisement Rs.2000/ with this demand curve
shift to AR2 equlibrium at ON2 and profit P2JSD. Lure to increase profit further advertisement
expences Rs. 3000/ revenue curve shift to AR3 equilibrium ON3 &AC3. New average cost
curve but less profit P3BWG so company will select P2 for profit maximisation.
EFFECT OF SELLING COST ON ELASTICITY OF DEMAND
Due to advertisement demand curve shift to right. Elsticity of demand at each price with
advertisement decline. Extent of decline is uncertain. Price and output both increase with
advertisement.
QS
CHAPTER – VII
MEANING AND NATURE OF INDIFFRENCE CURVEThe locus of points, each representing a different combination of two substitute goods, which yield the same utility or level of satisfaction to the consumer. Therefore, he is indifferent between any two combinations of goods when it comes to making a choice between them. Consumers consume a large number of commodities and services. One commodity may substitute by another and combinations gave him same satisfaction when such combinations plotted graphically the resulting curve is known as indifference curve also called iso utility curve or equal utility curve. Let us suppose that a consumer makes fine combinations a to e. All these combinations yield him the same level of satisfaction.
Combination Units of commodity y
Units of commodityX
Total utility
A 25 5 UB 15 7 UC 10 12 UD 6 20 U
E 4 30 U
25- --A
15 - -B
COMMODITY Y 6 - - C- 5 - -D 4 - e 5 7 12 20 30
COMMODITY X
PROPERTIES OF INDIFFERENCE CURVE1 Indifference curve have a negative slop that implies-
a two commodities substituted for each other b if quantity of one commodity decreases quantity of another commodity must increase so that consumer stays on same level of satisfaction.
2 Indifference curve are convex to origin implies- a two commodity are substitute to each other b Marginal rate of substitution decreases
3 Indifference curve neither intersect nor be tangent to each other.
4 Upper indifference represent a higher level of satisfaction than the lower ones.
ISOQUANT CURVE
Isoquant curve means equal quantus means quantity. Therefore also known as equal product curve or production indifference curve. An isoquant curve is locus of points representing various combinations two inputs capital and labor yielding the same output. To illustrate curve let us assume7(I) There are only two factors of production labor L capital K to produce a commodity.(ii) The two factors can substitute each other but at a diminishing rate. (iii) The technology of production is given.Given these conditions, it is always possible to produce a given quantity of commodity x with various combinations of capital and labor. The factor combinations are so formed that the substitution of one factor for the other leaves the output unaffected. This technological fact is presented through an isoquant curve IQ = 100. The curve IQ1 all along its length represent a fixed quantity 100 units of product x. This quantity of output can be produced with a number of labor capital combinations for e.g. point A,B,C,D on the isoquent iq1 show four different combinations of inputs K.L.
CAPITAL LABOUR COMBINATIONS AND OUTPUT INPPUT COMBINATIONPOINTS CAPITAL + LABOUR = OUTPUTA OK4 OL1 100B OK3 OL2 100C OK2 OL3 100D OK2 OL4 100
K4 A
Capital K
K3 B
K2 C IQ2
K1 DIQ1=100
0 L1 L2 L3 L4
Labor L
PROPERTIES OF ISOQUENT
(I) Isoquants have a negative slop.(ii) Isoquants are converse to origin.(iii) Isoquants cannot intersect or be tangent to each other.(iv) Upper Isoquants represent higher level of output.
CHAPTER - VIII Pricing
Price of a product or service is determined by the demand for it and greater demand smaller supply, the greater will price and vice versa. There are five basic determinants of the price of a commodity: 1 Demand 2 Cost function 3 Objectives of its producer 4 Nature of the competition in market 5 Government PoliciesLet the demand facing a firm for its product be expressed as Q = 25 – 0.5p Q = Quantity demanded P = Price and the supply of this firm as Q = 10 + 1.0 p Q = Quantity supplied P = Price, in absence of any influence from the Government the price is as
DEMAND = SUPPLY 25 – 0.5p = 10 + 1.0p i.e. P = 10 and Q = 20 if Government imposes sales tax at Rs. 3 per unit, new supply function would be: Q = 10 + 1.0 (p – 3) So 25 – 0.5p = 10 + 1.0 (p – 3) i.e. p = 12 if substitute this in demand we get Q =19.
Pricing under different market structures
Pricing under perfect competitionIn figure the firm demand curve is horizontal and the price determined in the industry by the intersection of demand and supply. The demand curve is also the firms average revenue curve.
Part B - Firm Part A –Industry D1 D S MC ATC P E1 AR’ = MR’ P1PRICE D1 D1 E D1 AR =MR P S D G F
O Q Q’ O Q1 Q1’ QUANTITY D1D1 = AR = MR, ATC =Average total cost MC = Marginal cost. The firm reaches its’ eqlibrium at E. When P = MC and MC curve intersect the MR curve from below. Firm’s equilibrium output is OQ1. Profit area is D1EFG. In the short run, a firm can
Markets
Perfect
Competition
Imperfect Competition
Monopoly Monopolistic
Oligopoly
make profit, loss or just breakeven depending upon its cost function and market conditions? However, in long run no firms make profit or loss under perfect competition. This follows from future of free entry and exit. If demand curve change from DD to D1D1 the market price would be OP1 and industry output OQ1 and the firm’s output OQ1, E‘s is economic profit. The supernormal profit lures other firms into the industry. Consequently supply curve shift rightward causing a fall in price. Firms occurring losses cannot survive in long run such firms quit the industry.
Pricing under monopoly
Absolute power to produce and sell a product, which has no close substitute A signal firm, exit in industry. Causes and kind of monopolies It prevent entry of other firms into the industry. Barriers are sources of power. The measure sources of power are
1. Legal restrictions 2. Sole control over the supply of key raw materials 3. Efficiency and economies of scale
Pricing and output decision in short run- are based on revenue and cost. A profit maximising monopoly firms chooses a price output combination at which MR=MC i.e. point N to X-axis determines the profit maxmising output for the firm at OQ. The output OQ can be sold per time unit at only one price i.e. PQ=OP1. Thus, the determination of output simultaneously determines the price for monopoly firm. Once price is fixed, the unit and total profits are also simultaneously determined.Hence, the monopoly firm is in the state of equilibrium. AR = Average revenue curve MR = Marginal revenue curve SAC = Short run Average cost curve SMC = Short run marginal cost curve in the
Y
P1 P
P2 M
NPR=D
MR
SMC
SACUnit Cost & Revenue
Q X
OUTPUT
Monopoly pricing and output decisions in long run –
The decision rules regarding optimum output and pricing the long run are the same as in the short run. In the long run a monopolist gets an opportunity to get expand the size of its’ firm with a view to enhance in long term profit. Expansion of plant is subject to condition as – A – Size of market B—Expected economic profit C—Risk of inviting legal restrictionsLet us assume that time being none of the above condition limits the expansions of monopoly
firm. The price and output determination in the long run. AR CURVE = Market demand MR CURVE = Marginal revenueLAC and MAC show the long run cost conditions. LMC and MR intersect at point P where output is OQ2. This is profit maxmising output. Given the AR curve, the price at which the total output OQ2 can be sold is P2Q2. Thus, in the long run, the output will be OQ2 and price P2Q2. This combination maximises the monopolist’s long run
profit LP2SM.
QS1) What is the differnce between perfect compitition market and monopoly market? (class
verbal presentation )
Price Discrimination selling the same or slightly differentiated product to different sections of consumers at different prices. Consumer discriminated on the basis of their income or purchasing power, geographical location, age, sex, marital status, quantity purchases, time of purchase etc. When consumers are discriminated based on above factors in regard to prices charged from them, it is called price discrimination. Another kind of discrimination is that the same price is charged from the consumers of different areas while cost of production in two different plants located differently is not the same ex. Doctors, Lawyers, Consultants. Charges on the basis of ability to pay. Merchandise sellers sell goods to relative and friends at lower price, Railway charge lower from children and students.
Necessary conditions for price discrimination – 1 Different market must be separate 2 Elasticity of demand must be different in different markets 3 there must be imperfect competition in the market
Degrees of price discrimination –
First degree – When seller knows that the price consumer is willing to pay so fixed price accordingly. Once he has extracted the whole consumer surplus, he lowers the price for extracting surpluses of second unit e.g.. Doctor. Second degree – Large market, monopolist-using block pricing method. Blocks – Rich – highest price, Medium – Low price, Poor – Lowest price.
Third degree – When a profit maxmising monopolist sets different prices in different markets.
The firm marginal cost is shown but MC which intersects MR at point T. Optimum level of output for this is determined at OQ at this level MR = MC. The whole quantity cannot be sold in any one market at a profit maxmising price. So OQ out allocation between the two markets in such proportion that profit maxmising is satisfied in both the markets. This can be accomplished by drawing a line from point T parallel to x-axis through Mob and Mra intersecting at point S and R.
Pricing under monopolistic competition Monopolistic competition has large number of sellers, free entry and free exit, perfect factor mobility / substitute, complete dissemination of market information, differentiated products e.g. T.V., Fridge, soap etc.
Short run pricing and output decisions Monopolistic competition is close to perfect competition but about pricing and output determination it is close to monopoly. Monopolistic competition faced a downward sloping curve due to (1) a strong preference of a section of consumers for the product ( 2 ) the quasi monopoly of the seller own the supply. Strong preference of consumers gives the sellers an opportunity to raise the price and yet retain some customers and since each product is a substitute for the other, the firm can attracts the consumers of other products by lowering the prices.
A FIRM MR intersect MC at point N. this points fulfills the necessary condition of profit maxmising at output OQ. This output can be sold at price PQ. Therefore, price is determined at PQ. Monopoly profit shown by P1PMP2. The economic profit Pm will exit in the short run because of no possibility of new firms entering the industry but profit level in monopolistic competition differ in different firms because of difference in the elasticity of demand. Some firms may make losses for the same reason.
Long run price and output determination It is similar to perfect competition. The existence of economic profits in the short run attracts new firms to the industry. The entry of new firms reduces the share of individual firms in total supply. This shifts the demand curve AR to left. Such shifts continue so long as economic profit exits. At the stage where AR = LAC the individual firms and also the industry attain the equilibrium level. In the long run, output is OQ. At this stage, no new firm will enter in the industry or old firm quitting the industry.
Pricing under oligopoly Oligopoly is a reduced form of monopolistic competition. It is a competition among few sellers (big), each selling either differentiated or homogeneous products. Number seller is too small that market share of each firm is so large that it influence the market price. It also implies that each seller commands a sizable proportion of the total market supply. Classification on product basis 1 heterogeneous oligopoly ex. Automobile industry. 2 – homogeneous / pure oligopoly ex. Gas, cement, and baby food. Keen competition – Action, reaction and counter action. In this market firm’s business decisions become interdependent, since a major policy change by one firm is bound to affect the interest of other firms. Consequently, strategic decisions regarding pricing, marketing, advertisement etc. are based on explicit assumptions regarding actions and reactions of rival firms. Competition between oligopolists generally takes three forms:1 Free competition: Price war against each other which ultimately takes the form of non price competition as showed by kinked demand curve analysis. 2 when oligopoly is a competitions among unequal, the larger firm plays the role of price maker and small ones become the price takers. This is known as price leadership model. 3 Collusions between firms under cartel system or price agreement i.e. Collusive module. In a market setting characterised by a few monopolistic sellers, the demand curve losses it‘s significance because it is indeterminate. The demand curves keep shifting back and forth from one position to another due to interdependent of firm’s decision.
Cornet’s model of oligopoly (Duopoly) He assumed: 1 Two firms, each owing an artesian mineral water well.2 both operate their wells at zero marginal cost. 3 both face a demand curve with constant negative slop.4 each sellers acts on assumption that his competitor will not react to his decision to change his output and price. Cornet has concluded that each seller ultimately supplies one third of the market and charges the same price and one third of the market remains unsupplied.
