Managerial Economics MB0042 Mba1 Shivram-econ

8/8/2019 Managerial Economics MB0042 Mba1 Shivram-econ

1/23


2/23

there is possibility to postpone the use of a commodity, demand tends to be elastic e.g., buying aTV set, motor cycle, washing machine or a car etc.

6. Level of Income of the peopleGenerally speaking, demand will be relatively inelastic in case of rich people because any change inmarket price will not alter and affect their purchase plans. On the contrary, demand tends to beelastic in case of poor.

7. Range of PricesThere are certain goods or products like imported cars, computers, refrigerators, TV etc, which arecostly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. In allthese cases, a small fall or rise in prices will have insignificant effect on their demand. Hence,demand for them is inelastic in nature. However, commodities having normal prices are elastic innature.

8. Proportion of the expenditure on a commodityWhen the amount of money spent on buying a product is either too small or too big, in that casedemand tends to be inelastic. For example: - salt, newspaper or a site or house. On the other hand,the amount of money spent is moderate; demand in that case tends to be elastic. For example: -vegetables and fruits, cloths, provision items etc.

9. HabitsWhen people are habituated for the use of a commodity, they do not care for price changes over acertain range. For example: - in case of smoking, drinking, use of tobacco etc. In that case, demandtends to be inelastic. If people are not habituated for the use of any products, then demandgenerally tends to be elastic. 10. Period of timePrice elasticity of demand varies with the length of the time period. Generally speaking, in the shortperiod, demand is inelastic because consumption habits of the people, customs and traditions etc.do not change. On the contrary, demand tends to be elastic in the long period where there ispossibility of all kinds of changes.

11. Level of KnowledgeDemand in case of enlightened customer would be elastic and in case of ignorant customers, itwould be inelastic.

12. Existence of complementary goodsGoods or services whose demands are interrelated so that an increase in the price of one of the products results in a fall in the demand for the other. Goods which are jointly demanded areinelastic in nature. For example, pen and ink, vehicles and petrol, shoes and socks etc haveinelastic demand for this reason. If a product does not have complements, in that case demandtends to be elastic. For example, biscuits, chocolates, ice creams etc. In this case the use of aproduct is not linked to any other products.

13. Purchase frequency of a productIf the frequency of purchase is very high, the demand tends to be inelastic. For e.g., coffee, tea,milk, match box etc. on the other hand, if people buy a product occasionally, demand tends to beelastic. For example: - durable goods like radio, tape recorders, refrigerators etc.Thus, the demand for a product is elastic or inelastic will depend on a number of factors.

2. How is demand forecasting useful for managers?Answer:It is to be noted that Demand forecasting is generally associated with forecasting sales. To usedemand forecasting in an active rather than a passive way, management must recognize thedegree to which sales are a result not only of external economic environment but also of the action

of the company itself.Managerial uses of demand forecasting:

In the short run:


3/23

Demand forecasts for short periods are made on the assumption that the company has a givenproduction capacity and the period is too short to change the existing production capacity. Generallyit would be one year period.

1. Production planning: It helps in determining the level of output at various periods and avoidingunder or over production.

2. Helps to formulate right purchase policy: It helps in better material management, of buyinginputs and control its inventory level which cuts down cost of operation.

3. Helps to frame realistic pricing policy: A rational pricing policy can be formulated to suit short runand seasonal variations in demand.

4. Sales forecasting: It helps the company to set realistic sales targets for each individual salesmanand for the company as a whole.

5. Helps in estimating short run financial requirements: It helps the company to plan the financesrequired for achieving the production and sales targets. The company will be able to raise therequired finance well in advance at reasonable rates of interest.

6. Reduce the dependence on chances: The firm would be able to plan its production properly andface the challenges of competition efficiently.

7. Helps to evolve a suitable labour policy: A proper sales and production policies help todetermine the exact number of labourers to be employed in the short run.

In the long run:Long run forecasting of probable demand for a product of a company is generally for a period of 3 to5 or 10 years.

1. Business planning: It helps to plan expansion of the existing unit or a new production unit. Capitalbudgeting of a firm is based on long run demand forecasting.

2. Financial planning: It helps to plan long run financial requirements and investment programs byfloating shares and debentures in the open market.

3. Manpower planning: It helps in preparing long term planning for imparting training to the existingstaff and recruit skilled and efficient labour force for its long run growth.

4. Business control: Effective control over total costs and revenues of a company helps to determinethe value and volume of business. This in its turn helps to estimate the total profits of the firm. Thusit is possible to regulate business effectively to meet the challenges of the market.

5. Determination of the growth rate of the firm: A steady and well conceived demand forecastingdetermine the speed at which the company can grow.

6. Establishment of stability in the working of the firm: Fluctuations in production cause ups anddowns in business which retards smooth functioning of the firm. Demand forecasting reducesproduction uncertainties and help in stabilizing the activities of the firm.

7. Indicates interdependence of different industries: Demand forecasts of particular productsbecome the basis for demand forecasts of other related industries, e.g., demand forecast for cottontextile industry supply information to the most likely demand for textile machinery, colour, dye-stuff industry etc.,

8. More useful in case of developed nations: It is of great use in industrially advanced countrieswhere demand conditions fluctuate much more than supply conditions.

The above analysis clearly indicates the significance of demand forecasting in the modern businessset up.

3. Explain production function. How is it useful for business? (5+5)


4/23

Answer:A production Function expresses the technological or engineering relationship between physicalquantity of inputs employed and physical quantity of outputs obtained by a firm. The production ispurely physical in nature and is determined by the quantum of technology, availability of equipments, labor, and raw materials, and so on employed by a firm.A production function can be represented in the form of a mathematical model or equation as Q = f (L, N, K.etc) where Q stands for quantity of output per unit of time and L N K etc are the variousfactor inputs like land, capital, labor etc.

Generally speaking, there are two types of production functions

1. Short Run Production FunctionIn this case, the producer will keep all fixed factors as constant and change only a few variablefactor inputs. In the short run, we come across two kinds of production functions:a. Quantities of all inputs both fixed and variable will be kept constant and only one variable inputwill be varied. For example, Law of Variable Proportions.b. Quantities of all factor inputs are kept constant and only two variable factor inputs are varied. For example, Iso-Quants and Iso-Cost curves.

2. Long Run Production Function

In this case, the producer will vary the quantities of all factor inputs, both fixed as well as variable inthe same proportion. For Example -The laws of returns to scale. Each firm has its own production function which is determined by the state of technology,managerial ability, organizational skills etc of a firm. If there are any improvements in them, the oldproduction function is disturbed and a new one takes its place.It may be in the following manner 1. The quantity of inputs may be reduced while the quantity of output may remain same.2. The quantity of output may increase while the quantity of inputs may remain same.3. The quantity of output may increase and quantity of inputs may decrease.

