Managerial Economics

MANAGERIAL
ECONOMICS
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Managerial Economics Index
CONTENTS
Chapter 1: Basics of Managerial Economics 3
Chapter 2: Firm and Theory of Firms 11
Chapter 3: Demand and Supply 33
Chapter 4: Theory of Production 78
Chapter 5: National Income 109
Chapter 6: Fiscal and Monetary Policy 134
Chapter 7: Business Cycle 180
Chapter 8: Market Prediction and Pricing Strategy 196
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Basics of Managerial Economics Managerial Economics
BASICS OF MANAGERIAL ECONOMICS
Objectives
 Why managerial economics is important and useful as an area of study
 How it relates to other disciplines
 What its core areas are
 Methods of analysis which it uses
Definition of Managerial Economics

Managerial economics is the application of economic principles & methodologies to
the decision-making process within the firm or organization. It is the application of
economic analysis to business problems; it has its origin in theoretical microeconomics.
Scope of Managerial Economics

Demand Analysis and Forecasting: Unless and until knowing the demand for a product
how can we think of producing that product. Therefore, demand analysis is something
which is necessary for the production function to happen. Demand analysis helps in
analyzing the various types of demand which enables the manager to arrive at
reasonable estimates of demand for product of his company. Managers not only assess
the current demand but she has to take into account the future demand also, i.e., she
should be able to use forecasting techniques.
Production Function: Conversion of inputs into outputs is known as production

function. With limited resources we have to make the alternative use of this limited
resource. Factor of production called as inputs is combined in a particular way to get
the maximum output. When the price of input goes up, the firm is forced to work out a
combination of inputs to ensure the least cost combination exists.
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Managerial Economics Basics of Managerial Economics
Cost analysis: Cost analysis is helpful in understanding the cost of a particular product
or service. It takes into account all the costs incurred while producing a particular
product / service. Under cost analysis we will take into account determinants of costs,
method of estimating costs, the relationship between cost and output, the forecast of
the cost, profit, these terms are very vital to any firm or business.
Inventory Management: What do you mean by the term inventory? Well the actual
meaning of the term inventory is stock. It refers to stock of raw materials which a firm
keeps. Now here the question arises how much of the inventory is ideal stock. Both the
high inventory and low inventory is not good for the firm. Managerial economics will
use such methods as ABC Analysis (Inventory categorization method), simple
simulation exercises, and some mathematical models, to minimize inventory cost. It
also helps in inventory controlling.
Advertising: Advertising is a promotional activity. In advertising while the copy,

illustrations, etc., are the responsibility of those who get it ready for the press, the
problem of cost, the methods of determining the total advertisement costs and
budget, the measuring of the economic effects of advertising are the problems of the
manager. There’s a vast difference between producing a product / service and
marketing it. It is through advertising only that the message about the product /
service should reach the consumer before she thinks to buy it. Advertising forms the
integral part of decision making and forward planning.
Pricing system: Here pricing refers to the pricing of a product. As it’s known that
pricing system as a concept was developed by economics and it is widely used in
managerial economics. Pricing is also one of the central functions of an enterprise.
While pricing commodity the cost of production has to be taken into account, but a
complete knowledge of the price system is quite essential to determine the price. It is
also important to understand how product has to be priced under different kinds of
competition (e.g., Perfect Competition, Monopoly, Oligopoly, Monopolistic
Competition, Duopoly etc.) for different markets. Pricing equals cost plus pricing and
the policies of the enterprise. Now it is clear that the price system touches the several
aspects of managerial economics and helps managers to take valid and profitable
decisions.
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Resource allocation: Scare resources are allocated according to the needs only to
achieve the level of optimization. We have to make the alternate use of the available
resources. For the allocation of the resources various advanced tools such as linear
programming is used to arrive at the best course of action.
Nature of Managerial Economics

Managerial economics aims at providing help in decision making by firms. It is heavily
dependent on microeconomic theory. The various concepts of micro economics used
frequently in managerial economics include Elasticity of demand; Marginal cost;
Marginal revenue and Market structures and their significance in pricing policies.
Macro economy is used to identify the level of demand at some future point in time,
based on the relationship between the level of national income and the demand for a
particular product. It is the level of national income only that the level of various
products depends. In managerial economics macro economics indicates the
relationship between (a) the magnitude of investment and the level of national
income, (b) the level of national income and the level of employment, (c) the level of
consumption and the level of national income. In managerial economics emphasis is
laid on those prepositions which are likely to be useful to management.
Relationship between Managerial Economics and other subjects

Before knowing the relationship between managerial economics and other related
fields it is customary to divide economics into “positive” and “normative” economics.
Economists make a distinction between positive and normative that closely parallels
popper’s line of demarcation.
Positive Economics: It deals with description and explanation of economic behavior,

Economics and Managerial economics. Managerial economics draws on positive
economics by utilizing the relevant theories as a basis for prescribing choices. A
positive statement is a statement about what is and which contains no indication of
approval or disapproval. It’s not like that positive statement is always right, positive
statement can be wrong. Positive statement is a statement about what exists not
about what does not exist or there is lack of certainty about its existence.
Normative Economics: It is concerned with prescription or what ought to be done. In

normative economics, it is inevitable that value judgment are made as to what should
and what should not be done. Managerial economics is a part of normative economics
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as its focus is more on prescribing choice and action and less on explaining what has
happened. It expresses a judgment about whether a situation is desirable or
undesirable. The primary task of Managerial economics is to fit relevant data to this
framework of logical analysis so as to reach valid conclusion as a basis for action.
Another branch of economics which is normative like managerial is public policies
analysis which is concerned with the problems of managing the government of a
country.
Economic and Managerial Economics: Economics contributes a great deal towards the
performance of managerial duties and responsibilities. Just as the Biology / Physiology
contribute to the medical profession and Physics to engineering, Economics
contributes to the managerial profession. All other qualifications being same,
managers with working knowledge of economics can perform their function more
efficiently than those without it.
What is the Basic Function of the Managers of the Business?

As you all know that the basic function of the manager of the firm is to achieve the
organizational objectives to the maximum possible extent with the limited resources
placed at their disposal. Economics contributes a lot to the managerial economics.
Mathematics and Managerial Economics: Mathematics in Managerial Economics has

an important agenda to pursue. Businessmen deal primarily with concepts that are
essentially quantitative in nature e.g. demand, supply, price, cost, wages etc. The use
of mathematical logic in the analysis of economic variable provides not only clarity of
concepts but also a logical and systematical framework.
Statistics and Managerial Economics: Statistical tools are a great aid in business
decision making. Statistical techniques are used in collecting, processing and analyzing
business data, testing and validity of economics laws with the real economic
phenomenon before they are applied to business analysis. The statistical tools for e.g.
theory of probability, forecasting techniques, and Correlation-regression analysis help
the decision makers in predicting the future course of economic events and probable
outcome of their business decision. Statistics is important to managerial economics in
several ways. Managerial Economics calls for marshalling of quantitative data and
reaching useful measures of appropriate relationship involves in decision making.
Operation Research and Managerial Economics: It’s an inter-disciplinary solution

finding techniques. It combines economics, mathematics, and statistics to build models
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for solving specific business problems. Linear programming and goal programming are
two widely used Operational Research in business decision making. It has influenced
Managerial Economics through its new concepts and model for dealing with risks.
Though economic theory has always recognized these factors to decision making in the
real world, the frame work for taking them into account in the context of actual
problem has been operationalized. The significant relationship between Managerial
Economics and Operational Research can be highlighted with reference to certain
important problems of Managerial Economics which are solved with the help of
Operational Research techniques, like allocation problem, competitive problem,
waiting line problem, and inventory problem.
Management Theory and Managerial Economics: As the definition of management

says that it’s an art of getting things done through others. Bet now a day we can define
management as doing right things, at the right time, with the help of right people so
that organizational goals can be achieved. Management theory helps a lot in making
decisions. ME has also been influenced by the developments in the management
theory. The central concept in the theory of firm in micro economic is the maximization
of profits. Managerial Economics should take note of changes concepts of managerial
principles, concepts, and changing view of enterprises goals.
Accounting and Managerial Economics: There exists a very close link between
Managerial Economics and the concepts and practices of accounting. Accounting data
and statement constitute the language of business. Gone are the days when
accounting was treated as just bookkeeping. Now it’s far more behind bookkeeping.
Cost and revenue information and their classification are influenced considerably by
the accounting profession. As a budding student of Masters in Business Administration
(MBA) you should be familiar with generation, interpretation, and use of accounting
data. The focus of accounting within the enterprise is fast changing from the concept of
bookkeeping to that of managerial decision making.
Computers and Managerial Economics: We all know that today’s age is known as
computer age. Every one of us is totally dependent on computers. These computers
have affected each one of us in every field. Managers also have to depend on
computers for decision making purposes. Through computers data which are
presented in such a nice manner that it’s really very easy to take decisions. There are
so many sites which help us in giving knowledge of various things, and in a way helps
us in updating our knowledge.
Hence, we can conclude that Managerial Economics is closely related to various

subjects i.e., Economics, mathematics, statistics, and accountings. Computers etc. a
trained managerial economist integrates concepts and methods from all these subjects
bringing them to bear on business problem of a firm. In particular all these subjects are
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getting closed to Managerial Economics and there appears to be trends towards their
integration.
Importance of Managerial Economics

• Helps in taking decisions related to type of product, investment, pricing & level
of production.
• Enables managers to select production techniques and best course of action.
• Comprises various economic concepts to study & analyze different business
problems.
• How to make future decisions about economic variables, viz. price, demand,
supply & cost.
• How to apply different economic theories & tools to the real world of business
environment.
• Determining and analyzing factors that affect business decisions.
• Formulating business policies.
• Assessing the relationship between different economic variables, viz., demand,
supply, income, employment and profit.
Scope of Managerial Economics

Demand Theory : Reading the buying behavior of customers. Elaborating the factors
that affect the buying decisions of customers and their needs & requirements. Deciding
type of product, level of production & pricing decisions.
Production Theory : Gauzing the relationship between input & output. Reaching the
maximization of output with limited resources. Instrumental in deciding the size of an
organization, labor & capital to be employed, and total output.
Price Theory : Determining the price of a product in different market conditions. Helps
in reading the conditions that are conducive & profitable for price discrimination.
Effective tool in deciding how advertising going to increase sales.
Profit Theory : Measuring Return on Capital (Employed), famously known as ROCE in
the arena of Finance Professionals & total profit. Uncertain business conditions can
lead to erratic profits being made at different time intervals. Managing profit of an
organization by minimizing the risk factors.
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Capital Theory : Guides how to make Capital & Investment Decisions. Capital is a scarce
resource, so investment of the same have to be done more diligently – checking all the
viable options and grasping that one offering the optimum return.
Methods
It is essential for anyone studying managerial economics to understand the methodology
involved. This is not just an academic exercise, it is essential for managers who have to
make decisions. True, they are not generally believed to develop and test theories
themselves, but in reality this is part of their job. This is explained later on in this section
after the meaning of the term theory and the process of testing theories have been
discussed. There are two aspects of methods that need to be explained: first, the
methods that professionals use to develop the subject; and, second, the methods used
to present material to students learning the subject.
The procedure above is a repetitive one; further empirical studies are carried out,
sometimes under different conditions, and as time goes on theories tend to become
modified and refined in order to improve them. The process of the development of
theories is illustrated in the following figure.
Hypothesis
Accept / Reject Empirical Study
Modify / Refine
Statistical Analysis
It is obviously of vital importance to managers to have good theories on which to base

their decision-making. A ‘good’ theory has the following characteristics:
1 It explains existing observations well.
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2 It makes accurate forecasts.

3 It involves mensuration, meaning that the variables involved can be measured
reliably and accurately.
4 It has general application, meaning that it can be applied in a large number of
different situations, not just a very limited number of cases.
SUMMARY
1. Managerial economics is about the application of economic theory and methods
to business decision-making.
2. The term business must be considered in very broad terms, to include any
transaction between two or more parties. Only then can we fully appreciate the
breadth of application of the discipline.
3. Decision-making involves a number of steps: problem perception, definition of
objectives, examination of constraints, identification of strategies, and
evaluation of strategies and determination of criteria for choosing among
strategies.
4. Managerial economics is linked to the disciplines of economic theory, decision
sciences and business functions.
5. The core elements of the economic theory involved are the theory of the firm,
consumer and demand theory, production and cost theory, price theory and
competition theory.
6. A neoclassical approach involves treating the individual elements in the economy
as rational agents with quantitative objectives to be optimized.
7. Positive statements are statements of fact that can be tested empirically or by
logic; normative statements express value judgments.
8. The application of economic principles is useful in making both of the above
types of statement.
9. A theory is a statement that describes or explains relationships between
phenomena that we observe, and which makes testable predictions.
10. There is always a risk. Taking chances is part of Managerial Decision Making.
11. Decisions should not be taken in a vacuum, so knowledge about the different
economic situations are of paramount importance.
12. Maximizing profit by recognizing all the costs involved by optimum usage of the
tools of Managerial Economics.
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Firm and Theory of Firms Managerial Economics
FIRM & THEORY OF FIRMS
Objectives:
 Various objectives of a business firm

 The concept of business environment
 To introduce the concept of the basic profit-maximizing model
 To describe the various assumptions which frequently underlie the
profit maximizing model and explain why they are made
 To explain the limitations of the basic profit-maximizing model
 To consider the nature of the agency problem in terms of how it
affects firms’ objectives
 To consider the problems associated with the measurement of profit,
and the implications for objectives
 Alternate objectives of a business firm
Definition of Business:
A business, also known as an enterprise or a firm, is an organization involved in the
trade of goods, services, or both to consumers. Businesses are prevalent in capitalist
economies, where most of them are privately owned and provide goods and services
to customers in exchange of other goods, services, or money. Businesses may also be
not-for-profit or state-owned. A business owned by multiple individuals may be
referred to as a company.
The etymology of "business" stems from the idea of being busy, and implies socially
valuable and rewarding work. A business can mean a particular organization or a more
generalized usage refers to an entire market sector, i.e. "the music business".
Compound forms such as agribusiness represent subsets of the word's broader
meaning, which encompasses all the activity by all the suppliers of goods and services.
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Managerial Economics Firm and Theory of Firms
Objectives of Business:
Business objectives are something which a business organization wants to achieve or
accomplish over a specified period of time. These may be to earn profit for its growth
and development, to provide quality goods to its customers, to protect the
environment etc. These are the objectives of business. In the following section let us
classify the objectives of business.
It is generally believed that a business has a single objective, that is, to make profit. But
it cannot be the only objective of business. While pursuing the objective of earning
profit, business units do keep the interest of their owners in view. However, any
business unit cannot ignore the interests of its employees, customers, the community,
as well as the interests of society as a whole.
For instance, no business can prosper in the long run unless fair wages are paid to the
employees and customer satisfaction is given due importance. Again a business unit
can prosper only if it enjoys the support and goodwill of people in general. Business
objectives also need to be aimed at contributing to national goals and aspirations as
well as towards international well-being. Thus, the objectives of business may be
classified as –
a. Economic Objectives
b. Social Objectives
c. Human Objectives
d. National Objectives
e. Global Objectives
Economic Objectives
Economic objectives of business refer to the objective of earning profit and also other
objectives that are necessary to be pursued to achieve the profit objective, which
includes creation of customers, regular innovations and best possible use of available
resources. Let us learn about these.
Profit Earning
Profit is the lifeblood of business, without which no business can survive in a
competitive market. In fact profit making is the primary objective for which a business
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unit is brought into existence. Profits must be earned to ensure the survival of
business, its growth and expansion over time. Profits help businessmen not only to
earn their living but also to expand their business activities by reinvesting a part of the
profits.
In order to achieve this primary objective, certain other objectives are also necessary
to be pursued by business, which are as follows:
a) Creation of customers
A business unit cannot survive unless there are customers to buy the products and
services. Again a businessman can earn profits only when he/she provides quality
goods and services at a reasonable price. For this it needs to attract more
customers for its existing as well as new products. This is achieved with the help of
various marketing activities.
b) Regular innovations
Innovation means changes, which bring about improvement in products, process of
production & distribution of goods. Business units, through innovation, are able to
reduce cost by adopting better methods of production and also increase their sales
by attracting more customers because of improved products. Reduction in cost and
increase in sales gives more profit to the businessman. Use of power-looms in
place of handlooms, use of tractors in place of hand implements in farms etc. are
all the results of innovation.
c) Best possible use of resources

As you know, to run any business you must have sufficient capital or funds. The
amount of capital may be used to buy machinery, raw materials, employ men and
have cash to meet day-to-day expenses. Thus, business activities require various
resources like men, materials, money and machines. The availability of these
resources is usually limited. Thus, every business should try to make the best
possible use of these resources. This objective can be achieved by employing
efficient workers, making full use of machines and minimizing wastage of raw
materials.
Social Objectives
Social objectives are those objectives of business, which are desired to be achieved for
the benefit of the society. Since business operates in a society by utilizing its scarce
resources, the society expects something in return for its welfare. No activity of the
business should be aimed at giving any kind of trouble to the society. If business
activities lead to socially harmful effects, there is bound to be public reaction against
the business sooner or later. Social objectives of business include production and
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supply of quality goods and services, adoption of fair trade practices and contribution
to the general welfare of society and provision of welfare amenities.
i. Production and supply of quality goods and services
Since the business utilizes the various resources of the society, the society expects
to get quality goods and services from the business. The objective of business
should be to produce better quality goods and supply them at the right time and at
a right price. It is not desirable on the part of the businessman to supply
adulterated or inferior goods which cause injuries to the customers. They should
charge the price according to the quality of the goods and services provided to the
society. Again, the customers also expect timely supply of all their requirements.
So it is important for every business to supply those goods and services on a
regular basis.
ii. Adoption of fair trade practices

In every society, activities such as hoarding, black-marketing and over-charging are
considered undesirable. Besides, misleading advertisements often give a false
impression about the quality of products. Such advertisements deceive the
customers and the businessmen use them for the sake of making large profits. This
is an unfair trade practice. The business unit must not create artificial scarcity of
essential goods or raise prices for the sake of earning more profits. All these
activities earn a bad name and sometimes make the businessmen liable for penalty
and even imprisonment under the law. Therefore, the objective of business should
be to adopt fair trade practices for the welfare of the consumers as well as the
society.
iii. Contribution to the general welfare of the society

Business units should work for the general welfare and upliftment of the society.
This is possible through running of schools and colleges for better education,
opening of vocational training centres to train the people to earn their livelihood,
establishing hospitals for medical facilities and providing recreational facilities for
the general public like parks, sports complexes etc.
Human Objectives
Human objectives refer to the objectives aimed at the well-being as well as fulfillment
of expectations of employees as also of people who are disabled, handicapped and
deprived of proper education and training. The human objectives of business may thus
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include economic well-being of the employees, social and psychological satisfaction of

employees and development of human resources.
i. Economic well being of the employees

In business employees must be provided with fair remuneration and incentives for
performance, benefits of provident fund, pension and other amenities like medical
facilities, housing facilities etc. By this they feel more satisfied at work and
contribute more for the business.
ii. Social and psychological satisfaction of employees

It is the duty of business units to provide social and psychological satisfaction to
their employees. This is possible by making the job interesting and challenging,
putting the right person in the right job and reducing the monotony of work.
Opportunities for promotion and advancement in career should also be provided
to the employees. Further, grievances of employees should be given prompt
attention and their suggestions should be considered seriously when decisions are
made. If employees are happy and satisfied they can put their best efforts in work.
iii. Development of human resources

Employees as human beings always want to grow. Their growth requires proper
training as well as development. Business can prosper if the people employed can
improve their skills and develop their abilities and competencies in course of time.
Thus, it is important that business should arrange training and development
programs for its employees.
iv. Well being of socially and economically backward people

Business units being inseparable parts of society should help backward classes and
also people those are physically and mentally challenged. This can be done in many
ways. For instance, vocational training program may be arranged to improve the
earning capacity of backward people in the community. While recruiting it staff,
business should give preference to physically and mentally challenged persons.
Business units can also help and encourage meritorious students by awarding
scholarships for higher studies.
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National Objectives
Being an important part of the country, every business must have the objective of
fulfilling national goals and aspirations. The goal of the country may be to provide
employment opportunity to its citizen, earn revenue for its exchequer, become self-
sufficient in production of goods and services, promote social justice, etc. Business
activities should be conducted keeping these goals of the country in mind, which may be
called national objectives of business. The following are the national objectives of
business.
i. Creation of employment
One of the important national objectives of business is to create opportunities for
gainful employment of people. This can be achieved by establishing new business
units, expanding markets, widening distribution channels, etc.
ii. Promotion of social justice

As a responsible citizen, a businessman is expected to provide equal opportunities
to all persons with whom he/she deals. He/She is also expected to provide equal
opportunities to all the employees to work and progress. Towards this objective
special attention must be paid to weaker and backward sections of the society.
iii. Production according to national priority

Business units should produce and supply goods in accordance with the priorities
laid down in the plans and policies of the Government. One of the national
objectives of business in our country should be to increase the production and
supply of essential goods at reasonable prices.
iv. Contribute to the revenue of the country

The business owners should pay their taxes and dues honestly and regularly. This
will increase the revenue of the government, which can be used for the
development of the nation.
v. Self-sufficiency and Export Promotion

To help the country to become self-reliant, business units have the added
responsibility of restricting import of goods. Besides, every business units should
aim at increasing exports and adding to the foreign exchange reserves of the
country.
Global Objectives
Earlier India had a very restricted business relationship with other nations. There was a
very rigid policy for import and export of goods and services. But, now-a-days due to
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liberal economic and export–import policy, restrictions on foreign investments have

been largely abolished and duties on imported goods have been substantially reduced.
This change has brought about increased competition in the market. Today because of
globalisation the entire world has become a big market. Goods produced in one
country are readily available in other countries. So, to face the competition in the
global market every business has certain objectives in mind, which may be called the
global objectives. Let us learn about them.
i. Raise general standard of living

Growth of business activities across national borders makes available quality goods
at reasonable prices all over the world. The people of one country get to use
similar types of goods that people in other countries are using. This improves the
standard of living of people.
ii. Reduce disparities among nations

Business should help to reduce disparities among the rich and poor nations of the
world by expanding its operation. By way of capital investment in developing as
well as underdeveloped countries it can foster their industrial and economic
growth.
iii. Make available globally competitive goods and services

Business should produce goods and services which are globally competitive and
have huge demand in foreign markets. This will improve the image of the exporting
country and also earn more foreign exchange for the country.
What is Business Environment?

Conditions or situations that affect business activities may be regarded as the
environment of business. In other words, business environment refers to the
surroundings and circumstances, which influence business operations. This
environment consists of forces and factors internal or external to a business firm.
The skill and ability of employees, their attitude to work, relations between managers
and subordinates etc. may be regarded as internal environment of business. These are
important factors, which may affect business operations. But these are within the
control of the businessman. By taking suitable steps the conditions can be improved.
On the other hand, external environment refers to all those aspect of the surrounding
of business, which are not within the control of the managers and may affect business
activities to a great extent. You may have noticed that sometimes there is less demand
of goods produced by a particular firm. It may be due to better quality substitutes
which customers find more useful. Again, if the government policy changes so as to
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allow foreign goods to be imported at lower rates of customs duty, similar good
produced in India may not sell, as the prices of imported goods may be lower. These
conditions are generally not within the control of the businessmen.
Let us discuss about the external factors which influence or affect business activities
and operations and are not controllable by businessmen. We may classify these factors
as economic factors, social factors, political factors and technological factors.
i. Economic Factors
Economic factors include those factors which affect the business environment due
to changes in income level of the people, rates of interest on borrowing,
availability of capital, tax rates, demand and supply of goods and also changes in
government economic policies, etc. For example, you may have noticed that if the
level of income of people goes up, there is increased demand for goods and
services. Similarly, when interest rates on loans are lower people spend more on
buying durable goods like, car, home etc. Growth of business naturally takes place
as a result of increased spending by consumers.
ii. Social Factors

The nature of goods and services in demand depends upon the changes in habits
and customs of people in the society. With rise in population the demand for
household as well as other goods has increased. The nature of food and clothing
has also changed to a great extent. Demand for packaged food and ready-made
garment has increased in recent times. All these force the business to produce
goods accordingly. So the social and cultural factors have also affected the
production pattern of business.
iii. Political Factors

Business environment is adversely affected by the absence of political stability. The
workers’ union may demand higher wages, may indulge in frequent strike etc.,
which affect the normal functioning of business. Problems of law and order
situation in border areas, conflicts between countries, absence of favorable
economic as well as export–import policy also affect the business activities.
Business activities suffer serious set-backs under such circumstances.
iv. Technological Factors

Technological advancement always leads to improvement in the process of
production, transportation and communication. Change in technology is mostly
associated with better service and cost efficiency. In recent years, information
processing and storage with the use of computers and telecommunication facilities
have developed rapidly. People now prefer to use mobile phones in place of landline
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phones. Now-a-days electronic appliances have replaced electrical equipments

widely. Business activities are bound to suffer if enterprises do not adopt up-to date
technology as and when necessary.
The Basic Profit Maximization (BPM) Model for a firm:

In economic analyses the most common objective that firms are regarded as pursuing
is profit maximization. This is a fundamental element in the neoclassical model and is
part of the more general assumption that economic entities rationally pursue their self-
interest. Using the marginal analysis on which much neoclassical theory is based, the
basic profit-maximizing model (BPM) prescribes that a firm will produce the output
where marginal cost equals marginal revenue.
The figure below illustrates a rising marginal cost (MC) curve, where each additional
unit costs more than the previous one to produce, and a falling marginal revenue (MR)
curve, assuming that the firm has to reduce its price to sell more units. The output Q*
is the profit-maximizing output. If the firm produces less than this it will add more to
revenue than to cost by producing more and this will increase profit; if it produces
more than Q* it will add more to cost than to revenue and this will decrease profit.
Although there is much intuitive appeal in the assumption of profit maximization, it
should be realized that it, in turn, involves a number of other implicit assumptions.
These assumptions now need to be examined, considering first of all their nature, then
their limitations, and finally their usefulness.
Assumptions
The basic profit-maximizing model incorporates the following assumptions:
1 The firm has a single decision-maker.
2 The firm produces a single product.
3 The firm produces for a single market.
4 The firm produces and sells in a single location.
5 All current and future costs and revenues are known with certainty.
6 Price is the most important variable in the marketing mix.
7 Short-run and long-run strategy implications are the same.
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MC
MR
Q+ Output
Profit Maximization
In the figure above, Output is measured in X-axis and MC & MR are measured in Y-axis
in monetary terms.
A. Single decision-maker
The meaning of this assumption is self-explanatory, unlike some of the other
assumptions. It is also obvious that it is not a realistic assumption since in any firm
above a small size the owner, or anyone else, is not going to have time to be able
to make all decisions. Thus the decision-making process involves delegation, so
that decisions of different importance and relating to different functional areas are
taken by different managers and other employees, while the board of directors
and shareholders still make some of the most important decisions.
B. Single product
Again this assumption is self-explanatory in meaning, as long as we remember that
the majority of products sold now are services rather than goods. It is also clear
that this assumption has even less basis in reality than the first one. Even small
firms may produce many products, while large firms may produce thousands of
different products. Given this situation the assumption may seem hard to justify,
yet all analysis at an introductory level implicitly involves it. The graphical
framework of analysis measures quantity on the horizontal axis, and this can only
relate to a single product, or at least similar products.
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C. Single market
This seemingly simple term does need a little explanation. The reason is that
economists have a somewhat different conception of a market from businessmen
in many cases. To an economist a market involves an interaction of buyers and
sellers, and this is the interpretation that has been used in the previous chapter.
Such a market does not necessarily have to involve a physical location; the Internet
provides a market, as does NASDAQ and similar stock exchange systems. However,
businessmen and managers often are referring only to buyers or potential buyers
when they use the term market. It is this sense that is meant in the assumption of
a single market. Thus a single market means a homogeneous group of customers.
D. Single location
While the meaning of producing and selling in a single location is clear, it is equally
clear that many firms do not do this. Some firms produce in many different
countries and sell in many different countries. The reason for using different
locations is the differences in costs and revenues involved. The analysis of these
spatial differentials is a specialized area in terms of the techniques involved and
again represents a complication in the analysis.
E. All current and future costs and revenues are known with certainty One might
expect a well-managed firm to have accurate, detailed and up-to date records of its
current costs and revenues. This is necessary in order to determine a firm’s cost
and revenue functions, in terms of the relationships between these and output; in
theory it is necessary to know these to determine a profit-maximizing strategy. In
practice it can be difficult to estimate these functions, especially in a constantly
changing environment. Even if these can be reliably estimated on the basis of
historical data, it still may be difficult to estimate reliably what these will be in the
future, next year, next quarter or sometimes even next week. This has important
implications for any decision or course of action that involves future time periods,
since risk and uncertainty are involved.
F. Price is the most important variable in the marketing mix. The nature of this
assumption requires considerable explanation. First of all the marketing mix must
be defined: it is normally viewed as ‘the set of marketing tools that the firm uses
to pursue its marketing objectives in the target market’. McCarthy has developed
a classification that is frequently used, the four Ps: product, price, promotion and
place (meaning distribution). Not all marketing professionals agree on the
components of the marketing mix, but they and business managers do generally
agree that price is not the most important of these. Aspects of the product are
normally regarded as the most important factor. So why then is price assumed to
be so important in the profit-maximizing assumption?
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There are two reasons for this. The most important concerns the general
orientation of economists. In any market economy it is the price system that is
responsible for allocating resources. For example, if there is a shortage of a
product or resource its price will rise, causing consumers to cut back consumption
and producers to increase production, motivated by profit. These actions will in
turn help to alleviate the shortage and bring the price back down. This focus on
price determination is the core of microeconomics. However, in managerial
economics we are not primarily concerned with price determination, which
essentially treats price as a dependent variable; we more often treat it from a
managerial perspective, as a controllable or marketing mix variable.
A further reason for concentrating on price lies in its ease of measurement. While
it is true that there may be certain problems with this in practice, it is certainly a
far easier variable to measure than product aspects.
It is therefore fair to say that the essential reason for the focus on price is the
inherent bias of economists, who tend to view price through a different lens from
business managers.
G. Short-run and long-run strategy implications are the same

This assumption means that any strategy aimed at maximizing profit in the short
run will automatically maximize profit in the long run and vice versa. Again, as will
realize in the future days, this is not a realistic assumption, with different strategies
being appropriate in each case, but the advantage of the assumption is that it
simplifies the analysis by ignoring the factor of the time frame.
Limitations of the BPM:

Some of the limitations of the standard assumptions of the basic profit-maximizing
model (BPM) have already been seen. At this point we need to focus on four of these:
1 The agency problem. We have now seen that whenever there is more than a single
decision-maker there are inevitably going to be agency costs, even if we regard
managers and other agents as being honest and co-operative, rather than self-
seeking opportunists.
2 The measurement of profit. It is important to realize that the concept of profit is

an ambiguous one, since it can be defined and measured in different ways.
Furthermore, it is unrealistic to assume that decision-makers should only consider
a short-term horizon like a year as far as measuring profit flows are concerned.
3 Risk and uncertainty. As soon as we start to consider longer time horizons the
existence of risk and uncertainty becomes important. As mentioned in the previous
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chapter, this relates not only to the measurement of profit but also to the agency
problem, since principals and agents frequently have different attitudes to risk.
4 Multiproduct firms. The problem of analyzing the behavior of firms producing

multiple products can only be partly solved by modeling the situation in terms of
drawing multiple graphs (or specifying multiple equations). Problems of
interactions on both the demand and cost sides still remain.
Usefulness of BPM:
There are two main aspects of usefulness to be considered. The first concerns the
implications of the BPM, along with the other elements of the neoclassical model, in
terms of welfare and efficiency. The second involves an ability to explain and predict,
combined with sensitivity to a relaxation of assumptions.
A. Welfare and efficiency implications

The neoclassical model is essentially a mathematical model involving consumers
and producers, with both individuals and firms acting as both consumers and
producers of inputs and outputs. All profits of firms are distributed to consumers in
the form of dividends. The price system is seen as having the functions of co-
ordination and motivation. The first function concerns the provision of relevant
information to buyers and sellers, while the second is concerned with motivating
buyers and sellers to act according to the prices charged. On this basis a
remarkable and much-celebrated conclusion, known as the fundamental theorem
of welfare economics, can be mathematically derived. The conclusion is that, even
if we assume in terms of these functions that (1) producers and consumers only
have local information, with no central planning or extensive information-
sharing, and (2) producers and consumers are motivated entirely by self-interest,
then the resulting allocation of resources will be efficient. This conclusion uses the
concept of what is called ‘Pareto efficiency’, that nobody can be made better off
without making somebody else worse off. There are a number of other
assumptions involved in this conclusion, particularly the ignoring of the existence
of market failure.
B. Ability to explain and predict

Regardless of how nice and neat a set of conclusions is, such conclusions are
useless in practice if the model underlying them is unable to produce accurate
explanations and predictions.
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The Divorce of Ownership & Control

• Individuals who own their firms may be extremely keen on profit maximisation.
• But in large firms there is a gap between ownership and control.
• Shareholders who own the firm, want to maximise their returns – profits and keep
cost low, but are not in position to run the firm.
• Shareholders appoint directors to represent their interests and directors appoint
managers to run the company.
• Professional managers are given control and the interests of managers may be
different from that of the shareholders.
• Directors and managers salaries are determined more by the size of the business
than the profitability of the firm.
• This may colour their actions and they may seek market size in terms of its output,
sales and employment rather than profitability.
• This would suggest that the sales growth will be an important objective of the
board of directors.
Alternative Objectives of Business Organizations

• Baumol’s Hypothesis of Sales Revenue Maximization. Managerial Theories
• Marris’s Hypothesis of Firm’s Growth Rate Maximization. Of Firms
• Williamson’s Hypothesis of Maximization of Managerial Utility.
• Rothchild’s Hypothesis of Long-run Survival & Market Share Goals.
• Cyert - March Hypothesis of Satisficing behavior (Simon’s Hypothesis). This is also
known Behavioral Theory of Firms.
• Entry Prevention & Risk Avoidance Hypothesis.
Baumol’s Hypothesis of Sales Revenue Maximization

Sales maximization model is an alternative model for profit maximization. This model
is developed by Prof. Boumol, an American economist. This alternative goal has
assumed greater significance in the context of the growth of Oligopolistic firms.
Baumol’s sales revenue maximization model highlights that the primary objective of a
firm is to maximize its sales rather than profit maximization. It states that the goal of
the firm is maximization of sales revenue subject to a minimum profit constraint. The
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minimum profit constraint is determined by the expectations of the share holders. This
is because no company can displease the share holders.
It is to be noted here that maximization of sales does not mean maximization of

physical sales but maximization of total sales revenue. Hence, the managers are more
interested in maximizing sales rather than profit. The basic philosophy is that when
sales are maximized automatically profits of the company would also go up. Hence,
attention is diverted to increase the sales of the company in recent years in the context
of highly competitive markets.
Rationalization of Baumol’s Sales Revenue Maximization Model
1. There is evidence that salaries and other earnings of top managers are correlated
more closely with sales than with profits.
2. The banks and other financial institutions keep a close eye on the sales of firms and
are more willing to finance firms with large and growing sales.
3. Personnel problems are handled more satisfactorily when sales are growing. The
employees at all levels can be given higher earnings and better terms of work in
general.
4. Large sales, growing over time, give prestige to the managers, while large profits go
into the pockets of shareholders.
5. Managers, prefer a steady performance with satisfactory profits to spectacular
profit maximization projects. If they realize maximum high profits in one period,
they might find themselves in trouble in other periods when profits are less than
maximum.
6. Large growing sales strengthen the power to adopt competitive tactics, while a low
or declining share of the market weakens the competitive position of the firm and
its bargaining power vis-à-vis rivals.
Arguments against Sales Maximization Model
In defense of this model, the following arguments are given:

1. Increase in sales and expansion in its market share is a sign of healthy growth of a
normal company.
2. It increases the competitive ability of the firm and enhances its influence in the
market.
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3. The amount of slack earnings and salaries of the top managers are directly linked
to it.
4. It helps in enhancing the prestige and reputation of top management, distribute
more dividends to share holders and increase the wages of workers and keep them
happy.
5. The financial and other lending institutions always keep a watch on the sales
revenues of a firm as it is an indication of financial health of a firm.
6. It helps the managers to pursue a policy of steady performance with satisfactory
levels of profits rather than spectacular profit maximization over a period of time.
Managers are reluctant to take up those kinds of projects which yield high level of
profits having high degree of risks and uncertainties. The risk averting and avoiding
managers prefer to select those projects which ensure steady and satisfactory levels of
profits.
Types of Baumol’s Sales Revenue Maximization Models
Prof. Boumol has developed two models. The first is static model and the second one is
the dynamic model.
The Static Model of Sales Maximization

This model is based on the following assumptions:
a) The model is applicable to a particular time period and the model does not operate
at different periods of time.
b) The firm aims at maximizing its sales revenue subject to a minimum
profit constraint.
c) The demand curve of the firm slope downwards from left to right.
d) The average cost curve of the firm is unshaped one.
The Dynamic Model of Sales Maximization
In the real world many changes takes place which affects business decisions of a firm.
In order to include such changes, Boumol has developed another dynamic model. This
model explains how changes in advertisement expenditure, a major determinant of
demand, would affect the sales revenue of a firm under severe competitions.
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Assumptions of dynamic model:

A) Higher advertisement expenditure would certainly increase sales revenue of a firm.
B) Market price remains constant.
C) Demand and cost curves of the firm are conventional in nature.
Generally under competitive conditions, a firm in order to increase its volume of sales
and sales revenue would go for aggressive advertisements. This leads to a shift in the
demand curve to the right. Forward shift in demand curve implies increased
advertisement expenditure resulting in higher sales and sales revenue. A price cut
may increase sales in general. But increase in sales mainly depends on whether the
demand for a product is elastic or inelastic.
A price reduction policy may increase its sales only when the demand is elastic and if
the demand is inelastic; such a policy would have adverse effects on sales. Hence, to
promote sales, advertisements become an effective instrument today. It is the
experience of most of the firms that with an increase in advertisement expenditure,
sales of the company would also go up.
A sales maximizer would generally incur higher amounts of advertisement expenditure

than a profit maximizer. However, it is to be remembered that amount allotted for
sales promotion should bring more than proportionate increase in sales and total
profits of a firm. Otherwise, it will have a negative effect on business decisions.
Thus, by introducing, a non-price variable in to his model, Boumol makes a successful

attempt to analyze the behavior of a competitive firm under oligopoly market
conditions. Under oligopoly conditions as there are only a few big firms competing with
each other either producing similar or differentiated products, would resort to heavy
advertisements as an effective means to increase their sales and sales revenue. This
appears to be more practical in the present day situations.
Implications of Baumol’s Sales Revenue Maximization Model

Implication of sales maximization theory of Baumol is that price would be lower and
output greater under sales maximization than under profit maximization. This is
because total and output revenue is maximized at the price output level is positive
where marginal revenue is zero, while at the profit maximization level of output
marginal revenue is positive, given that marginal costs are positive. Under sales
maximization with a minimum profit constraint, output will be greater and price lower
than under profit maximization objective. If this is true that oligopolists seek to
maximize sales or total revenue, then the greater output and lower price will have a
favorable effect on the welfare of the people.
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As explained above, another implication of sales maximization objective is more

advertising expenditure will be declined under it. Further, under sales maximization
objective of oligopolists, price is likely to remain sticky and the firms are more likely to
indulge in non price competition. This is what actually happens in oligopolistic market
situations in the real world. Another significance of Baumol’s Sales Revenue
Maximization Model is that there may be conflict between pricing in the long and short
run. In a short run situation where output is limited, revenue would often increase, if
prices were raised, but in the long run it might pay to keep price low in order to
compete more effectively for a large share of the market. This price policy to be
followed in the short run would then depend on the expected repercussions of short
run decisions on long run revenue.
So, in a nut-shell the above hypothesis can be stated as:

 Managers pursue those goals which further their interest.
 Salary & other management emoluments are more closely related to sales revenue
than to profit.
 Banks & other financial institutions look at sales revenue for credibility.
 Sales revenue trend is more readily available indicator of the firm’s performance.
 Managers find it difficult to maximize the profit consistently due to changing and
challenging conditions.
In fine, we can conclude that firms aim to maximize sales revenue but subject to a
profit constraint.
Marris’s Hypothesis of Firm’s Growth Rate Maximization

“Managers try to maximize firm’s balanced growth rate subject to managerial &
financial constraints.”-- Robin Marris.
According to Robin Marris, managers attempt to maximise a firm’s balanced growth

rate, subject to managerial and financial constraints. Marris defines firm’s balanced
growth rate (G) as:
G = GD = GC
Where GD and GC are growth rate of demand for the firm’s product and growth rate of
capital supply to the firm, respectively.
Simply stated, a firm’s growth rate is said to be balanced when demand for its product
and supply of capital to the firm increase at the same rate.
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Marris translated these two growth rates into two utility functions: (i) manager’s utility
function (Um), and (ii) business owner’s utility function (Uo), where:
Um = f (salary, power, job security, prestige, status).
Uo = f (output, capital, market-share, profit, public esteem).
The maximisation of business owner’s utility (Uo) implies maximisation of demand for
the firm’s product or growth of the supply of capital.
Williamson's Hypothesis of Maximization of Managerial Utility

Oliver E. Williamson hypothesized (1964) that profit maximization would not be the
objective of the managers of a joint stock organisation. This theory, like other
managerial theories of the firm, assumes that utility maximisation is a manager’s sole
objective. However it is only in a corporate form of business organisation that a self-
interest seeking manager can maximise his/her own utility, since there exists a
separation of ownership and control. The managers can use their ‘discretion’ to frame
and execute policies which would maximise their own utilities rather than maximising
the shareholders’ utilities. This is essentially the principal–agent problem. This could
however threaten their job security, if a minimum level of profit is not attained by the
firm to distribute among the shareholders.
The basic assumptions of the model are:

1. Imperfect competition in the markets.
2. Divorce of ownership and management.
3. A minimum profit constraint exists for the firms to be able to pay dividends to their
share holders.
Oliver E. Williamson propounded the hypothesis of maximisation of managerial utility

function. He argues that managers have the freedom to pursue objectives other than
profit maximisation. Managers seek to maximise their own utility function subject to a
minimum level of profit. According to Williamson, manager’s utility function can be
expressed as:
U = f(S, M, ID)
Where
S = additional expenditure on staff
M = managerial emoluments
ID = discretionary investments
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According to the hypothesis, managers attempt to maximise their utility function

subject to a satisfactory profit. A minimum profit is necessary to satisfy the
shareholders or else the manager’s job security will be at stake.
A Behavioral Theory of the Firm (Cyert & March 1963)

Conventional Theory of Firm
Assumption = Perfectly Competitive Market
Organizational goal = Max (profit) given price & production function
Equilibrium Position:
Max (Profit) = f (inputopt, outputopt, ………)
Research Areas in the Theory of Firm:
Focusing on solving for price, quantity, cost & demand-supply curve
1. Conditions for Maximizing profit
2. Shift in the equilibrium position
Example:
 Theory of Monopolistic Competition;
 Theory of Oligopoly.
What is missing in the conventional Theory?

