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Master of Business Administration- MBA Semester 1

Reg No.: 511011932

MB0026 / MB0042 Managerial Economics - 3 Credits

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q.1 Price elasticity of demand depends on various factors. Explain each factor with the help of an

example.

Ans A behavioral relationship between quantity consumed and a person's maximum willingness to pay

for incremental increases in quantity. It is usually an inverse relationship where at higher (lower) prices,

less (more) quantity is consumed. Other factors which influence willingness-to- pay are income, tastes and

preferences, and price of substitutes. Demand function specifies what the consumer would buy in each

price and wealth situation, assuming it perfectly solves the utility maximization problem. The quantity

demanded of a good usually is a storng function of its price. Suppose an experiment is run to determine the

quantity demanded of a particular product at different price levels, holding everything else constant.

Presenting the data in tabular form would result in a demand schedule.

Elasticity of demand is the economists way of talking about how responsive consumers are to price

changes. For some goods, like salt, even a big increase in price will not cause consumers to cut back very

much on consumption. For other goods, like vanilla ice cream cones, even a modest price increase will

cause consumers to cut back a lot on consumption. Elasticity of demand is an elasticity used to show the

responsiveness of the quantity demanded of a good or service to a change in its price. More precisely, it

gives the percentage change in demand one might expect after a one percent change in price. Elasticity is

almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity.

Only goods which do not conform to the law of demand, such as Veblen and Giffen goods, have a positive

elasticity demand. Goods with a small elasticity demand (less than one) are said to be inelastic: changes in

price do not significantly affect demand e.g. drinking water. Goods with large elasticity demands (greater

than one) are said to be elastic: even a slight change in price may cause a dramatic change in demand.

Revenue is maximised when price is set so as to create a ED of exactly one; elasticity demands can also be

used to predict the incidence of tax. Various research methods are used to calculate price elasticity,

including test markets, analysis of historical sales data and conjoint analysis. There is a neat way of

classifying values of elasticity. When the numerical value of elasticity is less than one, demand is said to be

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inelastic. When the numerical value of elasticity is greater than one, demand is elastic. So elastic

demand

means that people are relatively responsive to price changes (remember the vanilla ice cream cone).

Inelastic demand means that people are relatively unresponsive to price changes (remember salt). An

important relationship exists between the elasticity of demand for a good and the amount of money

consumers want to spend on it at different prices. Spending is price times quantity, p times Q. In general, a

decrease in price leads to an increase in quantity, so if price falls spending may either increase or decrease,

depending on how much quantity increases. If demand is elastic, then a drop in price will increase

spending, because the percent increase in quantity is larger than the percent decrease in price. On the other

hand, if demand is inelastic a drop in price will decrease spending because the percent increase in quantity

is smaller than the percent decrease in price.

The price elasticity of demand measures how responsive the quantity demanded of a good is to a change in

its price. The value illustrates if the good is relatively elastic (PED is greater than 1) or relatively inelastic

(PED is less than 1).

A good's PED is determined by numerous factors, these include;

Number of substitutes: the larger the number of close substitutes for the good then the easier the household

can shift to alternative goods if the price increases. Generally, the larger the number of close substitutes, the

more elastic the price elasticity of demand.

Degree of necessity: If the good is a necessity item then the demand is unlikely to change for a given

change in price. This implies that necessity goods have inelastic price elasticities of demand.

Price of the good as a proportion of income: It can be argued that goods that account for a large proportion

of disposable income tend to be elastic. This is due to consumers being more aware of small changes in

price of expensive goods compared to small changes in the price of inexpensive goods.

The following example illustrates how to determine the price elasticity of demand for a good.

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The price elasticity of demand for supermarket own produced strawberry jam is likely to be elastic. This is

because there are a very large number of close substitutes (both in jams and other preserves), and the good

is not a necessity item. Therefore, consumers can and will easily respond to a change in price.

Q.2 A company is selling a particular brand of tea and wishes to introduce a new flavor. How willthe company forecast demand for itAns - methods, such as educated guesses, and quantitative methods, such as the use of historicalsales dataor current data from test markets. Demand forecasting may be used in makingpricing decisions, inassessing future capacity requirements, or in making decisions on whetherto enter a new market. Oftenforecasting demand is confused with forecasting sales. But, failingto forecast demand ignores twoimportant phenomena[1]. There is a lot of debate in demand-planning literature about how to measure andrepresent historical demand, since the historicaldemand forms the basis of forecasting. The main questionis whether we should use the historyof outbound shipments or customer orders or a combination of the twoas proxy for the demand.Stock effects

The effects that inventory levels have on sales. In the extreme case of stock-outs, demand coming into your

store is not converted to sales due to a lack of availability. Demand is also untapped when sales for an item

are decreased due to a poor display location, or because the desired sizes are no longer available. For

example, when a consumer electronics retailer does not display a particular flat-screen TV, sales for that

model are typically lower than the sales for models on display. And in fashion retailing, once the stock

level of a particular sweater falls to the point where standard sizes are no longer available, sales of that item

are diminished.