Uses of Production FunctionThough production function may appear as highly abstract and unrealistic, in reality, it is both logical

and useful. It is of immense utility to the managers and executives in the decision making process atthe firm level.There are several possible combinations of inputs and decision makers have to choose the mostappropriate among them. The following are some of the important uses of production function.

1. It can be used to calculate or work out the least cost input combination for a given output or themaximum output-input combination for a given cost.

2. It is useful in working out an optimum, and economic combination of inputs for getting a certainlevel of output. The utility of employing a unit of variable factor input in the production process canbe better judged with the help of production function. Additional employment of a variable factor input is desirable only when the marginal revenue productivity of that variable factor input is greater than or equal to cost of employing it in an organization.

3. Production function also helps in making long run decisions. If returns to scale are increasing, it iswise to employ more factor units and increase production. If returns to scale are diminishing, it isunwise to employ more factor inputs & increase production. Managers will be indifferent whether toincrease or decrease production, if production is subject to constant returns to scale.Thus, production function helps both in the short run and long run decision - making process.

4. How do external and internal economies affect returns to scale?(5+5)

Answer:The concept of returns to scale is a long run phenomenon. An increase in scale means that allfactor inputs are increased in the same proportion. In returns to scale, all the necessary factor inputs are increased or decreased to the same extent so that whatever the scale of production, theproportion among the factors remains the same.

Three Phases of Returns to Scale


5/23

Generally speaking, we study the behavior pattern of output when all factor inputs are increased inthe same proportion under returns to scale. Many economists have questioned the validity of returns to scale on the ground that all factor inputs cannot be increased in the same proportion andthe proportion between the factor inputs cannot be kept uniform. But in some cases, it is possiblethat all factor inputs can be changed in the same proportion and the output is studied when the inputis doubled or tripled or increased five-fold or ten-fold. An ordinary person may think that when thequantity of inputs is increased 10 times, output will also go up by 10 times. But it may or may nothappen as expected.

It may be noted that when the quantity of inputs are increased in the same proportion, the scale of output or returns to scale may be either more than equal, equal or less than equal. Thus, when thescale of output is increased, we may get increasing returns, constant returns or diminishing returns.When the quantity of all factor inputs are increased in a given proportion and output increases morethan proportionately, then the returns to scale are said to be increasing; when the output increasesin the same proportion, then the returns to scale are said to be constant; when the output increasesless than proportionately, then the returns to scale are said to be diminishing.It is clear from the table that the quantity of land and labor (Scale) is increasing in the sameproportion, i.e. by 1 acre of land and 2 units of labor throughout in our example. The outputincreases more than proportionately when the producer is employing 4 acres of land and 9 units of labor. Output increases in the same proportion when the quantity of land is 5 acres and 11units of labor and 6 acres of land and 13 units of labor. In the later stages, when he employs 7 & 8 acres of land and 15 & 17 units of labor, output increases less than proportionately. Thus, one can clearlyunderstand the operation of the three phases of the laws of returns to scale with the help of thetable.

Diagrammatic representationIn the diagram, it is clear that the marginal returns curve slope upwards from A to B, indicatingincreasing returns to scale. The curve is horizontal from B to C indicating constant returns to scaleand from C to D, the curve slope downwards from left to right indicating the operation of diminishingreturns to scale.

Economies of ScaleThe advantages or benefits that accrue to a firm as a result of increase in its scale of production are called Economies of Scale.

I. Internal Economies or Real EconomiesInternal Economies are those economies which arise because of the actions of an individual firm toeconomize its cost. They arise due to increased division of labor or specialization and completeutilization of indivisible factor inputs. Prof. Cairncross points out that internal economies are opento a single factory or a single firm independently of the actions of other firms. They arise on accountof an increase in the scale of output of a firm and cannot be achieved unless output increases.The following are some of the important aspects of internal economies.1. They arise with in or inside a firm.2. They arise due to improvements in internal factors.3. They arise due to specific efforts of one firm.4. They are particular to a firm and enjoyed by only one firm.5. They arise due to increase in the scale of production.6. They are dependent on the size of the firm.


6/23

7. They can be effectively controlled by the management of a firm.8. They are called as Business Secrets of a firm.

Kinds of Internal Economies:

1. Technical EconomiesThese economies arise on account of technological improvements and its practical application inthe field of business. Economies of techniques or technical economies are further subdivided intofive heads.a) Economies of superior techniques : These economies are the result of the application of themost modern techniques of production. When the size of the firm grows, it becomes possible toemploy bigger and better types of machinery. The latest and improved techniques give place for specialized production. It is bound to be cost reducing in nature. For example: - cultivating the landwith modern tractors instead of using age old wooden ploughs and bullock carts, use of computersinstead of human labor, etc.

b) Economies of increased dimension: It is found that a firm enjoys the reduction in cost when itincreases its dimension. A large firm avoids wastage of time and economizes its expenditure. Thus,an increase in dimension of a firm will reduce the cost of production. For example: - operation of adouble decker bus instead of two separate buses.

c) Economies of linked process: It is quite possible that a firm may not have various processes of production with in its own premises. Also it is possible that different firms through mutual agreementmay decide to work together and derive the benefits of linked processes, for example, in diaryfarming, printing press, nursing homes etc.

d) Economies arising out of research and by - products: A firm can invest adequate funds for research and the benefits of research and its costs can be shared by all other firms. Similarly, alarge firm can make use of its wastes and by-products in the most economical manner by producingother products. For example, cane pulp, molasses, and bagasse fiber of sugar factory can be usedfor the production of paper, varnish, distilleries etc.

e) Inventory Economies. I nventory management is a part of better materials management. A bigfirm can save a lot of money by adopting latest inventory management techniques. For example,Just-In-Time or zero level inventory techniques. The rationale of the Just-In-Time technique is thatinstead of having huge stocks worth of lakhs and crores of rupees, it can ask the seller of the inputsto supply them just before the commencement of work in the production department each day.

2. Managerial Economies:They arise because of better, efficient, and scientific management of a firm. Such economies arisein two different ways.

a) Delegation of details: The general manager of a firm cannot look after the working of allprocesses of production. In order to keep an eye on each production process he has to delegatesome of his powers or functions to trained or specialized personnel and thus relieve himself for co-ordination, planning and executing the plans. This will enable him to bring about improvements inproduction process and in bringing down the cost of production.

b) Functional Specialization: It is possible to secure economies of large scale production bydividing the work of management into several separate departments. Each department is placedunder an expert and the rest of the work is left into the hands of specialists. This will ensure better and more efficient productive management with scientific business administration. This would leadto higher efficiency and reduction in the cost of production.

3. Marketing or Commercial economies:These economies will arise on account of buying and selling goods on large scale basis at favorableterms. A large firm can buy raw materials and other inputs in bulk at concessional rates. As thebargaining capacity of a big firm is much greater than that of small firms, it can get quantitydiscounts and rebates. In this way economies may be secured in the purchase of different inputs.