 Not consider (realistic) motivation & cognitive assumption
 Characteristics of “firm” is not realistic (too simple)
Motivational and Cognitive Assumptions

Conventional assumptions relying on rationality include
1. Firm’s Goal = Max (Profit)

Challenges to the profit maximization assumption
 Is profit the only goal of firms?  subjective utility & other summum bonum
 Do firms need to maximize profit?  Satisfactory profit = f (level of aspiration).
2. Firms operate with perfect knowledge
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 Information is not given  firms need to search for alternatives  decision

depends on the order of environmental search.
Conventional Concept of “Firm”

Weaknesses in the conventional theory
1. Fail to view the firm as an organization

Papandreou argues that
 Firm is a cooperative system
 ‘Peak Coordinator’ perform executive tasks involving
‐ Substantive planning = financial/budget planning
‐ Procedural planning = construct a system of communication and
authority
‐ Executing both plans
 Goals are influenced by both internal & external factors.
2. Fail to portray a process of decision‐making

Gordon proposes the process‐oriented arguments:
 Theory should reflect how cost is actually used in a firm
 Treatment of uncertainty is at variance with the way firms react to
uncertainty
 Discrepancy between theoretical time and real time
 Executives deals with only a subset of variables discussed in the theory
SUMMARY
1. The ownership of a complex asset like a firm is a difficult concept since four parties
have different types of claims regarding control and returns: shareholders,
directors, managers and other employees.
2. The conventional economic model of motivation is that individuals try to maximize
their utilities; this assumes that people act rationally in their self-interest.
3. The nature of the agency problem is that there is a conflict of interest between
principal and agent.
4. The basic profit-maximizing model (BPM) is useful because it enables managers to
determine strategy regarding price and output decisions; it thus enables the
economist to predict firms’ behavior.
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5. The basic model involves many other assumptions that do not appear to be at all
realistic.
6. Agency problems arise because of conflicts of interest between shareholders and
lenders, between shareholders and managers and between managers and other
employees.
7. There are various problems in measuring profit. Managers can take advantage of
various legal and accounting loopholes in reporting profits, which are in their
interests and may boost the share price, but are against the interests of
shareholders.
8. The profit-maximization assumption cannot be rejected on purely theoretical
grounds. It must be tested by empirical study, and when this is done the
assumption proves to be a good working theory in terms of predicting the behavior
of firms and managers.
9. Claims regarding ethical behavior and altruism need to be closely examined;
empirical evidence does not support the existence of these if they conflict with
maximizing profit.
10. Satisfying behavior by managers can arise for a number of reasons: risk aversion,
transaction costs, diminishing returns to managerial effort and conflicts of
objectives between different managers.
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Demand and Supply Managerial Economics
DEMAND & SUPPLY
Objectives
 The concept of the demand

 The concept of Law of Demand
 Individual Demand Vis-à-vis Market Demand
 Factors affecting demand for a product
 Sensitivity of demand to those factors – Concept of Elasticity
 The concept of Price Elasticity of Demand & its various types
 Different methods of calculating Price Elasticity of Demand
 The concept of Income Elasticity of Demand, Cross Price Elasticity of Demand &
Price Elasticity of Supply.
 Limitations of Price Elasticity of Demand
 Demand Forecasting & Its techniques
What is Demand?
One of the two words economists use most; one is Demand & the other is Supply.
These are the twin driving forces of the market economy. Demand is not just about
measuring what people want; for economists, it refers to the amount of a good or
service that people are both willing and able to buy. The demand curve measures the
relationship between the price of a good and the amount of it demanded. Usually, as
the price rises, fewer people are willing and able to buy it; in other words, demand
falls. When demand changes, economists explain this in one of two ways. A movement
along the demand curve occurs when a price change alters the quantity demanded;
but if the price were to go back to where it was before, so would the amount
demanded. A shift in the demand curve occurs when the amount demanded would be
different from what it was previously at any chosen price, for example, if there is no
change in the market price, but demand rises or falls. The slope of the demand curve
indicates the elasticity of demand.
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Managerial Economics Demand and Supply
Concept of Demand
As we have indicated earlier, ‘demand’ is a technical concept from Economics. Demand
for product implies:
• Desires to acquire it,
• Willingness to pay for it, and
• Ability to pay for it.
All three must be checked to identify and establish demand. For example: A poor
man’s desires to stay in a five-star hotel room and his willingness to pay rent for that
room is not ‘demand’, because he lacks the necessary purchasing power; so it is merely
his wishful thinking. Similarly, a miser’s desire for and his ability to pay for a car is not
‘demand’, because he does not have the necessary willingness to pay for a car. One
may also come across a well-established person who processes both the willingness
and the ability to pay for higher education. But he has really no desire to have it; he
pays the fees for a regular cause, and eventually does not attend his classes. Thus, in
an economics sense, he does not have a ‘demand’ for higher education
degree/diploma.
In economics, demand is an economic principle that describes a consumer's desire,

willingness and ability to pay a price for a specific good or service. Demand refers to
how much (quantity) of a product or service is desired by buyers.
The quantity demanded by an economic actor refers to the quantity that that economic
actor is ready, willing, and able to buy.
It is worth noting that this definition of demand incorporates three important

concepts:
1 It involves three parameters – price, quantity and time.
2 It refers to quantities in the plural, therefore a whole relationship, not a single
quantity.
3 It involves the ceteris paribus (other things being equal) assumption, which is a
very common one in making statements in economics.
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Law of Demand:
The law of demand states that other factors being constant (ceteris paribus), price and
quantity demand of any good and service are inversely related to each other. When
the price of a product increases, the demand for the same product will fall.
This Law of Demand is standing on THREE conceptual pillars –

 Demand Function;
 Demand Schedule;
 Demand Curve.
Demand Function:
The term demand is used for the entire price-quantity relationship depicted pictorially
by the demand curve.
Explicitly, the demand function refers to the function that outputs, at any given price,
the quantity demanded at that price.
Demand is a dependent variable, while price is an independent variable.
D = f(P), where D = Demand, P = Price, f = Functional Relationship.
As per Law of Demand, D α 1/P (Using the means of Proportions).
This is the most general way of describing the relationship since it does not involve any
specific mathematical form. It can obviously be expanded by including any number of
variables that might affect quantity demanded on the right hand side of the equation,
for example:
Q = f (P, A, Y, Ps, ……...)
where A represents advertising expenditure, Y represents average income of the market

and Ps represents the price of a substitute product.
Demand Schedule
Price of Onion (Rs. Per Kg) Quantity sold (Kilograms per day)
15 500
30 400
50 320
75 280
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90 240
We see that with a change in price, there is a corresponding change in quantity sold.
The data say that with the rise in price of onion per kg, there is a downward trend
shown in the quantity sold figures.
The features of Demand Schedule:

 A demand schedule is a discrete version of the demand curve, specifying demand
values for a number of different prices.
 It refers to a tabular representation of the relationship between price & quantity
demanded.
 It demonstrates the quantity of a product demanded by an individual or a group of
individuals at specified period & time.
 Thus, given the price level, it is easy to determine the expected quantity
demanded.
 It is used to highlight the law of demand.
 This demand schedule can be graphed as a continuous demand curve on a chart
having the Y-axis representing price and the X-axis representing quantity.
Then a wholesome definition of Demand Schedule could be written as:
“A table that represents the amount of some goods that buyers are willing and able to
purchase at various prices, assuming all determinants of demand other than the price
of the goods in question, such as income, tastes and preferences, the price of
substitute goods, and the price of complementary goods, remain the same.”
Demand Curve
The demand curve is a curve drawn with:
 The vertical axis is the price axis, measuring the price per unit of the
commodity.
 The horizontal axis is the quantity axis, measuring the quantity of the good
demanded in total by all the economic actors chosen above.
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Y D
P
PRICE
P1
D
O M M1 X
QUANTITY
This curve slopes downwards. This important property is called the “law of downward
sloping demand”.
Factors Affecting Demand

Now we will deal with identifying the factors which affect the quantity demanded of a
product, describing the nature of these factors, examining how they can be measured,
and examining the relationship with quantity demanded.
These factors can be considered in terms of a demand function:
Q = f (P, L, A, D, Y, …….)
where each symbol on the right hand side denotes a relevant factor. P refers to price of
the product or service under consideration, L to quality, A to advertising spending, D to
distribution spending and Y to the average income of the market.
It is useful from a managerial decision-making viewpoint to distinguish between

controllable and uncontrollable factors. Controllable in this context means controllable
by the firm; the distinction in practice between what can be controlled and what
cannot is somewhat blurred, as will be seen. The factors again can be categorized as
Controllable vis-à-vis Uncontrollable factors.
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Controllable factors are those factors which can be controlled by the marketer or
producer or seller or supplier of the product or service and uncontrollable factors are
those factors upon which the marketers has least control to exercise.
We can also say that controllable factors correspond to what are often referred to as
the Marketing Mix Variables. When price changes, quantity demanded will change 
movement along the same demand curve. When factors other than price change,
demand curve will shift either rightward or leftward.
The relevant factors are summarized in the following diagram:
FACTORS DETERMINING DEMAND
Controllable Uncontrollable
Income
Tastes
Price
Competitive factors
Government policy
Demographic factors
Product
DEMAND Climatic factors
Seasonal factors
Promotion Macroeconomic factors
Institutional factors
Technological factors
Place
Prices of substitutes and complements
Expectations of changes
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Shifts of the Demand Curve

The shift of a demand curve takes place when there is a change in any non-price
determinant of demand, resulting in a new demand curve. Non-price determinants of
demand are those things that will cause demand to change even if prices remain the
same—in other words, the things whose changes might cause a consumer to buy more
or less of a good even if the good's own price remained unchanged. Some of the more
important factors are the prices of related goods (both substitutes and complements),
income, population, and expectations. However, demand is the willingness and ability
of a consumer to purchase a good under the prevailing circumstances; so, any
circumstance that affects the consumer's willingness or ability to buy the good or
service in question can be a non-price determinant of demand. As an example,
weather could be a factor in the demand for umbrella in a rainy winter in Kolkata.
When income increases, the demand curve for normal goods shifts outward as more
will be demanded at all prices, while the demand curve for inferior goods shifts inward
due to the increased attainability of superior substitutes. With respect to related
goods, when the price of a good (e.g. a hamburger) rises, the demand curve for
substitute goods (e.g. chicken) shifts out, while the demand curve for complementary
goods (e.g. tomato sauce) shifts in (i.e. there is more demand for substitute goods as
they become more attractive in terms of value for money, while demand for
complementary goods contracts in response to the contraction of quantity demanded
of the underlying good).
Demand shifters
 Price of the product: Price of the product can effect individual demand.(If the price
is high, demand will fall and if the price is less, low demand will rise)
 Changes in disposable income, the magnitude of the shift also being related to
the income elasticity of demand.
 Changes in tastes and preferences - tastes and preferences are assumed to be fixed
in the short-run.
 This assumption of fixed preferences is a necessary condition for aggregation of
individual demand curves to derive market demand.
 Changes in expectations.
 Changes in the prices of related goods (substitutes and complements)
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 Population size and composition
P
D1 D2 S
P2
P1
Q1 Q2 Q
An example of a demand curve shifting. The shift from D1 to D2 means an increase

in demand with consequence from the other variables.
Movements along the Demand Curve
This happens when there is a change in price of the product, but other things are
assumed to be constant. In this case, following the Law of Demand, with the rise in the
price of the product there will be fall in the quantity demanded for the said product.
P1 B
A
P2
Price
C
P3
D
O Q1 Q2 Q3
Quantity Demanded
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In the diagram above, at point A on the demand curve, price is P2 and the respective
quantity demanded is Q2. Now, if the price moves up to P1 then the quantity
demanded will fall to Q1 which is essentially the point B in the demand curve. Or, if the
price goes down from P2 to P3, the quantity demanded goes up from Q2 to Q3 and
eventually we are at point C on the demand curve.
Hence, change in quantity demanded is a movement along the demand curve.
Exceptions of Law of Demand
Conspicuous Consumption: The goods which are purchased for ‘Snob appeal’ are
called as the conspicuous consumption. They are also called as ‘Veblen goods’ because
Veblen coined this term. For e.g. diamonds, curios. They are the prestige goods. They
would like to hold it only when they are costly and rare. So, what can be the policy
implication for the manager of a company who produces it? A producer can take
advantage by charging high premium prices.
Speculative Market: In this case the higher the price the higher will be the demand. It
happens because of the expectation to increase the price in the future. For e.g. shares,
lotteries, gamble and ply-win type of markets.
Giffen’s Goods: It is a special type of inferior goods where the increase in the price
results into the increase in the quantity demanded. This happens because these goods
are consumed by the poor people who would like to buy more if the price increases.
For e.g. a poor person who buys inferior quality vegetables. If the price of such
vegetable increase then they prefer to buy because they think that it would be of a
better quality.
Ignorance: Many a times consumer judges the quality of a good from its price. Such
consumers may purchase high price goods because of the feeling of possessing a better
quality. The exceptional demand curve shows a positive relation between the price and
the quantity demanded.
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Individual Demand and Market Demand
Demand
Individual Market
It refers to demand for a It refers to total demand of all

commodity from individuals buyers taken together.
point of view or from that of Aggregate of the quantities
family or households point of of a product demanded by
view individual buyers
At a given price over a given

period of time
Individual demand curves are demand curves for a single economic actor. This actor
could be an individual, a household, or a firm (where the firm may be a for-profit, a
non-governmental non-profit, or a governmental agency).
The market demand curve aggregates (or adds up) the demand curves for a number of
economic actors. For instance, the market household demand curve for a good in a
town is obtained by adding up the demand curves for all the households in the demand
curve. The market demand curve for steel in the automobile industry is obtained by
adding up the demand curves for steel for all firms in the automobile industry.
Market Demand is the aggregate of the demands of all potential customers (market
participants) for a specific product over a specific period in a specific market.
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Market Demand Curve from Individual Demand Curves
Consumer 1’s Consumer 2’s Market demand curve

3 demand curve 3 demand curve 3 for good X
for good X for good X
Price of good X
2 2 2 1+0=1
1 1 1 2+1=3
0 0 0
0 1 2 3 0 1 2 3 0 1 2 3 4 5
Derivation of Market Demand Curve: Horizontal Summation of

Individual Demand Curves
The assumptions related to Market Demand Curve:

# Individual consumers are unaware of their individual demand curves—they simply
decide how much to buy given the prices they see.
# Individuals certainly have little reason to be concerned with the demand curve
facing a particular business.
# Businesses, however, are very interested in the demand curve for the products
they sell.
# They would like to know the exact position and shape of each of the demand
curves for all the products they sell.
# The demand curve faced by a business acts as one of the most important
constraints the business faces.
Most importantly, Market Demand Curve is derived by horizontal summation (not
vertical summation) of the individual demand curves.
What do we understand by the word “Elasticity” in Economics

In economics, elasticity is the measurement of how responsive an economic variable is
to a change in another.
For example:
 "If I lower the price of my product, how much more will I sell?"
 "If I raise the price of one good, how will that affect sales of the other good?"
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 "If we learn that a resource is becoming scarce, will people scramble to acquire
it?"
Theoretically we could discuss elasticities for all the different controllable and
uncontrollable factors affecting demand but in practice there are four main types of
elasticity that tend to be measured and examined, corresponding to four particularly
important factors in the demand function: price, promotion, income and the price of a
related products.
Hence, elasticity can be defined as “The rate of responsiveness (i.e., the change) in
the demand of a commodity (or, a product, or a service) for a given change in price or
any other determinants of demand.”
Price Elasticity of Demand (PED)

PED is the percentage change in quantity demanded in response to a 1 per cent change
in price.
In symbols we can write:
PED =
Now, depending on the value of the PED, there are 5 types of Price Elasticity of Demand.
The quantity of a commodity demanded per unit of time depends upon various factors
such as the price of a commodity, the money income of consumers, the prices of
related goods, the tastes of the people, etc. Whenever there is a change in any of -the-
variables stated above, it brings about a change in the quantity of the commodity
purchased over a specified period of time. The elasticity of demand measures the
responsiveness of quantity demanded to a change in any one of the above factors by
keeping other factors constant.
When the relative responsiveness or sensitiveness of the quantity demanded is
measured to changes in its price, the elasticity is said to be price elasticity of demand.
When the change in demand is the result of the given change in income, it is named
income elasticity of demand. Sometimes, a change in the price of one good causes a
change in the demand for the other. The elasticity here is called cross electricity of
demand. The three Main types of elasticity are now discussed in brief.
They are as follows:
1. Perfect Elasticity of Demand (PED = Infinity, i.e., Undefined)
2. Perfect Inelasticity of Demand (PED = 0)
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3. Relatively Elastic Demand (PED > 1)

4. Relatively Inelastic Demand (PED < 1)
5. Unit Elasticity of Demand (PED = 1)
What is Perfect Elasticity of Demand:

When any quantity can be sold at a given price, and when there is no need to reduce
the price, the demand is said to be perfectly elastic. The quantity demanded increases
from OQ to OQ1, from OQ1 to OQ2 even though there is no change in price. Price is
fixed at OP*.
Price
P*
O Q Q1 Q2 Quantity
What is Perfect Inelasticity of Demand:

The degree of change in price leads to little change in the quantity demanded, then the
elasticity is said to be perfectly inelastic.
Increase the price from OP1 to OP2, the quantity demanded has not fallen. And there
is fall in the price from OP3 to OP2, the quantity demanded remains unchanged.
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Price
P3
P2
P1
O Q* Quantity
What is Relatively Elastic Demand:

The demand is said to be relatively elastic when the change in demand is more then
the change in the price. The quantity demand increase from OQ1 to OQ2 because of a
fall in Price from OP1 to OP2. The extent of increase in the quantity demanded is
greater than the extent of fall in the price.
Price
P1
P2
O Q1 Q2 Quantity
What is Relatively Inelastic Demand:

The demand is said to be relatively inelastic when the change in demand is less than
the change in the price. The quantity demanded increases from OQ1 to OQ2 because
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of a decrease in the price from OP1 to OP2. The extent of rise in the quantity
demanded is less than the extent of fall in the price.
Price
P1
P2
O Q1 Q2 Quantity
What is Unit Elasticity of Demand:

The elasticity of demand is said to be unity when the change in demand is equal to the
change in price.
The quantity demanded increases from OQ1 to OQ2 because of a decrease in the price
from OP1 to OP2. The extent of increase in the quantity demanded is equal to the
extent of fall in the price.
Price
P1
P2
O Q1 Q2
BIBS Quantity 48
Interpretation of Different types of PED
Value of Price
Descriptive Terms
Elasticity Coefficients
Ed = 0 Perfectly inelastic demand, when Demand doesn’t change at

all with the change in Price
0 < Ed < 1 Inelastic or relatively inelastic demand, when % change in

Demand is less than the % change in Price
Ed = 1 Unitarily elastic demand, when % change in Demand is

exactly the same with the % change in Price
1<E <α Elastic or relatively elastic demand, when % change in

d Demand is more than the % change in Price
Perfectly elastic demand, when a minute change of Price

Ed = α results in an infinitely large change in Demand, mostly
theoretical.
The Price Elasticity of Demand and Changes in Total Revenue

Situation I:
Price is Elastic, i.e., 1 < PED < ∞, then
An increase in price => reduction in total revenue.
A reduction in price => Rise in total revenue.
Total revenue moves in the direction of the quantity change.
Situation II:
Price is Inelastic, i.e., 0 < PED < 1, then
An increase in price => Rise in total revenue.
A reduction in price => Fall in total revenue.
Total revenue moves in the direction of the price change.
Situation III:
Unit Price Elasticity, i.e., PED = 1, then
An increase in price => No change in total revenue.
A reduction in price => No change in total revenue.
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Total revenue does not change as price changes.
Determinants of the Price Elasticity of Demand

Availability of substitutes: If there are lots of close substitute goods to choose from
consumers can switch easily. If a product has many close substitutes, for example, fast
food, people tend to react strongly to a price increase of one firm's fast food. Thus, the
price elasticity of demand of this firm's product is high.
The importance of the product's cost in one's budget: If a product, such as salt, is very
inexpensive, consumers are relatively indifferent about a price increase. Therefore, salt
has a low price elasticity of demand. Cars are expensive and a 10% increase in the price
of a car may make the difference whether people will choose to buy the car or not.
Therefore, cars have a higher price elasticity of demand.
The period of time under consideration: Price elasticity of demand is greater if you
study the effect of a price increase over a period of two years rather than one week.
Over a longer period of time, people have more time to adjust to the price change. If
the price of gasoline increases considerably, buyers may not decrease their
consumption much after one week. However, after two years, they have the ability to
move closer to work or school, arrange carpools, use public transportation, or buy a
more fuel-efficient car.
Life cycle of product: PED will vary according to where the product is in its life cycle.
When new products are launched, there are often very few competitors and PED is
relatively inelastic. As other firms launch similar products, the wider choice increases
PED. Finally, as a product begins to decline in its lifecycle, consumers can become very
responsive to price, hence discounting is extremely common.
Whether consumers are loyal to the brand: Brand loyalty reduces sensitivity to price
changes and reduces PED.
Whether the good is habit forming : Consumers are also relatively insensitive to
changes in the price of habitually demanded products. If a product is habit-forming or
addictive, such as cigarettes, demand is likely to be price inelastic. The impact of a
price rise will be relatively small. Similarly, demand for necessities such as bread,
coffee, tea, electricity, and gas is price inelastic. If, however, it is a ‘shopping good’, for
which people tend to around and compare prices between stores (for example,
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washing machines, dish washers, and beds), then demand is likely to be more price
elastic.
The breadth of the product category being considered: Demand for petrol as a whole
is likely to be price inelastic: car drivers cannot easily do without it. However, demand
for any particular petrol pump is likely to be more price elastic than for petrol as a
whole; this is because drivers can switch to a competitor’s petrol pump if there is a
noticeable price difference. Similarly, the demand for Marlboro cigarettes is more price
elastic than the demand for all cigarettes, the demand for Levis is more price elastic
than the demand for jeans, and the demand for Nescafe is more price elastic than
demand for instant coffee, because people can switch more easily from the brand than
from the product. The wider the category examined, therefore, the more price inelastic
demand will be.
Who is paying? If you have to pay a bill yourself, you are likely to be fairly sensitive to
the price. If, however someone else is paying (for example, your parents or your
company), then you are likely to be less sensitive to price. You may not be so
concerned about price increases or search so hard to compare prices, because it is not
your money. Demand would therefore be more price inelastic. You can see this while
travelling: first class & business class seats more expensive, because firms are paying
rather than the individuals themselves. How many of those passengers would have
travelled economy class if they had been paying themselves.
The degree of necessity of the good: A necessity like bread will be demanded
inelastically with respect to price.
Measurement of Price Elasticity of Demand

There are main methods like:
1. Percentage Method or Proportionate Method
2. Geometric Method or Point Method
3. Point Elasticity of Demand
4. Arc Elasticity of Demand
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Percentage method or proportionate method

• Price elasticity of demand is measured by a ratio between the proportionate
change in the quantity of a product demanded as a result of a proportionate
change in its price
• Formula for calculate this is given further as following
Percentage method or proportionate method
PED = Proportionate change in demand for x / Proportionate change in price for x
Geometric Method or Point Method
• This method attempts to measure numerical elasticity of demand at a particular

point on the demand curve
• Price elasticity can be measure by following method
PED =
Point Elasticity
• Measures the change between two observed points.
Qd Qb  Qa
Q Qa
Ed  
P Pb  Pa
P Pa
Arc Elasticity
• One way around the choice of base problem is to calculate what we call the ARC
ELASTICITY OF DEMAND.
• With ARC ELASTICITY OF DEMAND, rather than picking P1 or P2 as the base, we can
use the average of P1 and P2 as the base.
• The ARC ELASTICITY OF DEMAND value will always fall between the two (2) point
elasticities.
• We will use the ARC ELASTICITY OF DEMAND exclusively.
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It simply uses a different base. Instead of picking the P1 and Q1 as base or the P2 and Q2
as base we use Parc and Qarc.
where: Parc = (P1 + P2) / 2 and Qarc = (Q1 + Q2) / 2
• To avoid the endpoint problem take elasticity at the midpoint (average) of the two
points
Qd Qd 1  Qd 2
 Qd 1  Qd 2   Qd 1  Qd 2 
   
Ed   2    2 
P P1  P2
 P1  P2   P1  P2 
   
 2 
Cross Price Elasticity of Demand (PED ):  2 
x,y
• Cross price elasticity (PEDx,y) measures the responsiveness of demand for good X
following a change in the price of good Y.
• In effect we are measuring to which degree a good is a substitute or complement.
• PEDx,y describes the important distinction between substitutes and complements
quantitatively.
Q Q
x x
1 0  100
Q
% in Q for X x
PED  d  0
x, y % in Price of Y P P
y y
1 0  100
P
y
0
Cross Elasticity of Demand (PEDx,y) – Substitutes
• Substitutes:
– With substitute goods such as brands of razors, an increase in the price of one
good will lead to an increase in demand for the rival product
– Cross price elasticity will be positive
– Weak substitutes – low PEDx,y
– Close substitutes – high PEDx,y
Cross Elasticity of Demand (PEDx,y) – Complements

• Complements:
– Goods that are in complementary demand
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– The cross price elasticity of demand for two complements is negative

– Weak complements – low PEDx,y
– Close complements – high PEDx,y
• Note the higher the magnitude (ignoring the sign) the closer the complement.
Income Elasticity of Demand

• Income elasticity of demand (YED -- notation used for this type of elasticity)
measures the responsiveness (or, change in) of quantity demanded to changes in
real or disposable income.
• YED = % change in demand for a commodity (or a product) / % change in income of
the consumer
• Example:
– A rise in consumer real income of 7% leads to an 9.5% rise in demand for pizza
deliveries.
– The income elasticity of demand: = 9.5/ 7 = +1.36.
Effect Income elasticity

Classification of good
coefficient
A proportionately larger YED > 1
change in the quantity Luxury good
demanded
A proportionately smaller 0 < YED < 1
change in the quantity Normal
demanded
A negative change in the YED < 0

quantity demanded Inferior good
Inferior Goods:
Definition: An inferior good is a type of good whose demand declines when income
rises. In other words, demand of inferior goods is inversely related to the income of the
consumer.
Description: For example, there are two commodities in the economy -- wheat flour
and jowar flour -- and consumers are consuming both. Presently both commodities
BIBS 54
face a downward sloping graph, i.e. the higher the price the lesser will be the demand
and vice versa. If the income of consumer rises, then he would be more inclined
towards wheat flour, which is a little costly than jowar flour. The mindset of the
consumer behind this behavior is that now he can afford wheat flour because of his
increase in income. Therefore, he will switch his flour demand from jowar to wheat.
Hence jowar, whose demand has fallen due to an increase in income, is the inferior
good and wheat is the normal good
• Inferior goods have a negative income elasticity of demand. Demand falls as
income rises.
• For example:
– A 12% rise in incomes leads to a 3% decrease in the demand for bus travel
– The income elasticity of demand = -3 / +12
– Yed = -0.25.
Different Types of Goods and their Income Elasticity (Indicative List)
Luxury Normal Necessity Inferior Good

Air travel Fresh vegetables Frozen vegetables
Private Fruit juice Margarine

education
Private health Spending on utilities Tinned meat
care
Antique Shampoo / toothpaste / Value “own-brand”
furniture detergents bread
Designer clothes Rail travel Bus travel
Price Elasticity of Supply

Price elasticity of supply is the ratio of the percentage change in quantity supplied of a
good or service to the percentage change in its price, all other things unchanged.
Price Elasticity of Supply =
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Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a

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.
While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic,
to infinite, perfectly elastic.
Consider the following example:
A firm’s product’s market price increases from Rs. 100 to Rs. 110, and its supply
increases from 10 mn units to 12.5 mn units PES is:
+25 / +10 = (+) 2.5
The positive sign reflects the fact that higher prices will act an incentive to supply
more. Because the coefficient is greater than one, PES is elastic and the firm is
responsive to changes in price. This will give it a competitive advantage over its rivals.
What is the most desirable PES for a firm?
It is desirable for a firm to be highly responsive to changes in price and other market
conditions. This is because a high PES makes the firm more competitive than its rivals
and it allows the firm to generate more revenue and profits.
Improving PES
Because a high PES is desirable, it may be necessary for firms to undertake actions that
improve their speed of response to changes in market conditions. Examples of these
actions include:
1. Creating spare capacity
2. Using the latest technology
3. Keeping sufficient stocks
4. Developing better storage systems
5. Prolonging the shelf life of products
6. Developing better distribution systems
7. Providing training for workers
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8. Having flexible workers who can do a range of jobs

9. Locating production near to the market
10. Allowing inward migration of labour if there is a labour shortage
Practical Limitations of the Concept of Elasticity of

Demand
In theory, the various measures of elasticity of demand help managers to understand
the impact of changes in different variables on their sales. This is important to their
planning: when estimating their production and financial requirements, or required
staffing and stock. However, whilst knowledge of the price, income, and cross-price
elasticities of demand can certainly be useful, in reality using them can be difficult for
the following reasons.
 Each of the equations for the elasticity of demand measures the relationship
between one specific factor and demand: for example, the price elasticity of
demand analyses the impact of a change in price on the quantity demanded. In
reality, many factors may be changing at the same time, such as spending on
advertising, competitors’ promotional strategies, and customers’ incomes, as well
as the firm’s price. It may therefore be difficult to know what specifically has
caused any change in the quantity demanded. A fall in price may be accompanied
by an increase in quantity demanded, but this may not be the cause -- it could
have been due to other factors that also changed at the same time, such as the
weather. A value on the price elasticity of demand that is calculated assuming the
change in quantity demanded was all due to the price change may be very
misleading.
 To know the elasticity of demand, managers must either look back at what
happened in the past when, for example, prices or incomes were changed (but the
conditions are likely to have altered since then), or estimate for themselves what
the values are now (in which case, they may be wrong because it is an estimate).
The value of elasticity is, therefore, not actually known at any moment; rather, it is
merely estimated – perhaps based on past data. This means that managers should
be careful about basing decisions on their estimates of the elasticity, because the
values will be changing all of the time as demand conditions change.
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The Context of Demand Forecasting

Demand forecasting is the activity of estimating the quantity of a product or service
that consumers will purchase. Demand forecasting involves techniques including both
informal methods, such as educated guesses, and quantitative methods, such as the
use of historical sales data or current data from test markets. Demand forecasting may
be used in making pricing decisions, in assessing future capacity requirements, or in
making decisions on whether to enter a new market.
Forecasting product demand is crucial to any supplier, manufacturer, or retailer.

