study material for MBA I- Managerial Economics

MBA 102
Managerial Economics

Unit I
1. Define managerial economics. Explain briefly its nature and scope?
Ans. Managerial Economics consists of that part of economic theory which helps the business manager to take rational decisions. Economic theories help to analyze the practical problems faced by a business firm. Managerial Economics integrates economic theory with business practice. It is a special branch of economics that bridges the gap between abstract theory and business practice. It deals with the use of economic concepts and principles for decision making in a business unit It is over wise called Business Economics or Economics of the Firm. The terms Managerial Economics and Business Economics are used interchangably. Managerial Economics is economics applied in business decision-making. Hence it is also called Applied Economics.
Definition of Business Economics
In simple words, business economics is the discipline which helps a business manager in decision making for acheiving the desired results. In other words, it deals with the application of economic theory to business management.
According to Spencer and Siegelman, Business economics is "the integration of economic theory with business practise for the purpose of facilitating decision-making and forward planning by management".
According to Mc Nair and Meriam, "Business economics deals with the use of economic modes of thought to analyse business situation".
From the above said definitions, we can safely say that business economics makes in depth study of the following objectives:
(i) Explanation of nature and form of economic analysis
(ii) Identification of the business areas where economic analysis can be applied
(iii) Spell out the relationship between Managerial Economics and other disciplines
outline the methodology of managerial economics.
Characteristics of business economics
The following characteristics of business economics will indicate its nature:
1. Micro economics: Managerial economics :s micro economic in character. This is so because it studies the problems of an individual business unit. It does not study the problems of the entire economy.
2. Normative science: Managerial economics is a normative science. It is concerned with what management should do under particular circumstances. It determines the goals of the enterprise. Then it develops the ways to achieve these goals.
3. Pragmatic: Managerial economics is pragmatic. It concentrates on making economic theory more application oriented. It tries to solve the managerial problems in their day-today functioning.
4. Prescriptive: Managerial economics is prescriptive rather than descriptive. It prescribes solutions to various business problems.
5. Uses macro economics: Marco economics is also useful to business economics. Macro-economics provides an intelligent understanding of the environment in which the business operates. Managerial economics takes the help of macro-economics to understand the external conditions such as business cycle, national income, economic policies of Government etc.
6. Uses theory of firm: Managerial economics largely uses the body of economic concepts and principles towards solving the business problems. Managerial economics is a special branch of economics to bridge the gap between economic theory and managerial practice.
7. Management oriented: The main aim of managerial economics is to help the management in taking correct decisions and preparing plans and policies for future. Managerial economics analyses the problems and give solutions just as doctor tries to give relief to the patient.
8. Multi disciplinary: Managerial economics makes use of most modern tools of mathematics, statistics and operation research. In decision making and planning principles such accounting, finance, marketing, production and personnel etc.
9. Art and science.-Managerial economics is both a science and an art. As a science, it establishes relationship between cause and effect by collecting, classifying and analyzing the facts on the basis of certain principles. It points out to the objectives and also shows the way to attain the said objectives.
Scope of Business Economics
Managerial economics is a developing science which generates the countless problems to determine its scope in a clear-cut way. From the following fields, we can examine the scope of business economics.
1. Demand analysis and forecasting. The foremost aspect regarding scope is demand analysis and forecasting. A business firm is an economic unit which transformsproductive resources into saleable goods. Since all output is meant to be sold, accurate estimates of demand help a firm in minimising its costs of production and storage. A firm must decide its total output before preparing its production schedule and deciding on the resources to be employed. Demand forecasts serves as a guide to the management for maintaining its market share in competition with its rivals, thereby securing its profit.
2. Cost and production analysis. A firm's profitability depends much on its costs of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing variations in costs and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations.
Production process are under the charge of engineers but the business manager works to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing policies depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economies and Diseconomies of scale and cost control.
3. Pricing decisions, policies and practices. Another task before a business manager is the pricing of a product. Since a firm's income and profit depend mainly on the price decision, the pricing policies and all such decisions are to be taken after careful analysis of the nature of the market in which the firm operates. The important topics covered in this field of study are : Market Structure Analysis, Pricing Practices and Price Forecasting.
4. Profit management. Each and every business firms are tended for earning profit, it is profit which provides the chief measure of success of a firm in the long period. Economists tells us that profits are the reward for uncertainity bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues at different levels of output. The more successful a manager is in reducing uncertainity, the higher are the profits earned by him. It is therefore, profit-planning and profit measurement constitute the most challenging area of business economics.
5. Capital management. Still another most challenging problem for a modern business manager is of planning capital investment. Investments are made in the plant and machinery and buildings which are very high. Therefore, capital management requires top- level decisions. It means capital management i.e., planning and control of capital expenditure. It deals with Cost of capital, Rate of Return and Selection of projects.
6. Inventory management: A firm should always keep an ideal quantity of stock. If the stock is too much, the capital is unnecessarily locked up in inventories At the same time if the level of inventory is low, production will be interrupted due to non-availability of materials. Hence, a firm always prefers to have an optimum quantity of stock. Therefore, managerial economics will use some methods such as ABC analysis, inventory models with a view to minimising the inventory cost.
7. Linear programming and theory of games : Linear programming and theory of games have came to be regarded as part of managerial economics recently.
8. Environmental issues: There are certain issues of macroeconomics which also form a part of managerial economics. These issues relate to general business, social and political environment in which a business enterprise operates.
9. Business cycles: Business cycles affect business decisions. They refer to regular fluctuations in economic activities in the country. The different phases of business cycle are depression, recovery, prosperity, boom and recession.
Thus, managerial economics comprises both micro and macro-economic theories.
The subject matter of managerial economics consists of all those economic concepts, theories and tools of analysis which can be used to analyse the business environment and to find out solution to practical business problems.
Relationship of managerial economics with other sciences
To broadly appreciate the nature and scope of managerial economics it is necessary to examine its relationship with other sciences. At this juncture it is apt to specially mention the relationship of managerial economics with the important fields of study such as statistics, mathematics, operations research, and accounting.
Managerial economics and statistics
Statistics provides several tools to Managerial Economics; Statistical techniques are used in collecting, marshalling and analysing business data that makes possible an empirical testing of the economic generalisations before they are applied for decision making. Economic generalisations cannot be fully accepted until they are verified and found Valid against the real data. The theory of probability and forecasting techniques help the manager in decision-making process. When the manager is to meet with the reality of uncertainty in decision making the theory of probability provides the logic for dealing with such uncertainty.
Managerial economics and mathematics
Mathematics is especially of to the manager when several economic relationships are to logic in the analysis of economic events provides clarity of the concepts and also helps to establish a quantitative relationship. Managers deal primarily with concepts that are quantitative in nature eg., demand, price, cost, capital, wages, inventories etc. Mathematics is the manager's most useful logical tool.
Managerial economics and operations research
Operation research and managerial economics are related to a certain extent. Operation research is the application of mathematical and statistical techniques in solving business problems. It deals with construction of mathematical models that helps the decision making process. Operation research is helpful in business firms in studying the inter-relationship and relative efficiencies of various business aspects like sales, production etc. Linear programming, techniques of inventory control, game theory etc. are used in managerial economics. These are used to find out the optimum combination of various factors to achieve the objects of maximisation of profit, minimizations of cost and time etc.
Managerial economics and accounting
Accounting is closely related with managerial economics. Accounting is the main source of data regarding the operation and functioning of the firm. Accounting data and statements represent the language of the business. A business manager needs market information, production information and accounting information for decision-making. The profit and loss statement reflects the operational efficiency of the firm. The balance sheet tells the financial position of the firm. The accounting information provides a basis for the manager in decision making and forward planning. In short, accounting provides right information to take right decisions.

2. Explain the significance of managerial economics in decision making?
Ans. Managerial economics provides such tools necessary for business decisions. Managerial economics answers the five fundamental problems of decision making. These problem are : (a) what should be the product mix (b) which is the least cost production technique and input mix (c) what should be the level of output and price of the product (d) how to take investment decisions (e) how much should be the selling cost. In order to solve the problems of decision- making, data are to be collected and analysed in the lightof business objectives. Business economics supplies such data to the business economist.
As pointed out by Joel Dean "The purpose of managerial economics is to show how economic analysis can be used in formulating business policies"
The basic objective of managerial economics is to analyse economic problems of business and suggest solutions and help the managers in decision-making. The objectives of business economics are outlined as below:
1. To integrate economic theory with business practice.
2. To apply economic concepts: and principles to solve business problems.
3. To employ the most modern instruments and tools to solve business problems.
4. To allocate the scarce resources in the optimal manner.
5. To make overall development of a firm.
6. To help achieve other objectives of a firm like attaining industry leadership, expansion of the market share etc.
7. To minimise risk and uncertainty
8. To help in demand and sales forecasting.
9. To help in operation of firm by helping in planning, organising, controlling etc.
10. To help in formulating business policies.
11. To help in profit maximisation.
Business economics is useful because: (i) It provides tools and techniques for managerial decisions, (ii) It gives answers to the basic problems of business management, (iii) It supplies data for analysis and forecasting, (iv) It provides tools for demand forecasting and profit planning, (v) It guides the managerial economist. -
Thus, Business economics offers a number of benefits to business managers. It is also useful to individuals, society and government.

3. Explain the role and responsibilities of managerial economist in decision making?
Ans. Role of a managerial economist
1. Study of the business environment. Every firm has to take into consideration such external factors as the growth of national income, volume of trade and the general price trends, for its policy decision. A firm works within a business environment. The basic element of business environment for a firm are the trend of growth of national economy and world economy and phase of the business cycle in which the economy is moving. At what rate and where is population getting concentrated? Where are the demand prospects for established and new products? Where are the prospective markets? These questions lead the economists into purposeful studies of the economic environment.
The international economic outlook is a very important environmental factor for exporting firms. The nature and degree of competition within the industry in which a firm is placed are also a part of the business environment.
The kind of economic policies pursued by the government constitute a powerful element of the business environment of a firm. What are the priorities of the new five year plan? In which sectors of the economy have the outlays been bran increased? What are the budgetary trends? What about changes in expenditure, tax rates tariffs and import restrictions? For all purposes the economists place a significant role.
2. Business Plan and Forecasting. The business economists can help the management in the formation of their business plan by forecasting and economic environment. The management can easily decide the timing and locating of their specific action. The managerial economists has to interpret the national economic trends and industrial outlook for their relevance to the firm in which he is working. He advises top management by means of short, business like practical notes. In a partially controlled economy like India, the business economists translates the government's intentions in business jargon and also transmits the reaction of the industry to propose changes in government policy.
3. Study of business operations. The business economist can also help the management in decision making relating to the internal operations of a firm, i.e., in deciding about price, rate of operations, investment and growth of the firm for offering this advice ; the economist has specific analytical and forecasting techniques which yield meaningful conclusions. What will be the reasonable sales and profit budget for the next year? What are the suitable production schedules and inventory policies? What changes in wage and price policies are imperative now? What would be the sources of finance? Thus, he is trained to answer such questions posted by the top management.
4. Economic intelligence. The business economist also provides general intelligence services by supplying the management with economic information of general interest so that they can talk intelligently in conferences and seminars. They are also supplied the facts and figures for preparing the annual reports of the firm. Those facts and figures are mcollected by the business economist as he understands the literature available on business activities.
5. Specific functions. Business economists are now performing specific functions as consultants also. Their specific functions are demand forecasting, industrial market research, pricing problems of industry, production programmes, investment analysis and forecasts. They also offer advice on trade and public relations, primary commodities and foreign to capital projects in agriculture, industry, transport and tourism and also of the export environment.
6. Participation in Public Debates. The business economists participate in public debates organised by different agencies. Both governments and society seek their advice. Their practical experience in business and industry gives value to their observation. In nut shell a business economist can play a multi-faceted role. He is not only an analyst of current trends and policies for his employers but also a bridge between the businessmen in the specific industry and the Govt.
RESPONSIBILITIES OF A BUSINESS ECONOMIST
A business economist is well familiar with his responsibilities. He must keep in the mind the main objective of making a reasonable profit on the invested capital in his firm. Firms are not always after profit-maximization, but to continue in business, every firm has to operate for profit. Therefore, a business economist has the main responsibility of helping the management to make more profits than before. All his other responsibilities flow from this basic obligation. The responsibilities of a business economists are summarised below :
1. Making successful Forecasts. Managements have to take decisions concerning the future and it is uncertain. This uncertainity cannot be eliminated altogether but it can be reduced through scientific forecasts of the economic environment to his employers. This is required for business planning. If a business economist can make successful forecasts about business trends, the management will hold him in great esteem. A wise managerial economist will revise his forecasts from time to time keeping in view new developments in his business. As soon as he finds a change in his forecasts, he has to alert the management about it. He assists the management in making the needed adjustments. This will help him to strengthen his position as a member of the managerial team.
2. Maintaining Relationships. The managerial economists must establish and maintain contacts with data sources for his analysis and forecasts. He makes contacts with individual who are specialists in the different fields. He must join professional associations and subscribe to the journals giving him fresh and latest information. In other words, his business biggest quality is his ability to obtain information quickly by establishing contacts with the sources of such information.
3. Earning full Status on the Managerial team. A business economist has to participate in decision-making and forward- planning. For this he must be able to earn full status on the business team. He must be prepared to take up assignments on special project also. He should be able to express himself clearly so that his advice is understood and accepted. Finally, he must be in tune with the industry's thinking, and not lose the national perspective in giving advice to the management.
Thus, we can conclude from our discussion that managerial economists can earn an important place in the managerial team only if the understands and undertakes his responsibilities.

4. Elaborate the different principles of managerial economics which are helpful in decision making?
Ans. Fundamental concepts of applied managerial economics
Decision making is the core of Managerial Economics. Some fundamental concepts and techniques help the management to take correct decisions. The following are the six fundamental concepts used in Managerial Economics:
1. Principle of opportunity cost: Every scarce goods or activity has an opportunity cost. Opportunity cost of anything is the cost of the next best alternative which is given up. It refers to the cost of foregoing or giving up an opportunity. It is the earnings that would be realised if the available resources were put to some other use. It implies the income or benefit foregone because a certain course of action has been taken. Thus opportunity costs are measured by the sacrifices made in the decision. If there is no sacrifice involved by a decision there will be no opportunity cost. It is also called alternative cost or transfer cost.
The opportunity cost of using a machine to produce one product is the income forgone which would have been earned from the production of other products. If the machine has only one use, it has no opportunity cost. Similarly, the opportunity costs of funds invested in one's own business is the amount of interest earned if the amount had been used in other projects. If an old building is proposed to be used for a business, likely rent of the building is the opportunity cost. These are called opportunity costs because they represent the opportunities which are foregone.
Devenport, an American Economist explains the concept of opportunity cost with reference to an example. Suppose a girl had two kinds of fruits- one pear and one peach, and if a bad boy is after her to seize the fruits, then the best way for the girl is to drop one fruit and run with the other, so that, she can at least save one fruit, at the cost of the other. When the girl so drops by the way - side one fruit and runs with the other, then the opportunity cost of the fruit she saves is the foregone alternative of the fruit she lost. This is the opportunity cost theory.
The concept of opportunity cost plays an important role in managerial decisions. This concept helps in selecting the best possible alternative from among various alternatives available to solve a particular problem. This concept helps in the best allocation of available resources.
2. Principle of incremental cost and revenue: Two important incremental concepts used in Managerial Economics are fundamental concepts of Managerial Economics are incremental cost and incremental revenue. Incremental cost is a change in total cost resulting from a decision. Incremental revenue means the change in total revenue resulting from a decision. A decision is profitable only if
(i) It increases revenue more than costs,
(ii) It decreases some costs more than it increases others,
(iii) It increases some revenue more than it decreases others, and
(iv) It reduces costs more than revenue.
Incremental principle can be used in the theories of consumption, production, pricing and distribution. Incremental concept is closely related to marginal cost and marginal revenue in the theory of pricing.
3. Principle of Time Perspective. Another principle is the principle of time perspective which is useful in decision-making in output, prices, advertising and expansion of business. Economists distinguish between the short run and the long run in discussing the determination of price in a given market form because in the long run a firm must cover its full cost. On the contrary, in the short-run it can afford to ignore some of its (fixed) costs. Modern economists have started making use of an "intermediate run" between the short run and the long run in order to explain pricing and output behaviour under what is called oligopoly. The principle of time perspective can be stated as under : A decision should take into account both the short run and the long run effects on revenues and costs and maintain a right balance between the long run and the short run perspectives.
4. Discounting Principle. Generally people consider a rupee tomorrow to be worth less than a rupee today. This is also implied by the common saying that a bird in hand is worth than two in the bush. Anybody will prefer Rs. 1000 today to Rs. 1000 next year. There are two main reasons for this : (1) the future is uncertain and it is preferable to get Rs. 1000 today rather than a year after ; (2) even if one is sure to receive the Rs. 1000 next year, one would do well to receive Rs. 1000 now and invest it for a year and earn a rate of interest on Rs. 100 for one year. What is the present worth (PW) of Rs. 1000 obtainable after one year ? The relevant formula for finding this out is
PW = i Rs .100 where i is the rate of interest.
We find that PW of Rs. 100 = 100 ÷ (1 + 8%)
= 100 ÷ 108 = Rs. 92.59.
The principle of economics used in the calculations given above is called the discounting principle. It can be explained as "If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to obtain the present values of both before a valid comparison of alternatives can be made"present values of both before a comparison of alternatives can be made’’
5. Equi-marginal principle : This is one of the widely used concepts in managerial economics. This principle is also known the principle of maximum satisfaction. According to this principle, an input should be allocated in such a manner that the value added by the last unit of input is same in all uses. In this way, this principle provides a base for maximum exploitation of all the inputs of a firm so as to maximise the profitability.
The equi-marginal principle can be applied in different areas of management. It is used in budgeting. The objective is to allocate resources where hey are most productive. It can be used for eliminating waste in useless activities. It can be applied in any discussion of budgeting. The management can accept investments with high rates of return so as to ensure optimum allocation of capital resources. The equi-marginal principle can also be applied in multiple product pricing. A multi product firm will reach equilibrium when the marginal revenue obtained from a product is equal to that of another product or products. The equi-marginal principle may also be applied in allocating research expenditures.
6. Optimisation : This is another important concept used managerial economics. Managerial economics often aims at optimising a given objective. The objective may be maximisation of profit or minimisation of time or minimisation of cost. The important techniques for optimisation include marginal analysis, calculus, linear programming etc.


