Segment 01

Q1 Explain the Significance of Managerial Economics is Business firm?

Ans: Managerial economics does not give importance to the study of theoretical economic
concepts. Its main concern is to apply theories to find solutions to day-to-day practical
problems faced by a firm. The following points indicates the significance of Managerial
Economics:
1. It gives guidance for the identification of key variables in the decision-making
process.
2. It helps the business executives to understand the various difficulty of business and
managerial problems and to take the right decisions at the right time.
3. It provides the necessary conceptual, technical skills, toolbox of analysis and
techniques of thinking, and other such modern tools and instruments like elasticity of
demand and supply, cost and revenue, income and expenditure, profit and volume of
production, etc. to solve various business problems.
4. It helps in the optimum use of scarce resources of a firm to maximise its profits.
5. It helps a firm in forecasting the most important economic variables like demand,
supply, cost, revenue, price, sales and profit, etc and formulate sound business
policies.

Q2 Explain the functions of managerial economist.

Ans: Managerial economist is a specialist and an expert in analysing and finding answers to
business and managerial problems. He has in-depth knowledge of the subject. He is an
authority and has total command over his subject.
A managerial economist has to perform several functions in an organisation. Decisions
making, and forward planning are described as the two major (basic) functions and remaining
functions are derived from the two basic functions.
Decision Making: The word ‘decision’ suggests a deliberate choice made out of several
possible alternative courses of action after carefully considering them. Decision-making is
essentially a process of selecting the best option out of many alternative opportunities or
courses of action that are open to a manager. The choice made by the business executives are
difficult, crucial and have far-reaching consequences. The basic aim of making a decision is
to select the best course of action which maximises the economic benefits and minimises the
use of scarce resources of a firm. Hence, each decision involves cost-benefit analysis. A
slight error or delay in decision making may cause considerable economic and financial
damage to a firm. It is for this reason that the management experts are of the opinion that
right decision-making at the right time is the secret of a successful manager.
Forward Planning: The term ‘planning’ implies a consciously directed activity with certain
predetermined goals and means to carry them out. It is a deliberate activity. It is a
programmed action. Planning is concerned with systematically tackling future situations.
Forward planning implies planning in advance. It is associated with deciding the future
course of action of a firm. It is prepared based on past and current experience of a firm. It is
prepared in the background of uncertain and unpredictable environment and guess work. A
business executive must be intelligent enough to think in advance, prepare a sound plan and
take all possible precautionary measures to meet all types of challenges of the future
business. Hence, forward planning has acquired greater significance in business circles.

Q3 Explain the nature and scope of managerial economics?

Ans: The scope of managerial economics helps in understanding the subject, area of study,
boundaries and width of the subject. Following are the nature and scope of managerial
economics are:
a. Objectives of a firm: Historically, Profit maximization is considered as the main
objective of a business unit. All business organizations have multiple objectives, some
are competitive and some are supplementary. There are various goals like social,
economic, organizational, human and national. All the objectives are determined by
various factors and forces such as corporate environment, socio-economic conditions,
nature of power in the organization and external constraints under which a firm
operates.
b. Demand analysis and forecasting: A firm is a producing unit. It produces different
kinds of goods and services. It has to meet the requirements of the consumer in the
market. The basic problems like what to produce; where to produce; for whom to
produce; how to produce; how much to produce and how to distribute them in the
market, are to be answered by a firm. Hence, the firm has to study in detail about the
various determinants of demand, nature, composition and characteristics of demand,
elasticity of demand, demand distinctions, demand forecasting, etc. The production
plan prepared by a firm should include all these points.
c. Production and Cost analysis: Production means conversion of inputs into final
output. It may be in terms of physical and monetary terms. Production analysis deals
with a production function, laws of returns, returns to scale, economies of scale, etc.
Production cost is concerned with the estimation of costs to produce a given quantity
of output. Cost controls, cost reduction, cost-cutting, and cost minimisation plays an
important role in production and cost analysis. Maximization of output with minimum
cost is the basic goal of a business firm.
d. Profit Management: Basically, a firm can be a commercial or a business unit.
Consequently, its success or failure is measured in terms of the amount of profit it can
earn in a competitive market. The management will give topmost priority to this
aspect. There are many theories in profit management, like the emergence of profit,
functions of profit and its measurement, profit policies, techniques, profit planning,
profit forecasting, and breakeven point.
e. Capital Management: This is one of the essential areas of the business unit. The
success of any business is based on proper management and adequate capital
investment. Under capital management, managers should assess capital requirements,
methods of capital mobilisation, capital budgeting, optimal allocation of capital,
selection of highly profitable projects, cost of capital, return on capital, planning, and
control of capital expenditure, etc.
Q4 Law of demand and its exceptions?
Ans: The law of demand explains the relationship between price and quantity demanded of a
commodity. It says that demand varies inversely with the price. The law can be explained in
the following manner, “Keeping other factors that affect demand constant, a fall in price of a
product leads to increase in quantity demanded and a rise in price leads to decrease in
quantity demanded for the product”. The law can be expressed in mathematical terms as
“Demand is a function of price”.
Thus, symbolically D = F (p) where, D represents Demand, P stands for Price and F denotes
the Functional relationship.
The law explains only the general tendency of consumers while buying a product.
A consumer would buy more when price falls due to the following reasons:
1. A product becomes cheaper [Price effect]
2. Purchasing power of a consumer would go up [Income effect]
3. Consumers can save some amount of money
4. Cheaper products are substituted for costly products [substitution effect]
Exceptions to the law of demand: Generally speaking, customers would buy more when
price falls under the law of demand. Exceptions to law of demand states that with a fall in
price, demand also falls and with a rise in price demand also rises. This can be represented by
rising demand curve. In other words, the demand curve slopes upwards from left to right. It is
known as an exceptional demand curve or unusual demand curve.
Some examples that favour the unusual demand curve are as follows:
1. Giffen’s Paradox - Sir Robert Giffen, an Irish Economist, with the help of his
example (inferior goods) disproved the law of demand. The Giffen’s paradox holds
that “Demand is strengthened with a rise in price or weakened with a fall in price”. He
gave the example of poor people of Ireland who were using potatoes and meat as
daily food articles. When price of potatoes declined, customers instead of buying
larger quantities of potatoes started buying more of meat (superior goods). Thus, the
demand for potatoes declined despite of fall in its price.
2. Veblen’s Effect: Veblen’s effect states that demand for status symbol goods would go
up with a rise in price and vice-versa. In case of such status symbol commodities, it is
not the price which is important, but the prestige conferred by that commodity on a
person makes him to go for it. More commonly cited examples of such goods are
diamonds and precious stones, world famous paintings, commodities used by world
famous personalities, etc.
3. Fear of shortage: When serious shortages are anticipated by the people, (e.g., during
the war period) they purchase more goods at present even though the current price is
higher.
 4. Fear of future rise in price: If people expect future hike in prices, they buy more
even though they feel that current prices are higher. Otherwise, they have to pay a still
high price for the same product.
5. Emergencies: During emergency periods like war, famine, floods, cyclone, accidents,
etc., people buy certain articles even though the prices are quite high.

Q5 Discuss various types of elasticity of demand with examples.