Market response effect

The effect of market events that are within and beyond a retailers control. Demand for an item will likely

rise if a competitor increases the price or if you promote the item in your weekly circular. The resulting

sales increase reflects a change in demand as a result of consumers responding to stimuli that potentially

drive additional sales. Regardless of the stimuli, these forces need to be factored into planning and

managed within the demand forecast.

In this case demand forecasting uses techniques in causal modeling. Demand forecast modeling considers

the size of the market and the dynamics of market share versus competitors and its effect on firm demand

over a period of time. In the manufacturer to retailer model, promotional events are an important causal

factor in influencing demand. These promotions can be modeled with intervention models or use a

consensus to aggregate intelligence using internal collaboration with the Sales and Marketing functions.

3. Explain production function. How is it useful for business?

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A production function is a function that specifies the output of a firm, an industry, or an entire economy for

all combinations of inputs. Almost of all macroeconomic theories, like macroeconomic theory, real

business cycle theory, neoclassical growth theory (classical and

Master of Business Administration- MBA Semester 1Reg No.: 511011932

new) presuppose (aggregate) production function. Heckscher-Ohlin-Samuelson theory in international trade

theory also presupposes production function. In this sense, production function is one of the key concepts

of necoclassical macroeconomic theories. It is also important to know that there is a subversive criticism on

the very concept of production function.

A production function is a function that specifies the output of a firm, an industry, or an entire economy for

all combinations of inputs. A meta-production function (sometimes metaproduction function) compares the

practice of the existing entities converting inputs X into output y to determine the most efficient practice

production function of the existing entities, whether the most efficient feasible practice production or the

most efficient actual practice production.[1] In either case, the maximum output of a technologically-

determined production process is a mathematical function of input factors of production. Put another way,

given the set of all technically feasible combinations of output and inputs, only the combinations

encompassing a maximum output for a specified set of inputs would constitute the production function.

Alternatively, a production function can be defined as the specification of the minimum input requirements

needed to produce designated quantities of output, given available technology. It is usually presumed that

unique production functions can be constructed for every production technology.

By assuming that the maximum output technologically possible from a given set of inputs is achieved,

economists using a production function in analysis are abstracting away from the engineering and

managerial problems inherently associated with a particular production process. The engineering and

managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the

problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how

much of each input factor to use, given the price of the factor and the technological determinants

represented by the production function. A decision frame, in which one or more inputs are held constant,

may be used; for example, capital may be assumed to be fixed or constant in the short run, and only labour

variable, while in the long run, both capital and labour factors are variable, but the production function

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itself remains fixed, while in the very long run, the firm may face even a choice of technologies,

represented by various, possible production functions.

The relationship of output to inputs is non-monetary, that is, a production function relates physical inputs to

physical outputs, and prices and costs are not considered. But, the production function is not a full model of

the production process: it deliberately abstracts away from essential and inherent aspects of physical

production processes, including error, entropy or waste. Moreover, production functions do not ordinarily

model the business processes, either,


ignoring the role of management, of sunk cost investments and the relation of fixed overhead to variable

costs. (For a primer on the fundamental elements of microeconomic production theory, see production

theory basics).

The primary purpose of the production function is to address allocative efficiency in the use of factor inputs

in production and the resulting distribution of income to those factors. Under certain assumptions, the

production function can be used to derive a marginal product for each factor, which implies an ideal

division of the income generated from output into an income due to each input factor of production.

Q.4 Show how producers equilibrium is achieved with isoquants and isocost curves

Ans - Economies of scale external to the firm (or industry wide scale economies) are only considered

examples of network externalities if they are driven by demand side economies. In many industries, the

production of goods and services and the development of new products requires the use of specialized

equipment or support services. An individual company does not provide a large enough market for these

services to keep the suppliers in business. A localized industrial cluster can solve this problem by bringing

together many firms that provide a large enough market to support specialized suppliers. This phenomenon

has been extensively documented in

the semiconductor industry located in Silicon Valley.