Forecasts of future demand will determine the quantities that should be purchased,
produced, and shipped. Demand forecasts are necessary since the basic operations
process, moving from the suppliers' raw materials to finished goods in the customers'
hands, takes time. Most firms cannot simply wait for demand to emerge and then react
to it. Instead, they must anticipate and plan for future demand so that they can react
immediately to customer orders as they occur. In other words, most manufacturers
"make to stock" rather than "make to order" – they plan ahead and then deploy
inventories of finished goods into field locations. Thus, once a customer order
materializes, it can be fulfilled immediately – since most customers are not willing to
wait the time it would take to actually process their order throughout the supply chain
and make the product based on their order. An order cycle could take weeks or
months to go back through part suppliers and sub-assemblers, through manufacture of
the product, and through to the eventual shipment of the order to the customer.
Firms that offer rapid delivery to their customers will tend to force all competitors in
the market to keep finished goods inventories in order to provide fast order cycle
times. As a result, virtually every organization involved needs to manufacture or at
least order parts based on a forecast of future demand. The ability to accurately
forecast demand also affords the firm opportunities to control costs through leveling
its production quantities, rationalizing its transportation, and generally planning for
efficient logistics operations.
In general practice, accurate demand forecasts lead to efficient operations and high
levels of customer service, while inaccurate forecasts will inevitably lead to inefficient,
high cost operations and/or poor levels of customer service. In many supply chains, the
most important action we can take to improve the efficiency and effectiveness of the
logistics process is to improve the quality of the demand forecasts.
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The Nature of Customer Demand

Most of the procedures which are discussed here are intended to deal with the
situation where the demand to be forecasted arises from the actions of the firm’s
customer base. Customers are assumed to be able to order what, where, and when
they desire. The firm may be able to influence the amount and timing of customer
demand by altering the traditional "marketing mix" variables of product design, pricing,
promotion, and distribution. On the other hand, customers remain free agents who
react to a complex, competitive marketplace by ordering in ways that are often difficult
to understand or predict. The firm’s lack of prior knowledge about how the customers
will order is the heart of the forecasting problem – it makes the actual demand
random.
However, in many other situations where inbound flows of raw materials and
component parts must be predicted and controlled, these flows are not rooted in the
individual decisions of many customers, but rather are based on a production
schedule. Thus, if TDY Inc. decides to manufacture 1,000 units of a certain model of
personal computer during the second week of October, the parts requirements for
each unit are known. Given each part supplier’s lead-time requirements, the total parts
requirement can be determined through a structured analysis of the product's design
and manufacturing process. Forecasts of customer demand for the product are not
relevant to this analysis. TDY, Inc., may or may not actually sell the 1,000 computers,
but that is a different issue altogether. Once they have committed to produce 1,000
units, the inbound logistics system must work towards this production target. The
Material Requirements Planning (MRP) technique is often used to handle this kind of
demand. This demand for component parts is described as dependent demand
(because it is dependent on the production requirement), as contrasted with
independent demand, which would arise directly from customer orders or purchases of
the finished goods. The MRP technique creates a deterministic demand schedule for
component parts, which the material manager or the inbound logistics manager must
meet. Typically a detailed MRP process is conducted only for the major components (in
this case, motherboards, drives, keyboards, monitors, and so forth). The demand for
other parts, such as connectors and memory chips, which are used in many different
product lines, is often simply estimated and ordered by using statistical forecasting
methods.
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General Approaches to Forecasting
All firms forecast demand, but it would be difficult to find any two firms that forecast
demand in exactly the same way. Over the last few decades, many different forecasting
techniques have been developed in a number of different application areas, including
engineering and economics. Many such procedures have been applied to the practical
problem of forecasting demand in a logistics system, with varying degrees of success.
Most commercial software packages that support demand forecasting in a logistics
system include dozens of different forecasting algorithms that the analyst can use to
generate alternative demand forecasts.
1. Judgmental Approaches. The essence of the judgmental approach is to address the

forecasting issue by assuming that someone else knows and can tell you the right
answer. That is, in a judgment-based technique we gather the knowledge and
opinions of people who are in a position to know what demand will be. For
example, we might conduct a survey of the customer base to estimate what our
sales will be next month.
2. Experimental Approaches. Another approach to demand forecasting, which is

appealing when an item is "new" and when there is no other information upon
which to base a forecast, is to conduct a demand experiment on a small group of
customers and to extrapolate the results to a larger population. For example, firms
will often test a new consumer product in a geographically isolated "test market"
to establish its probable market share. This experience is then extrapolated to the
national market to plan the new product launch. Experimental approaches are very
useful and necessary for new products, but for existing products that have an
accumulated historical demand record it seems intuitive that demand forecasts
should somehow be based on this demand experience. For most firms (with some
very notable exceptions) the large majority of SKUs in the product line have long
demand histories.
3. Relational/Causal Approaches. The assumption behind a causal or relational

forecast is that, simply put, there is a reason why people buy our product. If we can
understand what that reason (or set of reasons) is, we can use that understanding
to develop a demand forecast. For example, if we sell umbrellas at a sidewalk
stand, we would probably notice that daily demand is strongly correlated to the
weather – we sell more umbrellas when it rains. Once we have established this
relationship, a good weather forecast will help us order enough umbrellas to meet
the expected demand.
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4. "Time Series" Approaches. A time series procedure is fundamentally different than

the first three approaches we have discussed. In a pure time series technique, no
judgment or expertise or opinion is sought. We do not look for "causes" or
relationships or factors which somehow "drive" demand. We do not test items or
experiment with customers. By their nature, time series procedures are applied to
demand data that are longitudinal rather than cross-sectional. That is, the demand
data represent experience that is repeated over time rather than across items or
locations. The essence of the approach is to recognize (or assume) that demand
occurs over time in patterns that repeat themselves, at least approximately. If we
can describe these general patterns or tendencies, without regard to their "causes",
we can use this description to form the basis of a forecast.
SUMMARY
1. The term ‘demand’ can be used in many contexts, as in demand schedules, curves,
equations, functions and quantity demanded. It is important to distinguish
between these different meanings.
2. Graphs and equations can be drawn and written with either price or quantity as
the dependent variable.
3. Coefficients in demand equations can have either graphical or economic
interpretations.
4. Marginal effects and elasticities are two different ways of describing the effect of a
variable on quantity demanded.
5. There are a large number of factors which affect demand in reality; it is useful to
distinguish between controllable and uncontrollable factors.
6. The concept of elasticity is vital in understanding and analysing demand
relationships.
7. Theoretical considerations relating to the sign and size of elasticities must always
be tested empirically.
8. There are several stages involved in demand estimation: stating a hypothesis,
model specification, data collection, estimating parameters, checking goodness of
fit, hypothesis testing and forecasting.
9. Statistical inference means drawing conclusions from a sample about a whole
population; in practice we are almost always limited to using sample data.
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LAWS OF SUPPLY
Objectives
 Supply and demand are among the most important parts of economics
and it is the strength of a market economy
 This chapter will help you to learn that supply and demand set the
price of a good or service
 The chapter shall help you to predict the movement of the market as it
develops policies
 The objective is to help you to determine the interaction of buyers and

sellers
 The chapter will provide the understanding for economic decisions by

individuals and managers of institutions
 You shall understand how markets add up individual decisions to make

social decisions
 This chapter explains how supply and demand is perhaps one of the
most fundamental concepts of economics and it is the backbone of a
market economy
Law of Supply
Business firms may have different objectives – profit maximization, sales maximization,
output maximization, security profits, satisfaction maximization, utility maximization,
growth maximization or satisfying. But the basic business activity of all firms is same –
they all produce and sell goods and services that are in “demand”. Demand is the basis
of all productive activities, rightly termed as "mother of production". It is, therefore,
necessary for business managers to have clear understanding of.
 What are the sources of demand?
 What are the determinants of demand?
 How do buyers decide the quantity of a product to be purchased?
 How do buyers respond to the change in a product price; their income;
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prices of other goods or services; and change in other determinants of

demand?
How can total or market demand for a product be assessed or forecast?
In a free market economy it is the price-mechanism that settles its fundamental

problems of what, how and for whom. The price of any commodity in the market is
determined by the general interaction of the forces of demand and supply. In this
lesson, we will deal with the concepts of demand. Before proceeding further, we may
define the term 'commodity' and 'market'. A commodity is any goods produced for sale
in the market. By this definition, food produced in the home kitchen for consumption
of the family is not a commodity. But the same food prepared by a hotel for its
customers' consumption is a commodity. Market in Economics is more than a
geographical area or a 'mandi' where goods are bought and sold. It means all the areas
in which buyers and sellers are in contact with each other for the purchase and sale of
the commodity. Thus, a commodity may have a local market, a regional market, a
national market or even an international market. Business firms may have different
objectives – profit maximization, sales maximization, output maximization, security
profits, satisfaction maximization, utility maximisation, growth maximization or
satisfying. But the basic business activity of all firms is same – they all produce and sell
goods and services that are in “demand”. Demand is the basis of all productive
activities, rightly termed as "mother of production".
In a free market economy it is the price-mechanism that settles its fundamental

problems of what, how and for whom. The price of any commodity in the market is
determined by the general interaction of the forces of demand and supply. In this
lesson, we will deal with the concepts of demand. Before proceeding further, we may
define the term 'commodity' and 'market'. A commodity is any goods produced for sale
in the market. By this definition, food produced in the home kitchen for consumption
of the family is not a commodity. But the same food prepared by a hotel for its
customers' consumption is a commodity.
Market in Economics is more than a geographical area or a 'mandi' where goods are
bought and sold. It means all the areas in which buyers and sellers are in contact with
each other for the purchase and sale of the commodity. Thus, a commodity may have a
local market, a regional market, a national market or even an international market.
Demand for a Commodity

In any market, there are a vast number of individual purchasers of a commodity. The
basic unit of consumption being the individual household, "how much of a commodity
would an individual household be willing to buy?” - is the demand for the commodity.
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We may define the demand for a commodity of the individual household is the
quantity of the commodity that he is willing to buy in the market in a given period of
time at a given price.Thus, a want with three attributes – 'desire to buy', 'willingness to
pay' and 'ability to pay'– becomes effective demand. Demand for a commodity has
always a reference to 'a price', 'a period of time' and 'a place'. For this reason,
"demand for apples in 5" carries no meaning for a business decision.
Determinants of Individual Demand

Knowledge of different factors and forces that determine the demand for a commodity
and the nature of relationship between the demand and its determinants are very
helpful in analyzing and estimating demand. The demand for a commodity of the
individual household depends upon a number of factors - some are quantifiable while
some are not quantifiable. These factors are:
 Price of the commodity
 The money income of the individual household
 The tastes and preferences of the individual household
 The prices of other commodities
Aggregate Demand
Aggregate demand is the sum of all demand in an economy. This can be computed by
adding the expenditure on consumer goods and services, investment, and not exports
(total exports minus total imports).
Why is the AD curve Downward Sloping?
We could explain this by going through each of the components of AD (C, I, G, and X −
M) to see why the real expenditure in each category changes as the price level
changes. This can get confusing, though. There are three main factors that explain the
shape of the AD curve, some of which will affect more than one component of AD.
Remember that for each of these explanations, we are talking about a movement
along the AD curve, not a shift in the curve (see the next section). The initial move is
always a change in the price, which then causes the following three things to happen.
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Interest Rates:
If the price level rises, the rate of interest rises in an effort to stop the price rise getting
out of hand (see the topic 'Unemployment and inflation' for details of why this is bad).
Consumers' mortgage payments will rise (in the UK, the majority of people have
variable rate mortgages). This means that consumers will have less money left over to
buy goods and services. Higher interest rates make it more expensive for consumers to
buy 'big ticket' items, like new cars, for which money tends to be borrowed. In the
same way, firms are less likely to borrow for investment. So, the response to a rise in
the price level in the final effect is a fall in plan consumption and investment, and a
consequent reduction in AD.
In the old days, the government would rather not raise interest rates until they had to,
because it made many people (voters!) feel less well off. They tended to raise rates in
response to a rising price level.
Changes in Real Wealth:
If the price level rises, for a given level of nominal wealth, then peoples' real wealth
will fall. This will be true for incomes too if nominal incomes remain constant. Basically,
people will feel less well off, and so will probably consume fewer goods and services.
The Foreign Sector:
For a given exchange rate, if the UK price level rises, then home produced goods will
become relatively more expensive in other countries, and so the demand for exports
will fall. Also, imports into the UK from other countries will appear relatively cheaper,
because their price level has remained unchanged while the price of the home
produced goods are rising. The demand for foreign imports will, therefore, rise. Both of
these effects cause the level of real national income to fall as the price level rises. Note
that sustained differences in the price levels of two different countries will eventually
cause the given exchange rate to change. See the topic called 'Exchange rates' for
details.
For all three of these explanations, one can reverse the analysis when considering a fall in the
price level. Also, note that none of the factors affected government spending (G). In these
models it is assumed that government spending is exogenous, which means 'determined
BIBS 65
outside the model'. In other words, increases in real government spending tend to be
unrelated to changes in the price level.
Price
Level
AD
Y National income
(real GDP)
Figure 12 A – Demand Curve – Downward Sloping
Shifts in the AD curve

It is important to understand why curves shift, both in the world of microeconomics
(why might the demand curve for chocolate bars shift to the left or to the right?) and in
the world of macroeconomics (why might the AD curve for the whole economy shift?).
It is certainly a bit more confusing when we look at AD. It should be noted, for
instance, that interest rates are a cause of a movement along an AD curve (following a
rise in the price level) and can also cause a shift in the AD curve (when the change in
the rate of interest happens independently of a change in the price level).
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Figure 12 B - In the diagram

alongside, the AD curve has shifted
to the left, from AD1 to AD2, so that
real national income falls at any
given price level. At P1, for example,
real national income has fallen from
Y1 to Y2 as a result of the inward
shift of the AD curve.
What are the other major reasons for the shift in AD Curve?
Unemployment: When unemployment rises during recessionary phases, many

households' purchasing power diminishes. The demand for goods and services, and
therefore AD, fall.
Taxation: If taxes increase, this will have the effect of reducing AD whatever the price
level; households will have less disposable income to spend. Businesses pay taxes as
well. Increased business taxes may cause a firm to reduce investment if it feels it can
no longer afford it.
Government spending: If government spending actually declines in real terms, then

the AD curve would shift from AD1 to AD2.
The stock market: Any fall in stock prices implies that investors feel less wealthy and
this directly affects the amount they spent. For this reason again, the AD curve will
shift to the left, ceteris paribus.
Business Confidence: This is fairly straightforward. Regardless of the price level or the
level of interest rates, firms will invest if they are confident about the future (of their
company and the economy generally) and will not invest if they are pessimistic. The
famous economist, Keynes, was keen on this factor. Whereas monetarists feel that the
rate of interest is the main determinant of firms' investments, Keynesians feel that
confidence is far more important. It doesn't matter how low the rate of interest is for a
firm if they believe that a downturn is around the corner, they simply will not invest.
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The exchange rate: If the currency of a particular country is fairly strong it makes its
exports relatively more expensive abroad, and its imports seem relatively cheap. The
decline in the demand for the country’s exports and the increase in demand for foreign
imports will cause the AD curve to shift to the left, ceteris paribus.
Aggregate Supply
We learned that aggregate demand is the total demand for goods and services in an
economy. But the aggregate demand curve alone does not tell us the equilibrium price
level or the equilibrium level of output. In order to obtain this information, we need to
add the aggregate supply curve to the diagram containing the aggregate demand curve.
Then, and only then, do the equilibrium values of the economy in the AS-AD model
appear. The aggregate supply curve shows the relationship between the price level and
the quantity of goods and services supplied in an economy.
Long run
aggregate Short run
supply aggregate
supply
Price
level
Output or Income
Figure 12 C - Supply Curve – Downward Sloping
Aggregate Supply in the Short Run

The equation for aggregate supply presented above holds only in the short run. Recall
that the aggregate supply curve shows the relationship between the price level and the
quantity of goods and services supplied. Also recall that the aggregate supply curve
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states that output deviates from the natural rate of output when the price level
deviates from the expected price level. All of these elements of aggregate supply point
to an upward sloping short-term aggregate supply curve and a vertical long-term
aggregate supply curve.
Why is the AS Curve Upward Sloping?

But how do we know that aggregate supply is upward sloping in the short run and
vertical in the long run? First, recall from microeconomics that output is a function of
capital and labor--the inputs to production. Thus, in the long run, the levels of capital
and labor in an economy fix the level of output. The only way to increase output in the
long run is to increase the levels of capital and labor. This is called increasing the
capital stock--the result of investment--and increasing the labor force--the result of
more people working.
Therefore, in the long run, the aggregate supply curve is affected only by the levels of
capital and labor and not by the price level. Thus, the long run aggregate supply is
vertical with respect to the price level.
Complete AS-AD Model
Unlike the aggregate demand curve, the aggregate supply curve does not usually shift
independently. This is because the equation for the aggregate supply curve contains no
terms that are indirectly related to either the price level or output. Instead, the
equation for aggregate supply contains only terms derived from the AS-AD model. For
this reason, to understand how the aggregate supply curve shifts, we must work from
the AS-AD model. The intersection of the short-run aggregate supply curve, the long-
run aggregate supply curve, and the aggregate demand curve gives the equilibrium
price level and the equilibrium level of output. This is the starting point for all problems
dealing with the AS- AD model.
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Figure 12 D – AS-AD Model Long run

aggregate Short run
supply aggregate
supply
Price
level
Aggregate
Demand
Output or Income
Shifts in Aggregate Demand in the AS-AD Model

The primary cause of shifts in the economy is aggregate demand. Recall that aggregate
demand can be affected by consumers both domestic and foreign, the RBI, and the
government. Any expansionary policy shifts the aggregate demand curve to the right
while any contractionary policy shifts the aggregate demand curve to the left. In the
long run, though, since long-term aggregate supply is fixed by the factors of
production, short-term aggregate supply may shift to the left so that the only effect of
a change in aggregate demand is a change in the price level.
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Long run
aggregate Short run Short run
supply aggregate aggregate
supply 1 supply 2
Price
level C
B
A
Aggregate
Demand 1
Aggregate
Demand 2
Output or Income
Figure 12 E - Graph of an expansionary shift in the AS-AD model.
Notice that we begin at point A where short-run aggregate supply curve 1 meets the
long-run aggregate supply curve and aggregate demand curve 1. The point where the
short-run aggregate supply curve and the aggregate demand curve meet is always the
short-run equilibrium. The point where the long-run aggregate supply curve and the
aggregate demand curve meet is always the long-run equilibrium. Thus, we are in long-
run equilibrium to begin.
Now say that the RBI pursues expansionary monetary policy. In this case, the aggregate
demand curve shifts to the right from aggregate demand curve 1 to aggregate demand
curve 2. The intersection of short- run aggregate supply curve 1 and aggregate demand
curve 2 has now shifted to the upper right from point A to point B. At point B, both
output and the price level have increased. This is the new short-run equilibrium.
But, as we move to the long run, the expected price level comes into line with the
actual price level as firms, producers, and workers adjust their expectations. When this
occurs, the short-run aggregate supply curve shifts along the aggregate demand curve
until the long-run aggregate supply curve, the short-run aggregate supply curve, and
the aggregate demand curve all intersect. This is represented by point C and is the new
equilibrium where short-run aggregate supply curve 2 equals the long-run aggregate
supply curve and aggregate demand curve 2. Thus, expansionary policy causes output
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and the price level to increase in the short run, but only the price level to increase in
the long run.
Long run
supply 1 supply 2
Price
level A
B
C
Aggregate
Demand 1
Aggregate
Demand 2
Output or Income
Figure 12 F – Graph of a contractionary shift in the AS- AD model
Notice that we begin again at point A where short-run aggregate supply curve 1 meets the
long-run aggregate supply curve and aggregate demand curve 1. We are in long-run
equilibrium to begin.
If the RBI pursues contractionary monetary policy, the aggregate demand curve shifts
to the left from aggregate demand curve 1 to aggregate demand curve 2. The
intersection of short-run aggregate supply curve 1 and the aggregate demand curve
has now shifted to the lower left from point A to point B. At point B, both output and
the price level have decreased. This is the new short-run equilibrium.
But, as we move to the long run, the expected price level comes into line with the
actual price level as firms, producers, and workers adjust their expectations. When this
occurs, the short-run aggregate supply curve shifts down along the aggregate demand
curve until the long-run aggregate supply curve, the short-run aggregate supply curve,
and the aggregate demand curve all intersect. This is represented by point C and is the
new equilibrium where short-run aggregate supply curve 2 meets the long-run
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aggregate supply curve and aggregate demand curve 2. Thus, contractionary policy
causes output and the price level to decrease in the short run, but only the price level
to decrease in the long run.
This is the logic that is applied to all shifts in aggregate demand. The long-run
equilibrium is always dictated by the intersection of the vertical long-run aggregate
supply curve and the aggregate demand curve. The short-run equilibrium is always
dictated by the intersection of the short-run aggregate supply curve and the aggregate
demand curve. When the aggregate demand curve shifts, the economy always shifts
from the long-run equilibrium to the short-run equilibrium and then back to a new
long-run equilibrium. By keeping these rules and the examples above in mind it is
possible to interpret the effects of any aggregate demand shift in both the short run
and in the long run.
Shifts in Aggregate Supply in the AS-AD Model

Shifts in the short-run aggregate supply curve are much rarer than shifts in the
aggregate demand curve. Usually, the short-run aggregate supply curve only shifts in
response to the aggregate demand curve. But, when a supply shock occurs, the short-
run aggregate supply curve shifts without prompting from the aggregate demand
curve. Fortunately, the correction process is exactly the same for a shift in the short-
run aggregate supply curve as it is for a shift in the aggregate demand curve. That is,
when the short-run aggregate supply curve shifts, short- run equilibrium exists where
the short-run aggregate supply curve intersects the aggregate demand curve. Then the
aggregate demand curve shifts along the short-run aggregate supply curve until the
aggregate demand curve intersects both the short-run and the long-run aggregate
supply curves. Once the economy reaches this new long-run equilibrium, the price level
is changed but output is not.
There are two types of supply shocks. Adverse supply shocks include things like
increases in oil prices, a drought that destroys crops, and aggressive union actions. In
general, adverse supply shocks cause the price level for a given amount of output to
increase. This is represented by a shift of the short-run aggregate supply curve to the
left. Positive supply shocks include things like decreases in oil prices or an unexpected
great crop season. In general, positive supply shocks cause the price level for a given
amount of output to decrease. This is represented by a shift of the short-run aggregate
supply curve to the right.
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Long run
supply 1 supply 2
Price
level A
B
C
Aggregate
Demand 1
Aggregate
Demand 2
Output or Income
Figure 12 G - Graph of a positive supply shock in the AS- AD model
Let's work through an example. For this example, refer to. Notice that we begin at
point A where short-run aggregate supply curve 1 meets the long-run aggregate supply
curve and aggregate demand curve 1. Thus, we are in long-run equilibrium to begin.
Now say that a positive supply shock occurs: a reduction in the price of oil. In this case,
the short-run aggregate supply curve shifts to the right from short-run aggregate
supply curve 1 to short-run aggregate supply curve 2. The intersection of short- run
aggregate supply curve 2 and aggregate demand curve 1 has now shifted to the lower
right from point A to point B. At point B, output has increased and the price level has
decreased. This is the new short-run equilibrium.
However, as we move to the long run, aggregate demand adjusts to the new price level
and output level. When this occurs, the aggregate demand curve shifts along the short-
run aggregate supply curve until the long-run aggregate supply curve, the short-run
aggregate supply curve, and the aggregate demand curve all intersect. This is
represented by point C and is the new equilibrium where short-run aggregate supply
curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2. Thus,
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a positive supply shock causes output to increase and the price level to decrease in the
short run, but only the price level to decrease in the long run.
Long run
supply 1 supply 2
Price
level C
B
A
Aggregate
Demand 1
Aggregate
Demand 2
Output or Income
Figure 12 H - Graph of an adverse supply shock in the AS- AD model
Let's work through another example. Notice that we begin at point A where short-run
aggregate supply curve 1 meets the long run aggregate supply curve and aggregate
demand curve 1. Thus, we are in long-run equilibrium to begin.
Now say that an adverse supply shock occurs: a terrifying increase in the price of oil. In
this case, the short-run aggregate supply curve shifts to the left from short-run
aggregate supply curve 1 to short-run aggregate supply curve 2. The intersection of
short-run aggregate supply curve 2 and aggregate demand curve 1 has now shifted to
the upper left from point A to point B. At point B, output has decreased and the price
level has increased. This condition is called stagflation. This is also the new short- run
equilibrium.
However, as we move to the long run, aggregate demand adjusts to the new price level
and output level. When this occurs, the aggregate demand curve shifts along the short-
run aggregate supply curve until the long-run aggregate supply curve, the short-run
aggregate supply curve, and the aggregate demand curve all intersect. This is
represented by point C and is the new equilibrium where short-run aggregate supply
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curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2.
Thus, an adverse supply shock causes output to decrease and the price level to
increase in the short run, but only the price level to increase in the long run.
This is the logic that is applied to all shifts in short-run aggregate supply. The long-run
equilibrium is always dictated by the intersection of the vertical long run aggregate
supply curve and the aggregate demand curve. The short-run equilibrium is always
dictated by the intersection of the short-run aggregate supply curve and the aggregate
demand curve. When the short-run aggregate supply curve shifts, the economy always
shifts from the long-run equilibrium to the short-run equilibrium and then back to a
new long-run equilibrium. By keeping these rules and the examples above in mind, it is
possible to interpret the effects of any short-run aggregate supply shift, or supply
shock, in both the short run and in the long run.
Conclusions from the AS-AD Model

This section has served a number of purposes. First, we covered how and why the
short-run aggregate supply curve shifts. Second, we reviewed how and why the
aggregate demand curve shifts. Third, we introduced the mechanism that moves the
economy from the long run to the short run and back to the long run when there is a
change in either aggregate supply or aggregate demand. At this stage, you have the
ability to use the highly realistic model of the macroeconomy provided by the AS-AD
diagram to analyze the effects of macroeconomic policies. This will prove to be the
most powerful tool in your collection for understanding the macroeconomy.
Economic Theory – Supply and Demand
In economic theory, the law of supply and demand is considered one of the
fundamental principles governing an economy. It is described as the state where as
supply increases the price will tend to drop or vice versa, and as demand increases the
price will tend to increase or vice versa. Basically this is a principle that most people
intuitively grasp regarding the relationship of goods and services against the demand
for those goods and services.
Gerhard Adam, Science 2.0
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Summary:
 The price of any commodity in the market is determined by the general
interaction of the forces of demand and supply
 Market in Economics is more than a geographical area or a ‘mandi’ where

goods are bought and sold. It means all the areas in which buyers and sellers
are in contact with each other for the purchase and sale of the commodity.
 In a free market economy it is the price-mechanism that settles its

fundamental problems of what, how and for whom. The price of any
commodity in the market is determined by the general interaction of the
forces of demand and supply.
 This lesson is concerned with the relationship between quantity demanded of

a commodity and its price, while all the other determinants of demand are
assumed to remain unchanged.
 Aggregate demand is the sum of all demand in an economy. This can be

computed by adding the expenditure on consumer goods and services,
investment, and not exports.
 The aggregate supply curve shows the relationship between the price level and
the quantity of goods and service supplied in an economy.
Suggestive Questions
1. What are the sources of demand?

2. What are the determinants of demand?
3. How do buyers decide the quantity of a product to be purchased?
4. How do buyers respond to the change in a product price; their income; prices of
other goods or services; and change in other determinants of demand?
5. How can total or market demand for a product be assessed or forecast?
6. What are the factors which shift aggregate demand to the right?
7. Explain the AS-AD model.
8. Why Does the Short-Run Aggregate Supply Curve Slope Upward?
9. What are the factors responsible for the increase in Aggregate Demand?
10. What are the two types of consumer demand for goods? Explain.
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Theory of Production Managerial Economics
THEORY OF PRODUCTION
Objectives
 The difference between economic short-run & economic long-run
 Understand the concept of Production Function
 Understand the relationship marginal product of labor and average

product of labor
 Explain & illustrate the relationship between marginal cost and

average total cost
 Graph average total cost, average fixed cost, average variable cost and
marginal cost
 Understand how firms use the long-run average cost (LRAC) curve in
their planning
The Behavior of Profit-Maximizing Firms

Profits and Economic Costs
Profit (economic profit) is the difference between total revenue and total cost.
Profit = total revenue - total economic cost
Total Revenue The amount received from the sale of the product (q · P), where q is the
quantity sold and price of that sold quantity.
The Production Function

A firm is an organization that produces goods or services for sale. To do this, it must
transform inputs into output. The quantity of output a firm produces depends on the
quantity of inputs; this relationship is known as the firm’s production function. As we’ll
see, a firm’s production function underlies its cost curves. As a first step, let’s look at
the characteristics of a hypothetical production function.
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Managerial Economics Theory of Production
Inputs and Output

To understand the concept of a production function, let’s consider a farm that we
assume, for the sake of simplicity, produces only one output, wheat, and uses only two
inputs, land and labor. This particular farm is owned by a couple named Varun and
Maria. They hire workers to do the actual physical labor on the farm. Moreover, we will
assume that all potential workers are of the same quality—they are all equally
knowledgeable and capable of performing farm work.
Varun and Maria’s farm sits on 10 acres of land; no more acres are available to them,
and they are currently unable to either increase or decrease the size of their farm by
selling, buying, or leasing acreage. Land here is what economists call a fixed input—an
input whose quantity is fixed for a period of time and cannot be varied. Varun and
Maria are, however, free to decide how many workers to hire. The labor provided by
these workers is called a variable input—an input whose quantity the firm can vary at
any time.
In reality, whether or not the quantity of an input is really fixed depends on the time
horizon. In the long run—that is, given that a long enough period of time has elapsed—
firms can adjust the quantity of any input. For example, in the long run, Varun and
Maria can vary the amount of land they farm by buying or selling land. So there are no
fixed inputs in the long run. In contrast, the short run is defined as the time period
during which at least one input is fixed. Later in this chapter, we’ll look more carefully
at the distinction between the short run and the long run. But for now, we will restrict
our attention to the short run and assume that at least one input is fixed.
Varun and Maria know that the quantity of wheat they produce depends on the
number of workers they hire. Using modern farming techniques, one worker can
cultivate the 10-acre farm, albeit not very intensively. When an additional worker is
added, the land is divided equally among all the workers: each worker has 5 acres to
cultivate when 2 workers are employed, each cultivates 31⁄3 acres when 3 are
employed, and so on. So as additional workers are employed, the 10 acres of land are
cultivated more intensively and more tons of wheat are produced. The relationship
between the quantity of labor and the quantity of output, for a given amount of the
fixed input, constitutes the farm’s production function. The production function for
Varun and Maria’s farm, where land is the fixed input and labor is a variable input, is
shown in the first two columns of the table in the following figure; the diagram there
shows the same information graphically. The curve in the following figure shows how
the quantity of output depends on the quantity of the variable input, for a given
quantity of the fixed input; it is called the farm’s total product curve. The physical
quantity of output, tons of wheat, is measured on the vertical axis; the quantity of the
variable input, labor (that is, the number of workers employed), is measured on the
horizontal axis. The total product curve here slopes upward, reflecting the fact that
more tons of wheat are produced as more workers are employed.
BIBS 79
Production Function and Total Product Curve for Varun and Maria’s Farm
Quantity
of wheat Marginal product
(tons) Quantity Quantity of labour
Adding a 7th
of labour L of wheat Q MPL = ΔQ/ΔL
worker leads to an (workers) (tons) (tons per worker)
increase in output
of only 7 tons Total product, TP 0 0
100 19
1 19
Adding a 2nd 17
80 worker leads to an 2 36
increase in output 15
of 17 tons 3 51
13
60 4 64
11
5 75
40 9
6 84
7
7 91
20 5
8 96
0 1 2 3 4 5 6 7 8
Quantity of labour (workers)
The table shows the production function, the relationship between the quantity of the variable input (labour,
measured in number of workers) and the quantity of output (wheat, measured tons) for a given quantity of
the fixed input. It also calculate the marginal product of labour on Varun and Maria’s farm. The total
product curve shows the production graphically. It slopes upward because more wheat is produced as
more workers are employed. It also becomes flatter because the marginal product of labour declines as
more and more workers are employed.
Although the total product curve in the above figure slopes upward along its entire
length, the slope isn’t constant: as you move up the curve to the right, it flattens out.
To understand why the slope changes, look at the third column of the table in the
above figure, which shows the change in the quantity of output that is generated by
adding one more worker. This is called the marginal product of labor, or MPL: the
additional quantity of output from using one more unit of labor (where one unit of
labor is equal to one worker). In general, the marginal product of an input is the
additional quantity of output that is produced by using one more unit of that input. In
this example, we have data on changes in output at intervals of 1 worker. Sometimes
data aren’t available in increments of 1 unit—for example, you might have information
only on the quantity of output when there are 40 workers and when there are 50
workers. In this case, we use the following equation to calculate the marginal product
of labor:
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Marginal product of labor = Change in quantity of output produced by one additional

unit of labor, i.e.,
Or
MPL =
In this equation, the ‘d’ means delta, represents the change in a variable. Now we can
explain the significance of the slope of the total product curve: it is equal to the
marginal product of labor. The slope of a line is equal to “rise” over “run”. This implies
that the slope of the total product curve is the change in the quantity of output (the
“rise”, Q) divided by the change in the quantity of labor (the “run”, L). And this, as we
can see from above, is simply the marginal product of labor. So in the above figure, the
fact that the marginal product of the first worker is 19 also means that the slope of the
total product curve in going from 0 to 1 worker is 19. Similarly, the slope of the total
product curve in going from 1 to 2 workers is the same as the marginal product of the
second worker, 17, and so on.
In this example, the marginal product of labor steadily declines as more workers are
hired—that is, each successive worker adds less to output than the previous worker. So
as employment increases, the total product curve gets flatter.
The following figure shows how the marginal product of labor depends on the number
of workers employed on the farm. The marginal product of labor, MPL, is measured on
the vertical axis in units of physical output—tons of wheat— produced per additional
worker, and the number of workers employed is measured on the horizontal axis. You
can see from the table in the above figure that if 5 workers are employed instead of 4,
output rises from 64 to 75 tons; in this case the marginal product of labor is 11 tons—
the same number found in the following figure. To indicate that 11 tons is the marginal
product when employment rises from 4 to 5, we place the point corresponding to that
information halfway between 4 and 5 workers. In this example the marginal product of
labor falls as the number of workers increases. That is, there are diminishing returns to
labor on Varun and Maria’s farm. In general, there are diminishing returns to an input
when an increase in the quantity of that input, holding the quantity of all other inputs
fixed, reduces that input’s marginal product. Due to diminishing returns to labor, the
MPL curve is negatively sloped.
BIBS 81
Marginal Product of Labour Curve for Varun and Maria’s Farm
The Marginal product of labor curve

places each worker’s marginal
product, the increase in the
quantity of output generated by These are diminishing
19 returns to labour.
each additional worker. The change
17
in the quantity of output is
15
measured on the vertical axis & the
13
number of workers employed on
11
the horizontal axis. The first worker
9
employed generated an increase in
7
output of 10 tons, the second
5
worker generates an increase of 17 Marginal product of labour, MPL
tons, and so on. The curve slopes
downward due to diminishing
returns to labor. 0 1 2 3 4 5 61 7 8
Quantity of labour (Workers)
To grasp why diminishing returns can occur, think about what happens as Varun and
Maria add more and more workers without increasing the number of acres of land. As
the number of workers increases, the land is farmed more intensively and the number
of tons produced increases. But each additional worker is working with a smaller share
of the 10 acres—the fixed input—than the previous worker. As a result, the additional
worker cannot produce as much output as the previous worker. So it’s not surprising
that the marginal product of the additional worker falls.
The crucial point to emphasize about diminishing returns is that, like many
propositions in economics, it is an “other things equal” proposition: each successive
unit of an input will raise production by less than the last if the quantity of all other
inputs is held fixed.
What would happen if the levels of other inputs were allowed to change? You can see
the answer illustrated in the following figure. Panel (a) shows two total product curves,
TP10 and TP20. TP10 is the farm’s total product curve when its total area is 10 acres
(the same curve as in the first figure). TP20 is the total product curve when the farm
has increased to 20 acres. Except when 0 workers are employed, TP20 lies everywhere
above TP10 because with more acres available, any given number of workers produces
more output. Panel (b) shows the corresponding marginal product of labor curves.
MPL10 is the marginal product of labor curve given 10 acres to cultivate (the same
curve as in the second figure), and MPL20 is the marginal product of labor curve given
20 acres. Both curves slope downward because, in each case, the amount of land is
fixed, albeit at different levels. But MPL20 lies everywhere above MPL10, reflecting the
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fact that the marginal product of the same worker is higher when he or she has more
of the fixed input to work with.
The figure below demonstrates a general result: the position of the total product curve
of a given input depends on the quantities of other inputs. If you change the quantity
of the other inputs, both the total product curve and the marginal product curve of the
remaining input will shift.
Product, Marginal Product and the Fixed Input
(a) Total Product Curves (b) Marginal Product Curves
Quantity Marginal product

of wheat of labour (tons
(tons) per worker)
160 30
TP20
140
25
120
100 20
TP20
80 15
60
10
40 MPL20
20 5 MPL20
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity of labour (workers) Quantity of labour (workers)
The figure shows how the quantity of output & marginal product of labor depend on the
level of fixed input. Panel (a) shows two total product curves for Varun & Maria’s farm,
TP10 when their farm is 10 acres and TP 20 when it is 20 acres. With more land, each worker
can produce more wheat. So an increase in the fixed input shifts the total product curve
up from TP10 to TP20 . This implies that the marginal product of each worker is higher the
farm is 20 acres than when it is 10 acres. Panel (b) shows the marginal product of labor
curves. The increase in acreage also shifts the marginal product of labor curve from MPL 10
to MPL20. Both marginal product of labor curve slope downward due to diminishing
returns to labor.
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Isoquant Curve and its properties
An isoquants shows all those combinations of factors which produce same level of
output. An isoquants is also known as equal product curve or iso-product curve.
Properties of Iso-Product Curves:
I. An isoquant lying above and to the right of another isoquant represents a higher
level of output.
This is because of the fact that on the higher isoquant, we have either more units of
one factor of production or more units of both the factors. This has been illustrated in
the following figure. In the figure, points A and B lie on the isoquant IQ1 and IQ2
respectively.
At point A we have = OX1 units of Labor and OY1 units of capital.
At point B we have = OX2 units of Labor and OY1 units of capital.
Though the amount of capital (OY1) is the same at both the points, point B is having
X1X2 units of labor more. Therefore, it will yield a higher output.
Hence, it is proved that a higher isoquant shows a higher level of output.
II. Two isoquants cannot cut each other

Just as two indifference curves cannot cut each other, two isoquants also cannot cut
each other. If they intersect each other, there would be a contradiction and we will get
inconsistent results. This can be illustrated with the help of a diagram as in figure 4.
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In the following figure, the isoquant IQ1 shows 100 units of output produced by various
combinations of labor and capital and the curve IQ2 shows 200 units of output,
On IQ1, we have A = C, because they are on the same isoquant.
On IQ2, we have A = B
Therefore B = C
This is however inconsistent since C = 100 and B = 200. Therefore, isoquants can’t
intersect
III. Isoquants are convex to the origin

An isoquant must always be convex to the origin. This is because of the operation of
the principle of diminishing marginal rate of technical substitution. MRTS is the rate at
which marginal unit of an input can be substituted for another input making the level
of output remain the same.
In the following figure, as the producer moves from point A to B, from B to C and C to D
along an isoquant, the marginal rate of technical substitution (MRTS) of labor for
capital diminishes. The MRTS diminishes because the two factors are not perfect
substitutes. In the figure, for every increase in labor units by (ΔL) there is a
corresponding decrease in the units of capital (ΔK).
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From the Production Function to Cost Curves

Once Varun and Maria know their production function, they know the relationship
between inputs of labor and land and output of wheat. But if they want to maximize
their profits, they need to translate this knowledge into information about the
relationship between the quantity of output and cost. Let’s see how they can do this.
To translate information about a firm’s production function into information about its
costs, we need to know how much the firm must pay for its inputs. We will assume
that Varun and Maria face a cost of Rs. 20000 for the use of the land. It is irrelevant
whether Varun and Maria must rent the land for Rs. 20000 from someone else or
whether they own the land themselves and forgo earning Rs. 20000 from renting it to
someone else. Either way, they pay an opportunity cost of Rs. 20000 by using the land
to grow wheat. Moreover, since the land is a fixed input, the Rs. 20000 Varun and
Maria pay for it is a fixed cost, denoted by FC—a cost that does not depend on the
quantity of output produced (in the short run). In business, fixed cost is often referred
to as “overhead cost.”
We also assume that Varun and Maria must pay each worker Rs. 10000. Using their
production function, Varun and Maria know that the number of workers they must hire
depends on the amount of wheat they intend to produce. So the cost of labor, which is
equal to the number of workers multiplied by Rs. 10000, is a variable cost, denoted by
VC—a cost that depends on the quantity of output produced. Adding the fixed cost and
the variable cost of a given quantity of output gives the total cost, or TC, of that
quantity of output. We can express the relationship among fixed cost, variable cost,
and total cost as an equation:
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Total cost = Fixed cost + Variable cost Or, TC = FC + VC

The table in the following figure shows how total cost is calculated for Varun and
Maria’s farm. The second column shows the number of workers employed, L. The third
column shows the corresponding level of output, Q, taken from the table in the first
figure. The fourth column shows the variable cost, VC, equal to the number of workers
multiplied by Rs. 10000. The fifth column shows the fixed cost, FC, which is Rs. 20000
regardless of how many workers are employed. The sixth column shows the total cost
of output, TC, which is the variable cost plus the fixed cost.
The first column labels each row of the table with a letter, from A to I. These labels will
be helpful in understanding our next step: drawing the total cost curve, a curve that
shows how total cost depends on the quantity of output.
Varun and Maria’s total cost curve is shown in the diagram in the figure below, where
the horizontal axis measures the quantity of output in tons of wheat and the vertical axis
measures total cost in dollars. Each point on the curve corresponds to one row of the
table in the figure below. For example, point A shows the situation when 0 workers are
employed: output is 0, and total cost is equal to fixed cost, Rs. 20000. Similarly, point B
shows the situation when 1 worker is employed: output is 19 tons, and total cost is Rs.
30000, equal to the sum of Rs. 20000 in fixed cost and Rs. 10000 in variable cost.
Like the total product curve, the total cost curve slopes upward: due to the variable
cost, the more output produced, the higher the farm’s total cost. But unlike the total
product curve, which gets flatter as employment rises, the total cost curve gets
steeper. That is, the slope of the total cost curve is greater as the amount of output
produced increases. As we will soon see, the steepening of the total cost curve is also
due to diminishing returns to the variable input. Before we can understand this, we
must first look at the relationships among several useful measures of cost.
BIBS 87
The table shows the variable cost,

Total cost, TC
fixed cost & total cost for various
I
output quantities on George &
H
Martha’s 10-acre farm. The total
G
cost curve shows how total cost F
(measured on the vertical axis) E
depends on the quantity of D
outputs (measured on the C
horizontal axis). The labeled points B
on the curve correspond to the A
rows of the table. The total cost

curve slopes upward because the 19 36 51 64 75 84 91 96
Quantity of wheat (tons)
number of workers employed, and
Quantity Quantity of
hence total cost, increases as the Variable Total cost
of labour wheat Fixed cost
cost TC – FC +
L Q FC
quantity of output increases. The (workers) (tons)
VC VC
curve gets steeper as output 0 0 Rs. 0 Rs. 20000 Rs. 20000