Unit II
5. What do you mean by demand? Explain the factors affecting/determinants of demand?
Ans. In common usage, demand means a desire or a want but in economics desire, want and demand are three different concepts. In economics, every desire is not  a want and every want is not a demand. Desire is the wish to have something or to enjoy a service.
Want= Desire + Resources + Willingness
But demand implies more than mere desire. It means that the person is willing and able to pay for the object he desire. Demand thus means desire backed by willingness and ability to pay. Besides, demand also signifies a price and a period of time in which demand is to be fulfilled. It is obvious that a person’s demand for anything varies with the price at which it is offered. He buys more of it at a lower price, and less of it at a higher price. Similarly, his demand varies with the period of time.
Demand= Want + Relationship of Want with certain price, time and quantity
“By demand we mean the various quantities of a given commodity or service which consumers would buy in one market in a given period of time at various prices, or at various incomes, or at various prices of related goods.”— (Bober).
We can represent demand symbolically as a functional relationship as under:
DA=F (Pa, Pc, Pd………………….: I: T)
In this equation DA stands for the households demand for goods A: Pa, Pc, Pd denote the prices of other goods: I stands for (he income of the household, and the households’ tastes are represented by T.
Kinds of Demand:
Three kinds of demand may be distinguished:
(a) Price demand,
(b) Income demand, and
(c) Cross demand.
Price Demand:
This demand refers to the various quantities of a commodi¬ty or service that a consumer would purchase at a given time in a market at various hypothetical prices. It is assumed that other things such as consumers’ income, his tastes and prices of related goods remain unchanged.
The demand of the individual consumer is called Individual Demand and the aggregate demand of all the consumers combined for the commodity or service is called Industry Demand. The total demand for the product of an individual firm at various prices is known as firm’s demand or Individual Seller’s Demand.
Income Demand:
The income demand refers to the various quantities of goods and services which would be purchased by the consumer at various levels of income. Here we assume that the prices of the commodity or service as well as the prices of related goods and the tastes and desires of consumers do not change.
The price demand expresses relationship between prices and quantities and the income demand brings out the relationship between income and quantities demanded. For preparing demand schedule of income demand, we write incomes in one column and quantities purchased at these incomes in the second column. Superior goods or high-priced articles command brisk sales when income increases. On the other hand, inferior goods command large sales when incomes are at a lower level.
Cross Demand:
Cross demand means the quantities of a good or service which will be purchased with reference to changes in the price not of this good but of other related goods. These goods are either substitutes or complementary good. A change in price of tea will affect demand for coffee. Similarly, if horses become sheep, demand for carriages may increase.
Some other kinds of demand
i.Individual and Market Demand:
Refers to the classification of demand of a product based on the number of consumers in the market. Individual demand can be defined as a quantity demanded by an individual for a product at a particular price and within the specific period of time. For example, Mr. X demands 200 units of a product at Rs. 50 per unit in a week.
The individual demand of a product is influenced by the price of a product, income of customers, and their tastes and preferences. On the other hand, the total quantity demanded for a product by all individuals at a given price and time is regarded as market demand.
In simple terms, market demand is the aggregate of individual demands of all the consumers of a product over a period of time at a specific price, while other factors are constant. For example, there are four consumers of oil (having a certain price). These four consumers consume 30 liters, 40 liters, 50 liters, and 60 liters of oil respectively in a month. Thus, the market demand for oil is 180 liters in a month.
ii. Organization and Industry Demand:
Refers to the classification of demand on the basis of market. The demand for the products of an organization at given price over a point of time is known as organization demand. For example, the demand for Toyota cars is organization demand. The sum total of demand for products of all organizations in a particular industry is known as industry demand.
For example, the demand for cars of various brands, such as Toyota, Maruti Suzuki, Tata, and Hyundai, in India constitutes the industry’ demand. The distinction between organization demand and industry demand is not so useful in a highly competitive market.
This is due to the fact that in a highly competitive market, organizations have insignificant market share. Therefore, the demand for an organization’s product is of no importance. However, an organization can forecast the demand for its products only by analyzing the industry demand.
iii. Autonomous and Derived Demand:
Refers to the classification of demand on the basis of dependency on other products. The demand for a product that is not associated with the demand of other products is known as autonomous or direct demand. The autonomous demand arises due to the natural desire of an individual to consume the product.
For example, the demand for food, shelter, clothes, and vehicles is autonomous as it arises due to biological, physical, and other personal needs of consumers. On the other hand, derived demand refers to the demand for a product that arises due to the demand for other products.
For example, the demand for petrol, diesel, and other lubricants depends on the demand of vehicles. Apart from this, the demand for raw materials is also derived demand as it is dependent on the production of other products. Moreover, the demand for substitutes and complementary goods is also derived demand.
iv. Demand for Perishable and Durable Goods:
Refers to the classification of demand on the basis of usage of goods. The goods are divided into two categories, perishable goods and durable goods. Perishable or non-durable goods refer to the goods that have a single use. For example, cement, coal, fuel, and eatables. On the other hand, durable goods refer to goods that can be used repeatedly.
For example, clothes, shoes, machines, and buildings. Perishable goods satisfy the present demand of individuals. However, durable goods satisfy both present as well as future demand of individuals. Therefore, consumers purchase durable items by considering its durability.
In addition, durable goods need replacement because of their continuous use. The demand for perishable goods depends on the current price of goods and customers’ income, tastes, and preferences and changes frequently, while the demand for durable goods changes over a longer period of time.
v. Short-term and Long-term Demand:
Refers to the classification of demand on the basis of time period. Short-term demand refers to the demand for products that are used for a shorter duration of time or for current period. This demand depends on the current tastes and preferences of consumers.
For example, demand for umbrellas, raincoats, sweaters, long boots is short term and seasonal in nature. On the other hand, long-term demand refers to the demand for products over a longer period of time.
Generally, durable goods have long-term demand. The long-term demand of a product depends on a number of factors, such as change in technology, type of competition, promotional activities, and availability of substitutes. The short-term and long-term concepts of demand are essential for an organization to design a new product.
Factors Influencing Demand for a Commodity:
They are many factors on which the demand for a commodity depends. They are called determinants of demand. They are discussed as under:
1. Income of the consumer:
A consumer’s demand is influenced by the size of his income. With increase in the level of income, there is increase in the demand for goods and services. A rise in income causes a rise in consumption. As a result, a consumer buys more. For most of the goods, the income effect is positive. But for the inferior goods, the income effect is negative. That means with a rise in income, demand for inferior goods may fall.

2. Price of the commodity:
Price is a very important factor, which influences demand for the commodity. Generally, demand for the commodity expands when its price falls, in the same way if the price increases, demand for the commodity contracts. It should be noted that it might not happen, if other things do not remain constant.

3. Changes in the prices of related goods:
Sometimes, the demand for a good might be influenced by prices changes of other goods. There are two types of related goods. They are substitutes and complements. Tea and Coffee are good substitutes. A rise in the price of coffee will increase the demand for tea and vice versa. Bread and butter are complements. A fall in the price of bread will increase the demand for butter and vice versa.

4. Tastes and preferences of the consumers:
Demand depends on people’s tastes, preferences, habits and social customs. A change in any of these must bring about a change in demand. For example, if people develop a taste for tea in place of coffee, the demand for tea will increase and that for coffee will decrease.

5. Change in the distribution of income:
If the distribution of income is unequal, there will be many poor people and few rich people in society. The level of demand in such a society will be low. On the other hand, if there is equitable distribution of income, the demand for necessaries commonly consumed by the poor will increase and the demand for luxuries consumed by the rich will decrease. However, the net effect of an equitable distribution of income is an increase in the level of demand.

6. Price expectations:
Expectations of people regarding the future prices of goods also influence their demand. If people anticipate a rise in the prices of goods in future due to some reasons, the demand for goods will rise to avoid more prices in future. Contrarily, if the people expect a fall in price, the demand for the commodity will fall.

7. State of economic activity:
The state of economic activity is major determinant influencing the demand for a commodity. During the period of boom, prosperity prevails in the economy. Investment, employment and income increase. The demand for both capital goods and consumer goods increase. But in period of depression demand declines due to low investment and low income.

8 . Population:
An increase in population of region will result in an increased demand of various goods. Also, the composition of population determines the demand of certain goods proportionately. For example, an increased number of females in the region will generate more demand for sarees, ornaments, cosmetics etc.
1. Government Policy:
Economic policy adopted by the government also influences the demand for commodities. If the government imposes taxes on various commodities in the form of sales tax, excise duties, octroi etc., the price of these commodities will increase. As a result, the demand of such commodities is very likely to fall.
2. Advertisement:
In this age of advertisement demand for many fashionable items are created by advertising agents through T.V., newspapers, radios etc.
3. Weather Conditions:
The demand for various household goods depends upon the changes in weather conditions. For example, the demand for woolen clothes, coal and electric heaters increases during winter and the demand for cold drinks, ice creams, room coolers, etc. goes up during hot weather.
The level of demand for a commodity is also influenced by other factors like pattern of saving, inventions and discoveries and outbreak of war, emergencies, technical progress etc.

6. Explain the law of demand with the help of a demand schedule and demand curve. Also point out the exception of the law?
Ans. Demand Schedule:
If we write down the different quantities that an individual or a group of individuals would buy at different prices, we get that individual’s or that group’s demand schedule. Thus, a demand schedule is a table or a chart which shows the quantities of a commodity demanded at different prices in a given period of time.
The following is the demand schedule of an imaginary consumer of milk:



Market Schedule:
The above is the demand schedule of a particular individual. But we can also construct a market schedule showing the total quantity of milk demanded at different prices in a market by the whole body of consumers. We can divide them into three classes: ‘A’—with u monthly income up to Rs. 500, ‘B’—Rs. 501 to Rs. 1000 and “C”—above Rs. 1000. We can see how much will each class buy at each price, and then total them up


Difficulties in the Construction of a Demand Schedule:
It is difficult to frame the demand schedule of an individual. It is all hypothetical. An individual cannot positively say how much he would purchase it the prices were different. Some prices in the schedule are unreal. The price of milk may never be Rs. 8 or Re 1 per liter. What is the use of asking an individual how much he would by at these prices? To construct a market schedule is still more difficult. Market schedule is even more hypothetical.
Practical Utility of a Demand Schedule:
It is not possible to construct a scientifically accurate demand schedule. But it is true that different quantities are bought at different prices.
The demand schedule is useful as follows:
(i) After all, businessmen do make an intelligent forecast of the quantity they could dispose of at higher or lower prices. Monopolists sometimes deliberately lower prices to stimulate demand. Businessmen would like to know the various quantities that are likely to be demanded at different prices. This would help them to forecast profits and to arrange production.
(ii) In order to find out the effect of different rates of taxes on the sale of a commodity, a Finance Minister has to get the help of demand schedules. The calculations may be rough, but they are all the same useful. Imposition of tax is bound to raise prices which would in turn reduce demand. The Government revenue will depend on how much is actually sold. Demand schedule is helpful in making these calculations.
Demand Curve:
With the help of the demand schedule of an individual given above, we can draw the curve as shown on the previous page. The quantities are measured along OX and prices (in rupees) along OY.

When the price is Rs. 7.00 a liter, the consumer purchases only half a liter. We travel half a point on OX-axis and plot a point against the price of Rs. 7.00; we plot the other points in the same manner, and by joining these points we get the curve. Like the individual demand curve, we can also have a market demand curve by plotting the market demand schedule given above.
Why Demand Curves Slope Downwards:
Generally the demand curve slopes downwards. This is in accordance with the law of diminishing utility. The purchases of most of us are governed by this law. When the price falls, new purchasers enter the market and old purchasers will probably purchase more. Since this commodity has become cheaper, it will be purchased by some people in preference to other commodities.
Only in a curve of this slope shall we find shorter price lines cutting longer pieces in the quantity axis. If the law of diminishing utility is true—and it is generally true—the curve must slope downward, for only then the phenomenon of increasing demand with falling prices can be represented.
These are the three obvious reasons why people buy more when the price falls:
(i) A unit of money goes farther and one can afford to buy more.
(ii) When a thing becomes cheaper one naturally likes to buy more.
(iii) A commodity tends to be put to more uses when it becomes cheaper. Thus, the old buyers buy more and some new buyers enter the market. The cumulative effect is an extension of demand when price falls. But let us go a bit deeper and try to find out why the demand increases when the price falls, other things being equal. Having a limited amount of money at his disposal, every consumer wants to get the maximum satisfaction out of it. Knowing his own scale of preferences he will, according to the law of substitution and equimarginal returns, so arrange his expenditure that he gets equal marginal utility from the last paisa that he spends in different ways.
He will keep to this arrangement if the prices remain the same. But if the price of a certain commodity included in his assortment of goods and services falls, then lie must make a corresponding alteration in his scheme of expenditure. By the fall in price, divergence has been created between the marginal utility and price and this must be rectified. This can be done by buying more of the cheaper commodity, thus bringing its marginal utility to the level of the price. That is why people buy more when the prices fall.
Substitution Effect, Income Effect and Price Effect:
If the price of a commodity rises relatively to other goods, the consumer will buy less of that commodity and buy more of the other goods in place of this particular good. This is called Substitution Effect in Economics. Another reason for buying less of goods whose prices have risen is that raise in prices means a loss of purchasing power. It is as it were that the consumer’s income has come down. This is called the Income Effect.
This is, the consumer has become relatively poor or wane off since his real income (i.e., income in terms of goods) has fallen. When the price of a commodity falls, more of it is demanded and substituted for of the commodities and there is income effect too, for the purchaser feels better o when the price falls and is able to buy more.
The combination of the substitution effect and income effect is known as the price effect. This is the case with normal or ordinary goods. But if the goods are considered inferior, the effect will be opposite, i.e. less will be purchased even if the price falls. But if the substitution effect is greater than the negating income effect, the law of demand will apply even to inferior goods, i.e. demand will extend when price falls.
Exceptional Demand Curves:
Sometimes the demand curve, instead of sloping downwards, will rise onwards. In other words, sometimes people will buy more when the price rises. This can be represented only by a rising curve. Such occasions are very rare, but we can imagine some.
We can think of the following four cases:
(a) In case a serious shortage is feared, people may be in a panic and buy more even though the price is rising. They are anxious to avoid the necessity of having to pay a still higher price in future.
(b) When the use of a commodity confers distinction, then the wealthy will buy more when the price rises, to be included among the few distinguished personages. Conversely, people tend to cut their purchases, if they believe the commodity to be inferior.
(c) Sometimes people buy more at a higher price in sheer ignorance.
(d) If the price of a necessary of life goes up, the consumer has to readjust his whole expenditure. He may cut down his expenses on other food articles and, in order to make up, more may have to be spent on this particular food, more of which will, therefore, be purchased in spite of its high price.
These are a few cases in which demand curve will rise upwards instead of sloping downwards.
7. Explain the concept of elasticity of Demand. What are the various concepts and types of elasticity of demand?
Ans. The degree of responsiveness of quantity demanded of a commodity to the change in price is called elasticity of demand. price elasticity of demand is popularly called elasticity of demand. It is the rate of which quantity demanded changes in response to the change in price. Elasticity of demand expresses the magnitude of change in quantity of a commodity.
Precisely stated, price elasticity demand is defined as the ratio of percentage change in quantity demanded to a percentage change in price. Thus elasticity of demand can be expressed in form of the following as price and quantity demanded move opposite.
Types of Elasticity:
Distinction may be made between Price Elasticity, Income Elasticity and Cross Elasticity. Price Elasticity is the responsiveness of demand to change in price; income elasticity means a change in demand in response to a change in the consumer’s income; and cross elasticity means a change in the demand for a commodity owing to change in the price of another commodity.
Five cases of Elasticity of Demand:
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively inelastic demand
5. Unitary elastic demand
1. Perfectly Elastic Demand:
When a small change in price of a product causes a major change in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. In such a case, the demand is perfectly elastic or ep = 00.
In perfectly elastic demand, the demand curve is represented as a horizontal straight line, which is shown in Figure-2:

From Figure-2 it can be interpreted that at price OP, demand is infinite; however, a slight rise in price would result in fall in demand to zero. It can also be interpreted from Figure-2 that at price P consumers are ready to buy as much quantity of the product as they want. However, a small rise in price would resist consumers to buy the product.
Though, perfectly elastic demand is a theoretical concept and cannot be applied in the real situation. However, it can be applied in cases, such as perfectly competitive market and homogeneity products. In such cases, the demand for a product of an organization is assumed to be perfectly elastic.
From an organization’s point of view, in a perfectly elastic demand situation, the organization can sell as much as much as it wants as consumers are ready to purchase a large quantity of product. However, a slight increase in price would stop the demand.
2. Perfectly Inelastic Demand:
A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. The numerical value for perfectly inelastic demand is zero (ep=0).
In case of perfectly inelastic demand, demand curve is represented as a straight vertical line, which is shown in Figure-3:

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2 and OP2 to OP3 does not show any change in the demand of a product (OQ). The demand remains constant for any value of price. Perfectly inelastic demand is a theoretical concept and cannot be applied in a practical situation. However, in case of essential goods, such as salt, the demand does not change with change in price. Therefore, the demand for essential goods is perfectly inelastic.
3. Relatively Elastic Demand:
Relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product. The numerical value of relatively elastic demand ranges between one to infinity.
Mathematically, relatively elastic demand is known as more than unit elastic demand (ep>1). For example, if the price of a product increases by 20% and the demand of the product decreases by 25%, then the demand would be relatively elastic.
The demand curve of relatively elastic demand is gradually sloping, as shown in Figure-4:

It can be interpreted from Figure-4 that the proportionate change in demand from OQ1 to OQ2 is relatively larger than the proportionate change in price from OP1 to OP2. Relatively elastic demand has a practical application as demand for many of products respond in the same manner with respect to change in their prices.
For example, the price of a particular brand of cold drink increases from Rs. 15 to Rs. 20. In such a case, consumers may switch to another brand of cold drink. However, some of the consumers still consume the same brand. Therefore, a small change in price produces a larger change in demand of the product.
4. Relatively Inelastic Demand:
Relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product. For example, if the price of a product increases by 30% and the demand for the product decreases only by 10%, then the demand would be called relatively inelastic. The numerical value of relatively elastic demand ranges between zero to one (ep<1 as="" being="" demand="" elasticity="" has="" inelastic="" less="" marshall="" p="" relatively="" termed="" than="" unity.="">The demand curve of relatively inelastic demand is rapidly sloping, as shown in Figure-5:

It can be interpreted from Figure-5 that the proportionate change in demand from OQ1 to OQ2 is relatively smaller than the proportionate change in price from OP1 to OP2. Relatively inelastic demand has a practical application as demand for many of products respond in the same manner with respect to change in their prices.
5. Unitary Elastic Demand:
When the proportionate change in demand produces the same change in the price of the product, the demand is referred as unitary elastic demand. The numerical value for unitary elastic demand is equal to one (ep=1).
The demand curve for unitary elastic demand is represented as a rectangular hyperbola, as shown in Figure-6:

From Figure-6, it can be interpreted that change in price OP1 to OP2 produces the same change in demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.
The different types of price elasticity of demand are summarized in Table-4:

