MB0026 - Set II - Managerial Economics

8/14/2019 MB0026 - Set II - Managerial Economics

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Name: Hala ABu Bakr Abd El-Hamid

Youssef NayelRoll No.: 530910875Course: MBA

Centre Code: 2541Centre City: Ras Al-Khaimah UAE.

MB0026 Managerial Economics


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Q1.What do you mean by pricing policy? Explain the variousobjective of pricing policy of a firm

Pricing policy refers to the policy of setting the price of the product orproducts and services by the management after taking into account ofvarious internal and external factors, forces and its own business objectives.

Objectives of the price policePricing objectives has to be established by top management to ensure notonly that the companys profitability is adequate but also that pricing iscomplementary to the total strategy of the organization. While formulatingthe pricing policy, a firm has to consider various economic, social, politicaland other factors. The following objectives are to be considered whilefixing the prices of the product

1. Profit maximization in the short term: The primary objective of thefirm is to maximize its profits. Pricing policy as an instrument to achieve

this objective should be formulated in such a way as to maximize thesales revenue and profit. Maximum profit refers to the highest possible ofprofit. In the short run, a firm not only should be able to recover its totalcosts, but also should get excess revenue over costs. This will build themorale of the firm and instill the spirit of confidence in its operations. Itmay follow skimming price policy, i.e., charging a very high price whenthe product is launched to cater to the needs of only a few sections ofpeople. It may exploit wide opportunities in the beginning. But it mayprove fatal in the long run. It may loose its customers and business in themarket. Alternatively, it may adopt penetration pricing policy, i.e.,charging a relatively lower price in the latter stages in the long run so as

to attract more customers and capture the market.2. Profit optimization in the long run: The traditional profit maximization

may not prove beneficial in the long run. With the sole motive of profitmaking a firm may resort to several kinds of unethical practices likecharging exorbitant prices, follow monopoly trade practices (MTP),restrictive trade practices(RTP) and unfair trade practices (UTP), etc. Thismay lead to opposition from the people. In order to over come these evils,a firm instead of profit maximization, aims at profit optimization.Optimum profit refers to the most ideal or desirable level of profit. Hence,earning the most reasonable or optimum profit has become a part andparcel of a sound pricing policy of a firm in recent years.

3. Price stabilization: Price stabilization over a period of time is anotherobjective. The prices as far as possible should not fluctuate too often.Price instability creates uncertain atmosphere in business circles. Salesplan becomes difficult under such circumstances. Hence, price stability isone of the pre requisite conditions for steady and persistent growth of afirm. A stable price policy only can win the confidence of customers and


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may add to the good will of the concern. It builds up the reputation andimage of the firm.

4. Facing competitive situation: One of the objectives of the pricingpolicy is to face the competitive situations in the market. In many cases,this policy has been merely influenced by the market share psychology.

Wherever companies are aware of specific competitive products, they tryto match the prices of their products with those of their rivals to expandthe volume of their business. Most of the firms are not merely interestedin meeting competition but are keen to prevent it. Hence, a firm is alwaysbusy with its counter business strategy.

5. Maintenance of market share: Market share refers to the share of afirms sales of a particular product in the total sales of all firms in themarket. The economic strength and success of a firm is measured interms of its market share. In a competitive world, each firm makes asuccessful attempt to expand its market share. If it is impossible, it has tomaintain its existing market share. Any decline in market share is a

symptom of the poor performance of a firm. Hence, the pricing policy hasto assist a firm to maintain its market share at any cost.

6. Capturing the market: Another objective in recent years is to capturethe market, dominate the market, command and control the market inthe long run. In order to achieve this goal, sometimes the firm fixes alower price for its product and at other times even it may sell at a loss inthe short term. It may prove beneficial in the long run. Such a pricing isgenerally followed in price sensitive markets.

7. Entry into new markets: Apart from growth, market share expansion,diversification in its activities a firm makes a special attempt to enter into

new markets. Entry into new markets speaks about the successful storyof the firm. Hence, it has to bear the pioneering and subsequent risks.The prices set by a firm have to be so attractive that the buyers in othermarkets have to switch on to the products of the candidate firm.

8. Deeper penetration of the market: The pricing policy has to bedesigned in such a manner that a firm can make inroads into the marketwith minimum difficulties. Deeper penetration is the first step in thedirection of capturing and dominating the market in the latter stages.

9. Achieving a target return: A predetermined target return on capitalinvestment and sales turnover is another long run pricing objective of afirm. The targets are set according to the position of individual firm.

Hence, prices of the products are so calculated as to earn the targetreturn on cost of production, sales and capital investment. Differenttarget returns may be fixed for different products or brands but suchreturns should be related to a single overall rate of return target.

10.Target profit on the entire product line irrespective of profit levelof individual products: The price set by a firm should increase the saleof all the products rather than yield a profit on one product only. A


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rational pricing policy should always keep in view the entire product lineand maximum total sales revenue from the sale of all products. A productline may be defined as a group of products which have similar physicalfeatures and perform generally similar functions.

11.Long run welfare of the firm: A firm has multiple objectives. They are

laid down on the basis of past experience and future expectations.Simultaneous achievement of all objectives are necessary for the over allgrowth of a firm. Objective of the pricing policy has to be designed insuch a way so as to fulfill the long run interests of the firm keepinginternal conditions and external environment in mind.

