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Tutorial/Assignment Sheet-Solution
Engineering & Managerial Economics- EHU -501
Tutorial sheet I-II
1. Discuss the various definitions of economics. Which one do you find most suitable?
Ans. The definition of economics has undergone perceptible changes. Broadly speaking, the various
definitions of economics can be listed under the following heads:-
(1) Wealth Definition(2) Welfare Definition(3) Scarcity Definition(4) Growth Definition
Wealth Definition:- This definition was given by Adam Smith in his book “An Inquiry into the nature and causes of wealth of Nations” published in 1776.As the title of book suggests that Adam Smith defines economics as the study of the nature and causes of the generation of wealth of a nation. He says that economics seeks to explain and analyse the generation of wealth and also its distribution. In this definition Smith has tried to explain the factors which are responsible for the generation of wealth. He argued that the larger amount of wealth and betterment of the whole society could be achieved by efficient allocation of resources through the market mechanism.Criticism:-
(i) It has given all the emphasis on wealth and ignored man and his welfare.
(ii) Adam Smith has restricted the meaning of wealth as he included in wealth only material
goods like tea, biscuits, and butter etc. and excluded immaterial goods like the services
of the doctors, soldiers and teachers etc.
Welfare Definition: - This definition was given Alfred Marshall in his book “Principles of
Economics” which was published in the year 1980.Marshall defines economics as the science
of welfare. In his definition the emphasis was shifted from wealth to man and also from wealth to
welfare. He pointed out that wealth is not an end in itself but it is only a means to an end and the
end is the promotion of human welfare. Through welfare definition of Marshall, no doubt, is a
great improvement over the wealth definition of Adam Smith, it is also not free from the
criticism.
Criticism
(i) Marshall’s view of economics is narrow and unscientific.
(ii) Material welfare can’t be measured by any scale and can’t be accepted as an end of
economics.
Scarcity Definition: - This definition was given by Leonel Robbins. He defines economics as a
science of scarcity or choice in his famous book “An Essay on the Nature and Significance of
Economic Science” published in the year 1932.According to Robbins, “Economics is the
science which studies the human behavior as a relationship between ends and scarce means which
have alternative uses.”
This definition has the following fundamental features:-
(i) Unlimited Wants (ends)
(ii) Limited Means
(iii) Limited means have the alternative uses.
Criticism:-
(i) The concept of ends and means is not in conformity to human actions.
(ii) Knight has criticized that economics is only concerned with means and not ends. It should discuss
the alternative ends and not only means for a given end.
Growth Definition: - This definition was given by Paul A.Samuelson. Though Robbins’
definition is the most accepted one but due to lack of practicability modern economist felt that the
better allocation and efficient use of means for economic growth should also be the subject matter
of economics. This definition is dynamic and incorporates both the problem of choice and
problem of development. The subject matter of economics has become so wide, so it is difficult
to define the economics in a nut shell. This definition is comprehensive and a suitable definition
involving wealth, welfare, choice of economic growth and that is why this definition is more
suitable in comparison to other definitions of economics.
2. Elaborate Robbins definition of economics.
Ans. Leonel Robbins gave scarcity definition of economics. He defines economics as a science of
scarcity or choice in his famous book “An Essay on the Nature and Significance of Economic
Science” published in the year 1932.According to Robbins, “Economics is the science which
studies the human behavior as a relationship between ends and scarce means which have alternative
uses.”
This definition has the following fundamental features:-
(iv) Unlimited Wants (ends)
(v) Limited Means
(vi) Limited means have the alternative uses.
This definition is analytical rather than classificatory. It focused on a particular aspect of behaviour, eg.
Behavior concerned with the utilization of scarce resources to achieve unlimited wants.
Criticism:-
(iii) The concept of ends and means is not in conformity to human actions.
(iv) Knight has criticized that economics is only concerned with means and not ends. It should discuss
the alternative ends and not only means for a given end.
(v) Robbins has reduced economics merely to the value theory. Theory of economic growth now a day
has become a very important branch of economics but Robbins’ definition does not cover it.
(vi) Robertson has criticized this definition and says that this definition is too narrow and too wide. It is
too narrow because it excludes the concepts like- employment policy, relation between capital and
labour etc. It is too wide because the problem of resources allocation may also arise in certain other
fields not generally included within the scope of economics.
In spite of these drawbacks, scarcity definition is more scientific and analytical than the older definitions
and has greater degree of acceptability.
3. Differentiate between micro and macro economics.
Ans. Microeconomics can be defined as that branch of economic analysis which studies the economic
behavior of the individual unit,may be a person, a household, a firm, or a n industry. It is a study of
one particular unit rather than all the units combined together. An important tool used in
microeconomics is that of Marginal Analysis. On the other hand Macroeconomics can be defined as
that branch of economic analysis which studies the behaviour of not one particular unit, but of all the
units combined together. Macroeconomics is a study of aggregates. It is the study of the economic
system as a whole; national income, aggregate demand, aggregate supply, total consumption, total
savings and total investment.
4. Differentiate between positive and normative economics.
Ans. Positive Economics: - Positive statements are objective statements dealing with matters of fact
or the question about how things actually are. Positive statements are made without obvious value –
judgment and emotions. Positive economics can be described as what is, what was, and what
probably will be. Positive statements are based on economic theory rather than emotion. Often these
statements will be expressed in the form of a hypothesis that can be analyzed and evaluated. eg. a rise
in interest rates will cause a rise in the exchange rate and an increase in the demand for imported
products. On the other hand Normative statements are subjective- based on opinion only with or
without a basis in fact or theory. They are more valuable statements that focus on “what ought to be”.
It is important to be able to distinguish between these statements – particularly when heated
arguments and debates are taking place. Eg.the decision to grant autonomy to private banks is unwise
and should be reversed; the national minimum wage should be increased by 10% as a method of
reducing poverty.
5. Discuss the nature and scope of economics.
Ans. Nature of Economics
There is a difference of opinion among economists regarding the nature of economics. Some consider it as a science and some as an art. If economics is a science, then is it a positive or normative science?
Economics as a Science: - A science can be defined as systematized body of knowledge as certainable by observation and experimentations. It is a body of generalizations, principles, theories or laws which traces out a causal relationship between cause and effect.
Arguments in Favour of Economics as a Science
(i) Systematized body of knowledge: In economics there is a systematized collection, classification and analysis of economic facts. For example, economics is divided into consumption,production,exchanages,distribution and public finance which have their laws and theories.
(ii) Scientific Laws: - Laws of economics are similar to the laws of other science. The law of demand tells that other things remaining the same, fall in price leads to increase in demand and rise in price leads to decrease in demand.
(iii) Experiments: - As experiments are the part and parcel of science so in economics. For example to control inflation government applied various monetary and fiscal measures it is an economic experiment.
(iv) Universal: - The laws of economics have the universal validity like the laws of science. The law of diminishing returns, law of demand, law of diminishing marginal utility etc.are equally applicable in all countries.
(v) Self – corrective Nature: - Like science, economics is self corrective in nature. Under new facts and observations economists revise their theories in different fields of economics related to macroeconomics, monetary economics, international economics, public finance and economic development.
