HS 200 – BUSINESS ECONOMICS

(As per KTU Syllabus)

 INDEX

Sr No Contents Pg No
1 Syllabus
2 Question paper pattern
3 Introduction to the subject
Module 1
4 Introduction to business economics
5 Basic concepts in economics
Module 2
6 Demand and Supply analysis
7 Production concepts
Module 3
8 Concept of costs
9 Break Even Analysis
10 Market Structures
Module 4
11 Circular flow of income
12 National Income Concepts
13 Inflation, deflation
14 Trade cycles
15 Theory of Money and Banking
16 Credit control methods
17 Emerging bitcoin concept
Module 5
18 Investment analysis & Capital Budgeting
19 Business decisions
20 Cost benefit analysis
Module 6
21 Balance sheet
22 Forecasting techniques
23 Business financing
24 Basic Principles of taxation
26 Question Bank
27 Model Question Paper
28 Solution to Model Question paper
 SYLLABUS
MODULE DETAILS
I Business Economics and its role in managerial decision making-meaning-scope-relevance-
economic problems-scarcity Vs choice

Basic concepts in economics-scarcity, choice, resource allocation- Trade-off-opportunity cost-

marginal analysis- marginal utility theory, Law of diminishing marginal utility -production
possibility curve
II Basics of Micro Economics I

Demand and Supply analysis-equillibrium-elasticity (demand and supply)

Production concepts-average product-marginal product-law of variable proportions- Production

function-Cobb Douglas function-problems

III Basics of Micro Economics II

Concept of costs-marginal, average, fixed, variable costs-cost curves-shut down point-long run
and short run

Break Even Analysis-Problems

Markets-Perfect Competition, Monopoly and Monopolistic Competition, Oligopoly-Cartel and

collusion
IV Basics of Macro Economics –

Circular flow of income-two sector and multi-sector models- National Income Concepts-
Measurement methods-problems-Inflation, deflation

Trade cycles

Money-stock and flow concept-Quantity theory of money-Fischer’s Equation and Cambridge

Equation -velocity of circulation of money-credit control methods-SLR, CRR, Open Market
Operations-Repo and Reverse Repo rate-emerging concepts in money-bit coin

V Business Decisions I

Investment analysis-Capital Budgeting-NPV, IRR, Profitability Index, ARR, Payback Period.

Business decisions under certainty-uncertainty-selection of alternatives-risk and sensitivity-

cost benefit analysis-resource management

VI Business Decisions II

Balance sheet preparation-principles and interpretation-forecasting techniques

Business financing-sources of capital- Capital and money markets-international financing-FDI,

FPI, FII

Basic Principles of taxation-direct tax, indirect tax-GST

 HS 200 - BUSINESS ECONOMICS

Question Paper Pattern

Max. marks: 100, Time: 3 hours

The question paper shall consist of three parts

Part A
4 questions uniformly covering modules I and II. Each question carries 10 marks
Students will have to answer any three questions out of 4 (3X10 marks =30 marks)

Part B
4 questions uniformly covering modules III and IV. Each question carries 10 marks
Students will have to answer any three questions out of 4 (3X10 marks =30 marks)

Part C
6 questions uniformly covering modules V and VI. Each question carries 10 marks
Students will have to answer any four questions out of 6 (4X10 marks =40 marks)
Note: In all parts, each question can have a maximum of four sub questions, if needed.

“When you want something, the entire

universe conspires in helping you to achieve
it.”
 Introduction to the subject area

Every day people make decisions that belong within the realm of economics. What to buy?
What to make and sell? How many hours to work? We have all participated in the economy as
consumers, many of us as workers, some of us also as producers. We have paid taxes. We
have saved our earnings in a bank account. All of these activities (and many more) belong to
the realm of economics. Households and firms are the basic units of an economy and are
concerned with the economic problem: how best to satisfy unlimited wants using the limited
resources that are available? As such, economics is the study of how society uses its scarce
resources. Its aim is to provide insight into the processes governing the production,
distribution and consumption of goods and services in an exchange economy.

The previous paragraph could be taken to imply that the ‘realm of economics’ is limited and
clearly defined. However, if economics is viewed as a way of thinking, or a set of tools that
can be used to analyse human behaviour and the world around us, then you will find that the
principles of economics can be applied to many different areas of life. The scope is thus very
broad, but the principles of analysis are well defined and these are what you will become
familiar with through undertaking this course. Although the course provides some information
that is descriptive, such as how the banking system works, for example, its main focus is on
introducing models and concepts which are used as tools of economic analysis. Concepts such
as opportunity cost and approaches such as marginal analysis can be widely applied and prove
very useful in understanding various aspects of society and people’s lives.

Studying economics doesn’t just impart knowledge; it also develops skills such as logical and
analytical thinking and problem-solving skills, which are useful beyond the formal study of
economics. For some of you, economics is not the main area of study, and you may not be
intending to pursue a career as an economist. However, we are sure that an understanding of
basic economic concepts will still prove useful to you in whatever direction your studies and
subsequent career may take.
 Module 1

What economics is about?

Economics is a social science that deals with human wants and their satisfaction. People
have unlimited wants. But the resources to satisfy these wants are limited.
An economy is a system which attempts to solve this basic economic problem.

Reasons For Studying Economics:

1. It is a study of society and as such is extremely important.

2. It trains the mind and enables one to think systematically about the problems of
business and wealth.
3. From a study of the subject it is possible to predict economic trends with some
precision.
4. It helps one to choose from various economic alternatives.

Robbins’ Definition: Science of Scarcity or Science of choice

Economics studies human behaviour as a relationship between ends and scarce means which
have alternate uses.

Managerial / Business Economics

Managerial economics is used synonymously with Business economics.

Spencer and Siegelman defines Managerial Economics as

“Managerial economics is the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by management.”

Managerial economics is the study of how scarce resources are directed most efficiently to
achieve managerial goals. It is a valuable tool for analyzing business situations to take better
decisions.

Managerial economics vs Business economics

The two terms are often used interchangeably. But in fact there is a slight difference between
the two.