12.Ability to pay: Pricing decisions are sometimes taken on the basis of theability to pay of the customers, i.e., higher price can be charged to thosewho can afford to pay. Such a policy is generally followed by those peoplewho supply different types of services to their customers.

13.Ethical pricing: Basically, pricing policy should be based on certainethical principles. Business without ethics is a sin. While setting theprices, some moral standards are to be followed. Although profit is one ofthe most important objectives, a firm cannot earn it in a moral vacuum.Instead of squeezing customer, a firm has to charge moderate prices forits products. The pricing policy has to secure reasonable amount of profitsto a firm to preserve the interests of the community and promote itswelfare.

Besides these goals, there are various other objectives such as promotion ofnew items, steady working of plants, maintenance of comfortable liquidityposition, making quick money, maintaining regular income to the company,continued survival, rapid growth of the firm, etc which forms may set whiletaking pricing decisions.

Q2.What is oligopoly? Explain the features of oligopolymarketsThe term oligopoly is derived from two Greek words oligoi means a few andpoly means to sell. Under oligopoly, we come across a few producersspecializing in the production of identical goods or differentiated goodscompeting with one another. The products traded by the oligopolists may bedifferentiated or homogenous.

Features of oligopoly1. Interdependence: Each and every firm has to be conscious of the

reactions of its rivals. Since the number of firms is very few, any change inprice, output, product, etc, by one firm will have direct effect on the policyof other firms. Therefore, economic calculations must be made alwayswith reference to the reactions of the rival firms, as they have a highdegree of cross elasticitys of demand for their products.


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2. Indeterminateness of the demand curve: Under oligopoly, there willbe the element of uncertainty. Firms will not be knowing the particularfactors which could affect demand. Naturally rise or fall in the demand forthe product cannot be speculated. Changes that would be taking placemay be contrary to the expected changes in the product curve. Thus, the

demand curve for the product will be indeterminate or indefinite. Prof.Sweezy explains it as a kinky demand curve.3. Conflicting attitude of firms: Under oligopoly, on the one hand, firms

may realize the disadvantages of competition and rivalry and desire tounite together to maximize their profits. On the other hand firms guidedby individualistic considerations may continuously come in clash andconflict with one another. This creates uncertainty in the market.

4. Element of monopoly and competition: Under oligopoly, a firm hassome monopoly power over the product it produces but not on the entiremarket. But monopoly power enjoyed by the firm will be limited by theextent of competition.

5. Price rigidity: Generally, prices tend to be sticky or rigid under oligopoly.This is because of the fact that if one firm changes its price, other firmsmay also resort to the same technique.

6. Aggressive or defensive marketing methods: Firms resort toaggressive and sometimes defensive marketing methods in order to eitherincrease their share of the market or to prevent a decline of their share inthe market. If one adopts extensive advertisement and sales promotionpolicy it provokes others to do the same. Prof. Boumal rightly remarks inthis connection- Under oligopoly, advertising can become a life and deathmatter where a firm which fails to keep up with the advertising budget ofits competitors may find its customers drifting off to rival firms.

7. Constant struggle: Competition is of unique type in an oligopolisticmarket. Hence, competition consists of constant struggle of rivals againstrivals.

8. Lack of uniformity: Lack of uniformity in the rise of different oligopoliesis another remarkable feature.

9. Small number of large firms: The numbers of firms in the market aresmall. But the size of each firm is big. The market share of each firm issufficiently large to dominate the market.

10. Existence of kinked demand curve: A kinked demand curve is said tooccur when there is a sudden change in the slope of the demand curve. Itexplains price rigidity under oligopoly.

Q3.State the psychological law of consumption. Explain thevarious factors that affect consumption function and itsimportance.Keynes Psychological law of consumption, states that, when aggregateincome increase, consumption expenditure shall also increase but by asomewhat smaller amount. This law tells us that people fail to spend on


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consumption the full amount of increment in income. As income increase, thewants of the people gets satisfied and as such when income increases theysave more than what they spend. This law may be considered as a roughindication of the actual macro-behavior of consumers in the short-run. This isthe fundamental principle upon which the Keynesian consumption function is

based.Factors determining consumption functionBroadly there are two factors, which influence consumption function in thelong run. They are:

1. Subjective factors: Subjective factors basically underlie and determinethe form of the consumption; the subjective factors are internal orendogenous in nature. They mainly depend upon the personal decisionstaken by the people. Keynes has listed eight main motives, which compelpeople to refrain from current spending. They are the motives ofprecaution, foresight, calculation, improvement, independence,

enterprise, pride and avarice.In addition to these factors, he also has added a list of motives, whichleads to consumption. We could also draw up a corresponding list ofmotives to consumption such as enjoyment, ostentation andextravagance Keynes.

2. Objective factors: Objective factors are those, which depends on meritsand facts. In this case personal factors will not come into picture. Thefollowing are some of the important objective factors, which influenceconsumption:

Distribution of national income.

Fiscal policy

Money income

Real income

Price and wage level

Changes in tastes and fashion

Changes in expectations

Wind fall (sudden) gains and losses

The level of consumer indebtedness

Attitude towards thrift

Liquid assets

Social and life insurances

Rate of interest

Business policies of corporations

Emonstration effect

Changes in expectations

Installment buying, etc

The objective factors generally remain unchanged in the short period. Thus,propensity to consume in the short period is generally stable. It is because of


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this, Keynes places his reliance on investment for the purpose of increasingemployment during depression.

Q4.What is a Monetary Policy? Explain the general objectivesand instruments of monetary policy.