Ans: The elasticity of demand is the responsiveness or sensitiveness of demand to a given
change in the price or non-price determinant of a commodity. It refers to the capacity of
demand either to stretch or shrink to a given change in price or non-price determinant.
Kinds of elasticity of demand:
A: Price Elasticity of Demand: explains the degree of responsiveness of the demand for a
product to a change in its price. Where Ep = Percentage change in quantity demanded /
Percentage change in price.
Degrees of Price Elasticity of Demand
1. Perfectly Elastic Demand (PED = infinite): When small change in price will lead to
change in quantity demanded infinitely. For Example, Gas. Diagrammatically, this
appears to be horizontal demand curve.
2. Perfectly Inelastic Demand (PED = 0): No matter how much the price has been
changed but the quantity demand will not change. Consumers will tend to buy the
same quantity in regardless to price increase or decrease. For Example, Medicines.
Diagrammatically, this appears to be vertical demand curve.
3. Unitary Elastic Demand (PED = 1): When the percentage change in price is equal to
the percentage change in quantity demanded, Consumers will likely to buy more
products when the price decreases. For Example, Bananas, Where people will buy
more than normal time when price decreases.
4. Relatively Elastic Demand (PED > 1): When small percentage change in price leads
to larger change in quantity demanded, When Consumers will tend to try more goods
or services when there is a slight change in price. For Example, Restaurants.
5. Relatively Inelastic Demand (PED < 1): Greater the percentage change in price will
have less than proportionate change in quantity, For Example: Salt, When the price
of salt decreases or increases, consumer will only buy how much he needs.
B: Income Elasticity of Demand: is the ratio or percentage change in the quantity demanded
of a commodity to a given percentage change in the income.
Ey = Percentage change in quantity demanded / Percentage change in income
Based on value of Ey, the commodities can be classified as:
1. Ey is negative, the commodity is inferior, e.g., Jowar, beedi, etc.
2. Ey is positive and greater than one, the commodity is luxury.
3. Ey is positive, but less than one, the commodity is essential.
4. Ey is zero, the commodity is neutral, e.g. salt, match-box, etc.
C: Cross Elasticity of Demand: is the percentage change in the quantity demanded of a
particular commodity in response to a change in the price of another related commodity.
Price of tea rises from rs. 4-00 to 6-00 per cup Demand for coffee rises from 50 cups to 90
cups. Cross elasticity of coffee in this case is 1.6.
Ec = Percentage change in quantity demanded of commodity X / Percentage change in the
price of Y
Symbolically, Ec = ΔDx/ ΔPy x Py / Dx
D: Advertisement elasticity of demand: is the responsiveness of demand or sales to change
in advertising or other promotional expenses.
Ea = Percentage change in demand or sales / Percentage change in advertisement expenditure
Symbolically, Ea = ΔD or ΔSales / ΔA x A / D or Sales
Original sales = 10,000 unit’s Original advertisement expenditure = 800-00
New sales = 50,000 unit’s New advertisement expenditure = 2000-00
In the above example, advertising elasticity of demand is 1.67. It implies that for everyone
time increase in advertising expenditure, the sales would go up 1.67 times. Thus, Ea is more
than one.

Q6 Examine the factors influencing Demand and elasticity of demand

Ans: Elasticity of Demand depends on several factors of which the following are some of the
important ones:
1. Nature of the Commodity: Commodities coming under the category of necessaries
and essentials tend to be inelastic, because people buy them whatever may be the
price. For example, rice, wheat, sugar, milk, vegetables, etc.; on the other hand, for
comforts and luxuries, demand tends to be elastic, e.g., TV sets, refrigerators, etc.
2. Existence of Substitutes: Substitute goods are those that are considered to be
economically interchangeable by buyers. If a commodity has no substitutes in the
market, demand tends to be inelastic because people have to pay higher price for such
articles. For example, salt, onions, garlic, ginger, etc. In case of commodities having
different substitutes, demand tends to be elastic. For example, blades, tooth pastes,
soaps, etc.
3. Number of uses for the commodity: Single-use goods are those, which can be used
for only one purpose and multiple-use goods can be used for a variety of purposes. If
a commodity has only one use (singe use product), demand tends to be inelastic
because people have to pay more prices if they have to use that product for only one
use, for example, all kinds of eatables, seeds, fertilizers, pesticides, etc. On the
contrary, for commodities having several uses, [multiple- use-products] demand tends
to be elastic, for example, coal, electricity, steel, etc.
4. Possibility of postponing the use of a commodity: In case there is no possibility to
postpone the use of a commodity, demand tends to be inelastic because people have to
buy them irrespective of their prices, e.g., medicines. If there is a possibility to
 postpone the use of a commodity, demand tends to be elastic, e.g., buying TV set,
motor cycle, washing machine, car, etc.
5. Level of income of the people: Generally speaking, demand will be relatively
inelastic in case of rich people, because any change in market price will not alter and
affect their purchase plans. On the contrary, demand tends to be elastic in case of
poor.

Q7 Differentiate between change in demand and increase or decrease in demand.

Ans: The concepts of "change in demand" and "increase or decrease in demand" are
fundamental in economics, and they refer to different phenomena:
A "change in demand" refers to a shift in the entire demand curve, either to the right or to the
left. This shift occurs when a factor other than the price of the good or service changes,
causing consumers to buy more or less of the good at every price level. Factors that can cause
a change in demand include:
1. Income: An increase in consumers' income can lead to an increase in demand for
normal goods, while a decrease can lead to a decrease in demand.
2. Taste and Preferences: Changes in consumer tastes and preferences can increase or
decrease demand.
3. Prices of related goods: The demand for a good can be affected by the prices of
related goods, such as substitutes and complements.
4. Expectations: If consumers expect prices to rise in the future, they may increase
current demand.
5. Number of Buyers: An increase in the number of buyers in the market will increase
demand, while a decrease will reduce demand.
When any of these factors change, the demand curve shifts:
• Rightward Shift: Indicates an increase in demand (more quantity demanded at every
price).
• Leftward Shift: Indicates a decrease in demand (less quantity demanded at every
price).
Increase or Decrease in Demand:
• Increase in Quantity Demanded: When the price of the good or service decreases, the
quantity demanded increases, resulting in a movement down along the demand curve.
• Decrease in Quantity Demanded: When the price of the good or service increases, the
quantity demanded decreases, resulting in a movement up along the demand curve.

Q8 Explain the methods of measuring elasticity of demand

Ans: There are different methods to measure the price elasticity of demand and among them,
the three most important methods are: total expenditure method, point method and arc
method.
Total Expenditure Method: Under this method, the price elasticity is measured by
comparing the total expenditure of the consumers (or total revenue i.e., total sales values
from the point of view of the seller) before and after variations in price.
Following points should be noted from the total expenditure method:
• When total expenditure increases with the fall in price and decreases with a rise in
price, then the PED is greater than one.
• When the total expenditure remains the same either due to a rise or fall in price, the
PED is equal to one.
• When total expenditure, decreases with a fall in price and increases with a rise in
price, PED is less than one.
Point Method: Prof. Marshall advocated this method. The point method measures price
elasticity of demand at different points on a demand curve. Hence, in this case, an attempt is
made to measure small changes in both price and demand. It can be explained either with the
help of mathematical calculation or with the help of a diagram or graphical representation.
To measure price elasticity at two points, A and B, the following formula is to be adopted.
PED = %change in demand / %change in price
To find out percentage change in demand, the formula is
Change in demand / Original demand x 100
To find out percentage change in price, the following formula is employed
Change in price / Original Price x 100
Arc Method: This method is suggested to measure large changes in both price and demand.
When elasticity is measured over an interval of a demand curve, the elasticity is called as an
interval or arc elasticity.
The following formula is used to measure arc elasticity.
Arc elasticity = (Q2 – Q1 / Q2 + Q1) x (P2 + P1 / P2 – P1)

Q9 Explain various methods of Demand forecasting

Ans: It is an estimation of most likely future demand for a product, under given conditions. It
seeks to investigate and measure the forces that determine sales for existing and new
products. It is an estimation of most likely future demand for a product, under given
conditions.
There are two methods of demand forecasting namely, survey methods and statistical
methods.
Survey Method:
1. Consumer’s Interview method
a. Survey of buyers’ intentions through questionnaire
b. Direct interview method: Complete enumeration method, Sample survey method
 2. Collective opinion method
3. Expert opinion method
4. End-use method
Statistical Method:
1. Trend Projection method
2. Economic Indicators

Q10 Identify the criteria for good demand forecasting.