1 19 10000 20000 30000
increases due to diminishing 2 36 20000 20000 40000
returns to labor. 3 51 30000 20000 50000
4 64 30000 30000 60000
5 75 50000 20000 70000
6 84 60000 20000 80000
7 91 70000 20000 90000
8 96 80000 20000 100000
Two Key Concepts: Marginal Cost and Average Cost

Marginal Cost
Marginal cost is the change in total cost generated by producing one more unit of
output. We’ve already seen that the marginal product of an input is easiest to calculate if
data on output are available in increments of one unit of that input. Similarly, marginal
cost is easiest to calculate if data on total cost are available in increments of one unit of
output. When the data come in less convenient increments, it’s still possible to calculate
marginal cost. But for the sake of simplicity, let’s work with an example in which the data
come in convenient one-unit increments.
Apollo Fruit Products produces bottled Jams and the following table shows how its
costs per day depend on the number of cases of Jams it produces per day. The firm has
fixed cost of Rs. 5000 per day, shown in the second column, which represents the daily
BIBS 88
cost of its food-preparation equipment. The third column shows the variable cost, and
the fourth column shows the total cost. Panel (a) of following figure in the next page
plots the total cost curve. Like the total cost curve for Varun and Maria’s farm in the
figure above, this curve slopes upward, getting steeper as you move up it to the right.
The significance of the slope of the total cost curve is shown by the fifth column of the
table below, which calculates marginal cost: the additional cost of each additional unit.
The general formula for marginal cost is:
Marginal cost (MC) = Change in total cost generated by one additional unit of output
Or, MC =
Quantity Fixed Total Marginal

Variable
of cost cost cost of case
cost
Jams Q FC TC – FC MC =
VC (Rs.)
(cases) (Rs.) + VC TC/Q
0 5000 0 5000
600
1 5000 600 5600
1640
2 5000 2400 7240
3160
3 5000 5400 10400
4200
4 5000 9600 14600
5400
5 5000 15000 20000
6600
6 5000 21600 26600
7800
7 5000 29400 34400
9000
8 5000 38400 43400
10200
9 5000 48600 53600
11400
10 5000 60000 650000
As in the case of marginal product, marginal cost is equal to “rise” (the increase in total
cost) divided by “run” (the increase in the quantity of output). So just as marginal
product is equal to the slope of the total product curve, marginal cost is equal to the
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slope of the total cost curve. Now we can understand why the total cost curve gets
steeper as we move up it to the right: as you can see in the table above, marginal cost
at Apollo Fruit Products rises as output increases. Panel (b) of the following figure
shows the marginal cost curve corresponding to the data in the above table. Notice
that, as in the second figure, we plot the marginal cost for increasing output from 0 to
1 case of Jams halfway between 0 and 1, the marginal cost for increasing output from 1
to 2 cases of Jams halfway between 1 and 2, and so on. Why does the marginal cost
curve slope upward? Because there are diminishing returns to inputs in this example.
As output increases, the marginal product of the variable input declines. This implies
that more and more of the variable input must be used to produce each additional unit
of output as the amount of output already produced rises. And since each unit of the
variable input must be paid for, the additional cost per additional unit of output also
rises. In addition, recall that the flattening of the total product curve is also due to
diminishing returns: the marginal product of an input falls as more of that input is used
if the quantities of other inputs are fixed. The flattening of the total product curve as
output increases and the steepening of the total cost curve as output increases are just
flip - sides of the same phenomenon. That is, as output increases, the marginal cost of
output also increases because the marginal product of the variable input decreases.
(a) Total Cost (b) Marginal Cost
Cost Cost
Of case
8th case of sales
Increases total
7000 cost by Rs.9000 TC TC
125
6000
100
In Rs. 5,000
2nd case of sales
Increases total cost
(’00) by Rs, 1800 75
400
300 50
200
25
100
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Quantity of Jams (cases) Quantity of Jams (cases)
Panel (a) shows the total cost curve from the table above. Like the total cost curve in
the fourth figure above, it slopes upward. Panel (b) shows the marginal cost curve. It
also slopes upward, reflecting diminishing returns to the variable input
BIBS 90
Average Total Cost

In addition to total cost and marginal cost, it’s useful to calculate another measure,
average total cost, often simply called average cost. The average total cost is total cost
divided by the quantity of output produced; that is, it is equal to total cost per unit of
output. If we let ATC denote average total cost, the equation looks like this:
ATC = =
Average total cost is important because it tells the producer how much the average or
typical unit of output costs to produce. Marginal cost, meanwhile, tells the producer how
much one more unit of output costs to produce. Although they may look very similar,
these two measures of cost typically differ.
Table below uses data from Apollo Fruit Products to calculate average total cost. For
example, the total cost of producing 4 cases of Jams is Rs. 15000, consisting of Rs. 5000 in
fixed cost and Rs. 10000 in variable cost (from the table above). So the average total cost
of producing 4 cases of Jams is Rs. 15000/4 = Rs. 3750. You can see from the following
table that as quantity of output increases, average total cost first falls, then rises.
Average Total Cost for Apollo Fruit Products’ Jams Sales

Average total cost Average fixed cost Average variable
Total Cost
Q (cases) of case of case cost of case
TC
ATC = TC/Q AFC = FC/Q AVC = VC/Q
1 Rs. 6000 Rs. 6000.00 Rs. 5000 Rs. 600
2 7800 3900.00 2500 1200
3 10800 3600.00 1666 1800
4 15000 3750.00 1250 2400
5 20400 4080.00 1000 3000
6 27000 4500.00 833 3600
7 34800 4970.00 714 4200
8 43800 5475.00 625 4800
9 54000 6000.00 555 5400
10 95400 9540.00 500 6000
The following figure plots that data to yield the average total cost curve, which shows
how average total cost depends on output. As before, cost is measured on the vertical
axis and quantity of output is measured on the horizontal axis. The average total cost
curve has a distinctive U shape that corresponds to how average total cost first falls
and then rises as output increases. Economists believe that such U-shaped average
total cost curves are the norm for producers in many industries.
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To help our understanding of why the average total cost curve is U-shaped, the table
above breaks average total cost into its two underlying components, average fixed cost
and average variable cost. Average fixed cost, or AFC, is fixed cost divided by the
quantity of output, also known as the fixed cost per unit of output.
For example, if Apollo Fruit Products produces 4 cases of Jams, average fixed cost is Rs.
5000/4 = Rs. 1250 per case. Average variable cost, or AVC, is variable cost divided by
the quantity of output, also known as variable cost per unit of output. At an output of 4
cases, average variable cost is Rs. 9600/4 = Rs. 2400 per case. Writing these in the form
of equations:
AFC = =
AVC = =
Cost of
cases
700 Average total cost,

Minimum ATC
600 average
total cost
500
(In Rs. ’00) 40 M
30
20
10
0 1 2 3 4 5 6 7 8 9 10
Minimum cost Quantity of Jams

output (cases)
BIBS 92
The average total cost curve at Apollo Fruit Products is U-shaped. At low levels of
output, average total cost falls because the “spreading effect” of falling average
fixed cost dominates the “diminishing returns effect” of rising average variable cost.
At higher levels of output, the opposite is true and average total cost rise. At point
M, corresponding to an output of three cases of Jams per day, average total cost is
at its minimum level, the minimum average total cost.
Average total cost is the sum of average fixed cost and average variable cost. It has a U
shape because these components move in opposite directions as output rises. Average
fixed cost falls as more output is produced because the numerator (the fixed cost) is a
fixed number but the denominator (the quantity of output) increases as more is
produced. Another way to think about this relationship is that, as more output is
produced, the fixed cost is spread over more units of output; the end result is that the
fixed cost per unit of output—the average fixed cost—falls. You can see this effect in
the fourth column of the second table: average fixed cost drops continuously as output
increases.
Average variable cost, however, rises as output increases. As we’ve seen, this reflects
diminishing returns to the variable input: each additional unit of output incurs more
variable cost to produce than the previous unit. So variable cost rises at a faster rate
than the quantity of output increases.
So increasing output has two opposing effects on average total cost—the “spreading
effect” and the “diminishing returns effect”:
• The spreading effect. The larger the output, the greater the quantity of output
over which fixed cost is spread, leading to lower average fixed cost.
• The diminishing returns effect. The larger the output, the greater the amount of
variable input required to produce additional units, leading to higher average
variable cost.
At low levels of output, the spreading effect is very powerful because even small
increases in output cause large reductions in average fixed cost. So at low levels of
output, the spreading effect dominates the diminishing returns effect and causes the
average total cost curve to slope downward. But when output is large, average fixed
cost is already quite small, so increasing output further has only a very small spreading
effect. Diminishing returns, however, usually grow increasingly important as output
rises. As a result, when output is large, the diminishing returns effect dominates the
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spreading effect, causing the average total cost curve to slope upward. At the bottom
of the U-shaped average total cost curve, point M in the above figure, the two effects
exactly balance each other. At this point average total cost is at its minimum level, the
minimum average total cost.
The figure brings together in a single picture four members of the family of cost curves
that we have derived from the total cost curve for Apollo Fruit Products’ Jams: the
marginal cost curve (MC), the average total cost curve (ATC), the average variable cost
curve (AVC), and the average fixed cost curve (AFC). All are based on the information in
above 2 tables. As before, cost is measured on the vertical axis and the quantity of
output is measured on the horizontal axis.
Let’s take a moment to note some features of the various cost curves. First of all,
marginal cost slopes upward—the result of diminishing returns that make an additional
unit of output more costly to produce than the one before. Average variable cost also
slopes upward—again, due to diminishing returns—but is flatter than the marginal cost
curve. This is because the higher cost of an additional unit of output is averaged across
all units, not just the additional units, in the average variable cost measure.
Meanwhile, average fixed cost slopes downward because of the spreading effect.
Cost of
case
125
MC
100
750
ATC
(In Rs. ’00) AVC
500 M
25
AFC
0 1 2 3 4 5 6 7 8 9 10
Quantity of Jams (cases)
Minimum-cost output
BIBS 94
Here we have the family of cost curves for Selena’s Gourmet Salsas: the
marginal cost curve (MC), the average total cost curve (ATC), the average
variable cost curve (AVC), and the average fixed cost curve (AFC). The average
total cost curve is U-shaped and the marginal cost curve crosses the average
total cost curve at the bottom of the U, point M, corresponding to the
minimum average total cost from the second table above and the previous
figure.
Finally, notice that the marginal cost curve intersects the average total cost curve from
below, crossing it at its lowest point, point M in the above figure. This last feature is
our next subject of study.
Minimum Average Total Cost
For a U-shaped average total cost curve, average total cost is at its minimum level at
the bottom of the U. Economists call the quantity of output that corresponds to the
minimum average total cost the minimum - cost output. In the case of Apollo Fruit
Products’ Jams, the minimum - cost output is three cases of Jams per day.
In the above figure, the bottom of the U is at the level of output at which the marginal
cost curve crosses the average total cost curve from below. Is this an accident? No—it
reflects general principles that are always true about a firm’s marginal cost and
average total cost curves:
• At the minimum -cost output, average total cost is equal to marginal cost.
• At output less than the minimum -cost output, marginal cost is less than average
total cost and average total cost is falling.
• At output greater than the minimum- cost output, marginal cost is greater than
average total cost and average total cost is rising.
To understand these principles, think about how your grade in one course— say, an
80% marks in Physics—affects your overall % score. If your % score before receiving
that marks was more than 90%, the new marks lowers your overall % score.
Similarly, if marginal cost—the cost of producing one more unit—is less than average
total cost, producing that extra unit lowers average total cost. This is shown in the
figure below by the movement from A1 to A2. In this case, the marginal cost of
producing an additional unit of output is low, as indicated by the point MCL on the
marginal cost curve. When the cost of producing the next unit of output is less than
average total cost, increasing production reduces average total cost. So any quantity of
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output at which marginal cost is less than average total cost must be on the downward
- sloping segment of the U.
Cost of MC
If marginal cost is
Unit
above average total
MCV ATC
cost, average total
cost is rising.
B2
A1
M B1
A2
MCc If marginal cost is

below average total
cost, average total
cost is falling.
Quantity
To see why the marginal cost curve must cut through the average total cost curve at
the minimum average total cost (point M), corresponding to the minimum-cost
output, we look at what happens if marginal cost is different from average total cost.
If marginal cost is less than average total cost, an increase in output must reduce
average total cost, as in the movement from A1 to A2. If marginal cost is greater than
average total cost, an increase in output must increase average total cost, as in the
movement from B1 to B2.
But if your % marks in Physics is more than the overall % marks of your previous scores,
this new marks raises your overall % marks. Similarly, if marginal cost is greater than
average total cost, producing that extra unit raises average total cost. This is illustrated
by the movement from B1 to B2 in the above figure, where the marginal cost, MCH, is
BIBS 96
higher than average total cost. So any quantity of output at which marginal cost is
greater than average total cost must be on the upward - sloping segment of the U.
Finally, if a new marks is exactly equal to your previous overall % score, the additional
marks neither raises nor lowers that average overall % score—it stays the same. This
corresponds to point M in the last figure: when marginal cost equals average total cost,
we must be at the bottom of the U, because only at that point is average total cost
neither falling nor rising.
Does the Marginal Cost Curve Always Slope Upward?

Up to this point, we have emphasized the importance of diminishing returns, which
lead to a marginal product curve that always slopes downward and a marginal cost
curve that always slopes upward. In practice, however, economists believe that
marginal cost curves often slope downward as a firm increases its production from zero
up to some low level, sloping upward only at higher levels of production: they look like
the curve MC in the figure below.
This initial downward slope occurs because a firm often finds that, when it starts with
only a very small number of workers, employing more workers and expanding output
allows its workers to specialize in various tasks. This, in turn, lowers the firm’s marginal
cost as it expands output. For example, one individual producing Jams would have to
perform all the tasks involved: selecting and preparing the ingredients, mixing the
Jams, bottling and labeling it, packing it into cases, and so on. As more workers are
employed, they can divide the tasks, with each worker specializing in one or a few
aspects of Jams - making. This specialization leads to increasing returns to the hiring of
additional workers and results in a marginal cost curve that initially slopes downward.
But once there are enough workers to have completely exhausted the benefits of
further specialization, diminishing returns to labor set in and the marginal cost curve
changes direction and slopes upward. So typical marginal cost curves actually have the
“swoosh” shape shown by MC in the figure below. For the same reason, average
variable cost curves typically look like AVC in the following figure: they are U-shaped
rather than strictly upward sloping.
However, as the following figure also shows, the key features we saw from the
example of Apollo Fruit Products’ Jams remain true: the average total cost curve is U-
shaped, and the marginal cost curve passes through the point of minimum average
total cost.
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More Realistic Cost Curve
Cost of 2…….. but diminishing

A realistic marginal cost curve MC
unit returns set in once the
has a “swoosh” shape. Starting
benefits from ATC
from a very low output level
specialization are
marginal cost often falls as the exhausted & MC rises. AVC
firm increases output. That’s
because hiring additional
workers allows greater
specialization of their tasks
and loads to increasing
returns. Once specialization is
achieved, workers set in and
marginal cost rises. The
corresponding average
variable cost cure is now U-
shaped, like the average total
1. Increasing specialization
cost curve.
leads to lower MC
Quantity
A realistic marginal cost curve has a “swoosh” shape. Starting from a very low output
level, marginal cost often falls as the firm increases output. That’s because hiring
additional workers allows greater specialization of their tasks & loads to increasing
returns. Once specialization is achieved, however, diminishing returns to additional
workers set in and marginal cost rises. The corresponding average variable cost curve
is now U-shaped, like the average total cost curve.
Short - Run versus Long - Run Costs
Up to this point, we have treated fixed cost as completely outside the control of a firm
because we have focused on the short run. But as we noted earlier, all inputs are
variable in the long run: this means that in the long run fixed cost may also be varied.
In the long run, in other words, a firm’s fixed cost becomes a variable it can choose. For
example, given time, Apollo Fruit Products can acquire additional food-preparation
equipment or dispose of some of its existing equipment. In this section, we will
examine how a firm’s costs behave in the short run and in the long run. We will also
see that the firm will choose its fixed cost in the long run based on the level of output it
expects to produce.
Let’s begin by supposing that Apollo Fruit Products is considering whether to acquire
additional food-preparation equipment. Acquiring additional machinery will affect its
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total cost in two ways. First, the firm will have to either rent or buy the additional
equipment; either way, that will mean higher fixed cost in the short run. Second, if the
workers have more equipment, they will be more productive: fewer workers will be
needed to produce any given output, so variable cost for any given output level will be
reduced.
The table in the following figure shows how acquiring an additional machine affects
costs. In our original example, we assumed that Apollo Fruit Products’ Jams had a fixed
cost of Rs. 5000. The left half of the table shows variable cost as well as total cost and
average total cost assuming a fixed cost of Rs. 5000. The average total cost curve for
this level of fixed cost is given by ATC1 in the following figure. Let’s compare that to a
situation in which the firm buys additional food-preparation equipment, doubling its
fixed cost to Rs. 10000 but reducing its variable cost at any given level of output. The
right half of the table shows the firm’s variable cost, total cost, and average total cost
with this higher level of fixed cost. The average total cost curve corresponding to Rs.
10000 in fixed cost is given by ATC2 in the following figure.
From the figure you can see that when output is small, 4 cases of Jams per day or
fewer, average total cost is smaller when Apollo Fruit Products forgoes the additional
equipment and maintains the lower fixed cost of Rs. 5000: ATC1 lies below ATC2. For
example, at 3 cases per day, average total cost is Rs. 3600 without the additional
machinery and Rs. 4500 with the additional machinery. But as output increases beyond
4 cases per day, the firm’s average total cost is lower if it acquires the additional
equipment, raising its fixed cost to Rs. 10800. For example, at 9 cases of Jams per day,
average total cost is Rs. 6000 when fixed cost is Rs. 5000 but only Rs. 3900 when fixed
cost is Rs. 10000.
Why does average total cost change like this when fixed cost increases? When output
is low, the increase in fixed cost from the additional equipment outweighs the
reduction in variable cost from higher worker productivity—that is, there are too few
units of output over which to spread the additional fixed cost. So if Apollo Fruit
Products plans to produce 4 or fewer cases per day, they would be better off choosing
the lower level of fixed cost, Rs. 5000, to achieve a lower average total cost of
production. When planned output is high, however, she should acquire the additional
machinery.
In general, for each output level there is some choice of fixed cost that minimizes the firm’s
average total cost for that output level. So when the firm has a desired output level that it
expects to maintain over time, it should choose the level of fixed cost optimal for that
level—that is, the level of fixed cost that minimizes its average total cost.
Now that we are studying a situation in which fixed cost can change, we need to take
time into account when discussing average total cost. All of the average total cost
curves we have considered until now are defined for a given level of fixed cost— that
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is, they are defined for the short run, the period of time over which fixed cost doesn’t
vary. To reinforce that distinction, for the rest of this chapter we will refer to these
average total cost curves as “short - run average total cost curves.”
For most firms, it is realistic to assume that there are many possible choices of fixed cost,
not just two. The implication: for such a firm, many possible short - run average total cost
curves will exist, each corresponding to a different choice of fixed cost and so giving rise to
what is called a firm’s “family” of short - run average total cost curves.
Choosing the Level of Fixed Cost for Apollo Fruit Jams
There is a trade-off between Cost of case

At low output levels,
higher fixed cost and lower At high output levels,
low FC yields lower high FC yields lower
variable cost for any given ATC ATC
output level and vice versa. 125
ATC1, is the average total cost
curve corresponding to a fixed 100
cost of Rs. 5000; it loads to
In
lower fixed cost and higher 75 Low Fixed cost
variable cost. ATC2 is the Rs.
ATC1
average total cost curve ‘00
50
corresponding to a higher fixed ATC2
cost of Rs. 1000 but lower High Fixed cost
25
variable cost. At low output
levels, at 4 or lower cases of
Jams per day. ATC1 has below 0 1 2 3 4 5 6 7 8 9 10
ATC2 average total cost is lower Quantity of Jams (cases)
with only Rs. 5000 in fixed cost.
But as output goes up, average High Fixed Cost (FC = Rs.
Low Fixed Cost (FC = Rs. 5000)
total cost is lower with the higher 10000)
amount of fixed cost. Rs. 10000 Average Average
at more than 4 cases of Jams Quantity High total Low total
Total Total
per day, ATC2 lies below ATC1. of salsa variable cost of variable cost of
cost cost
(cases) cost case cost case
ATC1 ATC2
Rs. Rs. Rs.
1 Rs. 600 Rs. 30 Rs.11100
6000 6000 11100
2 2400 7800 3900 1200 12000 6000
3 5400 10800 3600 2700 13500 4500
4 9600 15000 3750 4800 15600 3900
5 15000 20400 4080 7500 18300 3660
6 21600 27000 4500 10800 21600 3600
7 29400 34800 4971 14700 25500 3643
8 38400 43800 5475 19200 30000 3750
9 48600 54000 6000 24300 35100 3900
10 1,200 1308 130.80 600 816 81.60
There is a trade-off between higher fixed cost & lower variable cost for any given output level, and vice
versa. ATC1 is the average total cost curve corresponding to a fixed cost of Rs. 5000; it leads to lower fixed
cost and higher variable cost. ATC2 is the average total cost curve corresponding to a higher fixed cost of
Rs. 10000 but lower variable cost. At low output levels, at 4 or lower cases of Jams per day, ATC 1 lies
below ATC2: average total cost is lower with only Rs. 5000 in fixed cost. But as output goes up, average
total cost is lower with the higher amount of fixed cost, Rs. 10000: as more than 4 cases of salsa per day,
ATC2 lies below ATC1.
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At any given point in time, a firm will find itself on one of its short - run cost curves, the
one corresponding to its current level of fixed cost; a change in output will cause it to
move along that curve. If the firm expects that change in output level to be long -
standing, then it is likely that the firm’s current level of fixed cost is no longer optimal.
Given sufficient time, it will want to adjust its fixed cost to a new level that minimizes
average total cost for its new output level. For example, if Apple Fruit Products had
been producing 2 cases of Jams per day with a fixed cost of Rs. 5000 but found
themselves increasing their output to 8 cases per day for the foreseeable future, then
in the long run she should purchase more equipment and increase her fixed cost to a
level that minimizes average total cost at the 8-cases - per - day output level.
Suppose we do a thought experiment and calculate the lowest possible average total
cost that can be achieved for each output level if the firm were to choose its fixed cost
for each output level. Economists have given this thought experiment a name: the long
- run average total cost curve. Specifically, the long - run average total cost curve, or
LRATC, is the relationship between output and average total cost when fixed cost has
been chosen to minimize average total cost for each level of output. If there are many
possible choices of fixed cost, the long - run average total cost curve will have the
familiar, smooth U shape, as shown by LRATC in the figure below.
Constant
returns to
Increasing returns to scale scale Decreasing returns to scale
ATC1 ATC2 ATC3 LRATC
B Y
A X
C
3 4 5 6 7 8 9 Quantity of
Jams (cases)
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* IRS – Increasing Returns to Scale

CRS – Constant Returns to Scale
DRS – Decreasing Returns to Scale
Short-run and long-run average total cost curves differ because a firm can choose its
fixed cost in the long run. If Apollo Fruit Products has chosen the level of fixed cost
that minimizes short-run average total cost at an output of 6 cases, and actually
produces 6 cases, then she will be at point C on LRATC & ATC6. But if she produces
only 3 cases, she will move to point B. If she expects to produce only 3 cases for a
long time, in the long-run she will reduce her fixed cost and move to point A on
ATC3. Likewise, if she produces 9 cases (putting them at point Y) and expects to
continue this for a long time, they will increase their fixed cost in the long run &
move to point X.
In the long run, when a producer has had time to choose the fixed cost appropriate for
its desired level of output, that producer will be at some point on the long - run
average total cost curve. But if the output level is altered, the firm will no longer be on
its long - run average total cost curve and will instead be moving along its current short
- run average total cost curve. It will not be on its long - run average total cost curve
again until it readjusts its fixed cost for its new output level.
The above figure illustrates this point. The curve ATC3 shows short - run average total
cost if Apollo Fruit Products has chosen the level of fixed cost that minimizes average
total cost at an output of 3 cases of Jams per day. This is confirmed by the fact that at 3
cases per day, ATC3 touches LRATC, the long - run average total cost curve.
Similarly, ATC6 shows short - run average total cost if Apollo Fruit Products has chosen
the level of fixed cost that minimizes average total cost if their output is 6 cases per
day. It touches LRATC at 6 cases per day. And ATC9 shows short - run average total cost
if Apollo Fruit Products has chosen the level of fixed cost that minimizes average total
cost if her output is 9 cases per day. It touches LRATC at 9 cases per day.
Suppose that Apollo Fruit Products initially chose to be on ATC6. If they actually
produce 6 cases of Jams per day, their firm will be at point C on both its short - run and
long-run average total cost curves. Suppose, however, that Apollo Fruit Products ends
up producing only 3 cases of Jams per day. In the short run, her average total cost is
indicated by point B on ATC6; it is no longer on LRATC. If Apollo Fruit Products had
known that she would be producing only 3 cases per day, they would have been better
off choosing a lower level of fixed cost, the one corresponding to ATC3, thereby
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achieving a lower average total cost. Then their firm would have found itself at point A
on the long - run average total cost curve, which lies below point B.
Suppose, conversely, that Apollo Fruit Products end up producing 9 cases per day even
though they initially chose to be on ATC6. In the short run her average total cost is
indicated by point Y on ATC6. But they would be better off purchasing more equipment
and incurring a higher fixed cost in order to reduce their variable cost and move to
ATC9. This would allow her to reach point X on the long - run average total cost curve,
which lies below Y.
Returns to Scale
What determines the shape of the long - run average total cost curve? The answer is that
scale, the size of a firm’s operations, is often an important determinant of its long - run
average total cost of production. Firms that experience scale effects in production find
that their long - run average total cost changes substantially depending on the quantity
of output they produce. There are increasing returns to scale (also known as economies
of scale) when long - run average total cost declines as output increases. As you can see
in the above figure, Apollo Fruit Products’ Jams experiences increasing returns to scale
over output levels ranging from 0 up to 5 cases of Jams per day—the output levels over
which the long - run average total cost curve is declining. In contrast, there are
decreasing returns to scale (also known as diseconomies of scale) when long - run
average total cost increases as output increases. For Apollo Fruit Products’ Jams,
decreasing returns to scale occur at output levels greater than 7 cases, the output levels
over which its long - run average total cost curve is rising. There is also a third possible
relationship between long - run average total cost and scale: firms experience constant
returns to scale when long - run average total cost is constant as output increases. In this
case, the firm’s long - run average total cost curve is horizontal over the output levels for
which there are constant returns to scale. As you can see in the above figure, Apollo Fruit
Products’ Jams has constant returns to scale (CRS) when it produces anywhere from 5 to
7 cases of Jams per day.
What explains these scale effects in production? The answer ultimately lies in the
firm’s technology of production. Increasing returns often arise from the increased
specialization that larger output levels allow—a larger scale of operation means that
individual workers can limit themselves to more specialized tasks, becoming more
skilled and efficient at doing them. Another source of increasing returns is very large
initial set up cost; in some industries—such as auto manufacturing electricity
generating, or petroleum refining—incurring a high fixed cost in the form of plant and
equipment is necessary to produce any output. A third source of increasing returns,
found in certain high- tech industries such as software development, is known as a
network externality. The classic example is computer operating systems. Worldwide,
most personal computers run on Microsoft Windows. Although many believe that
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Apple has a superior operating system, the wider use of Windows in the early days of
personal computers attracted more software development and technical support,
giving it lasting dominance. Decreasing returns—the opposite scenario—typically arise
in large firms due to problems of coordination and communication: as the firm grows
in size, it becomes ever more difficult and so more costly to communicate and to
organize its activities. Although increasing returns induce firms to get larger,
decreasing returns tend to limit their size. And when there are constant returns to
scale, scale has no effect on a firm’s long - run average total cost: it is the same
regardless of whether the firm produces 1 unit or 100,000 units.
Summing Up Costs: The Short and Long of It

If a firm is to make the best decisions about how much to produce, it has to understand
how its costs relate to the quantity of output it chooses to produce. Table below
provides a quick summary of the concepts and measures of cost you have learned
about.
Concepts & Measures of Cost
Short Run And/ Or

Measurement Definition Mathematical Form
Long Run
Cost that does not
depend on the
Fixed Cost FC
Short Run quantity of output
produced
Fixed Cost per unit
Average Fixed Cost AFC = FC/Q
of output
Cost that depends
Variable Cost on the quantity of VC
output produced
Average Variable Variable Cost per
AVC = VC / Q
Cost unit of output
Sum of Fixed Cost
Short Run and TC = FC (Short Run) +
Total Cost (Short Run) &
Long Run VC
Variable Cost
Average Total Cost Total Cost per unit of
ATC = TC / Q
(Average Cost) output
The change in total
cost generated by
Marginal Cost MTC = dTC/dQ
producing one more
unit of output
Average Total Cost:
When fixed cost
Long Run Average
Long Run have been chosen to LRATC
Total Cost
minimize average
total cost for each
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level of output
Economies of scale
Economies of scale are factors that cause the average cost of producing something to
fall as the volume of its output increases. Hence it might cost Rs. 1,50,000 to produce
100 copies of a magazine but only Rs. 2,00,000 to produce 1,000 copies. The average
cost in this case has fallen from Rs. 1500 to Rs. 200 a copy because the main elements
of cost in producing a magazine (editorial and design) are unrelated to the number of
magazines produced.
Economies of scale were the main drivers of corporate gigantism in the 20th century.
They were fundamental to Henry Ford's revolutionary assembly line, and they continue
to be the spur to many mergers and acquisitions today.
There are two types of economies of scale:
• Internal. These are cost savings that accrue to a firm regardless of the industry,
market or environment in which it operates.
• External. These are economies that benefit a firm because of the way in which
its industry is organised.
Internal economies of scale arise in a number of areas. For example, it is easier for
large firms to carry the overheads of sophisticated research and development (R&D). In
the pharmaceuticals industry R&D is crucial. Yet the cost of discovering the next
blockbuster drug is enormous and increasing. Several of the mergers between
pharmaceuticals companies in recent years have been driven by the companies' desire
to spread their R&D expenditure across a greater volume of sales.
Economies of scale, however, have a dark side, called diseconomies of scale. The larger
an organisation becomes in order to reap economies of scale, the more complex it has
to be to manage and run such scale. This complexity incurs a cost, and eventually this
cost may come to outweigh the savings gained from greater scale. In other words,
economies of scale cannot be gleaned for-ever.
Frederick Herzberg, a distinguished professor of management, suggested a reason why

companies should not aim blindly for economies of scale:
Numbers numb our feelings for what is being counted and lead to adoration of the
economies of scale. Passion is in feeling the quality of experience, not in trying to
measure it.
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T. Boone Pickens, a geologist turned oil magnate turned corporate raider, wrote about
diseconomies of scale in his 1987 autobiography:
It's unusual to find a large corporation that's efficient. I know about economies of scale
and all the other advantages that are supposed to come with size. But when you get an
inside look, it's easy to see how inefficient big business really is. Most corporate
bureaucracies have more people than they have work.
Diseconomies of scale
Economic theory predicts that a firm may become less efficient if it becomes too large.
The additional costs of becoming too large are called diseconomies of scale.
Diseconomies of scale result in rising long run average costs which are experienced
when a firm expands beyond its optimum scale, at Q.
Cost &
Revenue
Long run
average cost
Economics of Diseconomies curve
scale of scale
A
C
Q Output
Examples of diseconomies include:
1. Larger firms often suffer poor communication because they find it difficult to
maintain an effective flow of information between departments, divisions or
between head office and subsidiaries. Time lags in the flow of information can also
create problems in terms of the speed of response to changing market conditions.
For example, a large supermarket chain may be less responsive to changing tastes
and fashions than a much smaller, ‘local’ retailer.
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2. Co-ordination problems also affect large firms with many departments and
divisions, and may find it much harder to co-ordinate its operations than a smaller
firm. For example, a small manufacturer can more easily co-ordinate the activities
of its small number of staff than a large manufacturer employing tens of
thousands.
3. ‘X’ inefficiency is the loss of management efficiency that occurs when firms become
large and operate in uncompetitive markets. Such loses of efficiency include over
paying for resources, such as paying managers salaries higher than needed to
secure their services, and excessive waste of resources. ‘X’ inefficiency means that
average costs are higher than would be experienced by firms in more competitive
markets.
4. Low motivation of workers in large firms is a potential diseconomy of scale that
results in lower productivity, as measured by output per worker.
5. Large firms may experience inefficiencies related to the principal-agent problem.
This problem is caused because the size and complexity of most large firms means
that their owners often have to delegate decision making to appointed managers,
which can lead to inefficiencies. For example, the owners of a large chain of
clothes retailers will have to employ managers for each store, and delegate some
of the jobs to managers but they may not necessarily make decisions in the best
interest of the owners. For example, a store manager may employ the most
attractive sales assistant rather than the most productive one.
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SUMMARY
1 A production function shows the maximum amounts of output that can be
produced from a set of inputs.
2 All points on a production function involve technical efficiency, but only one
represents economic efficiency, given prices for the inputs.
3 The functional form of a production function is important because it gives

information about the marginal products of the inputs, output elasticities and
returns to scale.
4 Returns to scale describe how a proportionate increase in all inputs affects output;
they can be increasing, constant or decreasing.
5 The optimal combination of inputs in the long run is achieved when the marginal
product of each input as a ratio of its price is equal.
6 In the short run, production is subject to increasing and then diminishing returns.
7 The optimal level of use of the variable factor in the short run is given by the
condition MRP = MFC.
8 There are three main applications of production theory in terms of managerial

decision-making: capacity planning, marginal analysis and evaluation of trade-offs.
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Managerial Economics National Income
NATIONAL INCOME
CONCEPT & MEASUREMENT
Objectives
 The chapter aims at determining the level of economic activity of a country
 This chapter will help you to understand that the productive capacity of a
nation will increase only if net investment is positive
 The objective is to prepare you to estimate the overall performance of the

country during a given financial year
 The National Income statistics will educate you on the factors responsible for
the growth of an economy
 You shall learn to provide economic policy relating to planning and active
government intervention in the Economy
 Learn about the importance of budget as an effective tool for planning
National Income – Concept & Measurement
Gross Domestic Product

Of all the concepts in macroeconomics, the single most important measure is the gross
domestic product (GDP), which measures the total value of goods and services
produced in a country. GDP is part of the national income and product accounts (or
national accounts), which are a body of statistics that enable policymakers to
determine whether the economy is contracting or expanding and whether a severe
recession or inflation threatens. When Economists want to determine the level of
economic development of a country, they look at its GDP per capita.
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National Income Managerial Economics
While the GDP and the rest of the national accounts may seem to be arcane concepts,
they are truly among the great inventions of the twentieth century. Much as a satellite
in space can survey the weather across an entire continent, so can the GDP give an
overall picture of the state of the economy. In this chapter, we shall explain how
economists measure GDP and other major macroeconomic concepts.
Gross Domestic Product: The Yardstick of an Economy’s

Performance
What is the gross domestic product? GDP is the name we give to the total market value
of the final goods and services produced within a nation during a given year. It is the
figure you get when you apply the measuring rod of money to the diverse goods and
services—from apples to zithers—that a country produces with its land, labor, and
capital resources. GDP equals the total production of consumption and investment
goods, government purchases, and net exports to other lands. The gross domestic
product (GDP) is the most comprehensive measure of a nation’s total output of goods
and services. It is the sum of the dollar values of consumption (C), gross investment (I),
government purchases of goods and services (G), and net exports (X) produced within
a nation during a given year.
In symbols:
GDP = C + I + G + X
GDP is used for many purposes, but the most important one is to measure the overall
performance of an economy. If you were to ask an economic historian what happened
during the Great Depression, the best short answer would be:
Between 1929 and 1933, GDP in the US fell from $104 billion to $56 billion.
This sharp decline in the dollar value of goods and services produced by the
American economy caused high unemployment, hardship, a steep stock
market decline, bankruptcies, bank failures, riots, and political turmoil.
We now discuss the elements of the national income and product accounts. We start
by showing different ways of measuring GDP and distinguishing real from nominal
GDP. We then analyze the major components of GDP. We conclude with a discussion of
the measurement of the general price level and the rate of inflation.
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Two Measures of National Product: Goods Flow and Earnings Flow

Circular Flow of Macroeconomic Activity
Consumption purchases
(a)
Final goods and services
(bread, computers, haircuts, etc.
Purchasers
(households, Producers
governments, (businesses)
…)
(b)
Productive services
(labor, land, etc.)
Wages, rents, profit, etc.
Figure 13 A: Gross Domestic Product Can Be Measured Either as (a) a Flow of Final
Products or, Equivalently, as (b) a Flow of Costs
How do economists actually measure GDP? One of the major surprises is that we can
measure GDP in two entirely independent ways. As Figure 5-1 shows, GDP can be
measured either as a flow of products or as a sum of earnings. To demonstrate the
different ways of measuring GDP, we begin by considering an oversimplified world in
which there is no government, foreign trade, or investment. For the moment, our little
economy produces only consumption goods, which are items that are purchased by
households to satisfy their wants. (Important note: Our first example is oversimplified
to show the basic ideas. In the realistic examples that follow, we will add investment,
government, and the foreign sector.)
Flow-of-Product Approach.
Each year the public consumes a wide variety of final goods and services: goods such as
apples, computer software, and blue jeans; services such as health care and haircuts.
We include only final goods—goods ultimately bought and used by consumers.
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Households spend their in-comes for these consumer goods, as is shown in the upper
loop of Figure 15-1. Add together all the consumption dollars spent on these final
goods, and you will arrive at this simplified economy’s total GDP.
Thus, in our simple economy, you can easily calculate national income or product as the
sum of the annual flow of final goods and services: (price of blue jeans _ number of blue
jeans) plus (price of apples _ number of apples) and so forth for all other final goods. The
gross domestic product is defined as the total money value of the flow of final products
produced by the nation.
National accountants use market prices as weights in valuing different commodities

because market prices reflect the relative economic value of diverse goods and
services. That is, the relative prices of different goods reflect how much consumers
value their last (or marginal) units of consumption of these goods.
Earnings or Cost Approach.