A is the only seller of mineral water in market. Following the profit maximising rule, he sells quantity OQ where his MC = O = MR at price OP2. His total profit is OP2PQ. B enters in the market. Market open is QM1/2 of total market. He assumed that A will not change his price and quantity as he is earning maximum profit. Market available to B is QM and demand PM. When he draws his MR curve PN is bisect QM at point N where QN = NM. In order to maximise his revenue B sells QN = ¼ = 1/2/2 of the market with entry B price falls to OP1, therefore A‘s profit falls to OP, RQ. An attempt to adjust his price and quantity to the changed situation. He assume that B will not change his output QN and price OP1 AS He is making maximum profit. Assume that B will continue to supply ¼ of market and he has ¾ of market available to him. To maximise his profit, A supplies ½ of (3/4) i.e. 3/8 of the market. It is noteworthy that A‘s market share as fallen from ½ to 3/8. Now it is B turn to react. B assume that A will continue to supply 3/8 of the market and market open to him equals 1-3/8 =5/8 .To maximise his profit under new conditions B supplies ½ / 8/5 = 5/16 of the market. Now it‘s a turn to react. This action reaction continues until both reach at equilibrium of equal market share 1/3 of each share. Any further attempt will produce same result.
Period Seller A Seller B
1 ½ (1) = ½ ½ (½) = ¼2 ½ (1-1/4) = 3/8 ½ (1-3/8) = 5/163 ½ (1-5/16) = 11/32 ½ (1-11/32) = 21/644 ½ (1-21/64) = 43/128 ½ (1-43/128) = 85/256
Cournets equilibrium solution is stable.
Criticism -1 Firms continue to make wrong calculation about the competitor‘s behavior.2 Assumption of zero cost of production is unrealistic.
KINKED DEMAND CURVE ANALYSIS OF PRICE STABILITY: SWEEZY’S MODEL
This model does not deal with price and output determination. Rather it seeks to establish that once a price –quantity combination is determined, an oligopoly firm will not find it profitable to change it’s price in respond to a moderate change in cost of production. Firms believe that if it reduces price of its product, rival firms would follow and neutralise the expected gain from price reduction. However, if it raises its prices, rival firms either would maintain their prices or may even cut their prices down. In either case, the price raising firms stands or loose, at least a part of its share in the market. All the firms in respect of others make these behavioral assumptions.
Suppose a firm raise it’s price rival firms may react in following way1 follow the price change, both cut & hike2 do not follow the price change 3 do not react to price hike but they follow the price cut.Let us suppose market demand curve for a product is given by dd’ curve and that the initial price is fixed at PQ. Now one firm change it’s price if rival firm react in manner (I) they react with hike for hike and cut for cut the price changing firm will move along the demand and if rival firm do not follow the price changes, then the price changing firm will move along the demand curve DD’. Note that the firm initiating the price change faces two different demand curves conforming to two different kinds of reactions (I) & (ii). The demand curve dd’ based on reaction (I) is less elastic than the demand curve DD’ based on reaction (ii) Given the two demand curve dd’ and DD’ let us now introduce reaction (iii) a more realistic one i.e. the rival firms follow the price cut and do not follow the price hike. This asymmetrical behavior of the rival firms makes only a part of the two demand curves relevant and produces a kinked demand curve. If a firm increases, price and rival do not it losses a part of its market to its rivals. The demand for its product decreases the firm is therefore forced down from demand curve dP to DP. Now suppose alternatively that the firm decreases its price. Then the rival firms also cut down their prices otherwise they would loose their customer’s. This counter price move does not allow the firm to take full advantage of DD’ curve. Therefore, its demand curve below point P rotates down. Let us now draw MR curve. Recall that MR = AR – AR/e. The MR curve drawn on the basis of relationship takes a shape by a discontinuous curve DJKL. The DJ & KL segments of
MR curve correspond to DP &Pd’. Suppose that original marginal cost curve resembles the curve MC1 which intersecting MR at point K. Since at output OQ MR = MC1 the firm makes maximum profit. Now even if MC curve shift upwards to MC2 any level between J & K firms profit would not affect. Therefore has no motivation to increase or decrease price.
CRITICISM1 It does not tell how initial price has been fixed at a certain level.2 There is lack of price rigidity in the model in real world firms is reluctant to the price hike.
Price Leadership model:It may emerge spontaneously due to technical reasons or explicit agreement among the firms to assign leadership role to one of them. Dominate firm takes lead in making price change and smaller one follows. Price leadership exit only. Conditions are –1Numbers of firms is small.2 Entry of firm is restricted.3 Product are homogeneous.4 Demand has low elasticity.5 Firms have almost similar cost curve.
Price Leadership by low cost firmsSmall firms face identical revenue curves as shown by MR and AR but they have different cost curves as shown by AC1 and MC1 whereas all rival firms smaller in size have their cost curves AC2 and MC2. This is so because larger firms has economies of scale its cost of production is lower than the other firms.
Given the cost and revenue conditions, the low cost firm would find OP2=LQ2 most profitable and sell quantity OQ2. At this level of output it‘s MC=MR and hence profit is maximum. High cost firm would maximize at OP3 and quantity OQ1 but if they keep price high they would loose their customers to lower cost firm so they are forced to
accept OP2 level and recognize the price leadership of low cost firm. The low cost firm can eliminate all firms by cutting the price to OP1 but he earns normal profit and fear of anti monopoly laws.
Price Leadership by a dominant firm- Dominant firm fixes the price and other follows.
Suppose the market demand curve is given by DDm in part (a). Supply curve of all the firms including dominating is Ss. Both intersect at Equilibrium price level P3. The total supply of small firms is P3E. Therefore at price OP3 the market left FC the dominate firm is zero. When price is OP1 market demand is P‘B out of which P‘A is supplied by the smaller firms. The market unsupplied by the smaller firm is AB thus at price op1 the demand for dominant firms product equal P‘B - P‘A = AB. Similarly when price is reduced to OP2 the demand for dominant firms product is CF. Following this process, the market share of dominant firm at other prices can be easily obtained. In graph P3DL as the demand curve for the dominant firm MC curve is MCL it‘s profit maximising output will be OQL and price PQL. Once the dominate firm sets it price at OP‘ the demand curve for small firms is the P‘B. They can sell as much as they produce, but in order to maximise the joint profit small firms will produce P‘A. Note the P‘B is the same as their MR=AR line and then supply curceP1SS intersects AR=MR AT POINT A for small firms profit maximising joint output is P‘A.
Critical Appraisal- 1 Small firm’s faithfulness is doubtful.2 Many cases of price leadership neither big nor low cost. (Political)3 If leading firm’s losses the cost advantage new firm becomes leader.4 It is assured those new firms are prevented by low cost but some enter through
diversification.
The Barometric Price Leadership-A firms initiated well-published changes in price that are generally followed by rival firms in the industry. The barometric firm is however supposed to have a better knowledge of prevailing market conditions and has an ability to predict the market conditions more precisely than any of it‘s competitors. This qualification of the barometric firm should have been established in the past. The firm having the qualifications of price leadership is regarded as a barometer, which reflects changes in business conditions and environment of industry. The price changes announced by the barometric firm serves as a barometer of changes in demand and supply conditions in the market. It is evolved due to following reasons:1 Cut throat competition makes them unacceptable as a leader so a firm has better predictive ability emerge as price leader. 2 No firms want to make calculation continuously so they find it advantageous to accept the price changes made by a firm.3 Price leadership often develops as a reaction to long warfare in which all firms are looser.
Collusion model: The Cartel It is an association of business firms formed by an explicit agreement between them. The firms jointly establish a cartel organization to make price and output decisions, to establish production quota’s for each firm and to supervise the market activities of firm in the industry. Cartel type of collusions is formed with a view to (1) eliminating uncertainty (2) restrain competition and they’re by ensuring monopoly gains to the cartel group. The cartel works through a board of control. One of the functions of the board is to determine market share of each firm. For this purpose, the board calculates the MC and MR of the industry. MC is summation of MC’s of individual firms. One the basis of MC and MR the total output of industry is determined. The total output then allotted between the member firms on the basis of their MC.
The industry out put is determined at OQ and price at PQ. The share of each firm in the industry out put OQ is determined at the level of their own out put, which equates their individual MC with the industry MC. The industry‘s marginal cost CQ is determined by the intersection of industries MC and MR at point C. The market share of each firm can be obtained by drawing a line from point C to parallel to x axis
through MC2 and MC1 to the y axis. The point of intersections C1and C2 determines the level of out put for firm And B. The share of each firm two A&B is determined at oq1 +oq2 = OQ. Their total profit can be computed as (price – ac) x firms out put. This shows the stability of price and out put under collusive oligopoly.
COST PLUS PRICING OR MARKS UP PRICING- also known as Average cost pricing or Full Cost Pricing. It is the most common method of pricing a product by the manufacturing firms. General practice under this method is to add a fair % of profit margin to the average variable cost (AVC). The price is set as P = AVC +AVC (m) where m is markup %.AVC (m) = gross profit margin (GPM)The markup % (m) is fixed to cover average fixed cost (AFC)& a net profit margin (NPM). Thus AVC (m) = AFC + NPM The procedure for arriving at AVC & price fixation may be summarised as follows: First step is to estimate the average variable cost. For this, the firm has to ascertain the volume of it’s output for a given period of, time usually one accounting year. To ascertain the out put, the firm uses its figure of planed budgeted out put or takes into account it’s normal level of production. The next step is to compute the total variable cost (TVC) of the standard out put. The TVC includes direct cost i.e. cost of labor and raw materials and other variable costs. This cost added together give the total variable cost. The average variable cost AVC is then obtained by dividing the total variable cost TVC by the standard out put QS i.e. AVC = TVC/QS. After AVC is obtained a mark so some % of AVC is added to, it for profit and the price is fixed.
Limitations – 1 it assumes that firm’s resources are optimally allotted and the standard cost of production is comparable with the average of the industry. In reality it is not so.2 historical cost is used rather than current cost data it led under pricing.3 Variable cost fluctuates frequently and significantly.4 It ignores demand side of the market.
MULTI PRODUCT PRICING – Price theory is based on assumption that a firm produces a single homogeneous product. In actual, all firms have more than one product. Even most specialisd firms produce a commodity in multiple models. Ex. Radio, TV. , Car, fridge. Models produced by the same company may be treated as different products for at least pricing purpose. Each model or product has different AR & MR curves and that one firm compete against the firm. The pricing under these conditions is known as multi product pricing or product line pricing.
MAJOR PROBLEM – Each product has separate demand curve and they have one inseparable marginal cost curve. Therefore, marginal rule of pricing cannot apply. The solution is third degree price discrimination. As a discriminating monopoly tries to maximise its revenue in all its markets so does a multiproduct firm from each of its product.
Suppose A firms has four different products A, B, C, D in its line of production. The AR = MR curves for the four goods are shown in four segments. The marginal cost for all the products taken together is shown by MC curve. Let us suppose that when the MRs for individual producers is horizontally summed up, the aggregate MR (not given in figure) passes through point C on MC curve. If a line parallel to x axis is drawn from point C to Y axis through the MRs, the intersecting points will show the points where MC &MR are equal for each product as shown by line EMR, the equal marginal revenue line
CHAPTER - IX PRICING IN LIFE CYCLE OF A PRODUCT Life cycle five stages 1 Introduction or initial stage 2 Growth 3 Maturity 4 Saturation 5 Decline
1 Introduction –to the customer through advertisement. Trial of the product. Sale constant.2 Growth – After successful trial. Product gain popularity. Sale increasing at increasing rate. Result of cumulative advertisement.3 Maturity –sale continue to increase at lower rate and eventually become constant.4 Saturation- sales do not saturate nor increase nor decrease becomes constant. After the saturation decline stage comes.5 Decline – A decline trend for such reasons as (I) increase in the availability of substitutes (ii) the loss of distinctiveness of the product.