7/23

A firm can reduce its selling costs also. A large firm can have own sales agency and channel. Thefirm can have a separate selling organization, marketing department manned by experts who arewell versed in the art of pushing the products in the market. It can follow an aggressive salespromotion policy to influence the decisions of the consumers.

4. Financial EconomiesThey arise because of the advantages secured by a firm in mobilizing huge financialresources. A large firm on account of its reputation, name and fame can mobilize huge funds frommoney market, capital market, and other private financial institutions at concessional interest rates.It can borrow from banks at relatively cheaper rates. It is also possible to have large overdrafts frombanks. A large firm can float debentures and issue shares and get subscribed by the general public.Another advantage will be that the raw material suppliers, machine suppliers etc., are willing tosupply material and components at comparatively low rates, because they are likely to get bulkorders. Thus, a big firm has an edge over small firms in securing sufficient funds more easily andcheaply.

5. Labor EconomiesThese economies will arise as a result of employing skilled, trained, qualified and highlyexperienced persons by offering higher wages and salaries. As a firm expands, it can employ alarge number of highly talented persons and get the benefits of specialization and division of labor.It can also impart training to existing labor force in order to raise skills, efficiency and productivity of workers. New schemes may be chalked out to speed up the work, conserve the scarce resources,economize the expenditure and save labor time. It can provide better working conditions,promotional opportunities, rest rooms, sports rooms etc, and create facilities like subsidizedcanteen, crches for infants, recreations. All these measures will definitely raise the averageproductivity of a worker and reduce the cost per unit of output.

6. Transport and Storage EconomiesThey arise on account of the provision of better, highly organized and cheap transport andstorage facilities and their complete utilization. A large company can have its own fleet of vehicles or means of transport which are more economical than hired ones. Similarly, a firm canalso have its own storage facilities which reduce cost of operations.

7. Over Head EconomiesThese economies will arise on account of large scale operations. The expenses onestablishment, administration, book-keeping, etc, are more or less the same whether production iscarried on small or large scale. Hence, cost per unit will be low if production is organized on largescale. 8. Economies of Vertical integrationA firm can also reap this benefit when it succeeds in integrating a number of stages of production. It secures the advantages that the flow of goods through various stages in productionprocesses is more readily controlled. Because of vertical integration, most of the costs becomecontrollable costs which help an enterprise to reduce cost of production.

9. Risk-bearing or survival economiesThese economies will arise as a result of avoiding or minimizing several kinds of risks anduncertainties in a business. A manufacturing unit has to face a number of risks in the business.Unless these risks are effectively tackled, the survival of the firm may become difficult. Hence manysteps are taken by a firm to eliminate or to avoid or to minimize various kinds of risks. Generallyspeaking, the risk-bearing capacity of a big firm will be much greater than that of a small firm. Riskis avoided when few firms amalgamate or join together or when competition between different firmsis either eliminated or reduced to the minimum or expanding the size of the firm. A large firmsecures risk-spreading advantages in either of the four ways or through all of them.o Diversification of output Instead of producing only one particular variety, a firm has to producemultiple products. If there is loss in one item, it can be made good in other items.o Diversification of market : Instead of selling the goods in only one market, a firm has to sell itsproducts in different markets. If consumers in one market desert a product, it can cover the losses inother markets.


8/23

o Diversification of source of supply : Instead of buying raw materials and other inputs from onlyone source, it is better to purchase them from different sources. If one person fails to supply, a firmcan buy from several sources.o Diversification of the process of manufacture : Instead adopting only one process of production to manufacture a commodity, it is better to use different processes or methods toproduce the same commodity so as to avoid the loss arising out of the failure of any one process.

II. External Economies or Pecuniary EconomiesExternal economies are those economies which accrue to the firms as a result of theexpansion in the output of whole industry and they are not dependent on the output level of individual firms . These economies or gains will arise on account of the overall growth of anindustry or a region or a particular area. They arise due to benefit of localization and specializedprogress in the industry or region. Prof. Stonier & Hague points out that external economies arethose economies in production which depend on increase in the output of the whole industry rather than increase in the output of the individual firm The following are some of the important aspects of external economies.1. They arise outside the firm.2. They arise due to improvement in external factors.3. They arise due to collective efforts of an industry.4. They are general, common & enjoyed by all firms.5. They arise due to overall development, expansion & growth of an industry or a region.6. They are dependent on the size of industry.7. They are beyond the control of management of a firm.8. They are called as open secrets of a firm.

Kinds of External Economies

1. Economies of concentration or AgglomerationThey arise because in a particular area a very large number of firms which produce the samecommodity are established. In other words, this is an advantage which arises from what is called

Localization of Industry. The following benefits of localization of industry is enjoyed by all the firms-provision of better and cheap labor at low or reasonable rates, trained, educated and skilled labor,transport and communication, water, power, raw materials, financial assistance through private andpublic institutions at low interest rates, marketing facilities, benefits of common repairs, maintenanceand service shops, services of specialists or outside experts, better use of by-products and other such benefits. Thus, it helps in reducing the cost of operation of a firm.

2. Economies of InformationThese economies will arise as a result of getting quick, latest and up to date informationfrom various sources. Another form of benefit that arises due to localization of industry iseconomies of information. Since a large number of firms are located in a region, it becomespossible for them to exchange their views frequently, to have discussions with others, to organize

lectures, symposiums, seminars, workshops, training camps, demonstrations on topics of mutualinterest. Revolution in the field of information technology, expansion in inter-net facilities, mobilephones, e-mails, video conferences, etc. has helped in the free flow of latest information from allparts of the globe in a very short span of time. Similarly, publication of journals, magazines,information papers etc have helped a lot in the dissemination of quick information. Statistical,technical and other market information becomes more readily available to all firms. This will help indeveloping contacts between different firms. When inter-firm relationship strengthens, it helps a lotto economize the expenditure of a single firm.

3. Economies of DisintegrationThese economies will arise as a result of dividing one big unit in to different small units for the sake of convenience of management and administration. When an industry grows beyond alimit, in that case, it becomes necessary to split it in to small units. New subsidiary units may growup to serve the needs of the main industry. For example, in cotton textiles industry, some firms mayspecialize in manufacturing threads, a few others in printing, and some others in dyeing andcoloring etc. This will certainly enhance the efficiency in the working of a firm and cut down unitcosts considerably.


9/23

4. Economies of Government ActionThese economies will arise as a result of active support and assistance given by thegovernment to stimulate production in the private sector units. In recent years, the governmentin order to encourage the development of private industries has come up with several kinds of assistance. It is granting tax-concessions, tax-holidays, tax-exemptions, subsidies, developmentrebates, financial assistance at low interest rates etc.It is quite clear from the above detailed description that both internal and external economies ariseon account of large scale production and they are benefits to a firm and cost reducing in nature.