Business economics Managerial Economics

It is economic theory used in business It is economic theory applied in all
organizations whether business or non
business
It deals with decision making in profit It deals with decision making in profit
making organizations making as well as non - profit organizations
and public corporations
Its scope is narrow Its scope is broad
Nature of business economics
1. Micro economics – It studies the problems of a particular business unit. It does not
study about the entire economy
2. Normative science – It concerns with what the management should do under particular
circumstances. It determines the goals of the enterprise and develops the ways to
achieve these goals.
3. Pragmatic – It is more application oriented. It tries to solve the managerial problems in
the day-to-day functioning of the business enterprises.
4. Prescriptive – It is prescriptive rather that descriptive. It prescribes solutions to various
business problems.
5. Uses macro economics – It provides an intelligent understanding of the environment in
which the business operates. It takes the help of macro economics to understand the
external conditions such as business cycle, national income, economic policies of
Government etc.
6. Multi disciplinary – Makes use of the most modern tools of mathematics, statistics and
operations research etc . In decision making and forward planning the principles of
accounting, finance, marketing, production, personnel etc are used.

Objectives of Business economics

1. Integrate economic theory with business practice
2. To apply economic concepts and principles to solve business problems
3. To employ the most modern instruments and tools to solve business problems
4. To allocate scarce resources in the optimum manner
5. To make all round development of a firm
6. To minimize risk and uncertainty
7. To help in demand and sales forecasting
8. To help in formulating business policies
9. To help in profit maximization

Scope of Business economics

1. Demand analysis and forecasting - Goods are produced to be sold in the market. The
volume of production depends upon demand. Therefore the management analyses the
demand and takes decisions on the basis of this analysis. For analyzing demand, the
management applies demand theory which explains the consumer behaviour. It is also
helpful in forecasting future demand.
2. Cost and production analysis – The resources to produce goods are scarce. But they
can be put to alternative uses. The limited resources must be utilized in such a manner
as to obtain maximum output or minimize total costs. For this theory of production
and cost analysis is useful.
3. Pricing policies – Once a product is ready for sale, the firm has to fix its price. The
price has to be fixed according to the conditions of the market. Firm’s revenue
earnings largely depend upon the pricing policy.
4. Study of market – After pricing the product, the manager has to the product in the
market. Markets are never constant. They go on changing. The manager should offer
 the products only in those markets where he will get maximum sales. Therefore he
should have clear knowledge about the markets.
5. Profit management – The pricing motive of a business enterprise is to earn maximum
profit. But profit is always uncertain because future costs and revenues are uncertain.
6. Capital budgeting – Capital is the foundation of the business. Like all other inputs,
capital is also a scarce and expensive factor. Its efficient allocation and management is
one of the most important tasks of the managers. The manager has to choose the most
profitable investment project.
7. Inventory management – A firm should keep an ideal quantity of stock. If the stock is
too much, the capital is unnecessarily locked up in the business. At the same time, if
the stock is low, production will be interrupted due to non-availability of materials.
Hence a firm always prefers to have an optimum quantity of stock. Therefore,
managerial economics will use inventory techniques with a view to minimizing
inventory cost.

Fundamental Economic Problems

The central problems relate to different aspects of resources are cited below:

(1) What to produce and in what quantities?

The first major decision relates to the quantity and the range of goods to be produced.
Since resources are limited, we must choose between different alternative collection of goods
and services that may be produced. It also implies the allocation of resources between
different types of goods. Eg consumer goods or capital goods, necessaries or luxurious goods
etc.

After deciding which goods should be produced society has to decide the quantity of each
good has to be produces.

(2) How to produce?

Having decided the quantity and the type of goods to be produced, we must next determine
the techniques of production to be used. Example: labour intensive or capital intensive.

(3) For whom to produce?

This problem refers who will consume the goods and services produced: A few rich and
many poor or vice-versa. The goods and services are produced for the people who can
purchase them. And the purchasing power of the people depends on how the produced goods
and services are distributed among the people who are helped to produce them. i.e., how is the
product distributed among the four factors of production-land, labour, capital and enterprise.
It shows how the national product is to be distributed ie who should get how much.

(4) Are resources economically used?

This is the problem of economic efficiency or welfare maximisation. There is to be no waste

or misuse of resources since they are limited.
(5) The problem of full employment of resources.

The problem of full employment of resources implies that existing resources, scarce as they
are, should not remain unutilized or under-utilized.

(6) The problem of growth of resources.

Another problem for an economy is to make sure that it keeps expanding or developing so that
it maintains conditions of stability.

Scarcity Vs Choice
The starting point of all economic activity is the existence of human wants. Wants give
rise to efforts and efforts secure satisfaction. The things which directly satisfy human wants
are called consumption goods. A few consumption goods like air, sunshine, etc. are
abundant. They are available at free cost. But most of goods are scarce. They are available
only by paying a price. And, therefore, they are called economic goods. They do not exist in
sufficient quantity to satisfy all wants.

Limited means and unlimited ends – Suppose your father has given you some amount of
money as pocket money. You will have different wants towards which the money will be
directed. But the amount of money that you have is limited whereas your wants are unlimited.
Economics helps you in such a situation. It will help you to derive maximum satisfaction from
the limited amount of money that you have.

Choosing between ends – Economics tells us how a person tries to satisfy his unlimited
wants with his limited means; in other words, how to use scarce goods that he has to his best
advantage or how to economise. Economics is a science of choice when faced with scarce
means and unlimited ends.

Basic concepts in economics

Scarcity, choice, resource allocation
Following are the reasons for emergence of economic problems:

1. Human wants (or ends) are unlimited

There is no end to human wants. As one want is satisfied, many others crop up and this goes
on endlessly.
2. Resources (means) to satisfy wants are limited (scarce)
Goods and services are produced by an economy with its resources namely-land, labour,
capital and enterprise. Unfortunately, such resources are limited in relation to its demand. Due
to scarcity of resources, we cannot produce all the goods and services that the various sections
of the society need.
3. Resources have alternative uses
The resources of an economy are not only scarce but also have alternative uses and therefore
choice has to be made in their use. For example, a plot of land can be used to produce wheat
or for construction of a factory or for a school building. If the plot is used for the cultivation
of wheat, it cannot be used for other purposes. In other words, production of one commodity
has to be sacrificed for production of other. Thus, the economy constantly faced with
choosing better alternative uses to which its resources should be put.
In short, the problem of making a choice among alternative uses of resources is called the
basic or central problem of an economy. Such problems are common to all economies

Trade-off
Since resources tend to be scarce, anyone that uses the resource has to make a decision about
how to use it. Suppose, for example, that you are a drink manufacturer. To produce a
beverage, you have to use some scarce resources: the plastic for the bottle, the workers' time,
a machine to fill the bottles, etc. If you choose to make one bottle of water, you have chosen
to not make a bottle of soda . Your scarce resources force you to make a choice and a trade-
off producing one product or another.