8. Explain the factors affecting elasticity of demand and also the practical importance of it?
Ans. Various factors which affect the elasticity of demand of a commodity are:
1. Nature of commodity:
Elasticity of demand of a commodity is influenced by its nature. A commodity for a person may be a necessity, a comfort or a luxury.
i. When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand is generally inelastic as it is required for human survival and its demand does not fluctuate much with change in price.
ii. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic as consumer can postpone its consumption.
iii. When a commodity is a luxury like AC, DVD player, etc., its demand is generally more elastic as compared to demand for comforts.
iv. The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor person but a necessity for a rich person.
2. Availability of substitutes:
Demand for a commodity with large number of substitutes will be more elastic. The reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa.
Thus, availability of close substitutes makes the demand sensitive to change in the prices. On the other hand, commodities with few or no substitutes like wheat and salt have less price elasticity of demand.
3. Income Level:
Elasticity of demand for any commodity is generally less for higher income level groups in comparison to people with low incomes. It happens because rich people are not influenced much by changes in the price of goods. But, poor people are highly affected by increase or decrease in the price of goods. As a result, demand for lower income group is highly elastic.
4. Level of price:
Level of price also affects the price elasticity of demand. Costly goods like laptop, Plasma TV, etc. have highly elastic demand as their demand is very sensitive to changes in their prices. However, demand for inexpensive goods like needle, match box, etc. is inelastic as change in prices of such goods do not change their demand by a considerable amount.
5. Postponement of Consumption:
Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic demand as their consumption can be postponed in case of an increase in their prices. However, commodities with urgent demand like life saving drugs, have inelastic demand because of their immediate requirement.
6. Number of Uses:
If the commodity under consideration has several uses, then its demand will be elastic. When price of such a commodity increases, then it is generally put to only more urgent uses and, as a result, its demand falls. When the prices fall, then it is used for satisfying even less urgent needs and demand rises.
For example, electricity is a multiple-use commodity. Fall in its price will result in substantial increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was not employed formerly due to its high price. On the other hand, a commodity with no or few alternative uses has less elastic demand.
7. Share in Total Expenditure:
Proportion of consumer’s income that is spent on a particular commodity also influences the elasticity of demand for it. Greater the proportion of income spent on the commodity, more is the elasticity of demand for it and vice-versa.
Demand for goods like salt, needle, soap, match box, etc. tends to be inelastic as consumers spend a small proportion of their income on such goods. When prices of such goods change, consumers continue to purchase almost the same quantity of these goods. However, if the proportion of income spent on a commodity is large, then demand for such a commodity will be elastic.
8. Time Period:
Price elasticity of demand is always related to a period of time. It can be a day, a week, a month, a year or a period of several years. Elasticity of demand varies directly with the time period. Demand is generally inelastic in the short period.
It happens because consumers find it difficult to change their habits, in the short period, in order to respond to a change in the price of the given commodity. However, demand is more elastic in long rim as it is comparatively easier to shift to other substitutes, if the price of the given commodity rises.
9. Habits:
Commodities, which have become habitual necessities for the consumers, have less elastic demand. It happens because such a commodity becomes a necessity for the consumer and he continues to purchase it even if its price rises. Alcohol, tobacco, cigarettes, etc. are some examples of habit forming commodities.
Finally it can be concluded that elasticity of demand for a commodity is affected by number of factors. However, it is difficult to say, which particular factor or combination of factors determines the elasticity. It all depends upon circumstances of each case.
Price Elasticity of Demand is useful in the following ways:
1. Useful for Business: It enables the business in general and the monopolists in particular to fix the price. Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic demand and lower prices for goods which have elastic demand. In this way, this helps him to maximize his profit.
2. Fixation of Prices: It is very useful to fix the price of jointly supplied goods. In the case of joint products like paddy and straw, the cost of production of each is not known. The price of each is then fixed by its elastic and inelastic demand.
3. Helpful to Finance Minister: It helps the Finance Minister to levy tax on goods. After levying taxes more and more on goods which have inelastic demand, the Government collects more revenue from the people without causing inconvenience to the people. Moreover, it is also useful for the planning.
4. Fixation of Wages: It guides the producers to fix wages for labourers. They fix high or low wages according to the elastic or inelastic demand for the labour.
5. In the Sphere of International Trade: It is of greater significance in the sphere of international trade. It helps to calculate the terms of trade and the consequent gain from foreign trade. If the demand for home product is inelastic, the terms of trade will be profitable to the home country.
6. Paradox of Poverty: It explains the paradox of poverty in the midst of plenty. A bumper crop instead of bringing prosperity may result in disaster, if the demand for it is inelastic. This is specially so, if the products are perishable and not storable.
7. Effect on Employment: The effect of machines on employment opportunities depends on elasticity of demand for the goods produced by such machines. In the initial stage, use of such machines cause unemployment and prices will also fall. But when demand for such commodities is more elastic, then fall in prices will generate more increase in its demand.
As a result, demand will stimulate greater production and hence more employment. If demand for commodities produced by these machines is inelastic, then even fall in price will not increase demand as well as employment.
8. Significant for Government Economic Policies: The knowledge of elasticity of demand is very important for the government in such matters as controlling of business cycles, removing inflationary and deflationary gaps in the economy. Similarly, for price stabilization and the purchase and sale of stocks, information about elasticity of demand is most useful.
9. Incidence of Taxation: Incidence of tax lies on the person who ultimately pays the tax. The incidence is on the buyer, if demand is perfectly inelastic. He will go on buying as much as before despite the price rise. Thus, the government has to keep the watch on the ultimate burden of the tax, which depends on the elasticity of demand of the commodity taxed. If necessaries, which have less elastic demand are taxed the burden will fall more on the poor sections of society. Therefore, principle of justice in taxation is based on elasticity of demand.
10. Changes in Rate of Exchange: Rate of exchange between two currencies can be changed through devaluation or overvaluation of one currency in relation to other currencies. A country while deciding for such a course of action will take into consideration the elasticity of demand for its exports and imports. If the government devalues the currency without considering the elasticity of demand for its exports and imports it may not be able to correct unfavorable balance of payments. Under these circumstances the demand both for its exports and imports turns out to be inelastic.
11. Joint Products: The concept of elasticity of demand plays an important role in determining the price of joint products. In case of joint products like skin and meat of goat, separate costs are not known. The producer will be guided mostly by demand and its nature while fixing his price. For instance, when goat is bought, it is not kept in mind the separate costs of skin and meat.
When the seller sells the skin and meat, the seller keeps in mind the elasticity of demand of skin and meat. If elasticity of demand for meat is less elastic, in that case the price of meat will be higher. On the other hand if elasticity of demand for skin is more elastic, in that case the price of the skin will be low and vice versa.
12. International Trade: The concept of elasticity of demand also plays a significant role in the international trade or the terms of trade. It is the nature of demand which is helpful in determining the amount of gain being enjoyed by different countries. The terms of trade would be favourable in case of those countries, whose exports are of the nature of more elastic demand. On the other hand, the terms of trade would be un-favourable if the exports of a country are of the nature of less elastic demand.
13. Market forms: The concept of elasticity of demand is also useful is knowing the different market forms. If cross elasticity of demand is infinite, in that case there is perfect competition in the market. If cross elasticity is zero (or Ec = 0) it is a case of absolute or pure monopoly. If cross elasticity of demand is less than one (or Ec < 1), in that case there is relative monopoly. And if cross elasticity of demand is greater than one (or Ec >1), in that case, there is monopolistic competition or imperfect competition.
14. Determination of Price of Public Utilities: This concept is significant in the determination of the prices of public utility services. Economic welfare of the society largely depends upon the cheap availability of the essential products like water, electricity, cooking gas, transportation etc. For such commodities, demand is inelastic and these should be controlled by the government.
The government will distribute these products at fair price. Therefore, Government helps to fix the prices of necessities of life. Thus, elasticity of demand is a very important tool of analysis and it plays an important role in economic analysis.

9. What do you mean by demand forecasting? Explain the different types of demand forecasting?
Ans. Future is uncertain. There is great deal of uncertainty with regard to demand. Since the demand is uncertain, production, cost, revenue, profit etc. are also uncertain. Through forecasting it is possible to minimise the uncertainties. Forecasting simply refers to estimating or anticipating future events. It is an attempt to foresee the future by examining the past. Thus demand forecasting means estimating or
anticipating future demand on the basis of past data.
Objectives of Demand Forecasting
A. Short Term Objectives
1. To help in preparing suitable sales and production policies.
2. To help in ensuring a regular supply of raw materials.
3. To reduce the cost of purchase and avoid unnecessary purchase.
4. To ensure best utilization of machines.
5. To make arrangements for skilled and unskilled workers so that suitable labour
force may be maintained.
6. To help in the determination of a suitable price policy.
7. To determine financial requirements.
8. To determine separate sales targets for all the sales territories.
9. To eliminate the problem of under or over production.
B. Long term Objectives
1. To plan long term production.
2. To plan plant capacity.
3. To estimate the requirements of workers for long period and make arrangements.
4. To determine an appropriate dividend policy.
5. To help the proper capital budgeting.
6. To plan long term financial requirements.
7. To forecast the future problems of material supplies and energy crisis.
Factors Affecting Demand Forecasting
For making a good forecast, it is essential to consider the various factors governing demand forecasting. These factors are summarized as follows.
1. Prevailing business conditions: While preparing demand forecast it becomes necessary to study the general economic conditions very carefully. These include the price level changes, change in national income, percapita income, consumption pattern, savings and investment habits, employment etc.
2. Conditions within the industry: Every business enterprise is only a unit of a particular industry. Sales of that business enterprise are only a part of the total sales of that industry. Therefore, while preparing demand forecasts for a particular business enterprise, it becomes necessary to study the changes in the demand of the whole industry, number of units within the industry, design and quality of product, price policy, competition within the industry etc.
3. Conditions within the firm: Internal factors of the firm also affect the demand forecast. These factors include plant capacity of the firm, quality of the product, price of the product, advertising and distribution policies, production policies, financial policies etc.
4. Factors affecting export trade: If a firm is engaged in export trade also it should consider the factors affecting the export trade. These factors include import and export control, terms and conditions of export, exim policy, export conditions, export finance etc.
5. Market behaviour : While preparing demand forecast, it is required to consider the market behavior which brings about changes in demand.
6. Sociological conditions: Sociological factors have their own impact on demand forecast of the company. These conditions relate to size of population, density, change in age groups, size of family, family life cycle, level of education, family income, social awareness etc.
7. Psychological conditions: While estimating the demand for the product, it becomes necessary to take into consideration such factors as changes in consumer tastes, habits, fashions, likes and dislikes, attitudes, perception, life styles, cultural and religious bents etc.
8. Competitive conditions: The competitive conditions within the industry may change. Competitors may enter into market or go out of market. A demand forecast prepared without considering the activities of competitors may not be correct.
Process of Demand Forecasting/ Steps in Demand Forecasting
Demand forecasting involves the following steps:
1. Determine the purpose for which forecasts are used.
2. Subdivide the demand forecasting programme into small I parts on the basis of product or sales territories or markets.
3. Determine the factors affecting the sale of each product and their relative importance.
4. Select the forecasting methods.
5. Study the activities of competitors.
6. Prepare preliminary sales estimates after, collecting necessary data.
7. Analyse advertisement policies, sales promotion plans, personal sales arrangements etc. and ascertain how far these programmes have been successful in promoting the sales.
8. Evaluate the demand forecasts monthly, quarterly, half yearly or yearly and necessary adjustments should be done.
9. Prepare the final demand forecast on the basis of preliminary forecasts and the results of evaluation.
M ETHODS OF DEMAND FORECASTING (FOR ESTABLISHED PRODUCTS)
There are several methods to predict the future demand. All methods can be broadly classified into two. (A) Survey methods, (B) Statistical methods
(A) Survey methods
Under this method surveys are conducted to collect information about the future purchase plans of potential consumers. Survey methods help in obtaining information about the desires, likes and dislikes of consumers through collecting the opinion of experts or by interviewing the consumers. Survey methods are used for short term forecasting.
Important survey methods are (a) consumers interview method, (b) collective opinion or sales force opinion methodic) experts opinion method, (d) consumers clinic and (f) end use method.
(a) Consumers' interview method (Consumers survey): Under this method, consumers are interviewed directly and asked the quantity they would like to buy. After collecting the data, the total demand for the product is calculated. This is done by adding up all individual demands. Under the consumer interview method, either all consumers or selected few are interviewed. When all the consumers are interviewed, the method is known as complete enumeration method. When only a selected group of consumers are interviewed, it is known as sample survey method
Advantages
1. It is a simple method because it is not based on past record.
2. It suitable for industrial products.
3. The results are likely to be more accurate.
4. This method can be used for forecasting the demand of a new product.
Disadvantages
1. It is expensive and time consuming.
2. Consumers may not give their secrets or buying plans.
3. This method is not suitable for long term forecasting.
4. It is not suitable when the number of consumer is large.
(b)Collective opinion method: Under this method the salesmen estimate the expected sales in their respective territories on the basis of previous experience. Then demand is estimated after combining the individual forecasts (sales estimates) of the salesmen. This method is also known as sales force opinion method.
Advantages
This method is simple.
1. It is based on the first hand knowledge of Salesmen.
2. This method is particularly useful for estimating demand of new products.
3. It utilises the specialised knowledge of salesmen who are in close touch with the prevailing market conditions.
Disadvantages
1. The forecasts may not be reliable if the salespeople are not trained.
2. It is not suitable for long period estimation.
3. It is not flexible.
4. Salesmen may give lower estimates that make possible easy achievement of sales quotas fixed for each salesman.
(c)Experts' opinion method: This method was originally developed at Rand Corporation in 1950 by Olaf Helmer, Dalkey and Gordon. Under this method, demand is estimated on the basis of opinions of experts and distributors other than salesmen and ordinary consumers. This method is also known as Delphi method. Delphi is the ancient Greek temple where people come and prey for information about their future.
Advantages
1. Forecast can be made quickly and economically
2. This is a reliable method because estimates are made on the basis of knowledge and experience of sales experts.
3. The firm need not spare its time on preparing estimates of demand.
4. This method is suitable for new products.
Disadvantages
1. This method is expensive.
2. This method sometimes lacks reliability
(d)Consumer clinics: In this method some selected buyers are given certain amounts of money and asked to buy the products. Then the prices are changed and the consumers are asked to make fresh purchases with the given money. In this way the consumers" responses to price changes are observed. Thus the behaviour of the consumers is studied. On this basis demand is estimated. This method is an improvement over consumer’s interview method.
Merits
1. It provides an opportunity to study the behaviour of consumers directly.
2. It provides reliable and realistic picture about future demand.
3. It gives useful information to aid in the decision making process.
Demerits
1. It is a time consuming method.
2. Selecting the participants is very difficult.
3. It is expensive.
4. Consumers may take it as a game. They may not reveal their preferences.
(e) End use method: This method is based on the fact that a product generally has different uses. In the end use method, first a list of end users (final consumers, individual industries, exporters etc.) is prepared. Then the future demand for the product is found either directly from the end users or indirectly by estimating their future growth. Then the demand of all end users of the product is added to get the total demand for the product.
Statistical Methods
Statistical methods use the past data as a guide for knowing the level of future demand. Statistical methods are generally used for long run forecasting. These methods are used for established products. Statistical methods include: (i) Trend projection method, (ii) Regression and Correlation, (iii) Extrapolation method, (iv) Simultaneous equation method, and (v) Barometric method.
(i)Trend projection method: Future sales are based on the past sales, because future is the grand-child of the past and child of the present. Under the trend projection method demand is estimated on the basis of analysis of past data. This method makes use of time series (data over a period of time). We try to ascertain the trend in the time series. The trend in the time series can be estimated by using any one of the following four methods: (a) Least-square method, (b) Free-hand method, (c) Moving average method and (d) semi-average method.
(ii) Regression and Correlation: These methods combine economic theory and statistical technique of estimation. Under these methods the relationship between the sales (dependent variable) and other variables (independent variables such as price of related goods, income, advertisement etc.) is ascertained. Such relationship established on the basis of past data may be used to analyse the future trend. The regression and correlation analysis is also called the econometric model building.
 (iii) Extrapolation: Under this statistical method, the future demand can be extrapolated by applying Binomial expansion method. This method is used on the assumption that the rate of charge in demand in the past has been uniform.
(iv) Simultaneous equation method.-This involves the development of a complete econometric model which can explain the behaviour of all the variables which the company can control. This method is not very popular.
(v) Barometric technique: This is an improvement over the trend projection method. According to this technique the events of the present can be used to predict the directions of change m the future. Here certain economic and statistical indicators from the selected time series are used to predict variables. Personal income, non-agricultural placements, gross national income, prices of industrial materials, wholesale commodity prices, industrial production, bank deposits etc. are some of the most commonly used indicators.
Advantages of Statistical Methods
1 The method of estimation is scientific
2 Estimation is based on the theoretical relationship between sales (dependent variable) and price, advertising, income etc. (independent variables)
3 These are less expensive.
4 Results are relatively more reliable.
Disadvantages of Statistical Methods
1 These methods involve complicated calculations.
2 These do not rely much on personal skill and experience.
3 These methods require considerable technical skill and experience in order to be effective.
Methods of Demand Forecasting for New Products
Demand forecasting of new product is more difficult than forecasting for existing product. The reason is that the product is not available. Hence, no historical data are available. In these conditions the forecasting is to be done by taking into consideration the inclination and wishes of the customers to purchase. For this a research is to be conducted. But there is one problem that it is difficult for a customer to say anything without seeing and using the product before. Thus it is very difficult to forecast the demand for new products. Any way Prof. Joel Dean has suggested the following methods for forecasting demand of new products:
1. Evolutionary approach: This method is based on the assumption that the new product is the improvement and evolution of the old product. The demand is forecasted on the basis of the demand of the old product. For example, the demand for black and white TV should be taken in to consideration while forecasting the demand for colour TV sets because the latter is an improvement of the former.
2. Substitute approach: Here the new product is treated as a substitute of an existing product, e.g. polythene bags for cloth bags. Thus the demand for a new product is analysed as a substitute for some existing goods or service.
3. Growth curve approach: Under this method the growth rate of demand of a new product is estimated on the basis of the growth rate of demand of an existing product. Suppose Pears soap is in use and a new cosmetic is to be introduced in the market. In this case the average sale of Pears soap will give an idea as to how the new cosmetic will be accepted by the consumers.
4. Opinion poll approach: Under this method the demand for a new product is estimated on the basis of information collected from the direct interviews (survey) with consumers.
5. Sales Experience approach: Under this method, the new product is offered for sale in a sample market, i.e. by direct mail or through multiple shop or departmental shop. From this the total demand is estimated for the whole market.
6. Vicarious approach: This method consists of surveying consumers' reactions through the specialised dealers who are in touch with consumers. The dealers are able to know as to how the customers will accept the new product. On the basis of their reports demand can be estimated.
The above methods are not mutually exclusive. It is de desirable to use a combination of two or more methods in order to get better results.