The second and equivalent way to calculate GDP is the earnings or cost approach. Go to
the lower loop in Figure 15-1. Through it flow all the costs of doing business; these costs
include the wages paid to labor, the rents paid to land, the profits paid to capital, and so
forth. But these business costs are also the earnings that households receive from firms. By
measuring the annual flow of these earnings or incomes, statisticians will again arrive at
the GDP.
Product approach Earnings approach

Components of gross domestic product: Earnings or costs as sources of gross domestic product:
Consumption (C) Wages, salaries and other labor income
+ Gross private domestic investment (l) + Interest, rent and other property income
+ Government purchases (G) + Indirect taxes
+ Net exports (X) + Depreciation
+ Profits
Equals : Gross domestic product Equals: Gross domestic product
Table 13 B - Overview of the National Income and Product Accounts

This table presents the major components of the two sides of the national
accounts. The left side shows the components of the product approach (or upper
loop); the symbols C, I, G, and X are often used to represent these four items of
GDP. The right side shows the components of the earnings or cost approach (or
lower loop). Each approach will ultimately add up to exactly the same GDP
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Hence, a second way to calculate GDP is as the total of factor earnings (wages, interest,
rents, and profits) that are the costs of producing society’s final products.
Equivalence of the Two Approaches:
Now we have calculated GDP by the upper-loop flow-of-product approach and by the
lower-loop earnings-flow approach. Which is the better approach? The surprise is that
they are exactly the same. We can see why the product and earnings approaches are
identical by examining a simple barber shop economy. Say the barbers have no
expenses other than labor. If they sell 10 haircuts at Rs8 each, GDP is Rs80. But the
barbers’ earnings (in wages and profits) are also exactly Rs80. Hence, the GDP here is
identical whether measured as flow of products (Rs80 of haircuts) or as cost and
income (Rs80 of wages and profits).
In fact, the two approaches are identical because we have included “profit” in the
lower loop along with other incomes. What exactly is profit? Profit is what remains
from the sale of a product after you have paid the other factor costs—wages, interest,
and rents. It is the residual that adjusts automatically to make the lower loop’s costs or
earnings exactly match the upper loop’s value of goods.
In Brief : GDP, or gross domestic product, can be measured in two

different ways:
(1) as the flow of final products, or
(2) as the total costs or earnings of inputs producing output.

Because profit is a residual, both approaches will yield exactly
the same total GDP.
The Problem of “Double Counting”

We defined GDP as the total production of final goods and services. A final product is
one that is produced and sold for consumption or investment. GDP excludes
intermediate goods—goods that are used up to produce other goods. GDP therefore
includes bread but not wheat, and home computers but not computer chips.
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For the flow-of-product calculation of GDP, excluding intermediate products poses no

major complications. We simply include the bread and computers in GDP but avoid
including the wheat and dough that went into the bread or the chips and plastic that
went into the computers. If you look again at the upper loop in Figure 5-1, you will see
that bread and computers appear in the flow of products, but you will not find any
flour or computer chips.
What has happened to products like flour and computer chips? They are intermediate
products and are simply cycling around inside the block marked “Producers.” If they
are not bought by consumers, they never show up as final products in GDP.
“Value Added” in the Lower Loop.

A new statistician who is being trained to make GDP measurements might be puzzled,
saying:
I can see that, if you are careful, your upper-loop product approach
to GDP will avoid including inter-mediate products. But aren’t you in
some trouble when you use the lower-loop cost or earnings
approach?
After all, when we gather income statements from the accounts of firms, won’t we pick
up what grain merchants pay to wheat farmers, what bakers pay to grain merchants,
and what grocers pay to bakers? Won’t this result in double counting or even triple
counting of items going through several productive stages?
These are good questions, but there is an ingenious answer that resolves the problem.
In making lower-loop earnings measurements, statisticians are very careful to include
in GDP only a firm’s value added. Value added is the difference between a firm’s sales
and its purchases of materials and services from other firms.
In other words, in calculating the GDP earnings or value added by a firm, the
statistician includes all costs except for payments made to other businesses. Hence
business costs in the form of wages, salaries, interest payments, and dividends are
included in value added, but purchases of wheat or steel or electricity are excluded
from value added. Why are all the purchases from other firms excluded from value
added to obtain GDP? That is because those purchases will get counted in GDP in the
values added by other firms.
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Bread Receipts, Costs and Value Added (Rs per loaf)

(1) (2) (3)
Less : Cost of Value added
Stage of Sales Intermediate (wages, profit, etc.)
Production Receipts products (3) = (1) – (2)
Wheat 23 0 = 23
Flour 53 23 = 30
Baked dough 110 53 = 57
Final product bread 190 110 = 80
Total 376 186 190

(sum of value added)
Table 13 C- GDP Sums Up Value Added At Each Production Stage
To avoid double counting of intermediate products, we calculate value added at

each stage of production. This involves subtracting all the costs of materials and
intermediate products bought from other businesses from total sales. Note that
every black intermediate-product item both appears in column (1) and is
subtracted in the next stage of production in column (2). (How much would we
overestimate GDP if we counted all receipts, not just value added? The
overestimate would be 186 cents per loaf.)
The above figure uses the stages of bread production to illustrate how careful
adherence to the value-added approach enables us to subtract purchases of inter-
mediate goods that show up in the income statements of farmers, millers, bakers, and
grocers. The final calculation shows the desired equality between –
1) Final sales of bread and
2) Total earnings, calculated as the sum of all values added in all the different
stages of bread production.
Value-added approach:
To avoid double counting, we take care to include only final goods in GDP and to
exclude the intermediate goods that are used up in making the final goods. By
measuring the value added at each stage, taking care to subtract expenditures on the
intermediate goods bought from other firms, the lower-loop earnings approach
properly avoids all double counting and records wages, interest, rent, and profit exactly
one time.
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Real vs. Nominal GDP
We define GDP as the currency value of goods and services. In measuring the currency
value, we use the measuring rod of market prices for the different goods and services.
But prices change over time, as inflation generally sends prices upward year after year.
Who would want to measure things with a rubber yard-stick—one that stretches in
your hands from day to day—rather than a rigid and invariant yardstick?
The problem of changing prices is one of the problems economists have to solve when they
use money as their measuring rod. Clearly, we want a measure of the nation’s output and
income that uses an invariant yardstick. Economists can replace the elastic yardstick with a
reliable one by removing the price-increase component so as to create a real or quantity
index of national output.
Here is the basic idea: We can measure the GDP for a particular year using the actual
market prices of that year; this gives us the nominal GDP or GDP at current prices. But
we are usually more interested in determining what has happened to the real GDP,
which is an index of the volume or quantity of goods and services produced. We
measure real GDP by multiplying the quantities of goods by an invariant or fixed set of
prices. Hence, nominal GDP is calculated using changing prices while real GDP is
calculated using constant prices.
When we divide nominal GDP by real GDP, we obtain the GDP deflator, which serves as a
measure of the overall price level. We can calculate real GDP by dividing nominal GDP by
the GDP deflator.
A simple example to illustrate the general idea

Say that a country produces 1000 tons of corn in year 1 and 1010 tons in year 2. The price of a bushel
is Rs 10 in year 1 and Rs 20 in year 2. We can calculate nominal GDP (PQ) as Rs 10 x 1000 = Rs
10,000 in year 1 and Rs 2 x 1010 = Rs 20,200 in year 2. Nominal GDP therefore grew by 102 percent
between the two years.
But the actual amount of output did not grow anywhere near that rapidly. To find real output, we need
to consider what happened to prices. We use year 1 as the base year, or the year in which we measure
prices. We set the price index, the GDP deflator, as P1= 1 in the first, or base, year. From the data in the
previous paragraph, we see that the GDP deflator is P2= Rs 20/Rs 10 = 2 in year 2. Real GDP (Q) is equal
to nominal GDP (PQ) divided by the GDP deflator (P). Hence real GDP was equal to Rs 10,000/10 = Rs
1,000 in year 1 and Rs 20,200/2 = Rs 1,010 in year 2. Thus the growth in real GDP, which corrects for
the change in prices, is 1% and equals the growth in the output of corn, as it should.
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• Nominal GDP is GDP evaluated at current market prices. Therefore, nominal GDP will
include all of the changes in market prices that have occurred during the current year
due to inflation or deflation
• Real GDP : The value of a nation’s output of goods and services in a particular year
adjusted for changes in the prices of goods and services (inflation) from a base year.
Hence, Real GDP is equal to nominal GDP adjusted for Inflation
• GDP deflator: It is another way to measure inflation of an economy. Using real GDP
and nominal GDP, one can calculate an implicit index of the price level for the year.
This index is called the GDP deflator and is given by the formula:
Deflator = Nominal GDP / Real GDP X 100
Output in 2009 (Base year)

Products Quantity (Q) Price (P) Value (PXQ)
Cheese 10 2 20
Chocolate 20 2 40
Shirts 5 10 50
Base year GDP for 2009 (20+40+50) = Rs 110
Output in 2009 (Base year)

Products Quantity (Q) Price (P) Value (PXQ)
Cheese 12 2.5 30
Chocolate 25 3 75
Shirts 5 11 55
Nominal GDP for 2010(30+75+55) = Rs 160
There is a big increase in the nominal GDP by approximately 45% ( i.e. ((160-110)/
110)*100).
If you refer to the second table, there is an increase in the output for 2 out of the 3
items while price has increased for all 3.
Calculating Real GDP for the year 2010 (Considering Quantity for the new year and
Prices for base year):
Output in 2010 Quantity (Q) -2010 Price (P) in 2009 Value (PXQ)
Cheese 12 2 24
Chocolate 25 2 50
Shirts 5 10 50
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Real GDP (24+50+50) = Rs 124
Growth in Real GDP is = (124-110)/110= 12.72%

(Nominal GDP/Real GDP) (160/124)*100= 129
This means that nominal GDP for 2010 needs to be deflated by 1.29 to arrive at the real
GDP.
Consumption
The first important part of GDP is consumption, or “personal consumption
expenditures.” Consumption is by far the largest component of GDP, equaling about
two-thirds of the total in recent years. Figure 5-3 shows the fraction of GDP devoted to
consumption over the last six decades. Consumption expenditures are divided into
three categories: durable goods such as automobiles, nondurable goods such as food,
and services such as medical care. The most rapidly growing sector is services.
Figure 13 E - Share of Consumption in National Output Has Risen Recently
The share of consumption in total GDP rose during the Great Depression as
investment prospects soured, then shrank sharply during World War II when
the war effort displaced civilian needs. In the last two decades, consumption
has grown more rapidly than total out-put as the national savings rate and
government purchases have declined. (Source: U.S. Department of
Commerce.)
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Investment and Capital Formation

So far, our analysis has banished all capital. In real life, however, nations devote part of
their output to production of capital—durable goods that increase future production.
Increasing capital requires the sacrifice of current consumption to increase future
consumption. Instead of eating more pizza now, people build new pizza ovens to make
it possible to produce more pizza for future consumption.
In the accounts, investment consists of the additions to the nation’s capital stock of
buildings, equipment, software, and inventories during a year. The national accounts
include mainly tangible capital (such as buildings and computers) but omit most in-
tangible capital (such as research and development or educational expenses).
Real investment vs. Financial Investment

Economists define “investment” (or sometimes real investment) as production of
durable capital goods. In common usage, “in-vestment” often denotes using money to
buy General Motors stock or to open a savings account. For clarity, economists call this
financial investment. Try not to confuse these two different uses of the word
“investment.” If I take Rs1000 from my safe and buy some Internet stocks, this is not
what macroeconomists call investment. I have simply exchanged one financial asset for
another. Investment takes place when a physical capital good is produced.
How does investment fit into the national ac-counts? If people are using part of
society’s production possibilities for capital formation rather than for consumption,
economic statisticians recognize that such outputs must be included in the upper-loop
flow of GDP. Investments represent additions to the stock of durable capital goods that
increase production possibilities in the future. So we must modify our original
definition to read:
In Brief
Gross domestic product is the sum of all final products. Along with
consumption goods and services, we must also include gross
investment.
Net vs. Gross Investment:
Our revised definition includes “gross investment” along with consumption. What does
the word “gross” mean in this context? It indicates that investment includes all
investment goods produced. Gross investment is not adjusted for depreciation, which
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measures the amount of capital that has been used up in a year. Thus gross investment
includes all the machines, factories, and houses built during a year—even though some
were produced simply to replace some old capital goods that burned down or were
thrown on the scrap heap.
If you want to get a measure of the increase in society’s capital, gross investment is not a
sensible measure. Because it excludes a necessary allowance for depreciation, it is too
large—too gross.
An analogy to population will make clear the importance of considering depreciation. If

you want to measure the increase in the size of the population, you cannot simply
count the number of births, for this would clearly exaggerate the net change in
population. To get population growth, you must also sub-tract the number of deaths.
The same point holds for capital. To find the net increase in capital, you must start with
gross investment and subtract the deaths of capital in the form of depreciation, or the
amount of capital used up.
Thus to estimate capital formation we measure net investment. Net investment is

always births of cap-ital (gross investment) less deaths of capital (capital depreciation):
In Brief
Net investment = Gross investment - Depreciation
Government
Up to now we have talked about consumers but ignored the biggest buyers of all—
central, state, and local governments. Somehow GDP must take into ac-count the
billions of dollars of product a nation collectively consumes or invests. How do we do
this?
Measuring government’s contribution to national output is complicated because most

government services are not sold on the marketplace. Rather, government purchases both
consumption-type goods (like food for the military) and investment-type items (such as
computers or roads). In measuring government’s contribution to GDP, we simply add all
these government purchases to the flow of consumption, investment, and, as we will see
later, net exports.
Hence, all the government payroll expenditures on its employees plus the costs of
goods it buys from private industry (lasers, roads, and airplanes) are included in this
third category of flow of products, called “government consumption expenditures and
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gross investment.” This category equals the contribution of RBI, state, and local
governments to GDP.
Exclusion of Transfer Payments:
Does this mean that every dollar of government expenditure is included in GDP?
Definitely not. GDP includes only government purchases of goods and services; it
excludes spending on transfer payments.
Government transfer payments are government payments to individuals that are not
made in ex-change for goods or services supplied. Examples of government transfers
include unemployment insurance, veterans’ benefits, and old-age or disability
payments. These payments meet important social purposes, but, since they are not
purchases of current goods or services, they are omitted from GDP.
Thus if you receive a wage from the government because you are a teacher, your wage
is a factor payment and would be included in GDP. If you receive a welfare payment
because you are poor, that payment is not in return for a service but is a transfer
payment and would be excluded from GDP.
One peculiar government transfer payment is the interest on the government debt.
Interest is treated as a payment for debt incurred to pay for past wars or government
programs and is not considered to be a purchase of a current good or service.
Government interest payments are considered transfers and are therefore omitted
from GDP.
Finally, do not confuse the way the national ac-counts measure government spending
on goods and services (G) with the official government budget. When the Treasury
measures its expenditures, it includes expenditures on goods and services (G) plus
transfers.
Taxes
In using the flow-of-product approach to compute GDP, we need not worry about how
the government finances it’s spending. It does not matter whether the government
pays for its goods and services by taxing, by printing money, or by borrowing.
Wherever the rupees come from, the statistician computes the governmental
component of GDP as the actual cost to the government of the goods and services.
But while it is fine to ignore taxes in the flow-of-product approach, we must account
for taxes in the earnings or cost approach to GDP. Consider wages, for example. Part of
my wage is turned over to the government through personal income taxes. These
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direct taxes definitely do get included in the wage component of business expenses
and the same holds for direct taxes (personal or corporate) on interest, rent, and
profit.
Or consider the sales tax and other indirect taxes that manufacturers and retailers have
to pay on a loaf of bread (or on the wheat, flour, and dough stages). Suppose these
indirect taxes total Rs 10 per loaf, and suppose wages, profit, and other value-added
items cost the bread industry Rs 90. What will the bread sell for in the product
approach? For Rs 90? Surely not. The bread will sell for Rs 100, equal to Rs 90 of factor
costs plus Rs 10 of indirect taxes.
Thus the cost approach to GDP includes both in-direct and direct taxes as elements of
the cost of producing final output.
Gross Domestic Product, Net Domestic Product, and Gross

National Product
Although GDP is the most widely used measure of national output in the United States,
two other concepts are frequently cited: net domestic product and gross national
product.
Recall that GDP includes gross investment, which is net investment plus depreciation. A
little thought suggests that including depreciation is rather like including wheat as well as
bread. A better measure would include only net investment in total output. By
subtracting depreciation from GDP we obtain net domestic product (NDP). If NDP is a
sounder measureof a nation’s output than GDP, why do national accountants focus on
GDP? They do so because depreciation is somewhat difficult to estimate, whereas gross
investment can be estimated fairly accurately.
In Brief
Net domestic product (NDP) equals the total final output produced
within a nation during a year, where output includes net investment,
or gross in-vestment less depreciation:
NDP = GDP - Depreciation

Gross national product (GNP) is the total final output produced with
inputs owned by the residents of a country during a year.
1. GDP from the product side is the sum of four major components:
 Personal consumption expenditure on goods and services ( C )
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 Gross private domestic investment (I)

 Government consumption expenditures and gross investment (G)
 Net exports of goods and services (X), or export minus imports
2. GDP from the cost side is the sum of the following major components:
 Wages and salaries, interest rents, and profits ( always with the careful
exclusion, by the vale-added technique, of double counting of intermediate
goods bought from other firms)
 Indirect business taxes that show up as an expense of producing the flow of
products
 Depreciation
3. The product and cost measures of GDP are identical (by adherence to the rules of
value-added bookkeeping and the definition of profit as a residual).
4. Net domestic product (NDP) equals GDP minus depreciations.
An alternative measure of national output, widely used until recently, is gross national
product (GNP). What is the difference between GNP and GDP? GNP is the total output
produced with labor or capital owned by U.S. residents, while GDP is the output
produced with labor and capital located inside the United States. For example, some of
the U.S. GDP is produced in Honda plants that are owned by Japanese corporations.
The profits from these plants are included in U.S. GDP but not in U.S. GNP because
Honda is a Japanese company. Similarly, when an American economist flies to Japan to
give a paid lecture on baseball economics, payment for that lecture would be included
in Japanese GDP and in American GNP. For the United States, GDP is very close to GNP,
but these may differ substantially for very open economies.
GDP and NDP: A Look at Numbers

Flow-of-Product Approach:
Look first at the left side of the table. It gives the upper-loop, flow-of-product approach
to GDP. Each of the four major components appears there, along with the production
in each component for 1999. Of these, C and G and their obvious sub-classifications
require little discussion.
Gross private domestic investment does require one comment. Its total ($ 1623 billion)
includes all new business fixed investment, residential construction, and increase in
inventory of goods. This gross total excludes subtraction for depreciation of capital.
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After subtracting $ 945 billion of depreciation from gross investment, we obtain $ 678
billion of net investment for country X.
Finally, note the large negative entry for net ex-ports, $ 254 billion. This negative entry
represents the fact that the nation imported $ 254 billion more in goods and services
than it exported.
Gross Domestic Product
Product Approach Earnings or Cost Approach

1. Personal consumption expenditure 6,257 1. Wages, salaries and supplements 5,332
Durable goods 759 2. Net interest 468
Nondurable goods 1,843 3. Rental income of persons 146
Services 3,656 4. Indirect business taxes, adjustments,
2. Gross private domestic investment 1,623 and statistical discrepancy 815
Residential fixed 411 5. Depreciation 945
Business fixed 1,167 6. Income of unincorporated enterprises 658
Change in inventories 45 7. Corporate profits before taxes (adjusted) 893
3. Government consumption and Corporate profit taxes 259
Investment purchases 1,630 Dividends 365
4. Net exports - 254 Undistributed profits 259
Exports 998
Imports 1,252
Gross domestic product 9,256 Gross domestic product 9,256
Table 13 G - The Two Ways of Looking at the GDP Accounts
The left side measures flow of products (at market prices). The right side measures
flow of costs (factor earnings and depreciation plus indirect taxes).
From GDP to Disposable Income

The basic GDP accounts are of interest not only for themselves but also because of
their importance for understanding how consumers and businesses behave. Some
further distinctions will help illuminate the way the nation’s books are kept.
National Income
To help us understand the division of total income among the different factors of
production, we construct data on national income (NI). NI represents the total incomes
received by labor, capital, and land. It is constructed by subtracting depreciation and
indirect taxes from GDP. National income equals total compensation of labor, rental
income, net interest, income of proprietors, and corporate profits.
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Disposable Income
A second important concept asks how many dollars per year do households actually have
available to spend. The concept of disposable personal income (usually called disposable
income, or DI) answers this question. To get disposable income, you calculate the market
and transfer incomes received by households and subtract personal taxes. Disposable
income is what actually gets into the public’s hands for consumers to dispose of as they
please.
In Brief
DI is what people divide between (1) consumption spending and (2)
personal saving.
Saving and Investment

As we have seen, output can be either consumed or invested. Investment is an
essential economic activity because it increases the capital stock available for future
production. One of the most important points about national accounting is the identity
between saving and investment. We will show that, under the accounting rules
described above, measured saving is exactly equal to measured investment. This
equality is an identity, which means that it must hold by definition.
In the simplest case, assume for the moment that there is no government or foreign
sector. Investment is that part of national output which is not consumed. Saving is that
part of national income which is not consumed. But since national income and output
are equal, this means that saving equals investment.
In symbols:
I _product-approach GDP minus C
S _earnings-approach GDP minus C
But the measures always give the same measure of GDP, so
I _ S: the identity between measured saving and investment
That is the simplest case. We also need to consider the complete case which brings
businesses, government, and net exports into the picture. On the saving side, total or
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national saving (ST) is composed of private saving by households and businesses (SP)
along with government saving (SG). Government saving equals the government’s
budget surplus or the difference between tax revenues and expenditures.
Net exports
Depreciation
Government Indirect taxes
Direct taxes
Transfer payments
Investment
Net business saving
GDP
National
DI
income
Consumption
Gross domestic product National Income Disposable Income

(GDP) (NI) (DI)
Figure 3 H - Starting with GDP, We Can Calculate National Income (N I) and

Disposable Personal Income (D I)
On the investment side, total or national investment (I T) starts with gross private
domestic investment (I) but also adds net foreign investment, which is approximately
the same as net exports (X).
In Brief
National Investment = Private Investment + Net Export = Private
Savings + Government Savings = National Savings
OR
I T= I + X = S P+ S G= S T
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National saving equals national investment by definition. The components of

investment are private domestic investment and foreign investment (or net exports).
The sources of saving are private saving (by households and businesses) and
government saving (the government budget surplus). Private in-vestment plus net
exports equals private saving plus the budget surplus. These identities must hold
always, whatever the state of the business cycle.
In the simplest case, assume for the moment that there is no government or foreign
sector. Investment is that part of national output which is not consumed. Saving is that
part of national income which is not consumed. But since national income and output
are equal, this means that saving equals investment. Saving involves income that is not
consumed. The Savings Ratio is the % of income that is saved.
Investment in economics is defined as an addition to the capital stock. (Gross fixed

capital formation) For example, investment can involve spending on factories or new
capital. Investment can also involve spending on human capital such as investment in
training and education.
Saving is a factor in influencing the level of investment. If there is an increase in

savings, then banks can lend more to firms to finance investment projects. In a simple
economic model, we can say the level of saving will equal the level of investment.
Beyond the National Accounts

Advocates of the existing economic and social system often argue that market
economies have produced a growth in real output never before seen in human history.
“Look how GDP has grown because of the genius of free markets,” say the admirers of
capitalism.
But critics point out the deficiencies of GDP. GDP includes many questionable entries
and omits many valuable economic activities.
Isn’t it true that GDP includes government production of bombs and missiles along
with salaries paid to prison guards? Doesn’t an increase in crime boost sales of home
alarms, which adds to the GDP? Doesn’t cutting our irreplaceable redwoods show up as
a positive output in our national accounts? Doesn’t GDP fail to account for
environmental degradation such as acid rain and global warming?
In recent years, economists have begun developing new measures to correct the major
defects of the standard GDP numbers and better reflect the true satisfaction-producing
outputs of our economy. The new approaches attempt to extend the boundaries of the
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traditional accounts by including important nonmarket activities as well as correcting

for harmful activities that are included as part of national output.
Price Indexes and Inflation

We have concentrated in this chapter on the measurement of output. But people are
also concerned with price trends, with movements in the overall price level, with
inflation. What do these terms mean?
A price index is a measure of the average level of prices. Inflation denotes a rise in the
general level of prices. The rate of inflation is the rate of change of the general price
level and is measured as follows:
But how do we measure the “price level” that is involved in the definition of inflation? The
price level is a weighted average of the prices of the different goods and services in an
economy. The government calculates the price level by constructing price indexes, which
are averages of prices of goods and services.
As an example, take the year 1999. In that year, the prices of most major categories
rose modestly— food prices rose 2 percent and medical-care prices rose 3.5 percent,
for example. Apparel prices declined, however, primarily because of sharp declines in
the prices of imported clothing. Overall, when weighted by total expenditures in
different areas, the consumer price index (CPI) rose 2.1 percent in 1999. In other
words, the inflation rate was 2.1 percent.
The opposite of inflation is deflation, which occurs when the general level of prices is
falling. Deflations have been rare in the late twentieth century. In the United States,
the last time consumer prices actually fell from one year to the next was 1955.
Sustained deflations, in which prices fall steadily over a period of several years, are
associated with depressions, such as those that occurred in the United States in the
1930s and the 1890s. More recently, Japan experienced a deflation in the late 1990s as
its economy suffered a prolonged recession.
Price Indexes
When newspapers tell us “Inflation is rising,” they are really reporting the movement
of a price index. A price index is a weighted average of the prices of a number of goods
and services. In constructing price indexes, economists weight individual prices by the
economic importance of each good. The most important price indexes are the
consumer price index, the GDP deflator, and the producer price index.
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The Consumer Price Index

The most widely used measure of inflation is the consumer price index, also known as
the CPI. The CPI measures the cost of buying a standard basket of goods at different
times. The market basket includes the prices of food, clothing, shelter, fuel,
transportation, medical care, college tuition, and other goods and services purchased for
day-to-day living. Prices on 364 separate classes of goods and services are collected from
23,000 establishments in 87 areas of the country.
How are the different prices weighted in constructing price indexes? It would clearly be
silly merely to add up the different prices or to weight them by their mass or volume.
Rather, a price index is constructed by weighting each price according to the economic
importance of the commodity in question.
In the case of the traditional CPI, each item is assigned a fixed weight proportional to
its relative importance in consumer expenditure budgets; the weights for each item are
proportional to the total spending by consumers on that item as determined by a
survey of consumer expenditures.
We can use a numerical example to illustrate how inflation is measured. Assume that
consumers buy three commodities: food, shelter, and medical care. A hypothetical
budget survey finds that consumers spend 20 percent of their budgets on food, 50 per-
cent on shelter, and 30 percent on medical care.
Using 1998 as the base year, we reset the price of each commodity at 100 so that
differences in the units of commodities will not affect the price index. This implies that
the CPI is also 100 in the base year [(0.20 - 100) - (0.50 - 100) - (0.30 - 100)]. Next, we
calculate the consumer price index and the rate of inflation for 1999. Suppose that in
1999 food prices rise 2 percent to 102, shelter prices rise 6 percent to 106 and medical-
care prices are up 10 percent to 110. We recalculate the CPI for 1999 as follows:
CPI (1999)
(0.20 - 102) - (0.50 - 106) - (0.30 - 110)
106.4
In other words, if 1998 is the base year in which the CPI is 100, then in 1999 the CPI is
106.4. The rate of inflation in 1999 is then [(106.4 - 100)/100] - 100 - 6.4 percent per year.
Note that in a fixed-weight index like the CPI, the prices change from year to year but the
weights remain the same.
This example captures the essence of how the traditional CPI measures inflation. The
only difference between this simplified calculation and the actual one is that the CPI in
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fact contains many more commodities and regions. Otherwise, the procedure is exactly
the same.
The GDP Deflator
Another widely used price index is the GDP deflator, which we met earlier in this chap-
ter. The GDP deflator is the price of all goods and services produced in the country
(consumption, in-vestment, government purchases, and net exports) rather than of a
single component (such as consumption). This index also differs from the traditional
CPI because it is a variable-weight index that takes into account the changing shares of
different goods. In addition, there are deflators for components of GDP, such as for
investment goods, computers, personal consumption, and so forth, and these are
sometimes used to supplement the CPI.
Why GDP deflator is considered a good measure of inflation?
The ratio between the GDP at current prices and GDP at constant prices gives an idea
of the increase in prices of all goods and services with reference to the base year. In
that sense it is a more comprehensive measure of inflation than price indices, which
are based only on a limited basket of goods collected from select centres. However,
the deflator comes with a lag, which limits its usefulness.
How is it used in India?
In India a combination of WPI and CPI is used as deflator. The usage is dependent on
the particular estimate we are trying to deflate. There will be different deflators for
private consumption and government consumption. There is a difference in the value
of quarterly and year-end deflators. This is due to the fact that prices are not constant.
At the year-end we have an overall measure of WPI/CPI, which is used appropriately.
This is why year-end estimates of GDP are more reliable than quarterly estimates.
In economics, it's helpful to be able to measure the relationship between nominal

GDP(aggregate output measured at current prices) and real GDP (aggregate output
measured at constant base year prices). To do this, economists have developed the
concept of the GDP deflator. The GDP deflator is simply nominal GDP in a given year
divided by real GDP in that given year and then multiplied by 100.
Wholesale Price Index

WPI represents the price of goods at a wholesale stage i.e. goods that are sold in bulk
and traded between organizations instead of consumers. Wholesale Price Index (WPI)
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represents the price of goods at a wholesale stage i.e. goods that are sold in bulk and
traded between organizations instead of consumers. WPI is used as a measure of
inflation in some economies.
WPI is used as an important measure of inflation in India. Fiscal and monetary policy
changes are greatly influenced by changes in WPI. In the United States, Producer Price
Index (PPI) is used to measure inflation. WPI is an easy and convenient method to
calculate inflation. Inflation rate is the difference between WPI calculated at the
beginning and the end of a year. The percentage increase in WPI over a year gives the
rate of inflation for that year.
WPI - inflation indicator in India

This index is the most widely used inflation indicator in India. This is published by the
Office of Economic Adviser, Ministry of Commerce and Industry. WPI captures price
movements in a most comprehensive way. It is widely used by Government, banks,
industry and business circles. Important monetary and fiscal policy changes are linked
to WPI movements. It is in use since 1939 and is being published since 1947 regularly.
We are well aware that with the changing times, the economies too undergo structural
changes. Thus, there is a need for revisiting such indices from time to time and new
set of articles / commodities are required to be included based on current economic
scenarios. Thus, since 1939, the base year of WPI has been revised on number of
occasions. The current series of Wholesale Price Index has 2004-05 as the base year.
Latest revision of WPI has been done by shifting base year from 1993-94 to 2004-05 on
the recommendations of the Working Group set up with Prof Abhijit Sen, Member,
Planning Commission as Chairman for revision of WPI series. This new series with base
year 2004-05 has been launched on 14th September, 2010.
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Summary
• GDP is the name we give to the total market value of the final goods and services
reduced within a nation during a given year
• We can measure GDP in two entirely independent ways -

• Flow-of-Product Approach
• Earnings or Cost Approach
• GDP excludes intermediate goods-goods that are used up to produce other goods to
prevent ‘double counting’. GDP therefore includes bread but not wheat, and home
computers but not computer chips
• When we divide nominal GDP by real GDP, we obtain the GDP deflator, which
serves as a measure of the overall price level
• Consumption is by far the largest component of GDP, equaling about two-thirds of

the total in recent year
• Economic define “investment” (or sometimes real investment) as production of

durable capital goods
Suggestive Questions:
1. Define carefully the following and give an example of each:
a. Consumption
b. Gross private domestic investment
c. Government consumption and investment purchase (in GDP)
d. Government transfer payment (not in GDP)
e. Exports
2. You sometimes hear, “You can’t add apples and oranges.” Show that we can and do
add apples and oranges in the national accounts. Explain how.
3. Examine the data in the appendix to Chapter 4. Locate the figures for nominal and
real GDP for 1999 and 1998. Calculate the GDP deflator. What were the rates of
growth of nominal GDP and real GDP for 1999? What was the rate of inflation (as
measured by the GDP deflator) for 1999?
4. Robinson Crusoe produces upper-loop product of Rs. 1000. He pays Rs. 750 in
wages, Rs. 125 in interest and Rs. 75 in rent. What must his profit be? If three-
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fourths of Crusoe’s output is consumed and the rest invested, calculate

Crusoeland’s GDP with both the product and the income approaches and show that
they must agree exactly.
5. Here are some brain teasers. Can you see why the following are not counted in U.S.
GDP?
a. The gourmet meals produced by a fine chef
b. The purchase of a plot of land
c. The purchase of an original Rembrandt painting
d. The value I get in 2000 from playing a 1997 compact disc
e. Damage to houses and crops from pollution emitted by electric utilities
f. Profits earned by IBM on production in a British factory
6. Consider the country of Agrovia, whose GDP is discussed in “A Numerical Example”

on page 98. Construct a set of national accounts like that in Table 5–6 assuming that
wheat costs Rs5 per bushel, there is no depreciation, wages are three-fourths of
national output, indirect business taxes are used to finance 100 percent of
government spending, and the balance of income goes as rent income to farmers.
7. Review the discussion of bias in the CPI. Explain why failure to consider the quality
improvement of a new good leads to an upward bias in the trend of the CPI. Pick a
good you are familiar with. Explain how its quality has changed and why it might be
difficult for a price index to capture the increase in quality.
8. In recent decades, women have worked more hours in paid jobs and fewer hours in
unpaid housework.
a. How would this increase in work hours affect GDP?
b. Explain why this increase in measured GDP will overstate the true increase in
output. Also explain how a set of augmented national accounts which includes
home production would treat this change from nonmarket work to market work.
c. Explain the paradox, “When a person marries his or her gardener, GDP goes
down.”
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Managerial Economics Fiscal and Monetary Policies
FISCAL AND MONETARY POLICIES
Objectives
 This chapter will help you to learn about fiscal policy, types of approaches
followed by governments in implementing fiscal policy, fiscal tools and policy
objectives.
 It will help you understand monetary policy, its target goals and objectives, the
tools used to as policy signals to achieve these objectives and the monetary
transmission mechanism of these measures.
 It will help you to distinguish between fiscal and monetary policy and analyze
inter-relationships between macroeconomic stability, growth and the financial
sector
 It will help you examine the interactions between fiscal, monetary policies and
financial stability objectives to understand current developments in the
economy and their consequences.
 It will help you understand the purpose of an expansionary / contractionary

policy – fiscal and monetary and the end economic objectives of such
measures.
 It will help you to understand the limitations of fiscal and monetary policy and
their effectiveness during different business cycles.
Fiscal Policy
The word ‘fisc’ means ‘state treasury’ and fiscal policy refers to the policy
concerning the use of ‘state treasury’ or the government finances to achieve macroeco
nomic goals.
Fiscal policy, therefore, is the use of government spending, taxation and transfer
payments to influence aggregate demand and, therefore, real GDP. If one imagines the
government as the doctor carrying the medical kit, these three things are in the toolkit:
government spending, taxes and transfer payments.
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Fiscal and Monetary Policies Managerial Economics
Fiscal and monetary policies are the two important instruments in the hands of the
modern public authorities.
Evolution of Fiscal Policy over the Decades
Classical economists before Keynes opposed large-scale fiscal policy and government
expenditure. They believed: “tax the least, spend the least”. They believed that
the free enterprise system is a self-equilibrating one and public intervention (say -
government spending) will only cause disturbances in its smooth working.
But Keynes opposed such a view. He pointed out that throughout the 19th century
western free enterprise economies suffered frequent problems of cyclical fluctuation.
During the Great Depression (1929-33), output and employment levels fell by 40
percent for a prolonged time.
It was Keynes who first recognized the need of regulating private enterprise economy.
In his General Theory (1936) he asserted that large-scale public expenditure is to be
made from time to time to avoid cyclical fluctuations in economic activities and to
maintain high levels of employment and income. Since then fiscal policy has come into
prominence. Almost all modern governments today collect resources to the extent of
30 percent or more of the national income and spend this on a variety of economic
activities.
Fiscal Policy Tools

Revenue tools: Revenue tools refer to the taxes collected by the government in various
forms. The taxes can be direct or indirect. Direct taxes are taxes levied on the income
or wealth of individuals and firms. This includes income tax, wealth tax, property tax,
corporate tax, capital gains tax, social, etc. Indirect taxes are taxes levied on goods and
services. This includes sales tax, value added tax, excise duty, import duty, custom duty
etc. axes help governments in meeting their fiscal needs. By levying high indirect taxes,
the government can also discourage use of items such as tobacco, and alcohol.
Spending Tools: Spending tools refer to increasing or decreasing government

spending/expenditure to influence the economy. Government spending can be in the
form of transfer payments, current spending and capital spending.
Current spending includes expenditure on essential goods and services such as health,
education, defense, etc.
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Capital spending is the public investment in infrastructure such as roads, hospitals,

schools, etc.
The above two also include subsidy or direct provision of merit goods and public goods,
which would otherwise be underprovided.
Transfer payments are the redistribution of income from taxpayers to those requiring
support, for example, unemployment benefits. It also includes interest payments on
government debt.
Hence, Fiscal policy works through the two sides of the government's fiscal budget --
spending and taxes. However, it's often useful to separate these two sides into three
specific tools -- government purchases, taxes, and transfer payments.
Types of Fiscal Policy