5. Economies of Physical FactorsThese economies will arise due to the availability of favorable physical factors andenvironment. As the size of an industry expands, positive physical environment may help to reducethe costs of all firms working in the industry. For example, Climate, weather conditions, fertility of thesoil, physical environment in a particular place may help all firms to enjoy certain physical benefits.

6. Economies of WelfareThese economies will arise on account of various welfare programs under taken by anindustry to help its own staff. A big industry is in a better position to provide welfare facilities to

the workers. It may get land at concessional rates and procure special facilities from the localgovernments for setting up housing colonies for the workers. It may also establish health care units,training centers, computer centers and educational institutions of all types. It may grant concessionsto its workers. All these measures would help in raising the overall efficiency and productivity of workers.

5. Discuss the profit maximization model.Answer:Profit-making is one of the most traditional, basic and major objectives of a firm.

Main propositions of the profit-maximization model

The model is based on the assumption that each firm seeks to maximize its profit given certaintechnical and market constraints. The following are the main propositions of the model.1. A firm is a producing unit and as such it converts various inputs into outputs of higher value under a given technique of production.2. The basic objective of each firm is to earn maximum profit.3. A firm operates under a given market condition.4. A firm will select that alternative course of action which helps to maximize consistent profits5. A firm makes an attempt to change its prices, input and output quantity to maximize its profit.

The modelProfit-maximization implies earning highest possible amount of profits during a given period

of time.A firm has to generate largest amount of profits by building optimum productive capacity both in theshort run and long run depending upon various internal and external factors and forces. Thereshould be proper balance between short run and long run objectives. In the short run a firm is ableto make only slight or minor adjustments in the production process as well as in businessconditions. The plant capacity in the short run is fixed and as such, it can increase its productionand sales by intensive utilization of existing plants and machineries, having over time work for theexisting staff etc.Thus, in the short run, a firm has its own technical and managerial constraints. But in the long run,as there is plenty of time at the disposal of a firm, it can expand and add to the existing capacitiesbuild up new plants; employ additional workers etc to meet the rising demand in the market. Thus,in the long run, a firm will have adequate time and ample opportunity to make all kinds of

adjustments and readjustments in production process and in its marketing strategies.It is to be noted with great care that a firm has to maximize its profits after taking in toconsideration of various factors in to account.They are as follows

1. Pricing and business strategies of rival firms and its impact on the working of the given firm.


10/23

2. Aggressive sales promotion policies adopted by rival firms in the market.3. Without inducing the workers to demand higher wages and salaries leading to rise inoperation costs.4. Without resorting to monopolistic and exploitative practices inviting government controls andtakeovers.5. Maintaining the quality of the product and services to the customers.6. Taking various kinds of risks and uncertainties in the changing business environment.7. Adopting a stable business policy.8. Avoiding any sort of clash between short run and long run profits in the business policy andmaintaining proper balance between them.9. Maintaining its reputation, name, fame and image in the market.10. Profit maximization is necessary in both perfect and imperfect markets. In a perfect market,a firm is a price-taker and under imperfect market it becomes a price-searcher.

Assumptions of the modelThe profit maximization model is based on tree important assumptions. They are as follows 1. Profit maximization is the main goal of the firm.

2. Rational behavior on the part of the firm to achieve its goal of profit maximization.3. The firm is managed by owner-entrepreneur.

Determination of profit maximizing price and outputProfit maximization of a firm can be explained in two different ways.a) Total Revenue and Total Cost approach.b) Marginal Revenue and Marginal Cost approach.

Profits of a firm are estimated by making comparison between total revenue and total costs. Profit isthe difference between TR and TC. In other words, excess of revenue over costs is the profits. Profit= TR TC. If TR is equal to TC in that case, there will be break even point. If TR is less than TC, inthat case, a firm will be incurring losses. In this case, we take in to account of total cost and totalrevenue of the firm while measuring profits.It is clear from the following diagram how profit arises when TR is greater than that of TC.

2. MR and MC approachIn this case, we take in to account of revenue earned from one unit and cost incurred to produceonly one unit of output. A firm will be maximizing its profits when MR= MC and MC curve cuts MRcurve from below. If MC curve cuts MR curve from above either under perfect market or under imperfect market, no doubt MR equals MC but total output will not be maximized and hence totalprofits also will not be maximized. Hence, two conditions are necessary for profit maximization-

1. MR = MC. 2. MC curve cut MR curve from below. It is clear from the following diagrams.


11/23

Justification for profit maximization1. Basic objective of traditional economic theory. The traditional economic theory assumes thata firm is owned and managed by the entrepreneur himself and as such he always aims at maximumreturn on his capital invested in the business. Hence profit-maximization becomes the naturalprinciple of a firm. 2. A firm is not a charitable institution. A firm is a business unit. It is organized on commercialprinciples. A firm is not a charitable institution. Hence, it has to earn reasonable amount of profits.

3. To predict most realistic price-output behavior. This model helps to predict usual and generalbehavior of business firms in the real world as it provides a practical guidance. It also helps inpredicting the reasonable behavior of a firm with more accuracy. Thus, it is a very simple, plain,realistic, pragmatic and most useful hypothesis in forecasting price output behavior of a firm.

4. Necessary for survival: It is to be noted that the very existence and survival of a firm dependson its capacity to earn maximum profits. It is a time-honored hypothesis and there is commonagreement among businessmen to make highest possible profits both in the short run and long run.

5. To achieve other objectives. In recent years several other objectives have become much morepopular and all these objectives have become highly relevant in the context of modern business set

up. But it is to be remembered that they can be achieved only when a firm is making maximumprofits.

Criticisms1. Ambiguous term. The term profit maximization is ambiguous in nature. There is no clear cutexplanation whether a firm has to maximize its net profit, total profit or the rate of profit in a businessunit. Again maximum amount of profit cannot be precisely defined in quantitative terms.2. It may not always be possible. Profit maximization, no doubt is the basic objective of a firm. Butin the context of highly competitive business environment, always it may not be possible for a firm toachieve this objective. Other objectives like sales maximization, market share expansion, marketleadership building its own image, name, fame and reputation, spending more time with members of the family, enjoying leisure, developing better and cordial relationship with employees andcustomers etc. also has assumed greater significance in recent years.

3. Separation of ownership and management. In many cases, to-day we come across thebusiness units are organized on partnership or joint stock company or cooperative basis. In case of many large organizations, ownership and management is clearly separated and they are run andmanaged by salaried managers who have their own self interests and as such always profitmaximization may not become possible.4. Difficulty in getting relevant information and data. In spite of revolution in the field of information technology, always it may not be possible to get adequate and relevant information totake right decisions in a highly fluctuating business scenario. Hence, profits may not be maximized.5. Conflict in inter-departmental goals. A firm has several departments and sections headed byexperts in their own fields. Each one of them will have its own independent goals and many a timesthere is possibility of clashes between the interests of different departments and as such alwaysprofits may not be maximized.