Labor Market Pooling

A cluster of firms can create a pooled market for workers with highly specialized skills.

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It is an advantage for:

Producers

They are less likely to suffer from labor shortages.

Workers

They are less likely to become unemployed.

Knowledge Spillovers

Knowledge is one of the important input factors in highly innovative industries.

The specialized knowledge that is crucial to success in innovative industries comes from:

Research and development efforts

Reverse engineering

Informal exchange of information and ideas

As firms become larger and their scale of operations increase they are able to experience reductions in their

average costs of production. The firm is said to be experiencing increasing returns to scale. Increasing

returns to scale results in the firm's output increasing at a great


proportion than its inputs and hence its total costs. As a consequence its average costs fall.

Thus initially the firm's long run average cost curve slopes downward as the scale of the enterprise

expands. The firm enjoys benefits called internal economies of scale. These are cost reductions accruing to

the firm as a result of the growth of the firm itself. (An external economy of scale is a benefit that the firms

experience as a result of the growth of the industry.)

After the firm has reached its optimum scale of output, where the long run average cost curves are at their

lowest point, continued expansion means that its average costs may start to rise as the firm now experiences

decreasing returns to scale. The long run average cost curve therefore starts to curve upwards. This occurs

because the firm is now experiencing internal diseconomies of scale.

Types of internal economies of scale

Types of internal economies of scaleFinancialThe farm has been able to gain loans and assistance at preferential interest ratesfrom the EIB, World Bank and the EUMarketingIt has managed to dedicate resources to its strategy of niche marketing

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TechnicalThe access to finance has allowed it to invest in sophisticated Israeli irrigation

technology

Managerial It large size enables it to employ specialised personnel such as estate managers

Risk

bearing

The farm has used some of its land to diversify into producing fresh vegetables forexport as well as continue producing maize.These large scale farms are attracting a considerable amount of overseas development aidfunding from organisations such as the World Bank and the European Union as they are see


as being an integral part of the export earning capacity of the country.

Q.5 Discuss the full cost pricing and marginal cost pricing method. Explain how the two methods

differ from each other

Ans - The profit maximization principle stresses on the fact that the motive of business firms to

maximize profit is solely justified as being a method of maximizing the income of their

shareholders.

Firms may maximize profit by maximizing sales, stock price, market share or cash flow. In order

to achieve maximum profit the firm needs to find out the point where the difference between

total revenue and total cost is the highest.

The rules that apply for profit maximization are:

i. increase output as long as marginal profit increases

ii. profit will increase as long as marginal revenue (MR) > marginal cost (MC)

iii. profit will decline if MR < MC

iv. summing up (ii) and (iii), profit is maximized when MR = MC

Profit Maximization model means a scenario where the busniess is runned by the motive ofprofit making and keep the cost low.

The business firm is the productive unit in an exchange economy. In order to survive, a firm must deal with

three constraints: the demand for its product, the production function, and the supply of its inputs. When

the firm successfully deals with these constraints, it makes a profit.

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These readings explore the assumption that firms maximize profits, pointing out some of the ambiguities of

this assumption. It then explores how the rules of maximization apply to the firm. It considers two ways in

which the maximization principle can be used: to determine the proper levels of inputs or to determine the

proper level of output. The first leads to the rule that marginal resource cost should equal marginal revenue

product, and the second to the rule that marginal cost should equal marginal revenue. The readings show

that these two rules are equivalent and simply represented different ways of using the information from the

three constraints that a firm faces. Much of this material is quite technical, but it is at the core of

microeconomics.

Profit is maximized where MR = MC.Profit maximization rule: Produce until the point where the change in revenue from producing 1more unit equals the change in cost from producing 1 more unit.Why?

Suppose MR > MC. If I produce 1 more unit, my revenues increase by more than my costs.SIKKIM MANIPAL UNIVERSITY DISTANCE EDUCATIO


Therefore, if MR > MC, producing more will increase my profit. If I can increase my profit by changing

how much I produce, then when producing where MR > MC can't be profit- maximizing.

Suppose MR < MC. If I produce 1 less unit, my revenues decrease by less than my costs decrease.

Therefor, if MR < MC, I can increase profit by decreasing output. If I can increase profit when MR < MC,

then choosing q such that MR < MC can not be profit-maximizing.

So, in order to maximize profit, I must choose a quantity q such that MR = MC.MR = MC is an equilibrium in the sense that it is the only place where there is no incentive tochange the production level.