Expansionary Fiscal Policy:
A form of fiscal policy in which an increase in government purchases, a decrease in

taxes, and/or an increase in transfer payments are used to correct the problems of a
business-cycle contraction.
The goal of an expansionary fiscal policy is to close a recessionary gap, stimulate the
economy, and decrease the unemployment rate. Expansionary fiscal policy is often
supported by an expansionary monetary policy.
Government Purchases
One of the three fiscal policy tools available to the government sector is government
purchases. Government purchases are expenditures by the government sector. It is
that portion of gross domestic product purchased by governments.
These purchases are used to buy everything from aircraft carriers to paper clips, from
office furniture to highway construction, from traffic lights to teacher salaries. The
actual purchases are typically undertaken by individual government agencies. Highway
construction, for example, is undertaken with funds appropriated to transportation.
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Expansionary fiscal policy involves an increase in the funds appropriated to these

assorted agencies. The agencies then make the additional purchases which stimulate
aggregate production, boost income, and increase the level of employment. A number
of stimulus packages have been announced by countries across the globe in addition to
the usual target government spending during recessionary periods.
While an increase in government purchases has been used frequently over the years to
implement expansionary fiscal policy, it can be a relatively involved process. Moreover,
additional government purchases leads to a relatively larger government sector. For
these reasons, policy makers often opt for the second fiscal policy tool -- taxes.
Taxes
The second of three fiscal policy tools is taxes, primarily personal income taxes levied
by the government, but other taxes are also used. Taxes are the involuntary payments
that the government sector imposes on the rest of the economy to generate the
revenue needed to provide public goods and services, to incur government spending
on utilities and fixed payments and to undertake other government functions. Taxes
also help to achieve a targeted redistribution of income from one segment to another.
Personal income taxes are more specifically the taxes collected on the income received
by members of the household sector.
Expansionary fiscal policy involves either a decrease of the income tax rates or a one-
time rebate of taxes previously paid. The reduction in taxes provides the household
sector with additional disposable income that can be used for consumption
expenditures, which then stimulates aggregate production and employment and leads
to further increases in income.
Because tax changes tend to be administratively easier to implement, they are often
preferred over government purchases when conducting expansionary fiscal policy.
Moreover, political leaders and voters usually prefer a reduction in the tax burden to
an increase in government spending.
Transfer Payments
The third fiscal policy tool is transfer payments. Transfer payments are payments made
by the government sector to the household sector with no expectations of productive
activity in return. The three common transfer payments are benefits to the elderly and
disabled, welfare to the poor among others.
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Like the income tax system, transfer payments rely on a payment schedule based on
qualifying characteristics of the recipients -- age, employment status, income, etc.
Those who meet the criteria then receive payments.
Expansionary fiscal policy involves either an increase in payment schedule for one or
more of the transfer systems or perhaps some sort of across-the-board lump-sum
payment to all who qualify.
Recessionary Gap
Expansionary fiscal policy is used to address business-cycle instability that gives rise to
the problem of unemployment, that is, to close a recessionary gap. A recessionary gap
exists if the existing level of aggregate production is less than what would be produced
with the full employment of resources. This gap arises during a business-cycle
contraction and typically gives rise to higher rates of unemployment.
Recessionary Gap
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A recessionary gap is commonly illustrated

using the aggregate market (AS-AD
analysis). The exhibit to the right presents
the standard aggregate market. The
vertical long-run aggregate supply curve,
labeled LRAS, marks full-employment real
production. Long-run equilibrium in the
aggregate market necessarily results in
full-employment real production.
The positively-sloped short-run aggregate

supply curve is labeled SRAS. Short-run
equilibrium in the aggregate market
occurs at the price level and real
production corresponding to the
intersection of the curve and this SRAS
curve. Should short-run real production
fall short of full-employment real
production, then a recessionary gap
results. However, to identify this gap an
aggregate demand curve needs to be
added to the graph.
Doing so reveals a short-run

equilibrium level of real production that is
less than full employment, which is a
recessionary situation. Note that the
aggregate demand curve intersects the
SRAS curve at a real production level to
the left of the LRAS curve. This means the
short-run real production is less than full-employment real production. The difference
between short-run equilibrium real production and full-employment real production is
the recessionary gap.
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Closing the Gap
Expansionary fiscal policy is designed to close a

recessionary gap by changing aggregate
expenditures and shifting the aggregate demand
curve. A recessionary gap is closed with a rightward
shift of the aggregate demand curve.
To illustrate how this occurs, consider the exhibit to

the right. The recessionary gap can be closed with
expansionary fiscal policy -- an increase in
government purchases, a decrease in taxes, or an
increase in transfer payments. This policy shifts the
aggregate demand curve to the right and closes the
gap. To illustrate how this works, click the
[Expansionary Policy] button. If done correctly, the aggregate demand curve intersects
the short-run aggregate supply curve at the full employment level of aggregate
production indicated by the long-run aggregate supply curve.
The Fiscal Policy Transmission Mechanism
This flow-chart identifies some of the channels involved with the fiscal policy
transmission mechanism – in the example shown we focus on an expansionary fiscal
policy designed to boost demand and output by reducing taxes. Similarly, the same
objective can be achieved through other means as well like increasing government
spending for instance.
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The multiplier effects of an expansionary fiscal policy depend on how much spare
productive capacity the economy has; how much of any increase in disposable income
is spent rather than saved or spent on imports.
A contractionary fiscal policy would involve one or more of the following:
 A cut in government expenditure either in real terms or as a share of GDP

 An increase in direct and/or indirect taxes
 An attempt to reduce the size of the budget deficit
Main Objectives of Fiscal Policy

The fiscal policy is designed to achieve certain objectives:
1. Development by effective Mobilization of Resources

The principal objective of fiscal policy is to ensure rapid economic growth and
development. This objective of economic growth and development can be achieved by
Mobilization of Financial Resources and is practiced by the central and the state
governments in India.
The financial resources can be mobilized by:-
Taxation: Through effective fiscal policies, the government aims to mobilize resources
by way of direct taxes as well as indirect taxes (the most important source of resource
mobilization in India is taxation).
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Public Savings: Resources can be mobilized through public savings by reducing

government expenditure and increasing surpluses of public sector enterprises.
Private Savings: Through effective fiscal measures such as tax benefits, the
government can raise savings of private sector and households. Resources can be
mobilized through government borrowings by ways of treasury bills, issue of
government bonds, etc., loans from domestic and foreign parties and by deficit
financing.
2. Efficient allocation of Financial Resources
The central and state governments have tried to make efficient allocation of financial
resources. These resources are allocated for Development Activities which includes
expenditure on railways, infrastructure, etc. While Non-development Activities
includes expenditure on defense, interest payments, subsidies, etc.
Fiscal policy is designed in such a manner so as to encourage production of desirable

goods and discourage those goods which are socially undesirable.
3. Reduction in inequalities of Income and Wealth
Fiscal policy aims at achieving equity or social justice by reducing income inequalities
among different sections of the society. The direct taxes such as income tax are
charged more on the rich people as compared to lower income groups (progressive
taxes). Indirect taxes are also more in the case of semi-luxury and luxury items, which
are mostly consumed by the upper middle class and the upper class. The government
invests a significant proportion of its tax revenue in the implementation of poverty
alleviation programmes to improve the conditions of poor people in society.
4. Price Stability and Control of Inflation
One of the main objectives of fiscal policy is to control inflation and stabilize price.
Therefore, the government always aims to control inflation by reducing fiscal deficits,
through productive use of financial resources, etc.
5. Employment Generation
The government is making every possible effort to increase employment in the country
through effective fiscal measures. Investment in infrastructure has resulted in direct
and indirect employment. Lower taxes and duties on small-scale industrial units
encourage more investment and consequently generate more employment. Various
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rural employment programmes have been undertaken by governments to solve

problems in rural areas. Similarly, self-employment scheme is taken to provide
employment to technically qualified persons in the urban areas.
6. Balanced Regional Development
Another main objective of the fiscal policy is to bring about a balanced regional
development. There are various incentives from the government for setting up projects
in backward areas such as Cash subsidy, Concession in taxes and duties in the form of
tax holidays, Finance at concessional interest rates, etc.
7. Reducing the Deficit in the Balance of Payment
Fiscal policy attempts to encourage more exports by way of fiscal measures like
Exemption of income tax on export earnings, Exemption of central excise duties and
customs, Exemption of sales tax and octroi, etc. Foreign exchange is also conserved by
providing fiscal benefits to import substitute industries, imposing customs duties on
imports, etc.
The foreign exchange earned by way of exports and saved by way of import substitutes
helps to solve balance of payments problem. In this way adverse balance of payment
can be corrected either by imposing duties on imports or by giving subsidies to export.
8. Capital Formation
The objective of fiscal policy in India is also to increase the rate of capital formation so
as to accelerate the rate of economic growth. An underdeveloped country is trapped in
a vicious (danger) circle of poverty mainly on account of capital deficiency. In order to
increase the rate of capital formation, the fiscal policy must be efficiently designed to
encourage savings and discourage and reduce spending.
9. Increasing National Income
The fiscal policy aims to increase the national income of a country. This is because fiscal
policy facilitates the capital formation. This results in economic growth, which in turn
increases the GDP, per capita income and national income of the country.
10. Development of Infrastructure
Government has placed emphasis on the infrastructure development for the purpose
of achieving economic growth. The fiscal policy measure such as taxation generates
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revenue to the government. A part of the government's revenue is invested in the

infrastructure development. Due to this, all sectors of the economy get a boost.
Conclusion
The objectives of fiscal policy such as economic development, price stability, social
justice, etc. can be achieved only if the tools of policy like Public Expenditure, Taxation,
Borrowing and deficit financing are effectively used. The success of fiscal policy
depends upon taking timely measures and their effective administration during
implementation.
Fiscal Policy and the “Budget”:
a) Revenue and Capital accounts: Modern public authorities have been popularly
making use of fiscal policy. It is planned and implemented through annual budgets of
the governments. A budget is an estimated or anticipated account of government
receipts and expenditure in the next financial year. It is discussed and voted (for or
against) in the legislature, in the Congress or Parliament. It is implemented by
executives such as ministers or secretaries.
The budget has two components – revenue account and capital account. The revenue
account displays receipts from tax collection and from other sources of public income
during the course of the year. The capital account shows all debt liabilities and
payments of interest on loans. Government loans may be internal in the form of
borrowing from the people, banks or the central bank. It may also be in the form
of external debt from international agencies like the International Monetary
Fund (IMF) or International Bank for Reconstruction and Development (IBRD).
b) Budgetary Surplus or Deficit: If the current or revenue account receipts are exactly
equal to proposed expenditure, then the budget is said to be balanced. If the revenue
receipts fall short of the proposed expenditure then it is a case of a deficit budget. On
the other hand if revenue receipts exceed the proposed expenditure then it is
called Surplus budget. In order to avoid public intervention in economic activities the
classical economists used to favor balanced budgets i.e. when the government
expenditure is exactly equal to the tax revenues.
In case of a deficit budget, the government expenditure has exceeded receipts.

Therefore, the government intends to spend more and increase the size of the
aggregate or effective demand. This can be done by raising fresh debts to finance extra
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expenditure. Alternatively, the tax rates can also be reduced in order to enable people
to spend more.
The case of surplus budget is exactly the opposite. Here, public revenue exceeds public
expenditure. It then becomes possible for the government to repay some debt burden.
It is also possible to raise tax rates and to withdraw some purchasing power from
circulation.
c) Deficit / Surplus with Expansionary and Contractionary policies: Fiscal policy

becomes meaningful when budgets either show deficits or surpluses. The deficit
budget is also known as an expansionary policy. This is because through deficits and
enhanced public spending, the overall level of effective demand can be expanded. Such
a policy is pursued during the period of deflation. Under such conditions the price level
is depressed, the output level is falling and the level of unemployment is increasing.
Therefore the rising level of effective demand is expected to act as a remedy.
On the other hand a surplus budget (which is also known as contractionary) policy is
useful under inflationary conditions. During inflation, the general price level shows a
strong tendency to move sharply upwards. Therefore such a situation can be corrected
by withdrawing some purchasing power from the people. This helps to bring down the
level of effective demand.
As is mentioned above, classical economists generally favored a balanced budget. It is

only Keynes and his followers who have popularized expansionary and contractionary
policies. However, here again the Keynesians emphasize expansionary policies. It is
only in exceptional situations of running away conditions of inflation that the
contractionary policy may be called in. Both expansionary and contractionary policies
can be illustrated.
Annexure
Fiscal Policy at work
i) During Unemployment:
Fiscal policy has been strongly recommended by Keynes and his followers under the
conditions of depression. Though the fiscal policy can take both expansionary and
contractionary forms, it is the expansionary fiscal policy and deficit financing that has
dominated the post Second World War period. It intends to maintain a high and
growing size of the effective demand. Keynesians are of the view that only such
policies can cure unemployment, stabilize the economy and help in maintaining high
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levels of output and employment. The classical opponents of Keynes however uphold
the price and wage-cut policy that leaves out public intervention in economic
activities. Those who follow the classical view also fear that government expenditure
and its attempts to increase effective demand may cause inflation. Keynesians counter
argue that if a choice is to be made between inflation and unemployment then the
former should be preferred. Inflation is a lesser evil than unemployment. The classicists
further state that without any government spending, natural full employment
equilibrium can be established with the help of a price-wage cut in the long run after a
lapse of time. But Keynes himself had made the witty statement: "In the long run all of
us are dead." This suggests that even if long run equilibrium is possible with a cut in the
wage-rate, it is not advisable to follow. Labor is an
extremely perishable commodity. Every day in the workman’s life matters. It is
improper to ask thousands or millions of workers to wait for few months or years
before the economic situation can be improved and jobs can be made available. The
controversy between the two viewpoints can conveniently be explained with the help
of a figure.
Level of Real Income / Employment
In the illustrated figure, we find that levels of real income and employment have been
shown on the horizontal axis and various price levels appear on the vertical axis.
AD1 and AD2 are aggregate or effective demand curves and SAS1 and SAS2 are short run
aggregate supply curves. The vertical line Y2e3 e2Ls is the long run supply curve. It
stands for natural or full employment level of resources and output. Let’s begin with
initial demand and supply conditions along AD1 and SAS1. The two curves have
intersected at point e1 which is an equilibrium position. At point e1 level of output (or
real income) and employment is Y1and level of price is P1.
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This is however not a full employment equilibrium. Since Y2 is a long run full
employment and output level, there is still some labor unemployed at Y 1. Now, one is
faced with the problem of how to overcome this amount of unemployment. The
classical writers assert that if price level is lowered and if wage rates are cut the cost of
production will reduce. Employers will be induced to invest more and employ the
workers who are unemployed. This will bring about a downward shift in the aggregate
supply curve which will now be SAS2. The new supply curve intersects AD1 at point e3.
This equilibrium point is on the long run supply curve and therefore ensures full
employment. In this equilibrium position output level is Y2 and price level is P3. It has
become possible to attain the condition of full employment without any government
spending, simply by cutting wage rate. This is the classical solution.
Keynes rejects this proposition. For him such equilibrium is unattainable. Laborers,
with the backing of their trade unions, will not accept a cut in wages. The wage rates
are downward sticky or rigid. Therefore the supply curve cannot shift downwards. Yet
unemployment can be cured. The only requirement here is to make adjustments on
the demand side. If the government undertakes fiscal policy and increases public
spending, effective demand will increase. This will cause aggregate demand curve to
shift upwards as AD2. The new demand curve intersects both the old supply curve
SAS1 as well as the long run supply curve at point e2. Therefore this is the full
employment equilibrium. At this point output and employment levels are Y2 and price
level is P2. Therefore though the price level P2 is somewhat higher, the problem of
unemployment has been solved immediately.
ii. During Inflation:
Keynesian expansionary policy helps to overcome the problem of unemployment with

an upward shift in the effective demand level. Similarly, his contractionary policy can
be used to mitigate an inflationary rise in the price level. In this case what is needed is
a downward shift in the effective demand and a reduction in public spending. This has
been shown in the figure.
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Level of Real Income and Employment
The levels of income are shown on the horizontal and that of price are shown on the
vertical axis. AD1 and AD2 are the two demand curves while SAS1 and SAS2 are two
supply curves. The only change this time is an upward shift of the supply curve in the
form of SAS2. The initial full employment equilibrium occurs at point e1 with Y1 as the
level of income and P1 as the price level. The point e1 is the point of intersection
between AD1 and SAS1. If now aggregate demand increases and shifts upward as
AD2 then a new equilibrium position is established at e2. This is the point of
intersection between AD2 and SAS1. At this point, the level of income is Y2 and the price
level is P2. Both income and prices appear to have risen because of the shift in the
demand curve. However, increase of income (Y1 to Y2) is purely nominal or monetary in
form. Since level Y1represents the full employment output level, there are no further
resources to be employed. Hence there cannot be any real additions to the output (or
real income) and income.
Again e2 point of equilibrium is not stable. Due to the rising price level, workers and
other resource owners will demand a rise in wages and remuneration. With this kind of
an increase in the cost of production, the supply curve will shift upwards as SAS2. The
new supply curve SAS2 intersects the new demand curve AD2 at point e3, establishing
a fresh equilibrium position. At e3 the income level has fallen back to full employment
level Y1. But the price level has sharply risen to P3. The point e3 is a stable equilibrium
point since it is on the long run full employment supply curve LS Y1. But at e3 the net
inflationary rise in the price level is P1 to P3. If the inflation is to be removed and price
level is to be restored as P1 then the effective demand will have to be contracted. With
a fall in public expenditure, the aggregate demand curve will shift down from AD2 to
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AD1. The economy will then revert to the old equilibrium point e1. Thus, the
contractionary policy of reducing public expenditure helps during periods of inflation.
It may be noted that either under expansionary or contractionary policies the level of
income increases or decreases from Y1 to Y2 respectively. This becomes possible
with fiscal policy of increasing or decreasing public expenditure. But such adjustments
in public expenditure need not be of the same size as of the desired changes in the
income level. Public expenditure needs to be smaller in size yet because of the
presence of the multiplier effect a much larger final change in the income becomes
possible.
iii. Crowding-out effect:
Keynes' fiscal policies of expansion and contraction have been popular with modern
public authorities. These policies have been used effectively over the past years in
many economies the world over. However, modern followers of the classical school,
also known as monetarists, point out the faults of such fiscal measures. It is pointed
out that extra government expenditure is financed through public borrowings. As a
result of this, the money available for loans is reduced and there is a greater demand
for loanable funds in the money and capital markets. With a sudden rises in the
demand the price of loanable funds or the rate of interest starts rising. Again extra
public expenditure, which gives rise to an upward movement of the price level, also
has a similar effect on the rate of interest. Rising level of the interest rate has a
discouraging effect on private investment activity. Thus increased public investment
expenditure causes a fall in the private investment activity. This is called the 'crowding-
out' effect. It is claimed therefore that fiscal policy is likely to develop a self-defeating
tendency. On the other hand, during the phase of inflation, contraction in public
expenditure can be equally self-defeating. In this case with a fall in the effective
demand, the rate of interest will tend to fall and will encourage private investment
activity. This is exactly the opposite case and therefore can be called the 'crowding-in'
effect.
Fiscal Policy and the Multiplier
Fiscal policy has a multiplier effect on the economy. Expansionary fiscal policy leads to
an increase in real GDP larger than the initial rise in aggregate spending caused by the
policy. The government spends an additional Rs. 4 Billion through discretionary fiscal
policy. The total effect on GDP will be larger than Rs. 4 Billion.
The multiplier effect refers to the additional shifts in aggregate demand that result
when expansionary fiscal policy increases income and thereby increases consumer
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spending. Conversely, contractionary fiscal policy leads to a fall in real GDP larger than
the initial reduction in aggregate spending caused by the policy.
A multiplier could also measure how a change in spending produces an even larger
change in income. For instance, suppose a government loosens fiscal policy, increasing
net public spending by pumping an extra Rs 10 billion into education. This has an
immediate effect by increasing the income of teachers and of people who sell
educational supplies or build or maintain schools. These people will in turn spend some
of their extra money, putting more cash into the pockets of others, who spend some of
it, and so on.
In theory, this process could continue indefinitely, in which case the multiplier would
have an infinite value. In practice, most people save some of their extra income rather
than spend it. How much they spend will depend on their marginal propensity to
consume. While the marginal propensity to consume pops up throughout the study of
macroeconomics, few if any topics are more important than the multiplier.
Marginal propensity to consume refers to variations in consumption in response to an

incremental change in disposable income (income induced consumption). It is found by
dividing the change in consumption by the change in disposable income that produced
the consumption change:
MPC = change in consumption / change in income
The above mentioned examples elucidate how a change in one factor leads to a larger
increase in another factor. However, this multiplier could also be less than or equal to
one.
• Autonomous Spending - spending that is determined outside the model

(independent of level of income and other variables).
• Invisible hand – According to Adam Smith’s theory, an invisible hand process is one in
which the outcome to be explained is produced in a decentralized way, with no explicit
agreements between the acting agents. The second essential component is that the
process is not intentional. The agents' aims are neither coordinated nor identical with
the actual outcome, which is a by-product of those aims. The process should work even
without the agents having any knowledge of it. This is why the process is called
invisible. The system in which the invisible hand is most often assumed to work is the
free market.
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• Aggregate expenditures - Total spending on goods and services in the economy as

the sum of four components: consumption, investment, government spending, and net
exports:
AE = C + I + G + NX
where,
AE = aggregate expenditures
C = consumption
I = investment
G = Government spending
NX = net exports (exports - imports)
• The consumption function represents the "planned" or "desired " level of

consumption for a given level of income:
C = C0 + c • Y
where,
C = desired level of consumption spending
C0 = fixed (autonomous) level of consumption, C0 > 0
c = constant, 0 < c < 1, also called the "marginal propensity to consume" (MPC)
Y = total income
• Autonomous consumption - the minimum level of consumption necessary to survive

(often called the "subsistence" level). Even if one is unemployed, one needs basic
necessities for survival.
Classical versus Keynesian View
Smith and the classical economists that followed believed that governments could be
their own worst enemies when it came to the economy. With laissez-faire (hands-off)
government policies, the economy would better achieve the goals of price stability, full
employment, and economic growth.
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The classical economists believed that prices, wages and interest rates would adjust "as
if led by an invisible hand" to return the economy to full employment and economic
growth.
Classical macro theory:
- Prices will fall thereby stimulating demand.
- Interest rates will fall thereby stimulating investment.
On the other hand, the foundation of Keynesian macroeconomic theory is that prices,
wages, and interest rates are fixed. Prices and wages are directly related because firms
could not lower product prices if wages were not lowered. Classical economic theory
suggested that high unemployment rates would lead to lower wage rates, which would
lead to lower prices, which would lead to higher demand because of the increased
purchasing power of existing wealth. But Keynes observed that wages were not falling
(actually there was a decline in the average price level during the early 1930s but
evidently not enough to matter). Keynes could not apply an economic theory to explain
why those people out of work were unwilling to accept a lower wage in order to get a
job. He simply accepted it as an unexplained socioeconomic fact of life and built a
theory around the assumption that prices and wages were rigid.
Keynesian macro theory:
- Prices, wages and interest rate are fixed.
- Government fiscal policy stimulus is needed.
Interest rates are a different story. Classical theory suggests that during a recession or
depression interest rates should fall, which would stimulate consumption and
investment spending. Keynes observed that if interest rates were already near zero,
they could hardly go any lower. Moreover, even if interest rates could decline further,
why would that lead to an increase in investment? With factories running well below
capacity because of the Depression, there would be no point in building new
production plants.
Multiplier
As stated earlier, the multiplier measures the magnified change in aggregate

production (gross domestic product) resulting from a change in an autonomous
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variable (such as investment expenditures). The magnified change occurs because a

change in production (such as what occurs when investment expenditures purchase
capital goods) generates income, which then induces consumption. However, the
resulting consumption is also an expenditure on production, which generates more
income, which induces more consumption. This next round of consumption also
triggers a change in production, which generates even more income, and which
induces even more consumption.
And on it goes, round after round. The end result is a magnified, multiplied change in
aggregate production initially triggered by the change investment, but amplified by the
change in consumption.
The MPC enters into the process because it determines how much consumption is
induced with each change in production and income. If the MPC is greater, then the
multiplier process is also greater as more consumption is induced with each round of
activity.
This connection between the multiplier process and the marginal propensity to
consume is illustrated in the standard formula for a basic expenditures multiplier:
1
expenditures
=
multiplier
(1 - marginal propensity to consume)
An increase in the marginal propensity to consume reduces the value of the

denominator on the right-hand side of the equation, which then increases the overall
value of the fraction and thus the size of the multiplier.
For example, a marginal propensity to consume of 0.75 results in a multiplier of 4. In

contrast, a larger marginal propensity to consume of 0.8 results in a larger multiplier of
5.
Monetary Policy
Monetary policy is the process by which the monetary authority of a country controls
the supply of money, often targeting a rate of interest for the purpose of
promoting economic growth and stability. The official goals usually include relatively
stable prices and low unemployment (sustainable economic growth).
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Equation of Exchange
Monetary policy, like fiscal policy, can also be used either as an alternative or
a complementary measure. It can be used for its expansionary and contractionary
effects. The classical economists would rely more on the monetary policy. This is
because it operates only indirectly and helps to avoid direct intervention of the public
authority in economic activities. But before we go on to analyze monetary policy, it
would not be out of context to consider the equation of exchange.
In the early present century Sir Irving Fisher introduced an equation of exchange. This
briefly summarizes classical position in this respect. The equation of exchange can be
stated as:
MV = PT or MV = PY
There are four terms in the equation; two each on the left and right sides.
On the left hand side of the equation we have total supply of money which is M
multiplied by V. The letter M stands for total quantity of money in the form of coins
and currency issued by the central bank as the supreme monetary agency. However,
total supply of money is much larger than this because each unit of money is
transferable and capable of changing hands frequently. The total function of money
supply as a medium of exchange therefore will depend upon the average number of
times a unit changes hands. This is called velocity or frequency of using money units.
Let’s illustrate this: if an individual consumer starts off with a currency note of Rs. 10 in
the morning, he may spend it on purchasing sugar. The sugar merchant later on may
purchase fruit against the same bill. The fruit seller in his turn may buy milk with the
same note. Finally, the note rests with the milkman. During the course of the day the
note of Rs. 10 has performed four exchange activities.
Rs. 10 worth sugar + Rs. 10 fruit + Rs. 10 milk + Rs. 10 income of milkman = Rs. 40. Thus
a single note or quantity (M) of Rs. 10 has performed Rs. 40 worth total exchange
activity which is the total supply of money. If this is divided by the quantity 'M' what
we get is velocity or the average number of times a particular unit of currency has been
used to purchase final goods and services over a year.
Total exchange or supply (= 40) M (the quantity = 10) = V
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Normally, value of 'V' settles itself between 3 and 4. It is only during highly inflationary
conditions that it moves above 4, and under deflationary conditions it falls below 3.
On the right hand side of the equation the two important terms are 'P', the average
price level or index number of prices and 'T', the volume of trade or transactions. The
total volume of all the goods and services is traded at the national level and hence it
can also be symbolized as real national income 'Y'.
This equation of exchange, therefore, may be viewed as an identity: the market value
of all goods and services must be equal to the supply of money multiplied by the
velocity of the circulation of one unit of currency.
Fisher has also presented an extended version of the equation of exchange. For this
purpose he had introduced bank money or credit (M1) and its velocity or circulation
(V1). The equation of exchange in its full form can then be stated as:
MV + M1V1 = PT
But it can be assumed that MV includes both currency and credit money and hence it
can be stated in its simplified form:
MV = PT
Value of Money
The equation of exchange is used by classical economists mainly for explaining

fluctuations in the value of money. Otherwise in its original form the equation is
a truism or an identity. It simply explains total money supply (MV) is equal to
total monetary expenditure (PT). While using it for explaining transitions in the value of
money two fundamental assumptions are made. These are related to the behavior of
'V' and 'T'. It is assumed that:
i) 'V', the velocity of circulation of the currency depends upon consumption patterns of
the people and the size of their income. Both these things are not likely to alter
significantly in the short run with any changes in the quantity (M) of money. Therefore
over a short interval 'V' can be assumed to be constant.
ii) The trade volume (T) or level of real income (Y) depends upon the availability of
resource supplies and technological conditions. These factors are not likely to alter in
the short run with the variations in the quantity of money (M). If these two
assumptions are granted then the only dependent variable that remains in the
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equation is the price level 'P'. Hence the conclusion at once follows: with 'V' and 'T'
remaining constant, 'P' will vary directly and proportionately with 'M'. This can be
illustrated:
Let M = 300, V = 4, T = 600 the P will be equal to 2.
But since 'V' and 'T' are constant 'M' and 'P' must vary directly and proportionately. If
M is doubled P will also be doubled.
Similarly when 'M' is halved P is also halved,
According to the followers of the equation of exchange, the price level directly and
proportionately depends upon quantity of money. But price level is inversely related to
the value of money. Hence value of money is inversely proportional to the quantity of
money. Money is general purchasing power. Therefore the capacity of a unit of money
to purchase more or less goods will depend upon the level of prices. By way of example
if the price of chocolates is Rs 20 per piece then Rs 100 can purchase 5 chocolates but
if its price rises to Rs 25 per piece the same Rs 100 can purchase only 4 pieces of
chocolates. Therefore with the rise in the price, the value of the Rs 100 or simply the
value of each rupee falls. Similarly, with a fall in the price level, the value of the
currency rises. We can relate this to the variations in the quantity of money.
Increase in M---- Rise in P---- Fall in value of M

Decrease in M---- Fall in P---- Rise in value of M,
This relationship forms the basis of the monetary policy.
Monetary Management
A monetary authority, usually in the form of the central bank controls money supply.
Monetary management is either to expand or contract supply of currency and credit
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from time to time according to the needs of the economy. For this purpose, the central
bank can employ both quantitative and qualitative measures.
Quantitative Instruments or General Tools
The Quantitative Instruments are also known as the General Tools of monetary policy.
These tools are related to the Quantity or Volume of the money. The Quantitative
Tools of credit control are also called as General Tools for credit control. They are
designed to regulate or control the total volume of bank credit in the economy. These
tools are indirect in nature and are employed for influencing the quantity of credit in
the country. The general tool of credit control comprises of following instruments.
1. Interest Rate Policy (Bank Rate Policy / Discount Rate)
The Bank Rate Policy (BRP) is a very important technique used in the monetary policy
for influencing the volume or the quantity of the credit in a country. The bank rate
refers to rate at which the central bank (i.e. RBI) rediscounts bills and prepares of
commercial banks or provides advance to commercial banks against approved
securities. It is "the standard rate at which the bank is prepared to buy or rediscount
bills of exchange or other commercial paper eligible for purchase under the RBI Act".
The Bank Rate affects the actual availability and the cost of the credit. Any change in
the bank rate necessarily brings out a resultant change in the cost of credit available to
commercial banks. If the RBI increases the bank rate then it reduces the volume of
commercial banks borrowing from the RBI. It deters banks from further credit
expansion as it becomes a more costly affair. Even with increased bank rate the actual
interest rates for short term lending go up checking credit expansion. On the other
hand, if the RBI reduces the bank rate, borrowing for commercial banks will be easy
and cheaper. This will boost credit creation. Thus any change in the bank rate is
normally associated with the resulting changes in the lending rate and in the market
rate of interest. However, the efficiency of the bank rate as a tool of monetary policy
depends on existing banking network, interest elasticity of investment demand, size
and strength of the money market, international flow of funds, etc.
2. Open Market Operation (OMO)
The open market operation refers to the purchase and/or sale of short term and long
term securities by the RBI in the open market. This is very effective and popular
instrument of monetary policy. The OMO is used to wipe out shortage of money in the
money market, to influence the term and structure of interest rates and to stabilize the
market for government securities, etc. It is important to understand the working of the
OMO.
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If the RBI sells securities in an open market, commercial banks and private individuals
buy it. This reduces the existing money supply (in the hands of banks for lending to the
economy) as money gets transferred from commercial banks to the RBI. Contrary to
this, when the RBI buys the securities from commercial banks in the open market,
commercial banks sell it and get back the money they had invested in them. Here, the
stock of money in the economy increases. This way when the RBI enters in OMO
transactions, the actual stock of money gets changed. Normally during an inflationary
period, in order to reduce purchasing power, the RBI sells securities and during a
recession or depression phase it buys securities and makes more money available in
the economy through the banking system. Thus, under OMO there is continuous
buying and selling of securities taking place leading to changes in the availability of
credit in an economy.
However there are certain limitations that affect OMO like an underdeveloped
securities market, excess reserves with commercial banks, indebtedness of commercial
banks, etc.
3. Variation in the Reserve Ratios (VRR)
The Commercial Banks have to keep a certain proportion of their total assets in the
form of Cash Reserves. Some part of these cash reserves are their total assets in the
form of cash. A part of these cash reserves are also to be kept with the RBI for the
purpose of maintaining liquidity and controlling credit in an economy. These reserve
ratios are known as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR) in
India. The CRR refers to some percentage of commercial bank's net demand and time
liabilities which commercial banks have to maintain with the central bank and SLR
refers to some percent of reserves to be maintained in the form of gold or government
and approved securities. In India the CRR by law remains in between 3-15 percent
while the SLR remains in between 22-40 percent of bank reserves. Any change in the
VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves positions. Thus,
by varying VRR commercial banks lending capacity can be affected. Changes in the VRR
helps in bringing changes in the cash reserves of commercial banks and thus it can
affect the banks credit creation multiplier. RBI increases VRR during inflationary
periods to reduce purchasing power and credit creation. But during the recession or
depression, it lowers the VRR making more cash reserves available for credit
expansion.
Qualitative Instruments or Selective Tools
The Qualitative Instruments are also known as the Selective Tools of monetary policy.
These tools are not directed towards the quality of credit or the use of the credit. They
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are used for discriminating between different uses of credit. It can be discrimination
favoring export over import or essential over non-essential credit supply. This method
can have influence over the lender and borrower of the credit. The Selective Tools of
credit control comprise of the following instruments:
1. Fixing Margin Requirements
The margin refers to the "proportion of the loan amount which is not financed by the
bank". Or in other words, it is that part of a loan which a borrower has to raise in order
to get finance for his purpose. A change in a margin implies a change in the loan size.
This method is used to encourage credit supply for the needy sector and discourage it
for other non-necessary sectors. This can be done by increasing margin for the non-
necessary sectors and by reducing it for other needy sectors. Example: If the RBI feels
that more credit supply should be allocated to agriculture sector, then it will reduce
the margin and even 85-90 percent of the margin can be given as loan.
2. Consumer Credit Regulation
Under this method, consumer credit supply is regulated through hire-purchase and
installment sale of consumer goods. Under this method the down payment,
installment amount, loan duration, etc is fixed in advance. This can help in checking the
credit use and then inflation in a country.
3. Publicity
This is yet another method of selective credit control. Through it Central Bank (RBI)
publishes various reports stating what is good and what is bad in the system. This
published information can help commercial banks to direct credit supply to the desired
sectors. Through its weekly and monthly bulletins, the information is made public and
banks can use it for attaining goals of monetary policy.
4. Credit Rationing
Central Bank fixes credit amount to be granted. Credit is rationed by limiting the
amount available for each commercial bank. This method controls even bill
rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told
to stick to this limit. This can help in lowering banks credit exposure to unwanted
sectors.
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5. Moral Suasion
This method exerts pressure on the Indian banking system without any strict action for
compliance of the rules. It is a suggestion to banks. It helps in restraining credit during
inflationary periods. Commercial banks are informed about the expectations of the
central bank through a monetary policy. Under moral suasion central banks can issue
directives, guidelines and suggestions for commercial banks regarding reducing credit
supply for speculative purposes.
6. Control through Directives
Under this method the central bank issue frequent directives to commercial banks.
These directives guide commercial banks in framing their lending policy. Through a
directive the central bank can influence credit structures, supply of credit to a certain
limit for a specific purpose. The RBI issues directives to commercial banks for not
lending loans to speculative sector such as securities, etc beyond a certain limit.
7. Direct Action
Under this method the RBI can impose an action against a bank. If certain banks are
not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and
securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are
in excess. Central banks can penalize a bank by changing some rates. At last it can even
put a ban on a particular bank if it does not follow its directives and works against the
objectives of the monetary policy.
These are various selective instruments of the monetary policy. However the success of
these tools is limited by the availability of alternative sources of credit in economy,
working of the Non-Banking Financial Institutions (NBFIs), profit motive of commercial
banks and undemocratic nature off these tools. But a right mix of both the general and
selective tools of monetary policy can give the desired results.
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Monetary Policy Tools used by the Reserve Bank of India

Primary – Quantitative Tools:
Open Market Operations (OMOs) involve sale and purchase of Government securities
(G-Secs) by the RBI to adjust the liquidity conditions in the system. RBI conducts such
selling operations to suck liquidity whenever it feels there is excess liquidity in the
system. Similarly, when the liquidity conditions are tight, RBI goes for such buying
operations in the open market, thereby releasing liquidity into the system.
Liquidity Adjustment Facility (LAF) is a policy tool which allows banks to borrow
money from the RBI through repurchase agreements, popularly called repo
transactions. As the name itself suggests, LAF has been provided to aid the banks in
adjusting their day-to-day liquidity mismatches. LAF consists of repo and reverse repo
operations. Repo transactions inject liquidity into the system, while reverse repo
transactions result in absorption of excess liquidity.
Repo Rate is the rate at which commercial banks borrow money from the RBI for a
short period of time using government securities as collateral. Banks sell their
securities or financial assets to the RBI with an agreement to repurchase them at a
predetermined price at some future date.
A high Repo Rate deters banks from raising funds from the RBI and forces them to keep
their lending and deposit rates high. It thereby keeps money supply in check.
Higher interest rates normally curtail investments, as a result of which the overall
consumption and aggregate demand start falling. Lower demand results in lower
resource utilization. When resource utilization is low, prices and wages usually rise at a
more modest rate. On the other hand, RBI purposefully reduces Repo Rate as and
when it wants to encourage banks to borrow money for further lending to spur
investments.
Reverse Repo Rate is the rate at which banks deposit their excess money with the RBI
for a short period of time. RBI lowers the Reverse Repo Rate whenever it wants banks
not to deposit incremental cash with it, thereby raising liquidity in the banking system
for further lending, raising overall investment levels and hence also raising the
aggregate demand. It also induces banks to offer lower rate of interest on the deposits
made by the general public. At the same time, it allows banks to lend at a lower rate
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due to a decline in their overall funding costs. Reverse Repo Rate remains fixed these
days at 100 basis points (or 1%) below the Repo Rate.
Cash Reserve Ratio (CRR) is the percentage of a bank’s total deposits, which the bank
is required to maintain with the RBI. Banks are mandated to deposit this amount with
the RBI on a fortnightly basis. CRR is a tool used by the RBI to control the liquidity in
the system.
So, when there is excess money floating around in the system, RBI will raise the CRR to
suck out the excess money. On the other hand, if there is a credit crunch, RBI cuts the
CRR to release money into the system. Normally, CRR cut increases liquidity in the
system after adjusting for the money multiplier effect, albeit with some time lag.
Statutory Liquidity ratio (SLR) is the proportion of deposits that banks are required to
maintain in cash or gold or government approved securities. Similar to CRR, a reduction
in SLR also increases some money supply in the financial system. After keeping the
required amount for CRR and SLR, the banks are free to use the remaining deposits for
their lending purposes.
Marginal Standing Facility (MSF) is a facility provided only to the scheduled

commercial banks under which they can borrow funds from the RBI for their overnight
liquidity requirements. Banks can do this borrowing only against their SLR holdings, up
to a certain percentage of their net demand and time liabilities (NDTL). MSF rate is the
rate at which banks can do this borrowing.
Types of Monetary Policy

In practice, to implement any type of monetary policy the main tool used is modifying
the amount of base money in circulation. The monetary authority does this by buying
or selling financial assets (usually government obligations). These open market
operations change either the amount of money or its liquidity (if less liquid forms of
money are bought or sold). The multiplier effect of fractional reserve banking amplifies
the effects of these actions.
Constant market transactions by the monetary authority modify the supply of currency
and this impacts other market variables such as short term interest rates and the
exchange rate.
The distinction between the various types of monetary policy lies primarily with the set
of instruments and target variables that are used by the monetary authority to achieve
their goals.
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Monetary Policy: Target Market Variable: Long Term Objective:

Inflation Targeting Interest rate on overnight A given rate of change in the CPI
debt
Price Level Interest rate on overnight A specific CPI number
Targeting debt
Monetary The growth in money A given rate of change in the CPI
Aggregates supply
Fixed Exchange The spot price of the The spot price of the currency
Rate currency
Gold Standard The spot price of gold Low inflation as measured by the
gold price
Mixed Policy Usually interest rates Usually unemployment + CPI change
The different types of policy are also called monetary regimes, in parallel to exchange-
rate regimes. A fixed exchange rate is also an exchange-rate regime; The Gold standard
results in a relatively fixed regime towards the currency of other countries on the gold
standard and a floating regime towards those that are not. Targeting inflation, the
price level or other monetary aggregates implies floating exchange rate unless the
management of the relevant foreign currencies is tracking exactly the same variables
(such as a harmonized consumer price index).
In economics, an expansionary fiscal policy includes higher spending and tax cuts that
encourage economic growth. In turn, an expansionary monetary policy is one that
seeks to increase the size of the money supply. As usual, inciting of money supply is
aimed at lowering the interest rates on purpose to achieve economic growth by
increase of economic activity. Conversely, contractionary monetary policy seeks to
reduce the size of the money supply. In most nations, monetary policy is controlled by
either a central bank. Neoclassical and Keynesian economists significantly differ on the
effects and effectiveness of monetary policy on influencing the real economy; there is
no clear consensus on how monetary policy affects real economic variables (aggregate
output or income, employment). Both economic schools accept that monetary policy
affects monetary variables (price levels, interest rates).
Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition
such as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central
Bank interest rate target. The interest rate used is generally the overnight rate at which
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banks lend to each other overnight for cash flow purposes. Depending on the country
this particular interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market
operations. Typically the duration that the interest rate target is kept constant will vary
between months and years. This interest rate target is usually reviewed on a monthly
or quarterly basis by a policy committee.
Price level targeting