Economics as an Art: - Many economists considered economics as an art. Art is the practice of knowledge.
Arguments in Favour of Economics as an Art
(i) Solution to the problem:- the various branches of economics provide practical solution to various economic problems. Economics solves the fundamental problems of an economy like allocation of scarce resources in satisfying the different wants.
(ii) Practical application: - The art is the practical application of knowledge. When we apply the economic law only then we come to know that whether their results are true or false. Price determination guides the policy makers to manage supply and to maintain price stability. Role of advertisement in monopolistic market, all these theories are practically applicable in day to day life to make different decisions.
Economics: A positive science or a Normative Science
Positive Economics: - Positive statements are objective statements dealing with matters of fact or the question about how things actually are. Positive statements are made without obvious value – judgment and emotions. Positive economics can be described as what is, what was, and what probably will be. Positive statements are based on economic theory rather than emotion. Often these statements will be expressed in the form of a hypothesis that can be analyzed and evaluated.
Normative Economics: - Normative statements are subjective- based on opinion only with or without a basis in fact or theory. They are more valuable statements that focus on “what ought to be”.
It is important to be able to distinguish between these statements – particularly when heated arguments and debates are taking place.
Scope of economics
Stonier and Hague have divided the subject matter of economics into three categories:-
Economic Theory: - it is theoretical part of economics. It contains economic theories and economic tools. It is divided into static and dynamic economics. It is also known as Economic Analysis.
Applied Economics: - It attempts to apply the results of economic analysis to descriptive economics. Industrial economics, managerial economics, and agricultural economics are some of the examples of applied economics.
Descriptive Economics: - In descriptive economics, relevant facts about a particular economic subject or topic are collected for the purpose of study. The subject ‘Indian Economics’ is the example of descriptive economics.
6. What is engineering economics? How is the study of economics useful for engineers?
Ans. Meaning: Engineering economics is a part of economics for application to engineering projects. Engineers seek solutions to the problems and economic viability of each potential solution is normally considered along with the technical aspects.
Characteristics of Engineering Economics
1. Engineering economics is a traditional and important part of engineering practice.2. Engineering economics is concerned with application of economic principles in technical and
managerial decision making. The broad economic principles are effects of various costs, production lot size on cost, capital investment, demand and supply including forecasting and Economies of scale.
3. Engineering economics is both microeconomics and macroeconomics in nature when applied to engineering problems. For example, the study of demand analysis is mostly concerned with individual or household as a small unit of study. Whereas, the study of impact of taxes on raw-materials is a macro concept.
4. Engineering economics also includes certain concepts and principles from other fields such as statistics, accounting and management etc.
5. Engineering economics aids decision making aspects of an engineer and it avoids the abstract nature of economic theory.
6. Engineering economics is mostly an application tool, whereas economics is a social science with a broad characteristic.
7. Engineering economics provides an analytical and scientific approach resulting in qualitative decisions.
Scope of Managerial Economics in Engineering Perspective
The scope of managerial economics can be discussed under the following heads:
1. It has wide scope in manufacturing, construction, mining and other engineering industries. Examples of economic application are as follows:(i) Selection of location and site for a new plant.(ii) Production planning and control.(iii) Selection of equipment and their replacement analysis.(iv) Selection of a material handling system.
2. Better decision making on the part of engineers.3. Efficient use of resources results in better output and economic development.4. Cost of production can be reduced.5. Alternative courses of action using economic principles may result in reduction of prices of goods
and services.6. Elimination of waste can result in application of engineering economics.7. More capital will be made available for investment and growth.8. Improves the standard of living with the result of better products, more wages, and salaries, more
output etc. from the firm applying engineering economics.
7. Define science, engineering and technology.
Ans. Meaning of Science: The word science comes from the Latin “scientia”, meaning knowledge. Science refers to a system of acquiring knowledge. The term science also refers to the organized body of knowledge gained by using a system. In other words science may be described as any systematic field of study or the knowledge gained from it. It is a systematic enterprise of gathering knowledge about the nature and organizing and condensing that knowledge into testable laws and theories.
Meaning of Engineering: Engineering can be defined as the application of scientific and mathematical principles used for practical purpose like design, manufacture, and operation of efficient and economical structures, machines, processes, and systems. Engineers apply the sciences of the physics and mathematics to find suitable solutions to problems.
Meaning of Technology: Technology word comes from the Greek word “techno logia” where techno means an art, skill, or craft and logia means the study of something, or the branch of knowledge of a
discipline.Technology can be broadly defined as the entities, both material and immaterial, created by the application of mental and
physical effort in order to achieve some value. In this usage, technology refers to the tools and machines that may be used to solve real-world problems.
8. Discuss the role of science and engineering in development of an economy.
Ans. Science, Engineering and Technology have significantly affected the human ability to control and adapt to their natural environments. They have affected the society in a number of ways. Some of their roles may be discussed as follows:
1. Economic Growth: With the advent of new technology emerging from science and better machines etc. developed by engineers both industrial and agricultural growth in an economy gains momentum even with the limited resources.
2. Increase in Production: The adoption of new and modern technology leads to greater increase in the output of the economies of the world.
3. Increase in Efficiency: Better equipments and techniques lead to growth in output without a proportional increase in input which means a rise in productivity and efficiency.
4. Better Infrastructure: all the economies of the world are investing in infrastructure for achieving the objective of economic development. Building up of good infrastructure is largely dependent on science and technology. Safety and other specifications of an infrastructure project are taken care of by the engineers.
5. Better Standard of living: People of the country and of the world in general now enjoy a better standard of living with new innovations which is making life more comfortable and enjoyable. Science, engineering and technology have added both comforts as well as luxuries to the life.
6. Faster Means of Communication: Telephones, mobiles and internet are the gifts of science and engineering to human beings which have made the world a global village and reduced communication barriers to facilitate business and personal life.
7. Global Competitiveness: The countries which are technologically sound and ahead in innovations are today the leading economies of the world. In the global era only those economies can be competitive which have adopted good science and technology policies and adopting the advanced technologies.
9. “Managerial economics is the application of economic tools and theories for managerial
decision making”. Elaborate.
Ans. Managerial economics uses a wide variety of economic concepts, tools, and techniques in the decision- making process. These concepts can be placed in three broad categories: (1) the theory of
the firm, which describes how businesses make a variety of decisions; (2) the theory of consumer behavior, which describes decision making by consumers; and (3) the theory of market structure and pricing, which describes the structure and characteristics of different market forms under which business firms operate.
The Theory of the Firm
Discussing the theory of the firm is an useful way to begin the study of managerial economics, since the theory provides a broad framework within which issues relevant to managerial decisions are analyzed. A firm can be considered a combination of people, physical and financial resources, and a variety of information. Firms exist because they perform useful functions in society by producing and distributing goods and services. In the process of accomplishing this, they use society's scarce resources, provide employment, and pay taxes. If economic activities of society can be simply put into two categories—production and consumption—firms are considered the most basic economic entities on the production side, while consumers form the basic economic entities on the consumption side.The behavior of firms is usually analyzed in the context of an economic model, an idealized version of a real-world firm. The basic economic model of a business enterprise is called the theory of the firm.