Ans: Criteria for Good Demand Forecasting:
• Accuracy
• Plausibility/Validity
• Simplicity
• Durability
• Flexibility
• Availability of data
• Economy
• Quickness

Segment 02

Q1 Explain the law of supply

Ans: Law of supply: Normally, a seller supplies more units of a commodity at a higher price
and vice-versa. Given the cost of production, profits are likely to be high at higher prices.
Higher the price, the greater is the attraction to the producers to produce and sell more and
appropriate more profits. Hence, more quantity is supplied at higher prices and less is
supplied at lower prices.
This relationship between the price and the quantity supplied is popularly known as the law
of supply.
It states that “Other things remaining constant, the quantity supplied varies directly with the
price i.e. when the price falls, supply will contract and when price rises, supply will extend”.
There is a functional relationship between supply and price.
Mathematically: S = F (P).
The other things which should remain constant for the law to operate are as follows:
 1. Number of firms, the scale of production, and the speed of production
2. Availability of other inputs
3. Techniques of production
4. Cost of production
5. Market prices of other related goods
6. Climate and weather conditions

Q2 Explain the determinants of supply

Ans: Apart from price, many other factors bring about changes in supply. Among them, the
important factors are:
1. Natural Factors: Favorable natural factors like good climatic conditions and timely,
adequate, well distributed rainfall results in higher production and expansion in
supply. On the other hand, adverse factors like bad weather conditions, earthquakes,
pests, droughts, and untimely, ill-distributed, inadequate rainfall, etc., may cause a
decline in production and contraction in supply.
2. Change in techniques of production: An improvement in techniques of production
and use of modern, highly sophisticated machines and equipment will go a long way
in raising the output and expansion in supply. On the contrary, primitive techniques
are responsible for lower output and hence lower supply.
3. Cost of production: Given the market price of a product, if the cost of production
rises due to higher wages, interest, and price of inputs, supply decreases. If the cost of
production falls on account of lower wages, interest, and price of inputs, supply rises.
4. Prices of related goods: If prices of related goods fall, the seller of a given
commodity offers more units in the market even though, the price of his product has
not gone up. The opposite will be the case when the price of related goods rises.
5. Number of sellers or firms: Supply would be more when there are a large number of
sellers. Similarly, production and supply tend to be more when production is
organized on a large scale basis. If the rate or speed of production is high, supply
expands. The opposite will be the case when the number of sellers is less, with small
scale production and low rate of production.
6. Complementary goods: In the case of joint demand, the production and sale of one
product may lead to the production and sale of other products also.

Q3 Explain the concepts of consumer surplus and producer’s surplus

Ans: Consumer’s surplus may be defined as the excess of what a consumer is willing to pay
over what he actually does pay (rather than go without the good). It is the excess of price
which a person would be willing to pay over which what he actually does pay. Consumer
surplus is the economic measure of the surplus satisfaction.
The concept may be explained with the help of a formula:
Consumers’ surplus = What we are prepared to pay – [minus] What we actually pay
It is the difference between ex-ante and ex-post satisfaction. Also, it is the difference between
the potential price and actual price.
It is essential to note that there is an inverse relationship between price and consumer’s
surplus. If price rises, consumer’s surplus falls and vice versa.
Producer surplus is a parallel concept to consumer’s surplus. Producer’s surplus is owner’s
surplus. It may be defined as the excess or surplus income received by a seller on the price at
which he is willing to sell a product. It is the difference between the actual price at which he
is selling and the price at which he is willing to sell. Hence, it arises when the actual price
received exceeds the minimum price that the seller is ready to accept.
Producer’s surplus = the value that the seller is actually receiving minus the value that
the seller is ready to receive.
It is the difference between ex-post and ex-ante income received.
Depending on market situations, producers try to convert consumers’ surplus in to producers’
surplus and consumers would try to convert producers’ surplus in to consumers’ surplus.

Q4 Explain the law of variable proportions.

Ans: The law can be stated as follows: “As the quantity of only one factor input is increased
to a given quantity of fixed factors, beyond a particular point, the marginal, average and total
output eventually decline”.
This law is stated by various economists. According to Prof. Benham, “As the proportion of
one factor in a combination of factors is increased, after a point, first the marginal and then
the average product of that factor will diminish”.
Assumptions to the law: Some assumptions of the law of proportions are as follows:
• Only one variable factor unit is to be varied while all other factors should be kept
constant.
• Different units of a variable factor are homogeneous.
• Techniques of production remain constant.
• The law will hold good only for a short and a given period.
• There are possibilities for varying the proportion of factor inputs.

Stage I: Law of increasing returns The total output increases at an increasing rate
(More than proportionately) up to point P because corresponding to this point P the MP is
rising and reaches its highest point. After point P, MP decline, and as such TP increases
gradually
Stage II: Law of diminishing returns in this case, as the quantity of variable inputs is
increased to a given quantity of fixed factors, output increases less than proportionately.
In this stage, the TP increases at a diminishing rate as both AP & MP are declining but
they are positive. It is known as the stage of “diminishing returns” because both the AP &
MP of the variable factor continuously fall during this stage.
Stage III: Law of negative returns in this case, as the quantity of variable input is
increased to a given quantity of fixed factors, the output becomes negative. During this
stage, TP starts diminishing, AP continues to diminish, and MP becomes negative. The
negative returns are the result of an excessive quantity of variable factors to a constant
quantity of fixed factors. Hence, output declines.

Q5 Explain the Law of returns to scale.

Ans: The concept of returns to scale is a long run phenomenon. In this case, we study the
change in output when all factor inputs are changed or made available in the required
quantity. An increase in scale means that all factor inputs are increased in the same
proportion. In returns to scale, all the necessary factor inputs are increased or decreased to
the same extent so that whatever the scale of production, the proportion among the factors
remains the same.
Three phases of returns to scale: Generally speaking, we study the behavior pattern of
output when all factor inputs are increased in the same proportion under returns to scale
1. Increasing returns to scale: Increasing returns to scale is said to operate when
the producer is increasing the quantity of all factors [scale] in a given proportion
leading to a more than proportionate increase in output. For example, when the
quantity of all inputs are increased by 10%, and output increases by 15%, then we
say that increasing returns to scale is operating.
Causes for increasing returns to scale:
• Wider scope for the use of latest tools, equipment, machineries, techniques
etc. to increase production and reduce cost per unit.
• As the size of the plant increases, more output can be obtained at lower
cost
2. Constant returns to scale: Constant returns to scale is operating when all factor
inputs [scale] are increased in a given proportion leading to an equi-proportional
increase in output. When the quantity of all inputs is increased by 10%, and output
also increases exactly by 10%, then we say that constant returns to scale are
operating.
Causes for constant returns to scale: In case of constant returns to scale, the
various internal and external economies of scale are neutralized by internal and
external diseconomies. Thus, when both internal and external economies and
diseconomies are exactly balanced with each other, constant returns to scale will
operate.
3. Diminishing returns to scale: Diminishing returns to scale is operating when
output increases less than proportionately when compared to the quantity of inputs
used in the production process. For example, when the quantity of all inputs is
increased by 10%, and output increases by 5%, then we say that diminishing
returns to scale is operating.
 Causes for diminishing returns to scale:
• Delays in management decisions.
• Productivity and efficiency declining unavoidably after a point.