Monetary policy is a part over all economic policy of a country. It is employedby the government as an effective tool to promote economic stability andachieve predetermined objectives.

Monetary policy deals with total money supply and its management in aneconomy. It is essentially a program of action undertaken by the monetaryauthorities generally the central bank to control and regulate the supply ofmoney with the public and the flow of credit with a view to achievingeconomic stability and certain predetermined macro economic goals.

Monetary goals can be explained in two different ways. In a narrow sense, itis concerned with administering and controlling a countrys money supplyincluding currency notes and coins, credit money, level of interest rates andmanaging the exchange rates. In a broader sense, monetary policy deals withall those monetary and non-monetary measures and decisions that affect thetotal money supply and its circulation in an economy. It also includes severalnon-monetary measures like wages and price control, income policy,budgetary operations taken by the government which indirectly influence themonetary situations in an economy.

Objectives of monetary policyObjectives of monetary policy must be regarded as a part of overall economicobjectives of the government. It should be designed and directed to achieve

different macro economic goals. The objectives may be manifold in relationto thee general economic policy of a nation. The various objectives may beinter-related, inter-dependent and mutually complementary to each other.They may also be mutually inconsistent and clash with each other. Hence,very often the monetary authorities are concerned with a careful choicebetween alternative ends. The priorities of the objectives depend on thenature of economic problems, its magnitude and economic policy of a nation.The various objectives also change over a time period.

General objectives of monetary policy

1. Neutral money policyProf. Wicksteed, Hayak, Robertson and others have advocated this policy.This objective was in vogue during the days of gold standard. According tothis policy, money is only a technical devise having no other role to play. Itshould be a passive factor having only one function, namely to facilitateexchange. It should not inject any disturbances. It should be neutral in itseffects on prices, income, output, and employment.


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They considered that changes in total money supply are the root cause forall kinds of economic fluctuations and as such if money supply is stabilizedand money becomes neutral, the price level will vary inversely with theproductive power of the economy.If productivity increase, cost per unit of output declines and prices fall and

vice versa.According to this policy, money supply is not rigidly fixed. It will changewhenever there are changes in productivity, population, improvements intechnology, etc to neutralize fundamental changes in the economy. Underthese conditions, increase or decrease in money supply is allowed toresult in either fall or raise in general price level. In a dynamic economy,this policy cannot be continued and it is highly impracticable in thepresent day economy.

2. Price stabilityWith the suspension of the gold standard, maintenance of domestic pricelevel has become an important aim of monetary policy all over the world.

The bitter experience of 1920s and 1930s has made all most alleconomies to go for price stability. Both inflation and deflation aredangerous and detrimental to smooth economic growth. They distort anddisturb the working of the economic system and create chaos. Both ofthem are bad as they bring unnecessary loss to some groups where asundue advantage to some others. They have potential power to createeconomic inequality, political upheavals and social unrest in any economy.In view of this, price stability is considered as one of the main objectivesof monetary policy in recent years. It is to be remembered that pricestability does not mean that prices of all commodities are kept constant orfixed over a period of time.

It refers to the absence of sharp variations or fluctuations in the averageprice level in the country.A hundred percent price stability is neither possible nor desirable in anyeconomy. It simply implies relative price stability.A policy of price stability checks cyclical fluctuations and smoothenproduction and distribution, keeps the value of money stable, preventartificial scarcity or prosperity, makes economic calculations possible,introduces an element of certainty, eliminate socio-economicdisturbances, ensure equitable distribution of income and wealth, securesocial justice and promote economic welfare.On account of all these benefits, monetary authorities have to takeconcrete steps to check price oscillations. Price stability is considered asone of the prerequisite condition for economic development and itcontributes positively to the attainment of a steady rate of growth in aneconomy. This is because price stability will build up public morale andinstall confidence in the minds of people, boost up business activity,expand various kinds of economic activities and ensure distributive justicein the country. Prof Basu rightly observes, A monetary policy which can


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maintain a reasonable degree of price stability and keep employmentreasonably full, sets the stage of economic development.

3. Exchange rate stabilityMaintenance of stable or fixed exchange rate was one of the major objectsof monetary policy for a long time under the gold standard. The stability of

national output and internal price level was considered secondary andsubservient to the former. It was through free and automatic imports andexports of gold that the country was able to remove the disequilibrium inthe balance of payments and ensure stability of exchange rates with othercountries. The government followed the policy of expanding currency andcredit with the inflow of gold and contracting currency and credit with theoutflow of gold. In view of suspension of gold standard and IMFmechanism, this object has lost its significance.However, in order to have smooth and unhindered international trade andfree flow of foreign capital in to a country. It becomes imperative for acountry to maintain exchange rate stability.

Changes in domestic prices would affect exchange rates and as such thereis great need for stabilizing both internal price level and exchange rates.Frequent changes in exchange rates would adversely affect imports,exports, inflow of foreign capital, etc. hence, it should be controlledproperly.

4. Control of trade cyclesOperation of trade cycles has become very common in moderneconomies. A very high degree of fluctuations in over all economicactivities is detrimental to the smooth growth of any economy. Economicinstability in the form of inflation, deflation or stagflation, etc would serve

as great obstacles to the normal functioning of an economy. Basically,changes in total supply of money are the root cause for business cyclesand its dampening effects on the entire economy.Hence, it has become one of the major objectives of monetary authoritiesto control the operation of trade cycles and ensure economic stability byregulating total money supply effectively.During the period of inflation, a policy of contraction in money supply andduring the period of deflation, a policy of expansion in money supply hasto be adopted. This would create the necessary economic stability forrapid economic development.