PRICING OF A NEW PRODUCT – A new product be either simply another brand have added to the existing once or an altogether new product. Pricing a new product for which many substitutes exist in the market is not a big problem as pricing a new product for which close substitute is not available. We confine here pricing strategy for new product. Two kinds of strategies 1 Skimming price policy 2 Penetration price policy.1 SKIMMING PRICE POLICY- it is intended to skim the cream of market i.e. Consumer’s surplus, by setting a high initial price; three or four times the ex. Factory price and subsequent lowering of price in series of reduction. Initial high price would be accompanied by heavy sales promoting expenditure. This policy succeeds for the following reasons:
1 Demand is relative inelastic because of consumers desire for distinctiveness by the consumption of a new product.
2 cross elasticity is very low for lack of a closer substitute
3 Step by step price cuts help skimming consumer’s surplus available at lower segments of demand curve
4 Initial advertisement elasticity is considerably high
5 High initial prices help in recouping the developmental cost. Post skimming strategy – Appropriate occasion for price reduction is the time of saturation of
the top-level demand or when a strong competition is apprehended.
2 PENETRATION PRICE POLICY: is adopted generally in case of new products for which substitute are available. Fixes a lower initial price designed to penetrate the market as quickly as possible and is intended to maximise profit in the long run. The success of policy requires the existence of following conditions: 1 Short runs demand for the product has an elasticity greater than unity. It helps in capturing the market at lower prices.2 Economies of large scale of firm production available.3 Potential market for the products large and has a good deals of future products4 Product should have high cost elasticity in relation to rival products. 5 the product by nature should be such that it can be easily accepted and adopted but the consumers.
PRICING IN MATURITY PERIOD: Second stage in life cycle of a product, It is between growth period and decline period .It may be define as the period of decline in growth rate of sales and the period of zero growth rate. The concept of maturity period is useful to the extent it gives out signals for taking precautions in regard to price policy. First step reduce price second product improvement and market segment.
PRICING A PRODUCT IN DECLINE- In this stage, the total sale of the product starts declining. First step – reduce price. The total should be reformulated and remodeled to suit consumer’s preference. Advertisement expenditure may be reduced or withdrawn completely and rely on residual market.
PRICING IN RELATION TO ESTABLISH PRODUCTS- new products are not very frequent. Most producers enter in the market with a new brand of commodity for with a number of substitute available. They face the problem of pricing his product because of strong competition with established products. In pricing a product in relation to its well-established substitutes, generally three types of pricing strategies are adopted.
1 PRICING BELOW THE MARKET PRICE- is generally preferred in two conditions. First – if a firm wants to expend its product mix with a view to utilize its unused capacity in face of tough competition with the established brand. Brand loyalty should be over weight by some incentive. Secondly, this technique has been found to be more successful in case of innovative products.
2 PRICING AT MARKET PRICE – To be most reasonable pricing strategy. Product can be sold in any quantity at the existing market rate. This strategy is adopted also when the seller is not a price leader but a price taker.
3 PRICING ABOVE THE EXISTING MARKET PRICE – This strategy is adopted when a seller intends to achieve a prestigious position among the sellers in the locality. Prestigious goods. Consumers of such goods prefer shopping in a gorgeous shop of a posh locality of the city. This is known as Veblen effect. After the seller achieves the distinction of selling high quality products, though at a high price, they may sell even the ordinary goods at a price much higher than the market price.
Transfer Pricing - The parent division buys the product of its subsidiaries such firms face the problem of determining an appropriate price for the product transferred from one division to other. This problem becomes more difficult when each division has a separate profit function to maximise. Pricing of intra, firm “transfer product” is referred to as transfer pricing.
TECHNIQUE OF TRANSFER PRICING – Let us suppose that a refrigeration company established a decade ago used to produce and sell refrigerators fitted with compressors bought from a compressor manufacturing company. Now the refrigeration company decided to set up it is subsidiary to manufacture compressors. Let us also assume ( I ) both parent and subsidiary companies have their own profit functions to maximise ( 2 ) refrigeration company sells it’s product in a competitive market and it’s demand is given by a straight horizontal line. & ( iii ) the refrigeration company uses all the copressors produced by its subsidiary. In addition, we assume that there is no external market for compressors.
TRANSFER PRICING WITHOUT EXTERNAL MARKET – MCt & MCb combined vertically gives common MCt for e.g. at out OQ, TQ+MQ = PQ.The MCt intersect line Arr = MRr at point P, An ordinate draw from P to Q determines most profitable out put of both refrigerator body & compressors each at OQ.
For price of compressors we have to assess MC & MR. The MC for the compressor is MCc. Therefore firm has to obtain marginal revenue MRc that can be obtained by subtracting non-compressor mc of the final goods from MRr. Thus MRc = MRr – (MCt – MCc) For e.g. at out put OQ, Mrt = PQ1 Mct = PQ by substituting these values in equation MRc = PQ- (PQ-MQ) = MQ since in figure. OQ-MQ =PM &PM = TQ therefore MRc = PQ –TQ = PT and PT = MQ at point P, MRc = MCc thus the price of compressor is determined at PQ.
TRANSFER PRICING WITH EXTERNAL CMPETITIVE MARKETNow assume that there is external market for compressors and market is competitive. Therefore, demand curve is P2D. Note that in absence of external market, the transfer price of compressor would have been fixed at OP1 =P’Q2 but compressor sold in competitive market the market price of compressor i.e. OP2 instead of OP1 where MRc = MCc besides the price OP2 is also the potential MR for the compressor division. Therefore, in maximise the profit compressor price will be set at point P where MRc is greater than MCc. Thus, price will be fixed at PQ1 and the Refrigerator Company would buy OQ1. The total output is determined at a level where MCc intersects the demand line D at point R so Q1Q3 sold in external market.
TRANSFER PRICING UNDER IMPERFECT EXTERNAL MARKET:Let us suppose(I) Average and marginal revenue curves for the compressors are given by Arx & MRx(ii) That the marginal net revenue from the internal use of compressors are represented by MRc & MCc with a view to maximising over all profits the refrigeration company will determine the out put of compressors where MCc = MRc + Mrx i.e. MCc intersects MRt at point P which determines output OQ3. Copressor division can maximise it ‘s profit by dividing it’s out put between the refrigeration company and the external market so as to equalise it’s MC & MR in both the markets. Draw a line PP1 determine shares, parent body share OQ1 and external market OQ2. Not that OQ1 + OQ2 = OQ3. Transfer price is set OP1.
QS1) What are the main problems come in fixing a price of an established product?2) What is the problem in transfer pricing? (class discussion)
COMPETITIVE BIDDING OR CONTRACT PRICINGA kind of price in which a firm is required to quote it’s price under uncertain cost and price conditions with a view to winning a contract or tender. The foremost problem is to quote a supply price, which can win the contract without unduly reducing the profit margin. Price should be lower than rivals should.
PEAK LOAD PRICINGElectricity & Telephone, demand varies in day & night, consumption of electricity reaches its peak in daytime, Peak load time. In night peak off time and reduce consumption. Unique and technical features of such product are that it cannot be stored. Production has to increase in peak load time and reduce in peak off time. Besides, given the installed capacity, their production can be increased but at an increasing marginal cost.
PROBLEMS IN PRICINGPricing of goods as if electricity is problematic. Short run setting in fig. DP – peak load demand curve DL – off load demand curve, short run marginal cost curve is SMC. P3 Peak load price change. It is unfair consumer will be charged for what they do not consume. Govt. will face public opposition. P1 off load if charged production will fall to OQ2 and there will be acute shortage of power. If P2 is charged it will have demerits of both peak load and off load and extent of AB excess production will go waste, during peak load shortage to extent BC which can be produced only at an extra marginal cost of CD.
DOUBLE PRICING SYSTEMFor the above reason generally a double pricing, system is adopted. A higher price P3 during peak load and P1 during off load. Production also gets increase and decrease.
ADVANTAGESPeak load pricing has two advantages-1-Day business pay higher rates 2 Billing system is greatest problem; consumer has to install two meters, which increase theft.
CHAPTER - X BREAKEVEN ANALYSIS Break Even Analysis also known as profit contribution analysis important analytical techniques used to study the relationship between total cost, total revenue & total profit & losses own the whole range of stipulated output.Breakeven point - Linear cost & revenue functionsE.g. Let us assume Fixed cost = Rs. 100 and its variable cost varies at a constant rate of Rs. 10 per unit in response to increase output. We assume a short run linier cost function of the form TC = 100 + 10 QLet us also assume that price for the firm’s product is given in market at Rs. 15 i.e. we assume a linier revenue function of the form TR = 15 Q The firm now needs for breakeven analysis of its business operations is to make a chart of its total fixed cost, total variable cost, total cost, and the total revenue and graph them to find out breakeven point B. Line TR shows the total revenue Q X P. Line TR intersect the TC at B where output Q = 20. Below B TC is higher than TR i.e. loss ahead TC is lower than TR i.e. profit. Algebraically calculation: We know that at breakeven point TR = TC That is, in terms of TR & TC function 15Q = 100 + 10 Q 5Q = 100 Q = 20
LIMITATIONS
Under the condition of linear cost and revenue function, Tc & TR are straight lines and intersect each other only at a point dividing whole range of out put in two parts – profitable and non profitable. It may not be true due to changing price and cost conditions. In reality, the cost and revenues functions may be nonlinear so that AVC and price vary with variation in the output. As a result, the total cost may increase at increasing rate while the total revenue increases at a decreasing rate. Therefore, at some stage of output TC may exceed TR Thus there might be two breakeven points. This may limit the profitable range of output and determine the lower and upper limits of profitable output, so analyst should therefore pretest and verify the validity of cost and revenue functions.
BREAKEVEN POINT: NON-LINIEAR COST AND REVENUE FUNCTIONS
TFC line shows the fixed cost at OF and the distance between TC AND TFC measures the total variable cost (TVC). TR curve shows the total sales proceeds or total revenue at different level of output and price. The vertical distance between TR & TC measures the profit or loss for various levels of output. In graph TR & TC intersects at two points B1 & BBBBB2 where TR = TC. These are lower and upper breakeven points. It implies that a firm producing more than OQ1 and less than OQ2 unit will make profit.
PROFIT VOLUME ANALYSIS CHART
The profit line is graphed by computing the profit or loss consisting of the difference between sales revenue and the total cost at each volume. The point where profit line intersects the horizontal axis is the break-even point. This has been shown in graph.
USE OF BREAKEVEN ANALYSIS
(I) Sales volume can be determined to earn a given amount of return on capital.(ii) Profit can be forecast if estimates of revenue and cost are available. (iii) Effect of change in volume of sales, sales price, cost of production can be appraised(iv) Choice of products can be made from the alternatives available(v) Impact of increase or decrease in fixed and variable costs can be high lighted.(vi) Effects of high fixed costs and low variable cost to the total cost can be studied.(vii) Inter firms comparisons of profitability can be made.(viii) It emphasizes the importance of capacity utilization for achieving economy
LIMITATIONS
1 It can be applied to single product system. In joint cost operations, it become difficult, to segregate product wise cost.2 It cannot be useful where cost and price data cannot be ascertain.
CHAPTER - XI National Income
According to Marshall “the labor and capital of a country acting on it’s natural resources produce annually a net aggregate of commodities, material and immaterial including services of all kinds”.
According to Pigou, “ National dividend is that part of the objective income of the community including of course income derived from abroad which can be mwasured in money.
