SOLUTION OF THE QUESTION PAPER

Engineering & Managerial Economics- EHU -501

Q1:Attempt any two of the following

a) “Managerial Economics plays a very crucial role in engineering”.Comment

Ans: Managerial Economics plays a very crucial role in engineering .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.

b) Describe the “law of Demand”.

Ans: Law of Demand – (Demand Price Relationship)The relationship between prices and quantity demanded is called the ‘law of demand’ in

economics. The demand curve 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”.

(Economics argue that they have observed the reality and found that people behave as described

above according to the law. Such a common behavior is believed to be a general phenomenon of

human behavior. As a result, it is regarded as a law.)

Assumptions of the Law

Income:

It is assumed that there is no change in the size and distribution of individual income. If there is

a change, the law will not operate. If income increases, consumer's purchasing power increases

and so demand may increase even if there is a rise in price.

Tastes and Preferences:

It is assumed that taste and preferences for a commodity remains unchanged and do not move in

favor of new products.

Population:

The size and composition of the total population in the country is assumed to be constant. If

population increases, demand for commodities would increase even when prices are rising.

Price of substitutes and complementary:

The price of substitutes and complimentary are assumed to be constant. If they fall in greater

proportion consumer's demand for the substitute will increase and that of the commodity will

decrease.

Speculation or Expectation regarding future prices:

If consumers expect a further fall in the price of the commodity the demand for it would be low

in the present even though its price falls. Hence, it is assumed that there should be no change in

the expectations regarding future changes in prices.

Government policy:

The level of taxation and fiscal policy of the government remains the same throughout the

operation of the law, otherwise changes in income tax for example may cause changes in

consumer's income and as a result demand will change.

Range of goods available to the Consumers:

The innovation or arrival of new variety of a product in the market may change consumer's

preference, so it is assumed to be a constant one.

Weather conditions:

In case of seasonal goods, a study of demand and price is made during a particular season only,

for example: demand for sugarcane juice, and ice creams are made during summer season only.

Advertisements:

Advertisement and publicity attracts the attention of the consumers. Due to this, there are might

be changes in the consumption pattern/ so it is assumed that there is no new product introduced

in the market or any new advertisement for the existing product.

Note: These Assumptions are expressed in the phrase “other things remaining equal” or “Ceteris

Paribus”.

Demand Curve DD

It is a geometrical device to express the inverse price-demand relationship, i.e. the law of

demand. A demand curve can be obtained by plotting a demand schedule on a graph and joining

the points so obtained, like the demand schedule we can derive an individual demand curve as

well as a market demand curve. The former shows the demand curve of an individual buyer

while the latter shows the sum total of all the individual curves i.e. a market or a total demand

curve. The following diagram shows the two types of demand curves.

In the above diagram, figure (A) shows an individual demand curve of any individual consumer

while figure (B) indicates the total market demand. It can be noticed that both the curves are

negatively sloping or downwards sloping from left to right. Such a curve shows the inverse

relationship between the two variables. In this case the two variable are price on Y axis and the

quantity demanded on X axis. It may be noted that at a higher price OP the quantity demanded

is OM while at a lower price say OP1, the quantity demanded rises to OM1 thus a demand

curve diagrammatically explains the law of demand.

c) What do you think about Economics and managerial Economics?

Ans: Stonier and Hague have divided the subject matter of economics into three categories

which can be discussed as follows:-

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.

We know economics as a branch of knowledge which deals with the allocation of scarce

resources. The problem of resource allocation has been regularly faced by the individuals,

enterprises, and nations over the years. In the field of economics in recent decades the use of

mathematical tools and statistical methodology has become increasingly important. Further

economics is not the study of choice making behavior only. Major national and international

issues become the part of modern economic science. Currently the theory of economic growth

has occupied an important place in the study of economics and it studies how the national

income grows over the years.

Economics has two major branches:

(1) Microeconomics (2) Macroeconomics

(1) Microeconomics: It 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. Some of the important laws and principles

of microeconomics have been derived directly from the marginal analysis.

The followings are the fields covered by microeconomics:

Theory of Consumer Behaviour and Demand

Theory of Production and Costs

Theory of Distribution or Factor pricing

Theory of Economic Welfare

(2) Macroeconomics: 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. The followings are the fields covered by macroeconomics:

Theory of Income, Output and Employment

Theory of Business Cycles

Theory of General Price level with theory of inflation and deflation

Theory of Economic Growth

Macro Theory of Distribution dealing with the relative shares of wages and profits in the total

national income

Theory of National Income

Theory of Money

Meaning of Managerial Economics

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.”