10. What do you mean by supply? Explain the factors affecting supply?
Ans. In economics, supply during a given period of time means, the quantities of goods which are offered for sale at particular prices. The supply of a commodity is the amount of the commodity which the sellers or producers are able and willing to offer for sale at a particular price, during a certain period of time.
Definition of Supply:
According to J. L. Hanson – “By supply is meant that amount that will come into the market over a range of prices.”
In short supply always means supply at a given price. At different prices, the supply may be different. Normally the higher the price, the greater the supply and vice-versa.
Factors Affecting Supply:
There are a number of factors influencing the supply of a commodity. They are known as the determinants of supply.
Important factors are as follows:
1. Price of the Commodity:
Price is the most important factor influencing the supply of a commodity. More is supplied at a lower price and less is supplied at a higher price.
2. Seller’s Expectations about the Future Price:
Seller’s expectations about the future price affect the supply. If a seller expects the price to rise in the future, he will with¬hold his stock at present and so there will be less supply now. Besides change in price, change in the supply may be in the form of increase or decrease in supply.
3. Nature of Goods:
The supply of every perishable goods is perfectly inelastic in a market period because the entire stock of such goods must be disposed of within a very short period, whatsoever may be the price. If not, they might get rotten. Further, if the stock of goods can be easily stored its supply would be relatively elastic and vice-versa.
4. Natural Conditions:
The supply of some commodities, such as agricultural products depends on the natural environment or climatic conditions like—rainfall, temperature etc. A change in the natural conditions will cause a change in the supply.
5. Transport Conditions:
Difficulties in transport may cause a temporary decrease in supply as goods cannot be brought in time to the market place. So even at the rising prices, quantity supplied cannot be increased.
6. Cost of Production:
If there is a rise in the cost of production of a commodity, its supply will tend to decrease. Similarly, with the rise in cost of production the supply curve tends to shift downward. Conversely, a fall in the cost of production tends to decrease the supply.
7. The State of Technology:
The supply of a commodity depends upon the methods of production. Advance in technology and science are the most powerful forces influencing productivity of the factors of production. Most of the inventions and innovations in chemistry, electronics, atomic energy etc. have greatly contributed to increased supplies of commodities at lower costs.
8. Government’s Policy:
Government’s economic policies like—industrial policy, fiscal policy etc. influence the supply. If the industrial licensing policy of the government is liberal, more firms are encouraged to enter the field of production, so that the supply may increase.
Import restrictions and high customs duties may decrease the supply of imposed goods but it would encourage the domestic industrial activity, so that the supply of domestic products may increase. A tax on a commodity or a factor of production raises its cost of production, consequently production is reduced. A subsidy on the other-hand provides an incentive to production and augments supply.

Question 15. Explain the Law of Supply with the help of a suitable example?
Ans. The law of supply states that, other things remaining the same, the quantity supplied of a commodity is directly or positively related to its price. In other words, when there is a rise in the price of a commodity the quantity supplied of it in the market increases and when there is a fall in the price of a commodity, its quantity supplied decreases, other things remaining the same. Thus, the supply curve of a commodity slopes upward from left to right.
Assumptions
The term “other things remaining the same” refers to the following assumptions in the law of supply:
1. No change in the state of technology.
2. No change in the price of factors of production.
3. No change in the number of firms in the market.
4. No change in the goals of the firm.
5. No change in the seller’s expectations regarding future prices.
6. No change in the tax and subsidy policy of the products.
7. No change in the price of other goods.
The law of supply can be explained with the help of supply schedule and supply curve as explained below.
Supply Schedule
Supply Schedule is a tabular presentation of various combinations of price and quantity supplied by the seller or producer during a period of time. We can show the supply schedule through the following imaginary table.


The given schedule shows positive relationship between price and quantity supplied of a commodity. In the beginning, when the price is Rs.10 per kg, quantity supplied by the seller is 1kg. As the price increases from Rs.10 per kg to Rs.20 per kg and then to Rs.30 per kg, the quantity supplied by the seller also increases from 1 kg to 2 kg and then to 3 kg respectively. Further rise in price to Rs.40 and then to Rs.50 per kg results in increase in quantity supplied by the seller to 4kg and then to 5kg. Thus, the above schedule shows that there is positive relationship in between price and quantity supplied of a commodity.
Supply curve
The supply curve is a graphical representation of a supply schedule. By plotting various combinations of price and quantity supplied of the table, we can derive an upward sloping demand curve as shown in the figure below:

In the given figure, price and quantity supplied are measured along the Y-axis and the X-axis respectively. By plotting various combinations of price and quantity supplied we derived points A,B, C, D, E curve and joining these points we find an upward sloping i.e. SS1. The positive slope of the supply curve SS1 establishes the law of supply and shows the positive relationship in between price and quantity supplied.
Exceptions and Limitations of the Law of Supply
The law of supply states that quantity supplied increases with increase in price and vice-versa. But this law doesn’t hold true in case of auction sale. An auction sale takes place at that time when the seller is in financial crisis and needs money at any cost.
Price expectation of seller
If the seller expects that the price of commodity is going to fall in near future, he will try to sell more even if the price level is very low. On the other hand, if the seller expects further rise in price of the commodity he will not sell more even if the price level is high. It is against the law of supply.
Stock clearance sale
When a seller wants to clear its old stock in order to store new goods, he may sell large quantity of goods at heavily discounted price. It is also against the law of supply.
Fear of being out of fashion
As we know that quantity supplied of a commodity is affected by fashion, taste and preferences of the consumer, technology and time. If the seller thinks that the goods are going to be outdated in the near future, he sells more at a lower price which is also against the law of supply.
Perishable goods
Those goods which have very short life-time and they become useless after that are all perishable goods. Those goods must be made available in the market at its right time whatever be its price. So the seller becomes ready to sell his goods at any offered price. It is also against the law of supply.

Question 16. Explain the different concepts of elasticity of supply?
Ans. Elasticity of supply: Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the proportionate change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes. The following equation can be used to calculate PES.

While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to infinite, perfectly elastic.
• High elasticity indicates the supply is sensitive to changes in prices, low elasticity indicates little sensitivity to price changes, and no elasticity means no relationship with price. It is also called price elasticity of supply.

If supply is elastic (i.e. PES > 1), then producers can increase output without a rise in cost or a time delay
• If supply is inelastic (i.e. PES <1 a="" change="" find="" firms="" given="" hard="" in="" it="" p="" period.="" production="" then="" time="" to="">• When Pes = 0, supply is perfectly inelastic
• When Pes = infinity, supply is perfectly elastic following a change in demand




Unit III
11. What does a production function explain? What are its kinds?
Ans. Meaning of Production
Production is the conversion of input into output. The factors of production and all other things which the producer buys to carry out production are called input. The goods and services produced are known as output. Thus production is the activity that creates or adds utility and value. In the words of Fraser, "If consuming means extracting utility from matter, producing means creating utility into matter". According to Edwood Buffa, “Production is a process by which goods and services are created".
Production is the result of co-operation of four factors of production viz., land, labour, capital and organization. Therefore, the producer combines all the four factors of production in a technical proportion. The aim of the producer is to maximize his profit. For this sake, he decides to maximize the production at minimum cost by means of the best combination of factors of production.
The Concept of Production Function
The supply of a product, depends upon its cost of production, which in turn depends upon:
(a) The physical relationship between inputs and output, and
(b) The prices of inputs.
The physical relationship between inputs and output plays an important part in determining the cost of production. The act of production involves the transformation of inputs into outputs. The word production in economics is not merely confined to bringing about physical transformation in the matter it is creation or addition of value.
The production function is largely determined by the level of technology. The production function varies with the changes in technology. Whenever technology improves, a new production function comes into existence. Therefore, in the modern times the output depends not only on traditional factors of production but also on the level of technology.
The production function can be expressed in an equation in which the output is the dependent variable and inputs are the independent variables. The equation is expressed as follows:
Q= f (L, K, T……………n)
Where, Q = output
L = labour
K = capital
T = level of technology
n = other inputs employed in production.

In simple words, production function refers to the functional relationship between the quantity of a good produced (output) and factors of production (inputs).
The production function of a firm can be studied by holding the quantities of some factors fixed, while varying the amount of other factors. This is done when the law of variable proportions is derived. The production function of a firm can also be studied by varying the amounts of all factors. The behaviour of production when all factors are varied is the subject-matter of the laws of returns to scale. Thus, in the theory of production, the study of (a) the law of variable proportions and (b) the laws of returns to scale is included.
Besides this, the theory of production is also concerned with explaining which combination of inputs (or factors of production) a firm will choose so as to minimise its costs of production for producing a given level of output or to maximise output for a given level of cost.
There are two types of production function - short run production function and long run production function. In the short run production function the quantity of only one input varies while all other inputs remain constant. In the long run production function all inputs are variable.
Assumptions of Production Function
The production function is based on the following assumptions.
1. The level of technology remains constant.
2. The firm uses its inputs at maximum level of efficiency.
3. It relates to a particular unit of time.
4. A change in any of the variable factors produces a corresponding change in the output.
5. The inputs are divisible into most viable units.
Managerial Use of Production Function
The production function is of great help to a manager or business economist. The managerial uses of production function are outlined as below:
1. It helps to determine least cost factor combination: The production function is a guide to the entrepreneur to determine the least cost factor combination. Profit can be maximized only by minimizing the cost of production. In order to minimize the cost of production, inputs are to be substituted. The production function helps in substituting the inputs.
2. It helps to determine optimum level of output: The production function helps to determine the optimum level of output from a given quantity of input. In other words, it helps to arrive at the producer's equilibrium.
3. It enables to plan the production: The production function helps the entrepreneur (or management) to plan the production.
4. It helps in decision-making :Production function is very useful to the management to take decisions regarding cost and output. It also helps in cost control and cost reduction. In short, production function helps both in the short run and long run decision-making process.

Features of Production Function:
Following are the main features of production function:
1. Substitutability:
The factors of production or inputs are substitutes of one another which make it possible to vary the total output by changing the quantity of one or a few inputs, while the quantities of all other inputs are held constant. It is the substitutability of the factors of production that gives rise to the laws of variable proportions.
2. Complementarity:
The factors of production are also complementary to one another, that is, the two or more inputs are to be used together as nothing will be produced if the quantity of either of the inputs used in the production process is zero.
The principles of returns to scale is another manifestation of complementarity of inputs as it reveals that the quantity of all inputs are to be increased simultaneously in order to attain a higher scale of total output.
3. Specificity:
It reveals that the inputs are specific to the production of a particular product. Machines and equipment’s, specialized workers and raw materials are a few examples of the specificity of factors of production. The specificity may not be complete as factors may be used for production of other commodities too. This reveals that in the production process none of the factors can be ignored and in some cases ignorance to even slightest extent is not possible if the factors are perfectly specific.
Production involves time; hence, the way the inputs are combined is determined to a large extent by the time period under consideration. The greater the time period, the greater the freedom the producer has to vary the quantities of various inputs used in the production process.
In the production function, variation in total output by varying the quantities of all inputs is possible only in the long run whereas the variation in total output by varying the quantity of single input may be possible even in the short run
12. What do you mean by returns to scale. How do returns to scale differ from law of variable proportion?
Ans. Law of Returns to Scale
In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of production can be changed by changing the quantity of all factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors change by the same proportion.” Koutsoyiannis
“Returns to scale relates to the behaviour of total output as all inputs are varied and is a long run concept”. Leibhafsky
Returns to scale are of the following three types:
1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale
Explanation:
In the long run, output can be increased by increasing all factors in the same proportion. Generally, laws of returns to scale refer to an increase in output due to increase in all factors in the same proportion. Such an increase is called returns to scale.
Suppose, initially production function is as follows:
P = f (L, K)
Now, if both the factors of production i.e., labour and capital are increased in same proportion i.e., x, product function will be rewritten as.

The above stated table explains the following three stages of returns to scale:
1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost refers to a situation when all factors of production are increased, output increases at a higher rate. It means if all inputs are doubled, output will also increase at the faster rate than double. Hence, it is said to be increasing returns to scale. This increase is due to many reasons like division external economies of scale. Increasing returns to scale can be illustrated with the help of a diagram 8.
 
In figure 8, OX axis represents increase in labour and capital while OY axis shows increase in output. When labour and capital increases from Q to Q1, output also increases from P to P1 which is higher than the factors of production i.e. labour and capital.
2. Diminishing Returns to Scale:
Diminishing returns or increasing costs refer to that production situation, where if all the factors of production are increased in a given proportion, output increases in a smaller proportion. It means, if inputs are doubled, output will be less than doubled. If 20 percent increase in labour and capital is followed by 10 percent increase in output, then it is an instance of diminishing returns to scale.
The main cause of the operation of diminishing returns to scale is that internal and external economies are less than internal and external diseconomies. It is clear from diagram 9.

In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour and capital are given while on OY axis, output. When factors of production increase from Q to Q1 (more quantity) but as a result increase in output, i.e. P to P1 is less. We see that increase in factors of production is more and increase in production is comparatively less, thus diminishing returns to scale apply.
3. Constant Returns to Scale:
Constant returns to scale or constant cost refers to the production situation in which output increases exactly in the same proportion in which factors of production are increased. In simple terms, if factors of production are doubled output will also be doubled.
In this case internal and external economies are exactly equal to internal and external diseconomies. This situation arises when after reaching a certain level of production, economies of scale are balanced by diseconomies of scale. This is known as homogeneous production function. Cobb-Douglas linear homogenous production function is a good example of this kind. This is shown in diagram 10. In figure 10, we see that increase in factors of production i.e. labour and capital are equal to the proportion of output increase. Therefore, the result is constant returns to scale.


 