5. Full employment

In recent years, it has become another major goal of monetary policy allover the world especially with the publication of general theory by LordKeynes. Many well-known economists like Crowther, Halm, GardnerAckley, William, Beveridge and Lord Keynes have strongly advocated thisobjective in the context of present day situations in most of the countries.Their major problem is to maintain this high level of employment situationthrough various economic policies. This object has become much more


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important and crucial in developing countries as there is unemploymentand under employment of most of the resources.Deliberate efforts are to be made by the monetary authorities to ensureadequate supply of financial resources to exploit and utilize resources inthe best possible manner so as to raise the level of aggregate effective

demand in the economy. It should also help to maintain balance betweenaggregate savings and aggregate investments. This would ensureoptimum utilization of all kinds of resources, higher national output,income and higher living standards to the common man.

6. Equilibrium in the balance of payments This objective has assumed greater importance in the context ofexpanding international trade and globalization. Today most of thecountries of the world are experiencing adverse balance of payments onaccount of various reasons. It is a situation where in the import paymentsare in excess of export earnings. Most of the countries which haveembarked on the road to economic development cannot do away with

imports on a large scale. Imports of several items have becomeindispensable and without these imports their development process willbe halted.Hence, monetary authorities have to take appropriate monetary measureslike deflation, exchange depreciation, devaluation, exchange control,current account and capital account convertibility, regulate credit facilitiesand interest rate structures and exchange rates, etc.In order to achieve a higher rate of economic growth, balance of paymentsequilibrium is very much required and as such monetary authorities haveto take suitable action in the direction.

7. Rapid economic growthThis is comparatively a recent objective of monetary policy. Achieving ahigher rate of per capita output and income over a long period of time hasbecome one of the supreme goals of monetary policy in recent times.A higher rate of economic growth would ensure full employment condition,higher output, and income and better living standards to the people.Consequently, monetary authorities have to take the necessary steps toraise the productive capacity of the economy, increases the level ofeffective demand for various kinds of goods and services and ensurebalance between demand for and supply of goods n services in theeconomy. Also they should take measures to increase the rate of savings,

capital formation, step up the volume of investment, direct credit moneyinto desired directions, regulate interest rate structure, minimizeeconomic and business fluctuations by balancing demand for money andsupply of money, ensure price and overall economic stability, better andfull utilization of resources, remove imperfections in money and capitalmarkets, maintain exchange rate stability, allow the inflow of foreigncapital into the country, maintain the growth of money supply inconsistent with the rate of growth of output minimize adversity in balance


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of payments conditions, etc. Depending upon the conditions of theeconomy money supply has to be changed from time to time. A flexiblepolicy of monetary expansion or contraction has to be adopted to meet aparticular situation. Thus, a growth-friendly monetary policy has to bepursued by monetary authorities in order to stimulate economic growth.

It is to be noted that the above mentioned objectives are inter-related,inter dependent and inter connected with each other. Each one of theobjectives would affect the other and in its turn is influenced by theothers.

Objectives of monetary policy in developing countriesAs the development problems of developing countries are different from thatof developed countries, the objectives of monetary policy also changes. Thefollowing objectives may be considered in the context of developing countries

1.

Development role: It has to promote economic development by creating,mobilizing and providing adequate credit to different sectors of theeconomy. Supply sufficient financial resources, its proper direction,canalization and utilization, control of inflation and deflation etc wouldcreate proper background for laying a solid foundation for rapid economicdevelopment.

2. Effective central banking: It has to achieve various objectives of monetarypolicy and to meet the ever-growing development requirements of theeconomy, the central bank of the country has to operate effectively. It hasto control the volume of credit money and its distribution through the useof various quantitative and qualitative credit instruments. Central bank of

the country should act as an effective leader to control the activities of allother financial institutions in the country. It should command the respectof other institutions.

3. Inducement to savings: It has to encourage the saving habits of thecommon man by providing all kinds of monetary incentives. It has to takethe necessary steps to expand the banking facilities in the country andmobilize savings made by them. Special steps are to be taken to mobilizerural small savings.

4. Investment of savings: It should help in converting savings into productiveinvestments. For this purpose, it has to create an institutional base and

investment climate in the country. People should have variety ofopportunities to invest their hard earned money and earn adequatereturns on them.

5. Developing banking habits: Monetary authorities have to take effectiveand imaginary steps to popularize the use of various credit instruments bythe common man. Banking transactions should become the part of theirday to day life.


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6. Magnetization of the economy: The monetary authorities have to takedifferent measures to convert non-monetized sector or barter sector intomonetized sector and make people use credit money extensively in theirday to day life. Increase in total money supply should be in accordancewith the degree of monetization of the economy.

7. Monetary equilibrium: It is the responsibility of the monetary authorities tomaintain a proper balance between demand for money and supply ofmoney and ensure adequate liquidity position in the economy so thatneither there will be excess supply of money nor shortage in thecirculation of money.

8. Maintaining equilibrium in the balance of payments: It is the job of themonetary authorities to employ suitable monetary measures to set rightdisequilibrium in the balance of payments of a country.

9. Creation and expansion of financial institutions: Monetary authorities ofthe country have to take effective steps to improve the existing currency

and credit system. They should help in developing banking industry, creditinstitutions, cooperative societies, development banks and other types offinancial institutions, to mobilize more savings and direct them toproductive activities.