This rule, the profit maximization rule, is just an application of the marginal principle (MB = MC). Why?

This MB of producing an extra unit is the extra revenue you get. MR is the MB. So the 2 statements are

equivalent. The marginal principle is more general, and the profit maximization rule is specific to the firm

production decision.

Q.6 Discuss the price output determination using profit maximization under perfect competition

in the short run.

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Ans - There is a predictable relationship between revenue and elasticity. Depending on PED, one may raise

revenue either by increasing prices and sacrificing quantity or by reducing them and outputting more.

revenues or revenue is income that a company receives from its normal business activities, usually from the

sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is

referred to as turnover. Some companies receive revenue from interest, dividends or royalties paid to them

by other companies. In general usage, revenue is income received by an organization in the form of cash or

cash equivalents. Sales revenue or revenues is income received from selling goods or services over a period

of time. Tax revenue is income that a government receives from taxpayers. In more formal usage, revenue

is a calculation or estimation of periodic income based on a particular standard accounting practice or the

rules established by a government or government agency. Two common accounting methods, cash basis

accounting and accrual basis accounting, do not use the same process for measuring revenue. Corporations

that offer shares for sale to the public are usually required by law to report revenue based on generally

accepted accounting principles or International Financial Reporting Standards. Revenues from a business's

primary activities are reported as sales, sales revenue or net sales. This excludes product returns and

discounts for early payment of invoices. Most businesses also have revenue that is incidental to the

business's primary activities, such as interest earned on deposits in a demand account. This is included in

revenue but not included in net sales. Sales revenue does not include sales ta

Master of Business Administration- MBA Semester 1

Reg No.: 511011932

collected by the business. Other revenue (a.k.a. non-operating revenue) is revenue from peripheral (non-

core) operations. For example, a company that manufactures and sells automobiles would record the

revenue from the sale of an automobile as "regular" revenue. If that same company also rented a portion of

one of its buildings, it would record that revenue as other revenue and disclose it separately on its income

statement to show that it is from something other than its core operations. A firm considering a price

change must know what effect the change in price will have on total revenue. Generally any change in price

will have two effects: the price effect: an increase in unit price will tend to increase revenue, while a

decrease in price will tend to decrease revenue. The quantity effect: an increase in unit price will tend to

lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold. Because of the

inverse nature of the price-demand relationship the two effects offset each other; in determining whether to

increase or decrease prices a firm needs to know what the net effect will be. Elasticity provides the answer.

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In short, the percentage change in revenue is equal to the change in quantity demanded plus the percentage

change in price. In this way, the relationship between PED and revenue can be described for any particular

good:

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not

affect the quantity demanded for the good; raising prices will cause revenue to increase.

When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantity

demanded is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises,

and vice versa.

When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the percentage

change in quantity is equal to that in price and a change in price will not affect revenue.

When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantity

demanded is greater than that in price. Hence, when the price is raised, the total revenue of producers falls,

and vice versa.

When the price elasticity of demand for a good is perfectly elastic (Ed is infinite i.e. undefined), any

increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the

price is raised, the total revenue of producers falls to zero.

Hence, to maximise revenue, a firm ought to operate close to its unit-elasticity pric

Mmmmbbbbb00000422222222 ka 22222 set

Master of Business Administration- MBA

Semester 1

Reg No.: 511011932

Note: Each question carries 10 Marks. Answer all

the questions.

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1. Under perfect competition how is equilibrium

price determined in the short and longrun?

In economics, perfect competition occurs in markets in which no participant has market power. Because the

conditions for perfect competition are strict, there are few if any perfectly competitive markets.

Nonetheless, the concept of perfect competition can serve as a useful benchmark against which to measure

real life, imperfectly competitive markets.

Generally, a perfectly competitive market exists when every participant is a "price taker," and no

participant influences the price of the product it buys or sells. Specific characteristics may include:

Infinite Buyers/Infinite Sellers Infinite consumers with the willingness and ability to buy the product at a

certain price, Infinite producers with the willingness and ability to supply the product at a certain price.

Zero Entry/Exit Barriers It is relatively easy to enter or exit as a business in a perfectlycompetitive market.Perfect Information - Prices and quality of products are assumed to be known to all consumersand producers.Transactions are Costless - Buyers and sellers incur no costs in making an exchangeFirms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal revenue,where they generate the most profit.Homogeneous Products The characteristics of any given market good or service do not varyacross suppliers.