Opportunity cost
The concept of trade-offs due to scarcity is formalized by the concept of opportunity cost. The
opportunity cost of a choice is the value of the best alternative forgone. In other words, if you
can only produce bottles of soda and water, the opportunity cost of producing a bottle of water
is the value of producing a bottle of soda. Similarly, there is an opportunity cost in everything:
the opportunity cost of you reading this is what you could be doing with your time instead
(say, watching a movie). When scarce resources are used (and just about everything is a
scarce resource), people and firms are forced to make choices that have an opportunity cost.

In practice, if an alternative (X) is selected from a set of competing alternatives (X,Y), then the
corresponding investment in the selected alternative is not available for any other purpose. If
the same money is invested in some other alternative (Y), it may fetch some return. Since the
money is invested in the selected alternative (X), one has to foregone the return from the other
alternative (Y). The amount that is foregone by not investing in the other alternative (Y) is
known as the opportunity cost of the selected alternative (X). So the opportunity cost of an
alternative is the return that will be foregone by not investing the same money in another
alternative.

Consider that a person has invested a sum of Rs. 50,000 in shares. Let the expected annual
return by this alternative be Rs. 7,500. If the same amount is invested in a fixed deposit, a
bank will pay a return of 18%. Then, the corresponding total return per year for the
investment in the bank is Rs. 9,000. This return is greater than the return from shares. The
foregone excess return of Rs. 1,500 by way of not investing in the bank is the opportunity cost
of investing in shares.
Marginal analysis

The process of identifying the benefits and costs of different alternatives by examining the
incremental effect on total revenue and total cost caused by a very small (just one unit) change
in the output or input of each alternative. Marginal analysis supports decision-making based
on marginal or incremental changes to resources instead of one based on totals or averages.

Marginal analysis is an examination of the associated costs and potential benefits of specific
business activities or financial decisions. The goal is to determine if the costs associated with
the change in activity will result in a benefit that is sufficient enough to offset them. Instead of
focusing on business output as a whole, the impact on the cost of producing an individual unit
is most often observed as a point of comparison.

Example of Marginal Analysis in the Manufacturing Field

When a manufacturer wishes to expand its operations, either by adding new product lines or
increasing the volume of goods produced from the current product line, a marginal analysis of
the costs and benefits is necessary. Some of the costs to be examined include, but are not
limited to, the cost of additional manufacturing equipment, any additional employees needed
to support an increase in output, large facilities for manufacturing or storage of completed
products, and as the cost of additional raw materials to produce the goods.

Once all of the costs are identified and estimated, these amounts are compared to the
estimated increase in sales attributed to the additional production. This analysis takes the
estimated increase in income and subtracts the estimated increase in costs. If the increase in
income outweighs the increase in cost, the expansion may be a wise investment.

Marginal utility theory

Total Utility (TU) is the total amount of satisfaction obtained from the consumption of all the
units of the commodity. It is the utility derived from all units of the commodity consumed within
a specified time period. It is the sum of utilities which the consumer obtains from the consumption
of all the units of commodity.

Marginal Utility (MU) is the additional utility obtained from the consumption of an additional
unit of the commodity. It is the additional utility derived from the consumption of an additional
unit of the commodity. Marginal Utility is the addition made to total utility when one more unit of
the commodity is consumed. It is the utility from the last unit. We can express marginal utility as
MU = ΔTU/ΔQ

Law of diminishing marginal utility

The law states that marginal utility of a commodity diminishes as an individual consume
more and more of the commodity. That is, as we consume more and more of commodity the
utility derived from the addition unit diminishes. The law of diminishing marginal utility means
that the total utility increases at a decreasing rate.

Thus if we are very thirsty and buy a drink to quench our thirst, the drink will yield a great deal of
satisfaction at first. After consumption of the first drink, however, we would not like to have
another, because our want has been practically satisfied. This is the case with most of the
commodities.

As an individual consumes more and more of a commodity within a limited time period, the
marginal utility of the additional unit decreases, becomes zero and if consumption is continued
becomes negative.
The following table shows the total and marginal utilities derived by a person from the
consumption of oranges.

No of oranges Total utility (in Marginal

consumed utils) utility (in
Utils)
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
8 24 -4

The table shows that as the consumption of oranges increases marginal utility falls. That is, total
utility is increasing at a diminishing rate. However, when number of oranges consumed increases
to seven, marginal utility becomes negative and total utility starts declining. The law of
diminishing marginal utility is diagrammatically illustrated below.

The figure shows that although total utility is increasing, it increases at a decreasing rate.
Marginal utility is decreasing and when TU reaches its maximum MU is zero. When TU
starts declining MU becomes negative. The significance of the diminishing marginal utility of a
commodity for the theory of demand is that the quantity demanded of the commodity rises as the
price falls and vice versa. Thus, it is because of the diminishing marginal utility that the demand
curve slopes downwards.