According to Fisher “National income consists solely of services as received by ultimate consumers whether from their material or human environment.
Keynes’s approach to national income- Earlier definitions do not throw light on the factors which determine the level of income and employment at a particular time in an economy. According to him, aggregate income of an economic system lies somewhere between the value of gross national and the net national product. Gross national product refers to the money value of final goods and services at a particular time. Keyne’s take into account depreciation and obsolesce changes to arrive at national income.
Net Income= A-U-V A- Gross National Income U- User cost—depreciation of machines V-Supplementry cost –other type of depreciation
Modern definitions- According to Simon Kuznets “It is the net output of commodities and services flowing during the year from the country’s production system in the hands of the ultimate consumers.
National Income Commission of India- National Income estimate measures the value of commodities and services turned out during a given period counted without depreciation.Different Concepts of National Income-
1. Gross National Product (GNP)- refers to total value of final goods and services produced in the country during the given.
Main Features-
A- does not take into account the depreciation of goods and services B- excludes maternity benefit unemployment, free scholarships, pensions etc.C- includes only those goods and services brought in market for sale and purchaseD-capital gains are excluded ex. Scooter Rs. 20,000 sold at Rs.22, 000 difference will not be included.E- Intermediate goods, which are used for making another goods, are not included.F- measured in monetary terms.
2- Net National Product- NNP = GNP- Depreciation3-Net National Product at Market Price- Gross National Product at Market Price - Capital Consumption Allowances (depreciation charges for renewal of plant wearing out and obsolescence of capital equipment) net money value.
Merits-
A - It stresses the long-term significance of maintaining the productive capacity of the economy
B- Extremely useful in the economic growthC- it clarifies the long run improvement in physical productivity of capitalD- Useful in analysis the net increase in total product.
4- Net National Product at Factor Cost - It is the sum total of income payments made to the factors of production. The sum total of goods and services produced with the cooperation of factors of production at factor cost during one year in a country.
Constituents-
1- Wages salaries and supplementary earnings of employees for their productive services.2- Net rent of all individuals including imputed rent3- Net interest paid to all individuals4- Net profit of all kinds minus5- Transfer payment (pension, maternity benefit etc.)
NNP at Factor Cost = NNP at market price – Indirect taxes (sales, excise) or NNP at factor cost = NNP at market price + subsidy – Indirect taxes.
5- Personal Income- Income received by individuals of a country in a year from all sources.
Personal Income = Net National Income + Transfer payments – Undivided corporate profit – corporate income tax – social security contribution.
6- Disposable Income – Actual income that can be spent on consumption by individuals and families. Income after tax deductions, Person does not spent full income but save a part so,
Disposable income = consumption expenditure + savings
7- Corporate income- Income and profits of companies or public corporation. We deduct the income tax and profit tax, we get corporate income.
8- Percapita Income- Average earning of an individual in a particular year.
Percapita Income = National Income of a country/ population of a country.
9- Private Income – obtained by private individuals from any source whether productive or nonproductive. Private Income = NNP at factor cost + Transfer payments +Interest on public debts – social securities – profits and surpluses of public undertakings.
10-Real Income - is the National income expressed in terms of level of prices of a particular year as base year when the general price level is neither too high nor too low and the price level for that year is assumed to be 100.
11-Domestic Income or Product- refers to the income generated by the factors of production within the country from it’s own resources. It includes wages, salaries, rent, interest, dividend, and undistributed direct taxes.
Relationship between different concepts of National Income-
1- Gross Domestic Product at Market Prices = Consumption of household + Govt.
consumption + Investment Expenditure.
2- Net Domestic Product at factor cost = N.D.P. at Mkt prices – Indirect taxes.
3- Net Domestic Product at Market Prices = G.D.P. at Mkt. Prices – Depreciation
4- National Income = Net National Product at factor cost.
Methods of Measuring National Income –
1- Income method- Adding together net income payments received by the citizens of a country in a particular year. In other words net income that accrue to the factors of production by way of net interest, net profit and net wages etc. are all added together but income received by way of transfer payment are excluded from it.
2- Product Method – or Inventory Method Commodity Service Method. N.I. is the sum total value of all the final goods and services produced during a given period in an economy.
3- Expenditure Method – known as consumption and investment method. In this, we add up personal consumption expenditure, Govt. purchases of goods and services, Net domestic investment and net foreign investment.
NATIONAL INCOME ANALYSIS: techniques of social accounting (S.A.) In the words of Peacock and Cooper, “Social Accounting” is concerned with the statistical classification of the activities of human beings and human institutions in ways, which help us to understand the operation of the economy as a whole. The field of studies summed up by words “Social Accounting” embraces, however not only the classification of economic activity, but also the application of the information thus assembled to the investigation of the operation of the economic system.
System presents a detailed factual record of the performance of various sectors and sub sectors of the economy during a specific period. All the transactions, big or small, that take
place in the economy are duly recorded in this comprehensive system of accounts. It is a method to study the structure of economic system in its entirety.In the s.a. system adopted by the N.I. committee in India, the entire economy has been classified in 3 main sectors – 1 Enterprise 2 Households 3 Govt. Each sector further sub divided in 4 heads 1 Production 2 Consumption 3 Addition to wealth 4 External accounts.
Entire framework of accounting has 12 accounts. Collection of statistical data on expenditure, saving, investment, capital information and depreciation. Private sector not interested in giving data and statistical dept. has own limitations. Manipulate facts and figures. This causes serious imbalances in sectors. U.S.-Dept. of commerce has followed a sect oral classification. Entire economy divided in 5 sectors-1 Personal or household 2 Business sector 3 Govt.4 Rest of the world or International 5 Saving and investment. Balance sheet of each sector.
(I) Personal or Household sector: individual, family, non-profit institutions, charitable organizations and voluntary associations operating on non-profit basis. Balance sheet has two columns- 1 Expenditures and 2 Receipts. The most prominent item of expenditures sector accounts is the consumer purchases of goods and services 70% approx which can be determined by commodity flow method - Producers sell goods to wholesaler- Retailers is in producer prices + margined of wholesaler and retailers + Transportation + storage + local tax. It is possible to determine the value of commodity purchased by the consumer.
(ii) Business sector- In U.S. constituted by corporate and non-corporate business concerns including enterprises owned by Govt. All type of producing units is included in it. This account includes the receipts and expenditure of all businesses units in a country.
(iii) Government sector- is composed of all govt. bodies and their sub divisions, federal, state and local. The main source of receipts is taxes and social security contributions. The govt. expenditure is incurred on the purchases of commodities and services and for making transfer payments. There may be a surplus or deficit on current account, which must also taken in consideration. Expenditure includes salary and wages.
(iv) Rest of the world sector- National income account must include the International transactions related to commodities and factor payments net foreign investment is receipts from transactions. It value may be calculated by net export from the country plus the services rendered to the foreigners and money received by them. From it, value of imports and services hired and money paid are to be deducted.
(v) The savings and Investment sector- Account of the gross saving and invest. is of great strategy importance in an economy.
Morgan has mentioned two important reason for this account –
1. It is important for measuring productivity, maximum total output and for determining the rate of purchase of new buildings, machines and inventories.2 .Its significance rests in the importance of the flow of savings and of investment for analyzing the inflationary or deflationary tendencies in a system
CHAPTER - XII
CLASSICAL THEORY OF EMPLOYMENT
Classical economists used the term full employment to signify a situation in which only all those people who are willing to work at the prevailing wage rate get work. Full employment means absence of involuntary unemployment. Involuntary unemployment means a worker is ready to work at exiting rate but does not get work.
According to classical economist, following kinds of unemployment could be possible-1. Voluntary unemployment – Existing level of wages unacceptable to labor.2. .Frictional unemployment – Due to shortage of raw material/ special skilled job.3. Seasonal unemployment – Ice business in winter.4. Structural unemployment – changes in country’s export trade. 5. Technical unemployment – change in technique of production.
Assumptions –
1. Full employment 2. Perfect competition 3. Laissez faire (no interference of Govt. in economy)4. Closed economy (no effect of foreign trade on economy 5. Techniques of production remain unchanged in short period) 6. Money medium of exchange (limited role of money) 7. Rationality (man is rational)8. Efficiency (use of resources, no wastage) 9. Equality between savings and investment 10.Production is subject to law of diminishing marginal returns.
Determination of output and employment - Classical economists opined that in an economy output and employment are determined by production function and the equilibrium of demand and supply.
Production function expresses the financial relation between input and output.
Q = F (N, L, K, T,) In the short period capital (K), land (L), Technique of production (T), Therefore volume of production (Q), depends on the level of employment L i.e. = F (L). F- Factor Y
P2P1 sP
OUTPUT
OL L1 L2
Level of employment
In diagram curve so is output curve. It denotes the relation between employment and output. It is obvious from this curve that as the level of employment increases output too is increases. Dig. Shows that increase in the proportion of output is less than the increase in the proportion of employment.
In an economy, level of employment is determined by the equilibrium of demand and supply of labor. IN the classical system the demand for labor (ND) is assumed to be a function of the real wage i.e. the purchasing power of a given money wage (W/P) as: ND = F (W/P) like demand for labor, supply of labor (NS) is also a function of real wage rate. Supply has positive relationship with real wages as NS = F (W/P) if supply of labor and price rise proportionately; It indicates no relation to money wages.
Determination of output and employment according to classical theory:
Out Put K
S
O
Wages
Employment
OS curve denotes production function. In B diag. ss is the supply curve of labor and DD is demand curve. Both cut each other at E equilibrium. In equilibrium OL get employment at OW wage rate. Thus, there will be no involuntary unemployment. If some labor is still unemployed, they will be called voluntary unemployed and are not ready to work at existing wage rate. Therefore, classical economist held the views that equilibrium position would always be in full employment situation. According to classical economist if a situation of disequilibria arises in the economy, then wage rate, prices and rate of interest would change in such a way that equilibrium situation is reestablished.
D
D
E
S
SW
L
Flexibility of wages: At equilibrium E wage rate is w and employment is N, If wage increase w1 than less number of labors ON1 and rate of supply is ON2. Labor will agree to work on fewer wages so this force to come down on W at equilibrium. If wage falls OW2 then supply of labor will be ON1 and it’s demand will be ON2. Real wage = Money wage/price
Wages
O N1 N N2 Employment
Flexibility of Rate of interest – At equilibrium E rate of interest is R at this saving = investment. If the rate of interest increase to OR1 than supply will be more and demand, will less. It will decrease the rate of interest. If rate of interest decrease OR2 then demand of capital is more and supply is less.
Rate Of Interest
I > S = Saving/Investment
Flexibility of price level- Aggregate demand (MV) = Aggregate supply (PT) M - supply of money P – Price level V – Velocity of circulation of money T - goods traded, if V and T remain constant then there will be direct relation between price level & supply of money as P =F (M) This equation is called quantity theory of money. Money market equilibrium at MV=PT
S
D
D
S
EW1WW2
D
D
S
R1RR2
S
E
If unemployment is there in an economy money wage rate will fall. Result more employment, Production & supply. Price falls is less than money waging therefore real wage to fall.
Criticism of Classical Theory of Employment – According to Keynes the classical theory of employment is perfectly logical and proves it’s points provided the assumptions are strictly adhere to but in reality the assumptions are perfectly unrealistic in practical working of economy. Hence, the criticism is levied against the basic assumptions as below –
1. Full employment – According to Keynes some unemployment always exit in an economy. Full employment equilibrium as exceptions. He says under employment situation is normal.
2. Rejection of say’s law- Supply creates it is own demand. Keynes says there is always a disequlibrium (constant) between demand and supply.