Q6 Explain the Concepts of Economies and Diseconomies of scale

Ans:
1. Economies of scale The study of economies of scale is associated with large scale
production. Today there is a general tendency to organize production on a large scale.
Mass production of standardized goods has become the order of the day. Large scale
production is beneficial and economical in nature.
A. Internal Economies of Scale or real economies: Internal economies are those
economies which arise because of the actions of an individual firm to economize
its cost. They arise due to increased division of labor or specialization and
complete utilization of indivisible factor inputs.

Kinds of internal economies – There are few kinds of internal economies

I. Technical economies: These economies arise on account of technological
improvements and their practical application in the field of business.
a. Economies of superior techniques - These economies are the result of the
application of the most modern techniques of production. When the size of the
firm grows, it becomes possible to employ bigger and better types of machinery.
b. Economies of increased dimension - It is found that a firm enjoys the reduction
in cost when it increases its dimension. A large firm avoids wastage of time and
economizes its expenditure. Thus, an increase in dimension of a firm will reduce
the cost of production
II. Managerial Economies: They arise because of better, efficient, and scientific
management of a firm. The general manager of a firm cannot look after the
working of all processes of production. In order to keep an eye on each
production process he has to delegate some of his powers or functions to
trained or specialized personnel and thus relieve himself for co-ordination,
planning and executing the plans. This will enable him to bring about
improvements in production process and in bringing down the cost of
production.
III. Marketing or commercial economies: These economies arise on account of
buying and selling goods on large scale basis at favorable terms. A large firm
can buy raw materials and other inputs in bulk at concessional rates. As the
bargaining capacity of a big firm is much greater than that of small firms, it
can get quantity discounts and rebates. In this way, economies may be secured
in the purchase of different inputs.
IV. Financial Economies: They arise from advantages secured by a firm in
mobilizing huge financial resources. A large firm on account of its reputation,
name and fame can mobilize huge funds from money market, capital market,
and other private financial institutions at concessional interest rates. It can
 borrow from banks at relatively cheaper rates. It is also possible to have large
overdrafts from banks.
V. Labor Economies: These economies arise as a result of employing skilled,
trained, qualified and highly experienced persons by offering higher wages
and salaries. As a firm expands, it can employ a large number of highly
talented persons and get the benefits of specialization and division of labor.

B. External economies: External economies are those economies which accrue to

the firms as a result of the expansion in the output of the whole industry and they
arise outside the firm also arise due to the external factors.
Kinds of external economies
I. Economies of concentration: They arise due to a very large number of firms
which produce the same commodity being established in a particular area. In
other words, this advantage is called “Localization of industry”
II. Economies of information: These economies arise as a result of getting
quick, latest and up-to-date information from various sources. Another form of
benefit that arises due to localization of industry is economies of information.
III. Economies of government action: These economies arise as a result of active
support and assistance given by the government to stimulate production in the
private sector units. In recent years, the government in order to encourage the
development of private industries has come up with several kinds of
assistance. It is granting tax- concessions, tax-holidays, tax exemptions,
subsidies, development rebates, financial assistance at low interest rates, etc.

2. Diseconomies of Scale: When a firm expands beyond the optimum limit, economies
of scale will be converted into diseconomies of scale.
a. Internal Diseconomies:
I. Financial Diseconomies: As there is overgrowth, the required amount of
finance may not be available to a firm. Consequently, higher interest rates are
to be paid for additional funds
II. Managerial Diseconomies: Excess growth leads to loss of effective
supervision, control, management, coordination of factors of production
leading to all kinds of wastages, indiscipline and rise in production and
operating costs.
III. Marketing Diseconomies: Unplanned excess production may lead to
mismatch between demand and supply of goods leading to fall in prices.
Stocks may pile up; sales may decline leading to fall in revenue and profits
IV. Technical Diseconomies: When output is carried beyond the plant capacity,
per unit cost will certainly go up. There is a limit for division of labour and
specialisation. Beyond a point, they become negative. Hence, operation costs
would go up.
b. External Diseconomies: When several business units are concentrated in one
place or locality, it may lead to congestion, environmental pollution, scarcity of
 factor inputs like, raw materials, water, power, fuel, transport and communications
etc. leading to higher production and operational costs.

Thus, it is very clear that a firm can enjoy benefits of large-scale production only
up to a limit. Beyond the optimum limit, it is bound to experience diseconomies of
scale. Hence, there should be proper check on the growth and expansion of a firm.

Q7 Explain the Cost-output relationship in the Short run

Ans: In the short run, the cost-output relationship describes how a firm's costs change with
variations in its output level, assuming some inputs are fixed while others are variable.
Understanding this relationship is crucial for firms to make efficient production and pricing
decisions. Here are the key concepts involved:
• Fixed Costs: These are costs that do not change with the level of output. They are
incurred even if the firm produces nothing. Examples include rent, salaries of
permanent staff, and depreciation of machinery.
• Variable Costs: These costs vary directly with the level of output. Examples include
raw materials, labor costs (if workers are paid by the hour or by the piece), and utility
costs related to production.
• Total Cost: Total cost is the sum of fixed and variable costs. TC = FC + VC.
• Average Fixed Cost: An AFC is the fixed cost per unit of output. AFC = FC / Q,
where Q is the quantity of output.
• Average Variable Cost: AVC is the variable cost per unit of output. AVC = VC / Q.
• Average Total Cost: ATC is the total cost per unit of output. ATC = TC / Q, or
equivalently, ATC = AFC + AVC.
• Marginal Cost: MC is the additional cost of producing one more unit of output. MC
= ΔTC / ΔQ.
Cost-output relationship in the Short run:
• The shape of these cost curves reflects the law of diminishing marginal returns, which
states that adding more of a variable input (like labor) to fixed inputs (like capital)
will eventually yield lower per-unit returns.
• In the short run, firms aim to produce at the output level where marginal cost equals
marginal revenue (MC = MR) to maximize profit.
• The minimum points of the AVC and ATC curves represent the most cost-efficient
points of production in the short run. At these points, the firm is utilizing its variable
inputs most effectively relative to the fixed inputs.

Q8 Explain different cost concepts

Ans: Understanding different cost concepts is crucial for both managerial decision-making
and economic analysis.
 A. Money cost and Real cost
B. Implicit or imputed costs and explicit costs
C. Actual cost and Opportunity cost
D. Direct cost- and Indirect cost-depreciation
E. Past and future cost
F. Fixed and Variable cost
G. Marginal and Incremental cost
H. Accounting and economic cost
I. Private cost and Social cost
J. Historical cost and Replaceable cost
K. Controllable and Uncontrollable cost

Segment 03

Q1 Explain different types of pricing strategies

Ans: Pricing strategies are critical for businesses to attract customers, maximize profits, and
compete effectively in the market. Different types of pricing strategies cater to various
business objectives, market conditions, and consumer behaviors. Here are some common
pricing strategies:
• Premium Pricing: Premium pricing is the process of establishing higher prices than
most of the competitors in the market. It helps create perceived value, luxury and
quality. Companies that sell exclusive high-tech products often use this pricing
strategy, as customers pay a premium price if they have a positive brand perception.
When a company implements this market strategy, it may charge more than its
production costs to get a high-profit margin.
• Penetration Pricing: This is the process of establishing comparatively low prices to
draw customers' attention from high-priced competitors and earn sales. New
businesses often use this marketing strategy while entering the market. Initially, the
company may charge low prices to reach new customers. They may raise the prices
once the new customers become loyal followers of the brand.
• Skimming Pricing: Setting a high initial price for a new or innovative product, then
gradually lowering the price. Targets early adopters willing to pay a premium and
helps recover development costs quickly. Example: New technology gadgets like
smartphones.
• Psychological Pricing: Setting prices to create a psychological impact, such as
pricing just below a round number. It aims to make the price appear more attractive to
consumers. Example: Retailers pricing products at $19.99 instead of $20.00.
• Bundle Pricing: Bundle pricing is when you sell two or more products or services at
a single price. It is a great way to market products to customers who may want to pay
extra for multiple products. Beauty salons, cosmetics brands, restaurants and retail
stores often use this pricing strategy to increase sales as customers discover more
products with this strategy and end up purchasing additional products.
 • Geographical Pricing: Geographical pricing is the process of charging product prices
depending on geographical location or market. With geographical pricing, you can set
prices according to local consumer interests, requirements and preferences. While
executing this strategy, it is important to conduct extensive research about local
region-specific taxation laws and have a streamlined accounting process to ensure its
success.