Some subset of these conditions is presented in most textbooks as defining perfect competition. More

advanced textbooks try to reconcile these conditions with the definition of perfect competition as

equilibrium price taking; that is whether or not firms treat price as a parameter or a choice variable. It

should be noted that a general rigorous proof that the above conditions indeed suffice to guarantee price

taking is still lacking.

In the short term, perfectly-competitive markets are productively inefficient as output will not occur where

marginal cost is equal to average cost, but allocatively efficient, as output will always occur where

marginal cost is equal to marginal revenue, and therefore where marginal cost equals average revenue. In

the long term, such markets are both allocatively and productively efficient. Under perfect

competition, any profit-maximizing producer faces a market price equal to its marginal

cost. This implies that a factor's price equals the factor's marginal revenue product. This

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allows for derivation of the supply curve on which the neoclassical approach is based.

The abandonment of price taking creates considerable difficulties to the demonstration of

existence of a general equilibrium except under other, very specific conditions such as

that of monopolistic competition.

Perfect competition is used as a yardstick to compare with other market structure (such

monopoly and oligopoly) because it displays high levels of economic efficiency. In both

the short and long run, price is equal to marginal cost (P=MC) and therefore allocative

efficientcy is achieved - the price that consumers are paying in the markwet reflects the

factor cost of resouces used up in producing/providing the good or service. Productive

efficiency occurs when price is equal to average cost at its minimum point. This is not

achieved int eh short run-firms can be operating at any point on their short run average

total cost curve, but productive efficiency is attained in the long run because the profit

maximixing ouput is achieved at a level where average revenue is tagential to the average

total cost curve. The long run of perfect competition, therefore, exhibits levels of static

economic efficiency. There is of course another form of economic efficiency - dynamic

efficiency - which relates to aspects of market competition such as the rate of innovation

in a market, the quality of output provided over time.

Master of Business Administration- MBA Semester 1Reg No.: 5110119322. Under what conditions is price discrimination possible?

Price discrimination or yield management occurs when a firm charges a different price to

different groups of consumers for an identical good or service, for reasons not associated

with costs. It is important to stress that charging different prices for similar goods is not

pure price discrimination. Differences in price elasticity of demand between markets:

There must be a different price elasticity of demand from each group of consumers. Thefirm is then able to charge a higher price to the group with a more price inelastic demand

and a relatively lower price to the group with a more elastic demand. By adopting such a

strategy, the firm can increase its total revenue and profits (i.e. achieve a higher level of

producer surplus). To profit maximise, the firm will seek to set marginal revenue = to

marginal cost in each separate (segmented) market. Barriers to prevent consumers

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switching from one supplier to another: The firm must be able to prevent market

seepage or consumer switching defined as a process whereby consumers who have

purchased a good or service at a lower price are able to re-sell it to those consumers who

would have normally paid the expensive price. This can be done in a number of ways, and is probably easier to achieve with the provision of a unique service such as a haircut

rather than with the exchange of tangible goods. Seepage might be prevented by selling a

product to consumers at unique and different points in time for example with the use of

time specific airline tickets that cannot be resold under any circumstances.

Examples of price discrimination

Price discrimination is an extremely common type of pricing strategy operated by

virtually every business with some discretionary pricing power. It is a classic part of price

competition between firms seeking a market advantage or to protect an established

market position.

(a) Perfect Price Discrimination charging whatever the market will bear

Sometimes known as optimal pricing, with perfect price discrimination, the firm

separates the whole market into each individual consumer and charges them the price

they are willing and able to pay. If successful, the firm can extract all consumer surplus

that lies beneath the demand curve and turn it into extra producer revenue (or producer

surplus). This is impossible to achieve unless the firm knows every consumers

preferences and, as a result, is unlikely to occur in the real world. The transactions costs

involved in finding out through market research what each buyer is prepared to pay is the

main block or barrier to a businesses engaging in this form of price discrimination.

If the monopolist is able to perfectly segment the market, then the average revenue curve

effectively becomes the marginal revenue curve for the firm. The monopolist will

continue to see extra units as long as the extra revenue exceeds the marginal cost of

production.

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The reality is that, although optimal pricing can and does take place in the real world,

most suppliers and consumers prefer to work with price lists and price menus from which

trade can take place rather than having to negotiate a price for each unit of a product

bought and sold.

Second Degree Price DiscriminationThis type of price discrimination involves businesses selling off packages of a productdeemedto be surplus capacity at lower prices than the previously published/advertised price.