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.

1. 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.

Q2:Attempt any two of the following:

a) Plot a diagram showing Total cost, fixed cost and variable cost. Also describe each.

Ans:  The total cost of a firm in the short run is divided into two categories (1) Fixed cost and (2)

Variable cost. The two types of economic costs are now discussed in brief.

     

(1) Total Fixed Cost (TFC): 

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. We can say that fixed cost of a firm is that part of total cost which

does not vary with changes in output per period of time. Fixed cost is to be incurred even if the

output of the firm is zero.

For example, the firm's resources which remain fixed in the short run are building, machinery

and even staff employed on contract for work over a particular period.

 

(2) Total Variable Cost (TVC):   

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.

 

For example, wages paid to the labor engaged in production, prices of raw material which a

firm. incurs on the production of output are variable costs. A firm can reduce its variable cost by

lowering output but it cannot decrease its fixed cost. These expenses remain fixed in the short

run. In the long run there are no fixed resources. All resources are variable. Therefore, a firm

has no fixed cost in the long run. All long run costs are variable costs.

 

(3) Total Cost (TC):           

Total cost is the sum of fixed cost and variable cost incurred at each level of output. Total cost

of production of a firm equals its fixed cost plus its:

 Formula:

TC = TFC + TVC

  Where:

  TC = Total cost.,TFC = Total fixed cost., TVC = Total variable cost.

Explanation:Short run costs of a firm is now explained with the help of a schedule and

diagrams. 

(in Dollars)

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

 

The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant

at $1000/- regardless of the level of output.

 

The column 3 indicates variable cost which is associated with the level of output. Total variable

cost is zero when production is zero. Total variable cost increases with the increase in output.

The variable does not increase by the same amount for each increase in output. Initially the

variable cost increases by a smaller amount up to 3rd unit of output and after which it increases

by larger amounts.

 

Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for

each level of output. The rise in total cost is more sharp after the 4 th level of output.

The concepts of costs, i.e., (1) total fixed cost (2) total variable cost and (3) total cost can be

illustrated graphically.

 

(i) Total Fixed Cost Curve/Diagram:

 

 

In this diagram (13.1) the total fixed cost of a firm is assumed to be $1000 at various levels of

output. It remains the same even if the firm's output is zero.

 

(ii) Total Variable Cost Curve/Diagram:

 

 

In the figure (13.2), the total variable cost curve (TVC) increases with the higher level of

output. It starts from the origin. Then increases at a diminishing rate up to the 4th units of

output. It then begins to rise at an increasing rate.

 

Total Cost Curve Curve/Diagram:

 

 

In the figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost at

various levels of output has nearly the same shape. The difference between the two is by only a

fixed amount of $1,000. The total variable cost curve and the total cost curve begin to rise more

rapidly as production is increased. The reason for this is that after a certain output, the business

has passed its most efficient use of its fixed costs machinery, building etc., and its diminishing

return begins to set in.

b) What are the determinants of demand?

Ans: Demand Function:

D = ∫ of (Price)

Or in Broader sense

D = ∫ of (P, Y, PR, A, T&P, E, O)

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.

a) 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.

b) 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.

c) 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.

d) 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.

e) 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.

f) 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.

g) 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.

h) countries try to copy the consumption patterns of rich countries.

c) Brief any two methods of demand Forecasting.

Ans: Qualitative Forecasting Methods

Your company may wish to try any of the qualitative forecasting methods below if you do not

have historical data on your products' sales.

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.

Q3:Attempt any two of the following:

a) “A market is a body of persons in such commercial relations that each can easily acquaint

himself with the rates at which certain kind of exchange of goods or services are from time

to time made by others”. Comment.

Ans: Usually, market means a place where buyer and seller meets together in order to carry on

transactions of goods and services. But in Economics, it may be a place, perhaps may not be. In

Economics, market can exist even without direct contact of buyer and seller. This fact can be

explained with the help of the following statement.

Thus, above statement indicates that face to face contact of buyer and seller is not necessary for

market. e.g. in stock or share market, buyer and seller can carry on their transactions through

internet. So internet, here forms an arrangement and such arrangement also is included in the

market.