10. Integration of organized and unorganized money markets: The moneymarkets are under developed, undeveloped, highly unorganized and theyare not functioning on any well laid down principles.

11. Integrated interest rate structure: The monetary authorities have tominimize the existence of different interest rates in different segments ofthe money market and ensure an integrated interest rate structure.

12. Debt management: Monetary authorities have to decide the total volumeof internal as well as external borrowings, timing of the issue of bonds,stabilizing their prices, the interest rates to be paid for them, nature ofdebt servicing, time and methods of debt redemption, the number ofinstallments, time of repayment, etc.

13. Long term loan for industrial development: The monetary policy should beframed in such a way as to promote rapid industrial development in acountry by providing adequate finance for them.

14. Reforming rural credit system: The existing rural credit system is defectiveand as such it has to be reformed to assist the rural masses.

15.To create a broad and continuous market for government securities: It isthe responsibility of the monetary authorities of the country to develop awell organized securities market so that funds are easily available for theneedy people.

Instruments of monetary policy


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Broadly speaking there are two instruments through which monetary policyoperates. They are also called techniques of credit control.

1. Quantitative techniques of credit controls: They include bank rate policy,open market operations and variable reserve ratio.The operation of the quantitative techniques will have a general impact on

the entire economy regulating the supply of credit made available todifferent activities. The bank rate is the rate at which the central bank of acountry is willing to discount first class bills. If the bank rate is raised, themarket rates and other lending rates of the money market also go up.Conversely, the lending rates go down when the central bank lowers itsbank rates. These changes affect the supply and demand for money.Borrowing is discouraged when the rates go up and encouraged when theygo down.The flow of foreign short term capital also is affected. There is an inflow offoreign funds when the rates are raised and an outflow when they arereduced. Internal price level tends to fall with the contraction of credit. And

it tends to rise with its expansion. Business activity, both industrial andcommercial, is stimulated when the rates of interest are low, anddiscouraged when they are high.Adverse balance of payments in foreign trade can be corrected throughlowering of costs and prices. Thus bank rate through its influence on supplyof and demand for money helps in the establishment of stability in theeconomy.Varying reserve ratio- Variations of reserve requirements affect the liquidityposition of the banks and hence their ability to lend. By raising the reserverequirements inflationary trend can be kept under control. The lowering ofthe reserve ratio makes more cash available with the banks. The reserve

bank of India has been empowered to vary the cash reserve ratio from theminimum requirement of 3% to 15% of the aggregate liabilities. Cashreserves maintained by commercial banks are called statuary reserve andthe reserve over and above the statuary reserves is called excess reserve.

2. Qualitative techniques of credit control: Changes in the marginrequirements, direct action, moral suasion, rationing of credit, issue ofdirectives, and regulation of consumer credit are some of the qualitativetechniques which are in practice generally. While lending money againstsecurities banks keep a certain margin. Central Bank can issue directives tocommercial banks to maintain higher margins when it wants to curtail credit

and lower the margin requirements to expand credit.Direct action implies a coercive measure like, central bank refusing toprovide the benefit of rediscounting of bills for such banks whose creditpolicy is not in accordance with the wishes of the central bank. The credit isrationed by limiting the amount available for each applicant. Central bankmay also restrict its discounts to bills maturing after short periods. Centralbanks, in the form of directives to commercial banks can see that theavailable funds are utilized in a proper manner. Regulation of consumer


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credit can have a direct impact on the demand for various consumerdurables. Thus, Crowther concludes that the policy of the central bank usingits free discretion within limits that are normally very broad can control thevolume of money and credit, in its own field the central bank is clearly adictator.

Q5.What is a business cycle? Describe the different phases ofa business cycle.The term business cycle refers to a wave like fluctuation in the over all levelof economic activity particularly in national output, income, employment andprices that occur in a more or less regular time sequence. It is nothing butrhythmic fluctuations in the aggregate level of economic activity of a nation.

Different Phases of a business cycle:Basically, a business cycle has only 2 parts- expansion and contraction orprosperity and depression. Burns and Mitchell observe that peaks andtroughs are the 2 main mark-off points of a business cycle. The expansionphase starts from revival and includes prosperity and boom. Contractionphase includes recession, depression and trough. In between these two mainparts, we come across a few other interrelated transitional phases. In itsbroader perspective, a business cycle has 5 phases. They are as follows:

1. Depression, contraction or downswingIt is a first phase of a trade or business cycle. It is protracted period in whichbusiness activity is far below the normal level and is extremely low.According to Prof. Haberler depression is a state of affairs in which the real

Boom

P

Recove

ry

Recove

ry

Recession

Recession

DepressionDepression Trough

Boom peak

O Number of Years X

Y

Levelof

business

activity Full employment Line

Q


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income consumed or volume of production per head and the rate ofemployment are falling and are sub-normal in the sense that there are idleresources and unused capacity, especially unused labor.

This period is characterized by:

A sharp reduction in the volume of output, trade and other

transactions. An increase in the level of unemployment.

A sharp reduction in the aggregate income of the communityespecially wages and profits. In a few cases, profits turns out to benegative.

A drop in prices of most of the products, and fall in interest rates.

A steep decline in consumption expenditure and fall in the level ofaggregative effective demand.

A decline in marginal efficiency of capital and hence the volume ofinvestment.