Price level targeting is a monetary policy that is similar to inflation targeting except
that CPI growth in one year over or under the long term price level target is offset in
subsequent years such that a targeted price-level is reached over time, e.g. five years,
giving more certainty about future price increases to consumers. Under inflation
targeting what happened in the immediate past years is not taken into account or
adjusted for in the current and future years.
Uncertainty in price levels can create uncertainty around price and wage setting
activity for firms and workers, and undermines any information that can be gained
from relative prices, as it is more difficult for firms to determine if a change in
the price of a good or service is because of inflation or other factors, such as an
increase in the efficiency of factors, if inflation is high and volatile. An increase
in inflation also leads to a decrease in the demand for money, as it reduces
the incentive to hold money and increases transaction costs and shoe leather costs.
Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the
money supply. This approach was refined to include different classes of money and
credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued
with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
While monetary policy typically focuses on a price signal of one form or another, this
approach is focused on monetary quantities. As these quantities could have a role on
the economy and business cycles depending on the households' risk aversion level,
money is sometimes explicitly added in the central bank's reaction function.
Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There
are varying degrees of fixed exchange rates, which can be ranked in relation to how
rigid the fixed exchange rate is with the anchor nation.
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Under a system of fiat fixed rates, the local government or monetary authority declares
a fixed exchange rate but does not actively buy or sell currency to maintain the rate.
Instead, the rate is enforced by non-convertibility measures (e.g. capital controls,
import/export licenses, etc.). In this case there is a black market exchange rate where
the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank
or monetary authority on a daily basis to achieve the target exchange rate. This target
rate may be a fixed level or a fixed band within which the exchange rate may fluctuate
until the monetary authority intervenes to buy or sell as necessary to maintain the
exchange rate within the band. (In this case, the fixed exchange rate with a fixed level
can be seen as a special case of the fixed exchange rate with bands where the bands
are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of
local currency must be backed by a unit of foreign currency (correcting for the
exchange rate). This ensures that the local monetary base does not inflate without
being backed by hard currency and eliminates any worries about a run on the local
currency by those wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term
"dollarization") is used freely as the medium of exchange either exclusively or in
parallel with local currency. This outcome can come about because the local
population has lost all faith in the local currency, or it may also be a policy of the
government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or
government as monetary policy in the pegging nation must align with monetary policy
in the anchor nation to maintain the exchange rate. The degree to which local
monetary policy becomes dependent on the anchor nation depends on factors such as
capital mobility, openness, credit channels and other economic factors.
Gold Standard
The gold standard is a system under which the price of the national currency is
measured in units of gold bars and is kept constant by the government's promise to
buy or sell gold at a fixed price in terms of the base currency. The gold standard might
be regarded as a special case of "fixed exchange rate" policy, or as a special type of
commodity price level targeting.
Today this type of monetary policy is no longer used by any country, although the gold
standard was widely used across the world between the mid-19th century through
1971. Its major advantages were simplicity and transparency. The gold standard was
abandoned during the Great Depression, as countries sought to reinvigorate their
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economies by increasing their money supply. The Bretton Woods system, which was a
modified gold standard, replaced it in the aftermath of World War II. However, this
system too broke down during the Nixon shock of 1971.
The gold standard induces deflation, as the economy usually grows faster than the
supply of gold. When an economy grows faster than its money supply, the same
amount of money is used to execute a larger number of transactions. The only way to
make this possible is to lower the nominal cost of each transaction, which means that
prices of goods and services fall, and each unit of money increases in value. Absent
precautionary measures, deflation would tend to increase the ratio of the real value of
nominal debts to physical assets over time. For example, during deflation, nominal
debt and the monthly nominal cost of a fixed-rate home mortgage stays the same,
even while the dollar value of the house falls, and the value of the dollars required to
pay the mortgage goes up. Economists generally consider such deflation to be a major
disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause
problems during recessions and financial crisis lengthening the amount of time an
economy spends in recession. William Jennings Bryan rose to national prominence
when he built his historic (though unsuccessful) 1896 presidential campaign around the
argument that deflation caused by the gold standard made it harder for everyday
citizens to start new businesses, expand their farms, or build new homes.
Monetary Policy Transmission through Interest Rate Signal

Movements in the Central Bank’s key policy rates (repo and reverse repo, bank rate)
are quickly passed through to other market interest rates such as money market rates
and bond yields. These interest rates are also influenced by the risk tolerance of
investors and preferences for holding funds in a form that are readily redeemable. The
interbank call money rate and other capital market interest rates then feed through to
the whole structure of deposit and lending rates. Most deposits and loans that are at
variable or short-term fixed rates see a high pass through of changes in the cash rate to
deposit and lending rates. But because of the other factors influencing capital market
rates, and fluctuations in the level of competition in the banking sector, deposit and
lending rates do not always move in lockstep with the cash rate.
The changes in interest rates affect economic activity and inflation with much longer
lags, because it takes time for individuals and businesses to adjust their behaviour.
Interest rates affect economic activity via a number of mechanisms. They can affect
savings and investment behaviour, the spending behaviour of households, the supply
of credit, asset prices and the exchange rate, all of which affect the level of aggregate
demand.
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In turn, developments in aggregate demand, in conjunction with developments in

aggregate supply, influence the level of inflation in the economy. Inflation is also
influenced by the effect that changes in interest rates have on imported goods prices,
via the exchange rate, and through their effect on inflation expectations more
generally in the economy.
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Expansionary Monetary Policy

An expansionary or loose monetary policy is a policy by monetary authorities to
expand money supply and boost economic activity, mainly by keeping interest rates
low to encourage borrowing by companies, individuals and banks.
Economic Growth
Expansionary monetary policy spurs economic growth during a recession. Adding

money to the economic system lowers interest rates and eases credit restrictions that
banks apply to loan applications. This means consumers and businesses can borrow
money more easily, leading them to spend more money.
High Employment
When consumers spend more money, businesses enjoy increased revenues and profits.
This allows companies to update plant and equipment assets and to hire new
employees. During a period of expansionary monetary policy, unemployment declines
because companies find it easier to borrow money to expand their operations. As more
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people find jobs, they have more money to spend, which increases revenues to
business and results in more jobs.
Price Stability
Inflation can be a result of expansionary monetary policy if the economy is too robust
and creates too much money. Many people incorrectly believe that inflation comes
from high prices. In fact, inflation occurs when there is so much money chasing
available goods and services that the money loses its value in relation to the products it
purchases. This results in higher prices for the limited products because buyers are in
effect competing to buy them and the highest price paid wins. Expansionary monetary
policy also restricts deflation, which occurs during recessions when there is a shortage
of money in circulation and companies lower their prices in order to attract business.
This also results in higher unemployment and reduced wages.
Considerations
Low interest rates paid by banks on their CDs and savings accounts and low interest
rates available in bonds make saving money less attractive because the interest earned
is minimal. When prices on goods and services start to rise as the economy expands,
consumers and businesses find that saving money at 5 percent does not keep up with
price increases of 10 percent or more at the grocery store and business suppliers.
Expansionary monetary policy works because people and businesses tend to seek
better returns by spending their money on equipment, new homes, new cars, investing
in local businesses and other expenditures that promote the movement of money
throughout the system, increasing economic activity.
During a recession when unemployment is a problem
To increase the money supply, any Central Bank (using interest rates as a tool) can
1. buy government bonds (an open market purchase)

2. lower the discount rate
3. lower the reserve requirement
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Note the order:
 First the MS increases (1) which CAUSES

 the interest rate to decrease (2) which CAUSES
 the amount of investment to increase (3) (the graph does not shift), this
CAUSES
 AD to increase (4) which CAUSES two things:
 real GDP increases (5) causing UE to go down, and
 the price level rises (5) cause a little inflation
Contractionary Monetary Policy

Slows Inflation
The main purpose of a contractionary monetary policy is to slow down the rampant
inflation that accompanies a booming economy. The government uses several methods
to do this, including slowing its own spending. The Fed can raise interest rates, making
money more expensive to borrow. Slowing inflation by reining in economic growth
cools off the markets and brings down overall demand--and prices go down with
demand.
Slows Production
Production is reduced in the economy as a by-product of slowing the economic engine.
More expensive investment capital and a reduced demand for products and services
are the culprits. Once companies gear down production, it can take years to ramp it up
again. If the contractionary monetary policy overshoots the mark and tightens the
economy more severely than intended, companies can button down production and
shutter planned expansions. This can throw the economy into a recessionary loop.
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Stabilizes Prices
Inflation causes ever-increasing prices, which can negatively impact consumer
spending power. This price fluctuation can make consumers nervous and erratic in
their spending patterns. A monetary contraction stabilizes prices in the market as the
inflation slows. This increase in consumer confidence keeps the economy on an even
keel and encourages stable spending patterns.
Increases Unemployment
Increased unemployment results from the slowing production and increasing interest
rates. As companies slow their growth rates, they hire fewer employees. Increases in
unemployment cost the government in increased unemployment insurance
administration costs and social services expenses. Governments must carefully weigh
this cost against the economic benefits of reducing inflation. Higher unemployment
rates can also shake consumer confidence if the spike happens rapidly. Increases in
unemployment reduce the demand for many products and services, making the
economic contraction more severe.
When inflation is the problem:
To decrease the money supply, any Central Bank (using interest rates as a tool) can:
1. sell government bonds (an open market sale)

2. raise the discount rate
3. raise the reserve requirement
Note the order:
o First the MS decreases (1) which CAUSES

o the interest rate to increase (2) which CAUSES
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o the amount of investment to decrease (3) (the graph does not shift),
this CAUSES
o AD to decrease (4) which CAUSES two things:
o the price level decreases (5) reducing inflation
o real GDP increases (5) causing UE to go up a little
Objectives of Monetary Policy

The objectives of a monetary policy in India are similar to the objectives of its five year
plans. In a nutshell, planning in India (just as is the case with nations across the globe),
aims at growth, stability and social justice. After the Keynesian revolution in
economics, many people accepted significance of monetary policy in attaining
following objectives.
 Rapid Economic Growth

 Price Stability
 Exchange Rate Stability
 Balance of Payments (BOP) Equilibrium
 Full Employment
 Neutrality of Money
 Equal Income Distribution
These are the general objectives which every central bank of a nation tries to attain by
employing certain tools (Instruments) of a monetary policy. The first two or three
objectives are usually the primary targets for any central bank. In India too, the RBI has
always aimed at the controlled expansion of bank credit and money supply, in order to
achieve the twin objectives of growth and price stability, while maintaining a healthy
exchange rate. Let us now see objectives of monetary policy in detail:
Economic Growth: It is the most important objective of a monetary policy. The

monetary policy can influence economic growth by controlling real interest rate and its
resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by
reducing interest rates, the investment level in the economy can be encouraged. This
increased investment can speed up economic growth. Faster economic growth is
possible if the monetary policy succeeds in maintaining income and price stability.
Price Stability: All the economics suffer from inflation and deflation. It can also be
called as Price Instability. Both of these are harmful to the economy. Thus, the
monetary policy having an objective of price stability tries to keep the value of money
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stable. It helps in reducing the income and wealth inequalities. When the economy
suffers from recession the monetary policy should be an 'easy money policy' but when
there is inflationary situation there should be a 'dear money policy'.
Exchange Rate Stability: Exchange rate is the price of a home currency expressed in
terms of any foreign currency. If this exchange rate is very volatile leading to frequent
ups and downs in the exchange rate, the international community might lose
confidence in our economy. The monetary policy aims at maintaining the relative
stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to
influence the demand for foreign exchange and tries to maintain the exchange rate
stability.
Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer
from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary
policy tries to maintain equilibrium in the balance of payments. The BOP has two
aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess
money supply in the domestic economy, while the later stands for stringency of
money. If the monetary policy succeeds in maintaining monetary equilibrium, then the
BOP equilibrium can be achieved.
Full Employment: The concept of full employment was much discussed after Keynes's
publication of the "General Theory" in 1936. It refers to absence of involuntary
unemployment. In simple words 'Full Employment' stands for a situation in which
everybody who wants jobs get jobs. However it does not mean that there is Zero
unemployment. In that senses the full employment is never full. Monetary policy can
be used for achieving full employment. If the monetary policy is expansionary then
credit supply can be encouraged. It could help in creating more jobs in different sector
of the economy.
Neutrality of Money: Economists such as Wicksted, Robertson have always considered

money as a passive factor. According to them, money should play only a role of
medium of exchange and not more than that. Therefore, the monetary policy should
regulate the supply of money. The change in money supply creates monetary
disequilibrium. Thus monetary policy has to regulate the supply of money and
neutralize the effect of money expansion. However this objective of a monetary policy
is always criticized on the ground that if money supply is kept constant then it would
be difficult to attain price stability.
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Equal Income Distribution: Many economists used to justify that the role of the fiscal
policy is maintaining economic equality. However in recent years economists have
given the opinion that the monetary policy can help and play a supplementary role in
attainting an economic equality. Monetary policy can make special provisions for the
neglect supply such as agriculture, small-scale industries, village industries, etc. and
provide them with cheaper credit for longer term. This can prove fruitful for these
sectors to come up. Thus in recent period, monetary policy can help in reducing
economic inequalities among different sections of society.
Effectiveness of the Monetary Policy:
Keynes and his followers have strongly criticized this policy and pointed out
several limitations of it. Monetary policy is both inadequate and ineffective to solve
fundamental problems of fluctuations and disequilibrium in employment and income
levels. Some of the important criticisms are:
i) Monetary policy operates only on the supply side of the economy. It attempts to
control the supply of currency and credit. But leaves demand side outside its scope
altogether. As a result, such a one-sided approach has no chance of achieving any
significant success in solving major issues.
ii) Even on the supply side, the monetary policy faces various difficulties. It is expected
that whenever the central bank wants to expand or contract credit supply, the bankers
should act accordingly. But this need not be the case. Bankers are likely to be affected
by the central bank policies only through their reserve funds positions. But many
bankers play safe and are cautious in credit supply activity. They often maintain larger
cash reserves than the minimum limits set by the central bank. In such cases bankers
can continue to expand or contract credit supply even when the central bank does not
desire them to do so. This reduces the signal effect of monetary policy tools.
iii) Bank credit supply activity and investors demand for it depends upon general
market conditions. If the central bank reading about the market behavior is not correct
then its policy will be a failure. Even when it intends to make credit supply the
unwilling investors will wish to utilize credit resources. On the other hand if investors
strongly wish to borrow and invest then any attempt to raise bank rate and to make
credit dearer will not prevent them to do s
iv) Monetary policy suffers from time lags. There are usual administrative delays in
making the decision. Then it is published and made known to the bankers. Before the
bankers take official note of it and make adjustments in their current transactions
there may be further time lapses. There is usually 4 to 6 months or even a longer
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interval of time lag between the original decision of the monetary authority and
its final impact. In the meantime the original economic situation might have altered
significantly. Therefore the monetary policy then becomes irrelevant.
v) Monetary policy is based on the functioning of the equation of exchange. The

equation is based on two basic assumptions. It presumes both the velocity of
circulation (V) and the trade volume or level of real income (T) to remain constant,
despite changes in the supply of money. But none of these assumptions are realistic.
During periods of inflation, when money is losing its value, people show a greater
tendency to quickly convert money into stock of real goods. This tends to reduce the
value of (V) the velocity of circulation. On the contrary, during a deflationary phase,
when the value of money is increasing, people reduce consumption and prefer to hold
on to money. This causes a rise in the value of (V) the velocity. The second assumption
about constancy of (T) trade volume is also not correct. At the most one can say that
the equation of exchange works under full employment conditions. But in reality, the
economic conditions are frequently fluctuating. This results in a situation where some
resources are kept unemployed or underemployed. So long as the resources are
unemployed, the equation of exchange cannot hold good. Variations in the supply of
money cannot simply raise or lower the price level. It is incorrect therefore, to believe
that money supply has no real effects on the levels of output and employment. In
modern times money cannot remain a neutral medium. It does influence real economic
activities.
vi) Monetary policy operates only to bring about variations in the fluctuating price
level. But this is a highly unsatisfactory approach. Price level is only a superficial part of
the deeper economic phenomenon. When price level is in disorder there is something
fundamentally wrong with the real economic processes. Therefore mere changes in the
supply of money, intending to correct price level, cannot achieve anything substantial.
It is more important to detect real causes of disequilibrium on the supply and demand
sides of money and to correct them.
vii) Monetary policy attempts to operate through the supply of credit and rate of
interest. Keynesian economists agree that higher or lower rates of interest may have
some indirect effect on the marginal efficiency of capital (MEC). This may influence
investment behavior to some extent. But the ability of monetary policy to alter the rate
of interest significantly is itself a matter of doubt. Keynes’ concept of ’liquidity trap’
shows that the rate of interest is always positive and it never falls below a certain
minimum level. Therefore monetary policy ceases to be of any effect beyond such a
point.
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Conclusion:
The goals of the monetary policy and fiscal policy are the same which is to promote
stable and growing economic conditions in an economy, but the instruments used to
carry these out and the bodies that carry these out are different.
They should be in synch to work well and such that actions of one don’t scuttle the
actions of another and they succeed in their goals of maintaining a reasonable level of
inflation and steady economic growth.
Annexure
Monetarists’ views
i) Demand for money: The classical viewpoint in opposition to the Keynesian analysis
has been put forth in the recent past by the monetarists. After 1954, Professor Milton
Friedman and his followers have repeatedly contributed to such monetarist
arguments. Their views are significantly modified and more realistic than the
traditional rigid outlook. Before arriving at their reaction to monetary policy, it would
be appropriate to consider the demand for money.
Demand for money is the opposite of the velocity of circulation of money. It is the
reciprocal of velocity in its value. If (V) is velocity and (d) is demand for money then,
This is an obvious relationship. Velocity is speed or frequency of rotating units of

money and its value can be increased only by restricting spending. An individual
possessing Rs. 100 can either spend it or hold a part of it. If he spends Rs. 90, he can
only hold Rs. 10. But if he spends Rs. 70 he can hold only Rs. 30 in cash. Therefore
spending more is demanding less and demanding more is spending less of money
possessed.
ii. Monetarists and monetary policy: The monetarists point out that demand for
money, as a proportion of the total income is stable. Therefore during the
expansionary phase when a greater amount of money income is received, people tend
to spend the surplus income quickly. Such spending causes aggregate or effective
demand to increase and the curve to shift upwards. Moreover in the short run some
resources may be underutilized or unemployed. In that case such extra expenditure
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induces some increase in employment. But once the full employment condition is
established, there is no further scope for real output and employment to increase. If
the expansionary policy persists and monetary expenditure continues to increase, then
it will cause a pure inflationary rise in the price level. Thus in the short run monetary
policy may have an impact on the real economic activities but in the long run the
equation of exchange holds good.
iii) Abuse of monetary policy: Monetarists further argue that it is not monetary policy
as such but the abuse of it that is objectionable. Such abuse arises out of rigid and
incorrect judgments of monetary authority about market conditions. During the period
of the Great Depression, the deflationary policy was pursued; this was a wrong move
that had accentuated the crisis.
Moreover, the average man as a consumer or a firm goes by 'expectations' about

future changes in the monetary policy. Normally the average annual growth rate of
price level is said to be permissible and desirable to the extent of 4 percent. This can
compensate for real growth rate of income (GDP). But if people expect higher or lower
rate of inflation in the future then their reactions alter and cause disturbances in the
economy. Therefore the best thing for the monetary authority to do is to maintain a
steady growth rate of money supply and maintain steady rate of inflation. The
monetarists believed that the monetary policy should be able to allow for a rise in the
growth rate and at the same time not result in either inflation or deflation.
The modern public authority has a responsibility of promoting public welfare. It cannot
play a passive role during such major economic crises. Again the classical school
generally suggested that if there is any problem of inflation or deflation then public
authority instead of directly intervening in the form of fiscal policy can use monetary
policy. This basically concerns the regulation of money supply. It may be said that the
economy can be kept in order with the help of the monetary policy which operates
indirectly. Keynes, however, opposes this argument.
Summary:
 Fiscal policy involves the use of government spending, taxation and

borrowing to affect the level and growth of aggregate demand, output and
jobs.
 An Expansionary fiscal policy involves government spending exceeding tax

revenue, and is usually undertaken during recessions.
 A Contractionary fiscal policy occurs when government spending is lower than

tax revenue, and is usually undertaken to pay down government debt.
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 The goals of the monetary policy and fiscal policy are the same which is to
promote stable and growing economic conditions in an economy, but the
instruments used to carry these out and the bodies that carry these out are
different.
 The key objectives of monetary policy are economic growth, price stability and
stable exchange rates among others.
 Monetary policy objectives are achieved through quantitative tools like reserve
requirements, borrowing / lending rates of central banks (discount rate) and
open market operations and qualitative ones like directives ad moral suasion
among others.
 Expansionary Monetary Policy - during a recession to increase the money

supply and consequent demand, the Central Bank can
1. buy government bonds (an open market purchase)

2. lower the discount rate
3. lower the reserve requirement
 Contractionary Monetary Policy - when inflation is the problem, to decrease

the money supply, the Central Bank can
1. sell government bonds (an open market sale)

2. raise the discount rate
3. raise the reserve requirement
Questions
1. What is meant by fiscal policy?
2. What are the key objectives of fiscal policy?
3. What are the key tools used to implement fiscal policy measures?
4. Briefly describe the role of fiscal policy in ensuring growth in any economy.
5. Enlist and explain the key components of a government’s budget?
6. What is monetary policy and how does it differ from fiscal policy?
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7. Describe the instruments of monetary policy. How do they work and what are
their limitations?
8. What is “open market operation”? How does it work to regulate money

supply?
9. Explain the working mechanism of an expansionary monetary policy.
10. Distinguish between quantitative and qualitative measures of money control.
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Business Cycle Managerial Economics
BUSINESS CYCLE
&
STABILIZATION
Objectives
 This chapter aims at understanding the excessive economic fluctuations and,

at the same time, allowance for fluctuations necessary for a long-term,
sustained economic growth
 You shall learn the efficient utilization of labor and other productive resources
 You shall learn that all businesses operate around certain business cycles. A
business cycle refers to various trends that occur within a business or industry,
such as growth or contraction.
 This chapter highlights one of the main cycles business management will
encounter in the life of a business is one that sees four, distinct trends:
slowdown, bottom, growth and peak.
Business Cycle
The business cycle is the periodic but irregular up-and-down movement in economic
activity, measured by fluctuations in real gross domestic product (GDP) and other
macroeconomic variables. A business cycle is typically characterized by four phases—
recession, recovery, growth, and decline—that repeat themselves over time.
Economists note, however, that complete business cycles vary in length. The duration
of business cycles can be anywhere from about two to twelve years, with most cycles
averaging six years in length. Some business analysts use the business cycle model and
terminology to study and explain fluctuations in business inventory and other
individual elements of corporate operations. But the term "business cycle" is still
primarily associated with larger (industry-wide, regional, national, or even
international) business trends.
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Managerial Economics Business Cycle
Stages of a Business Cycle
PEAK PEAK
PROSPERITY RECESSION
RECOVERY DEPRESSION
Trough
Four Phases of Business Cycle
Figure 15 A - The business cycle starts from a trough (lower point) and
passes through a recovery phase followed by a period of expansion (upper
turning point) and prosperity. After the peak point is reached there is a
declining phase of recession followed by a depression. Again the business
cycle continues similarly with ups and downs.
Explanation of Four Phases of Business Cycle

The four phases of a business cycle are briefly explained as follows:-
1. Prosperity Phase
When there is an expansion of output, income, employment, prices and profits, there
is also a rise in the standard of living. This period is termed as Prosperity phase.
The features of prosperity are:-

 High level of output and trade.
 High level of effective demand.
 High level of income and employment.
 Rising interest rates.
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 Inflation.
 Large expansion of bank credit.
 Overall business optimism.
A high level of MEC (Marginal efficiency of capital) and investment:
Due to full employment of resources, the level of production is Maximum and there is
a rise in GNP (Gross National Product). Due to a high level of economic activity, it
causes a rise in prices and profits. There is an upswing in the economic activity and
economy reaches its Peak. This is also called as a Boom Period.
2. Recession Phase
The turning point from prosperity to depression is termed as Recession Phase.

During a recession period, the economic activities slow down. When demand starts
falling, the overproduction and future investment plans are also given up. There is a
steady decline in the output, income, employment, prices and profits. The
businessmen lose confidence and become pessimistic (Negative). It reduces
investment. The banks and the people try to get greater liquidity, so credit also
contracts. Expansion of business stops, stock market falls. Orders are cancelled and
people start losing their jobs. The increase in unemployment causes a sharp decline in
income and aggregate demand. Generally, recession lasts for a short period.
3. Depression Phase
When there is a continuous decrease of output, income, employment, prices and

profits, there is a fall in the standard of living and depression sets in.
The features of depression are:-

 Fall in volume of output and trade.
 Fall in income and rise in unemployment.
 Decline in consumption and demand.
 Fall in interest rate.
 Deflation.
 Contraction of bank credit.
 Overall business pessimism.
 Fall in MEC (Marginal efficiency of capital) and investment.
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In depression, there is under-utilization of resources and fall in GNP (Gross National

Product). The aggregate economic activity is at the lowest, causing a decline in
prices and profits until the economy reaches its Trough (low point).
4. Recovery Phase
The turning point from depression to expansion is termed as Recovery or Revival

Phase.
During the period of revival or recovery, there are expansions and rise in economic
activities. When demand starts rising, production increases and this causes an increase
in investment. There is a steady rise in output, income, employment, prices and profits.
The businessmen gain confidence and become optimistic (Positive). This increases
investments. The stimulation of investment brings about the revival or recovery of the
economy. The banks expand credit, business expansion takes place and stock markets
are activated. There is an increase in employment, production, income and aggregate
demand, prices and profits start rising, and business expands. Revival slowly emerges
into prosperity, and the business cycle is repeated.
Thus we see that, during the expansionary or prosperity phase, there is inflation and
during the contraction or depression phase, there is a deflation.
Factors That Shape Business Cycles
For centuries, economists in both the United States and Europe regarded economic
downturns as "diseases" that had to be treated; it followed, then, that economies
characterized by growth and affluence were regarded as "healthy" economies. By the
end of the 19th century, however, many economists had begun to recognize that
economies were cyclical by their very nature, and studies increasingly turned to
determining which factors were primarily responsible for shaping the direction and
disposition of national, regional, and industry-specific economies. Today, economists,
corporate executives, and business owners cite several factors as particularly
important in shaping the complexion of business environments.
Volatility of Investment Spending

Variations in investment spending are one of the important factors in business cycles.
Investment spending is considered the most volatile component of the aggregate or total
demand (it varies much more from year to year than the largest component of the
aggregate demand, the consumption spending), and empirical studies by economists
have revealed that the volatility of the investment component is an important factor in
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explaining business cycles in the United States. According to these studies, increases in
investment spur a subsequent increase in aggregate demand, leading to economic
expansion. Decreases in investment have the opposite effect. Indeed, economists can
point to several points in American history in which the importance of investment
spending was made quite evident. The Great Depression, for instance, was caused by a
collapse in investment spending in the aftermath of the stock market crash of 1929.
Similarly, the prosperity of the late 1950s was attributed to a capital goods boom.
There are several reasons for the volatility that can often be seen in investment
spending. One generic reason is the pace at which investment accelerates in response
to upward trends in sales. This linkage, which is called the acceleration principle by
economists, can be briefly explained as follows. Suppose a firm is operating at full
capacity. When sales of its goods increase, output will have to be increased by
increasing plant capacity through further investment. As a result, changes in sales
result in magnified percentage changes in investment expenditures. This accelerates
the pace of economic expansion, which generates greater income in the economy,
leading to further increases in sales. Thus, once the expansion starts, the pace of
investment spending accelerates. In more concrete terms, the response of the
investment spending is related to the rate at which sales are increasing. In general, if
an increase in sales is expanding, investment is spending rises, and if an increase in
sales has peaked and is beginning to slow, investment spending falls. Thus, the pace of
investment spending is influenced by changes in the rate of sales.
Momentum
Many economists cite a certain "follow-the-leader" mentality in consumer spending. In

situations where consumer confidence is high and people adopt more free-spending
habits, other customers are deemed to be more likely to increase their spending as
well. Conversely, downturns in spending tend to be imitated as well.
Technological Innovations
Technological innovations can have an acute impact on business cycles. Indeed,

technological breakthroughs in communication, transportation, manufacturing, and
other operational areas can have a ripple effect throughout an industry or an economy.
Technological innovations may relate to production and use of a new product or
production of an existing product using a new process. The video imaging and personal
computer industries, for instance, have undergone immense technological innovations
in recent years, and the latter industry in particular has had a pronounced impact on
the business operations of countless organizations. However, technological
innovations—and consequent increases in investment—take place at irregular
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intervals. Fluctuating investments, due to variations in the pace of technological

innovations, lead to business fluctuations in the economy.
There are many reasons why the pace of technological innovation varies. Major
innovations do not occur every day. Nor do they take place at a constant rate. Chance
factors greatly influence the timing of major innovations, as well as the number of
innovations in a particular year. Economists consider the variations in technological
innovation as random (with no systematic pattern). Thus, irregularity in the pace of
innovations in new products or processes becomes a source of business fluctuations.
Variations in Inventories
Variations in inventories—expansion and contraction in the level of inventories of

goods kept by businesses—also contribute to business cycles. Inventories are the
stocks of goods firms keep in hand to meet demand for their products. How do
variations in the level of inventories trigger changes in a business cycle? Usually, during
a business downturn, firms let their inventories decline. As inventories dwindle,
businesses eventually use down their inventories to the point where they are short.
This, in turn, starts an increase in inventory levels as companies begin to produce more
than is sold, leading to an economic expansion. This expansion continues as long as the
rate of increase in sales holds up and producers continue to increase inventories at the
preceding rate. However, as the rate of increase in sales slows, firms begin to cut back
on their inventory accumulation. The subsequent reduction in inventory investment
dampens the economic expansion, and eventually causes an economic downturn. The
process then repeats itself all over again. It should be noted that while variations in
inventory levels impact overall rates of economic growth, the resulting business cycles
are not really long. The business cycles generated by fluctuations in inventories are
called minor or short business cycles. These periods, which usually last about two to
four years, are sometimes also called inventory cycles.
Fluctuations in Government Spending
Variations in government spending are yet another source of business fluctuations.

This may appear to be an unlikely source, as the government is widely considered to be
a stabilizing force in the economy rather than a source of economic fluctuations or
instability. Nevertheless, government spending has been a major destabilizing force on
several occasions, especially during and after wars. Government spending increased by
an enormous amount during World War II, leading to an economic expansion that
continued for several years after the war. Government spending also increased, though
to a smaller extent compared to World War II, during the Korean and Vietnam Wars.
These also led to economic expansions. However, government spending not only
contributes to economic expansions, but economic contractions as well. In fact, the
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recession of 1953—54 was caused by the reduction in government spending after the
Korean War ended. More recently, the end of the Cold War resulted in a reduction in
defense spending by the United States that had a pronounced impact on certain
defense-dependent industries and geographic regions.
Politically Generated Business Cycles
Many economists have hypothesized that business cycles are the result of the
politically motivated use of macroeconomic policies (monetary and fiscal policies) that
are designed to serve the interest of politicians running for re-election. The theory of
political business cycles is predicated on the belief that elected officials (the president,
members of Congress, governors, etc.) have a tendency to engineer expansionary
macroeconomic policies in order to aid their re-election efforts.
Monetary Policies
Variations in the nation's monetary policies, independent of changes induced by

political pressures, are an important influence in business cycles as well. Use of fiscal
policy—increased government spending and/or tax cuts—is the most common way of
boosting aggregate demand, causing an economic expansion. The Central Bank, in the
case of India, the Reserve Bank of India (RBI), has two legislated goals—price stability
and full employment. Its role in monetary policy is a key to managing business cycles
and has an important impact on consumer and investor confidence as well.
Fluctuations in Exports and Imports
The difference between exports and imports is the net foreign demand for goods and
services, also called net exports. Because net exports are a component of the aggregate
demand in the economy, variations in exports and imports can lead to business
fluctuations as well. There are many reasons for variations in exports and imports over
time. Growth in the gross domestic product of an economy is the most important
determinant of its demand for imported goods—as people's incomes grow their appetite
for additional goods and services, including goods produced abroad, increases. The
opposite holds when foreign economies are growing—growth in incomes in foreign
countries also leads to an increased demand for imported goods by the residents of
these countries. This, in turn, causes U.S. exports to grow. Currency exchange rates can
also have a dramatic impact on international trade—and hence, domestic business
cycles—as well.
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Business Cycle Variants, Stagflation and the Jobless Recovery

Business cycles are difficult to anticipate accurately, in part because of the number of
variables involved in large economic systems. Nonetheless, the importance of tracking
and understanding business cycles has led to a great deal of study of the subject and
knowledge about the subject. It was as a result somewhat surprising when, in the
1970s, the nation found itself stuck in a period of seemingly contradictory economic
conditions, slow economic growth and rising inflation. The condition was named
stagflation and paralyzed the U.S. economy from the mid-1970s through the early
1980s.
Another somewhat unexpected business cycle phenomenon has occurred in the early
2000s. It is what has come to be known as the "jobless recovery." According to the
National Bureau of Economic Research's Business Cycle Dating Committee, in a late
2003 report, "the most recent economic peak occurred in March 2001, ending a
record-long expansion that began in 1991. The most recent trough occurred in
November 2001, inaugurating an expansion." The problem with the expansion has
been that it has not included a rise in employment or real personal income, something
seen in all previous recoveries.
The reasons for the jobless recovery are not fully understood but are the cause of
much debate within the economic and political circles. Within this debate there are
four leading explanations that analysts have given for the jobless recovery. According
to a study published in Economic Perspectives in the summer of 2004, these four
explanations are:
 An imbalance in labor available by sector.
 The emergence of just-in-time hiring practices.
 The rising cost of health care benefits.
 Rapidly increasing productivity not being off-set by aggregate demand.
 Only time and further analysis will show which of these factors, or which
combination of factors explains the advent of a jobless recovery. Neil Shister, editorial
director of the World Trade summarizes a discussion of the jobless recovery this way,
"The culprit is ourselves. We have become dramatically more productive." This
assessment suggests that much more will need to be understood about modern
business cycles before we can again anticipate them and plan for their effects on the
economy generally.
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Keys to Successful Business Cycle Management

Small business owners can take several steps to help ensure that their establishments
weather business cycles with a minimum of uncertainty and damage. The concept of
cycle management is earning adherents who agree that strategies that work at the
bottom of a cycle need to be adopted as much as those which work at the top of a
cycle. While there is no definitive formula for every company, the approaches generally
emphasize a long-term view focused on a company's core strengths and stressing the
need to plan with greater discretion at all times. Essentially, efforts are made to adjust
a company's operations in such a manner that it maintains an even keel through the
ups and downs of a business cycle.
 Specific tips for managing business cycle downturns include the following:
 Flexibility—Having a flexible business plan allows for development times that span
the entire cycle and includes various recession-resistant funding structures.
 Long-term Planning—Consultants encourage small businesses to adopt a moderate
stance in their long-range forecasting.
 Attention to Customers—This can be an especially important factor for businesses
seeking to emerge from an economic downturn. Maintaining close relations and open
communication with customers is a tough discipline to maintain in good times, but it is
especially crucial coming out of bad times. Customers are the best gauges of when a
company is likely to begin recovering from an economic slowdown.
 Objectivity—Small business owners need to maintain a high level of objectivity
when riding business cycles. Operational decisions based on hopes and desires
rather than a sober examination of the facts can devastate a business, especially in
economic down periods.
 Study—Timing any action for an upturn is tricky. The consequences of getting the
timing wrong, of being early or late, can be serious. How, then, does a company
strike the right balance between being early or late? Listening to economists,
politicians, and media to get a sense of what is happening is useful. The best route,
however, is to avoid trying to predict the upturn. Instead, listen to your customers
and know your own response-time requirements.
What GDP Can You Expect in Each Business Cycle Phase?