Examples of this can often be found in the hotel and airline industries where spare rooms

and seats are sold on a last minute standby basis. In these types of industry, the fixed

costs of production are high. At the same time the marginal or variable costs are small

and predictable. If there are unsold airline tickets or hotel rooms, it is often in the

businesses best interest to offload any spare capacity at a discount prices, always

providing that the cheaper price that adds to revenue at least covers the marginal cost of

each unit.

There is nearly always some supplementary profit to be made from this strategy. And, it

can also be an effective way of securing additional market share within an oligopoly as

the main suppliers battle for market dominance. Firms may be quite happy to accept asmaller profit margin if it means that they manage to steal an advantage on their rival

firms.

The expansion of e-commerce by both well established businesses and new entrants toonlineretailing has seen a further growth in second degree price discrimination.Early-bird discounts extra cash-flow

The low cost airlines follow a different pricing strategy to the one outlined above.

Customers booking early with carriers such as EasyJet will normally find lower prices if

they are prepared to commit themselves to a flight by booking early. This gives the

airline the advantage of knowing how full their flights are likely to be and a source of

cash-flow in the weeks and months prior to the service being provided. Closer to the date

and time of the scheduled service, the price rises, on the simple justification that

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consumers demand for a flight becomes more inelastic the nearer to the time of the

service. People who book late often regard travel to their intended destination as a

necessity and they are therefore likely to be willing and able to pay a much higher price

very close to departure.

The internet and price discrimination

A number of recent research papers have argued that the rapid expansion of e-commerce

using the internet is giving manufacturers unprecedented opportunities to experiment

with different forms of price discrimination. Consumers on the net often provide

suppliers with a huge amount of information about themselves and their buying habits

that then give sellers scope for discriminatory pricing. For example Dell Computer

charges different prices for the same


computer on its web pages, depending on whether the buyer is a state or local government, or a

small business.

Two Part Pricing Tariffs

Another pricing policy common to industries with pricing power is to set a two-part tariff for consumers. A

fixed fee is charged (often with the justification of it contributing to the fixed costs of supply) and then a

supplementary variable charge based on the number of units consumed. There are plenty of examples of

this including taxi fares, amusement park entrance charges and the fixed charges set by the utilities (gas,

water and electricity). Price discrimination can come from varying the fixed charge to different segments of

the market and in varying the charges on marginal units consumed (e.g. discrimination by time).

Peak time pricing a common feature of many local transport marketsProduct-line pricing

Product line pricing is also becoming an increasingly common feature of many markets, particularly

manufactured products where there are many closely connected complementary products that consumers

may be enticed to buy. It is frequently observed that a producer may manufacture many related products.

They may choose to charge one low price for the core product (accepting a lower mark-up or profit on cost)

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as a means of attracting customers to the components / accessories that have a much higher mark-up or

profit margin.

3. Explain the average and marginal propensity to consume.

In economics, the marginal propensity to consume (MPC) is an empirical metric that quantifies induced

consumption, the concept that the increase in personal consumer spending (consumption) that occurs with

an increase in disposable income (income after taxes and transfers). For example, if a household earns one

extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the

household will spend 65 cents and save 35 cents.

Mathematically, the marginal propensity to consume (MPC) function is expressed as thederivative of the consumption (C) function with respect to disposable income (Y).

For example, suppose you receive a bonus with your paycheck, and it's $500 on top of your normal annual

earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this

marginal increase in income on a new business suit, your marginal propensity to consume will be 0.8 ($400

/ $500).

The marginal propensity to consume is measured as the ratio of the change in consumption tothe change in income, thus giving us a figure between 0 and 1. The MPC can be more than on

if the subject borrowed money to finance expenditures higher than theirincome. One minus the MPC equals the marginal propensity to save (in atwo sector closed economy), both of which are crucial to Keynesianeconomics and are key variables in determining the value of the multiplier.The MPC relies heavily upon the real (inflation-adjusted) rate of interest. Ahigh rate of interest causes spending in the future to become increasinglyattractive due to the intertemporal substitution effect on consumption.Because a rate increase primarily decreases the present value of lifetimewealth, the consumer relies on becoming a lender to offset this effect. In atwo period model, as S(1+r) increases with the interest rate, so does future

income[C= -(1+r)c +we(1+r)]. Therefore, every dollar of current incomespent by the consumer is 1(1+r) dollars the consumer will not be able tospend in the second period.Economists often distinguish between the marginal propensity to consumeout of permanent income, and the marginal propensity to consume out oftemporary income, because if a consumer expects a change in income to be