Absence of incentives for production as the market has become dull. A low demand for loanable funds, surplus cash balances with the

banks leading to a contraction in the creation of bank credit.

A high rate of business failures.

An increasing difficulty in returning old debts by the debtors. Thisforces them to sell their inventories in the market where prices arealready falling. This deepens depression further.

A decline in the level of investment in stocks as it becomes lessattractive and less profitable. This reduces the deposits with the banksand other financial institutions leading to a contraction in bank credit.

A lot of excess capacity exists in capital and consumer goods industries

which work much below their capacity due to lack of demand.During depression, all construction activities come to a more or less haltingstage. Capital goods industries suffer more than consumer goodsindustries. Since costs are sticky and do not fall as rapidly as prices, theproducers suffer heavy losses. Prices of agricultural goods fall rapidly thanindustrial goods.During this period, purchasing power of money is very high but the generalpurchasing power of the community is very low. Thus, the aggregate levelof economic activity reaches its rock bottom position. It is the stage oftrough. The economy enters the phase of depression, as the process ofdepression is complete. It is also called, the period of slump.During this period, there is disorder, demoralization, dislocation anddisturbances in the normal working of the economic system. Consequently,one can notice all-round pessimism, frustration and despair. The entireatmosphere is gloomy and hopes are less. It is a period of great sufferingand hardship to the people. Thus, it is the worst and most fearful phase ofthe business cycle. USA experienced depression 2 times, between 1873-1879 and 1929-1933.


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2. Recovery or revivalDepression cannot last long, forever. After a period of depression, recoverystarts. It is a period where in, economic activities receive stimulus andrecover from the shocks. This is the lower turning point from depression torevival towards upswing. Depression carries with itself the seeds of its own

recovery. After sometime, the rays of hope appear on the business horizon.Pessimism is slowly replaced by optimism. Recovery helps to restore theconfidence of the business people and create a favorable climate forbusiness ventures.

The recovery may be initiated by the following factors:

Increase in government expenditure so as to increase purchasing powerin the hands of consumers.

Changes in production techniques and business strategies.

Diversification in investments or investment in new regions.

Explorations and exploitation of new sources of energy, etc.

New innovations- developing new products or services, new marketingstrategy, etc.As a result of these factors, business people take more risks and investmore. Low wages and low interest rates, low production costs, recovery inmarginal efficiency of capital etc induce the business people to take up newventures.In the early phase of the revival, there is considerable excess capacity inthe economy so, the output increases without a proportionate increase intotal costs. Repairs, renewals and replacement of plants take place.Increase in government expenditure stimulates the demand forconsumption goods, which in its turn pushes up the demand for capital

goods. Construction capacity receives an impetus. As a result, the level ofoutput, income, employment, wages, prices, profits, start rising.Rise in dividends induce the producers to float fresh investment proposalsin the stock market. Recovery in the stock market begins. Share prices goup. Attracted by the profits, banks lend more money leading to a high levelof investment. The upward trends in business give a sort of fillip toeconomic activity. Through multiplier and acceleration effects, theeconomy moves upward rapidly. It is to be noted that revival may be slowor fast, weak or strong; the wave of recovery once initiated begins to feedupon itself. Generally, the process of recovery once started takes theeconomy to the peak of prosperity.

3. Prosperity or Full-employmentThe recovery once started gathers momentum. The cumulative process ofrecovery continues till the economy reaches full employment. Fullemployment may be defined as a situation where in all available resourcesare fully employed at the current wage rate. Hence, achieving fullemployment has become the most important objective of all most alleconomies. Now, there is all round stability in output, wages, prices,income, etc.


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According to Prof. Haberler Prosperity is a state of affair in which the realincome consumed, produced and the level of employment are high or risingand there are no idle resources or unemployed workers or very few ofother.During the period of prosperity an economy experiences the following:

A high level of output, income, employment and trade. A high level of purchasing power, consumption expenditure and effective

demand.

A high level of Marginal Efficiency of capital and volume of investment.

A period of mild inflation sets in leading to a feeling of optimism amongbusinessmen and industrialists.

An increase in the level of inventories of both inputs and outputs.

A rise in interest rate.

A large expansion in bank credit and financial institutions lend moremoney to businessmen.

Firms operate almost at full capacity along with its production possibilityfrontier.

Share markets give handsome gains to investors as dividends and shareprices go up. Consequently, idle funds find their way to productive investments.

A state of exuberance and enthusiasm exists in business community.

Industrial and commercial activity, both speculative and non-speculativeshow remarkable expansion.

There is all round expansion, development, growth and prosperity in theeconomy. Every one seems to be happy during this period.

4. Boom or Over Full Employment of InflationThe prosperity phase does not shop at full employment. It gives way to the

emergence of a boom. It is a phase where in there will be an artificial andtemporary prosperity in an economy. Business optimism stimulates furtherinvestment leading to rapid expansion in all spheres of business activitiesduring the stage of full employment, unutilized capacity graduallydisappears. Idle resources are fully employed. Hence, rise in investment canonly mean increased pressure for the available men and materials. Factorinputs become scarce commanding higher remuneration. This leads to a risein wages and prices. Production cost goes up. Consequently, higher outputis obtained only at higher costs of production. Once full employment isreached, a further increase in the demand for factor inputs will lead to anincrease in prices rather than an increase in output and income. Demand forloanable funds increases leading to a rise in interest rates. Now there will behectic economic activity. Soon a situation develops in which the number ofjobs exceed the number of workers available in the market. Such a situationis known as overfull employment or hyper-employment.During this phase:

Prices, wages, interest, incomes, profits, etc move in the upwarddirection.