Q2 Differentiate between different types of market structures

Ans: Market structures refer to the competitive environments in which firms operate.
Different market structures have distinct characteristics that influence the behavior and
performance of firms within them. Here are the main types of market structures and their key
differences:
• Perfect Competition: In a perfect competition market structure, there are a large
number of buyers and sellers. All the sellers of the market are small sellers in
competition with each other. There is no one big seller with any significant influence
on the market. So all the firms in such a market are price takers.
The products on the market are homogeneous, i.e. they are completely identical
Free entry and free exit of firms.
• Monopolistic Competition: Monopolistic competition exists when many companies
offer competing products or services that are similar, but not perfect substitutes.
Demand is highly elastic for goods and services of the competing companies and
pricing is often a key strategy for these competitors. Examples, Restaurants, Hair
salons.
• Oligopoly: In an oligopoly, there are only a few firms in the market. So in the case of
an oligopoly, the buyers are far greater than the sellers. The firms in this case either
compete with another to collaborate together, they use their market influence to set
the prices and in turn maximize their profits. So the consumers become the price
takers. In an oligopoly, there are various barriers to entry in the market, and new firms
find it difficult to establish themselves.
• Monopoly: In a monopoly type of market structure, there is only one seller, so a
single firm will control the entire market. It can set any price it wishes since it has all
the market power. Consumers do not have any alternative and must pay the price set
by the seller.

Q3 Explain Baumol’s theory of sales revenue maximization

Ans: Sales maximization model is an alternative model for profit maximization. This model
is developed by Prof. W. J. Baumol, an American economist. This alternative goal has
assumed greater significance in the context of the growth of Oligopolistic firms. The model
highlights that the primary objective of a firm is to maximize its sales rather than to maximize
its profits.
Prof. Baumol has developed two models. The first is the static model and the second one is
the dynamic model.
The Static Model: This model is based on the following assumptions:
• The model is applicable to a particular time period
• The firm aims at maximizing its sales revenue subject to a minimum profit constraint.
• The demand curve of the firm slopes downwards from left to right.
• The average cost curve of the firm is U-shaped.
The Dynamic Model: Baumol has developed another model, the dynamic model. This model
explains how changes in advertisement expenditure, a major determinant of demand, would
affect the sales revenue of a firm under severe competition. There are some assumptions in
Baumol’s dynamic model. They are as follows:
• Higher advertisement expenditure would certainly increase sales revenue of a firm.
• Market price remains constant.
• Demand and cost curves of the firm are conventional in nature.

Q4 Explain Williamson’s Theory of Managerial Discretion

Ans: Managerial discretionary theory by Prof. O. Williamson. He has developed a highly
useful and most practical managerial utility model to explain goals of a business firm in
recent years. In many organizations, we can see that when a firm achieves a certain amount of
growth, the top managers concentrate their attention on maximizing their self-interest and
allow the growth rate to continue. Thus, profit maximization and managers’ utility
maximization go together.
The model Williamson is of the opinion that managers, as a powerful group in any
organization, have their own set of utility functions. They have certain expectations and
demands. Generally, they aim at maximizing their managerial utility function rather than
maximizing total profits of the company. They feel that a firm is making profits on account of
the efforts of top management and so they are entitled to certain special privileges and are
eligible to enjoy special benefits. The various kinds of managerial satisfaction include the
degree of freedom and autonomy given to them, their status, prestige, power enjoyed by
them, dominance, professional excellence, security of their jobs, salary and other perquisites,
etc. Out of these variables, only salary is measurable, and all other variables are non-
measurable. In order to measure other variables, Williamson introduces the concept of
“expense preference”. This concept helps to measure the level of satisfaction which managers
would derive from certain types of expenditures.
The managers’ utility function is expressed as U = f [S, M, Id], where,
S = Additional expenditure of staff - includes the wages and salaries paid to the additional
staff- members, who have been employed to work under the top management. Now,
managers will have a larger team than before and can allot the work to new staff as a firm
expands.
M = Managerial Emoluments - include expenses on entertainment, luxurious air-
conditioned office, costly company cars and other allowances given to managers. It has been
pointed out that these expenses are justified by managers as it would enhance their status,
prestige, power, better working environment and image of the company in the eyes of public,
etc.
Id = Discretionary investment - includes those investment expenses which confer certain
personal benefits and satisfaction to managers, for example, expenditure on latest equipment,
furniture, decoration materials, etc. These expenses are expected to elevate the status and
esteem of managers. They satisfy their ego and sense of pride.
There is no direct relationship between managers’ utility function and better performance,
always. The empirical evidence is not enough for the verification of the theory. Always, a
firm cannot spend more money on only improvements in the working conditions of
managers. It has to look into the interests of all groups in an organization.

Q5 Explain the Cyert and March’s Behavior Theory

Ans: It is non-profit maximizing theory that has been developed by Cyert and March. They
explain how complicated decisions are taken in big industrial houses under various kinds of
risks and uncertainties in an imperfect market in the background of limited data and
information.
Cyert and March consider the modern firm as a multi-product, multi-goal and multi-decision
making coalition business unit. Like a coalition government, it is managed by a number of
groups. The group consists of shareholders, managers, workers, customers, suppliers,
distributors, financiers, legal experts, etc. Each group is independent by itself and has its own
set of objectives and they try to maximize their individual benefits. For example,
Shareholders expect faster growth of the company and higher dividends; Workers expect
maximum wages and minimum work, better working conditions, welfare measures;
Managers want higher salary, greater power, autonomy in day to day working, dominance,
control, etc.; Suppliers expect quick and immediate payments, etc. This may create
heartburns and conflict between different groups in the same organization.
Cyert and March are of the opinion that out of several objectives, a firm has five important
goals. They are as follows:
• Production Goal: Production is to be organized on the basis of demand in the market.
Neither should there be overproduction nor underproduction but a quantity that is just
adequate to meet the market demand. Development of excess capacity, over-
utilization of capital assets and lay-off of workers, etc. should be avoided.
• Inventory Goal: Inventory refers to stock of various inputs. In order to ensure
continuity in production and supply, a certain minimum level of inventory has to be
maintained by a firm. Neither surplus stock nor shortage of different inputs should
occur. Proper balance between demand and supply is to be maintained.
• Sales Goal: There should be adequate sales in any organization to earn reasonable
amount of profits. In order to create demand, sales promotion policies may be adopted
from time to time.
 • Market-share Goal: Each firm has to make consistent effort to increase its market
share to compete successfully with other firms and make sufficient profits.
• Profit Goal: This is one of the basic objectives of any firm. The very survival and
success of the firm would depend upon the volume of profits earned by it.