Production possibility curve

A production possibility frontier (PPF) shows the maximum possible output combinations of two
goods or services an economy can achieve when all resources are fully and efficiently employed
Opportunity Cost and the PPF
 Reallocating scarce resources from one product to another involves an opportunity
cost
 If we increase our output of consumer goods (i.e. moving along the PPF from point A
to point B) then fewer resources are available to produce capital goods
  Eg. Suppose economy is producing two goods
– Wheat and Cloth
– All the resources are fully utilized
– Science and technology does not change
– There is no change in income, taste and preference or price of the product

Eg. Production Possibilities

Goods A B C D E
Wheat
100 90 70 40 0
(lakh tones)
Cloth
0 1 2 3 4
(1000 bales)

120

100 A
B .F
80
C
Wheat

60
.G D
40

20
E
0
0 1 2 3 4 5
Cloth
 • A production possibility curve is used to illustrate the concepts of opportunity cost,
trade – offs, and effects of growth
• Points within the curve – unutilized resources - ( point G)
• Points on the PPC – full utilization of resources (i.e., A,B,C,D and E)
• Points beyond PPC – unattainable point –(point F) - scarcity of resources
• Reallocating scarce resources from one product to another involves an opportunity
cost
• Producing more of both goods would represent an improvement in welfare

“No matter what he does, every person on

earth plays a central role in the history of the
world. And normally he doesn't know it.”
 Module 2

Demand and Supply Analysis

Demand
In economics, demand refers to the various quantities of a good or service that people will be and
able to purchase at various prices during a period of time. Demand implies both the desire to
purchase and ability to pay for the good. Unless demand is backed by purchasing power, it does
not constitute demand.

Demand Function
Short Run demand Function:
Short run is a very short period of time. For many purposes in economics, it is useful to focus on
the relationship between quantity demanded of a good and its own price, while keeping other
determining factors constant. Thus, we can write the demand function as
Qxd = f (Px)
This implies that the quantity demanded of the commodity x is a function of its own price, other
determinants remaining constant.
Long run demand function:
Long run is a long period of time. Demand for a commodity is determined by several factors. An
individual‘s demand for a commodity depends on the own price of the commodity, his income,
prices of related commodities, his tastes and preferences, advertisement expenditure made by the
producers of the commodity, expectations etc. Thus, individual‘s demand for a commodity can be
expressed in the following general functional form,
Qxd = f (Px, I, Pr, T, A, E)

Where,
Qxd = Quantity demanded of commodity ―x
Px = Price of commodity x
I = Income of the individual consumer
Pr = Price of related commodities
T = Tastes and preferences of individual consumer
A = Advertisement expenditure
E = Expectations

Law of Demand

Law of demand expresses the functional relationship between price and quantity demanded.
According to the law of demand, other things being equal, if the price of the commodity falls
the quantity demanded of it will rise and if the price of the commodity rises, its quantity
demanded will decline. Thus, according to law of demand, there is an inverse relationship
between price and quantity demanded, other things remaining the same. The other things which
are assumed to be constant are tastes and preferences of the consumer, the income of the
consumer, prices of related commodities etc. Thus, the law of demand assumes that all things
other than price remain constant.
The law of demand can be illustrated through a demand schedule and through demand curve.
Demand schedule shows various quantities of good or service that people will buy at various
possible prices during some specified period, while holding constant all other relevant
economic variables on which demand depends. A demand schedule is presented below:

Price Quantity demanded

10 20
8 40
6 60
4 80
2 100

We can convert the demand schedule into demand curve by graphically plotting the various price-
quantity combinations, as shown below.

Assumptions of Law of Demand

1. Income of the buyer remains constant
2. Tastes and preferences of the consumers remain the same
3. Price of related goods (substitutes and complementary goods) remain the same
4. Consumers do not know about any new substitute product
5. There is no expectation of change in the price of commodity in the near future
6. The size of population remains constant

Factors affecting demand (Determinants of demand)

The following are the factors that determine the demand of a commodity:

1. Price of commodity – Price is the basic factor that determines demand. When price
changes demand also changes. When price decreases, demand falls and vice versa.
2. Nature of the commodity- Demand depends on whether the commodity is a necessity or
a luxury. Demand of necessary goods generally remains constant. Demands of comforts
and luxuries change with the change in their prices. Demand of prestige goods generally
remains constant. Demand of durable goods changes with the change in their price. Thus
the nature of the commodity determines the demand.
3. Income and wealth of consumers – Change in income can bring about a change in
demand. If the income of consumer increases, the demand for normal goods will also
 increase because with the increase in income, he can spend more amounts on the purchase
of such goods. If the income decreases the demand for normal goods also decreases.
4. Tastes and preferences of consumers – Any change in fashion, taste and preferences of
consumers brings about changes in demand. Eg particular styles of clothes, food items etc
5. Price of related goods – The demand for a commodity is affected by not only its own
price but also by the price of related goods. These related goods fall into two categories:
substitutes and complements.
Substitute goods – Two goods are said to be substitutes of each other when one can be
used in place of another. For example, tea and coffee are substitute goods. If the price of
substitute commodity increases, the demand for the original commodity will increase and
vice versa.
Complementary goods – Two goods are said to be complementary to each other when
they are used together. In the case of complementary goods, if the demand of original
commodity increases, the demand of complementary goods will also increase and vice
versa.

Reasons for law of Demand / Why the demand curve slopes downwards?
1. The Law of Diminishing Marginal Utility – Law of demand is derived from the Law of
Diminishing Marginal Utility. Law of Diminishing marginal utility states that when a
consumer consumes more of a commodity, every additional unit of that commodity will
give him less satisfaction. Therefore the consumer will buy more only at a lower price. If
the price is higher, he will restrict its consumption. For this reason, the demand of a
commodity increases at a lower price and decreases at a higher price and thus the demand
curve slopes downwards. In other words, the demand curve slopes downwards because the
marginal utility curve also slopes downwards.

2. Income effect - When the price of the commodity falls, the consumer can buy more
quantity of the commodity with his given income. If he chooses to buy the same amount
of the commodity as before, some money will be left with him. That is, consumer‘s real
income or purchasing power increases. This increase in real income induces the
consumer to buy more of the commodity. This is called the income effect of the
change in price of the commodity. This is the reason why a consumer buys more of a
commodity whose price falls. Similarly, an increase in the price of the commodity results
in the reduction of real income of the consumer. Hence, the consumer buys less of a
commodity whose price rises.

3. Substitution effect - Again, when price of the commodity falls, it becomes relatively
cheaper than other commodities. This induces the consumer to substitute the commodity
whose price has fallen for other commodities which have now become relatively dearer.
This change in quantity demanded resulting from substituting one commodity for
another is referred to as substitution effect of the price change. As a result of this
substitution effect, the quantity demanded of the commodity whose price has fallen rises.
For normal commodities, the income and substitution effect of a price decline are positive
and reinforce each other leading to a greater quantity demanded of the commodity.