12/23

6. Changes in business environment. In the context of highly competitive and changing businessenvironment and changes in consumers tastes and requirements, a firm may not be able to copeup with the expectations and adjust its policies and as such profits may not be maximized.7. Growth of oligopolistic firms. In the context of globalization, growth of oligopoly firms hasbecome so common through mergers, amalgamations and takeovers. Leading firms dominate themarket and the small firms have to follow the policies of the leading firms. Hence, in many cases,there are limited chances for making maximum profits.8. Significance of other managerial gains. Salaried managers have limited freedom in decisionmaking process. Some of them are unable to forecast the right type of changes and meet themarket challenges. They are more worried about their salaries, promotions, perquisites, security of jobs, and other types of benefits. They may lack strong motivations to make higher profits as profitswould go to the organization. They may be contented with only satisfactory level of profits rather than maximum profits.

9. Emphasis on non-profit goals. Many organizations give more stress on non-profit goals. Fromthe point of view of todays business environment, productivity, efficiency, better management,customer satisfaction, durability of products, higher quality of products and services etc. havegained importance to cope with business competition. Hence, emphasis has been shifted from profitmaximization to other practical aspects.10. Aversion to reduction in power. In case of several small business units, the owners do notwant to share their powers with many new partners and hence, they try to keep maximum powers intheir hands. In such cases, keeping more power becomes more important than profit maximization.11. Official restrictions over profits of public utilities. Public utilities or public corporations arelegally prohibited to make huge profits in many developing countries like India.

Thus, it is clear that a firm cannot maximize its profits always. There are many constraints in thebackground of multiple objectives. Each one of the objectives has its own merits and demerits and afirm has to strike a balance between all kinds of objectives.

6. Examine the relationship between revenue concepts and price elasticity of demand.Answer:Elasticity of Demand, Average Revenue and Marginal RevenueThere is a very useful relationship between elasticity of demand, average revenue and marginalrevenue at any level of output. Elasticity of demand at any point on a consumers demand curve isthe same thing as the elasticity on the given point on the firms average revenue curve. With thehelp of the point elasticity of demand, we can study the relationship between average revenue,marginal revenue and elasticity of demand at any level of output.

In the diagram AR and MR respectively are the average revenue and the marginal revenue curves.Elasticity of demand at point R on the average revenue curve = RT/Rt Now in the triangles PtR andMRT.tPR = RMT (right angles)

tRP = RTM (corresponding angles)

PtR= MRT (being the third angle)


13/23

Therefore, triangles PtR and MRT are equiangular.

Hence RT / Rt = RM / tP

In the triangles PtK and KRQ

PK = RK

PKt = RKQ (vertically opposite)

tPK = KRQ (right angles )

Therefore, triangles PtK and RQK are congruent (i.e., equal in all respects).

Hence Pt = RQ

Elasticity at R = RT / Rt = RM / tP = RM / RQ

RM RMIt is clear from the diagram that ----- = -----------RQ RM-QM

Hence elasticity at R = RM / RM QM

It is also clear from the diagram that RM is average revenue and QM is the marginal revenue at theoutput OM which corresponds to the point R on the average revenue curve. Therefore elasticity at R= Average Revenue / Average Revenue Marginal Revenue. If A stands for Average Revenue, Mstands for Marginal Revenue and e stands for point elasticity on the average revenue curve Then e= A / A M.Thus, elasticity of demand is equal to AR over AR minus MR.By using the above elasticity formula, we can derive the formula for AR and MR separately.

Therefore Average Revenue or price = M (e / e 1)Thus the price (i.e., AR) per unit is equal to marginal revenue x elasticity over elasticity minus one.The marginal revenue formula can be written straight away asM = A ((e 1) / e)The general rule therefore is: at any output,Average Revenue = Marginal Revenue x (e / e 1) andMarginal Revenue = Average Revenue x (e 1 / e) Where, e stands for point elasticity of demand on the average revenue curve. With the help of theseformulae, we can find marginal revenue at any point from average revenue at the same point,provided we know the point elasticity of demand on the average revenue curve. Suppose that theprice of a product is Rs.8 and the elasticity is 4 at that price. Marginal revenue will be:

M = A ((e 1) / e)= 8 ((4 1 / 4)= 8 x 3 /4= 24 / 4= 6. Marginal Revenue is Rs. 6.


14/23

Suppose that the price of a product is Rs.4 and the elasticity coefficient is 2 then the correspondingMR will be:M = A ((e-1) / e)= 4 ((2 1) / 4)= 4 x 1 / 4= 4 / 4= 1 (Marginal revenue is Rs. 1)

Suppose that the price of commodity is Rs.10 and the elasticity coefficient at that price is 1 MR willbe:M = A ((e-1) / e)=10 ((1-1) /1)=10 x 0/1= 0Whenever elasticity of demand is unity, marginal revenue will be zero, whatever be the price (or AR). It follows from this that if a demand curve shows unitary elasticity throughout its length thecorresponding marginal revenue will be zero throughout, that is, the x axis itself will be the marginalrevenue curve.

Thus, the higher the elasticity coefficient, the closer is the MR to AR / price. When elasticitycoefficient is one for any given price, the corresponding marginal revenue will be zero, marginalrevenue is always positive when the elasticity coefficient is greater than one and marginal revenueis always negative when the elasticity coefficient is less than one.


15/23

Master of Business Administration- MBA Semester 1MB0042 Managerial Economics - 3 Credits

(Book ID: B1131) Assignment Set- 2 (60 Marks)

1. Under perfect competition how is equilibrium price determined in the short and long run?

Answer:

Under a perfectly competitive market, in case of the industry, market price of the product is determinedby the interaction of supply and demand. The market price is not fixed by either the buyer or the seller,firm, industry or the government. It is only the market forces, i.e., demand and supply determines theequilibrium price of the product. We come across this peculiar feature under perfect competition alone.

Alfred Marshall compared supply and demand to the two blades of a scissors. Just as both the bladeswork together to cut a piece of cloth, both supply and demand interact with each other to determine themarket price at which exchange takes place. In the process of price determination, supply is not moreimportant than demand or demand is not more important than supply. Both forces play an equallyimportant role.

We can explain how price is determined in the market by the interaction of demand and supply with thehelp of the following schedule.

From the table above, it is clear that equilibrium price is determined at Rs. 6.00 where quantitydemanded is exactly equal to quantity supplied i.e., 5000 units.

Case of industry, interaction of supply and demand will determine the equilibrium market price. In thediagram, P indicates OR as equilibrium price and OQ as equilibrium output. The price at whichdemand and supply are equal is known as equilibrium price. The quantity bought and sold at theequilibrium price is known as equilibrium output.

In the figure equilibrium price is determined at the point P where both demand and supply are equal.The upper limit to the price of a product/service is determined by the demand. This price should notexceed what the market can bear. In short, the price of the product / service should not exceed thevalue of its benefit to the buyers (price should not be more than the utility of product / service).