Q6 Explain the Marris’ Growth Maximization Model

Ans: Prof. Marris has developed an alternative growth maximization model. It is commonly
seen that each firm aims at maximizing its growth rate, because this goal would answer many
of the objectives of a firm. Marris points out that a firm has to maximize its balanced growth
rate over a period of time.
Marris assumes that the ownership and control of the firm is in the hands of two groups of
people, i.e., owners and managers. He further points out that both of them have two
distinctive goals. Managers have a utility function in which the amount of salary, status,
position, power, prestige, security of job, etc., are the most important variables whereas,
owners are more concerned about the size of output, volume of profits, market share, sales
maximization, etc.
Utility function of the owners and that of the managers are expressed in the following manner
Uo = f [size of output, market share, volume of profit, capital, public esteem etc.]
Um = f [salaries, power, status, prestige, job security, etc.]
Where Uo = Utility function of Owner, Um = Utility function of manager
Note: These two functions depend on the size of the firm.
Marris identifies two constraints in the rate of growth of a firm as follows:
• There is a limit up to which the output of a firm can be increased more economically,
limit to manage the firm efficiently, limit to employ highly qualified and experienced
managers, limit to research, development and innovation, etc.
• The ambition of job security puts a limit to the growth rate of the firm itself,
deliberately. If growth reaches the maximum, then there would be no opportunity to
expand further and then the managers may lose their jobs. Rapid growth and financial
soundness should go together. Managers hesitate to take unwanted risks and
uncertainties in the organization at the cost of their jobs. They would like to avoid
risky investment projects, concentrate on generating more internal funds and invest
more resources on only those products and services which bring more profits. Hence,
managers would like to ensure their job security through adoption of a cautious and
prudent financial policy.
In this case, the managers would maximize their utility function and the owners would
maximize their utility functions. The managers are able to get their job security with a high
rate of growth of the firm and shareholders would be satisfied as they receive higher
dividends.
Demerits
There are some demerits of Marris’ growth maximization model. They are as follows:
• It is doubtful whether both managers and owners would maximize their utility
functions simultaneously, always.
• The assumption of constant price and production costs are not correct.
• It is difficult to achieve both growth maximization and profit maximization together.
Thus, Marris’ growth maximization model also has some drawbacks.

Segment 04

Q1 Explain the features of Monopoly and oligopolistic competition

Ans: A monopoly is a market structure where a single firm dominates the entire market,
offering a unique product with no close substitutes. This firm has significant control over the
market price and output.
Features of Monopoly are:
• Single Seller: The market is dominated by one firm, which is the sole provider of the
product or service.
• Unique Products: The product has no close substitutes, making the firm the only
source for consumers.
• Price Maker: The monopolist has considerable control over the price since it controls
the supply of the product. It can set prices to maximize profits.
• Profit Maximization: The monopolist sets the output level where marginal cost
(MC) equals marginal revenue (MR) to maximize profits. This often results in higher
prices and lower output compared to competitive markets.
• Lack of Competition: Without competition, the monopolist may lack the incentive to
innovate or improve product quality.
The term oligopoly is derived from two Greek words “Oligoi” means a few and ‘Poly’
means to sell. Under oligopoly, we come across a few producers specializing in the
production of identical goods or differentiated goods competing with one another. the
oligopolists may be differentiated or homogeneous. Examples: cigarettes, refrigerators,
T.V. sets, etc.
Features of Oligopolistic Competition are:
• Small number of large firms: The number of firms in the market is small; but the
size of each firm is big. The market share of each firm is sufficiently large to
dominate the market.
• Existence of kinked demand curve: A kinked demand curve is said to occur when
there is a sudden change in the slope of the demand curve. It explains price rigidity
under oligopoly.
• Price Rigidity: Prices tend to be sticky or rigid under oligopoly. This is because of
the fact that if one firm changes its price, other firms may also resort to the same
technique.
 • Element of monopoly and competition: Under oligopoly, a firm has some
monopoly power over the product it produces but not on the entire market. However,
monopoly power enjoyed by the firm will be limited by the extent of competition.
• Lack of uniformity: Lack of uniformity rise in different oligopolies

Q2 Explain the features of Monopolistic competition and price-output determination

Ans: Perfect competition and monopoly are two extreme forms of market situations, rarely to
be found in the real world. Generally, markets are imperfect. It is a market structure in which
a large number of small sellers sell differentiated products which are close, but not perfect
substitutes for one another.
Features of Monopolistic Competition are:
• Existence of a large number of firms: Under Monopolistic Competition, the number
of firms producing a product will be large. The size of each firm is small.
• Free Entry and Free Exit of Firms: There are no barriers for the small firms to enter
into this market
• Homogeneous Products: Under monopolistic competition, the firm produces
commodities which are similar to one another but not identical or homogenous. For
example, toothpastes, blades, cigarettes, shoes, etc.,
• Non-price competition: In this market, there will be competition among “Mini-
monopolists” for their products and not for the price of the product. Thus, there is
“product competition” rather than “price competition”.
• More elastic demand curve: Product differentiation makes the demand curve of the
firm much more elastic. It implies that a slight reduction in the price of one product,
assuming the price of all other products remaining constant leads, to a large increase
in the demand for the given product.
Price-output determination in the long run: Long run is a period of time where a firm will
get adequate time to make any changes in the productive process or business. A firm can
initiate several measures to minimize its production costs and enjoy all the benefits of large
scale production. The cost conditions, as a result, differ slightly in the long run. While fixing
the price, a firm in the long run should consider its AC and AR.
Generally, in the long run, a firm can earn only normal profits. If AR is greater than AC,
there will be supernormal profits. This leads to entry of new firms – increase in the total
number of firms - total production – fall in prices - decline in profit ratio.
On the other hand, if AC is greater than AR, there will be losses. This leads to the exit of old
firms - decrease in the number of firms - total production - rise in prices – increase in profit
ratio. Thus, the entry and exit of firms continue till AR becomes equal to AC.

Q3 Explain the concept of Index number

Ans: The value of everything is measured in terms of money because money acts as a
measuring rod or measure of value. However, the value of money cannot be measured in
terms of money itself. Hence, economists have developed index numbers to measure the
changes in the value of money over a period of time.
When a number of commodities and their prices at two different periods are arranged in a
tabular form, it is called as an index schedule. Index number is a statistical measure by which
changes in the prices of the same articles at different periods are calculated and computed
There are different kinds of index numbers. Some of them are: wholesale price index,
consumer or retail price index, cost of living index, wage index numbers, industrial index
numbers, etc. Out of them, the most important ones are:
• Consumer price index (CPI) - In this case, we include the prices of a basket of
consumption goods and services. Generally speaking, goods and services which are
commonly consumed are included in this basket. The goods and services consumed
by consumers widely differ from group to group and place to place. It also varies as
tastes and preferences of consumers change. In order to measure the changes in prices
of consumer goods and services, we take into account prices existing at the base year
and the prices in the current year.

The formula to calculate CPI is as follows

CPI = Prices existing at the current year / Prices at the base year x 100

• Wholesale price index (WPI) - These index numbers are constructed on the basis of
the wholesale prices of certain important commodities. The items included in WPI are
totally different from those included in CPI. The items included are fertilizers,
industrial raw materials, minerals, semi- finished goods, machineries, etc. It is an
index of prices paid by producers for their inputs. Wholesale prices are published by
various government agencies at regular intervals and are collected for the purpose of
calculating variations in their prices for different periods.

The method of calculating WPI is same as that of the CPI.