4. Price effect – When there is a fall in the price of any commodity, the consumers who
were not purchasing that commodity earlier will now purchase some units of the
commodity. In addition to this, existing consumers will buy more quantity because the
 price has fallen. In both cases the demand increases due to fall in price. When there is
increase in price of a commodity some consumers will stop buying of the commodity and
switch to the substitutes. Further the existing consumers will buy less quantity of it. In
both cases the demand falls due to increase in price.

5. Different uses of commodity – If a commodity can be used for several purposes, its
demand will be affected by a change in its price. For example, electricity can be used for
several uses. If the price of electricity increases, it will be used only for limited or more
important purposes (eg for lighting only). If the price falls, it will be used freely for
lighting, heating, cooking etc.

Exceptions to the Law of Demand

1. Veblen goods - Some consumers measure the utility of a commodity entirely by its price.
That is, for them, the greater the price of the commodity, the greater it‘s utility. These
consumers demand more of such commodities the more expensive these commodities are
in order to impress people. E.g. Diamonds. This form of conspicuous consumption is
called ―Veblen effect. When the price of such commodities goes up, their prestige value
also goes up.

2. Giffen goods - If the price of an inferior good falls, consumer‘s real income increases. So,
instead of buying more inferior goods, consumers substitute other superior goods. In such
case, quantity demanded of inferior goods falls as price falls. Such goods are called Giffen
Goods. Thus law of demand does not apply to inferior goods such as second hand
appliances, coarse cloth, jowar, bajra, low quality ball pens,etc.

3. Demand for necessaries – The law of demand does not apply to necessary goods.
Whatever be the prices, we buy certain quantity of necessary goods like salt, kerosene,
matches, medicines etc

4. Fear of shortage – In case a serious shortage is feared, eg in times of wars, people may
buy more even though the price is rising due to the fear of further price rise.

5. Festival, marriage etc – In the season of festival, marriage etc, people may buy more
even though the prices are high.
Extension and Contraction in demand

A movement along the demand curve is caused by a change in price of the good, other things
remaining constant . Rise in demand due to fall in price of commodity- results downward
movement along demand curve – extension in demand. Fall in demand due to rise in price of a
commodity, other things remain constant – contraction in demand

In the above figure, suppose P is the initial price and Q is the demand. A fall in price from P
to P2 brings about an extension in demand from OQ to OQ2. A rise from P to P1 will result
in contraction in demand from OQ to OQ1

Shift in Demand

• The change in demand due to change in factors other than price is known as increase
or decrease in demand and the resultant demand curve is called shift in demand

D to D1 is increase in demand; D to D2 is decrease in demand

Elasticity of Demand
The law of demand states that the demand of a commodity increases on a fall in its price and
decreases on an increase in its price. Thus law of demand tells us only the direction of change. It
does not tell the rate at which the changes take place. The concept of elasticity of demand has
been introduced to measure the change in demand. Elasticity of demand refers to the sensitiveness
or responsiveness of quantity demanded of a good to a change in its own price, income and prices
of related goods.

Accordingly, there are three kinds of elasticity of demand. They are:

1. Price elasticity of demand - Price elasticity of demand measures the sensitivity of quantity
demanded to change in own price of good

= Proportionate change in quantity demanded

Proportionate change in price

∆𝑞 𝑃
Ep = .
∆𝑃 𝑞

2. Income elasticity of demand - Income elasticity of demand measures the sensitivity of quantity
demanded to change in income of the consumer.

= Proportionate change in quantity demanded

Proportionate change in income

∆𝑞 𝑌
Ey = .
∆𝑌 𝑞

3. Cross elasticity of demand - Cross elasticity of demand analyses the responsiveness of quantity
demanded of one good to changes in the price of another good.

= Proportionate change in quantity demanded of Commodity X

Proportionate change in price of commodity Y

∆𝑞𝑥 𝑃𝑦
Exy = .
∆𝑃𝑦 𝑞𝑥
Degrees of Elasticity of Demand (Types of price elasticity)
The value of price elasticity of demand ranges from zero to infinity. That is, 0< E p<∞. Based on
the value of elasticity or degree of responsiveness of quantity demanded, price elasticity of
demand is classified into five categories. They are
1) Perfectly inelastic demand
2) Perfectly elastic demand
3) Elastic demand
4) Inelastic demand
5) Unitary elastic demand

(1) Perfectly inelastic demand

When quantity demanded does not change as a result of change in price, demand is said to be
perfectly inelastic. In other words, same quantity will be bought whatever the price may be.
Numerical value of elasticity will be zero (E = 0) when there is perfectly or completely inelastic
demand. This is an imaginary situation

(2) Perfectly Elastic demand

If a small change in price leads to an infinitely large change in quantity demanded, we can say that
demand is perfectly elastic. At the going price, consumers will buy an infinite amount (if
available). Above this price, they will buy nothing. The coefficient of elasticity will be infinity
when demand will be infinite when demand is perfectly elastic (E =∞). This is also an imaginary
concept
(3) Elastic Demand
When the percentage change in quantity demanded exceeds the percentage change in price, the
demand is said to be elastic. That is, a certain percentage change in price leads to a greater
percentage change in quantity demanded. The value of coefficient of elasticity will be greater than
one when demand is elastic. E>1

(4) Inelastic Demand

When percentage change in quantity demanded is less than percentage change in price, demand
is said to be inelastic. That is, a certain percentage change in price leads to a smaller percentage
in quantity demanded. The coefficient of elasticity will be less than one but greater than zero
(E <1) when demand is inelastic.

(5) Unitary Elastic Demand

If a certain percentage change in price leads to an equal percentage change in quantity
demanded, then demand said to have unitary elasticity. Unitary elasticity is the boundary
between elastic and inelastic demand. The coefficient of elasticity will be equal to one when
demand is unitary elastic (E =1)
Determinants or factors affecting elasticity
1. Necessaries – Demand is inelastic. Whatever the price we must buy them.
2. Luxuries and comforts- Demand is more elastic. A little fall in their price stimulates demand and
vice versa.
3. Existence of substitutes – For commodities having substitutes, the demand is elastic. Eg tea and
coffee. If the price of any one of them falls, it will be purchased in larger quantities.
4. Several uses – When a commodity has several uses, demand for it is elastic. With a fall in price
such a commodity tends to be put to less urgent uses. Thus its demand extends and vice versa. If a
commodity has only one use, a change in price of the commodity will influence its one use only.
5. Possibility of postponements – When we can postpone buying a commodity, the demand is
elastic. More is purchased when price falls, and less when it rises. Eg if the price of warm suiting goes
up its demand will considerably contract because its purchase can be conveniently postponed.