13. Explain the different concepts of cost?
Ans. The analysis of cost is important in the study of business operations and decisions because it provides a basis for two important decisions made by managers:
(a) whether to produce or not and
(b) how much to produce when a decision is taken to produce.
1. Opportunity Cost and Actual Cost: Opportunity cost refers to the loss of earnings due to opportunities foregone due to scarcity of resources. If resources were unlimited, there would be no need to forego any income-yielding opportunity and, therefore, there would be no opportunity cost. Resources are scarce but have alternative uses with different returns. Incomes maximizing resource owners put their scarce resources to their most productive use and forego the income expected from the second best use of the resources.
Therefore, the opportunity cost may be defined as the expected returns from the second best use of the resources foregone due to the scarcity of resources. For example, suppose that a person has a sum of Rs. 1,00,000 for which he has only two alternative uses. He can buy either a printing machine or, alternatively, a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000. If he is a profit maximizing investor, he would invest his money in printing machine and forego the expected income from the lathe. The opportunity cost of his income from printing machine is the expected income from the lathe, i.e., Rs. 15,000.
On the other hand, actual costs are those which are actually incurred by the firm in payment for labour, material, plant, building, machinery, equipment, travelling and transport, advertisement, etc. The total money expenses, recorded in the books of accounts are, for all practical purposes, the actual costs.
2. Business Costs and Full Costs: Business costs include all the expenses which are incurred to carry our business. The concept of business costs is similar to the actual or real costs. Business costs “include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment”. These cost concepts are used for calculating business profits and losses and for filling returns for income-tax and also for other legal purposes.
Full costs, on the contrary, include business costs, opportunity cost and normal profit. The opportunity cost includes the expected earnings from the second best use of the resources, or the market rate of interest on the total money capital, and also the value of entrepreneur’s own services which are not charged for in the current business. Normal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its present occupation.
3. Explicit and Implicit or Imputed Costs: Explicit costs refer to those which fall under actual or business costs entered in the books of accounts. The payments for wages and salaries, materials, license fee, insurance premium, depreciation charges are the examples of explicit costs. These costs involve cash payments and are recorded in normal accounting practices.
In contrast with these costs, there are not certain other costs which do not take the form of cash outlays, nor do they appear in the accounting system. Such costs are known as implicit or imputed costs. Implicit costs may be defined as the earning expected from the second best alternative use of resources. For instance, suppose an entrepreneur does not utilize his services in his own business and works as a manager in some other firm on a salary basis.
If he starts his own business, he foregoes his salary as manager. This loss of salary is the opportunity costs of income from his own business. This is an implicit cost of his own business; implicit, because the entrepreneur suffers the loss, but does not charge it as the explicit cost of his own business. Thus, implicit wages, rent and interest are the highest wages, rents and interest which owner’s labour, building and capital can respectively earn from their second best use.
Implicit costs are not taken into account while calculating the loss or gains of the business, but they form an important consideration in whether or not a factor would remain in its present occupation. The explicit and implicit costs together make the economic cost.
4. Out-of-Pocket and Book Costs: Out-of-pocket costs means costs that involve current cash payments to outsiders while book costs such as depreciation do not require current cash payments. In concept, this distinction is quite different from traceability and also from variability with output. Not all out-of- pocket costs are variable, e.g., salaries paid to the administrative staff.
Neither are they all direct, e.g., the electric power bill. Book costs are in some cases variable and in some cases readily traceable, and hence become a part of direct costs. The distinction primarily shows how cost affects the cash position. Book costs can be converted into out-of-pocket costs by selling the assets and having them on hire. Rent would then replace depreciation and interest.
B. Some Analytical Cost Concepts:
5. Fixed and Variable Costs: Fixed costs are those costs which are fixed in volume for a certain given output. Fixed cost does not vary with variation in the output between zero and certain level of output. The costs that do not vary for a certain level of output are known as fixed cost. Fixed costs are costs which do not change per unit of output. Even if no crops are grown on a piece of land, the bank will insist on a mortgage payment from the farmer; even if no output is produced by a corporation, its bondholders will legally insist on payments of interest. The only way to avoid these payments is to go out of business; they are accordingly NOT considered in making a short-run operating decision, but ARE considered in making long-run, entry or exit decisions.
The fixed costs include:
(i) Cost of managerial and administrative staff.
(ii) Depreciation of machinery, building and other Axed assets, and
(iii) Maintenance of land, etc. The concept of fixed cost is associated with short-run.
Variable costs are those which vary with the variation in the total output. They are a function of output. Variable costs include cost of raw materials, running cost on fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with the level of output, and the costs of all other inputs that vary with output. Variable cost is also known as operating cost.
6. Total, Average and Marginal Costs:
Total cost represents the value of the total resource requirement for the production of goods and services. It refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level of output. It includes both fixed and variable costs. The total cost for a given output is given by the cost function.
Average cost:
Average cost (AC) is of statistical nature, it is not actual cost. Average cost is total cost per unit of output, or it is obtained by dividing the total cost (TC) by the total output (Q), i.e. AC = TC/Q
Average cost plays a major role in long-run, entry and exit decisions. The basic decision rules are parallel to those for marginal cost:
1. If AC < P, the industry is profitable. (Enter)
2. If AC > P, the industry is unprofitable. (Exit)
3. If AC = P, the industry yields zero profit.
Marginal cost:
Marginal, as always in economics, should be read as extra. Here, it is the extra cost of one more item of output; or the change in total cost divided by change in output. Marginal cost is the addition to the total cost on account of producing an additional unit of the product. Or, marginal cost is the cost of marginal unit produced. Given the cost function, it may be defined as MC = TC/ Q. Marginal cost is the type of cost to consider in short-run output decisions.
The rules to apply are:
1. If MC < P, increase output.
2. If MC > P, decrease output.
3. If MC = P, leave output unchanged. The firm is in short-run equilibrium.
Relation Between Marginal Cost (MC) and Average Cost (AC): The relationship between MC and AC may be explained as follows:
1. When MC falls, AC also falls but at lower rate than that of MC. So long as MC curve lies below the AC curve, the AC curve is falling.
2. When MC rises, AC also rises but at lower rate than that of MC. That is, when MC curve lies above AC curve, the AC curve is rising.
3. MC intersects AC at its minimum. That is, MC = AC at its minimum.
 7. Short-Run and Long-Run Costs:
Short-run and long-run cost concepts are related to variable and fixed costs respectively, and often marked in economic analysis interchangeably. Short-run costs are the costs which vary with the variation in output, the size of the firm remaining the same. In other words, short-run costs are the same as variable costs. Long-run costs, on the other hand, are the costs which are incurred on the fixed assets like plant, building, machinery, etc. Such costs have long-run implication in the sense that these are not used up in the single batch of production. In the long-run, however, even the fixed costs become variable costs as the size of the firm or scale of production increases.
8. Incremental Costs and Sunk Costs:
Incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation. While marginal cost refers to the cost of the marginal unit of output, incremental cost refers to the total additional cost associated with the marginal batch of output. Incremental costs arise also owing to the change in product lines, addition or introduction of a new product, replacement of worn out plant and machinery, replacement of old technique of production with a new one, etc.
The Sunk costs are those which cannot be altered, increased or decreased, by varying the rate of output. For example, once it is decided to make incremental investment expenditure and the funds are allocated and spent, all the preceding costs are considered to be the sunk costs since they accord to the prior commitment and cannot be revised or reversed or recovered when there is change in market conditions or change in business decisions.
9. Historical and Replacement Costs:
Historical costs are those costs of an asset acquired in the past whereas replacement cost refers to the outlay which has to be made for replacing an old asset. Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm. The replacement cost figures in the business decision regarding the renovation of the firm.
10. Private and Social Costs:
There are not certain other costs which arise due to functioning of the firm but are not normally marked in the business decisions. The costs of this category are borne by the society.
Thus, the total cost generated by a firm’s working may be divided into two categories:
(i) Those paid out or provided for by the firms, and
(ii) Those not paid or borne by the firms- it includes use of resource freely available plus the disutility created in the process of production.
The costs of the former category are known as private costs and of the latter category are known as external or social costs. The example of social cost are: Mathura Oil Refinery discharging its wastage in the Yamuna river causes water pollution; Mills and factories located in a city cause air pollution by emitting smoke.
Similarly, plying cars, buses, trucks, etc., cause both air and noise pollution. Such pollutions cause tremendous health hazards which involve health cost to the society as a whole. Such costs are termed external costs from the firm’s point of view and social cost from society’s point of view..
Private costs are those which are actually incurred or provided for by an individual or a firm on the purchase of goods and services from the market. For a firm, all the actual costs both explicit and implicit are private costs. Private costs are internalized costs that are incorporated in the firm’s total cost of production. Social costs on the other hand, refer to the total cost to the society on account of production of a commodity. Social costs include both private cost and the external cost.
C. Other Costs Concepts:
11. Urgent and Postponable Cost:
Urgent costs are those costs which must be incurred in order to continue operations of the firm. For example, the costs of materials and labour which must be incurred if production is to take place.
Postponable costs refer to those costs which can be postponed at least for some time e.g., maintenance relating to building and machinery. Railways usually make use of this distinction. They know that the maintenance of rolling stock and permanent way can be postponed for some time.
12. Escapable and Unavoidable Costs:
Escapable costs refer to costs which can be reduced due to a contraction in the activities of a business enterprise. It is the net effect on costs that is important, not just the costs directly avoidable by the contraction. For Example:
1. Closing apparently unprofitable branch house-storage costs of other branches and transportation charges would increase.
2. Reducing credit sales-costs estimated may be less than the benefits otherwise available.
Escapable costs are different from controllable and discretionary costs. The latter are like chopping off the additional fat and are not directly associated with a special curtailment decision.
13. Controllable and Non-Controllable Costs:
The controllability of a cost depends upon the levels of responsibility under consideration. A controllable cost may refer to one which is reasonably subject to regulation by the executive with whose responsibility that cost is being identified. Thus a cost which is uncontrollable at one level of responsibility may be regarded as controllable at some other, usually higher level.
Direct material and direct labour costs are usually controllable. Regarding so for, overhead costs, some costs are controllable and others are not. Indirect labour, supplies and electricity are usually controllable. An allocated cost is not controllable. It varies with the formula adopted for allocation and is independent of the actions of the supervisor.
14. Direct and Indirect Costs (Traceable and Common Costs):
A direct or traceable cost is that which can be identified easily and indisputably with a unit of operation (costing unit/cost centre). Common or indirect costs are those that are not traceable to any plant, department or operation, or to any individual final product. To take an example, the salary of a divisional manager, when division is a costing unit, will be a Direct Cost.
The monthly salary of the general manager, when one of the divisions is a costing unit, would be an Indirect Cost. The salary of the manager of the other division is neither a direct nor an indirect cost. Thus, whether a specific cost is direct or indirect depends upon the costing unit under consideration. The concepts of direct and indirect costs are meaning-less without identification of the relevant costing unit.
14. Explain the different concepts of revenue?
Ans. Meaning of Revenue:
The amount of money that a producer receives in exchange for the sale proceeds is known as revenue. For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the amount of Rs. 16,000 is known as revenue. Revenue refers to the amount received by a firm from the sale of a given quantity of a commodity in the market. Revenue is a very important concept in economic analysis. It is directly influenced by sales level, i.e., as sales increases, revenue also increases. The concept of revenue consists of three important terms; Total Revenue, Average Revenue and Marginal Revenue.

Total Revenue (TR):
Total Revenue refers to total receipts from the sale of a given quantity of a commodity. It is the total income of a firm. Total revenue is obtained by multiplying the quantity of the commodity sold with the price of the commodity.
 
Average Revenue (AR):
Average revenue refers to revenue per unit of output sold. It is obtained by dividing the total revenue by the number of units sold. “The average revenue curve shows that the price of the firm’s product is the same at each level of output.” Stonier and Hague

AR Curve and Demand Curve are the same:
A buyer’s demand curve graphically represents the quantities demanded by a buyer at various prices. In other words, it shows the various levels of average revenue at which different quantities of the good are sold by the seller. Therefore, in economics, it is customary to refer AR curve as the Demand Curve of a firm.
Marginal Revenue (MR):
 Marginal revenue is the additional revenue generated from the sale of an additional unit of output. It is the change in TR from sale of one more unit of a commodity. In algebraic terms, marginal revenue is the net addition to the total revenue by selling n units of a commodity instead of n – 1.
Therefore,

MR in mathematical terms is the ratio of change in total revenue to change in output
MR = ∆TR/∆q or dR/dq = MR
Total Revenue, Average Revenue and Marginal Revenue:
The relation of total revenue, average revenue and marginal revenue can be explained with the help of table and fig.


From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re. 1, the output sold increases from 1 to 10. Total revenue increases from 10 to 30, at 5 units. However, at 6th unit it becomes constant and ultimately starts falling at next unit i.e. 7th. In the same way, when AR falls, MR falls more and becomes zero at 6th unit and then negative. Therefore, it is clear that when AR falls, MR also falls more than that of AR: TR increases initially at a diminishing rate, it reaches maximum and then starts falling.
In fig. 1 three concepts of revenue have been explained. The units of output have been shown on horizontal axis while revenue on vertical axis. Here TR, AR, MR are total revenue, average revenue and marginal revenue curves respectively.
In figure 1 (A), a total revenue curve is sloping upward from the origin to point K. From point K to K’ total revenue is constant. But at point K’ total revenue is maximum and begins to fall. It means even by selling more units total revenue is falling. In such a situation, marginal revenue becomes negative. Similarly, in the figure 1 (B) average revenue curves are sloping downward. It means average revenue falls as more and more units are sold.
In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It signifies the fact that MR with the sale of every additional unit tends to diminish. Moreover, it is also clear from the fig. that when both AR and MR are falling, MR is less than AR. MR can be zero, positive or negative but AR is always positive.



15. Explain the cost-output relations in short run and long run?
Ans. Cost-Output Relations
The cost-output relationship plays an important role in determining the optimum
level of production. Knowledge of the cost-output relation helps the manager in cost
control, profit prediction, pricing, promotion etc. The relation between cost and output is
technically described as the cost function.
TC = (Q)
Where
TC = Total cost
Q = Quantity produced
F = function
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The production function combined with the prices of inputs determines the cost
function of the firm. Considering the period the cost function can be classified as (a)
short-run cost function and (b) long run-cost function.
In economic theory, the short-run is defined as that period during which the
physical capacity of the firm is fixed, and during which output can be increased only by
using the existing capacity more intensively. The long-run is a period during which it is
possible to increase the firm's capacity or to reduce it in size, if trade is very bad.
12.2 Short-run Cost-Output Relation
The cost concepts made use of in the cost behavior are total cost, average cost and
marginal cost. Total cost if the actual money spent to produce a particular quantity of
output. It is the summation of fixed and variable costs.
TC = TFC + TVC
Upto a certain level of production total fixed cost, i.e. the cost of plant, building,
equipment etc. remains fixed. But the total variable costs i.e., the cost of labour, raw
materials etc. vary with the variation in output
AC =
Q
TC
Or it is the total of average fixed cost (TFC / Q) and average variable cost
(TVC/Q)
Marginal cost is the addition to the total cost due to the production of an
additional unit of product. Or it is the cost of the marginal unit produced. It can be arrived
at by dividing the change in total cost by the change in total output.
MC =
Q
TC
In the short-run there will not be any change in total fixed cost. Hence change in
total cost implies change in total variable cost only.
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Short-run Cost-Output Relations
Units
of
output
Q
Total
Fixed
cost
TFC
Total
variable
cost
Total
cost
TC
(2+3)
Average
variable
cost
AVC
3/1
Average
fixed
cost
AFC
2/1
Average
cost
(5+6)
AC
Marginal
cost
MC
1 2 3 4 5 6 7 8
0
1
2
3
4
5
6
60
60
60
60
60
60
60
-
20
36
48
64
90
132
60
80
96
108
124
150
192
-
20
18
16
16
18
22
-
60
30
20
15
12
10
-
80
48
36
31
30
32
-
20
16
12
16
26
42
Table 1
Table 1 represents the cost-output relation. The table is prepared on the basis of
the Law of Diminishing Marginal Returns. The fixed cost Rs.60 may include rent of
factory building, interest on capital, salaries of permanently employed staff, insurance etc.
These fixed costs are independent of output, whose amount cannot be altered in the shortrun.
But the average fixed cost, i.e. the fixed cost per unit, falls continuously as the out
put increase. The greater the out put, lower the fixed cost per unit. The total variable cost
(TVC) increases but not at the same rate. If more and more units are produced with a
given physical capacity AVC will fall initially. AVC declines upto 3rd unit, it is constant
upto 4th unit and then rises. This is because the efficiency first increases and then
decreases. The variable factors seem to produce somewhat more efficiently near a firm's
optimum capacity output level than at very low levels of output. But once the optimum
capacity is reached, any further increase in output will increase AVC.
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Fig. 1
Fig. 1
The average total cost (AC) declines first and then rises. The rise in AC is felt
only after the AVC starts rising. In the table AVC starts rising from the 5th unit onwards
whereas the AC starts rising from the 6th unit only. AFC continues to fall with increase
in output. But AVC initially declines and then rises. Thus there will be a stage where the
AVC may have started rising, yet AC is still declining because the rise in AVC is less
than the drop in AFC, the net effect being a decline in AC. Thus the table A shows an
increasing returns or diminishing cost in the first instance and eventually diminishing
returns or increasing cost.
The short-run cost-output relationship can be shown graphically also. Fig.1 shows
the relationship between output and total fixed cost, total variable cost and total cost. TFC
curve is a horizontal straight line representing Rs.60, whatever be the output TVC curve
slopes upward starting from zero, first gradually but later at a fast rate. TC = TFC+TVC.
As TFC remains constant, increase in TC means increase in TVC only. As TFC remains
constant the gap between TVC and TC will always be the same. Hence TC curve has the
same pattern of behaviour as TVC curve.
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Fig. 2
Fig.2 shows the law of production more clearly. AFC curve continues to fall as
output rises from lower levels to higher levels. This is because the total fixed cost is
spread over more and more units as output increases. TVC increases with the increase in
production since more raw materials, labour, power etc. would be required for increasing
output. But AVC curve (i.e.variable cost per unit) first falls and then rises. This is due to
the operation of the law of variable proportions.
The behaviour of AC curve depends upon the behaviour of AVC curve and AFC
curve. In the initial stage of production both AFC and AVC are declining. Hence AC also
declines. AFC continues to fall with an increase in output while AVC first declines and
then rises. So long as AFC and AVC decline AC will also decline. But after a certain
point AVC starts rising. If the rise in AVC is less than the decline in AFC, AC will still
continue to decline. When the rise in AVC is more than the drop in AFC, AC begins to
rise. In the table we can see that when the production is increased to 5 units AVC
increases but AC still declines. Here the increase in AVC is less than the decline in AFC,
the net effect being a decline in AC. AC curve, thus declines first and then rises.
At first AC is high due to large fixed cost. As output increases the total fixed cost
is shared by more and more units and hence AC falls. After a certain point, owing to the
operation of the law of diminishing marginal returns, the variable cost and, therefore, AC
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starts increasing. The lower end of AC curve thus turns up. and gives it a U-shape. That is
why AC curves are U-shaped. The least-cost combination of inputs is indicated by the
lowest point in Ac curve i.e. where where the total average cost is the minimum. It is the
short-run stage of optimum output. It may not be the maximum output level. It is the
point where the per unit cost of production will be at its lowest.
A downward trend in MC curve shows increasing marginal productivity
(i.e.decreasing marginal cost) of the variable input. Similarly, an upward trend in MC
curve shows the rate of increase in TVC, on the one hand and the decreasing marginal
productivity (i.e. increasing marginal cost) of the variable input on the other. MC curve
intersects both AVC and AC curves at their lowest points.
The relationship between AVC, ATC and AFC can be summed up as follows:
1. If both AFC and AVC fall, AC will also fall because AC=AFC+AVC
2. When AFC falls and AVC rises(a) AC will fall where the drop in AFC is more
than the rise in AVC (b) AC remains constant if the drop in AFC=rise in AVC (c) AC
will rise where the drop in AFC is less than the rise in AVC.
12.3 Long-Run Cost-Output Relations
Long-run is a period long enough to make all inputs variable. In the long-run a
firm can increase or decrease its output according to its demand, by having more or less
of all the factors of production. The firms are able to expand the scale of their operation
in the long-run by purchasing larger quantities of all the inputs. Thus in the long-run all
factors become variable. The long-run cost-output relations therefore imply the
relationship between total costs and total output. As the change in production in the longrun
is possible by changing the scale of production, the long-run cost-output relationship
is influenced by the law of returns to scale.
In the long-run a firm has a number of alternatives in regard to the scale of
operations. For each scale of production or plant size, the firm has a separate short-run
average cost curve. Hence the long-run average cost curve is composed of a series of
short-run average cost curves.
A short-run average cost (SAC) curve applies to only one plant whereas the longrun
average cost (LAC) curve takes into consideration many plants. At any one time the
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firm has only one size of plant. That plant remains fixed during that period. Any increase
in production in that period is possible only with that plant capacity. That plant has a
corresponding average cost (SAC) curve. But in a long period the firm can move from
one plant size to another. Each plant has its corresponding SAC curve.
Fig. 3
The long-run cost-output relationship is shown graphically by the LAC curve. To
draw an LAC curve we have to start with a number of SAC curves. In the fig. 5.3 we
have assumed that there are only three sizes of plants-small, medium and large, S ACj
refers to the average cost curve for the small plant, S AC, for the medium size plant and
SAC3 for the large size plant. If the firm wants to produce OP units or less, it will choose
the small plant. For an output beyond OQ the firm will opt for medium size plant. Even if
an increased production is possible with small plant production beyond OQ will increase
cost of production per unit. For an output OR the firm will choose the large plant. Thus in
the long-run the firm has a series of SAC curves. The LAC curve drawn will be
tangential to the three SAC curves i.e. the LAC curve touches each SAC curve at one
point. The LAC curve is also known as Envelope Curve as it envelopes all the SAC
curves. No point on any of the LAC curve can ever be below the LAC curve. It is also
known as Planning Curve as it serves as a guide to the entrepreneur
In his planning the size of plant for future expansion. The plant which yields the
lowest average cost of production will be selected. LAC can, therefore, be defined as the
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lowest possible average cost of producing any output, when the management has
adequate I time to make all desirable changes and adjustments.
In the long-run the demand curve of the firm depends on the law of returns to
scale. The law of returns to scale states that if a firm increases the quantity of all inputs
simultaneously and proportionately, the total output initially increases more than
proportionately but eventually increases less than proportionately. It implies that when
production increases, per unit cost first’ decreases but ultimately increases. This means
LAC curve falls initially and rises subsequently. Like SAC curve LAC curve also is Ushaped,
but it will be always flatter then SAC curves. The U-shape implies lower and
lower average cost in the beginning until the optimum scale of the firm is reached and
successively higher average cost thereafter. The increasing return is experienced on
account of the economies of scale or advantages of large-scale production Increase in
scale makes possible increased division and _pecialization of labour and more efficient
use of machines. After a certain point increase in production makes management more
difficult and less efficient resulting in less than proportionate increase in output
Long-run Marginal Cost Curve
Fig. 4
Fig. 4
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The long-run marginal cost curve represents the cost of an additional unit of
output when all the inputs vary. The long-run marginal cost curve (LMC) is derived from
the short-run marginal cost (SMC) curves. LMC curve intersects LAC curve at its
minimum point C. There is only one plant size whose minimum SAC coincides with the
minimum LAC and LMC.
SAC2 = SMC2 = LAC = LMC
The point C indicates also the optimum scale of production of the firm in the
long-run or optimum output. Optimum output level is the level of production at which the
cost of production per unit, i.e. AC, is the lowest. The optimum level is not the maximum
profit level. The optimum point is where AC=MC. Here C is the optimum point.
16. What is meant by isoquants? What are their main properties?
Ans. Iso-Quant Curve: The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or product = output.
Thus it means equal quantity or equal product. Different factors are needed to produce a good. These factors may be substituted for one another.
A given quantity of output may be produced with different combinations of factors. Iso-quant curves are also known as Equal-product or Iso-product or Production Indifference curves. Since it is an extension of Indifference curve analysis from the theory of consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations of two factors yielding the same total product. Like, indifference curves, Iso- quant curves also slope downward from left to right. The slope of an Iso-quant curve expresses the marginal rate of technical substitution (MRTS).
Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm can produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a given output.” Samuelson
“An Iso-quant curve may be defined as a curve showing the possible combinations of two variable factors that can be used to produce the same total product.” Peterson
“An Iso-quant is a curve showing all possible combinations of inputs physically capable of producing a given level of output.” Ferguson
Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.
3. Constant Technique:
Technique of production is constant or is known before hand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function is of ‘variable proportion’ type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule shows the different combination of these two inputs that yield the same level of output as shown in table 1.