On the basis of Place, market is classified into :-

1. Local Market or Regional Market.

2. National Market or Countrywide Market.

3. International Market or Global Market.

On the basis of Time, market is classified into :-

1. Very Short Period Market.

2. Short Period Market.

3. Long Period Market.

4. Very Long Period Market.

On the basis of Competition, market is classified into :-

1. Perfectly competitive market structure.

2. Imperfectly competitive market structure.

Both these market structure widely differ from each other in respect of their features, price etc.

under imperfect competition, there are different forms of markets like monopoly, duopoly,

oligopoly and monopolistic competition.

b) Plot and describe about the short-run equilibrium of a perfectly competitive firm.

Ans: PERFECT COMPETITION

In economic theory, perfect competition describes markets such that no participants are large

enough to have the market power to set the price of a homogeneous product. Because the

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

Still, buyers and sellers in some auction-type markets, say for commodities or some financial

assets, may approximate the concept. Perfect competition serves as a benchmark against which

to measure real-life and imperfectly competitive markets.

BASIC STRUCTURAL CHARACTERISTICS

Generally, a perfectly competitive market exists when every participant is a "price taker", and

no participant influences the price of the product it buys or sells. Specific characteristics may

include:

Infinite buyers 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.

SHORT RUN AND LONG RUN CURVES

In the short-run, it is possible for an individual firm to make an economic profit. This situation

is shown in this diagram, as the price or average revenue, denoted by P, is above the average

cost denoted by C.

C) Give a brief description of Phases of Business cycle with diagrammatic presentation.

Ans: BUSINESS CYCLES

Definition: A business cycle is the periods of growth and decline in an economy. There are four

stages in the business cycle:

1. Contraction - When the economy starts slowing down.

2. Trough - When the economy hits bottom, usually in a recession.

3. Expansion - When the economy starts growing again.

4. Peak - When the economy is in a state of "irrational exuberance."

The business cycle starts from a trough (lower point) and passes through a recovery phase

followed by a period of expansion (upper turning point) and prosperity. After the peak point is

reached there is a declining phase of recession followed by a depression. Again the business

cycle continues similarly with ups and downs.

Explanation of Four Phases of Business Cycle

The four phases of a business cycle are briefly explained as follows :-

1. Prosperity Phase

When there is an expansion of output, income, employment, prices and profits, there is also a

rise in the standard of living. This period is termed as Prosperity phase.

The features of prosperity are :-

1. High level of output and trade.

2. High level of effective demand.

3. High level of income and employment.

4. Rising interest rates.

5. Inflation.

6. Large expansion of bank credit.

7. Overall business optimism.

8. A high level of MEC (Marginal efficiency of capital) and investment.

Due to full employment of resources, the level of production is Maximum and there is a rise in

GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in

prices and profits. There is an upswing in the economic activity and economy reaches its Peak.

This is also called as a Boom Period.

2. Recession Phase

The turning point from prosperity to depression is termed as Recession Phase.

During a recession period, the economic activities slow down. When demand starts falling, the

overproduction and future investment plans are also given up. There is a steady decline in the

output, income, employment, prices and profits. The businessmen lose confidence and become

pessimistic (Negative). It reduces investment. The banks and the people try to get greater

liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are

cancelled and people start losing their jobs. The increase in unemployment causes a sharp

decline in income and aggregate demand. Generally, recession lasts for a short period.

3. Depression Phase

When there is a continuous decrease of output, income, employment, prices and profits, there is

a fall in the standard of living and depression sets in.

The features of depression are :-

1. Fall in volume of output and trade.

2. Fall in income and rise in unemployment.

3. Decline in consumption and demand.

4. Fall in interest rate.

5. Deflation.

6. Contraction of bank credit.

7. Overall business pessimism.

8. Fall in MEC (Marginal efficiency of capital) and investment.

In depression, there is under-utilization of resources and fall in GNP (Gross National Product).

The aggregate economic activity is at the lowest, causing a decline in prices and profits until the

economy reaches its Trough (low point).

4. Recovery Phase

The turning point from depression to expansion is termed as Recovery or Revival Phase. During

the period of revival or recovery, there are expansions and rise in economic activities. When

demand starts rising, production increases and this causes an increase in investment. There is a

steady rise in output, income, employment, prices and profits. The businessmen gain confidence

and become optimistic (Positive). This increases investments. The stimulation of investment

brings about the revival or recovery of the economy. The banks expand credit, business

expansion takes place and stock markets are activated. There is an increase in employment,

production, income and aggregate demand, prices and profits start rising, and business expands.