Significance of elasticity of demand

The concept of elasticity is very useful to producers and policy makers. It is a valuable tool to decide
increase or decrease in price to effect a change in quantity demanded. The following are its
application:

1. Price fixation

While fixing the price of this product, a businessman has to consider the elasticity of demand for the
product. He should consider whether a lowering of price will stimulate demand for his product, and if
so to what extent and whether his profits will also increase a result thereof. If the increase in his sales
is more than proportionate, to the reduction in price his total revenue will increase and his profits
might be larger. On the other hand, if increase in demand is less than proportionate to fall in price,
his total revenue we will fall and his profits would be certainly less.

In general, for items having inelastic demand, the producer will fix a higher price and items whose
demand is elastic the businessman will fix a lower price.

2. International trade:

In order to fix prices of the goods to be exported, it is important to have knowledge about the
elasticity’s of demand for such goods. A country may fix higher prices for the products with inelastic
demand. However, if demand for such goods in the importing country is elastic, then the exporting
country will have to fix lower prices.

3. Formulation of Government Policies:

The concept of price elasticity of demand is important for formulating government policies, especially
the taxation policy. Government can impose higher taxes on goods with inelastic demand, whereas,
low rates of taxes are imposed on commodities with elastic demand.

4. Factor Pricing:

Price elasticity of demand helps in determining price to be paid to the factors of production. Share of
each factor in the national product is determined in proportion to its demand in the productive
activity. If demand for a particular factor is inelastic as compared to the other factors, then it will
attract more rewards.

5. Decisions of Monopolist:

A monopolist considers the nature of demand while fixing price of his product. If demand for the
product is elastic, then he will fix low price. However, if demand is inelastic, then he is in a position to
fix a high price.

Income Elasticity of Demand

Type of Goods Numerical Measure of Verbal description
Income elasticity

Inferior Goods Negative Quantity demanded decreases as income

increases

Normal goods Positive Quantity demanded increases as income

increases

Necessity Less than one Quantity demanded increases less than

proportion to increase in income

Luxury Greater than one Quantity demanded increases more than

proportion to increase in income

Cross Elasticity of Demand

Type of goods Numerical measure of Verbal description

cross elasticity

Substitutes Positive Quantity demanded of a good increases if the

price of substitutes increases

Complementary Negative Quantity demanded of a good decreases if the

price of complements increases

Independent Zero Quantity demanded of a good remains

unchanged to change in the price of other good
Theory of Supply
Nature of Supply
Supply refers to the various quantities of a good or service that sellers will be able to offer for
sale at various prices during a period of time. It shows how price of a good or service is related to
the quantity which the sellers are willing and able to make available in the market.

Supply Function
Like demand, supply also depends on many things. In general, quantity supplied of a product is
expected to depend on own price, prices of related products, prices of inputs, state of technology,
expectations, number of producers (sellers) in the market etc. This list can be summarised in a
supply function
Q xS = f (Px, Pr, Pi, T, E, N)

Where,
QXS = Quantity supplied of commodity x
Px = Price of the commodity x
Pr = Prices of related products
Pi = Prices of inputs
T = State of technology
E = Expectations
N = Number of producers in the market
For a simple theory of price, we need to know how quantity supplied varies with the product‘s
own price, all other things being held constant. Thus we can write the supply function as;
Q xS = f (Px)
That is, quantity supplied of commodity x is a function of its own price, other determinants are
assumed to remain constant.

Law of Supply
The functional relationship between price and quantity supplied is called the law of supply.
According to the law of supply, as the price of the commodity falls, the quantity supplied
decreases or alternatively, as the price of the commodity rises the quantity supplied increases,
other things being equal. Therefore, there is a direct relationship between of the commodity and
quantity supplied.

The law of supply can be illustrated through a supply schedule and supply curve. Supply schedule
is a table that shows various quantities of a good or service that sellers are willing and able to
offer for sale at various possible prices during some specified period. A supply schedule is
presented below
Supply schedule shows that as price rises, a greater quantity is offered for sale. By plotting the
information contained in the supply schedule on a graph we can derive the supply curve as shown
below

The supply curve is a graph showing various quantities of a good or service that sellers are willing
and able to offer for sale at various possible prices. The supply curve slopes upwards because of
the direct relationship between price and quantity supplied.

Why there is a direct relationship between price and quantity supplied? The main reason is that
higher prices serve as an incentive for sellers to offer greater quantity for sale. The sellers or
producers can be induced to produce and offer a greater quantity for sale by higher prices.

Elasticity of Supply
Price elasticity of supply measures the responsiveness or sensitiveness of quantity supplied of a
commodity to a change in its price. It is given by the percentage change in the quantity supplied of
a commodity divided by the percentage change in price.

E= percentage change in quantity supplied

percentage change in price

Types of Supply Elasticity

When the supply curve is upward sloping, the elasticity of supply will be anything between zero
and infinity. On the basis of the value of the coefficient of elasticity of supply we can classify it
into the following five categories
(1) Perfectly inelastic supply
(2) Inelastic supply
(3) Unitary elastic supply
(4) Elastic supply
(5) Perfectly elastic supply

(1) Perfectly Inelastic Supply

When the quantity supplied of a commodity does not change at all in response to the change in
price, elasticity of supply is said to be perfectly inelastic. This is the case of zero elasticity (E = o)
and the supply curve will be vertical straight line
(2) Perfectly Elastic Supply
At any given price infinite quantity is supplied, supply is said to be perfectly elastic. The
coefficient of elasticity will be infinity (E = ∞ ) when supply is perfectly elastic. Perfectly elastic
supply curve is depicted by a horizontal supply curve parallel to quantity axis.