The table 1 shows that the five combinations of labour units and units of capital yield the same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by combining.
(a) 1 units of labour and 15 units of capital
(b) 2 units of labour and 11 units of capital
(c) 3 units of labour and 8 units of capital
(d) 4 units of labour and 6 units of capital
(e) 5 units of labour and 5 units of capital

Iso-Product Curve:
From the above schedule iso-product curve can be drawn with the help of a diagram. An. equal product curve represents all those combinations of two inputs which are capable of producing the same level of output. The Fig. 1 shows the various combinations of labour and capital which give the same amount of output. A, B, C, D and E.
Iso-Product Map or Equal Product Map:
An Iso-product map shows a set of iso-product curves. They are just like contour lines which show the different levels of output. A higher iso-product curve represents a higher level of output. In Fig. 2 we have family iso-product curves, each representing a particular level of output.
The iso-product map looks like the indifference of consumer behaviour analysis. Each indifference curve represents particular level of satisfaction which cannot be quantified. A higher indifference curve represents a higher level of satisfaction but we cannot say by how much the satisfaction is more or less. Satisfaction or utility cannot be measured.

An iso-product curve, on the other hand, represents a particular level of output. The level of output being a physical magnitude is measurable. We can therefore know the distance between two equal product curves. While indifference curves are labeled as IC1, IC2, IC3, etc., the iso-product curves are labelled by the units of output they represent -100 metres, 200 metres, 300 metres of cloth and so on.
Properties of Iso-Product Curves:
The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When we increase labour, we have to decrease capital to produce a given level of output.
The downward sloping iso-product curve can be explained with the help of the following figure:

The Fig. 3 shows that when the amount of labour is increased from OL to OL1, the amount of capital has to be decreased from OK to OK1, The iso-product curve (IQ) is falling as shown in the figure.
The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the help of the following figure 4:

(i) The figure (A) shows that the amounts of both the factors of production are increased- labour from L to Li and capital from K to K1. When the amounts of both factors increase, the output must increase. Hence the IQ curve cannot slope upward from left to right.
(ii) The figure (B) shows that the amount of labour is kept constant while the amount of capital is increased. The amount of capital is increased from K to K1. Then the output must increase. So IQ curve cannot be a vertical straight line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour increases, although the quantity of capital remains constant. When the amount of capital is increased, the level of output must increase. Thus, an IQ curve cannot be a horizontal line.
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have to understand the concept of diminishing marginal rate of technical substitution (MRTS), because convexity of an isoquant implies that the MRTS diminishes along the isoquant. The marginal rate of technical substitution between L and K is defined as the quantity of K which can be given up in exchange for an additional unit of L. It can also be defined as the slope of an isoquant.
It can be expressed as:
MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.
Equation (1) states that for an increase in the use of labour, fewer units of capital will be used. In other words, a declining MRTS refers to the falling marginal product of labour in relation to capital. To put it differently, as more units of labour are used, and as certain units of capital are given up, the marginal productivity of labour in relation to capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C to D along an isoquant, the marginal rate of technical substitution (MRTS) of capital for labour diminishes. Everytime labour units are increasing by an equal amount (AL) but the corresponding decrease in the units of capital (AK) decreases.
Thus it may be observed that due to falling MRTS, the isoquant is always convex to the origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut each other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2 represent two levels of output. But they intersect each other at point A. Then combination A = B and combination A= C. Therefore B must be equal to C. This is absurd. B and C lie on two different iso-product curves. Therefore two curves which represent two levels of output cannot intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output as shown in the figure 7 given below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital. IQ1 represents an output level of 100 units whereas IQ2 represents 200 units of output.
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be necessarily equal. Usually they are found different and, therefore, isoquants may not be parallel as shown in Fig. 8. We may note that the isoquants Iq1 and Iq2are parallel but the isoquants Iq3 and Iq4 are not parallel to each other.

6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with the help of labour alone without using capital at all. These logical absurdities for OL units of labour alone are unable to produce anything. Similarly, OC units of capital alone cannot produce anything without the use of labour. Therefore as seen in figure 9, IQ and IQ1 cannot be isoquants.

7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a consequence of the fact that if a producer uses more of capital or more of labour or more of both than is necessary, the total product will eventually decline. The firm will produce only in those segments of the isoquants which are convex to the origin and lie between the ridge lines. This is the economic region of production. In Figure 10, oval shaped isoquants are shown.

Curves OA and OB are the ridge lines and in between them only feasible units of capital and labour can be employed to produce 100, 200, 300 and 400 units of the product. For example, OT units of labour and ST units of the capital can produce 100 units of the product, but the same output can be obtained by using the same quantity of labour T and less quantity of capital VT.
Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100. The dotted segments of an isoquant are the waste- bearing segments. They form the uneconomic regions of production. In the up dotted portion, more capital and in the lower dotted portion more labour than necessary is employed. Hence GH, JK, LM, and NP segments of the elliptical curves are the isoquants.
Isoquant Curve and Returns to a Factor:
Returns to a factor refers to the behavior of output in response to changing application of one factor of production while other factors remaining constant. As in the case of returns to scale, there are three different aspects of returns to a factor, viz., increasing returns, constant returns and diminishing returns.
The returns to a factor can be explained using isoquant techniques. It is assumed that capital is a fixed input and labour is a variable input.
Different Stages of Returns to a Factor:
The different returns to a factor can be explained as follows:
(i) Increasing Returns to a Factor:
It occurs when additional application of the variable factor i.e., labour increases total output at increasing rate. Fig. 17 explains the situation of increasing returns to a factor.
In Fig. 17 capital is taken constant at OR units. The line RP shows how larger quantities of labour can be employed to expand production. It is called output path.
The isoquant curves for 100, 200, 300 and 400 units of output shows that output is increasing by a constant amount by 100 units. These isoquants intersect the output path RP at point E, F, G and H.

We see here that the distance between successive isoquant curves is decreasing, that is, less and less labour is needed for every additional 100 units of output. This means an increasing marginal product of labour. However, the distance EF is greater than FG and FG is greater than GH i.e.
EF = FH = GH
This means that 100 units increase in output can be obtained by employing successively lesser increments of labour. Let us suppose that EF is 20 units of labour and FG is 10 units of labour. Then from E to F the additional 100 units of output are obtained by employing additional 20 units of labour. From F to G additional 100 units of output is obtained by employing only 10 more units of labour. In short, the marginal product of labour increases when output is expanded along the output path RP.
(ii) Diminishing Returns to a Factor. Diminishing returns to a factor is a situation when increasing application of the variable factor increases total output only at the diminishing rate.
Fig. 18 illustrates the situation of diminishing rate. When capital is taken constant at OR and production is expanded by adding more labour, the distance between successive Isoquants becomes increasingly greater, that is even more and more labour is needed for every additional 100 units of output. This shows a diminishing marginal product of labour. The distance EF is less than FG and FG is less than GH.
EF < FG < GH Thus, 100 units increase in output can be obtained only by employing successively greater increments of labour. Between E to F additional 100 units of output is obtained by applying additional 10 units of labour. Between F to G additional 100 units of output is obtained by applying additional 20 units of labour. Therefore, the marginal product of labour diminishes when output is expanded along the output path RP.


(iii) Constant Returns to a Factor:
A constant return to a factor occurs when increasing application of the variable factor increases total output only at a constant rate. Fig. 19, we see that when capital is taken constant at OR and production is increased by adding more labour, the distance between isoquants remains constant, so that same amount of labour is needed for every additional 100 units of output.
This means a constant marginal product (MP) of labour. In other words, 100 units increase in output can be obtained by employing equal increment of labour. The distance between different iso-quants remains equal. It can be written as;
EF = FG = GH


17. What are the internal and external economies of large scale production?
18. Ans. Economies of scale are defined as the cost advantages that an organization can achieve by expanding its production in the long run. In other words, these are the advantages of large scale production of the organization. The cost advantages are achieved in the form of lower average costs per unit. It is a long term concept. Economies of scale are achieved when there is an increase in the sales of an organization. As a result, the savings of the organization increases, which further enables the organization to obtain raw materials in bulk. This helps the organization to enjoy discounts. These benefits are called as economies of scale.
19. The economies of scale are divided into internal economies and external economies discussed as follows:
20. I]. INTERNAL ECONOMIES: It refers to real economies which arise from the expansion of the plant size of the organization. These economies arise from the growth of the organization itself.
21. The examples of internal economies of scale are as follows:
22. a. Technical economies of scale:
23. It occurs when organizations invest in the expensive and advanced technology. This helps in lowering and controlling the costs of production of organizations. These economies are enjoyed because of the technical efficiency gained by the organizations. The advanced technology enables an organization to produce a large number of goods in short time. Thus, production costs per unit falls leading to economies of scale.
24. b. Marketing economies of scale:
25. It occurs when large organizations spread their marketing budget over the large output. The marketing economies of scale are achieved in case of bulk buying, branding, and advertising. For instance, large organizations enjoy benefits on advertising costs as they cover larger audience. On the other hand, small organizations pay equal advertising expenses as large organizations, but do not enjoy such benefits on advertising costs.
26. c. Financial economies of scale:
27. It takes place when large organizations borrow money at lower rate of interest. These organizations have good credibility in the market. Generally, banks prefer to grant loans to those organizations that have strong foothold in the market and have good repaying capacity.
28. d. Managerial economies of scale:
29. It occurs when large organizations employ specialized workers for performing different tasks. These workers are experts in their fields and use their knowledge and experience to maximize the profits of the organization. For instance, in an organization, accounts and research department are created and managed by experienced individuals, SO that all costs and profits of the organization can be estimated properly.
30. e. Commercial economies:
31. It refers to economies in which organizations enjoy benefits of buying raw materials and selling of finished goods at lower cost. Large organizations buy raw materials in bulk; therefore, enjoy benefits in transportation charges, easy credit from banks, and prompt delivery of products to customers.
32.
33. II]. EXTERNAL ECONOMIES:
34. Occur outside the organization. These economies occur within the industries which benefit organizations. When an industry expands, organizations may benefit from better transportation network, infrastructure, and other facilities. This helps in decreasing the cost of an organization.
35. Some of the examples of external economies of scale are discussed as follows:
36. a. Economies of Concentration: Refer to economies that arise from the availability of skilled labour, better credit, and transportation facilities.
37. b. Economies of Information: Imply advantages that are derived from publication related to trade and business. The central research institutions are the source of information for organizations.
38. c. Economies of Disintegration: Refer to the economies that arise when organizations split their processes into different processes.
39.
40. Diseconomies of scale occur when the long run average costs of the organization increases. It may happen when an organization grows excessively large. In other words, the diseconomies of scale cause larger organizations to produce goods and services at increased costs.
41. There are two types of diseconomies of scale, namely, internal diseconomies and external diseconomies, discussed as follows:
42. I]. INTERNAL DISECONOMIES OF SCALE:
43. It refers to diseconomies that raise the cost of production of an organization. The main factors that influence the cost of production of an organization include the lack of decision, supervision, and technical difficulties.
44. II]. EXTERNAL DISECONOMIES OF SCALE:
45. It refers to diseconomies that limit the expansion of an organization or industry. The factors that act as restraint to expansion include increased cost of production, scarcity of raw materials, and low supply of skilled labourer.
Some of the causes which lead to diseconomies of scale are as follows:
i. Poor Communication:
It acts as a major reason for diseconomies of scale. If production goals and objectives of an organization are not properly communicated to employees within the organization, it may lead to overproduction or production. This may lead to diseconomies of scale. Apart from this, if the communication process of the organization is not strong then the employees would not get adequate feedback. As a result, there would be less face-to-face interaction among employees- thus the production process would be affected.
ii. Lack of Motivation:
It leads to fall in productivity levels. In case of a large organization, workers may feel isolated and are less appreciated for their work, thus their motivation diminishes. Due to poor communication network, it is harder for employers to interact with the employees and build a sense of belongingness. This leads to fall in the productivity levels of output owing to lack of motivation. This further leads to increase in costs of the organization.
iii. Loss of Control:
It acts as the main problem of large organizations. Monitoring and controlling the work of every employee in a large organization becomes impossible and costly. It is harder to make out that all the employees of an organization are working towards the same goal. It becomes difficult for managers to supervise the sub-ordinates in large organizations.
iv. Cannibalization:
It implies a situation when an organization faces competition from its own product. A small organization faces competition from products of other organizations, whereas sometimes large organizations find that their own products are competing with each other.
46. Explain how price and output is determined under perfect competition?
Ans. Perfect Competition is a market structure where there is a perfect degree of competition and single price prevails. Under this condition, no individual firm will be in the position to influence the market price of the product.
According to Bilas, “The perfect competition is characterized by the presence of many firms; they all sell the same product which is identical. The seller is the price- taker”. In this market a uniform price prevail during a particular period of time. It is a rare phenomenon which does not exist in reality. Ex. Street food vendors
Main Features of Perfect Competition
1. Many Sellers: In this market, there are many sellers who form total of market supply. Individually, seller is a firm and collectively, it is an industry. In perfect competition, price of commodity is decided by market forces of demand and supply i.e. by buyers and sellers collectively. Here, no individual seller is in a position to change the price by controlling supply. Because individual seller's individual supply is a very small part of total supply. So, if the seller alone raises the price, his product will become costlier than other and automatically, he will be out of market. Hence, that seller has to accept the price which is decided by market forces of demand and supply. This ensures single price in the market and in this way, seller becomes price taker and not price maker.
2. Many Buyers: Individual buyer cannot control the price by changing or controlling the demand. Because individual buyer's individual demand is a very small part of total demand or market demand. Every buyer has to accept the price decided by market forces of demand and supply. In this way, all buyers are price takers and not price makers. This also ensures existence of single price in market.
3. Homogenous Product: In this case, all sellers produce homogeneous i.e. perfectly identical products. All products are perfectly same in terms of size, shape, taste, colour, ingredients, quality, trade marks etc. This ensures the existence of single price in the market.
4. Zero Advertisement Cost: Since all products are identical in features like quality, taste, design etc., there is no scope for product differentiation. So advertisement cost is nil.
5. Free Entry and Exit: There are no restrictions on entry and exit of firms. This feature ensures existence of normal profit in perfect competition. When profit is more, new firms enter the market and this leads to competition. Entry of new firms competing with each other results into increase in supply and fall in price. So, this reduces profit from abnormal to normal level. When profit is low (below normal level), some firms may exit the market. This leads to fall in supply. So remaining firms raise their prices and their profits go up. So again this ensures normal level of profit.
6. Perfect Knowledge: On the front of both, buyers and sellers, perfect knowledge regarding market and pricing conditions is expected. So, no buyer will pay price higher than market price and no seller will charge lower price than market price.
7. Perfect Mobility of Factors: This feature is essential to keep supply at par with demand. If all factors are easily mobile (moveable) from one line of production to another, then it becomes easy to adjust supply as per demand. Whenever demand is more additional factors should be moved into industry to increase supply and vice versa. In this way, with the help of stable demand and supply, we can maintain single price in the Market.
8. No Government Intervention: Since market has been controlled by the forces of demand and supply, there is no government intervention in the form of taxes, subsidies, licensing policy, control over the supply of raw materials, etc.
9. No Transport Cost: It is assumed that buyers and sellers are close to market, so there is no transport cost. This ensures existence of single price in market.
10. Determination of price: In a perfect competition market, price is determined by the market force of demand and supply. Every firm will charge the price determine by the equality of demand and supply force.
Price determination under perfect competition
Equilibrium of the Industry: An industry in economic terminology consists of a large number of independent firms, each having a number of factories, farms or mines under its control. Each such unit in the industry produces a homogeneous product so that there is competition amongst goods produced by different units called firms. When the total output of the industry is equal to the total demand, we say that the industry is in equilibrium; the price then prevailing is equilibrium price, whereas a firm is said to be in equilibrium when it has no incentive to expand or contract production.
As stated above, under competitive conditions, the equilibrium price for a given product is determined by the interaction of the forces of demand and supply for it as is shown in figure.










         Fig.: Equilibrium of a competitive industry
In Fig., OP is the equilibrium price and OQ is the equilibrium quantity which will be sold at that price. The equilibrium price is the price at which both demand and supply are equal and therefore, no buyer who wanted to buy at that price goes dissatisfied and none of the sellers is dissatisfied that they could not sell their goods at that price. It may be noticed that if the price were to be fixed at any other level, higher or lower, demand remaining the same, there would not be an equilibrium in the market. Likewise, if the quantities of goods were greater or smaller than the demand, there would not be an equilibrium.
Equilibrium of the Firm: The firm is said to be in equilibrium when it maximizes its profit. The output which gives maximum profit to the firm is called equilibrium output. In the equilibrium state, the firm has no incentive either to increase or decrease its output. Since it is the maximum profit giving output which only gives no incentive to the firm to increase or decrease it, so it is in equilibrium when it gets maximum profit.
Firms in a competitive market are price takers. This is because there are a large number of firms in the market who are producing identical or homogeneous products. As such these firms cannot influence the price in their individual capacities. They have to accept the price fixed (through interaction of total demand and total supply) by the industry as a whole.





             PRICE





Industry price OP is fixed through the interaction of total demand and total supply of the industry. Firms have to accept this price as given and as such they are price-takers rather than price makers. They cannot increase the price OP individually because of the fear of losing customers to other firms. They do not try to sell the product below OP because they do not have any incentive for lowering it. They will try to sell as much as they can at price OP.
As such, P line acts as demand curve for the firm. Thus the demand curve facing an individual firm in a perfectly competitive market is a horizontal one at the level of market price set by the industry and firms have to choose that level of output which yields maximum profit.
Table–4: Trends of Revenue for the Firm

Price (`) Quantity Sold Total Revenue Average Revenue Marginal Revenue
2 8 16 2 2
2 10 20 2 2
2 12 24 2 2
2 14 28 2 2
2 16 32 2 2

Firm X’s price, average revenue and marginal revenue are equal to `2. Thus, we see that in a perfectly competitive market a firm’s AR= MR= price.
Conditions for equilibrium of a firm: As discussed earlier, a firm, in order to attain the equilibrium position, has to satisfy two conditions:
(i) The marginal revenue should be equal to the marginal cost. i.e. MR= MC. If MR is greater than MC, there is always an incentive for the firm to expand its production further and gain by sale of additional units. If MR is less than MC, the firm will have to reduce output since an additional unit adds more to cost than to revenue. Profits are maximum only at the point where MR= MC.
(ii) The MC curve should cut MR curve from below. In other words, MC should have a positive slope.