Segment 05

Q1 Explain the concept of consumption and investment function

Ans: Consumption function - The consumption function indicates the relationship between
consumption and income. Consumption is an increasing function of income. Lord Keynes in
his theory of income and employment has given a very significant place to this concept.
According to him, the level of national output, income and employment directly depends on
effective demand in an economy. Higher the level of effective demand, higher would be the
level of income and employment and vice-versa.
To understand the concept clearly it is necessary to distinguish between consumption and
consumption function. The term consumption refers to a particular amount of consumption
out of a given amount of income.
If consumption is represented by C and income by Y then, the propensity to consume is
C= f (Y)
This law is also called the fundamental law of consumption. It consists of three interrelated
propositions: -
• When the aggregate income increases, expenditure on consumption will also increase
but by a smaller amount.
• The increased income is distributed over both spending and saving.
• As income increases, consumption, spending and saving will go up.
The average propensity to consume (APC) – The relationship between income and
consumption is measured by the average and marginal propensity to consume. The APC
explains the relationship between total consumption and total income. At a certain period of
time, it indicates the ratio of aggregate consumption expenditure to aggregate income. Thus,
it is the ratio of consumption to income and is expressed as C/Y.
Thus APC = Total Consumption / Total Income APC = C / Y i.e. 45,000 / 1,00,000 = 0.45%
Marginal Propensity to consume (MPC) - MPC may be defined as the incremental change
in consumption as a result of a given increment in income. It refers to the ratio of the change
in aggregate consumption to the change in the level of aggregate income. It may be derived
by dividing an increment in consumption by an increment in income. Symbolically:
MPC = ΔC / ΔY
Investment function - Investment is the second important component of effective demand.
Investment, according to Keynes, refers to real investment. It implies creation of new capital
assets or additions to the existing stock of productive assets. It refers to that part of the
aggregate income, which is used for the creation of new structures, new capital equipment,
machines, etc. that help in the production of final goods and services in an economy.
There are 5 types of investment as follows:
• Private Investment: It is made by private entrepreneurs on the purchase of different
capital assets like machinery, plants, construction of houses and factories, offices,
shops, etc. It is influenced by MEC and interest rate. It is profit – elastic. Profit motive
is the basis for private investment.
• Public Investment: It is undertaken by the public authorities like central, state and
local authorities. It is made on building infrastructure of the economy, public utilities
and on social goods, for example, expenditure on basic industries, defense industries,
construction of multipurpose river valley projects, etc. In this case, the basic criterion
and motto is social net gain, social welfare and not profits.
 • Foreign Investment: It consists of excess of exports over the imports of a country. It
depends on many factors such as propensity to export of a given country, foreigners’
capacity to import, prices of exports and imports, state trading and other factors.
• Induced Investment: Induced investment is another name for private investment.
Investment, which varies with the changes in the level of national income, is called
induced investment. When national income increases, the aggregate demand and level
of consumption of the community also increases.
• Autonomous Investment: Autonomous investment is another name for public
investment. The investment, which is independent of the level of income, is called as
autonomous investment. Such investments do not vary with the level of income.
Therefore, it is called income-inelastic. It does not depend on changes in the level of
income, consumption, rate of interest or expected profit.

Q2 Explain the concept of Multiplier and Accelerator

Ans: Multiplier - Prof. Kahn developed the concept of “Multiplier” with reference to
employment. Lord Keynes, on the lines of employment multiplier, developed an “Investment
Multiplier”. It is derived from the concept of marginal propensity to consume, and refers to
the effects of changes in investment outlays, on aggregate income through consumption
expenditure.
There are various types of multiplier such as; income multiplier, investment multiplier,
employment multiplier, foreign trade multiplier, etc.
Multiplier may be defined as a ratio of change in income to a change in investment. It
expresses the relationship between an initial increment in investment and the final increment
in income.
For example, if an increase in investment of $5 lakhs causes an increase in income of $. 25
lakhs, then the multiplier would be 5. If the increase in income is $. 30 lakhs, then the
multiplier would be 6. Algebraically, this relationship can be expressed as follows:
K = Change in Income (ΔY) / Change in Investment (ΔI) | K = 25/5 = 5
Where delta (Δ) stands for change or increase, K for multiplier, Y for income and I for
investment respectively.
The size of the multiplier is directly derived from the size of the MPC. Higher the MPC,
higher would be the size of multiplier and vice-versa. The multiplier is equal to the reciprocal
of 1 minus MPC. The formula to calculate the size of the multiplier is as follows:
K = 1/1-MPC
Accelerator - The principle of “accelerator or acceleration” is another important tool of
economic analysis. It is older than multiplier. Prof. J. M. Clark, an American economist who
was mainly responsible for popularizing it in 1917.
Multiplier and accelerator are two parallel concepts. Multiplier explains the effects of
investment on consumption and how the volume of consumption depends on the volume of
investment. The multiplier fails to analyses the effect of increase in consumption on
investment. In order to know how consumption affects the volume of investment, we have to
study the concept of accelerator.
Accelerator shows the effect of changes in consumption on induced investment and tells us
how the volume of investment depends on the level of consumption. The combined action of
both multiplier and accelerator will clearly explain how the aggregate national income
increases as a result of increase in the volume of investment in an economy.
The ratio between the net change in consumption expenditure and the induced investment is
called ‘Acceleration Co-efficient”. Symbolically,

A = ΔI / ΔC,

A stands for acceleration co-efficient

ΔI stands for net change in investment expenditure
ΔC stands for net change in consumption expenditure

Q3 Explain the objectives of Monetary policy and fiscal policy

Ans: Monetary policy definition: Monetary policy deals with the total money supply and its
management in an economy. It is essentially a program of action undertaken by the monetary
authorities, generally the central bank, to control and regulate the supply of money with the
public, and the flow of credit with a view to achieving economic stability and certain
predetermined macroeconomic goals.
Objectives of Monetary Policy:
• Neutral money policy: According to this policy, it should be neutral in its effects on
prices, income, output and employment.
• Price Stability: Price stability doesn't mean constant prices but rather avoiding sharp
fluctuations in the average price level.
• Exchange rate stability: Exchange rate stability remains crucial for smooth
international trade and foreign capital flow. Frequent exchange rate fluctuations can
harm imports, exports, and foreign capital inflow, so they need to be properly
controlled.
• Control of trade cycles: Trade cycles, characterized by fluctuations in economic
activities, are common in modern economies and can hinder smooth economic
growth. Instability in the form of inflation, deflation, or stagflation disrupts normal
economic functioning. Therefore, monetary authorities aim to control these cycles by
regulating the money supply.
• Full Employment: Developed countries focus on maintaining high employment
levels, while developing countries face significant unemployment and
underemployment. Monetary authorities aim to ensure adequate financial resources to
fully utilize economic resources and boost aggregate demand. This approach helps
higher national output and better standard of living.
Fiscal policy definition: Fiscal policy refers to the use of government spending and taxation
to influence the economy. It aims to manage economic growth, control inflation, and reduce
unemployment. Fiscal policy is a crucial tool for achieving macroeconomic stability and
promoting sustainable economic growth.
Objectives of Fiscal policy:
• Optimum allocation of scarce resources and its maximum utilization
• To accelerate the rate of capital formation
• To encourage investment
• To ensure price stability
• To break the vicious circle of poverty

Q4 Explain the instruments of Monetary policy and fiscal policy

Ans: Quantitative Instruments of Monetary Policy:
• Bank rate policy
• Open market operations
• Variable reserve ratio
Qualitative Instruments of Monetary Policy:
• Margin requirements
• Rationing of credit
• Regulation of consumer credit
• Differential rate of interest
• Moral suasion-bank to refrain from lending for speculative or nonessential activities.
• Issue of directives
• Direct action and Publicity