(3)Elastic Supply
If the percentage change in quantity supplied is greater than percentage change in price, supply is
said to be elastic. The value of the coefficient of elasticity will be greater than unity (E>1) when
the supply is elastic.

(4)Inelastic Supply
If the percentage change in quantity supplied is smaller than the percentage change in price,
supply is said to be inelastic. The value of the coefficient of supply will be greater than zero but
less than unity (E<1).
(5)Unitary Elastic Supply
If the percentage change in quantity supplied is equal to percentage change in price, supply is said
to be unitary elastic. The value of coefficient of elasticity will be equal to one (E =1) when supply
is unitary elastic.

Market Equilibrium

The market equilibrium occurs when the prevailing price equates quantity demanded to quantity
supplied. Consumers bring demand to the market for buying goods to satisfy their wants.
Producers or sellers bring supply of their goods to the market to sell them and earn profit. The
market demand and supply determine prices of goods and services exchanged between buyers and
sellers. Thus, market equilibrium is reached when market demand for and market supply of a good
are equal and as a result, equilibrium prices and equilibrium quantities are determined. At such
equilibrium, buyers find that they are able to buy exactly the same amount that they are
demanding at the prevailing price and sellers are able to sell exactly the amount they are willing to
supply at the prevailing price.

When the price of commodity X is Rs.1, buyers are willing and able to purchase 100 units but
sellers are willing and able to offer only 20 units for sale. Therefore, there is a shortage of 80
units. At price of Rs.5, buyers are willing and able to purchase only 20 units while sellers are
willing to offer 140 units. Therefore, there will be a surplus of 120 units in the market. Let us now
consider a price of Rs.3. At this price, buyers are willing to purchase 60 units and sellers are
willing to offer 60 units for sale. That is, at this price, there is neither a surplus nor a shortage.
Quantity supplied of commodity is equal to the quantity supplied. Thus P X = Rs.3 is the
equilibrium price and Q XS = QXD =6o is the equilibrium quantity.

The determination of equilibrium price and quantity can also be shown graphically by bringing
together the market demand and market supply curve on the same graph, as shown below.
The intersection of market demand curve DD and market supply curve SS at point E defines the
equilibrium price P* and the equilibrium quantity Q*. At the equilibrium price, quantity
demanded is equal to the quantity supplied. Because there is no excess demand or excess supply
there is no pressure for the price to change further.

Production CONCEPTS

Theory of Production

This chapter examines the theory of production or how firms combine resources or inputs to
produce final commodities.

Production refers to the transformation of resources/inputs into outputs of goods and services.
For example, General Motors hires workers who use machinery in factories to transform steel,
plastic, glass, rubber, and so on into automobiles. The output of a firm can either be a final
commodity such as automobiles or an intermediate product such as steel (which is used in the
production of automobiles and other goods). The output can also be a service rather than a good.
Examples of services are education, medicine, banking, legal counsel, accounting work,
communications, transportation, storage, wholesaling, and retailing.

Total Product refers to the total volume of goods and services produced by a firm. It is the total
physical output corresponding to each set of inputs.

Average Product is the product per unit of variable factor. It can be obtained by dividing the total
product by the number of units of the variable factor.

AP = TP or TP
No of units of variable factor L
Here ‗L‘ = value of the units of labour

Marginal Product is the additional product received by the firm due to the employment of an
additional unit of the variable factor. It is the addition to the total product when one more factor
input is used. It is also defined as the rate of change in Total product per unit change in the
variable factor.
MP = Change in TP
Change in L

Where, MP = The marginal Product

Production Function
Production function expresses the relationship between inputs outputs. It refers to how much
output can be produced with a given level of input. The output of a firm can change with the
change in inputs. Thus production function expresses the functional relationship between physical
inputs and physical outputs. It can be represented by a table, a graph, or and equation and shows
the maximum output of a commodity that can be produced per period of time with each set of
inputs.
It can be written as;
Q = f [F1,F2------Fn]
Where ‘Q’ is physical amount of a certain product, and
F1, F2,------Fn stand for various inputs needed to produce “Q”

Types of production function

It may be noted that to increase the physical quantity of ‘Q’ we will have to increase all factor
inputs or some of the factor inputs. Whether the firm can increase all factor inputs or only one of
these depends on the time period – that is, short period or the long period.

Short period is the period in which supplies of certain inputs are fixed while others are variable.
Therefore, the firm can increase output only by changing the variable factors.

In the long period supplies of all inputs are variable. Therefore, the firm can increase output by
changing all factors in the long run.

Among the various forms of production function we are mainly concerned with the two
qualitative forms of production function. They are:

I. Fixed proportion production function

Under fixed proportion we study input output relation where the application of all factors is varied
and proportion in which various factor inputs are combined remains the same. Production function
based on fixed proportion deals with the returns to scale. It explains the ‘Law of Returns to Scale’.

II. Variable proportions production function

In the variable proportions, we study the production function when the application of a single
factor is varied, while the application of all other factors is unchanged. Then the proportion in
which the various factor inputs are combined changes. Production function based on variable
proportions deals with the returns to a factor and explains the ‘Law of Variable Proportions’.

The Law of Variable Proportions

The law of variable proportions is the new name for the famous ‘Laws of Diminishing Returns of
the classical school. To be more precise, the law of variable proportions is a statement of more
general tendency than that of the Law of Diminishing Returns which focuses on the second stage
of production. The Law of Variable Proportions cover all the stages of production. It deals with
three stages of relations between inputs and output.
The Law states that “When more and more units of variable factor are combined with fixed
quantities of other factors, the increase in total production after a point, become smaller and
smaller”. That is, 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. Thus there are
three stages showing three different situations of returns as depicted below. In the figure TP is the
total product curve, MP is the marginal product curve and AP is the average product curve.

Stage I

This is the stage of increasing returns. Here total product (TP) is increasing up to the point F at
increasing rate. After this point, TP is increasing at a diminishing rate. It is because Marginal
Product Curve (MP) increases up to the point F and then it falls. The point F is called the point of
inflection.
Stage II

This is the stage of diminishing returns. Here the TP continue to increase at a diminishing rate
until it reaches its maximum at point H, where the second stage ends. In this stage both MP and
AP are diminishing but still they are positive. At this stage TP reaches its maximum point H when
MP is equal to zero. This stage is very crucial because it shows the maximum range upto which
production can undertook.