Profit maximization and the firm
Under the simplest version of the theory of the firm it is assumed that profit maximization is its primary goal. In this version of the theory, the firm's owner is the manager of the firm, and thus, the firm's owner-manager is assumed to maximize the firm's short-term profits (current profits and profits in the near future). Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money (where the value of a dollar further and further in the future is increasingly smaller than a dollar today).
Profit Maximisation versus Other Motivations behind Managerial Decisions
The present value maximization criterion as a basis for the study of the firm's behavior has come under severe criticism from some economists. The critics argue that business managers are interested, at least partly, in factors other than the firm's profits. In particular, they may be interested in power, prestige, leisure, employee welfare, community well-being, and the welfare of the larger society.
Theory of Consumer Behaviour
Consumers play an important role in the economy since they spend most of their incomes on goods and services produced by firms. In other words, they consume what firms produce. Thus, studying the theory of consumer behavior is quite important. What is the ultimate objective of a consumer? Economists have an optimization model for consumers, similar to that applied to firms or producers. While firms are assumed to be maximizing profits, consumers are assumed to be maximizing their utility or satisfaction. Of course, more goods and services will, in general, provide greater utility to a consumer.
Theories associated with the Market Structures
As mentioned earlier, firms' profit maximizing output decisions take into account the market structure under which they are operating. There are four kinds of market organizations: perfect competition, monopolistic competition, oligopoly, and monopoly.
Perfect Competition
Perfect competition is the idealized version of the market structure that provides a foundation for understanding how markets work in a capitalist economy. Three conditions need to be satisfied before a market structure is considered perfectly competitive: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production.
Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation.
Monopolistic competition
Many industries that we often deal with have market structures that are characterized by monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition. As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers.
Oligopoly
Oligopoly is a fairly common market organization. In the United States, both the steel and automobile industries (with three or so large firms) provide good examples of oligopolistic market structures. Probably the most important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. Unlike under monopolistic competition, however, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry. Thus, an oligopolist always considers the reactions of its rivals in formulating its pricing or output decisions.
Monopoly
Monopoly can be considered as the polar opposite of perfect competition. It is a market form in which there is only one seller. While, at first glance, a monopolistic form may appear to be rarely found market structure, several industries in the United States have monopolies. Local electricity companies provide an example of a monopolist.There are many factors that give rise to a monopoly. Patents can give rise to a monopoly situation, as can ownership of critical raw materials (to produce a good) by a single firm.
10. “Managerial economics has a wide scope for managerial decision making”. Elaborate.
Ans. Refer the answer for the scope of Managerial Economics
11. “Managerial economics is different in approach from traditional economics”. Explain.
Ans. Managerial Economics and Economics
Managerial Economics has been described as economics applied to decision making. It may be viewed as a special branch of economics bridging the gulf between pure economic theory and managerial practice.
Economics has two main divisions :- (i) Microeconomics and (ii) Macroeconomics. Microeconomics has been defined as that branch of economics where the unit of study is an individual or a firm. Macroeconomics, on the other hand, is aggregate in character and has the entire economy as a unit of study.
Microeconomics, also known as price theory (or Marshallian economics) is the main source of concepts and analytical tools for managerial economics. To illustrate various micro-economic concepts such as elasticity of demand, marginal cost, the short and the long runs, various market forms, etc., all are of great significance to managerial economics. The chief contribution of macroeconomics is in the area of forecasting. The modern theory of income and employment has direct implications for forecasting general business conditions. As the prospects of an individual firm often depend greatly on general business conditions, individual firm forecasts depend on general business forecasts.
A survey in the U.K has shown that business economists have found the following economic concepts quite useful and of frequent application :-
1. Price elasticity of demand,2. Income elasticity of demand,3. Opportunity cost,4. The multiplier,5. Propensity to consume,6. Marginal revenue product,7. Speculative motive,8. Production function,9. Balanced growth, and10. Liquidity preference.
Business economics have also found the following main areas of economics as useful in their work :-
1. Demand theory,2. Theory of the firm-price, output and investment decisions,3. Business financing,4. Public finance and fiscal policy,5. Money and banking,6. National income and social accounting,7. Theory of international trade, and8. Economics of developing countries
12. Explain the meaning and nature of managerial economics.
Ans. Managerial economics is a science which deals with the use of basic economic concepts, theories and analytical tools suitable in the decision- making process of a business firm.
In other words, managerial economics is a science which is concerned with those aspects of economic theory and its applications that are directly relevant to the managerial practice in the decision- making process of a business firm.
According to Milton H. Spencer and Louis Siegelman, “Managerial economics is the integration of economic theory with business practice for the purpose of facilitating decision- making and forward planning by management.”
According to Haynes, Mote and Paul, “Managerial economics is applied in decision making. It is a special branch of economics bridging the gap between abstract economic theory and managerial practice.”
Bryan Carsberg defines, “Managerial economics is the application of basic economic theory to the practical problems of a business firm.”
Nature of Managerial Economics
1. Pragmatic in nature: It is pragmatic in nature because it deals with making economic theory more application- oriented. Further managerial economics is concerned with the use of analytical tools of economic theory in solving practical managerial problems and improving decision- making in business.
2. Micro –economic in nature: Managerial economics is micro-economic in nature because it involves the application of the micro-economic concepts and theories. Microeconomics deals with the single units- single firm, single industry, single demand, price, and consumer and not with a whole. As it deals with the behaviour of small units including firm, industry so it is micro- economic in nature.
3. Normative in nature: Managerial economics is normative in nature because it not only deals with the different theories, principles, different dependent and independent variables but also prescribes what the firms should do in different situations keeping them in consideration. For e.g., economic theory can tell us the relationship between the price of a product and its quantity supplied but it doesn’t tell us whether the outcome of this relationship is good or bad. This is positive nature of economic theory but managerial economics on the other hand not only explains the impact of change in price on supply or vice versa but also suggests whether such course of
action should be taken or not. Thus managerial economics is normative in nature which generally not only tells ‘what is’ but also tells us ‘what ought to be’, i.e. to suggest the best course of action.
4. Macro-economic in nature: Managerial Economics is macro-economic in nature because apart from studying the internal environment of a firm it also studies the external environment of the firms. The firms have to analyse the economic environment such general price level, industrial relation, taxation policy of the governments, business cycles etc. in which they take decisions. Managerial economics helps the firms to cope up with the negative impact of the external environment.
5. Goal-oriented: Managerial Economics is goal-oriented in nature as it mainly aims at achieving maximum objectives of the business firms. The objectives of a firm include the objective of profit maximization, sales maximization, growth maximization, long run survival etc.
6. Application-oriented: managerial economics is an application-oriented science in the sense that it is concerned with economics applied in practical decision-making in business.
7. Tool in the different fields: managerial economics serves as a tool in the study of business administration especially in the functional areas such as finance, accounting, marketing, personnel management and production management.
13. Discuss the nature and scope of managerial economics giving its importance in decision
making.
Ans. Nature of Managerial Economics
1. Pragmatic in nature: It is pragmatic in nature because it deals with making economic theory more application- oriented. Further managerial economics is concerned with the use of analytical tools of economic theory in solving practical managerial problems and improving decision- making in business.