Segment 06

Q1 Explain the different phases of Business cycle

Ans: A Business cycle has two phases – Expansion and Contraction or Prosperity and
Depression. Peaks and troughs are the two main mark-off points of a business cycle. The
expansion phase starts from revival and includes prosperity and boom. The contraction phase
includes recession, depression, and trough. A business cycle has five phases. They are as
follows:
 • Depression, contraction or downswing: It is the first phase of a trade cycle. It is a
protracted period in which business activity is far below the normal level and is
extremely low. A sharp reduction in the volume of output, trade, and other
transactions, an increase in the level of unemployment, a drop in the prices of most of
the products and fall in interest rates.
• Recovery or Revival: Depression cannot last long. After a period of depression,
recovery starts. It is a period wherein economic activities receive stimulus and recover
from the shocks. An increase in government expenditure so as to increase the
purchasing power in the hands of consumers, Changes in production techniques and
business strategies, etc.
• Prosperity or full-employment: The recovery once started gathers momentum. The
cumulative process of recovery continues till the economy reaches full employment.
A high level of output, income, employment, and trade, a high level of purchasing
power, consumption expenditure, and effective demand, a rise in interest rate.
• Boom or overfull employment or inflation: The prosperity phase does not stop at
full employment. It gives way to the emergence of a boom. It is a phase wherein there
will be an artificial and temporary prosperity in an economy. The prices, wages,
interests, incomes, profits, etc. move in the upward direction, MEC raises leading to
business expansion.
• Recession – a turn from prosperity to depression: The period of recession begins
when the phase of prosperity ends. It is a period of time during which the aggregate
level of economic activity starts declining. 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.
Inventories of finished goods pile up. Future investment plans are given up. Orders
placed for new equipment and raw materials and other inputs are cancelled.
Replacement of worn out capital is postponed.
A detailed study of the various phases of a business cycle is of paramount importance to the
management of a business. It helps the management to formulate various anti-cyclical
measures to be taken up to check the adverse effects of a trade cycle and create the necessary
conditions for ensuring stability in business.

Q2 Explain the measures to control Business cycle

Ans: Control of business cycles has become an important objective of almost all economies
at present. Broadly speaking, the remedial measures can be classified under three heads, viz,
monetary, fiscal, and miscellaneous measures.
• Monetary measures: According to Hawtrey, Hicks, and many others, expansion and
contraction of supply of money is the major cause for the operation of business
cycles.
Monetary policy and the expansionary phase
 When the economy is moving fast in the upward direction, the monetary measures
should aim at restricting the issue of legal tender money and putting restrictions to the
expansion of bank credit by adopting both quantitative and qualitative techniques of
credit control.
A check can be imposed on the liquidity position of the commercial banks by raising
the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
During the period of depression, to enlarge employment opportunities and raise the
level of income, all-out measures are to be adopted to increase the level of investment.
• Fiscal Policy: During the period of inflation or uptrend in the economy, when the
private enterprise is overenthusiastic and there is overexpansion and overproduction,
the government can use taxation and licensing policy as very effective instruments to
check such unwieldy growth. Price control measures can be adopted. The government
should adopt surplus budget, reduce public expenditure, and resort to public
borrowing. The cumulative result of these measures would reduce the supply of
money in circulation, purchasing power, and demand.
• Physical Controls: During the period of inflation, a price control policy has to be
adopted whereas during depression, a price-support policy has to be followed. During
the period of contraction, unemployment insurance schemes, proper management of
savings, investments, production, distribution, expansion of income and employment,
etc. are needed depending upon the nature of economic fluctuations.
• Miscellaneous Measures:
i. Introduction of automatic stabilizers: An automatic stabilizer (or built- in
stabilizer) is an economic shock absorber that helps the cyclical business
fluctuations to operate smoothly of its own accord, without requiring
deliberate action on the part of the government.
ii. Price support policy followed in the U.S.A. during the post war period to fight
the prospects of depression.
iii. Granting of aid might help in recovering from slump.
Thus, several measures are to be taken to make the cyclical movements smooth and to ensure
economic stability in an economy.

Q3 Explain the causes and effects of inflation

Ans: Inflation refers to the general increase in prices or the money supply, both of which can
cause the purchasing power of a currency to decline.
Causes of Inflation:
• Demand Side: Increase in aggregative effective demand is responsible for inflation.
In this case, aggregate demand exceeds aggregate supply of goods and services.
Demand rises much faster than supply.
 Increase in money supply – Supply of money in circulation increases on account of
the expansion in public expenditure
Increase in exports – An increase in the foreign demand for a country’s exports
reduces the stock of goods available for home consumption. This creates shortages in
the country leading to a rise in price level.
High rates – Higher rates of indirect taxes would lead to a rise in prices.
• Supply Side: Generally, the supply of goods and services do not keep pace with the
ever- increasing demand for goods and services. Thus, supply does not match the
demand.
Shortage in supply of goods and services – When there is shortage in the supply of
factors of production like raw materials, labor, capital equipment’s, etc. there will be a
rise in their prices.
War – During the period of war, shortage of essential goods creates rise in prices.
Role of natural calamities – Natural calamities such as earthquake, floods, and
drought conditions also affect the supplies of agricultural products adversely.
• Role of Expectations: Expectations also play a significant role in rise of inflation.
If people expect further rise in price, the current aggregate demand increases, which
in turn causes a rise in the prices.
Effects of Inflation: There are few positive effects of inflation such as;
• Rise in Investment: Rise in prices leads to a rise in profits, incomes, savings, and
finally the volume of investment by entrepreneurs.
• Better Opportunities: Rise in prices, which is much higher than the production costs,
creates better and more opportunities in new fields of business activities.
• Encourages Entrepreneurship: As profits rise, it encourages entrepreneurs to enter
into business in an increasing manner.
• Increase in the demand for money: As prices rise, people require more money to
buy the same quantity of goods and services. Hence, it leads to an expansion in
money supply in the country, which leads to a higher growth rate in the economy.
• Inflation Tax: Government, in order to cover the deficit in the budget, may resort to
inflation tax.

Q4 Explain the measures to control inflation and deflation

Ans: The measures to control inflation are broadly classified into three categories.
Monetary Measures: Inflation is basically a monetary phenomenon. Excess money supply
over the quantity of goods and services is mainly responsible for rise in prices. Hence,
monetary authorities aim at reducing and absorbing excess supply of money in an economy.
The following are some of the anti-inflationary monetary measures:
• Restrictions on bank credits
 • Freezing and blocking particular type of assets.
• Increasing bank rate and other interest rates.
• Raising the legal reserve requirements like CRR and SLR.
• Regulation of consumer credit.
Fiscal Measures: The following are some of the important anti-inflationary fiscal measures:
• Reduction in the volume of public expenditure.
• Rise in the levels of taxes, introduction of new taxes
• Postponing the repayment of debt
• Incentive to savings
• Introduction of compulsory deposit schemes
Other Measures – Direct or administrative measures: Direct controls refer to the
regulatory or administrative measures taken by the government directly with an objective of
controlling the rise in prices. The following are some of the direct measures taken by the
modern governments.
• 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
• Control of population: This is considered as one of the most important methods
because if population is controlled it is possible to keep a check on the demand for
goods and services.
The measures to control deflation are broadly classified into three categories.
• Monetary Policy: Central bank will have to follow a cheap money policy – reducing
the bank rate, organizing open market purchase of securities, reducing the margin
requirements, etc. to encourage borrowing.
• Fiscal Policy: Fiscal measures like deficit financing, reduction in tax rates, tax
concessions, public works programs, may prove to be more efficient in improving the
situation than the monetary measures.
• Other Measures: Price support programs, rationing of essential commodities, import
of essential goods, grant of subsidies, development of infrastructure, marketing
facilities, etc., may ease the situation to some extent.
Both inflation and deflation are dangerous. Of the two, deflation is more dangerous as it
cripples the system and establishes a hopeless situation everywhere.