3. Wages cut and unemployment – Keynes says that unemployment is due to wage rigidity and that flexible wage rates will lead to full employment.4. Emphasis on macro economic study – Classical says that unemployment is temporary phenomenon. Keynes says that it is serious problem and it is too risky to call it temporary. He emphasized to look at macro level & evolve a forceful policy of the trade cycles to solve this problem.
5. Money acts as a store value – Classical says money plays no role. Keynes says money as an active factor, which acts as a store of value.
6. Classical Economics ignores short period problems – They focus long run equilibrium, Keynes stress on short period problems. He says in long run all shall die.
7. Savings & investments are interest inelastic: Keynes pointed out that savings are income elastic. According to Keynes, equality between saving and investment is brought about through the changes in level of incomes.
8. Necessity of state of intervention –Keynes did not agree with the classical that interventions are a stumbling block in the working of the economy. Keynes suggests that Govt. intervention is must to tackle the problems of depression and inflation in the economy.
9. No Automatic Adjustment – Classical says that economy has its inherent power to bring a state of full employment. Keynes says system need out side intervention for achieving a state of full employment.
10. Lacks Empirical facts – Capitalist economies are ordinarily subjects to the problem of inflation, unemployment, Trade cycles etc.
QS1) How full employment can be achieved in our country from classical economists point of
view?2) What factor you would like to suggest in our economy for employment generation?
CHAPTER - XIII
KEYNES THEORY OF EMPLOMENT
Great depression of 1930’s leads to high unemployment. It was only Keynes who concluded that main cause of this unemployment was the shortage of aggregate demand and suggested that if aggregate demand is increased, unemployment absolutely can removed. Aggregate demand is of two types – the demand for consumption goods and demand for investment goods in the short period consumption remain constant and the aggregate demand can be increased by increasing investment. Keynes was also in favor of Govt. intervention, which can remove unemployment.
3.Perfect Competition – Prices get affected by demand and supply only.
4. Diminishing Marginal Productivity of factors – It diminishes as quantity increased. Keynes also assumed that under perfect competition marginal productivity of labor are always equals to its wage rate.
5. Money IlLusion – Workers are under impression tar real wages will increase in same ratio as the increase in money wages.
6. Money acts as a store of value – Since money can be stored, it is essential that people will spend the whole for their money income.
7. Labor acts as a variable factor – Keynes assumed that the only size of labor affects the size of production in short run.
8. Under employment equilibrium – Keynes assumed that capitalist economics is subject to boom and depression under laissez-fair policy so there always exists some unemployment. Full employment a special case.
9. Saving and Investment functions – Keynes assumed that savings are income elastic and investment is interest elastic.
10. Limited role of Govt. – Keynes principles is based on the assumption that aggregate demand is affected by consumption expenditure and investment expenditure has hardly an effect of Govt. influence of it.
11. Role of Interest – A monetary phenomenon, Keynes believed that rate of interest is determined by the monetary factors. Demand for money is revealed in liquidity preference and the liquidity preference is for transactions, precautionary and speculative motives.
12. Current consumption: depends upon current income with out any time leg.
KEYNES THEORY – according to Keynes theory of employment, in the short run the total production and National income of a capitalistic economy depends on the level of employment. The level of employment depends on effective demand. Effective demand is that level of aggregate demand at which it is equal to aggregate supply. So effective demand is essence of Keynes theory. According to his theory, the level of employment is determined by the aggregate demand and aggregate supply. The level of employment increases as effective demand increases and vice versa.
Keynesian theory of employment, Total output = National Income and National Income depends on the level of employment. Y = F (N) Employment depends on effective demand N = F (ED) Effective demand depends on aggregate demand and aggregate supply.
EFFECTIVE DEMAND
Further, aggregate demand depends on consumption and investment.
AD = C + IAs the consumption increases, total income also increases. It depend on following two –
1. Propensity to consume – It refers to the proportion of consumption expenditure on different level of incomes.
Average propensity to consume APC = C/Y C = consumption Y = National Income, Marginal propensity to consume MPC = change in consumption/ change in National Income
2. Size of National Income – According to Keynes C= F (Y) as the income increases, consumption also increases, but less than income as a result National Income increases.
Investment – It refers to that expenditure which leads to addition in the total stock of capital assists. It is important constitution of aggregate demand. Investment depends on two factors 1 rate of interest 2 marginal efficiency of capital.
1. Rate of Interest – According to Keynes; investment increases with fall in rate of interest and decrease with rise of rate of interests. Rate of interest is determined by demand for and supply of money. Demand for money is as above chart.2. Marginal efficiency of capital – means rate of profit. MEC is the addition made to the total profit by applying one more unit of capital assets. MEC depends on (a) Prospective yield – the amount of profit expected per unit of capital per aunum is called prospective yield.
(b) Supply price – Supply price refers to that price of a machine, which is paid for a similar new machine. An entrepreneur compares rate of interest with MEC, if MEC is more than the rate of interest he will invest to earn more profit.
Determination of Employment Table
Employment (laces)
Aggregate supply
(Crows)
Aggregate demand (crors)
Trend in Employment
0 0 120 Increase10 100 200 - Do -20 200 280 - Do -30 300 360 - Do -40 400 440 - Do -50 500 520 - do -60 600 600 Equilibrium70 700 680 Full80 800 760 -do -90 900 840 -do -100 1000 920 -do -
Table Explain That
1. When the level of employment is zero then AD. Is 120 cr, AS =0
2. Employment increases unto 50 lac there is increase in AD. And AS. ,AD. is greater than AS. Producer will continue to produce more.
3. When 60 laces persons get employed AD = AS. Equilibrium point level of employment determined.
4. After 60 laces persons as more and more persons are employed. AD fall short than AS.
ACHIEVEMENT OF FULL EMPLOYMENT – It is clear from analysis that in an economy equilibrium possible with the existence of unemployment. It is termed as under employment. If in short, run investment increase AD. Curve will shift upward and cross supply curve at point F. know as full employment. Further investment push AD above F. knows as over full employment.
DETERMINATION OF INCOME AND OUTPUT - According to Keynes Income and out put depends on the level of employment. Income & out put depends on the level of employment . Income and output can be determined with the help of following equation:
Y= C+ I Y=Income C = Consumption I= Investment C=Co +By Co = Autonomous Consumption b= Marginal propensity to consumeI= I = Autonomous Investment Y=Co +By +I
E
AS
ADF
600
600
TABLE
Income Consumption Saving Investment Aggregate demand
When income is zero still consumption is there at point F saving = investment, Equilibrium point is E where AS =AD. Equilibrium income is Q.
Criticism of Keynes Theory –
1 Ignored the importance of long run2 static in character 3 lack generality 4 closed economy5 perfect competitions is not a reality6 wage unit, as a measure of employment is unscientific7 lacks practicability 8 ignores cost push inflation9 ignores acceleration effect10 depression economics11 over aggregate and less analytical economics
QS1) What are the applications of Keynes theory in our economy? Present your views in
class.2) How mpc can be increased in our country? Present your views.
CHAPTER - XIV
RELATIVE INCOME HYPOTHESIS (J.Duesenberry)He states that
1) Every individual consumption behavior is not independent but interdependent of the behavior of every other individual and2) That consumption relations are irreversible and not reversible in time.Consumers has the tendency is to strive constantly toward a higher consumption level and to emulate the consumption pattern of one’s rich neighbors and associates. Thus, consumer preferences are independent. A rich person has lower APC (consumption income ratio) because he spends a lower portion of income to maintain but a poor have higher APC because he is to keep up standard of neighbour. This provides constancy of long run APC because lower and higher APC would balance out in aggregate. If absolute size of incomes in a country increases, the APC for economy as a whole at the higher level of income would be constant.The second part is “Past peak of Income” states that during a period of prosperity consumption will increase and attain gradually a level or standard is attained. People become accustomed to this standard they will not reduce their consumption in recession. Dussenbery combined his two hypothesis related in the following form: Ct/ Yt = a-b Yt/ Yo C - consumption Y – income t - current period o - previous peak period a is constant relating to positive autonomous consumption b - consumption function CL– long run consumption function Cs & Cs2 – short run consumption function.
C2 E2 CS2
C1 E1
E0
Y0 Y1 Y2
Suppose peak level income is OY1 where E1Y1 is consumption. Now income falls to Oyo they will not reduce to Oyo but slight reduction and less savings, they will maintainC1Yo level of consumption. Period of recovery starts. Consumers will reach on E1Y1 and restore their previous level of saving. If income increase up to Y2 level. Consumer will move
CL
CS1
Consumption
Income
upward with CL and reaching at E2. If income falls back from E2 to E1 to C2. This is known as ratchet effect.
CRITICISM
1. Proportional increase in income and consumption hypothesis is wrong they differ.
2. This hypothesis assumes relation between consumption and income to be direct but this has not been born out experience. Recessions do not always lead to decline in consumption, as was the case during the recessions of 1948-49 & 1974-75.
3. Theory based on assumption that the distribution of income remains unchanged with the change in the aggregate level of income. If with increase in income, a redistribution occurs towards greater equality, between rich and poor then consumption function will not shift to Cs1 to Cs2.
4. Consumers behavior change over a time and slowly reversible.
5. Theory is related to previous peak income. Neglect other factors e.g. Age, urbanization, asset holdings etc.
6. Poor copy rich neighbors, it is not always true.
PERMANENT INCOME HYPOTHESIS (FRIEDMAN)
He rejects the use of current income as the determinant of consumption expenditure and instead divides both consumption and income into permanent and transitory components so that Y=Yp + Yt, P= permanent and t = transitory Y = Income c - consumption
Permanent income is defined as “the amount a consumer unit could consume while maintaining its wealth intact. Y income will depend directly on Yt – Transitory Income. If wind fall gain in Yt then y > Yp if loss due to theft y <Yp.
Permanent consumption is defined as the value of the services that it is planned to consume during the period in question. Measured consumption divided in Cp & Ct.So measured consumption directly depends on Ct i.e. positive, negative or zero.
ASSUMPTIONS-
1. There is no correlation between Yp & Yt.2. There is no correlation between Cp & Ct.2. No relation between Ct & Yt.
4. Only differences in permanent income affect consumption systematically.
Proportional
E2
E3 E0
E4
O Y3 Y4 Y0 Y2 Y1 Income
In diag. CL is long run consumption function. Cs is non-proportional short run consumption function. At Oyo CS =CL at Eo changes in permanent income and measured income are identical. Here transitory factors are non-existent andPy=1. If we move E3 from Eo then measured income declines to OY3 due to heavy losses, since permanent income is OY4 is higher than OY3, permanent consumption will remain at OC3 (=Y4E4). It moves Eo toE1 on Cs income is OY1and consumption is OC2. Permanent consumption level will be maintained at E2 at income level Y2. OY1 is windfall due to profit.
CRITICISM –
1. Fried’sman assumption of no correlation between transitory consumption and income is wrong.
2. Consumption income ratio (APC) is same for rich and poor in long run is wrong.
3. Used of permanent, transitory and measured create confusion.
4. Permanent incomes do not make difference between human and non-human wealth.
CL
Non- Proportional
CS
E1C0
C3
C2
CHAPTER - XV CHANGE IN AGGREGATE DEMAND AND MULTIPLIER
Aggregate Demand may increase in either aggregate demand for consuming goods(C) or (I) aggregate demand for capital goods or both. Let us assume the agg. DemandIncrease due to increase in capital goods (I). The increase in investment I may be result by a firm and Govt. Let us suppose that the aggregate demand increased from C+ I to C+I+ I, When agg. Demand increase, National Income increase in some multiple of I due to multiplier. The numerical value of a multiple is known as multiplier. Thus multiplier is a number which multiplied by the addition investment I gives the additional increase in national income. If m is multiplier then Y = I x m and m = Y/I.The multiple increases in National Income as a result of I depend on the mpc. When I take place, it generates income Y will lead to increase in consumption C depending on mpc. If mpc = b then C = bY. Those who supply goods & services to the tune of C, earn an income equal to bY in the second period. They would consume b times bY their consumption = b2 Y. this process continues until Y = .0 in this process a series of new incomes are generated leading to increase in National Income. The whole series of new incomes Ys over n period may be summarized as follows: Y = Y +bY+b2Y +b3Y----------+b n-1Y = Y (1/ 1-B)Once change y calculated multiplier could be obtained as M = Y/IThe whole process is known as dynamic multiplier.