2. Micro –economic in nature: Managerial economics is micro-economic in nature because it involves the application of the micro-economic concepts and theories. Microeconomics deals with the single units- single firm, single industry, single demand, price, and consumer and not with a whole. As it deals with the behaviour of small units including firm, industry so it is micro- economic in nature.
3. Normative in nature: Managerial economics is normative in nature because it not only deals with the different theories, principles, different dependent and independent variables but also prescribes what the firms should do in different situations keeping them in consideration. For e.g., economic theory can tell us the relationship between the price of a product and its quantity supplied but it doesn’t tell us whether the outcome of this relationship is good or bad. This is positive nature of economic theory but managerial economics on the other hand not only explains the impact of change in price on supply or vice versa but also suggests whether such course of action should be taken or not. Thus managerial economics is normative in nature which generally
not only tells ‘what is’ but also tells us ‘what ought to be’, i.e. to suggest the best course of action.
4. Macro-economic in nature: Managerial Economics is macro-economic in nature because apart from studying the internal environment of a firm it also studies the external environment of the firms. The firms have to analyse the economic environment such general price level, industrial relation, taxation policy of the governments, business cycles etc. in which they take decisions. Managerial economics helps the firms to cope up with the negative impact of the external environment.
5. Goal-oriented: Managerial Economics is goal-oriented in nature as it mainly aims at achieving maximum objectives of the business firms. The objectives of a firm include the objective of profit maximization, sales maximization, growth maximization, long run survival etc.
6. Application-oriented: managerial economics is an application-oriented science in the sense that it is concerned with economics applied in practical decision-making in business.
7. Tool in the different fields: managerial economics serves as a tool in the study of business administration especially in the functional areas such as finance, accounting, marketing, personnel management and production management.
Scope of Managerial Economics
The scope of managerial economics includes all those economic concepts, theories and analytical tools which can be used to analyse business environment and to find solutions for practical business problems. The scope of managerial economics covers two areas of decision making which are as follows:
1. Internal or Operational Issues
Operational decisions are those which the manager takes as his official role. These are concerned with the issues which arise in within the business firms and so they are under the control of management. These decisions are delegated or distributed in different hierarchy of the management. They deal with the general aspects as what to produce, how to produce, and for whom to produce. The internal or operational issues can further be divided under the following as the scope of managerial economics:-(i) Demand analysis and forecasting: Demand analysis is of great importance in
managerial economics. it seeks to identify and measure the factors that determine the demand for a product in the product market. The demand for a firm’s product reflects what the consumers actually buy. In every business firm, executive manager has to estimate current demand and forecast future demand for the output produced by the firm. Such demand decisions can be evaluated through an analysis of consumer behaviour. The important aspects dealt with under demand analysis are: individual and market demand; demand estimation; demand function; demand distinctions; demand forecasting and elasticity of demand and its relevance in decision- making in business. Demand forecasting attempts to estimate the likely demand for a product in future periods. If future demands are identified, production can be better planned.
(ii) Production analysis: Production analysis helps the firm to achieve the optimal levels in the production process. It helps to get maximum output with minimum level of inputs of
a firm. The main concepts dealt under the production analysis are: production functions, returns to scale, isoquants, economies and diseconomies of scale.
(iii) Cost analysis: cost analysis plays an important role in decision-making of a business firm. It is discussed in monetary terms of the product produced in the business firm. The main aspects dealt with under cost analysis are: cost concepts, cost behaviour in the short run and long run, cost functions, cost determinants, cost control and cost reduction. Cost analysis especially deals with the various cost concepts and their practical usefulness in managerial decision-making.
(iv) Pricing analysis: pricing analysis is a core concept of managerial economics. It plays an important role in profit planning. The success of a firm depends upon correct price decisions taken by it. If the price is too high, the firm may not find enough consumers to buy its product. If the price is set too low, the firm may not be able to cover its costs. Thus, setting an appropriate price is important for every business firm. The pricing decision depends on the types of market. If the market is perfect competition, monopoly, monopolistic, oligopoly and duopoly etc, the firm takes the decision about fixation of price accordingly. The main aspects dealt with under pricing analysis are: concepts of market mechanism, price determination under different markets, pricing policies, pricing methods and approaches.
(v) Profit analysis: profit is the index of good performance of a business firm. Generally, firms aim at making profits. But the survival of every business firm depends upon its ability to earn profit. Hence, decisions concerning level of profit, rate of profit, reinvestment of profit, etc., are relevant in every business firm now a days. The main aspects covered under the profit analysis are: nature and measurement of profit, profit theories, profit policies, profit planning and control (break-even analysis) and profit forecasting.
(vi) Investment analysis: As the capital is scarce and expensive factor of production, issues related to the decision making about it are important. The major concerning issues related to capital investment are as follows:
Choice of source of funding The choice of investment project Evaluation of capital efficiency Most efficient allocation
(vii) Strategic or long term planning: Strategic or long term planning requires decisions to frame and to achieve the long term goals and objectives of a firm. Managerial economics helps a firm to come up with decisions related to the strategic planning and to achieve those strategic goals and objectives.
2. External or Environmental Issues
In managerial economics the external or environmental issues refer to the business environment of a firm in which it operates. These external or Environmental issues can be either political, social or economic within which the firm is operating. A study of these External or Environmental Issues include the study of:
(i) Nature of the economic system existing in the country.(ii) Business cycle phases through which each firm has to undergo.(iii) Working pattern of the financial institutions like banks, insurance companies, share
market etc in the country.(iv) Trends in the foreign trade.(v) Trends in the labour and capital markets in the country.(vi) Policies of the government related to industries, monetary policy, fiscal policy and
pricing policy, etc.
Finally, we can conclude that external issues are dealt with the help of study of macro-economic aspects while the internal issues are dealt with the help of study of micro-economic aspects. The use of both micro-economic and macro-economic aspects for business decision making is provided by Managerial economics.
Tutorial sheet III/IV
1. Describe the law of demand with the help of demand schedule and demand curve.
Ans. The relationship between prices and quantity demanded is called the ‘law of demand’ in
economics. The market demand curve also slopes downwards from left to right.The slope implies that
price and quantity demanded are inversely related, ceteris paribus. In other words an increase in the price
leads to a fall in the demand and vice versa. This relationship can be stated as” Other things being equal,
the demand for a commodity varies inversely as the price”. It can be explained with the help of diagram.
It is a geometrical device to express the inverse price-demand relationship, i.e. the law of demand. It is
clear from the graph that when the price is OP, demand is OM and as price decreases to OP 1, demand
increases to OM1.
Assumptions of the Law
No change in income of the consumer
No change in the Tastes and Preferences:
No change in Population:
No change in the Price of substitutes and complementary:
No change in the Speculation or Expectation regarding future prices
2. What is meant by demand? What factors determine demand of a commodity?
Ans. Demand for anything means the quantity of that commodity, which is bought, at a given price, per
unit of time.”In Other Words, an individual demand refers to the quantity of a good a consumer is willing
to buy and able to buy at all prices within a period of time, ceteris paribus.”
Determinants (Factors Affecting) of Demand
The law of demand, while explaining the price-demand relationship assumes other factors to be constant.