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MEC raises leading to business expansion.

Business people borrow more and invest. This adds furl to the fire. Thetempo of boom reaches new heights.

There is higher output, income and employment. Living standards of thepeople also increases.

There is higher purchasing power and the level of effective demand willreach new heights.

There is an atmosphere of over optimism all round, which results inover investment. Cost of living increases at a rate relatively higher than theincrease in household incomes.

It is a symptom of the end of prosperity phase and the beginning ofrecession.

The boom carries with it the gems of its own destruction. The prosperityphase comes to an end when the forces favoring expansion becomesprogressively weak. Bottlenecks begin to appear. Scarcity of factor inputsand rise in their prices disturb the cost calculations of the entrepreneurs.

Now the entrepreneurs realize that they have over stepped the mark andbecome over cautious and their over-optimism paves the way for theirpessimism. Thus, prosperity digs its own grave. Generally the failure of acompany or a bank bursts the boom and ushers in a recession. USAexperienced prosperity between1923 to 1929.

5. Recession- A turn from Prosperity to DepressionThe period of recession begins when the phase of prosperity ends. It is aperiod of time where in the aggregate level of economic activity startsdeclining. There is contraction or slowing down of business activities.After reaching the peak point, demand for goods decline. Over investment

and production creates imbalance between supply and demand. Investoriesof finished goods pile up. Future investment plans are given up. Ordersplaced for new equipments and raw materials and other inputs arecancelled. Replacement of worn out capital is postponed. The cancellationof orders for the inputs by the producers of consumer goods creates a chainreaction in the output market.Incomes of the factor inputs decline this creates demand recession. In orderto get rid of their high inventories, and to clear off their bank obligations,producers reduce market prices. In anticipation of further fall in prices,consumers postpone their purchases.Production schedules by firms are curtailed and workers are laid-off. Banks

curtail credit. Share prices decline and there will be slackness in stock andfinancial market. Consequently, there will be a decline in investment,employment, income and consumption. Liquidity preference suddenlydevelops. Multiplier and accelerator work in the reverse direction.Unemployment sets in the capital goods industries and with the passage oftime, it spreads to other industries also. The process of recession iscomplete. The wave of pessimism gets terminated to other sectors of theeconomy. The whole economic system thereby runs in to a crisis.


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Failure of some business creates panic among businessmen and theirconfidence in shaken. Business pessimism during this period ischaracterized by a feeling of hesitation, nervousness, doubt and fear. Prof.M. W. Lee remarks, A recession, once started, tends to build upon itselfmuch as forest fire. Once under way, it tends to create its own drafts and

find internal impetus to its destructive ability.Once the recession starts, it becomes almost difficult to stop the rot. It goeson gathering momentum and finally coverts itself in to a full-fledgeddepression, which is the period of utmost suffering for businessmen. Thus,now we have a full description about a business cycle. The USA experiencedone of the severe recessions during 1957-1958.Lord Overstone describes the course of business cycle in the followingwords- A state of quiescence (inert or silent) next improvement- growingconfidence- prosperity- excitement- overtrading- convulsion- pressure-distress- ending- again in quiescenceA detailed study of the various phases of a business cycle is of paramount

importance to the management. It helps the management to formulatevarious anti-cyclical measures to be taken up to check the adverse effectsof a trade cycle and creates the necessary conditions for ensuring stabilityin business.

Q6.Define inflation. Discuss different kinds of inflation andthe measures adopted to control it.

Inflation refers to a period of steady rise in price level. It is generallyconsidered as a monetary phenomena caused by excess supply of money.The effects of inflation are different on different sections of the society. A

mild inflation is beneficial to economic growth, producers and business menare benefited by it. But when it assumes larger proportions it becomesdangerous to the growth of the economy and is painful to consumers andlaborers.

Different kinds of inflation:Depending upon the rate of rise in prices and the prevailing situation,inflation has been classified under different heads.

1. Creeping inflation: When the rise in prices is very slow like that of a snailor creeper, (less than 3%) it is called creeping inflation.

2. Walking inflation: When the price rise is moderate (is in the range of 3 to

7%) and the annual inflation rate is of a single digit, it is called walkinginflation. It is a warning signal for the government to control it before itturns into running inflation.

3. Running inflation: When the prices rise rapidly, at a rate of speed 10 to 20percent per annum, it is called running inflation. Such inflation affects thepoor and middle classes adversely. Its control requires strong monetaryand fiscal measures; otherwise it leads to hyper inflation.


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4. Hyper inflation: It is also called by various names like jumping, runawayor galloping inflation. During this period prices rise very fast, at double ortriple digit rates from more than 20 to 100 percent per annum or moreand becomes absolutely uncontrollable. Such a situation brings a totalcollapse of the monetary system because of the continuous fall in the

purchasing power of money.5. Demand pull inflation: It may be defined as a situation where the total

monetary demand persistently exceeds total supply of goods and servicesat current prices, so that prices are pulled upwards by the continuousupward shift of the aggregate demand function. It arises as a result of anexcessive aggregate effective demand over aggregate supply of goodsand services in a slowly growing economy. The productive ability of theeconomy is so poor that it is difficult to increase the supply at a quickerrate to match the increase in demand for goods and services.