permanent, then they have a greater incentive to increase their consumption

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(Barro and Grilli, p. 417-8). This implies that the Keynesian multipliershould be smaller in response to permanent changes in income than it is inresponse to temporary changes in income (though the earliest Keynesiananalyses ignored these subtleties). However, the distinction between

permanent and temporary changes in income is often subtle in practice, andit is often quite difficult to designate a particular change in income as being

permanent or temporary. What is more, the marginal propensity to consumeshould also be affected by factors such as the prevailing interest rate and thegeneral level of consumer surplus that can be derived from purchasing.4. What is monetary policy? What are the objectives of such policy?Monetary policy is the process a government, central bank, or monetaryauthority of a country uses to control (i) the supply of money, (ii)availability of money, and (iii) cost of money or rate of interest to attain a setof objectives oriented towards the growth and stability of the economy.[1]

Monetary theory provides insight into how to craft optimal monetary policy.Monetary policy is referred to as either being an expansionary policy, or acontractionary policy, where an expansionary policy increases the totalsupply of money in the economy, and a contractionary policy decreases thetotal money supply. Expansionary policy is traditionally used to combatunemployment in a recession by lowering interest rates, while contractionary

policy involves raising interest rates to combat inflation. Monetary policy iscontrasted with fiscal policy, which refers to government borrowing,spending and taxation


The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance

to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that

monetary policy can make to achieve a favourable economic environment and a high level of employment.

These Treaty provisions reflect the broad consensus that the benefits of price stability are substantial (see

benefits of price stability). Maintaining stable prices on a sustained basis is a crucial pre-condition for

increasing economic welfare and the growth potential of an economy. The natural role of monetary policy

in the economy is to maintain price stability (see scope of monetary policy). Monetary policy can affect

real activity only in the shorter term (see the transmission mechanism). But ultimately it can only influence

the price level in the economy. The Treaty provisions also imply that, in the actual implementation of

monetary policy decisions aimed at maintaining price stability, the Eurosystem should also take into

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account the broader economic goals of the Community. In particular, given that monetary policy can affect

real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output

and employment if this is in line with the pursuit of its primary objective.

5. Explain briefly the phases of business cycle. Through what phase did the world passin 2009-09.

The business cycle is the periodic but irregular up-and-down movements in economic activity,measured by fluctuations in real GDP and other macroeconomic variables.If you're looking for information on how various economic indicators and their relationship to thebusiness cycle, please see A Beginner's Guide to Economic Indicators.

A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a

clock. Its timing is random and, to a large degress, unpredictable. A business cycle is identified as a

sequence of four phases:

Contraction (A slowdown in the pace of economic activity)Trough (The lower turning point of a business cycle, where a contraction turns into an

expansion)

Expansion (A speedup in the pace of economic activity)

Peak (The upper turning of a business cycle)

A recession occurs if a contraction is severe enough... A deep trough is called a slump or adepression.The difference between a recession and a depression, which is not well-understood by non-

economists, is explained in the article "Recession? Depression? What's the difference?". Th


following articles are also useful for understanding the business cycle, and why recessions

happen:

Why Don't Prices Decline During A Recession?

Do Changes in Stock Prices Cause Recessions?

Are Recessions Good For the Economy?

A Beginner's Guide to Economic Indicators

Business cycle phase 2009 is slow or negative economic growth and perhaps falling prices. As the

slowdown or recession progresses, credit demand surges as businesses run low on cash. Consumers pay

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down their debts and businesses get rid of workers and reduce inventories to bring production into line with

demand.

Raw material prices fall sharply and after a lag, consumer prices slow their ascent. Finally, when the pain

of recession grows too severe for the government to tolerate, the Fed eases credit and of course the cycle

begins all over again.

Some business cycles are more severe and therefore more distinct than others. But regardless, there are

certain types of investments that are best in each stage of the business cycle. For instance, in phase one, at

the bottom of a recession, common stocks are the best place to be while bonds, real estate and commodities

are okay but gold and collectibles should be avoided. In phase two when the economy accelerates and

prices begin to climb, all commodities, including gold, are the best investments; stocks are good and bonds

are fair. During phase three of the cycle with rising interest rates and a coming recession, equities start to

weaken and bonds begin to move up.

Finally, in phase four the slowdown or recession is progressing full steam ahead. This is when fixed income

instruments, like bonds provide great returns. Late in this phase, stocks start looking good again.

Commodities and real estate should be avoided during this phase.