In reality however, these factors such as income, population, tastes, habits, preferences etc., do not remain
constant and keep on affecting the demand. As a result the demand changes i.e. rises or falls, without any
change in price.
1. Income: The relationship between income and the demand is a direct one. It means the demand changes
in the same direction as the income. An increase in income leads to rise in demand and vice versa.
2. Population: The size of population also affects the demand. The relationship is a direct one. The higher
the size of population, the higher is the demand and vice versa.
3. Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc. of the consumer have
a profound effect on the demand for a commodity. If a consumer dislikes a commodity, he will not buy it
despite a fall in price. On the other hand a very high price also may not stop him from buying a good if he
likes it very much.
4. Other Prices: This is another important determinant of demand for a commodity. The effect depends
upon the relationship between the commodities in question. If the price of a complimentary commodity
rises, the demand for the commodity in reference falls. E.g. the demand for petrol will decline due to rise
in the price of cars and the consequent decline in their demand. Opposite effect will be experienced incase
of substitutes.
5. Advertisement: This factor has gained tremendous importance in the modern days. When a product is
aggressively advertised through all the possible media, the consumers buy the advertised commodity even
at a high price and many times even if they don’t need it.
6. Fashions: Hardly anyone has the courage and the desire to go against the prevailing fashions as well as
social customs and the traditions. This factor has a great impact on the demand.
7. Imitation: This tendency is commonly experienced everywhere. This is known as the demonstration
effects, due to which the low income groups imitate the consumption patterns of the rich ones. This
operates even at international levels when the poor countries try to copy the consumption patterns of rich
countries.
3. What is price elasticity of demand? What are the various degrees of measuring it?
The concept of price elasticity reveals that the degree of responsiveness of demand to the change in price
differs from commodity to commodity. Demand for some commodities is more elastic while that for
certain others are less elastic.
Types/Degrees of Price Elasticity
Using the formula of elasticity, it possible to mention following different types of price elasticity:
1. Perfectly inelastic demand (ep = 0)
2. Inelastic (less elastic) demand (e < 1)
3. Unitary elasticity (e = 1)
4. Elastic (more elastic) demand (e > 1)
5. Perfectly elastic demand (e = ∞)
1. Perfectly inelastic demand (ep = 0)
This describes a situation in which demand shows no response to a change in price. In other words,
whatever be the price the quantity demanded remains the same. It can be depicted by means of the
alongside diagram.
The vertical straight line demand curve as shown alongside reveals that with a change in price (from OP
to Op1) the demand remains same at OQ. Thus, demand does not at all respond to a change in price. Thus
ep = O. Hence, perfectly inelastic demand. Fig a
2. Inelastic (less elastic) demand (e < 1)
In this case the proportionate change in demand is smaller than in price. The alongside figure shows this
type.
In the alongside figure percentage change in demand is smaller than that in price. It means the demand is
relatively c less responsive to the change in price. This is referred to as an inelastic demand. Fig e
3. Unitary elasticity demand (e = 1)
When the percentage change in price produces equivalent percentage change in demand, we have a case
of unit elasticity. The rectangular hyperbola as shown in the figure demonstrates this type of elasticity. In
this case percentage change in demand is equal to percentage change in price, hence e = 1. Fig c
4. Elastic (more elastic) demand (e > 1)
In case of certain commodities the demand is relatively more responsive to the change in price. It means a
small change in price induces a significant change in, demand. This can be understood by means of the
alongside figure.
It can be noticed that in the above example the percentage change in demand is greater than that in price.
Hence, the elastic demand (e>1) Fig d
5. Perfectly elastic demand (e = ∞)
This is experienced when the demand is extremely sensitive to the changes in price. In this case an
insignificant change in price produces tremendous change in demand. The demand curve showing
perfectly elastic demand is a horizontal straight line. Fig b
It can be noticed that at a given price an infinite quantity is demanded. A small change in price produces
infinite change in demand. A perfectly competitive firm faces this type of demand.
From the above analysis it can be concluded that theoretically five different types of price elasticity can
be mentioned. In practice, however two extreme cases i.e. perfectly elastic and perfectly inelastic demand,
are rarely experienced. What we really have is more elastic (e > 1) or less elastic (e < 1 ) demand. The
unitary elasticity is a dividing line between these two cases.
4. Describe the factors that determine the price elasticity of demand is elastic or inelastic
Ans. Determinants of Elasticity
1. Nature of the Commodity: Humans wants, i.e. the commodities satisfying them can be classified
broadly into necessaries on the one hand and comforts and luxuries on the other hand. The nature of
demand for a commodity depends upon this classification. The demand for necessities is inelastic and for
comforts and luxuries it is elastic.
2. Number of Substitutes Available: The availability of substitutes is a major determinant of the elasticity
of demand. The large the number of substitutes, the higher is the elastic. It means if a commodity has
many substitutes, the demand will be elastic. As against this in the absence of substitutes, the demand
becomes relatively inelastic because the consumers have no other alternative but to buy the same product
irrespective of whether the price rises or falls.
3. Number Of Uses: If a commodity can be put to a variety of uses, the demand will be more elastic. When
the price of such commodity rises, its consumption will be restricted only to more important uses and
when the price falls the consumption may be extended to less urgent uses, e.g. coal electricity, water etc.
4. Possibility of Postponement of Consumption: This factor also greatly influences the nature of demand
for a commodity. If the consumption of a commodity can be postponed, the demand will be elastic.
5. Range of prices: The demand for very low-priced as well as very high-price commodity is generally
inelastic. When the price is very high, the commodity is consumed only by the rich people. A rise or fall
in the price will not have significant effect in the demand. Similarly, when the price is so low that the
commodity can be brought by all those who wish to buy, a change, i.e., a rise or fall in the price, will
hardly have any effect on the demand.
6. Proportion of Income Spent: Income of the consumer significantly influences the nature of demand. If
only a small fraction of income is being spent on a particular commodity, say newspaper, the demand will
tend to be inelastic.
7. According to Taussig, unequal distribution of income and wealth makes the demand in general, elastic.
8. In addition, it is observed that demand for durable goods, is usually elastic.
9. The nature of demand for a commodity is also influenced by the complementarities of goods.
From the above analysis of the determinants of elasticity of demand, it is clear that no precise conclusion
about the nature of demand for any specific commodity can be drawn. It depends upon the range of price,
and the psychology of the consumers. The conclusion regarding the nature of demand should, therefore be
restricted to small changes in prices during short period. By doing so, the influence of changes in habits,
tastes, likes customs etc., can be ignored.
5. What is Income Elasticity of Demand? How it can be measured?
Ans. The discussion of price elasticity of demand reveals that extent of change in demand as a result of
change in price. However, as already explained, price is not the only determinant of demand. Demand for
a commodity changes in response to a change in income of the consumer. In fact, income effect is a
constituent of the price effect. The income effect suggests the effect of change in income on demand. The
income elasticity of demand explains the extent of change in demand as a result of change in income. In
other words, income elasticity of demand means the responsiveness of demand to changes in income.