When exports increase the money income of the people rises. With the

excess money income, purchasing power, demand, prices move in theupward direction.It is essential to note that demand-pull inflation is the result of increase inmoney supply. This leads to fall in the interest rate-rise in investment-increase in production-increase in the incomes of factors of production-increase in the demand of goods and services and finally, in the level ofprices. Thus, excess supply of money results in escalation of prices.Again, when there is a diversion of productive resources from theproduction of consumer goods to either capital or defense goods or non-essential goods, prices start rising in view of scarcity of consumer goodsand excess income in thee hands of people. It is clear from the following

diagram.

Y S

P2

PRICE P1LEVEL

P F D2D1

DS

O Y X

OUTPUT


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In the diagram, the point F indicates the equilibrium position whereaggregate demand is equal to aggregate supply of goods and services.OP is the price level and OY indicates the supply of goods and services. Asdemands increases, supply being constant, the price level rises from OPto OP1 and OP2.

6. Cost-push inflation: It refers to a situation where in prices rise on accountof increasing cost of production. Thus, in this case, rise in price is initiatedby growing factor costs. Hence, such a price rise is termed as cost-pushinflation as prices are being pushed up by the rising factor costs. Anumber of factors contribute for the increase in cost of production.

Demand for higher wages by the labor class.

Fixing up of higher profit margins by the manufacturers.

Introduction of new taxes and raising the level of old taxes.

Increase in the prices of different inputs in the market.

Rise in administrative prices by the government etc.

These factors in turn cause prices to rise in the market. Out of manycauses, rise in wages is the most important one. It is estimated andbelieved that wages constitute nearly 70% of the total cost of production.A rise in wages leads to a rise in the total cost of production and aconsequent rise in the price level. Thus cost-push inflation occurs due towage push or profit push.In the following diagram, the cost-push inflation is explained. Here thepoint F indicates the original equilibrium position where demand andsupply are equal to each other. OP is the original price level and OY is thesupply. A is the new equilibrium point when the supply curve shifts

upwards an account of cost-push factors. OP1 will be the new price level,which is higher than the original one. OY1 will be the new supply and soon.


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OReal OutputY2 Y1

FP

D1

D2

S

P4

P3

P2

P1

G

D

Y

Price

Level

H

BS3

A

S1

S Y


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Monetary Measures :The anti-inflammatory measures or measures tocontrol inflation are as follows:

1. Monetary Measures: Inflation is basically a monetary phenomenon. Excessmoney supply over the quality of goods and services is mainly responsiblefor the rise in prices. Hence, monetary authorities aim at reducing and

absorbing excess supply of money in an economy. The following are someof the anti-inflammatory monetary measures:

The volume of legal tender money may be reduced either bywithdrawing a part of the notes already issued or by avoiding large-scale issue of notes.

Restrictions on bank credits.

Freezing and blocking particular type of assets.

Increasing bank rate and other interest rates.

Sale of government, securities in the open market by central bank.

Raising the legal reserve requirements like CRR and SLR

Prescribing a higher margin that bank and other lenders must maintainfor the loans granted by them against stocks and shares.

Regulation of consumers credit.

Rationing of credit, etc. Thus, the government to control inflation may exercise variousquantitative and qualitative techniques of credit controls.

2. Fiscal Measures: The following are some of the important anti-inflammatory fiscal measures:

Reduction in the volume of public expenditure.

Rise in the levels of taxes, introduction of new taxes and bringing more

people under the coverage of taxes.More internal borrowings by public authorities.

Postponing the repayment of debt to people.

Control on the volume of deficit financing.

Preparation of a surplus budget

Introduction of compulsory deposit schemes.

Incentive to savings.

Diverting the public expenditure towards the projects where the timegap between investment and production is least, (small gestationperiod).

Tariffs should be reduced to increase imports and thus allow a part ofthe increased domestic money income to leak-out.

Inducing wage earners to buy voluntarily government, bonds andsecurities, etc.

Thus, fiscal measures succeed to a greater extent to contain inflation inits own way.

3. Other Measures- direct or administrative measures: Direct controls refer tothe regulatory or administrative measures taken by the government


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directly with an objective of controlling rise in prices. Modern governmentsdirectly intervene in the working of the economy in several ways. Hence,the governments take several concrete measures to check the rise inprices. The following are some of these direct measures taken by moderngovernments:

Expansion in the volume of domestic output so as to meet the ever-increasing rise in the demand for them.

Direct control of prices and introduction of rationing.

Control of speculative and gambling activities.

Wage- profit freeze by adopting appropriate wage-profit policy.

Adopting an appropriate income policy.

Overvaluation of currency- Overvaluation of domestic currency in termsof foreign currencies in order to increase imports to add to the stockswith in the country and decrease in exports so that more goods willbecome available for domestic consumption.

Indexing- It refers to monetary corrections by periodic adjustments inmoney incomes of the people and in the value of financial assets,saving deposits, etc held by the public in accordance with the changesin price level. For if price rise by 15%, the money incomes and thevalue of the financial assts should be increased by 15% under thesystem of indexing.

Control of population- It is considered as one of the most importantmethods because if population is controlled, it is possible to keep acheck on demand for goods and services.

Exhortations- It implies authoritative persuasions, publicity campaignsetc, National saving campaign, requests to trade union for voluntary

resistance to demand for rise in wages companies to restrict dividenddistributions to workers and management to increase productivity andoutput, etc.

The above said measures are to be employed in a judicious manner in orderto combat the demon of inflation in a country.

Documents

MB0026 - Set II - Managerial Economics