ASSUMPTIONS
1 I am one injection investment.2 It remains constant.3 Economic systems is closed one.4 There is autonomous investment in economy.5 There is excess capacity in economy and out put is responsive to changes in aggregate demand. 6 There is no time lag between receipt of income and its disposal in form of consumption. Given an investment multiplier 6, invest worth Rs.50 cores will raise income by Rs.300 cores without any time lag between investment and income. Y = M X I = 6 X 50 = 300 coresThe investment multiplier m can be derived from Keynes psychological law of consumption. The basic proposition of this law is that marginal propensity to consume is less than unity.
USES OF MULTIPLIER
It is an important tool of analyzing growth, planning and projecting the investment requirement of an economy given the growth objective.
LIMITATIONS
1) Formula m= 1/ 1 (1-MPC) implies that higher the mpc the higher is multiplier. It means that the less developed countries with higher mpc would grow at a much higher rate than the developed countries having low mpc but this is not true. It means actual multiplier does not depend on mpc alone but other factor also.2) A chain of investment through consumption is not true. People may purchase assets, pay loan back, purchase shares. These are called leakages in consumption flow, which reduce the rate of multiplier. The money thus keeps circulating but does not generate the demand for new consumers. In this case multiplier will be 1. Other leakages holding idle cash, deposits in foreign bank etc.3) Assumption that goods and services are available may not be true.4) Under the condition of full employment, the theory of multiplier does not work because goods and services cannot be produced in excess of their full employment level.
THE BALANCED BUDGET MULTIPLIERWhen Govt. expenditure G = T – taxes, both are simultaneously change, the Govt. budget is said to be balance. The effect of balanced budget on the national income is analysed by balanced budget theorem states that the balanced budget multiplier is always equal to one. That is why the balanced budget theorem is also called unit multiple theorem. The proof the theorem can be provided as follows- Y = 1/1-b (a – Bt + I + G)----------------- (1) B = mpc a = constant T = Tax I = Investment G = Govt. Expenditure, by incorporating G and T (while both equal) and resulting combined change in income Y can be expressed as Y + Y = 1/ 1-b [a-b (T +T) + I + G + G]--------------- (2)By subtracting equation (1) from equation (2) we get Y = 1/ 1-B (-b T + G) Since T = G we can write as Y = 1/1-b (- b G +G) By multiplying both side by 1-b we get T (1-B) = -b G + G OR Y (1-b) = G (1-b) OR Y = G We can obtain balanced budget multiplier ( Bm ) by dividing both sides of equation by G that is Bm = y/g
= G/G = 1
Operation of Acceleration :Due to operation of multiplier, increase in income leads to increase in demand. If there is lack of surplus production capacity in economy, then investment will have to be increased to meet the increase in demand caused by rise in income. Increase in investment will depend on the technique of production. Technique of production will determine capital output ratio or accelerator. Therefore, accelerator analysis shows a change in net investment or capital due to change in income. It depends on technological factors. Symbolically W = K/ Y = 1/YW –accelerator, K – change in capital stock or net investment ( I ), Y – changes in income. Accelerator is related to induced investment. Above account reveals that
K W K I Y C I Y.
Super multiplier
Multiplier and Accelerator influenced each other and help in the increase in income. Their mixed influence can be understood with the help of the following formula:Given Y = C + IY = C + I -------------------- (1 )C = Ca + c y ---------------- ( 2 )I = Ia + d Y ---------------- ( 3 )putting value of ( 2 ) & ( 3 ) in ( 1 ) we getY = Ca + c y + Ia + d Yy – c y – d Y = Ca + Iay ( I-C-D ) = Ca + Iaor Y = 1/ I-C-D ( Ca + Ia )or Y/ Ca + Ia = 1/ I-C-D - SUPER MULTIPLIERY = change in income, C = change in consumption, I = change in investment, c = marginal propensity to consume, d = marginal propensity to invest, Ia = autonomous investment, Ca = autonomous consumption. Thus it is clear from above that when change in income due to change in investment and change in investment due to change in income take place in the economy the multiplier that comes into being due to mixed effect of multiplier and accelerator, is called super multiplier by Hicks. Its value will be more than that of an ordinary multiplier.
In diagram, OS is aggregate supply curve and MD is aggregate demand curve. Both curve intersects each other at point E. so oy is the equilibrium income. If induced investment increases aggregate demand curve MD shifts to MN and this curve is also start from M and gap widens in both demand curve. It indicates that with increase in income demand is increasing. Consequently new equilibrium is achieved at E1 and equilibrium income OY2. This increase in income due to super multiplier. Contrary to this if autonomous investment increased only, the new demand curve would have started from point P to become PR and equilibrium at a and new income oy1, income due to multiplier alone will beYY1 and with mixed effect of accelerator YY2 which is high.
CHAPTER - XVI
PHASES OF ECONOMIC CYCLEPeriodic booms and slumps in economic activityUps and downs in economy reflected by fluctuations in production, investment, employment, prices, wages, bank credits etc.Upward and downward movement in these magnitudes shows different phases of business cycles. Basically only two phases Prosperity and Depression.
VARIOUS PHASES OF A TRADE CYCLE
1 Expansion of economic activities2 Prosperity or peak of boom3 Recession the downtrend4 Trough, the bottom of depression 5 Recovery and expansionProsperityExpansion or peak
Rise in National income, consumer and capital expenditures in the prices of raw materials and finished goods, and rise in level of employment. Inventories of both input and output grow. Debtors find it more convenient to pay off their debts. Bank advances grow rapidly even though bank rate increases. Idle funds find productive investment. Stock prices increases due to increase in profitability and dividend. So long condition permit. Expansion continues following multiplier process.
In later stage of prosperity- inputs falls short- labor shortage- wage high- high cost of production-price increase and over take increase in output and employment. Cost of living increased at a rate relatively higher than the increase in household’s incomes. Consumers and wage people review their consumption pattern. Consumer’s resistance gets momentum. Actual demand stagnant or decrease. First impact falls for demand for new houses .Subsequently demand falls for cement, iron, construction labor, consequently appear in other durable goods. This marks reaching the peak.
TURNING POINT AND RECESSION
At peak demand halt than decrease in some sector. On the other hand businessman continue to invest and production. Supply increase and demand decrease by unnoticed. Producers sudden relies that their inventories are piling up. Realise over investment and over production. Cancel all investment and orders of input for production reduction. Start decline chain known as turning point and beginning of recession. Since demand for input decrease leads decrease in income and interest. Earners demand recess. Producers reduce price to get rid of inventories. Consumers wait for further cut. Result discrepancy between demand and supply continues to grow. Reduce further in income and consumption which reversible multiplier effect. Process is exactly reverse of expansion. Investment curtailed. Production and employment decline. Decline further in demand of consumer goods and capital goods. Borrowing for investment decrease, bank credit shrinks, share prices decrease, unemployment increase. At this stage, the process of recession is completed and economy enters in period of depression.
DEPRESSION AND TROUGH
Economic activities slide down their normal level. Growth rate become negative. Decline in National income and expenditure, Prices of consumer and capital goods, unemployment increase. Debtors find difficult to pay off their debts. Bank credit becomes low increase in cash. Investment in stock becomes least profitable. At the depth of depression all economic activities touch the bottom and the phase of trough is reached. Even the expenditure on maintenance is defer. Weaker firms eliminate from industries. At this point the process of depression is complete. Price decrease halt.
How is the process is reversed Price decrease halt. Producers become optimistic offer job to unemployed labor at lower job wages. Consumer also resumes that old consumption pattern which was postponed for reduction in price. Hence, demand pickup gradually. Producers note that prices of inputs decline greater than prices of finished goods. So they also investor cautiously and slowly to generate stocks. Due to increase in income and consumption the process of multiplier further accelerate and phase of recovery gets underway.
THE RECOVERYGet momentum firms plans additional investment, some undertake renovation programmes and some undertake both. These activities generate construction activities. Individual also observe least construction cost start their plan for construction. Leads to increase in employment. Wage rate also start increasing consumption also increase. At this business start expansions for higher profit. A number of related developments begin to take place. Economy enters in phase of expansion and prosperity. Cycle gets completed.
1)The pure monetary theoryThe main cause of business fluctuations is the unstable monetary and credit system. Fluctuations in supply of money and bank credit are the basic casual factor at work in cyclical process. Hawtrey state that main proponent of business cycle is successive phases of inflation and deflation. All changes in the levels of Economic activity are only reflections of changes of money flows. money supply expands price rise, profit increase, and total output increase. Money supply falls prices decrease, profit decrease, production falls. The principal factor affecting the money supply is the credit mechanism.
2) THE MONETORY OVER INVESTMENT THEORY
focus the role of imbalance between the desired and actual investment in economic fluctuations. Hayek stated that to keep economy in equilibrium, investment pattern must correspond to the pattern of consumption and for economic equilibrium, it is necessary that voluntary savings are equal to actual investment. Total investment so distributed among industries that each industry supplies equal to demand of consumer. Economic stability gets upset due to supply of money and saving investment relations. Investment may increase due to marginal efficiency, low rate of interest , optimism of Businessman for future prospects.
Critical Evaluation :a) Theory presumes that when market rate of interest is lower than the natural rate, the
new bank credit flows to the capital good industries. This would be true only under the condition of full employment but business cycles have taken place even when resources were not fully employed.
b) It focuses on rate of interest only. It ignores businessman own expectations.c) Theory lays undue emphasis on imbalance between the investment in capital goods
and consumer goods industries. In modern economy such imbalances are self-correcting and do not create depressions.
3) Schumpeter’s theory of Innovation- emphasis’s innovations in business as the main cause of increase in investment and business fluctuations. Model has two stages-(1) First approximation- Model starts with economic system in equilibrium in which no involuntary employment. Each firm has mc=mr and price = average cost. In addition, there is no incentive for additional investment nor disincentive to reduce it. In this condition, firm introduces innovation. Addition finance will be given by bank. Firm will go on bidding higher prices for other inputs with a view to withdraw them from consumers. Due to increase spending in economy, prices begin to rise. This process further accelerated when other firm copies. Innovate and Invest. Product comes in market but firms cannot increase after a point. Prices start decrease and firm’s start pay back loans. This start flow of money leads to contraction in money supply. Prices start decrease. The process of recession begins and continuous until equilibrium is once again restored.(2) Second Approximation- Model analyses the secondary waves that are created by way of first approximation. Main element is speculation. When primary wave expansion begin investors in capital goods expect that upswing is permanent. They borrow heavily. Even consumers anticipating higher price in further go to debt to acquire goods. This heavy indebt
ness causes problem, when prices began to fall. Debtors both investors and consumers find it difficult to meet their obligations. This situation lead to depression. The lower turning point comes when the necessary liquidation has been completed, the debt structure has been brought to order and uneconomic firms are eliminated.
Critical Evaluation A.W.Lee states that this theory is based on sociological rather than economic factors. Difficult to test. This theory differ from investment theory in a way that is variation in investment when economy is in equilibrium. This theory leaves many other factors of fluctuations.