Price inRs.

Demandin Units

Supplyin Units State of Market

Pressure onprice

10 1000 9000 Surplus S > D Downward8 3000 7000 Surplus S > D Downward6 5000 5000 Equilibrium S =D Neutral4 7000 3000 Shortage D > S Upward2 9000 1000 Shortage D > S Upward


16/23

The lower limit to the price is determined by production cost. In the long run, the price should not fallbelow production costs of making and distributing the product / service. With reference to the industry,the point P can be regarded as the position of stable equilibrium. Even if there are changes in price,there will be automatic adjustments in supply and demand, restoring the original equilibrium position.When the price rises from OR to OR1 supply exceeds demand, there will be excess supply over demand excess supply of goods push down the price from OR1 to OR, the original price.

Similarly, when price falls from OR to OR2, demand exceeds supply, excess demand over supply in itsturn push up the prices from OR2 to OR the original price. Thus, equality between demand andsupply determine the market price.

Under perfect competition, a firm will not have any independence to fix the price of its own product. Theindustry is the price maker or giver and a firm is a price taker or price acceptor and quantityadjuster. As a part of the industry, it has to simply charge the price which is determined by the industry.If it charges a higher price it will loose its sales and if it charges lesser price, it will incur losses.

2. Under what conditions is price discrimination possible?Answer:Price discrimination is possible a monopolistic market form. Monopoly may be defined as a condition of

production in which a person or a number of persons acting in combination have the power to fix theprice of the commodity or the output of the commodity. It is a situation where there exists a singlecontrol over the market producing a commodity having no substitutes and no possibilities for any one toenter the industry to compete.

Generally, speaking the monopolist will not charge uniform price for all the customers in the market. Hewill follow different methods under different circumstances.The policy of price discrimination refersto the practice of a seller to charge different prices for different customers for the samecommodity, produced under a single control without corresponding differences in cost. When amonopoly firm adopts this policy, it will become a discriminatory monopoly. According to Prof. Benham,Monopolist may be able however, to divide his sales among a number of different markets and tocharge a different price in each market.

According to Mrs. Joan Robbinson The act of selling the same article produced under a single controlat different prices to different customers is known as price discrimination.

Kinds of Price Discrimination:

Prof. A.C. Pigou speaks of three kinds of price discrimination.

1. Discrimination of the first degree: Under price discrimination of the first degree the producer exploits the consumers to the maximum possible extent by asking him to pay the maximum he isprepared to pay rather than go with out the commodity. In this case, the monopolist will not allowany consumers surplus to the consumer. This type of price discrimination is called perfectdiscrimination.

2. Discrimination of the second degree: In case of discrimination of the second degree, themonopolist charges different prices for different units of the same commodity, but not at maximumpossible rate but at a lower rate. The monopolist will leave a certain amount of consumers surpluswith the consumers . This is done to keep the consumers satisfied and prevent the entry of potentialrivals. This method is adopted by railway companies.

3. Discrimination of the third degree: In case of discrimination of the third degree, the markets aredivided into many sub markets or sub groups. The price charged in each case roughly depends on theability to pay of different sub groups in the market. This is the most common type of discriminationfollowed by a monopolist.

Price Discrimination May Take the Following Forms: (Basis of Price Discrimination)


17/23

1. Personal differences: This is nothing but charging different prices for the same commodity becauseof personal differences arising out of ignorance and irrationality of consumers, preferences, prejudicesand needs.

2. Place: Markets may be divided on the basis of entry barriers, for e.g. price of goods will be high inthe place where taxes are imposed. Price will be low in the place where there are no taxes or low taxes.

3. Different uses of the same commodity: When a particular commodity or service is meant for different purposes, different rates may be charged depending upon the nature of consumption. For e.g.different rates may be charged for the consumption of electricity for lighting, heating and productivepurposes in industry and agriculture.

4. Time: Special concessions or rebates may be given during festival seasons or on importantoccasions.

5. Distance: Railway companies and other transporters, for e.g., charge lower rates per KM if thedistance is long and higher rates if the distance is short.

6. Special orders: When the goods are made to order it is easy to charge different prices to differentcustomers. In this case, particular consumer will not know the price charged by the firm for other consumers.

7. Nature of the product: Prices charged also depends on nature of products e.g., railway departmentcharge higher prices for carrying coal and luxuries and less prices for cotton, necessaries of life etc.

8. Quantity of purchase: When customers buy large quantities, discount will be allowed by the sellers.When small quantities are purchased, discount may not be offered.

9. Geographical area: Business enterprises may charge different prices at the national andinternational markets. For example, dumping charging lower price in the competitive foreign market

and higher price in protected home market.10. Discrimination on the basis of income and wealth: For e.g., a doctor may charge higher fees for rich patients and lower fees for poor patients.

11. Special classification of consumers: For E.g., Transport authorities such as Railway andRoadways show concessions to students and daily travelers. Different charges for I class and II classtraveling, ordinary coach and air conditioned coaches, special rooms and ordinary rooms in hotels etc.

12. Age: Cinema houses in rural areas and transport authorities charge different rates for adults andchildren.

13. Preference or brands: Certain goods will be sold under different brand names or trade marks inorder to attract customers. Different brands will be sold at different prices even though there is not muchdifference in terms of costs.

14. Social and or professional status of the buyer: A seller may charge a higher price for thosecustomers who occupy higher positions and have higher social status and lesser price to common manon the street.

15. Convenience of the buyer: If a customer is in a hurry, higher price would be charged. Otherwisenormal price would be charged.

16. Discrimination on the basis of sex: In selling certain goods, producers may discriminate betweenmale and female buyers by charging low prices to females.

17. If price differences are minor, customers do not bother about such discrimination.


18/23

18. Peak season and off peak season services: Hotel and transport authorities charge different ratesduring peak season and off-peak seasons.

Pre-Requisite conditions for Price Discrimination (when price discrimination is possible)

1. Existence of imperfect market: Under perfect competition there is no scope for price discriminationbecause all the buyers and sellers will have perfect knowledge of market. Under monopoly, there will be

place for price discrimination as there are buyers with incomplete knowledge and information about themarket.

2. Existence of different degrees of elasticity of demand in different markets: A Monopolist willsucceed in charging higher price in inelastic market and lower price in the elastic market.

3. Existence of different markets for the same commodity: This will facilitate price discriminationbecause buyers in one market will not know the prices charged for the same commodity in other markets.

4. No contact among buyers: If there is possibility of contact and communication among buyers, theywill come to know that discriminatory practices are followed by buyers.

5. No possibility of resale: Monopoly product purchased by consumers in the low priced marketshould not be resold in the high priced market. Prevention of re exchange of goods is a must for pricediscrimination.