In figure, DD and SS are the industry demand and supply curves which equilibrate at E to set the market price as OP. The firms of perfectly competitive industry adopt OP price as given and considers P- Line as demand (averagerevenue) curve which is perfectly elastic at P. As all the units are priced at the same level, MR is a horizontal line equal to AR line. Note that MC curve cuts MR curve at two places T and R respectively. But at T, the MC curve is cutting MR curve from above. T is not the point of equilibrium as the second condition is not satisfied. The firm will benefit if it goes beyond T as the additional cost of producing an additional unit is falling. At R, the MC curve is cutting MR curve from below. Hence, R is the point of equilibrium and OQ2 is the equilibrium level of output.
Supply curve of the firm in a competitive market: One interesting thing about the MC curve of a firm in a perfectly competitive industry is that it depicts the firm’s supply curve. This can be shown with the help of the following example.

Can a competitive firm earn profits? In the short run, a firm will attain equilibrium position and at the same time, it may earn supernormal profits, normal profits or losses depending upon its cost conditions.
Supernormal Profits: There is a difference between normal profits and supernormal profits. When the average revenue of a firm is just equal to its average total cost, it earns normal profits. It is to be noted that here a normal percentage of profits for the entrepreneur for his managerial services is already included in the cost of production. When a firm earns supernormal profits, its average revenues are more than its average total cost. Thus, in addition to normal rate of profit, the firm earns some additional profits.




                                     PRICE




Fig.: Short run equilibrium: Supernormal profits of a competitive firm
The diagram shows that in order to attain equilibrium, the firm tries to equate marginal revenue with marginal cost. MR (marginal revenue) curve is a horizontal line and MC (marginal cost) curve is a U-shaped curve which cuts the MR curve at E. At E, MR=MC. OQ is the equilibrium output for the firm. The firm’s profit per unit is EB (AR-ATC), AR is EQ and ATC is BQ. Total profits are ABEP.
Normal profits: When a firm just meets its average total cost, it earns normal profits. Here AR=ATC.









The figure shows that MR=MC at E. The equilibrium output is OQ. Since AR=ATC or OP=EQ, the firm is just earning normal profits.
Losses: The firm can be in an equilibrium position and still makes losses. This is the position when the firm is minimizing losses. When the firm is able to meet its variable cost and a part of fixed cost it will try to continue production in the short run. If it recovers a part of the fixed costs, it will be beneficial for it to continue production because fixed costs (such as costs towards plant and machinery, building etc.) are already incurred and in such case it will be able to recover a part of them. But, if a firm is unable to meet its average variable cost, it will be better for it to shut down.


In figure .the equilibrium point and at this point AR= EQ and ATC= BQ since BQ>EQ, the firm is earning BE per unit loss and the total loss is ABEP.
Long Run Equilibrium of the Firm: In the long run, firms are in equilibrium when they have adjusted their plant so as to produce at the minimum point of their long run AC curve, which is tangent to the demand curve defined by the market price. In the long run, the firms will be earning just normal profits, which are included in the ATC. If they are making supernormal profits in the short run, new firms will be attracted into the industry; this will lead to a fall in price (a downward shift in the individual demand curves) and an upward shift of the cost curves due to increase in the prices of factors as the industry expands. These changes will continue until the ATC is tangent to the demand curve. If the firms make losses in the short run, they will leave the industry in the long run. This will raise the price and costs may fall as the industry contracts, until the remaining firms in the industry cover their total costs inclusive of the normal rate of profit.
In Fig., we show how firms adjust to their long run equilibrium position. If the price is OP, the firm is making super-normal profits working with the plant whose cost is denoted by SAC1. It will, therefore, have an incentive to build new capacity and it will move along its LAC. At the same time, new firms will be entering the industry attracted by the excess profits. As the quantity supplied in the market increases, the supply curve in the market will shift to the right and price will fall until it reaches the level of OP1 at which the firms and the industry are in long run equilibrium.







(a) (b)
Fig.: Long run equilibrium of the firm in a perfectly competitive market
The condition for the long run equilibrium of the firm is that the marginal cost should be equal to the price and the long run average cost i.e. LMC = LAC = P. The firm adjusts its plant size so as to produce that level of output at which the LAC is the minimum possible. At equilibrium the short run marginal cost is equal to the long run marginal cost and the short run average cost is equal to the long run average cost. Thus, in the long run we have,
SMC=LMC=SAC=LAC=P=MR
This implies that at the minimum point of the LAC, the corresponding (shortrun) plant is worked at its optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts the LAC at its minimum point and the SMC cuts the SAC at its minimum point. Thus, at the minimum point of the LAC the above equality is achieved.
Long run equilibrium of the industry: A perfectly competitive industry is in long run equilibrium when (i) all the firms are earning normal profits only i.e. all the firms are in equilibrium (ii) there is no further entry or exit from the market.


INDUSTRY
D S



S



D


Fig.: Long run equilibrium of a competitive industry and its firms

Figure shows that in the long-run AR=MR=LAC=LMC at E1. Since E1 is the minimum point of LAC curve, the firm produces equilibrium output OM at the minimum (optimum) cost. A firm producing output at optimum cost is called an optimum firm. All the firms under perfect competition, in long run, are optimum firms having optimum size and these firms charge minimum possible price which just covers their marginal cost.
Thus, in the long run, in perfect competition, the market mechanism leads to an optimal allocation of resources. The optimality is shown by the following conditions associated with the long run equilibrium of the industry:
a. The output is produced at the minimum feasible cost.
b. Consumers pay the minimum possible price which just covers the marginal cost i.e. MC=AR.
c. Plants are used at full capacity in the long run, so that there is no wastage of resources i.e. MC=AC.
d. Firms earn only normal profits i.e. AC=AR.
e. Firms maximize profits (i.e.MC=MR), but the level of profits will be just normal. In other words, in the long run, LAR= LMR= P= LMC= LAC and there will be optimum allocation of resources.
But it should be remembered that the perfectly competitive market system is a myth. This is because the assumptions on which this system is based are never found in the real world market conditions.

47. Explain how price and output is determined under monopoly and monopolistic competition?
Ans. Monopoly is that market form in which a single producer controls the entire supply of a single commodity which has no close substitutes. There must be only one seller or producer. The commodity produced by the producer must have no close substitutes. Monopoly can exist only when there are strong barriers to entry. The barriers which prevent the entry may be economic, institutional or artificial in nature.

Features
1. There is a single producer or seller of the product.
2. There are no close substitutes for the product. If there is a substitute, then the monopoly power is lost.
3. No freedom to enter as there exists strong barriers to entry.
4. The monopolist may use his monopolistic power in any manner to get maximum revenue. He may also adopt price discrimination.

PRICE-OUTPUT DETERMINATION UNDER MONOPOLY
The aim of the monopolist is to maximise profits. Therefore, he will produce that level of output and charge a price which gives him the maximum profits. He will be in equilibrium at that price and output at which his profits are maximum. In order words, he will be in equilibrium position at that level of output at which marginal revenue equals marginal cost. The monopolist, to be in equilibrium should satisfy two conditions :
1. Marginal cost should be equal to marginal revenue and
2. The marginal cost curve should cut marginal revenue curve from below.
The short run equilibrium of the monopolist is shown in figure below.

AR is the average revenue curve, MR is the marginal revenue curve, AC is the average cost curve and MC is the marginal cost curve. Upto OQ level of output marginal revenue is greater than marginal cost but beyond OQ the marginal revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium where MC = MR. Thus a monopolist is in equilibrium at OQ level of output and at OP price. He earns abnormal profit equal to PRST.
But it is not always possible for a monopolist to earn super- normal profits. If the demand and cost situations are not favourable, the monopolist may realise short run losses.


Though the monopolist is a price maker, due to weak demand and high costs, he suffers a loss equal to PABC.
Long run equilibrium
In the long run the firm has the time to adjust his plant size or to use the existing plant so as to maximise profits. The long run equilibrium of the monopolist is shown in figure below.

The monopolist is in equilibrium at OL output where LMC cuts MR curve. He will charge OP price and earn an abnormal profit equal to TPQH.

In order to show the difference between the short run equilibrium and long run equilibrium under monopoly, both can be shown in a single figure.

The monopolist is in the s h o r t r u n equilibrium at E producing OS level of output. In the long run he can change the plant and will be in equilibrium at F where MR curve cuts LMC curve. The monopolist has increased his output from OS to OL and price has fallen from OP to OJ. Profits have also increased in the long run from TPQR to GHKJ.
Perfect competition and monopoly are rarely found in the real world. Therefore, professor Edward. H. Chamberlin of Harvard University brought about a synthesis of the two theories and put forth, "Theory of Monopolistic Competition" in 1933. Monopolistic competition is more realistic than either pure competition or monopoly. It is a blending of competition and monopoly. "There is competition which is keen though not perfect, between many firms making very similar products". Thus monopolistic competition refers to competition among a large number of sellers producing close but not perfect substitutes.
FEATURES
1. Large number of sellers
In monopolistic competition the number of sellers is large. No one controls a major portion of the total output. Hence each firm has a very limited control over the price of the product. Each firm decides its own price-output policy without considering the reactions of rival firms. Thus there is no interdependence between firms and each seller pursues an independent course of action.



2. Product differentiation
One of the most important features of monopolistic competition is product differentiation. Product differentiation implies that products are different in some ways from each other. They are heterogeneous rather than homogeneous. Products are close substitutes but not perfect substitutes. Product differentiation may be due to differences in the quality of the product. Product may be differentiated in order to suit the tastes and preferences of the consumers. The products are differentiated on the basis of materials used, workmanship, durability, size, shape, design, colour, fragrance, packing etc.
3. Free entry and exit of firms
Another feature of monopolistic competition is the freedom of entry and exit of firms. Firms under monopolistic competition are small in size and they are capable of producing close substitutes. Hence they are free to enter or leave the industry in the long run. Product differentiation increases entry of new firms in the group because each firm produces a different product from the others.
4. Selling cost
It is an important feature of monopolistic competition. As there is keen competition among the firms, they advertise their products in order to attract the customers and sell more. Thus selling cost has a bearing on price determination under monopolistic competition.
5. Group equilibrium
Chamberlin introduced the concept of group in the place of industry. Industry refers to a number of firms producing homogeneous products. But, firms under monopolistic competition produce similar but not identical products. Therefore, chamberlin uses, the concept of group to include firms producing goods which are close substitutes.
6. Nature of demand curve
Under monopolistic competition, a single firm can control only a small portion of the total output. Though there is product differentiation, as products are close substitutes, a reduction in price leads to increase in sales and vice-versa. But it will have little effect on the price-output conditions of other firms. Hence each will loose only few customers, due to an increase in price. Similarly a reduction in price will increase sales. Therefore the demand curve of a firm under monopolistic competition slopes downwards to the right. It is highly elastic but not perfectly elastic. In other words, under monopolistic competition, the demand curve faced by the firm is highly elastic. It means that it has some control over price due to product differentiation and there are price differentials between the firms.
Price-Output Determination under Monopolistic Competition
Since, under monopolistic competition, different firms produce different varieties of products, prices will be determined on the basis of demand and cost conditions. The firms aim at profit maximisation by making adjustments in price and output, product adjustment and adjustment of selling costs.
Equilibrium of a firm under monopolistic competition is based upon the following assumptions:
1. The number of sellers is large and they act independently of each other.
2. The product is differentiated.
3. The firm has a demand curve which is elastic.
4. The supply of factor services is perfectly elastic.
5. The short run cost curves of each firm differ from each other.
6. No new firms enter the industry.
Individual Equilibrium and Price Variation
Based on these assumptions, each firm fixes such price and output which maximises its profit. Product is held constant. The only variable is price. The equilibrium price and output is determined at a point where the short run marginal cost equals marginal revenue. The equilibrium of a firm under monopolistic competition is shown in figure 25. DD is the demand curve of the firm. It is also the average revenue curve of the firm. MC is the marginal cost of the firm. The firm will maximise profits by equating marginal cost with marginal revenue. The firm maximises its profit by producing OM level of output and selling it at Fig. 25 a price of OP. The profit earned by the firm is PQRS. Thus in the short run, a firm under monopolistic competition earns supernormal profits.



In the short run, the firm may incur losses also. This is shown in figure 26.


The firm is in equilibrium by producing an output of OQ. It fixes the price at OP. As price is less than cost, it incurs losses equal to pabc. Thus a firm in equilibrium under monopolistic competition may be making supernormal profits or losses depending upon the position of the demand curve and average cost curve.
Group Equilibrium and Price Variation
Group equilibrium refers to price-output determination in a number of firms whose products are close substitutes. The product of each firm has special characteristics. The difference in the quality of the products of the firms under monopolistic competition results in large variation in elasticity and position of the demand curves of the various firms. Similarly the shape and position of cost curves too differ. As a result there exist differences in prices, output and profits of the various firms in the group. For the sake of simplicity in the analysis of group equilibrium, Chamberlin ignores these differences by adopting infirmity assumption. He assumes that the cost and demand curves of all the products in the group are uniform. Chamberlin introduces another assumption known as 'symmetry assumption'. It means that the number of firms under monopolistic competition is large and hence the action of an individual firm regarding price and output will have a negligible effect upon his rivals.
Based on these assumptions, short run equilibrium of a firm under monopolistic competition can be shown in Figure. 27.






Figure (A) represents short run equilibrium and figures (B) the long run equilibrium. In the short run, the price is OP and average cost is only MR. Hence there is supernormal profit equal to PQRS. But in the long run, as shown in figure 27 (B), the excess profit is competed away. MC = MR at OM level of output. LAR is tangent to LAC. Price is equal to average cost and there is no extra profit. Only normal profit is earned.


48. Explain how price and output is determined under oligopoly?
Ans. Oligopoly is a situation in which few large firms compete against each other and there is an element of interdependence in the decision making of these firms. A policy change on the part of one firm will have immediate effects on competitors, who react with their counter policies.
Features
Following are the features of oligopoly which distinguish it from other market structures :
1. Small number of large sellers.
The number of sellers dealing in a homogeneous or differentiated product is small. The policy of one seller will have a noticeable impact on market, mainly on price and output.
2. Interdependence.
Unlike perfect competition and monopoly, the oligopolist is not independent to take decisions. The oligopolist has to take into account the actions and reactions of his rivals while deciding his price and output policies. As the products of the oligopolist are close substitutes, the cross elasticity of demand is very high.
3. Price rigidity.
Any change in price by one oligopolist invites retaliation and counter- action from others, the oligopolist normally sticks to one price. If an oligopolist reduces his price, his rivals will also do so and therefore, it is not advantageous for the oligopolist to reduce the price. On the other hand, if an oligopolist tries to raise the price, others will not do so. As a result they capture the customers of this firm. Hence the oligopolist would never try to either reduce or raise the price. This results in price rigidity.
4. Monopoly element.
As products are differentiated the firms enjoy some monopoly power. Further, when firms collude with each other, they can work together to raise the price and earn some monopoly income.
5. Advertising.
The only way open to the oligopolists to raise his sales is either by advertising or improving the quality of the product. Advertisement expenditure is used as an effective tool to shift the demand in favour of the product. Quality improvement will also shift the demand favorably. Usually, both advertisements as well as variations in designs and quality are used simultaneously to maintain and increase the market share of an oligopolist.
6. Group behaviour.
The firms under oligopoly recognise their interdependence and realise the importance of mutual cooperation. Therefore, there is a tendency among them for collusion. Collusion as well as competition prevail in the oligopolistic market leading to uncertainty and indeterminateness.
7. Indeterminate demand curve.
It is not possible for an oligopolist to forecast the nature and position of the demand curve with certainty. The firm cannot estimate the sales when it decides to reduce the price. Hence the demand curve under oligopoly is indeterminate.
TYPES OF OLIGOPOLY
Oligopoly may be classified in the following ways:
a. Perfect and imperfect oligopoly.
On the basis of the nature of product, oligopoly may be classified into perfect (pure) and imperfect (differentiated) oligopoly. If the products are homogeneous, then oligopoly is called as perfect or pure oligopoly. If the products are differentiated and are close substitutes, then it is called as imperfect or differentiated oligopoly.
b. Open or closed oligopoly.
On the basis of possibility of entry of new firms, oligopoly may be classified into open or closed oligopoly. When new firms are free to enter, it is open oligopoly. When few firms dominate the market and new firms do not have a free entry into the industry, it is called closed oligopoly.
c. Partial and full oligopoly.
Partial oligopoly refers to a situation where one firm acts as the leader and others follow it. On the other hand, full oligopoly exists where no firm is dominating as the price leader.
d. Collusive and non- collusive oligopoly.
Instead of competition with each other, if the firms follow a common price policy, it is called collusive oligopoly. If the collusion is in the form of an agreement, it is called open collusion. If it is an understanding between the firms, then it is a secret collusion. On the other hand, if there is no agreement or understanding between oligopoly firms, it is known as non-collusive oligopoly.
e. Syndicated and organised oligopoly.
Syndicated oligopoly is one in which the firms sell their products through a centralised syndicate. Organised oligopoly refers to the situation where the firms organise themselves into a central association for fixing prices, output, quota etc.

P. Sweezy introduced the kinked demand curve to explain the determination of equilibrium in' oligopolistic market. The demand curve facing an oligopolist has a kink at the prevailing price. This is because each oligopolist believes that if he lowers the price below the prevailing level increases his price above the prevailing level his competitors will not follow his increase in price. Due to this behavioural pattern of the oligopolists, the upper segment of the demand curve is relatively elastic and the lower portion is relatively inelastic.
If the oligopolist reduces its price below the prevailing price level MP, the competitors will fear that their customers would go away from them. Therefore, they will also reduce the price. Since all the competitors are reducing their price, the oligopolist will gain only very little sales. Hence the demand curve which lies below the prevailing price is inelastic. If the oligopolist raises his price above the prevailing price level his sales Fig. 38 will be reduced. As a result of a rise in price, his customers will go to his competitors.
Thus an increase in price will lead to a large reduction in sales. This shows that the demand curve which lies above the current price level is elastic. Since the oligopolist will not gain a larger share of the market by reducing his price below the prevailing level and will loose a large share of the market by increasing his price he will not change the price.





For determining profit maximising price-output, combination, marginal revenue curve has to be drawn. The marginal revenue curve corresponding to the kinked demand curve has a gap or discontinuity between G and H. This gap in MR curve occurs due to the kink in the demand curve and lies right below the kink. The length of the gap depends on the relative elasticities of the two portions of the demand curve. The greater the difference in the two elasticities the greater the length of the discontinuity. If the marginal of the oligopolist passes through the discontinuous portion of the MR curve the oligopolist will be maximising his profit at the prevailing price level OP. As he is maximising profits at the prevailing price level he will have no incentive to change the price.
Even if cost conditions change the price will remain stable.


When the marginal cost curve shifts upward from MC to MC1 , the price remains unchanged as MC1 passes through the gap GH.
Similarly, the price will remain stable even when the demand conditions change. When the demand for the oligopolist increases from D to D1, the given marginal cost curve MC cuts the new marginal revenue curve MR within the gap. This means that the same price continues to prevail in the market.
The major drawback of the kinked demand curve is that it does not explain the determination of price. It explains only price rigidity. Further it is not applicable to price leadership and cartels. Kinked demand curve is also not applicable to oligopoly with product differentiation. Due to these deficiencies, a general theory of pricing is impossible under oligopoly.