Thus, income elasticity of demand can be expressed as:
EY = [Percentage change in demand / Percentage change in income]
The following types of income elasticity can be observed:
1. Income Elasticity of Demand Greater than One: When the percentage change in demand is greater than
the percentage change in income, a greater portion of income is being spent on a commodity with an
increase in income- income elasticity is said to be greater than one.
2. Income Elasticity is unitary: When the proportion of income spent on a commodity remains the same or
when the percentage change in income is equal to the percentage change in demand, EY = 1 or the
income elasticity is unitary.
3. Income Elasticity Less Than One (EY< 1): This occurs when the percentage change in demand is less
than the percentage change in income.
4. Zero Income Elasticity of Demand (EY=o): This is the case when change in income of the consumer does
not bring about any change in the demand for a commodity.
5. Negative Income Elasticity of Demand (EY< o): It is well known that income effect for most of the
commodities is positive. But in case of inferior goods, the income effect beyond a certain level of income
becomes negative. This implies that as the income increases the consumer, instead of buying more of a
commodity, buys less and switches on to a superior commodity. The income elasticity of demand in such
cases will be negative.
Tutorial- VI/VII
1. Explain the meaning of demand forecasting. What are the objectives of demand
forecasting? Discuss.
Ans Demand Forecasting
A demand forecast is the prediction of what will happen to your company's existing product
sales. It would be best to determine the demand forecast using a multi-functional approach. The
inputs from sales and marketing, finance, and production should be considered. The final
demand forecast is the consensus of all participating managers. You may also want to put up a
Sales and Operations Planning group composed of representatives from the different departments
that will be tasked to prepare the demand forecast.
Determination of the demand forecasts is done through the following steps:
• Determine the use of the forecast
• Select the items to be forecast
• Determine the time horizon of the forecast
• Select the forecasting model(s)
• Gather the data
• Make the forecast
• Validate and implement results
The time horizon of the forecast is classified as follows:
Description Forecast Horizon
Short-range Medium-range Long-range
Duration Usually less than 3
months, maximum of
1 year
3 months to 3 years More than 3 years
Applicability Job scheduling,
worker assignments
Sales and production
planning, budgeting
New product development,
facilities planning
2. Explain any four qualitative methods of demand forecasting.
Ans
Qualitative Method Description
Jury of executive opinion The opinions of a small group of high-level managers are pooled and
together they estimate demand. The group uses their managerial
experience, and in some cases, combines the results of statistical
models.
Sales force composite Each salesperson (for example for a territorial coverage) is asked to
project their sales. Since the salesperson is the one closest to the
marketplace, he has the capacity to know what the customer wants.
These projections are then combined at the municipal, provincial and
regional levels.
Delphi method A panel of experts is identified where an expert could be a decision
maker, an ordinary employee, or an industry expert. Each of them
will be asked individually for their estimate of the demand. An
iterative process is conducted until the experts have reached a
consensus.
Consumer market survey The customers are asked about their purchasing plans and their
projected buying behavior. A large number of respondents is needed
here to be able to generalize certain results.
3. What are the various statistical methods of demand forecasting? Explain any two of
them.
Ans Quantitative Forecasting Methods
There are two forecasting models here – (1) the time series model and (2) the causal model. A
time series is a s et of evenly spaced numerical data and is o btained by observing responses at
regular time periods. In the time series model , the forecast is based only on past values and
assumes that factors that influence the past, the present and the future sales of your products will
continue.
On the other hand, t he causal model uses a mathematical technique known as the regression
analysis that relates a dependent variable (for example, demand) to an independent variable (for
example, price, advertisement, etc.) in the form of a linear equation. The time series forecasting
methods are described below:
Time Series
Forecasting
Method
Description
Naïve Approach Assumes that demand in the next period is the same as demand in most
recent period; demand pattern may not always be that stable
For example:
If July sales were 50, then Augusts sales will also be 50
Time Series
Forecasting
Method
Description
Moving Averages
(MA)
MA is a series of arithmetic means and is used if little or no trend is present
in the data; provides an overall impression of data over time
A simple moving average uses average demand for a fixed sequence of
periods and is good for stable demand with no pronounced behavioral
patterns.
Equation:
F 4 = [D 1 + D2 + D3] / 4
F – forecast, D – Demand, No. – Period
(see illustrative example – simple moving average)
A weighted moving average adjusts the moving average method to reflect
fluctuations more closely by assigning weights to the most recent data,
meaning, that the older data is usually less important. The weights are based
on intuition and lie between 0 and 1 for a total of 1.0
Equation:
WMA 4 = (W) (D3) + (W) (D2) + (W) (D1)
WMA – Weighted moving average, W – Weight, D – Demand, No. – Period
(see illustrative example – weighted moving average)
Exponential
Smoothing
The exponential smoothing is an averaging method that reacts more strongly
to recent changes in demand by assigning a smoothing constant to the most
recent data more strongly; useful if recent changes in data are the results of
actual change (e.g., seasonal pattern) instead of just random fluctuations
F t + 1 = a D t + (1 - a ) F t
Where
F t + 1 = the forecast for the next period
D t = actual demand in the present period
F t = the previously determined forecast for the present period
• = a weighting factor referred to as the smoothing constant
(see illustrative example – exponential smoothing)
Time Series
Decomposition
The time series decomposition adjusts the seasonality by multiplying the normal
forecast by a seasonal factor
(see illustrative example – time series decomposition)
Tutorial- VIII/IX
1. Discuss the meaning and importance of production function.
Ans Production Function:
A given output can be produced with many different combinations of factors of production (land,
labor, capita! and organization) or inputs. The output, thus, is a function of inputs. The functional
relationship that exists between physical inputs and physical output of a firm is called production
function.
Formula:
In abstract term, it is written in the form of formula:
Q = f (x1, x2, ......., xn)
Q is the maximum quantity of output and x1, x2, xn are quantities of various inputs. The
functional relationship between inputs and output is governed by the laws of returns.
The laws of returns are categorized into two types.
(i) The law of variable proportion seeking to analyze production in the short period.
(ii) The law of returns to scale seeking to analyze production in the long period.
2. What do you mean by ‘returns to scale’? How does increasing returns to scale
operate?
Ans Law of Returns to Scale:
The law of returns are often confused with the law of returns to scale. The law of returns
operates in the short period. It explains the production behavior of the firm with one factor
variable while other factors are kept constant. Whereas the law of returns to scale operates in the
long period. It explains the production behavior of the firm with all variable factors.
There is no fixed factor of production in the long run. The law of returns to scale describes the
relationship between variable inputs and output when all the inputs, or factors are increased in
the same proportion. The law of returns to scale analysis the effects of scale on the level of
output. Here we find out in what proportions the output changes when there is proportionate
change in the quantities of all inputs. The answer to this question helps a firm to determine its
scale or size in the long run.
It has been observed that when there is a proportionate change in the amounts of inputs, the
behavior of output varies. The output may increase by a great proportion, by in the same
proportion or in a smaller proportion to its inputs. This behavior of output with the increase in
scale of operation is termed as increasing returns to scale, constant returns to scale and
diminishing returns to scale. These three laws of returns to scale are now explained, in brief,
under separate heads.