4) Multiplier – Accelerator interaction Theory- Samuelson’s model is regarded as the first step in integrating theory of multiplier and principal of acceleration. His model show how both interact with each other to generate income, to increase consumption and investment demands more than expected and how this cause economic fluctuations.To understand model first distinguish between autonomous and derived investment.Autonomous Investment- undertaken due to exogenous factors such as new inventions in technique of production, production process and of new market.Derived Investment- in capital equipments, which is undertaken due to increase in consumption necessitating new inventions.Interaction Process- when autonomous investment takes place, income rises and process of multiplier begins. Increase in income leads to increase in demand for consumer goods depending on the mpc. If there is no excess production capacity, producers takes new investment. Thus, increase in consumption creates demand for investment (derived investment). This marks begin acceleration process. Derived Investment takes place leads to rise in income. Same manner Autonomous investment. This is now multiplier and accelerator interact and make the income grow at a rate much faster then expected.Exogenous factors → Autonomous Investment → Multiplier Effect → Derived Investment + Acceleration of Investment. Derived Investment → multiplier effect leading to accelerator. This is called multiplier – acceleration interaction.In his analysis of interaction process, Samuelson assumes:
(1) No excess production capacity(2) One year lag in consumption(3) One year lag in increase in consumption and investment demand(4) No Govt. activities and no foreign trade.Samuelson’s model and his conditions for economic fluctuations mat be briefly presented as below: given the assumption 4 the economy will be in equilibrium when Yt = Ct + It ----------------- (1)Yt = National Income Ct = total consumption expenditure It = Investment expenditure all in period t.Given the assumption2 the consumption function may be as Ct = a Y t-1 --------------------- (2)Yt-1 is income in period t-1i.e. Income in preceding year and a is mpc. Or ∆C/∆Y(Determine multiplier)Investment function with one-year lag is expressed as- It = b (Ct – Ct -1) -------------------- (3)Where b represents capital / output ratio. Parameter b determines the acceleration here. By substituting equation (2) & (3) in (1) equilibrium can be rewritten as Yt = aYt-1 +b (Ct - Ct-1)------------- (4)
Note that Ct = a Yt-1 and Ct-1 = a Yt-2 by substitution in equation (4) Yt = a Yt-1 +b (aYt-1 – aYt-2)--------(5)By solving equation (5) we get Yt = a (1+b) y t-1 – ab Yt-2 ----------(6)This form of equation is used to derive the necessary information for analyzing the business cycle. Equation reveals that if values of a & b and incomes of two preceding two years are known, income for any past or future year can be determined.Samuelson has also shown various kinds of cycles that would be generated by different combination of a & b.
Areas marked by ABCD each having different pattern of cycle. Natures of cycles may be described as belowArea A – All combinations make the incomes move upward or downward at decreasing rates asymptotically reaching a new equilibrium. In this area rise or fall in one way.Area B – All combinations produce cycles of amplitude growing smaller and smaller until the cycle disappears and economy stabilizes. That is the case of damped cycle.Area C – All combination produce a series of cycle with larger and larger amplitude. This area is of explosive cycles.Area D - all combination makes income increase (or decrease) at an exponential rate until the ceiling (or bottom) is hit. This is a case of one-way explosion.Point E shows a special case in which cycles are of equal amplitude and continue forever.
Critical Evaluation (1) Highly simplifying assumptions(2) Focus on interaction and leaving many factors untouched like businessman
expectations, changing business psychology, changing consumer preferences.(3) Major short coming- assume constancy of capital / output ratio.(4) Shapiro’s pointed out many cycle patterns suggested by the model do not conform to the world experience.
(5) HICK’S THEORY OF TRADE CYCLE Hick’s uses
(i) Keynesian concept of saving investment relation and multiplier (ii) Clark’s acceleration principal(iii) Samuelson’s interaction of multiplier and accelerator (iv) Growth model of Harrods Domar.
ASSUMPTIONS
Hick’s assumes an equilibrium rate of growth in the model economy in which realized growth rate (Gr) equals the natural growth rate (Gn). The autonomous investment (AI) increases at a constant rate, which always equals the rate of increases in voluntary savings. The equilibrium growth rate is determine by the rate of Autonomous Investment and savings. Hicks also assume a Samuelson type of consumption function i. e. Ct = aYt-1 (with one year lag in consumption). The reasons he gives for lagged consumption function are: (1) lag of expenditure behind income (ii) lag in non-wage income behind the change in GNP. The saving function naturally become the function of past year’s income. Hick’s multiplier becomes a “mathematical truism” with the lagged relations between income and saving investment; the multiplier process has a dampening effect on the fluctuations. The lagged multiplier acts as a depressant on upswing and a counterforce on the down swing. Hick’s assumes that autonomous investment is a function of current out put, and is undertaken to replace the worn out capital. The induced investment in his model is a function of change in out put. The change in out put generates induced investment, which bring the accelerator principal in action. It may be noted here that this acceleration inter acts with multiplier effect upon income and consumption.Finally, Hick’s prescribe ceilings and bottom for the upswing and downswing. Upward ceiling is due to scarcity of employable resources. As regard downswing he says there is no such direct limit on contraction but an indirect limit is imposed by the mechanism of accelerator of the downswing.
GRAPHICAL PRESENTATION OF HICK’S THEORY
IN DIAGRAMVertical axis logarithm of out put and employment, horizontal axis by semi logarithm measures time.F-Full employment ceilingE- Equilibrium path of out put which a constant multiple of autonomous investmentL- Equilibrium path during the period of slump assuming that out put level will never go below this levelA- Autonomous investment increasing at a constant rate
Let us suppose economy is progressing on dynamic path and revealed point Po. Suppose autonomous investment takes place due to some invention. Consequently out put increases and the economy leaves the path EE. After a certain lag begins the multiplier process caused by autonomous investment. As a result out put and employment increase. Increase in out put leads to induced investment, which in turn bring acceleration in action. The inter action between both multiplier and accelerator causes expansion in economy which than movesPoP1. The expansion beyond P1 will not possible due to full employment constraint. The most it can do to creep along FF. but it cannot do for long. For the initial burst of autonomous investment was supposed to short lived. Thus on the upper path PoP1 has been mainly on account of induced investment during the preceding periods. But when ceiling is hit, the expansion sustained by the induced investment along FF is bound to end and a down swing becomes inevitable. For, increase in out put along FF is not high enough to induce investment and hence it ceases to take place. The down swing may be prolonged if out put investment (induced ) relation has a 3 or 4 year lag, but the down fall inevitable. Once down fall started, it must continue to hit EE line. Since there is nothing to stop it at EE line, down fall will continue further. The rate of fall should be lower since the disinvestments are limited to the rate of depreciation, which goes on decreasing . Following the decrease in out put. That is the reverse accelerator does not work as fast as it does during the up swing: There is a marked lack of symmetry. Even though the process of decline in out put may be slower, a situation characterized by slump does takes place in due course. Here
the autonomous investment is reduced a little below the normal level, while induced investment is zero. The course of slump is shown by Q1Q2. The absolute magnitude of out put decreases along the curve Q1Q2 towards the slump equilibrium line LL. This line is geared by the (autonomous investment ) AA and rises with it. Thus at any stage out put will again have started to rise. This increase in out put should bring the accelerator back into action . This marks beginning of recovery. Once the autonomous investment starts coming in the process of multiplier, later accelerator makes the economy to grow on the path of expansion towards equilibrium path EE. This completes cycle.
CRITICAL EVALUATION1- This theory does not provide sufficient reasons for linier consumption function and a
constant multiplier.2- Assumption regarding constancy of multiplier under the dynamic conditions is looked
upon with skepticism.3- Regarded as a highly abstract formulation, which seems incapable of explaining the
phenomenon of fluctuations in real life.
CHAPTER - XVII
Economic stabilization policies
Violent fluctuations are harmful to business and bring misery to human beings by unemployment and poverty. In 1930-great depression, came and orthodox belief was that invisible market forces would automatically maintain balance in economy. Recently Govt. realized through trade cycles that need for stabilization. Keynes assigned a big role to Govt. Govt. in free enterprise economy not only entered in production of commodity and services but also adopt a number of fiscal and monetary measures to control and regulate violent economic fluctuations. In developing countries like India, Govt. is the key player in economic growth With, employment and stabilization. Communist has regimented economy. Problems of trade cycles are similar in developed and developing economies. Advanced countries faced depression during 1980 with growth rate 2% - 3%; developing countries faced double inflation, in addition to unemployment, balance of payment crises. The major stabilization problem in developing economies is to control prices while in developed economies preventing growth rate from sliding further down. The stabilization issue is quite important today.
CONCEPT AND OBJECTIVES OF STABILISATION
Preventive extreme up and downs, stabilization should permit a reasonable degree of flexibility for self-adjusting forces of the economy.
MAJOR OBJECTIVES OF STABILISATION POLICY
1 Prevent excessive fluctuations, making allowance for fluctuations for a long term, sustained economic growth.2 Efficient utilisation of labor and other productive resources.3 Encouraging free competitive enterprises with minimum interference with the functioning of marketing economy.4 Avoiding, as far as possible, the conflict between the internal external interests of economy.Two important widely used economic policies to achieve economic stability are 1 Fiscal policy2 Monetary policyIn dire need away from above two policies, Govt. adopts direct controls to supplement above two policies.
FISCAL POLICY – refers to Govt. policy of changing its taxes and public expenditure programmes intended to achieve certain predetermined objectives.Taxation is a measure of transferring funds from individual purse to public coffers. It amount to withdraw of fund from the private use.Public expenditure increase the flow of funds in economy it increase private income and private expenditure. Tax revenue and public expenditure form the two sides of Govt. budget.
Taxation and public expenditure policies are also jointly called as budgetary policy / fiscal policy.Fiscal policy is regarded as powerful instrument of economy stablisation. It rest on the fact that Govt. activities in modern economy are greatly enlarged and Govt. tax revenue and expenditure account for a considerable portion of GNP ranging from 10 – 25 % so Govt. may affect private economic activities to the same extent through variation in tax and expenses. Fiscal policy directly affect the private decisions while monetary indirectly. If fiscal policy is so formulated that it generates additional purchase power during depression and it contracts during the period of expansion known as “counter cycle fiscal policy “. The counter cycle fiscal policy is based on relation of public expenditure and taxes to the National income, the GNP as below –
PUBLIC EXPENDITURE AND GNP – An increase in public expenditure raises the level of GNP. The size in increase in GNP because of additional public expenditure is determined by the multiplier. Public expenditure increase households incomes, wage, interest, rent and business profit in turn increase Govt. tax. Process continues and GNP increases by the rate of multiplier.
TAXATION AND GNP
All taxes, especially direct tax has deflationary impact on the economy. Increase in the taxation through increase in the rates of exiting taxes and imposition of new taxes reduces GNP. The size of decrease in GNP because of increase in taxation depends on the tax multiplier. It should be noted here that the negative multiplier would not be as high as in case of public expenditure because the payment of taxes at the first instance does not reduce the GNP, as it is only a transfer of income.
COUNTER CYCLE FISCAL POLICY: Automatic and discretionary changes.Increased in public expenditure and reduction in taxation to fight depression Deficit budgetDecrease in public expenditure and increase in taxation to control inflation Surplus budgetSome of the budgetary changes are automatic and some are discretionary. Automatic adjustment takes place only when fiscal policy has built in flexibility. The automatic budget changes should follow the change in GNP. Built in flexibility implies that as GNP falls, both income and consumption decline. Consequently, the revenue from both direct and indirect taxes decline. Govt. establishment and committed expenditure remaining the same, public expenditure exceeds its revenue and the budget automatically runs into deficit. When GNP increases, tax base expends and tax revenue increases. Expenditure level remain same, the budget automatically show surpluses.
THE DISCRETIONARY CHANGES: in the budget refer to the changes in the tax structure and in the level and pattern of public expenditures by the Govt. on its own discretion. Discretionary changes include changes in tax rate structure, abolition of existing taxes, imposition of new taxes, increase and decrease public expenditure, changing the patter of public expenditure etc.