Unit IV
49. Define macro economics. Also explain its nature and importance?
Ans. Macroeconomics (Greek makro = ‘big’) describes and explains economic processes that concern aggregates. Macro Economics is the study of aggregates or averages covering the entire economy, such as total employment, national income, national output, total investment, total consumption, total savings, aggregate supply, aggregate demand and general price level, wage level and cost structure. Otherwise, it is aggregative economics which examines the interrelations among the various aggregates, their determination and causes of fluctuations in them.
Prof. Ackley defines Macro Economics as “Macro Economics deals with economic affairs ‘in the large, it concerns the overall dimensions of economic life. It looks at the total size and shape and functioning of the elephant of economic experience, rather than working of articulation or dimensions of the individual parts. It studies the character of the forest, independently of the tress which compose it.”
Macroeconomics is the study of what is happening to the economy as a whole, the economy-in-the-large, the macroeconomy. Macroeconomists' principal tasks: to try to figure out why overall economic activity rises and falls: the value of production, total incomes, unemployment, inflation. Intermetdiate variables like interest rates, stock market values, and exchange rates--that play a major role in determining the overall levels of production, income, employment, and prices.

Example: The decision of a firm to purchase a new office chair from company X is not a macroeconomic problem. The reaction of Austrian households to an increased rate of capital taxation is a macroeconomic problem.
Scope of Macro Economics
Macro Economics is of much theoretical and practical importance. Let us see what are the importance and the scope where macro economics are being used.
1. To Understand the working of the Economy
The study of macro economics variables is requisite for considerate the operation of the financial system. Our main economic complexities are associated with the performance of total income, irredundant and the normal price scale in the fiscal. These variables are geometrically measurable in this manner facilitating the probabilities of analysing the effects on the functioning of the economy.
2. In Economic Policies
Macro Economics is extremely useful from the view point of the fiscal policy. Modern Governments, particularly, the underdeveloped economies are confronted with innumerable national problems. They are the problems of over population, inflation, balance of payments, general under production etc. The main conscientiousness of these governments rests in the regulation and control of over population, general prices, general volume of commerce, general productivity etc.
I. In General Unemployment
Redundancy is caused by deficiency of effectual demand. In order eradicate it, effective demand should be raised by increasing total investment, total productivity, total income and consumption. Thus, macro economics has special significance in studying the causes, effects and antidotes of general redundancy.
II. In National Income
The study of macro economics is very significant for evaluating the overall performance of the economy in terms of national income. This led to the construction of the data on national income. National income data help in anticipating the level of fiscal activity and to comprehend the distribution of income among different groups of people in the economy.
III. In Economic Growth
The economics of growth is also a study in macro economics. It is on the basis of macro economics that the resources and capabilities of an economy are evaluated. Plans for the overall increase in national income, productivity, employment are framed and executed so as to raise the level of fiscal development of the economy as a whole.
IV. In Monetary Problems
It is in terms of macro economics that monetary problems can be analysed and understood properly. Frequent changes in the value of money, inflation or deflation, affect the economy adversely. They can be counteracted by adopting monetary, fiscal and direct control measures for the economy as a whole.
V. In Business Cycle
Moreover, macro economics as an approach to fiscal problems started after the great Depression, thus its significance falls in analysing the grounds of fiscal variations and in providing remedies.
3. For Understanding the Behaviour of Individual Units
For understanding the performance of individual units, the study of macro economics is imperative. Demand for individual products depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate demand are analysed it is not feasible to understand fully the grounds for a fall in the demand of individual products. The reasons for increase in costs of a specific firm or industry cannot be analysed without knowing the average cost conditions of the whole economy. Thus, the study of individual units is not possible without macro economics.

50. Define business cycles? Explain the characteristics and phases of business cycles. Also suggest the measures to control them?
Ans. While the topic of economic growth is concerned with changes in GDP over very long periods of time, it is an economic fact of life that GDP changes occur over much shorter time-horizons as well.  The periodic ups and downs of economic activity are termed the “business cycle.” It is the recurrent ups and downs in economic activity observed in  market economies.
1. Business cycles occur periodically- Though they do not show same regularity, they have some distinct phases such as expansion, peak, contraction or depression and trough. Further the duration of cycles varies a good deal from minimum of two years to a maximum of ten to twelve years.
2. Secondly, business cycles are Synchronic- That is, they do not cause changes in any single industry or sector but are of all embracing character. For example, depression or contraction occurs simultaneously in all industries or sectors of the economy. Re¬cession passes from one industry to another and chain reaction continues till the whole economy is in the grip of recession. Similar process is at work in the expansion phase, prosperity spreads through various linkages of input-output relations or demand relations between various industries, and sectors.
3. Thirdly, it has been observed that fluctuations occur not only in level of production but also simultaneously in other variables such as employment, investment, consump¬tion, rate of interest and price level.
4. Another important feature of business cycles is that investment and consumption of durable consumer goods such as cars, houses, refrigerators are affected most by the cyclical fluctuations. As stressed by J.M. Keynes, investment is greatly volatile and unstable as it depends on profit expectations of private entrepreneurs. These expec¬tations of entrepreneurs change quite often making investment quite unstable. Since consumption of durable consumer goods can be deferred, it also fluctuates greatly during the course of business cycles.
5. An important feature of business cycles is that consumption of non-durable goods and services does not vary much during different phases of business cycles. Past data of business cycles reveal that households maintain a great stability in consumption of non-durable goods.
6. The immediate impact of depression and expansion is on the inventories of goods. When depression sets in, the inventories start accumulating beyond the desired level. This leads to cut in production of goods. On the contrary, when recovery starts, the inventories go below the desired level. This encourages businessmen to place more orders for goods whose production picks up and stimulates investment in capital goods.
7. Another important feature of business cycles is profits fluctuate more than any other type of income. The occurrence of business cycles causes a lot of uncertainty for businessmen and makes it difficult to forecast the economic conditions. During the depression period profits may even become negative and many businesses go bankrupt. In a free market economy profits are justified on the ground that they are necessary payments if the entrepreneurs are to be induced to bear uncertainty.
8. Lastly, business cycles are international in character- That is, once started in one country they spread to other countries through trade relations between them. For ex¬ample, if there is a recession in the USA, which is a large importer of goods from other countries, will cause a fall in demand for imports from other countries whose exports would be adversely affected causing recession in them too. Depression of 1930s in USA and Great Britain engulfed the entire capital world.
A typical business cycle has two phases ex¬pansion phase or upswing or peak and con¬traction phase or downswing or trough. The upswing or expansion phase exhibits a more rapid growth of GNP than the long run trend growth rate. At some point, GNP reaches its upper turning point and the downswing of the cycle begins. In the contraction phase, GNP declines.
At some time, GNP reaches its lower turning point and expansion begins. Starting from a lower turning point, a cycle experiences the phase of recovery and after some time it reaches the upper turning point the peak. But, continuous prosperity can never occur and the process of downhill starts. In this con¬traction phase, a cycle exhibits first a reces¬sion and then finally reaches the bottom—the depression.
Thus, a trade cycle has four phases:
(i) depression,
(ii) revival,
(iii) boom, and
(iv) recession.
These phases of a trade cy¬cle are illustrated below. In this figure, the secular growth path or trend growth rate of GNP has been labelled as EG. Now we briefly describe the essential characteristics of these phases of an idealised cycle.



1. Depression or Trough:
The depression or trough is the bottom of a cycle where eco¬nomic activity remains at a highly low level. Income, employment, output, price level, etc. go down. A depression is generally character¬ised by high unemployment of labour and capital and a low level of consumer demand in relation to the economy’s capacity to pro¬duce. This deficiency in demand forces firms to cut back production and lay-off workers.
Thus, there develops a substantial amount of unused productive capacity in the economy. Even by lowering down the interest rates, fi¬nancial institutions do not find enough bor¬rowers. Profits may even become negative. Firms become hesitant in making fresh invest¬ments. Thus, an air of pessimism engulfs the entire economy and the economy lands into the phase of depression. However, the seeds of recovery of the economy lie dormant in this phase.
2. Recovery:
Since trough is not a permanent phenomenon, a capitalistic economy experiences expansion and, therefore, the process of recovery starts.
During depression some machines wear out completely and ultimately become useless. For their survival, businessmen replace old and worn-out machinery. Thus, spending spree starts, of course, hesitantly. This gives an optimistic signal to the economy. Industries begin to rise and expectations tend to become more favourable. Pessimism that once prevailed in the economy now makes room for optimism. Investment becomes no longer risky. Additional and fresh investment leads to a rise in production.
Increased production leads to an increase in demand for inputs. Employment of more labour and capital causes GNP to rise. Further, low interest rates charged by banks in the early years of recovery phase act as an incentive to producers to borrow money. Thus, investment rises. Now plants get utilised in a better way. General price level starts rising. The recovery phase, however, gets gradually cumulative and income, employment, profit, price, etc., start increasing.
3. Prosperity:
Once the forces of revival get strengthened the level of economic activity tends to reach the highest point—the peak. A peak is the top .of a cycle. The peak is characterised by an allround optimism in the economy—income, employment, output, and price level tend to rise. Meanwhile, a rise in aggregate demand and cost leads to a rise in both investment and price level. But once the economy reaches the level of full employment, additional investment will not cause GNP to rise.
On the other hand, demand, price level, and cost of production will rise. During prosperity, existing capacity of plants is overutilised. Labour and raw material shortages develop. Scarcity of resources leads to rising cost. Aggregate demand now outstrips aggregate supply. Businessmen now come to learn that they have overstepped the limit. High optimism now gives birth to pessimism. This ultimately slows down the economic expansion and paves the way for contraction.
4. Recession:
Like depression, prosperity or pea, can never be long-lasting. Actually speaking, the bubble of prosperity gradually dies down. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough or depression. Between trough and peak, the economy grows or expands. A recession is a significant decline in economic activity spread across the economy lasting more then a few months, normally visible in production, employment, real income and other indications.
During this phase, the demand of firms and households for goods and services start to fall. No new industries are set up. Sometimes, existing industries are wound up. Unsold goods pile up because of low household demand. Profits of business firms dwindle. Output and employment levels are reduced. Eventually, this contracting economy hits the slump again. A recession that is deep and long-lasting is called a depression and, thus, the whole process restarts.
The four-phased trade cycle has the following attributes:
(i) Depression lasts longer than prosperity,
(ii) The process of revival starts gradually,
(iii) Prosperity phase is characterised by extreme activity in the business world,
(iv) The phase of prosperity comes to an end abruptly.
The period of a cycle, i.e., the length of time required for the completion of one complete cycle, is measured from peak to peak (P to P’) and from trough to trough (from D to D’). The shortest of the cycle is called ‘seasonal cycle’.

51. What do you mean by inflation? Explain its types and different measures taken by government to control them?
Ans. Some of the most important measures that must be followed to control inflation are: 1. Fiscal Policy: Reducing Fiscal Deficit 2. Monetary Policy: Tightening Credit 3. Supply Management through Imports 4. Incomes Policy: Freezing Wages.
We discuss below the efficacy of the various policy measures to check demand-pull inflation which is caused by excess aggregate demand.
1. Fiscal Policy: Reducing Fiscal Deficit:
The budget deals with how a Government raises its revenue and spends it. If the total revenue raised by the Government through taxation, fees, surpluses from public undertakings is less than the expenditure it incurs on buying goods and services to meet its requirements of defence, civil admin¬istration and various welfare and developmental activities, there emerges a fiscal deficit in its budget.
It may be noted here that the budget of the government has two parts:
(1) Revenue Budget,
(2) Capital Budget.
In the revenue budget on the receipts side revenue raised through taxes, interests, fees, surpluses from public undertakings are given and on the expenditure side consumption expenditure by the government on goods and services required to meet the needs of defence, civil administration, education and health services, subsidies on food, fertilizers and exports, and interest payments on the loans taken by it in the previous years are important items.
In the capital budget, the main items of receipts are market borrowings by the government from the Banks and other financial institutions, foreign aid, small savings (i.e., Provident Fund, National Savings Schemes etc.). The important items of expenditure in the capital budget are defence, loans to public enterprises for developmental purposes, and loans to states and union territories.
The deficit may occur either in the revenue budget or capital budget or both taken together. When there is overall fiscal deficit of the Government, it can be financed by borrowing from the Reserve Bank of India which is the nationalised central bank of the country and has the power to create new money, that is, to issue new notes.
Thus, to finance its fiscal deficit, the Government borrows from Reserve Bank of India against its own securities. This is only a technical way of creating new money because the Government has to pay neither the rate of interest nor the original amount when it borrows from Reserve Bank of India against its own securities.
It is thus clear that budget deficit implies that Government incurs more expenditure on goods and services than its normal receipts from revenue and capital budgets. This excess expenditure by the Government financed by newly created money leads to the rise in incomes of the people. This causes the aggregate demand of the community to rise to a greater extent than the amount of newly created money through the operation of what Keynes called income multiplier.
However, when there is too much resort to monetisation of fiscal deficit, it will create excess of aggregate demand over aggregate supply. There is no wonder that this has contributed a good deal to the general rise in prices in the past and has been an important factor responsible for present inflation in the Indian economy.
To reduce fiscal deficits and keep deficit financing (which is now called monetization of fiscal deficit) within a safe limit, the Government can mobilise more resources through raising:
(a) Taxes, both direct and indirect,
(b) Market borrowings, and
(c) Raising small savings such as receipts from Provident Funds.
National Saving Schemes (NSC and NSS) by offering suitable incentives. The Government borrows from the market through sales of its bonds which are generally purchased by banks insurance companies, mutual funds and corporate firms.
Therefore, to check inflation the Government should try to reduce fiscal deficit. It can reduce fiscal deficit by curtailing its wasteful and inessential expenditure. In India, it is often argued that there is a large scope for pruning down non-plan expenditure on defence, police and General Administration and on subsidies being provided on food, fertilizers and exports.
Thus, both by greater resource mobilisation on the one hand and pruning down of wasteful and inessential Government expenditure on the other, the fiscal deficit and consequently inflation can be checked.
2. Monetary Policy: Tightening Credit:
Monetary policy refers to the adoption of suitable policy regarding interest rate and the avail-ability of credit. Monetary policy is another important measure for reducing aggregate demand to control inflation. As an instrument of demand management, monetary policy can work in two ways.
First, it can affect the cost of credit and second, it can influence the credit availability for private business firms. Let us first consider the cost of credit. The higher the rate of interest, the greater the cost of borrowing from the banks by the business firms. As anti-inflationary measure, the rate of interest has to be kept high to discourage businessmen to borrow more and also to provide incen¬tives for saving more.
It is noteworthy that a recent monetary theory emphasizes that it is the changes in the credit availability rather than cost of credit (i.e., rate of interest) that is a more effective instrument of regulating aggregate demand. There are several methods by which credit availability can be reduced.
Firstly, it is through open market operations that the central bank of a country can reduce the availability of credit in the economy. Under open market operations, the Reserve Bank sells Govern¬ment securities. Those, especially banks, who buy these securities, will make payment for them in terms of cash reserves. With their reduced cash reserves, their capacity to lend money to the busi¬ness firms will be curtailed. This will tend to reduce the supply of credit or loanable funds which in turn would tend to reduce investment demand by the business firms.
The Cash Reserve Ratio (CRR) can also be raised to curb inflation. By law banks have to keep a certain proportion of cash money as reserves against their deposits. This is called cash reserve ratio. To contract credit availability Reserve Bank can raise this ratio. In recent years to squeeze credit for checking inflation, cash reserve ratio in India has been raised from time to time.
Another instrument for affecting credit availability is the Statutory Liquidity Ratio (SLR). According to statutory liquidity ratio, in addition to CRR, banks have to keep a certain minimum proportion of their deposits in the form of specified liquid assets.
And the most important specified liquid asset for this purpose is the Government securities. To mop up extra liquid assets with banks which may lead to undue expansion in credit availability for the business class, the Reserve Bank has often raised statutory liquidity ratio.
Selective Credit Controls:
By far the most important anti-inflationary measure in India is the use of selective credit control. The methods of credit control described above are known as quantitative or general methods as they are meant to control the availability of credit in general. On the other hand, selective credit controls are meant to regulate the flow of credit for particular or specific purposes.
Whereas the general credit controls seek to regulate the total available quantity of credit (through changes in the high powered money) and the cost of credit, the selective credit control seeks to change the distribution or allocation of credit between its various uses. These selective credit controls are also known as Qualitative Credit Controls. The selective credit controls have both the positive and negative aspect.
In its positive aspect, measures are taken to stimulate the greater flow of credit to some particular sectors considered as important:
(1) Changes in the minimum margin for lending by banks against the stocks of specific goods kept or against other types of securities.
(2) The fixation of maximum limit or ceiling on advances to individual borrowers against stock of particular sensitive commodities.
(3) The fixation of minimum discriminatory rates of interest chargeable on credit for particular purposes.
3. Supply Management through Imports:
To correct excess demand relative to aggregate supply, the latter can also be raised by importing goods in short supply. In India, to check the rise in prices of food-grains, edible oils, sugar etc., the Government has often taken steps to increase imports of goods in short supply to enlarge their available supplies.
When inflation is of the type of supply-side inflation, imports are increased to augment the domestic supplies of goods. To increase imports of goods in short supply the Govern¬ment reduces customs duties on them so that their imports become cheaper and help in containing inflation. For example in 2008-09 the Indian Government removed customs duties on imports of wheat and rice and reduced them on oilseeds, steel etc. to increase their supplies in India.
1. Incomes Policy: Freezing Wages:
Another anti-inflationary measure which has often been suggested is the avoidance of wage increases which are unrelated to improvements in productivity. This requires exercising control over wage-income. It is through wage-price spiral that inflation gets momentum.

When cost of living rises due to the initial rise in prices, workers demand higher wages to compensate for the rise in cost of living. When their wage demands are conceded to, it gives rise to cost-push inflation. And this generates inflationary expectations which add fuel to the fire.

To check this vicious circle of wages-chasing prices, an important measure will be to exercise control over wages. However, if wages are raised equal to the increase in the productivity of labour, then it will have no inflationary effect. Therefore, the proposal has been to freeze wages in the short run and wages should be linked with the changes in the level of productivity over a long period of time. According to this, wage increases should be allowed to the extent of rise in labour productivity only. This will check the net growth in aggregate demand relative to aggregate supply of output.

However, freezing wages and linking it with productivity only irrespective of what happens to the cost of living has been strongly opposed by trade unions. It has been validly pointed out why freeze wages only, to ensure social justice the other kinds of income such as rent, interest and profits should also be freeze similarly. Indeed, effective way to control inflation will be to adopt a broad- based incomes policy which should cover not only wages but also profits, interest and rental incomes.