In January, the economy entered the second year of its recession. The magnitude of the downturn is not

unprecedented by any means. Several of the past recessions brought larger decreases in gross domestic

product and higher levels of unemployment. But the speed of the current deterioration is daunting. The bulk

of it took place in the last quarter of 2008. AIERs statistical indicators of business-cycle conditions

continue to point to further contraction. It seems unlikely that the recession has reached its trough.

The percentage of primary leading indicators appraised as expanding fell to 17 from 20 last month. Only

two primary leading indicatorsM1 money supply and the yield curve index are appraised as

expanding, but they reflect only the expansionary monetary policy. Employment situation remains grim and

production continues to contract. As a response to a slowdown, both


consumer and producer prices began to fall.

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The cyclical score, which is based on a separate purely mathematical analysis of the leaders, decreased to

28 from 33 last month. Both the cyclical score and the percentage of leaders expanding continue to signal

that further contraction is likely.

The primary roughly coincident indicators strongly confirm that the economy is in recession. None of the

indicators is appraised as expanding. The cyclical score for the coinsiders fell to 23 from 36 last month,

reinforcing the view that the economy is in recession.

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

A sustained rise in the prices of commodities that leads to a fall in the purchasing power of a nation is

called inflation. Although inflation is part of the normal economic phenomena of any country, any increase

in inflation above a predetermined level is a cause of concern.

High levels of inflation distort economic performance, making it mandatory to identify the causing factors.

Several internal and external factors, such as the printing of more money by the government, a rise in

production and labor costs, high lending levels, a drop in the exchange rate, increased taxes or wars, can

cause inflation.

Different schools of thought provide different views on what actually causes inflation. However, there is a

general agreement amongst economists that economic inflation may be caused by either an increase in the

money supply or a decrease in the quantity of goods being supplied. The proponents of the Demand Pull

theory attribute a rise in prices to an increase in demand in excess of the supplies available. An increase in

the quantity of money in circulation relative to the ability of the economy to supply leads to increased

demand, thereby fuelling prices. The case is of too much money chasing too few goods. An increase in

demand could also be a result of declining interest rates, a cut in tax rates or increased consumer

confidence.

The Cost Push theory, on the other hand, states that inflation occurs when the cost of producing rises and

the increase is passed on to consumers. The cost of production can rise because of rising labor costs or

when the producing firm is a monopoly or oligopoly and raises prices, cost of imported raw material rises

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due to exchange rate changes, and external factors, such as natural calamities or an increase in the

economic power of a certain country.

An increase in indirect taxes can also lead to increased production costs. A classic example of cost-push or

supply-shock inflation is the oil crisis that occurred in the 1970s, after the OPEC raised oil prices. The US

saw double digit inflation levels during this period. Since oil is used in every industry, a sharp rise in the

price of oil leads to an increase in the prices of all


commodities. However, the central bank indicated that, in the wake of an expected improvement in

agricultural production as well as low international commodity prices, inflationary pressures are expected

to remain at a low level through the greater part of the 2009-10. According to the report, global crude oil

prices are expected to remain stable during the current financial year, at the current level of $50 per barrel.

"If global economic recovery begins earlier and is stronger, there is an upside risk of even higher oil prices

from the current level. Assuming that there are no major crude oil supply disruptions, average WTI (West

Texas Intermediate) prices are expected to be $52.6 per barrel in 2009, which is 47 per cent lower than the

average price for the year 2008 ($99.6 per barrel). In view of the relatively tight demand supply-balance

over the long run, the long-term outlook for oil, however, remains highly uncertain," the apex bank said.

Price-rise down due to base effect

Driven by the reduction in the administered prices of petroleum products and electricity, as well as the

decline in prices of freely priced minerals, oil items, iron & steel, oilseeds, edible oils, oil cakes and raw

cotton, year-on-year (y-o-y) headline inflation in the country showed a sharp correction from a historic

peak of 12.90 per cent on August 2, 2008 to 0.3 per cent as on March 28, 2009.

"A significant part of the end year reduction in WPI inflation could also be attributed to the base effect

reflecting the rapid increase in inflation recorded during the last quarter of 2007-08," the report said.

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With the decline in prices of sugar, edible oils/oil cakes, textiles, chemicals, iron & steel and machinery &

machine tools, manufactured products' inflation fell to 1.4 per cent on March 28, 2009 compared with 7.3

per cent a year ago.

While money growth is considered to be a principal long-term determinant of inflation, non- monetary

sources, such as an increase in commodity prices, have played a key role in triggering inflation in the past

four decades.

Inflation has become a major concern worldwide in 2008, with global prices rises in oil, food,steel and other commodities being the culprit.

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