(1) Increasing Returns to Scale:
If the output of a firm increases more than in proportion to an equal percentage increase in all
inputs, the production is said to exhibit increasing returns to scale.
For example, if the amount of inputs are doubled and the output increases by more than double,
it is said to be an increasing returns returns to scale. When there is an increase in the scale of
production, it leads to lower average cost per unit produced as the firm enjoys economies of
scale.
(2) Constant Returns to Scale:
When all inputs are increased by a certain percentage, the output increases by the same
percentage, the production function is said to exhibit constant returns to scale.
For example, if a firm doubles inputs, it doubles output. In case, it triples output. The constant
scale of production has no effect on average cost per unit produced.
(3) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs.
For example, if a firm increases inputs by 100% but the output decreases by less than 100%, the
firm is said to exhibit decreasing returns to scale. In case of decreasing returns to scale, the firm
faces diseconomies of scale. The firm's scale of production leads to higher average cost per unit
produced.
The three laws of returns to scale are now explained with the help of a graph below:
The figure 11.6 shows that when a firm uses one unit of labor and one unit of capital, point a, it
produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm doubles its outputs
by using 2 units of labor and 2 units of capital, it produces more than double from q = 1 to q =
So the production function has increasing returns to scale in this range. Another output from
quantity 3 to quantity 6. At the last doubling point c to point d, the production function has
decreasing returns to scale. The doubling of output from 4 units of input, causes output to
increase from 6 to 8 units increases of two units only.
3. Define the following terms: incremental cost, sunk cost, replacement cost, historical
cost, short un cost, long run cost, fixed cost, variable cost.
Ans Opportunity Cost Principle - the economic cost of an input used in a production process is
the value of output sacrificed elsewhere. The opportunity cost of an input is the value of
foregone income in best alternative employment.
• Implicit vs. Explicit Costs
– Explicit costs – costs paid in cash
– Implicit cost – imputed cost of self-owned or self employed resources based on their
opportunity costs.
• A firm’s total cost of producing a given level of output is the opportunity cost of the owners
– Explicit (involving actual payments)
• Money actually paid out for the use of inputs
– Implicit (no money changes hands)
• The cost of inputs for which there is no direct money payment
• This is the core of economists’ thinking about costs
4. Explain the cost output relationship in the long run with the help of diagram.
Ans
5. What do you understand by economies and diseconomies of scale? Explain.
Ans An increase in output causes LRATC to decrease
– The more output produced, the lower the cost per unit
– LRATC curve slopes downward
– Long-run total cost rises proportionately less than output
• Increasing return to scaleThe advantages of large scale production that result in lower unit
(average) costs (cost per unit)
• AC = TC / Q
• Economies of Scale – spreads total costs over a greater range of output
Internal – advantages that arise as a result of the growth of the firm
• Technical
• Commercial
• Financial
• Managerial
• Risk Bearing
The disadvantages of large scale production that can lead to increasing average costs
• Problems of management
• Maintaining effective communication
• Co-ordinating activities – often across the globe!
• De-motivation and alienation of staff
• Divorce of ownership and control
Tutorial- X/XI Solution
8. Explain the relationship between Average cost and Marginal cost diagrammatically.
Average Cost (AC): Average cost refers to fixed cost per unit of output. Average fixed Cost is
found out by dividing the total cost by the corresponding output.
AFC = TFC
output (Q)
Marginal Cost (MC): Marginal Cost is an increase in total cost that results from a one unit increase in
output. It is defined as:"The cost that results from a one unit change in the production rate".
Marginal Cost = Change in Total Cost = ΔTC
Change in Output Δq
9. What are the features of Perfect Competitive market?
Specific characteristics may include:
Infinite buyers and sellers – Infinite consumers with the willingness and ability to
buy the product at a certain price, and infinite producers with the willingness and
ability to supply the product at a certain price.
Zero entry and exit barriers – It is relatively easy for a business to enter or exit in
a perfectly competitive market.
Perfect factor mobility - In the long run factors of production are perfectly mobile
allowing free long term adjustments to changing market conditions.
Perfect information - Prices and quality of products are assumed to be known to
all consumers and producers.
Zero transaction costs - Buyers and sellers incur no costs in making an exchange
(perfect mobility).
Profit maximization - Firms aim to sell where marginal costs meet marginal
revenue, where they generate the most profit.
Homogeneous products – The characteristics of any given market good or service
do not vary across suppliers.
Non-increasing returns to scale - Non-increasing returns to scale ensure that there
are sufficient firms in the industry.
10. Differentiate variable costs & fixed costs.
Total fixed cost occur only in the short run. Total Fixed cost as the name implies is the cost of the firm's fixed resources, Fixed cost remains the same in the short run regardless of how many units of output are produced.
Total variable cost as the name signifies is the cost of variable resources of a firm that are used
along with the firm's existing fixed resources. Total variable cost is linked with the level of
output. When output is zero, variable cost is zero. When output increases, variable cost also
increases and it decreases with the decrease in output. So any resource which can be varied to
increase or decrease with the rate of output is variable cost of the firm.
Units of Output (in
Hundred)
Total Fixed
CostTotal Variable Cost Total Cost
0 1000 0 1000
1 1000 60 1060
2 1000 100 1100
3 1000 150 1150
4 1000 200 1200
5 1000 400 1400
6 1000 700 1700
7 1000 1100 2100
11. Explains the price output determination under a perfectly competitive market in the short run and long run.
In prefect competition, price is determined by the market forces of demand and supply. All
buyers and sellers are price takers and not price makers. Buyer represents demand side in the
market. Every rational buyer aims at maximising his satisfaction by purchasing more at lower
price and lower at higher price. This is called demand behaviour of buyer i.e. Law of Demand
'Tutorial- XII/XIII Solution
1. Explain the types of inflation in detail.
On the basis of its rate, inflation can be classified as :
1) Moderate inflation
2) Galloping inflation
3) Hyper inflation
4) Suppressed inflation
5) Demand-pull inflation
6) Cost-push inflation
1) Moderate inflation :
Creeping inflation
When the rate of annual inflation is in a single digit, it is known as moderate inflation.
2) Galloping inflation :
A high rate of inflation usually in the double or triple-digit range of 20 to 200 percent a
year is called galloping inflation.
Distortion of relative prices.
3) Hyper Inflation :
It is a sever type of inflation in which prices rise at a rate of more than three digit per
annum.
It is also called “run-away” inflation.
4) Suppressed Inflation :
In a free-market economy, government does not control and regulate prices. So the prices
rise without any control and regulation due to supply-demand imbalances. This is called
open-inflation.
Suppressed inflation occurs in a controlled economy. Prices are controlled by the
government.