6. Legal sanction: In some cases, price discrimination is legally allowed. For E.g., The electricitydepartment will charge different rates per unit of electricity for different purposes. Similarly charges ontrunk calls; book post, registered posts, insured parcel, and courier parcel are different.

7. Buyers illusion: When consumers have an irrational attitude that high priced goods are of highquality, a monopolist can resort to price-discrimination.

8. Ignorance and lethargy: Due to laziness and lethargy consumers may not compare the price of thesame product in different shops. Ignorance of consumers with regard to price variations would enablethe monopolist to charge different prices.

9. Preferences and Prejudices of buyers: The monopolist may charge different prices for differentvarieties or brands of the same product to different buyers. For e.g. low price for popular edition of thebook and high price for deluxe edition.

10. Non-transferability features: In case of direct personal services like private tuitions, hair-cuts,beauty and medical treatments, a seller can conveniently charge different prices.

11. Purpose of service: The electricity department charges different rates per unit of electricity for different purposes like lighting, AEH, agriculture, industrial operations etc. railways charge differentrates for carrying perishable goods, durable goods, necessaries and luxuries etc.

12. Geographical distance and tariff barriers: When markets are separated by large distances andtariff barriers, the monopolist has to charge different prices due to high transport cost and high rate of taxes etc.


19/23

Price Output determination under Discriminatory Monopoly

Prices to be charged by the monopolist under price discrimination depend upon elasticity of demand for the products in different markets. The total output to be produced and supplied depends on marginalrevenue and marginal cost. The principle of equilibrium under price discrimination is that marginalrevenues in different markets are equal to marginal cost of the total output.

MR1 = MR2 = MC of the total output.

The monopolist, for the sake of his convenience, divides the market into two sub-markets, sub-market Aand sub-market B, on the basis of price elasticity of demand. His total sales are distributed in these twomarkets. In the sub-market A, the demand for the product is inelastic and hence he charges a relativelyhigher price of P1 & M1. The output sold in this market is OM1. E1 is the equilibrium position where MR= MC. P1 & E1 indicates the price over and above MR & MC.

In the sub-market B, the demand for the product is elastic. He is charging a relatively lower price of P2and M2. The output, sold in this market is OM2. E2 is the equilibrium position where MR = MC. Thedistance between P2 & E2 indicates the excess of price over MR and MC.

The third diagram represents the total market for the product of the monopolist. AMR is the aggregateMR in both the markets and AAR is the aggregate AR in both the markets. MC is the marginal costcurve. At E MR = MC, the equilibrium position of the monopoly firm. The total output sold in the two

sub-markets is represented by OM.The above description clearly shows that the monopolist has discriminated the two markets andcharged different prices in these two markets.

3. Explain the average and marginal propensity to consume.Answer:

The Average Propensity to consume and the Marginal Propensity to Consume

1. The Average Propensity to consume

The relationship between income and consumption is measured by the average and marginalpropensity to consume. The APC explains the relationship between total consumption and totalincome. At a certain period of time, it indicates the ratio of aggregate consumption expenditure toaggregate income. Thus, it is the ratio of consumption to income and is expressed as C/Y .


20/23

Suppose the income of the community is Rs.10, 000 crore and consumption expenditure is Rs. 8,000crore, then the APC is 8000/10,000 = 80% or 0.8.

Thus, %808.010000

8000or

Y

C APC

eTotalIncom

mtionTotalConsu APC ====

Thus, we can derive APC by dividing consumption expenditure by the total income.

2. Marginal Propensity to consume

MPC may be defined as the incremental change in consumption as a result of a given incrementin income. It refers to the ratio of the change in aggregate consumption to the change in thelevel of aggregate income. It may be derived by dividing an increment in consumption by anincrement in income. Symbolically

Y

C

=MPC

Suppose total income increases from Rs.10, 000 crore to Rs. 20,000 crore and total consumptionincreases from Rs8000 crore to Rs 15,000 crore, then,

%707.010000

7000or MPC ==

4. What is monetary policy? What are the objectives of such policy? ( 4+6)Answer:Measures employed by governments to influence economic activity, specifically by manipulating themoney supply and interest rates. Monetary and fiscal policy are two ways in which governments attemptto achieve or maintain high levels of employment, price stability, and economic growth. Monetary policyis directed by a nation's central bank. In the U.S., monetary policy is the responsibility of the FederalReserve System, which uses three main instruments: open-market operations, the discount rate, andreserve requirements. In the post-World War II era, economists reached a consensus that, in the longrun, inflation results when the money supply grows at too rapid a rate.

The usual goals of monetary policy are to achieve or maintain full employment, to achieve or maintain ahigh rate of economic growth, and to stabilize prices and wages. Until the early 20th century, monetarypolicy was thought by most experts to be of little use in influencing the economy. Inflationary trendsafter World War II, however, caused governments to adopt measures that reduced inflation byrestricting growth in the money supply.

Monetary policy is the domain of a nations central bank. The Federal Reserve System (commonly

called the Fed) in the United States and the Bank of England of Great Britain are two of the largest suchbanks in the world. Although there are some differences between them, the fundamentals of their operations are almost identical and are useful for highlighting the various measures that can constitutemonetary policy.

The Fed uses three main instruments in regulating the money supply: open-market operations, thediscount rate, and reserve requirements. The first is by far the most important. By buying or sellinggovernment securities (usually bonds), the Fedor a central bankaffects the money supply andinterest rates. If, for example, the Fed buys government securities, it pays with a check drawn on itself.This action creates money in the form of additional deposits from the sale of the securities bycommercial banks. By adding to the cash reserves of the commercial banks, then, the Fed enablesthose banks to increase their lending capacity. Consequently, the additional demand for government

bonds bids up their price and thus reduces their yield (i.e., interest rates). The purpose of this operationis to ease the availability of credit and to reduce interest rates, which thereby encourages businesses toinvest more and consumers to spend more. The selling of government securities by the Fed achievesthe opposite effect of contracting the money supply and increasing interest rates.


21/23

The second tool is the discount rate, which is the interest rate at which the Fed (or a central bank) lendsto commercial banks. An increase in the discount rate reduces the amount of lending made by banks. Inmost countries the discount rate is used as a signal, in that a change in the discount rate will typicallybe followed by a similar change in the interest rates charged by commercial banks.

The third tool regards changes in reserve requirements. Commercial banks by law hold a specificpercentage of their deposits and required reserves with the Fed (or a central bank). These are heldeither in the form of non-interest-bearing reserves or as cash. This reserve requirement acts as a brakeon the lending operations of the commercial banks: by increasing or decreasing this reserve-ratiorequirement, the Fed can influence the amount of money available for lending and hence the moneysupply. This tool is rarely used, however, because it is so blunt. The Bank of England and most other central banks also employ a number of other tools, such as treasury directive regulation of installmentpurchasing and special deposits.