Revival slowly emerges into prosperity, and the business cycle is repeated.

Thus we see that, during the expansionary or prosperity phase, there is inflation and during the

contraction or depression phase, there is a deflation.

Q4: Answer any two of the following:

a) Describe the application of tools, techniques and concepts of managerial Economics

in our engineering career.

Ans: As per the answer of Q1-a)

b) Describe the boom. Which point shows the condition of boom?

Ans: As per the answer of Q3-c)

c) What is Inflation? Describe about the causes of inflation.

Ans: INFLATION

Inflation is a state in which the value of money is falling or prices are rising.

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.

Inflation is demoralizing in character as it promotes speculation rather than production. All

factors are employed in some way or the other.

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.

Causes of Inflation

  Cost Push InflationCost-push inflation occurs when businesses respond to rising production

costs, by raising prices in order to maintain their profit margins. There are many reasons why

costs might rise:

Rising imported raw materials costs perhaps caused by inflation in countries that are heavily

dependent on exports of these commodities or alternatively by a fall in the value of the pound in

the foreign exchange markets which increases the UK price of imported inputs. A good example

of cost push inflation was the decision by British Gas and other energy suppliers to raise

substantially the prices for gas and electricity that it charges to domestic and industrial

consumers at various points during 2005 and 2006.

Rising labour costs - caused by wage increases which exceed any improvement in productivity. 

This cause is important in those industries which are ‘labour-intensive’. 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.

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. These taxes

are levied on producers (suppliers) who, depending on the price elasticity of demand and supply

for their products, can opt to pass on the burden of the tax onto consumers. For example, if the

government was to choose to levy a new tax on aviation fuel, then this would contribute to a

rise in cost-push inflation.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve.

This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real

national output together with a rise in the general level of prices.

Demand Pull Inflation: Demand-pull inflation is likely when there is full employment of

resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an

increase in prices. AD might rise for a number of reasons – some of which occur together at the

same moment of the economic cycle

A depreciation of the exchange rate, which has the effect of increasing the price of imports and

reduces the foreign price of UK exports.  If consumers buy fewer imports, while foreigners buy

more exports, AD will rise.  If the economy is already at full employment, prices are pulled

upwards.

A reduction in direct or indirect taxation.  If direct taxes are reduced consumers have more real

disposable income causing demand to rise.  A reduction in indirect taxes will mean that a given

amount of income will now buy a greater real volume of goods and services. Both factors can

take aggregate demand and real GDP higher and beyond potential GDP.

The rapid growth of the money supply – perhaps as a consequence of increased bank and

building society borrowing if interest rates are low. Monetarist economists believe that the root

causes of inflation are monetary – in particular when the monetary authorities permit an

excessive growth of the supply of money in circulation beyond that needed to finance the

volume of transactions produced in the economy.

Rising consumer confidence and an increase in the rate of growth of house prices – both of

which would lead to an increase in total household demand for goods and services

Faster economic growth in other countries – providing a boost to UK exports overseas.

In the first diagram the SRAS curve is drawn as non-linear. In the second, the macroeconomic

equilibrium following an outward shift of AD takes the economy beyond the equilibrium at

potential GDP. This causes an inflationary gap to appear which then triggers higher wage and

other factor costs. The effect of this is to cause an inward shift of SRAS taking real national

output back towards a macroeconomic equilibrium at Yfc but with the general price level higher

than it was before. 

The wage price spiral – “expectations-induced inflation”

Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue

rising, they are unlikely to accept pay rises less than their expected inflation rate because they

want to protect the real purchasing power of their incomes. For example a booming economy

might see a rise in inflation from 3% to 5% due to an excess of AD. Workers will seek to

negotiate higher wages and there is then a danger that this will trigger a ‘wage-price spiral’ that

then requires the introduction of deflationary policies such as higher interest rates or an increase

in direct taxation.

Q5: write a short note on any four of the following:

a) Scope of economics in production

Ans: We know economics as a branch of knowledge which deals with the allocation of scarce

resources. The problem of resource allocation has been regularly faced by the individuals,

enterprises, and nations over the years. In the field of economics in recent decades the use of

mathematical tools and statistical methodology has become increasingly important. Further

economics is not the study of choice making behavior only. Major national and international issues

become the part of modern economic science. Currently the theory of economic growth has

occupied an important place in the study of economics and it studies how the national income

grows over the years.

It 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. Some of the important laws and principles of

microeconomics have been derived directly from the marginal analysis.