PROBLEMS IN FORMULATING COUNTER CYCLE FISCAL POLICY – Eckstein pointed1 All expenditures do not have the same multiplier effect.2 Not all taxes have same multiplier effect.3 Deficit financing through public borrowing may reduce private investment.4 Practical difficulties in assessment of time lags and accuracy of forecasts.
MONETARY POLICY – Refers to the central banks programme of changing monetary variables viz- total supply of money, interest rates, and credit rationing to achieve certain predetermined objectives. Monetary policy main object is to achieve economic stability. The following are the traditional monetary instruments through which a bank carries out monetary policy-1 Open market operations2 changes in bank rate (or discount rate)3 changes in statutory reserve ratios.
(I) Open market operation by the central bank is the sale and purchase of Govt bonds, treasury bills, securities etc.
(ii) Bank rate is the rate at which central bank discounts the commercial banks bills of exchanges or first class bill.
(iii) Statutory reserve / liquidity ratio (SLR) is the proportion of commercial banks time and demand deposits which they are required to deposit with the central bank. All these instruments when operated by the central bank reduce (or enhance) directly or indirectly the credit creation capacity of the commercial banks and thereby reduce (or increase) the flow of funds from the banks to public. Often these instruments of monetary control, the open market operation is considered the most effective weapon available to central bank, especially in less developed countries having under developed money market.This instrument is flexible and easily adjustable to the changing conditions.
SELECTIVE CREDIT COTROLS – to control flow from undesired to desired sector.Moral sustain – banks ask to work in interest of nation.
MONETARY POLICY
Instruments are two types1 QUANTITATIVE, GENERAL, OR INDIRECT2 QUALITATIVE, SELECTIVE OR DIRECTThe affect of level of aggregate demand through the supply of money cost of money and availability of credit.
1 BANK RATE POLICYThe bank rate is the minimum-lending rate of the central bank at which it rediscounts first class bills of exchange and Govt. securities held by the commercial banks. In inflation it increase, borrowing becomes costly. In depression it lower, borrowing becomes cheap.2 OPEN MARKET OPERATIONSIT refers to sale and purchase of securities in the money market by the central bank. When price rises, bank sells securities. The reserves of commercial banks are reduced and they are not in position to lend. Investment get discouraged price check. When recession starts central bank, buy securities. Reserves of commercial banks raised. Lend more, investment, output, employment, income and demand rise and fall in price check.
CHANGES IN RESERVE RATIO
This weapon was suggested by Keynes. Every bank is required by law to keep a certain % of its total deposits in the form of a reserve fund in its vaults and a certain % with the central bank. Price rise central bank raise the ratio. Price falls central bank decrease the ratio.
4 SELECTIVE CREDIT COTROLS Selective credit controls are used to influence specific types of credit for particular purposes. They usually take the form of changing margin requirements to control speculative activities in economy. E.g. raising margin to 60 % means pledger of securities of Rs. 1000 will get Rs. 400. In case of recession, in particular sector central bank encourages borrowing by lowering marginal requirements.For an effective analytical monetary policy all four should be adopted simultaneously but all economists has agreed that1 The success of monetary policy is nil in a depression when business confidence is at its lowest ebb. 2 It is successful against inflation.In inflation, scope is very limited to control it. Limitations are –1 Increase in the velocity of residual public money2 Private sector makes new methods to make better use of available money supply.3 Discrimination – Restricted monetary policy affect poor traders rather than rich because rich do not depend on credit4 Threat to credit market – Investor may postpone investment to have profit of increasing rate of interest. Credit fund may dry.5 After expectations of borrowers and lenders.6 Time lags – Its recognition and operation in due time.
RATE OF MONETARY POLICY IN A DEVELOPING ECONOMY
1 To control inflationary pressures2 To achieve price stability3 To bridge balance of payment deficit4Interest rate policy and savings5 To create banking and financial institutions6 Debt management
LIMITATIONS IN UNDER DEVELOP COUNTRIES
1 Large non-magnetized sector (barter system in rural)2 Undeveloped money and capital markets (lack bill)3 High liquidity of commercial banks4 Foreign banks5 Small bank money (share is small)6 Money not deposited with banks
FISCAL POLOICY IN DEVELOPING ECONOMY
1 To increase rate of investment2 To encourage socially optimal investment (sector development)3 To increase employment opportunities4 To promote economic stability in the face of international instability5 To counteract inflation 6 To increase and redistribute national income.
CHAPTER - XVIII
INFLATIONA sizable and a rapid increase in general price level, which results in decline in the purchasing power of money. Prof. H.G. Johnson had divided definitions in two categories 1 casual definitions 2 definitions in term of price rise.
CASUAL DEFINITIONS
(I) A.C.Pigeon explains “ Inflation exit when money income is expending more than in proportion to income earning activities. (2) In the words of E.James “ Inflation is a self perpetuating and irreversible upward movement of prices caused by an excess of demand over capacity to supply.
(3) Keynes – Inflation is the result of the excess of aggregate demand over the available supply and true inflation starts only after full employment.
DEFINITIONS IN TERM OF PRICE RISE
(1) P.J.Curian – An economy regarded as suffering from inflation if it is undergoing period of continuously rising process.
( 2 ) L.B.Thomas – Inflation as persistent rise in level of prices.
( 3 ) Golden Weiser – Inflation occurs when the volume of money actively bidding for goods and services increases faster than the available supply of goods.
KEYNSIAN VIEW OF INFLATION
Inflation is based on the concept of full employment. According to him, inflation is the result of the excess aggregate demand over the available aggregate supply and true inflation starts after full employment.
Keynes mentioned prices may rise even before full employment, mainly due to the existence of certain bottlenecks in the expansion of but he termed such a rise in prices as semi inflation i.e. in diagram.
MODERN VIEW
Two types 1 demand-pull2 cost-push
1 In demand pull, inflation and falling unemployment are supposed to go together while in cost push, inflation and rising unemployment are suppose to occur simultaneously.
2 A.W.Phillips – less inflation meant more unemployment.
3 During late 1960’s monetarists held view that the trade of between inflation and unemployment existed only in short run and not in long run. In the long run inflation and unemployment will simultaneously increase.
4 Fried man combined demand-pull and cost-push inflation as one integrated completely.
CHARACTERISTICS
Rise in prices, economic phenomenon, and condition of economic diseqlibrium, caused by demand-pull or cost-push or by both. First mild than instant get momentum.
TYPES OF INFLATION
1 CRITERION OF NATURE
A Wage induced inflation – It occurs because of an increase of money wages without an equal increase in productivity. Trade union pressure. This rise in wages leads to increase in the cost of production. B Deficit induced inflation – caused by adoption of deficit financing or by the Govt. spending excess of revenue receipts. In order to meet increasing expenditure Govt. Prints more currency notes thus supply of money increase. C Profit induced inflation – Higher profit margin leads to rise in prices. D Scarcity induced inflation – Supply of goods not increase due to natural calamities. Thus prices tend to rise. E Currency induced inflation – Supply of money exceeds the available output of goods and services. F Credit induced investment – Due to expansion of credit without raising quantity of money. G Foreign trade induced inflation – Sudden rise in demand for it exports against inelastic supply of exports in domestic market.
2 Criterion of scope – A Comprehensive inflation – When the prices of goods and services increase throughout economy. This leads to increase in price index. B Sporadic inflation – It affects few sectors of economy therefore prices of some goods increase.
3 CRITERION OF EMPLOYMENT
A Partial inflation – Rising prices level that prevails before full employment. Keynes says this lead to more employment know as desired inflation. B Full inflation – It occurs after full employment.
4 CRITERION OF TIME INFLATION
A Wartime inflation – Govt. want to win the war so increase utilisation of resource by more expenses, prints more currency. B Post war inflation – due to reconstruction and continuous decline of output. C Peace inflation – due to planned economic developments in under developed countries deficit financing leads to greater expenditure with no correspondence with increase in production.
5 CRITERION OF SPEED INFLATION
A Creeping inflation – mildest form, for economic growth.B Walking inflation – rise in prices become more marked. Danger signal ahead.C Running inflation – rise in prices starts running. Difficult to measure.D Hyperinflation – starts after full employment reached, caused by issue too currency by Govt. prices increase many times.
6 CRITERION OF GOVT.REACTION INFLATIONA Open inflation – no interference of govt.B Suppressed inflation - price control by monetary and fiscal policy.C Potential inflation – wartime forced savings. In future may turn in expenses.
7 CRTERION OF GENERAL INFLATION
A Ratchet inflation – when prices in certain sectors are not allowed to fall through there is every reason for the fall. Not decline due to resistance of industrialists and trade unions.B Stagflation – due to simultaneously existence of high rate of inflation and high unemployment in economy. Observed in 1960’s in developing countries who pursued stabilisation policies to achieve full employment.
THEORIES OF INFLATION:
A DEMAND PULL INFLATION ( TRADITIONAL THEORY )B COST PUSH INFLATION ( MODERN THEORY )
A DEMAND PULL INFLATION –
Peterson – Demand pull inflation theory holds that inflation is caused by an excess of demand ( spending ) relative to the available supply of goods and services exceeds the supply available at existing prices.
Shapiro – Demand Pull Inflation the general price level rises because the demand for goods and services exceeds the supply available at existing prices.
THREE APPROACHES TO DEMAND PULL INFLATION
1 TRADITIONAL QUANTITATIVE THEORY OF MONEY
After full employment level , there is direct and proportional relationship between supply of money and price level. If money supply is doubled prices will be doubled. If money supply is halved price will be halved, if other things remain equal.
2 KEYNES THEORY
When aggregate demand is more than aggregate supply there is increase in prices. AD = C + I + GSo when ever increase in consumption , investment or Govt. expenditure.
3 MODERN QUANTITY THEORY
Prof.Millton Friedman – Increase in money lead to inflation. The theory does not assume full employment or velocity of money. According to this theory demand function in real term is stable. Given the demand function of money the change in money supply determine the rates therefore rise in wages in industries having organised labor sooner or later spread from one industry to another without increase in productivity the resultant upward shift in the aggregate supply will lead to cost push inflation.Profit push inflation occurs in imperfectly competitive markets where prices rise faster than costs. This lead to greater profits. All sellers lead. Shortage of supply also leads.
3 Increase in the price of Imported inputs: pushed the cost of production, result increase in price of final goods in the economy.
4 Heavy taxation- Govt. imposes heavy taxes, sellers push it to customers in form of price rise leads to cost push inflation.
In fig. Real income is on ox axis and price level oy ss is the only supply curve and DD is original demand curve. Equilibrium E point oy income and op is price. This is also the point of full employment. If cost of production increases due to increase in wages. Profit supply curve shifts upwards1s, equilibrium shifts to E1 and out put reduce oy to oy1 and price increase to op1 further push to E2 oy2 price higher op2. We can conclude price level rises while out put and employment falls.
Interaction of Demand-pull and cost-push inflation: Great controversy between demand-pulls and cost-push.In free economy demand and supply fix the price. When weightage given to demand then demand-pull, when weightage given to supply then cost-push. Cost and incomes are basic factors of the flow of money. One factor is from angle of buyers and others from angle of sellers. Once process starts both merge with each other and difficult to separate both merge to intensify the pressure of inflation.
In diagram ss original supply curve DD is the original demand curve, E is equilibrium OY income OP is price. E to E1 is due to demand-pull but E1 to E2 is cost-push.
CONTROL OF INFLATION – A –Monetary Policy B – Fiscal Policy C – Direct Measures
A- Monetary Policy –
1 control over money 2 control above credit –(a) increasing bank rate (b) higher cash reserve ratio (c) open market operations (d) selective credit control –