In the Contraction phase, GDP growth rates usually slow to the 1%-2% level before
actually turning negative. The 2008 recession was so nasty because the economy
immediately shrank 2.7% in the first quarter 2008, rebounded 2% in the second
quarter, leading everyone to think the downturn was over. It fell another 2% in the
third quarter, before plummeting a whopping 8.3% in the fourth quarter. The economy
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received another wallop in the first quarter of 2009, when the economy contracted a
brutal 5.4%. (For more, see 2008 GDP Statistics)
In the Trough phase, GDP growth may still be negative, but it's not as bad. It's clear
that the economy has turned a corner. According to the NBER, this occurred in the
second quarter 2009, when GDP contracted a mere .4%.
In the Expansion phase, GDP growth turns positive again, and should be in the healthy
2-3% range. If the economy is managed well, it can stay in the Expansion phase for
years. The current expansion phase started in the third quarter 2009, when GDP rose
1.3%. This was thanks to the stimulus spending from the American Recovery and
Reinvestment Act. However, four years into the expansion phase, the unemployment
rate was still above 7%. That's because the Contraction phase was so harsh.
The Peak phase is when the economy's expansion slows. It's usually the last healthy
growth quarter before the recession starts. You usually don't know you are in a peak
until it is too late. However, if the GDP growth rate is 4% or higher for two or more
quarters in a row, you can bet the peak is not far off. In the 2008 recession, the peak
occurred in the fourth quarter 2007, when the GDP growth was 1.5%.
Theories of Business Cycle

Macroeconomics emphasizes the interrelatedness of the various sectors of the
economy. Hence, disturbances in one part of the economy can result in symptoms in
other parts that seem far removed. Two central questions of macroeconomics are
where does disturbance originates in the system, and where the forces prevent the
system from quick and smooth readjustment when it is disturbed.
Many economists see the process of money creation and destruction as a source of
past macroeconomic disturbances. This group of readings will add the short-run story
that many economists who believed the quantity theory of money told (and tell). The
readings also introduce another story that many economists tell, that economic
disturbances can originate not in the supply and demand for money, but in goods
markets.
The central idea of business-cycle literature, that the economy has regular and periodic
waves—a cycle—lasting for several years, has few adherents today. Perhaps such
cycles never existed, or perhaps they once did but no longer do because the
government now plays a large and active role in the economy. However, the business-
cycle approach remains useful because it is an easy way to introduce a number of
macroeconomic topics, including the adjustment process that remains central in
macroeconomics. It also provides a transition from our examination of monetary
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theories to an introduction to Keynesian economics, a very different way of viewing

the macroeconomy.
Economic Stabilization Policies

A macroeconomic strategy enacted by governments and central banks to keep
economic growth stable, along with price levels and unemployment. Ongoing
stabilization policy includes monitoring the business cycle and adjusting benchmark
interest rates to control aggregate demand in the economy. The goal is to avoid erratic
changes in total output, as measured by Gross Domestic Product (GDP) and large
changes in inflation; stabilization of these factors generally leads to moderate changes
in the employment rate as well.
Stabilization policies are also used to help an economy recover from a specific
economic crisis or shock, such as sovereign debt defaults or a stock market crash. In
these instances stabilization policies may come from governments directly through
overt legislation, securities reforms, or from international banking groups, such as the
World Bank.
As economies become more complex and advanced, top economists believe that
maintaining a steady price level and pace of growth is the key to long-term prosperity.
When any of the aforementioned variables becomes too volatile, there are unforeseen
consequences and effects to the broad economy that keep markets from functioning at
their optimum level of efficiency. Most modern economies employ stabilization
policies, with much of the work being done by central banking authorities.
During periods of high or rising unemployment associated with a business-cycle

contraction, the appropriate action is to stimulate the economy through expansionary
policies. During periods of high or rising inflation associated with a business-cycle
expansion, the appropriate action is to dampen the economy through contractionary
policies.
Fiscal and Monetary
The two most frequently used stabilization policies are fiscal policy and monetary
policy.
Fiscal Policy:
This policy makes use of government spending and/ortaxes, the two components of
the government's "fiscal" budget. When government increases or decreases spending,
especially by changing the quantity of gross domestic product purchased, then
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aggregate, employment, and national income are also affected. Government can
change the amount of taxes collected from the public, as well, which then affects the
amount of income available to purchase gross domestic product. This also triggers
changes in aggregate production, employment, and national income.
Monetary Policy:
This policy involves the total amount of money in circulation throughout the economy,
as well as interest rates in financials. By changing the amount of money in circulation,
the public has more or less of an ability to purchase gross domestic product, which
then triggers changes in overall economic activity. Money supply changes also
invariably cause changes in interest rates, which subsequently affect the willingness
and ability to borrow the funds used for expenditures.
Expansionary and Contractionary

Stabilization policies can be either expansionary or contractionary, depending on
whether the most pressing problem is excessive unemployment or excessive inflation.
Expansionary Policy:
This policy is designed to stimulate the economy and to reduce unemployment by
countering or preventing a business-cycle contraction. Expansionary fiscal policy is an
increase in government spending and/or a decrease in taxes. Expansionary monetary
policy is an increase in the money supply and/or a decrease in the interest rate.
Contractionary Policy:
This policy is designed to dampen the economy and to reduce inflation by countering
or preventing the inflationary excesses of a business-cycle expansion. Contractionary
fiscal policy is a decrease in government spending and/or an increase in taxes.
Contractionary monetary policy is a decrease in the money supply and/or an increase
in the interest rate.
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Long-Run
Trend
Real GDP
Regular
Business Cycle
Months
Figure 5 B - Stabilizing the Business Cycle
The graph illustrates the goal of stabilization policies. The red line is the
"natural" business cycle. Rising and falling around the blue long-run trend line. But it
rises and falls too much, causing inflation and unemployment. Policy makers would
rather have a business cycle more like that revealed with a click of the [Stabilization
Policies] button.
Stabilization policies can achieve this result by countering business cycle ups and
downs. When unemployment rises with a business-cycle contraction, expansionary
policies are appropriate. When inflation worsens with a business-cycle expansion,
contractionary policies are appropriate. Once again, note that stabilization policies are
a countercyclical. Contractionary policies counter an expansion and expansionary
policies counter a contraction.
Economists’ View
Currently, there are quite a few people advocating the use of tax cuts to combat a
potential slowdown in the economy due to the financial crisis. That is certainly an
option, if the tax cuts are well-targeted so that they do, in fact, provide the intended
stimulus to the economy, and if they can be put into place quickly enough to hit before
the economy recovers on its own. But there is another aspect of using tax cuts for
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stabilization policy that needs to be in place that would be difficult to achieve in the
current political environment.
If we are going to use tax cuts as a fiscal policy tool to stabilize the economy, we have
to be willing to move the tax rate in both directions, up as well as down. We are quite
willing, currently; to move the tax rate down but when people like Martin Feldstein call
for a temporary tax cut to stimulate the economy, if such a policy were to be enacted
does anyone doubt the difficulty of raising taxes again later even with automatic
expiration provisions?
Backing up slightly, why do we need to increase taxes again instead of leaving them
where they are? This is stabilization policy, not growth policy, and the goal is to keep the
economy anchored as closely as possible to the target rate of output. If in each
successive business cycle the tax rate is lowered, but it is never raised again, there will
eventually come a time when the tax rate cannot be lowered any further. If a severe
recession then hits, and monetary policy isn't providing the needed stimulus or interest
rates are already so low that further decreases will be ineffective, and then fiscal policy
will be unavailable as a backup stimulus device, much to our detriment.
Instead, assuming as in most models that the target rate of output is centrally located,
the goal is to bring the economy up when the economy is dragging (use tax cuts that
increase the deficit) and to slow the economy down when it begins to overheat (use
tax increases that reduce the deficit). Managed properly over business cycles, tax cuts
in bad times, tax increases in good times, the economy will stabilize around the target
and there will be no long-run consequences for the deficit or the size of government.
But if we insist that only tax cuts are available, that there is a ratchet effect in place
and taxes can never be increased again, then - abstracting for the moment from
changes in government spending or assuming that changes in spending are infeasible
for use as a stabilization tool - at some point we could well run out of options.
There is nothing special about using tax changes for stabilization policy, changes in
government spending can also be used. Changes in government spending may even be
preferred in some cases and combinations of changes in government spending and
changes in taxes can also be used to stabilize the economy around the long-run growth
path if that is the preference. Want a smaller government? Use tax cuts to stimulate the
economy in recessions, and use reductions in government spending to slow the economy
when it threatens to overheat and be inflationary. Want a larger government? Do the
opposite, increase government spending whenever the economy is lagging, and increase
taxes to slow the economy when it begins to overheat.
The point is that stabilization policy - changes in taxes or changes in government

spending - does not necessarily change the size of government in any particular
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direction that is a policy choice. Traditionally stabilization policy maintains a constant

budget balance in the long-run and whether to use tax changes or spending changes is
a matter of effectiveness, not a matter of ideology about the size of government.
Unfortunately, disputes over this issue can make it difficult to use fiscal policy as a
stabilization tool. Even when both sides agree something needs to be done, different
ideas about the size and functions of government can cause differences in the choice of
tax changes or changes in spending as the means of stimulating or slowing the
economy leading to policy gridlock.
In the political arena, gridlock can also occur when growth policy and stabilization
policy are confused in order to block certain types of policies. For example, a tax
increase during a robust economic expansion to pay off the tax cut enacted in the
previous slowdown may be blocked by objections that it will slow economic growth.
But that is the point of the policy in the short-run - the increase in the tax rate is
supposed to stop the economy from overheating - just as the cut in taxes was intended
to stimulate the economy on the other side. It's the average tax rate over the long-run
that matters for growth (the stability of taxes also matters which is one of the reasons
to prefer changes in government spending over changes in taxes as the stabilization
tool). Politically, in the current environment, it is difficult to do anything to pay off the
debt when the economy is expanding, increases in taxes or cuts in spending, because
one of the primary objections is that it will slow growth. But if we are serious about
stabilization policy we have to somehow realize that the good times are the best
choice for paying off the debts we accumulated when things weren't going so well.
Summary
 A business cycle is typically characterized by four phases—recession, recovery,
growth, and decline—that repeat themselves over time
 When there is an expansion of output, income, employment, prices and profits,

there is also a rise in the standard of living. This period is termed as Prosperity
phase
 The turning point from prosperity to depression is termed as Recession Phase.
During a recession period, the economic activities slow down.
 When there is a continuous decrease of output, income, employment, prices and

profits, there is a fall in the standard of living and depression sets in
 The turning point from depression to expansion is termed as Recovery or Revival
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Phase. During the period of revival or recovery, there are expansions and rise in
economic activities.
 Variations in investment spending is one of the important factors in business

cycles.
 Investment spending is considered the most volatile component of the aggregate

or total demand
 Technological innovations can have an acute impact on business cycles. Indeed,

technological breakthroughs in communication, transportation, manufacturing,
and other operational areas can have a ripple effect throughout an industry or an
economy
 Variations in inventories—expansion and contraction in the level of inventories of

goods kept by businesses—also contribute to business cycles
 The concept of cycle management is earning adherents who agree that strategies
that work at the bottom of a cycle need to be adopted as much as those which
work at the top of a cycle
Suggestive Questions
1. What Are the Deﬁning characteristics of the Business Cycle?
2. Describe the phases of Business Cycle with example?
3. How do economists keep track of Business Cycle?
4. What are the factors responsible for shaping business cycle?
5. What do you understand by fluctuations in government spending?
6. What are the four phases of a typical business cycle?
7. What is the difference between business cycles, growth rate cycles, and inflation
cycles?
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Market Prediction & Pricing Strategy Managerial Economics
MARKET PREDICTION AND

PRICING STRATEGY
Objectives: -
 To understand the issues related to market failure and predictions.

 Asymmetric information and its effect.
 Different Pricing strategies.
Market failure, in economics, is a situation defined by an inefficient distribution of

goods and services in the free market. In an ideally functioning market, the forces of
supply and demand balance each other out, with a change in one side of the equation
leading to a change in price that maintains the market's equilibrium. In a market
failure, however, something interferes with this balance.
When markets fail, the individual incentives for rational behaviour do not lead to
rational outcomes for the group. In other words, each individual makes the correct
decision for themselves, but those prove to be the wrong decisions for the group as a
whole.
Understanding Market Failure
A market failure refers to the inefficient distribution of resources that occurs when the
individuals in a group end up worse off than if they had not acted in rational self-
interest. In the case of a market failure, the overall group incurs too many costs or
receives too few benefits. The economic outcomes under market failure deviate from
what economists usually consider optimal and are usually not economically efficient.
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Managerial Economics Market Prediction & Pricing Strategy
Contrary to what the name implies, market failure does not describe imperfections just
in the market economy—there can be market failures in government activity, too. One
noteworthy example is rent seeking by special interest groups.
Special interest groups can benefit by lobbying for small costs on everyone else, such
as through a tariff. When each small group imposes its costs, the whole group is worse
off than if no lobbying had taken place.
Not every bad outcome from market activity counts as a market failure. In addition,
while correcting the imbalances underlying a market failure often requires government
intervention, private-market actors may also be able to solve the problem. On the flip
side, not all market failures have a potential solution, even with prudent regulation or
extra public awareness.
Asymmetric Information
Definition:-
Asymmetric information is the situation when one party in an economic transaction

possesses more information about the product/service involved than the other party.
Now, we will take a look into what happens when one party (seller) possesses more
information than another party (buyer) involved in the economic transaction.
The asymmetric information theory states that high-quality products and low-quality
products can be sold at the same price because buyers don't have enough information
about the products.
Example
Asymmetric Information Market for smartphones
Let us suppose there are two types of smartphones available in the market, i.e., High-
quality smartphones and Low-quality smartphones which can be distinguished by the
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buyer by just having a look at them. From Figure 1 above, we can illustrate that there
are two markets for both qualities of products.
The supply curve is denoted by SH and SL of high-quality smartphones and low-quality

smartphones respectively. Similarly, DH denotes the demand for high-quality
smartphones, and DL denotes the demand for low-quality smartphones. DH is higher
than DL because the buyers are willing to pay a higher amount for high-quality
smartphones. The market price for a high-quality smartphone is $900 and the market
price of a low-quality smartphone is $500 while both are selling 20,000 units at the
given price point.
The sellers of smartphones of both qualities know more about the quality of their
products than the buyers. As the same quantity of both of the products is sold, the
buyers expect that the product they get will be medium-quality. The demand curve for
medium-quality smartphones is DM in Figure 1. We can see that medium-quality
smartphones are sold for $700 each but this time the quantities sold of high-quality
smartphones have decreased to 10,000 units. However, the quantity sold of the low-
quality smartphone has increased to 30,000 units.
We can see that 3/4th of the smartphones sold now are of low quality. Therefore,
smartphone buyers now expect that they are more likely to get a low-quality than a
high-quality phone. This causes the perceived demand to shift further to the left. The
price and quantity sold of high-quality products decrease as the quantity sold of low-
quality products increases.
This process will continue and shift the mix of products more toward low-quality
smartphones. Slowly, in the long run, the price of any product will be very low, and no
high-quality smartphones will be sold. The low-quality product has driven the high-
quality product out of the market.
This is an extreme case where the low-quality product drives the high-quality one out
of the market. We can have a market equilibrium that allows a mix of both varieties to
be sold, but the quantity sold of the low-quality product will be higher than the
quantity sold of the high-quality one.
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Asymmetric Information Types
By now, you already know about asymmetric information and its effects on the market,
but there are various types of situations that involve asymmetric information. Let's talk
about these.
Asymmetric Information: Adverse Selection
The example of smartphones of different qualities sold at the same price point is the
perfect example of adverse selection. Adverse selection occurs when products of
different qualities are sold at the same price due to the information asymmetry
between buyers and sellers.
This causes a problem to determine the true quality of the product while purchasing it.
Hence, it causes a higher quantity of low-quality products and less quantity of high-
quality products being sold in the market.
Adverse selection is also a problem for the insurance market. Let's consider an
example in the health insurance market.
People who purchase insurance are far more informed about their health than the
insurance company. Even if the insurance company runs many screening tests, they
may not be able to identify all of the health problems. In this case, there is an
information asymmetry between the insurance buyers and the insurance company.
Knowing that less healthy people are more likely to get insurance, insurance
companies raise the price of their premiums. This forces more relatively healthy people
to drop out, leaving the insurance pool with even less healthy people. You can see why
this can turn into a problematic cycle for the insurance market.
Asymmetric Information: Moral Hazard
The situation when an individual alters his/her behaviour knowing that their actions
are unobserved is known as a moral hazard.
Let us suppose that Emily gets full insurance on her house against theft. Now, her
behaviour might alter. She might not be as careful as before while locking the doors,
and she might choose to not get an alarm system. The change in her behaviour as she
is insured is an example of a moral hazard.
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Moral hazard does not only alter the behaviour of an individual, it leads to economic
inefficiency. Economic inefficiency arises because, in comparison to actual cost and
benefits, the insured person perceives the cost and benefits differently.
A moral hazard is a situation where an individual alters his/her behaviour knowing that
their actions are unobserved.
Asymmetric Information : Market Failure
Asymmetric information can be a possible reason for market failure.
Market failure is when the free market leads to an inefficient distribution of goods and
services.
For example, in the market for smartphones, consumers must be able to choose
between high-quality smartphones and low-quality smartphones as per their
preferences. Some people might not want to spend much on a smartphone and might
select a low-quality smartphone for a lower cost, but some people might spend more
because they prefer a higher-quality product.
However, if the quality of a smartphone can only be known by the buyer after they
purchase it, the majority of people would choose the lower quality product as they
cost less and buyers have less to lose even if the smartphone is not of the desired
quality. This decreases the demand for high-quality smartphones, and the sellers start
to decrease the price of their products. Slowly, high-quality smartphones disappear
from the market even though some people would prefer high-quality smartphones.
Hence, market failure arises.
Asymmetric Information Problem
Asymmetric information problems are eminent in almost every market. Each market is
unique and different types of problems might arise depending on the type of market.
Now we will look into the mechanism that can be used by sellers and buyers to deal
with the problem of asymmetric information.
Signalling
One of the widely used mechanisms to reduce the problem of asymmetric information
is signalling. The concept of market signalling was developed by Michael Spence, who
stated that sellers send signals to the buyers which help them determine the quality of
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the product. Depending on the type of product, sellers use different signalling
mechanisms.
Alex is a seller of high-quality electronic goods. The market of electronic goods is very
fragmented and various types of sellers are in the market selling both high-quality and
low-quality products. How will Alex stand out in such a market and convince the buyers
that his product is of higher quality than his competitors?
He will start using warranties and guarantees while selling his products. As warranties
and guarantees are given mainly by high-quality product sellers, it effectively signals
the quality of a product. Low-quality product sellers are reluctant to provide warranties
and guarantees, as they would have to repair the damages at their own cost. Hence,
the buyers of products sold by Alex will view warranties and guarantees as a signal of a
high-quality product.
Therefore, signalling is one of the most effective ways of helping buyers distinguish
between the different qualities of products. Hence, this mechanism helps in reducing
the problem of asymmetric information.
Asymmetric Information - Key Takeaways
 Asymmetric information is the situation when one party in an economic

transaction possesses more information about the product/service involved
than the other party.
 Asymmetric information can be a possible reason for market failure.
 Adverse selection occurs when products of different qualities are sold at the
same price due to the information asymmetry between buyers and sellers.
 A moral hazard is a situation when an individual alters his/her behavior
knowing that his/her actions are unobserved. Moral hazard alters the behavior
of an individual and leads to economic inefficiency.
 Sellers can send signals to the buyers that help them determine the quality of
the product.
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Adverse Selection
Adverse selection refers generally to a situation in which sellers have information that
buyers do not have, or vice versa, about some aspect of product quality. In other
words, it is a case where asymmetric information is exploited. Asymmetric information,
also called information failure, happens when one party to a transaction has greater
material knowledge than the other party. Typically, the more knowledgeable party is
the seller. Symmetric information is when both parties have equal knowledge.
In the case of insurance, adverse selection is the tendency of those in dangerous jobs
or high-risk lifestyles to purchase products like life insurance. In these cases, it is the
buyer who actually has more knowledge (i.e., about their health). To fight adverse
selection, insurance companies reduce exposure to large claims by limiting coverage or
raising premiums.
Understanding Adverse Selection
Adverse selection occurs when one party in a negotiation has relevant information the
other party lacks. The asymmetry of information often leads to making bad decisions,
such as doing more business with less profitable or riskier market segments.
In the case of insurance, avoiding adverse selection requires identifying groups of

people more at risk than the general population and charging them more money. For
example, life insurance companies go through underwriting when evaluating whether
to give an applicant a policy and what premium to charge.
Underwriters typically evaluate an applicant’s height, weight, current health, medical

history, family history, occupation, hobbies, driving record, and lifestyle risks such as
smoking; all these issues impact an applicant’s health and the company’s potential for
paying a claim. The insurance company then determines whether to give the applicant
a policy and what premium to charge for taking on that risk.
Consequences of Adverse Selection
A seller may have better information than a buyer about products and services being
offered, putting the buyer at a disadvantage in the transaction. For example, a
company’s managers may more willingly issue shares when they know the share price
is overvalued compared to the real value; buyers can end up buying overvalued shares
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and lose money. In the second hand car market, a seller may know about a vehicle’s
defect and charge the buyer more without disclosing the issue.
The general consequence of adverse selection is that it increases costs since

consumers lack information held by sellers or producers, creating an asymmetry in the
market. This can also lower consumption as buyers may be wary of the quality of the
products that are offered for sale. Or, it may exclude certain consumers that do not
have access to or cannot afford to obtain information that could lead them to make
better buying decisions.
One indirect effect of this is a negative impact on consumers' health and well-being. If
you buy a faulty product or dangerous medication because you don't have good
information, consuming these products can cause physical harm. Or, by refraining from
buying certain healthcare products (e.g., vaccines), consumers may wrongly judge a
safe intervention as overly risky.
Adverse Selection in Insurance
Because of adverse selection, insurers find that high-risk people are more willing to
take out and pay greater premiums for policies. If the company charges an average
price but only high-risk consumers buy, the company takes a financial loss by paying
out more benefits or claims.
However, by increasing premiums for high-risk policyholders, the company has more
money with which to pay those benefits. For example, a life insurance company
charges higher premiums for race car drivers. A car insurance company charges more
for customers living in high-crime areas. A health insurance company charges higher
premiums for customers who smoke. In contrast, customers who do not engage in
risky behaviours are less likely to pay for insurance due to increasing policy costs.
A prime example of adverse selection in regard to life or health insurance coverage is a

smoker who successfully manages to obtain insurance coverage as a non-smoker.
Smoking is a key identified risk factor for life insurance or health insurance, so a
smoker must pay higher premiums to obtain the same coverage level as a non-smoker.
By concealing their behavioural choice to smoke, an applicant is leading the insurance
company to make decisions on coverage or premium costs that are adverse to the
insurance company's management of financial risk.
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Another example of adverse selection in the case of auto insurance would be a

situation where the applicant obtains insurance coverage based on providing a
residence address in an area with a very low crime rate when the applicant actually
lives in an area with a very high crime rate. Obviously, the risk of the applicant's vehicle
being stolen, vandalized, or otherwise damaged when regularly parked in a high-crime
area is substantially greater than if the vehicle was regularly parked in a low-crime
area.
Adverse selection might occur on a smaller scale if an applicant states that the vehicle
is parked in a garage every night when it is actually parked on a busy street.
How to Minimize Adverse Selection
Adverse selection by increasing access to information, thus minimizing asymmetries.

For consumers, the internet has greatly increased access while reducing costs.
Crowdsourced information in the form of user reviews along with more formal reviews
by bloggers or specialist websites are often free and warn potential buyers about
otherwise obscure issues around quality.
Warranties and guarantees offered by sellers can also help, allowing consumers to use
a product risk-free for a certain period to see if it has flaws or quality issues and the
ability to return them without consequence if there are issues. Laws and regulations
can also help, such as Lemon Laws in the used car industry. Federal regulatory
authorities such as the Food and Drug Administration (FDA) also help ensure that
products are safe and effective for consumers.
Insurers reduce adverse selection by requesting medical information from applicants in

the form of requiring paramedical examinations, querying doctors' offices for medical
records, and looking at one's family history. This gives the insurance company more
information that an applicant may fail to disclose on their own.
Moral Hazard vs. Adverse Selection
Like adverse selection, moral hazard occurs when there is asymmetric information
between two parties, but where a change in the behaviour of one party is exposed
after a deal is struck. Adverse selection occurs when there's a lack of symmetric
information prior to a deal between a buyer and a seller.
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Moral hazard is the risk that one party has not entered into the contract in good faith
or has provided false details about its assets, liabilities, or credit capacity. For instance,
in the investment banking sector, it may become known that government regulatory
bodies will bail out failing banks; as a result, bank employees may take on excessive
amounts of risk to score lucrative bonuses knowing that if their risky bets do not pan
out, the bank will be saved anyhow.
Why Is It Called Adverse Selection?
"Adverse" means unfavourable or harmful. Adverse selection is therefore when certain

groups are at higher-risk because they lack full information. In fact, they are selected
(or choose to select) to enter into a transaction precisely because they are at a
disadvantage (or advantage).
How Does Adverse Selection Impact Markets?
Adverse selection arises from information asymmetries. In economic theory, markets

are assumed to be efficient and that everybody has full and "perfect" information.
When some have more information than others, they can take advantage of those less-
informed, often to their detriment. This creates market inefficiencies that can increase
prices or prevent transactions from occurring.
Example of Adverse Selection in Trading and Investing
In stock markets, there are some natural information asymmetries. For example,
companies that issue shares know more about their internal finances and earnings
before the general public does. This can lead to cases of insider trading, where those
in-the-know profit from stock trades before public announcements are made (which is
an illegal practice).
Another asymmetry involves the inventories of market makers and some institutional
traders. While large holders of a company's stock are made public, this information is
only disseminated on a quarterly basis. This means that these players in the market
may have a particular "axe to grind" - for example, a strong desire or need to buy or
sell - that is not known by the investing public.
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Externalities
Positive externalities are benefits that are infeasible to charge to provide; negative
externalities are costs that are infeasible to charge to not provide. Ordinarily, as Adam
Smith explained, selfishness leads markets to produce whatever people want; to get
rich, you have to sell what the public is eager to buy. Externalities undermine the social
benefits of individual selfishness. If selfish consumers do not have to pay producers for
benefits, they will not pay; and if selfish producers are not paid, they will not produce.
A valuable product fails to appear. The problem, as David Friedman aptly explains, “is
not that one person pays for what someone else gets but that nobody pays and
nobody gets, even though the good is worth more than it would cost to produce”
(Friedman 1996, p. 278). Admittedly, the real world is rarely so stark. Most people are
not perfectly selfish, and it is usually feasible to charge consumers for a fraction of the
benefit they receive. Due to piracy, for example, many people who enjoy a CD fail to
pay the artist, which reduces the incentive to record new CDs. But some incentive to
record remains, because many find piracy inconvenient and others refrain from piracy
because they believe it is wrong. The problem, then, is that externalities lead to what
economists call underproduction of CDs rather than the nonexistence of CDs.
Research and development is a standard example of a positive externality, air pollution

of a negative externality. Ultimately, however, the distinction is semantic. It is
equivalent to say “clean air has positive externalities and so clean air is under
produced” or “dirty air has negative externalities and so dirty air is over produced.”
Economists measure externalities the same way they measure everything else:
according to human beings’ willingness to pay. If one thousand people would pay ten
dollars each for cleaner air, there is a ten-thousand-dollar externality of pollution. If no
one minds dirty air, conversely, no externality exists. If someone likes dirty air, this
unusual person’s willingness to pay for smog must be subtracted from the rest of the
population’s willingness to pay to curtail it.
Externalities are probably the argument for government intervention that economists
most respect. Externalities are frequently used to justify the government’s ownership
of industries with positive externalities and prohibition of products with negative
externalities. Economically speaking, however, this is overkill. If laissez-faire—that is,
no government intervention—provides too little education, the straightforward
solution is some form of subsidy to schooling, not government production of
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education. Similarly, if laissez-faire provides too much cocaine, a measured response is

to tax it, not ban it completely.
Especially when faced with environmental externalities, economists have almost

universally objected to government regulations that mandate specific technologies
(especially “best-available technology”) or business practices. These approaches make
environmental cleanup much more expensive than it has to be because the cost of
reducing pollution varies widely from firm to firm and from industry to industry. A
more efficient solution is to issue tradable “pollution permits” that add up to the target
level of emissions. Sources able to cheaply curtail their negative externalities would
drastically cut back, selling their permits to less flexible polluters (Blinder 1987).1
While the concept of externalities is not very controversial in economics, its application
is. Defenders of free markets usually argue that externalities are manageably small;
critics of free markets see externalities as widespread, even ubiquitous. The most
accepted examples of activities with large externalities are probably air pollution,
violent and property crimes, and national defense.2
Other common candidates include health care, education, and the environment, but
claims that these are externalities are much less tenable. Prevention and treatment of
contagious disease has clear externalities, but most health care does not. Educated
workers are more productive, but this benefit is hardly “external”; markets reward
education with higher wages. The externalities of many environmentalist measures,
including national parks, recycling, and conservation, are hard to discern. The people
who enjoy national parks are visitors, who can easily be charged for admission. If the
price of aluminum cans fails to spark recycling, that suggests that the cost of
recycling—including human effort—is more than the benefit. Similarly, as long as
resources are privately owned, firms balance their current profits of logging and drilling
against their future profits. If an oil driller knows that the price of oil will rise sharply in
ten years, he has an incentive to conserve oil instead of selling it today.
Externalities are often blamed for “market failure,” but they are also a source of
government failure. Many economists who study politics decry the large negative
externalities of voter ignorance. An economic illiterate who votes for protectionism
hurts not just himself but also his fellow citizens (Caplan 2003; Downs 1957). Other
economists believe externalities in the budget process lead to wasteful spending. A
congressman who lobbies for federal funds for his district improves his chances of
reelection but hurts the financial health of the rest of the nation.
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Putative externalities have been found in unlikely places. Some argue that wealth itself
has an externality: inflaming envy. Others maintain that there are externalities of
altruism—when I give money to help the poor, everyone else who cares about the
needy is better off. Defenders of Prohibition and the war on drugs emphasize the
externalities of drunkenness and drug addiction, though they typically lump private
costs, such as low earnings and unemployment, in with the external costs of drunk
driving and violent crime. In the Big Tobacco class action suit, one of the plaintiffs’
main arguments was that, given government’s role in medical care, smoking costs
taxpayers money.3
In principle, externalities could be used to rationalize censorship, persecution of

religious minorities, forced veiling of women, and even South Africa’s apartheid. If
most people were to find Darwinism offensive, the logic of externalities would
recommend a tax on Darwinian expression. Few economists have pursued such
possibilities, probably out of a tacit sense that, in extreme cases, individual rights
override economic efficiency.
Even from a strictly economic point of view, however, some externalities are not worth
correcting. One reason is that many activities have positive and negative externalities
that roughly cancel out. For example, mowing your lawn has the positive externality of
improving the appearance of your neighborhood and the negative externality of
creating a loud noise. A subsidy or a tax would alleviate one problem but amplify the
other. To take a more controversial example, some economists question efforts to
prevent global warming, calculating that the benefits for people in cold climates more
than balance out the costs for people in warm climates.
Another economic rationale for government inaction is as follows: sometimes an

externality is large at low levels of production but rapidly fades out as the quantity
increases. As long as output is high enough, such externalities can be safely ignored.
For example, during a famine, doubling the supply of food has large positive
externalities because starvation leads to robbery, hunger riots, and even cannibalism.
During times of plenty, however, doubling the food supply would probably have no
noticeable effect on crime.
Yet, it is to Nobel laureate Ronald Coase that we owe the most influential argument for
letting externalities solve themselves. In “The Problem of Social Cost” (1960), Coase
bypasses the earlier view that it is literally impossible to charge for some benefits.
Instead, he observes that every exchange has some transactions costs, which vary from
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negligible—such as putting coins into a vending machine—to enormous—such as

negotiating a contract with six billion signatories to improve air quality.
Coase drew strong implications from his common sense observation. Instead of
arguing about whether or not something is an “externality,” it is more productive to
ask about transactions costs. If transactions costs are reasonably low, then the affected
parties negotiate tolerably efficient solutions without government intervention.
To take Coase’s classic example, suppose that a railroad emits sparks on a farmer’s
crops. As long as transactions costs are low, the railroad and the farmer will work out a
solution. Coase was particularly clever to emphasize that, in terms of economic
efficiency, it does not matter whether the law sides with the railroad or the farmer.
Suppose that it costs one thousand dollars to control the sparks and the lost crops are
worth two thousand dollars. Even if the law sides with the railroad, the farmer will pay
the railroad to control the sparks. Alternately, suppose that it costs two thousand
dollars to control the sparks, the lost crops are worth only one thousand, and the law
sides with the farmer. Then the railroad pays the farmer for permission to continue
sparking.
Coase’s argument was initially controversial. As George Stigler recounts in his

autobiography, when Coase first presented his idea to a group of twenty-one
colleagues, none agreed. After an evening’s argument, however, Coase convinced
them all. Coase’s approach subsequently spread widely in both economics and law.
Faced with externalities, modern analysts almost immediately inquire about
transactions costs. For example, in the early 1950s, J. E. Meade advocated subsidizing
apple orchards to correct for the positive externalities they provide to beekeepers.
Inspired by Coase, however, Steven Cheung (1973) wrote a careful case study of the
bee-apple nexus. In the real world, beekeepers and apple orchard owners do not wait
for government to solve their problem. They can and do negotiate detailed contracts
to deal with externalities.
Coase’s approach is probably the main reason economists are sceptical of antismoking
legislation. While it is costly for smokers and non-smokers to directly negotiate with
each other, the owners of bars, restaurants, and workplaces can cheaply balance their
conflicting interests. If non-smokers are willing to pay more to avoid the smell of
tobacco than smokers are willing to pay to smoke, restaurants will disallow smoking—
and charge a premium for their smoke-free atmosphere. If unregulated markets fail to
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deliver a smoke-free world, Coasean logic suggests that smokers value smoking more
than non-smokers value not being subjected to cigarette smoke.
Pricing strategy
A pricing strategy is an approach taken by businesses to decide how much to charge
for their goods and services. The interaction between margin, price, and selling level is
given specific consideration while pricing products. Therefore, it’s important and
complicated to design a proper pricing plan that ensures business success.
The price is a component that affects a company’s revenue significantly. It forms the
key variable in the company’s financial modelling and affects its income, profits, and
investments in the long term. Price reflects the idea of a business and shows its
behaviour towards competitors and the value it gives customers.
Pricing strategy in marketing, in simple terms, is adjusting prices according to market

determinants. Price is the value one assigns to a good or service which they determine
by research. A pricing strategy considers market conditions, consumer willingness to
pay, competition, trade margins, costs incurred, etc. Pricing involves setting a price for
ownership and usage of goods.
Pricing is about making decisions. It starts with assessing the business requirements
and the goals it aims to achieve. The next step is market research and evaluation of the
level of competition. After that, an effective pricing strategy will help the business
stand up. The final research stage involves speaking with the target audience—the
consumers—about their views regarding the brand, product, or service.
Setting a price varies from pricing strategy. It employs factors that are not taken into
consideration while selecting a price. For example, the approach considers the timing
of the market, the seasonality of demand, and the customer’s preferences and
purchasing patterns in addition to the analysis of the products available in the market.
However, the strategy is most beneficial when consumers are heterogeneous (varying
tastes and preferences). And when demand variability and uncertainty are high,
especially with stable production levels (a chance to reap greater profits).
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Types
The following are a few pricing strategies that businesses adopt:-
#1 – Price Skimming:
A skimming pricing strategy is a pricing technique in which a business sets its initial
price high and gradually lowers it when more competitors enter the market. This is
ideal for businesses that are entering an emerging market. Here, businesses maximizes
profit utilizing the price demand of certain markets. They possess the first-mover
advantage, where they are the first to introduce or market the product or service. The
skimming pricing strategy makes a profit in the early stages of the product or service’s
market until other competitors enter and supply increases.
#2 – Pricing for market penetration:
It is the opposite of price skimming. Skimming starts with huge prices, and the
penetration pricing strategy uses low prices to enter the market. This is done to attract
the existing consumer base of the competitors. Once there is establishment of a
reliable pool of consumers, the costs slowly increase. Penetration pricing strategy
depends mostly on the ability of the business to bear the losses made in the initial
years. Big MNCs especially employ this to get a strong footing in developing countries’
markets.
#3 – Premium pricing:
Premium pricing strategy involves businesses that create high-quality products and
market them to high-income or net-worth individuals. The key here is to manufacture
unique, high-quality designs and products that convince the users to pay such huge
amounts. The premium pricing strategy targets the luxury goods market.
#4 – Economy pricing:
The strategy targets customers who prefer to save money. Big companies employ the
strategy to make customers feel they are in control. Walmart in the U.S. is an example
where they offer deals that please customers. This does depend on the overhead costs
and the value of the products.
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#5 – Bundle pricing:
As the name suggests, it is a strategy where a business sells a bundle of goods

together. Typically, the total of the goods is lower than the individual products sold
separately. This helps in moving the inventory and selling the stocks that are left over.
The strategy has the potential to make profits (or save from losses) on low-value items.
#6 – Value-based Pricing:
A concept is similar to premium-based pricing. Here, the business decides the price
based on the customer’s valuation of the product’s worth. This is best suited for
unique products.
#7 – Dynamic Pricing:
A dynamic pricing strategy in marketing involves changing the price of the items based
on the present market demand.
Examples
Take a look at these examples to get a better idea:
Example – #1
Starbucks, a big American multinational chain of coffeehouses and roaster reserves,

employs Value-based Pricing. It has been increasing prices despite Dunkin’ Donuts and
Folgers (its competitors in the market) lowering their costs due to the declining price of
Arabica beans in 2015. Starbucks’ customers buy coffee for convenience, brand loyalty,
flavor, and caffeine addiction. In addition, the brand value it has created for itself is
huge. It does not sell coffee as small or large. They have rebranded the sizes as
“Grande and Venti,” making them popular. For the loyal base, it has hardly ever
noticed the price change. Therefore, they would buy the coffee for the value they have
as a perceived-an elite brand.
Example – #2
Uber’s American mobility service provider is a good example of a dynamic pricing

system. The pricing system employed by Uber modifies charges depending on a
number of factors, including traffic, the prevailing rider-to-driver demand, the time and
distance of the route, etc. Occasionally, this may entail a brief price increase at very
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busy times. As a result, there will be consumer demand for travel for the purposes in
the above situations. Accordingly, they use this customer urgency to make money.
Key Takeaways
 Pricing strategy involves changing and adjusting the price of goods and services
in response to market factors.
 Research, Market conditions, consumers’ willingness to pay, competition,
trade margins, expenditures incurred, etc., are all considered while developing
a pricing strategy.
 Setting a price varies from pricing strategy. It employs factors that are not
taken into consideration while setting a price.
 There are a variety of pricing strategies available. Price skimming, Pricing for
market penetration, premium pricing, economy pricing, bundle pricing, value-
based Pricing, and dynamic Pricing are a few of them.
 Price determination involves assessing the business and competitors’ goals and
consumer preferences.
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Managerial Economics

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Managerial Economics

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MANAGERIAL

Chapter 1: Basics of Managerial Economics 3

Chapter 2: Firm and Theory of Firms 11

Chapter 3: Demand and Supply 33

Chapter 4: Theory of Production 78

Chapter 5: National Income 109

Chapter 6: Fiscal and Monetary Policy 134

Chapter 7: Business Cycle 180

Chapter 8: Market Prediction and Pricing Strategy 196

BASICS OF MANAGERIAL ECONOMICS

 Why managerial economics is important and useful as an area of study

 How it relates to other disciplines

 What its core areas are

 Methods of analysis which it uses

Definition of Managerial Economics

Scope of Managerial Economics

Production Function: Conversion of inputs into outputs is known as production

Advertising: Advertising is a promotional activity. In advertising while the copy,

Nature of Managerial Economics

Relationship between Managerial Economics and other subjects

Positive Economics: It deals with description and explanation of economic behavior,

Normative Economics: It is concerned with prescription or what ought to be done. In

What is the Basic Function of the Managers of the Business?

Mathematics and Managerial Economics: Mathematics in Managerial Economics has

Operation Research and Managerial Economics: It’s an inter-disciplinary solution

Management Theory and Managerial Economics: As the definition of management

Hence, we can conclude that Managerial Economics is closely related to various

Importance of Managerial Economics

Scope of Managerial Economics

Accept / Reject Empirical Study

It is obviously of vital importance to managers to have good theories on which to base

2 It makes accurate forecasts.

FIRM & THEORY OF FIRMS

 Various objectives of a business firm

c) Best possible use of resources

ii. Adoption of fair trade practices

iii. Contribution to the general welfare of the society

include economic well-being of the employees, social and psychological satisfaction of

i. Economic well being of the employees

ii. Social and psychological satisfaction of employees

iii. Development of human resources

iv. Well being of socially and economically backward people

ii. Promotion of social justice

iii. Production according to national priority

iv. Contribute to the revenue of the country

v. Self-sufficiency and Export Promotion

liberal economic and export–import policy, restrictions on foreign investments have

i. Raise general standard of living

ii. Reduce disparities among nations

iii. Make available globally competitive goods and services

What is Business Environment?

ii. Social Factors

iii. Political Factors

iv. Technological Factors

phones. Now-a-days electronic appliances have replaced electrical equipments

The Basic Profit Maximization (BPM) Model for a firm:

1 The firm has a single decision-maker.

2 The firm produces a single product.

3 The firm produces for a single market.