Theory of Production and Costs

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.

  Cost of production:

 (a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d)

Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g)

Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of

production, the imputed value of the factor of production owned by the firm itself is also added,

(k) The normal profit of the entrepreneur is also included In the cost of production.

b) Price Elasticity:

Ans: Price Elasticity

The concept of price elasticity reveals the percentage change in quantity demanded due to the

percentage change in price assuming other thing as constant (ceteris paribus). 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:

A. Perfectly inelastic demand (ep = 0)

B. Inelastic (less elastic) demand (e < 1)

C. Unitary elasticity (e = 1)

D. Elastic (more elastic) demand (e > 1)

E. Perfectly elastic demand (e = ∞)

1. Perfectly inelastic demand (ep = 0)

a. The vertical straight line demand curve (parallel to the Y axis) as shown in ‘Fig (a)’ reveals that

with a change in price (from OP to Op1) the demand remains same at OQ. Thus, demand does

not at all change to a change in price. Thus ep = O. Hence, it is perfectly inelastic demand.

2. Relatively Inelastic (less elastic) demand (e < 1)

a. In this case the proportionate change in quantity demand of a commodity is smaller than change

in its price.

3. Unitary elastic demand (e = 1)

a. In the ‘fig (e)’ percentage change in demand is smaller than that in price. It means the demand is

relatively less elastic to the change in price. This is referred as relatively an inelastic demand.

When the percentage change in quantity demanded is equal to percentage change in price, it is a

case of unit elasticity. The rectangular hyperbola as shown in the Fig ‘(c)’ represents this type

of elasticity. In this case percentage change in demand is equal to percentage change in price,

hence e = 1.

4. Relatively Elastic (more elastic) Demand (e > 1)

a. 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.Hence, the elastic demand (e>1) Fig d

5. Perfectly Elastic Demand (e = ∞)

a. 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

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.

c) 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.

 

(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.

d) Oligopoly:

Ans: OLIGOPOLY

Oligopoly is that market situation in which the number of firms is small but each firm in the

industry takes into consideration the reaction of the rival firms in the formulation of price

policy. The number of firms in the industry may be two or more than two but not more than 20.

Oligopoly differs from monopoly and monopolistic competition in this that in monopoly, there

is a single seller; in monopolistic competition, there is quite a larger number of them; and in

oligopoly, there are only a small number of sellers.

CHARACTERISTICS OF OLIGOPOLY:

1.      Every seller can exercise an important influence on the price-output policies of his rivals.

2.     It is more elastic than under simple monopoly and not perfectly elastic as under perfect

competition.

3.      It is often noticed that there is stability in price under oligopoly. This is because the

oligopolist avoids experimenting with price changes. He knows that if raises the price, he will

lose his customers and if he lowers it he will invite his rivals to price war.

PRICE DETERMINATION MODELS OF OLIGOPOLY Kinky Demand Curve):

The kinky demand curve model tries to explain that in non-collusive oligopolistic industries

there are not frequent changes in the market prices of the products. The demand curve is drawn

on the assumption that the kink in the curve is always at the ruling price. The reason is that a

firm in the market supplies a significant share of the product and has a powerful influence in the

prevailing price of the commodity. Under oligopoly, a firm has two choices:

(a)    The first choice is that the firm increases the price of the product. Each firm in the industry

is fully aware of the fact that if it increases the price of the product, it will lose most of its

customers to its rival. In such a case, the upper part of demand curve is more elastic than the

part of the curve lying below the kink.

(b)   The second option for the firm is to decrease the price. In case the firm lowers the price, its

total sales will increase, but it cannot push up its sales very much because the rival firms also

follow suit with a price cut. If the rival firms make larger price cut than the one which initiated

it, the firm which first started the price cut will suffer a lot and may finish up with decreased

sales. The oligopolists, therefore avoid cutting price, and try to sell their products at the

prevailing market price. These firms, however, compete with one another on the basis of

quality, product design, after-sales services, advertising, discounts, gifts, warrantees, special

offers, etc.

In the above diagram, we shall notice that there is a discontinuity in the marginal revenue curve

just below the point corresponding to the kink. During this discontinuity the marginal cost curve

is drawn. This is because of the fact that the firm is in equilibrium at output ON where the MC

curve is intersecting the MR curve from below. 

e) GDP:

Ans: 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.

f) Law of returns to scale:

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.

 

Graph/Diagram:

 

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

= 3.

 

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.