2. Discuss the causes of inflation. How can inflation be controlled?
Causes of Inflation:-
a) Rising imported raw materials costs
b) Rising labour costs
c) Higher indirect taxes imposed by the government
d) A depreciation of the exchange rate
e) A reduction in direct or indirect taxation
f) The rapid growth of the money supply
g) Rising consumer confidence and an increase in the rate of growth of house prices
h) Faster economic growth in other countries
Measures to control Inflation :-
1) Monetary measures
2) Fiscal measures
3) Fixed Exchange Rates
4) Gold Standard
5) Wage and Price Controls
3. What are the causes of inflation? How an economy can control it? Give your answer
with reference to India.
a) Rising labour costs - caused by wage increases which exceed any improvement in
productivity. This cause is important in those industries which are ‘labour-intensive’.
b) Firms may decide not to pass these higher costs onto their customers (they may be able to
achieve some cost savings in other areas of the business) but in the long run, wage inflation tends
to move closely with price inflation because there are limits to the extent to which any business
can absorb higher wage expenses.
c) Higher indirect taxes imposed by the government – for example a rise in the rate of excise
duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of
Value Added Tax or an extension to the range of products to which VAT is applied
Controlling Inflation :-
Monetary measures used to control inflation include:
o Bank rate policy
o Cash reserve ratio and
o Open market operations.
Fiscal measures to control inflation include taxation, government expenditure and public borrowings.
The value of a currency unit should not vary much, failing which, there would be an economic
crisis in monetary terms.
Under a gold standard, the long term rate of inflation or deflation would be determined by the growth rate of the supply of gold relative to total output.
The price and wage controls go together because price-push and cost-push inflation go
hand in hand whatever may be the cause of initial inflation.
4. “Inflation is unjust and deflation is inexpedient, of the two perhaps deflation is worse.”
Comment.
a) Inflation windens the gulf between the rich and the poor. During high rate of inflation, rich
gain at the expense of the poor. However, the real income of the nation is not reduced.
b) Inflation is a full-time employment phenomenon. A moderate rate of inflation may be good
for a depressed economy. Inflation can be controlled to some extent by applying monetary and
fiscal measures.
c) Deflation reduces national income as production decreases and unemployment increases. The
level of economic activity goes down.
d) Deflation results in whole system of production remaining idle. It is an under-employment
phenomenon leading to further un-employment. Deflation in all its form is adverse for the
economy. Deflation cannot be checked so easily and leads to a depressed economy.
Tutorial- XIV
1. Explain the concepts of national income.
Ans CONCEPTS OF NATIONAL INCOME
The important concepts of national income are:
1. Gross Domestic Product (GDP)
2. Gross National Product (GNP)
3. Net National Product (NNP) at Market Prices
4. Net National Product (NNP) at Factor Cost or National Income
5. Personal Income
6. Disposable Income
Let us explain these concepts of National Income in detail.
1. Gross Domestic Product (GDP): Gross Domestic Product (GDP) is the total market value of
all final goods and services currently produced within the domestic territory of a country in a
year.
Four things must be noted regarding this definition.
First, it measures the market value of annual output of goods and services currently produced.
This implies that GDP is a monetary measure.
Secondly, for calculating GDP accurately, all goods and services produced in any given year
must be counted only once so as to avoid double counting. So, GDP should include the value of
only final goods and services and ignores the transactions involving intermediate goods.
Thirdly, GDP includes only currently produced goods and services in a year. Market transactions
involving goods produced in the previous periods such as old houses, old cars, factories built
earlier are not included in GDP of the current year.
Lastly, GDP refers to the value of goods and services produced within the domestic territory of a
country by nationals or non-nationals.
2. Gross National Product (GNP): Gross National Product is the total market value of all final
goods and services produced in a year. GNP includes net factor income from abroad whereas
GDP does not. Therefore,
GNP = GDP + Net factor income from abroad.
Net factor income from abroad = factor income received by Indian nationals from abroad –
factor income paid to foreign nationals working in India.
3. Net National Product (NNP) at Market Price: NNP is the market value of all final goods
and services after providing for depreciation. That is, when charges for depreciation are deducted
from the GNP we get NNP at market price. Therefore’
NNP = GNP – Depreciation
Depreciation is the consumption of fixed capital or fall in the value of fixed capital due to wear
and tear.
4. Net National Product (NNP) at Factor Cost (National Income): NNP at factor cost or
National Income is the sum of wages, rent, interest and profits paid to factors for their
contribution to the production of goods and services in a year. It may be noted that:
NNP at Factor Cost = NNP at Market Price – Indirect Taxes + Subsidies.
5. Personal Income: Personal income is the sum of all incomes actually received by all
individuals or households during a given year. In National Income there are some income, which
is earned but not actually received by households such as Social Security contributions, corporate
income taxes and undistributed profits. On the other hand there are income (transfer payment),
which is received but not currently earned such as old age pensions, unemployment doles, relief
payments, etc. Thus, in moving from national income to personal income we must subtract the
incomes earned but not received and add incomes received but not currently earned. Therefore,
Personal Income = National Income – Social Security contributions – corporate income taxes –
undistributed corporate profits + transfer payments.
Disposable Income: From personal income if we deduct personal taxes like income taxes,
personal property taxes etc. what remains is called disposable income. Thus,
Disposable Income = Personal income – personal taxes.
Disposable Income can either be consumed or saved. Therefore,
Disposable Income = consumption + saving.
2. Discuss the methods of measurement of national income and the precautions under
each method.
Ans MEASUREMENT OF NATIONAL INCOME
Production generate incomes which are again spent on goods and services produced. Therefore,
national income can be measured by three methods:
1. Output or Production method
2. Income method, and
3. Expenditure method.
Let us discuss these methods in detail.
1. Output or Production Method: This method is also called the value-added method. This
method approaches national income from the output side. Under this method, the economy is
divided into different sectors such as agriculture, fishing, mining, construction, manufacturing,
trade and commerce, transport, communication and other services. Then, the gross product is
found out by adding up the net values of all the production that has taken place in these sectors
during a given year.
In order to arrive at the net value of production of a given industry, intermediate goods purchase
by the producers of this industry are deducted from the gross value of production of that
industry. The aggregate or net values of production of all the industry and sectors of the
economy plus the net factor income from abroad will give us the GNP. If we deduct depreciation
from the GNP we get NNP at market price. NNP at market price – indirect taxes + subsidies will
give us NNP at factor cost or National Income.
The output method can be used where there exists a census of production for the year. The
advantage of this method is that it reveals the contributions and relative importance and of the
different sectors of the economy.
2. Income Method: This method approaches national income from the distribution side.
According to this method, national income is obtained by summing up of the incomes of all
individuals in the country. Thus, national income is calculated by adding up the rent of land,
wages and salaries of employees, interest on capital, profits of entrepreneurs and income of self-
employed people.
This method of estimating national income has the great advantage of indicating the distribution
of national income among different income groups such as landlords, capitalists, workers, etc.
3. Expenditure Method: This method arrives at national income by adding up all the
expenditure made on goods and services during a year. Thus, the national income is found by
adding up the following types of expenditure by households, private business enterprises and the
government: -
(a) Expenditure on consumer goods and services by individuals and households denoted by C.
This is called personal consumption expenditure denoted by C.
(b) Expenditure by private business enterprises on capital goods and on making additions to
inventories or stocks in a year. This is called gross domestic private investment denoted by I.
(c) Government’s expenditure on goods and services i.e. government purchases denoted by G.
(d) Expenditure made by foreigners on goods and services of the national economy over and
above what this economy spends on the output of the foreign countries i.e. exports – imports
denoted by (X – M). Thus,
GDP = C + I + G + (X – M).