Historically, under the gold standard of currency valuation, the primary goal of monetary policy was toprotect the central banks gold reserves. When a nations balance of payments was in deficit, an outflowof gold to other nations would result. In order to stem this drain, the central bank would raise thediscount rate and then undertake open-market operations to reduce the total quantity of money in thecountry. This would lead to a fall in prices, income, and employment and reduce the demand for imports

and thus would correct the trade imbalance. The reverse process was used to correct a balance of payments surplus.

The inflationary conditions of the late 1960s and 70s, when inflation in the Western world rose to a levelthree times the 195070 average, revived interest in monetary policy. Monetarists such as Harry G.Johnson, Milton Friedman, and Friedrich Hayek explored the links between the growth in money supplyand the acceleration of inflation. They argued that tight control of money-supply growth was a far moreeffective way of squeezing inflation out of the system than were demand-management policies.Monetary policy is still used as a means of controlling a national economys cyclical fluctuations.

5. Explain briefly the phases of business cycle. Through what phase did the world pass in2009-09.

Answer:The term business cycle is referred to the recurrent ups and downs in the level of economic activity thatextend over a period of time. The business fluctuations occur in aggregate variable such as nationalincome, employment and price level. The variables nearly move at the same time and in the samedirection. However they vary in duration and intensity. The upturns and downturns in the level of economic activity are generally divided into four phases and these are called the phases of thebusiness cycle. There are four phases of business cycle which are generally labeled as Peak,Recession, Trough and Recovery.

Peak: In an economic expansion, businesses experience record sales and profits. They can hardlykeep up with demand. In anticipation of a continued sales growth, inventories are built up andproduction facilities are expanded. This creates demand for suppliers of raw material and equipment.The equipment takes time to be built and installed. Banks are willing to lend given the bright predictionsof continued cash flows. A large number of loan applications push banks to raise interest rates whichcompanies can afford to pay. Companies find it difficult to hire all the employees they need, and areforced to pay higher wages, for instance, for overtime hours. But, that is not a serious problem in light of healthy sales and profits. Furthermore, a strong consumer demand justifies raising prices for manyproducts. With higher wages, employees are still able to buy in spite of higher prices; moreover,anticipation of continued employment encourages them to use consumer credit if their income isinsufficient. The overheating of the economy is evident in shortages of employees, materials,equipment, loan-able funds and products. These shortages imply inflation. Because of difficulties inobtaining resources, this is no longer a good time to start a business even if sales appear encouraging.Prices, wages and interest rates continued rise puts eventually a stop to further expanding productdemand, new hiring and new lending. The economy has reached its peak.

Recession: Sales are no longer expanding. The economy starts slowing down. The slow down is mildat first. As sales stop increasing, inventories pile up. Companies can adjust to that by reducing ordersfor raw materials, avoiding overtime and resorting to sales promotions. Suppliers start to feel the pinch


22/23

and are forced to lay off a few workers. These lay-offs are seen as a signal of potential hard timesahead. Employees prefer to set aside some wages, and reduce their consumption. Sales start to dropas consumer demand shies away. Companies are now burdened by the loans they took out to installnew equipment. Their profits shrink with decreasing revenues, still high employee salaries, and a largeoverhead. The hardest hit, are the manufacturers of equipment who see their orders dwindling. Fewer and fewer businesses are started. Often, plans to open business are canceled. Some firms go out of business.

Trough: The slow down becomes a serious contraction. Surpluses are everywhere: product inventoriesare bulging, excess capacity causes newly purchased equipment to turn idle, banks have loan-ablemoneys that no project justifies, raw materials are not needed, and employees are too many. Lay-offsbecome widespread. Shrinking revenues force companies to replace full-time employees by lower paidpart time and temporary workers (if labor unions do not intervene), or even to ask for wage concessionsfrom the existing staff. Decreasing disposable income causes even more reduction in product demand.Companies are forced to cut prices. Revenues disappear and profits turn to losses. Businesses defaulton their loans. Highly leverages companies close down. These are bankruptcies of large operations. Inturn, these bankruptcies can cause some banks to close as well.

Pessimism and hardship are widespread. If the loss of income is not too severe it is called a recession,

otherwise it is branded a depression. Firms try to survive as they can by selling off the inventory onhand. More bankruptcies are observed, but the number and the size of the bankrupt firms are bottomingout. All prices, interest rates and wages are at their lowest. Unemployment is ubiquitous. Theunemployed are ready to take any job. The contraction has run its course. The economy has reachedits Trough .

Recovery: The recovery starts. Having sold off their inventories, companies start to place orders for new supplies. Consumers have postponed some purchases and made do with cars or appliance byrepairing them. But this has gone long enough, it is time to buy at least the indispensable; moreover credit is cheap. Families have saved up in hard times. Bank reserves are plentiful and bankers areeager to lend anew, even at very low rates. Interest rates are indeed so low that some companyprojects become attractive again. New sales are observed in all sectors. Companies start rehiring at the

low wages first. New businesses are started. Bankruptcies are less noticeable. The economy isapproaching expansion.In expansion, attitudes turn optimistic. Manufacturers of durable goods see their order books fill up.Employees are more secure in their jobs, and start planning for vacations and renewed consumption.Businesses no longer need to mark down their inventory. The newly received merchandise fromsuppliers reflects new fashion and attracts customers. Sales continue to pick up, and healthy profitmargins bring back profits. Rehiring employees pushes the unemployment rate down. As the expansionbecomes more and more entrenched; memories of hard times vanish with their warning, andanticipation of continued growth is about to cause the economy to overheat anew.

6. What are the causes of inflation? What were the causes that affected inflation in India duringthe last quarter of 2009?

Answer:Demand-pull inflation refers to the idea that the economy actual demands more goods and servicesthan available. This shortage of supply enables sellers to raise prices until equilibrium is put in placebetween supply and demand. The cost-push theory, also known as "supply shock inflation", suggeststhat shortages or shocks to the available supply of a certain good or product will cause a ripple effectthrough the economy by raising prices through the supply chain from the producer to the consumer.You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven upand result in higher prices at the pump. Money supply plays a large role in inflationary pressure as well.Monetarist economists believe that if the Federal Reserve does not control the money supplyadequately, it may actually grow at a rate faster than that of the potential output in the economy, or realGDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond witha high level of money supply and allow for more investment in big business and new ideas whicheventually leads to unsustainable levels of inflation as cheap money is available. The credit crisis of 2007 is a very good example of this at work.Inflation can artificially be created through a circular increase in wage earners demands and then thesubsequent increase in producer costs which will drive up the prices of their goods and services. Thiswill then translate back into higher prices for the wage earners or consumers. As demands go higher


23/23

from each side, inflation will continue to rise.

Date post:	10-Apr-2018
Category:	Documents
Upload:	ahteshamakhtar
View:	228 times
Download:	0 times

Managerial Economics MB0042 Mba1 Shivram-econ

Documents