Stage III

This is the stage of negative returns. Here TP begins to fall because MP goes below the X axis
showing negative returns.
A rational producer will always seek to select the second stage since the first abd the third ones
are non-economical stages. The law of variable proportions is relevant only in the short run. In the
long run it may not happen so.

The following points about the diagram needs special attention.

1. When MP is greater than AP, AP rises.

2. When AP and MP become equal, AP is at the maximum.

3. When MP becomes less than AP, AP falls.

 4. When MP is equal to zero, TP is at the maximum.

5. MP is the maximum at the point of inflection of TP.

Assumptions of law of variable proportions

1. The technology remains constant. If there is improvement in technology, due to inventions,

the average and marginal product will increase instead of decreasing
2. Only one input factor is variable and other factors are kept constant
3. All the units of the variable factor are homogeneous
4. It is possible to change the factor proportions
5. Factors of production are scarce
6. The law operates in the short run

Reasons for the operation of Law of variable proportion

1. Imperfect substitutes – There is a limit to which one factor can be substituted for another. In
other words, two factors are not perfect substitutes. For example in the construction of
building, capital cannot fully substitute labour.
2. Scarcity of factors of production – Output can be increased only by increasing the variable
factors. In the short run certain input factors like land and capital are scarce. This leads tp
diminishing marginal productivity of variable factors
3. Economies and diseconomies of scale – The internal and external economies of large scale
production are available as production is expanded. Therefore average cost goes on
diminishing. But this continues only up to a certain stage. When the production is expanded
beyond a level, diseconomies start entering into production. Hence output will come down
4. Specialisation – The stage of diminishing returns comes into operations when the limit to
maximum degree of specialization reaches. This stage emerges when the fixed factor
becomes more and more scare in relation to the variable factor thereby giving less and less
support to the latter. As a result the efficiency and productivity of the variable factor
diminishes.

Law of Returns to scale

Returns to scale refers to the long-run production function. It represents the changes in output
when all factors or inputs in a particular production function are changed proportionately. In the
long run all inputs are variable. So returns to scale refers to change in output as a result of change
in all factors in the same proportion.

There are three types of returns to scale.

1. Increasing returns to scale

Increasing returns to scale happens when an increase in all factor inputs in a given proportion
causes a more than proportionate increase in output. When the scale of production increases, there
will be scope of specialization and division of lahour. This will result in internal and external
economies of scale. Internal economies occur as a result of the expansion of the individual firm.
External economies of scale are those economies which occur to all firms as the industry expands.
As a result, output increases higher than the increase in input.
2. Constant returns to scale

Constant returns to scale happens when an increase in all factor inputs in a given proportion
causes an equal and proportionate increase in output.

3. Diminishing Returns to Scale

Diminishing returns happen when an increase in all factor inputs in a given proportion causes a
less than proportionate increase in output. The increase of the scale of production beyond the
optimum capacity brings diseconomies of scale in the form of congestion confusion inefficiency,
etc. This is why diminishing returns occur. The three stages of returns to scale is illustrated below.

Assumptions of the law of returns to scale

1. All input factors are variable

2. There are no technological changes
3. There is perfect competition
4. The output is measured in quantities

Economies and Diseconomies of Scale

The term economies of scale refers to the advantages resulting when a firm increases its scale of
operation. The firm accrues technical, financial and managerial economies from large scale
production. As output increases, the firm‘s average cost of producing that output is likely to
decline. This can happen for the following reasons:
1. If a firm operates on a larger scale, workers can specialize in the activities at which they are
most productive.

2. Scale can provide flexibility. By varying the combination of inputs utilized to produce the
firm‘s output, managers can organize the production process more effectively.

3. The firm may be able to acquire some production inputs at lower cost because it is buying them
in large quantities and can therefore negotiate better prices. The mix of inputs may change with
the scale of the firm‘s operation if managers take advantage of lower-cost inputs.

The term diseconomies of scale refers to the disadvantages resulting from the very large scale
production. As the scale of production increases much it becomes difficult for the managers to co-
ordinate the business. Similarly, the advantages of buying in bulk may have disappeared once
certain quantities are reached. At some point, the supply of key inputs may be limited pushing
their costs up.

Cobb- Douglas Production Function

Paul H Douglas and CW Cobb of USA have studies the production of the American
manufacturing industries and they formulated a statistical production function. It is popularly
known as Cobb-Douglas Production Function. It is stated as follows:

Q = A L a K(1-a)

Where, Q = output
L = quantity of labour
K = quantity of capital
A = Total factor productivity
a = output elasticity of labour
(1-a) = output elasticity of capital.

In this production function the output (Q) is a function of two inputs L and K.

According to Cobb- Douglas production function, about ¾ of the increase in output is due to
labour and the remaining ¼ is due to capital. On this basis, Cobb-Douglas production function
can be expressed as under:

Q = AL 3/4 K 1/4

L+K = 3/4 +1/4 =1

An important point in Cobb-Douglas production function is that it indicates constant returns

to scale. It means that if each input factor is increased by one percent, output will exactly
increase by one percent. In other words there will be no economies or diseconomies of scale.

Importance of Cobb-Douglas Production Function

1. It is the most commonly used production function in the field of econometrics

2. It is suitable to all industries
3. It is useful in international and inter-industry comparisons
4. It is more popular in empirical research
5. It is useful in interpreting macroeconomic results

Limitations of Cobb-Douglas Production Function

1. It includes only two factors (Inputs). It neglects other inputs

2. It assumes constant returns to scale. It is not correct
3. It assumes perfect competition in the factor market. This is unrealistic
4. There is the problem of measurement of capital which takes only the quantity of
capital available for production
5. It is based on the substitutability of factors. It neglects complementarity of factors.
 MODULE 3

Concept of costs
Meaning

Cost is analysed from the producer‘s point of view. Cost estimates are made in terms of
money. Cost calculations are indispensable for management decisions.
In the production process, a producer employs different factor inputs. These factor inputs are
to be compensated by the producer for the services in the production of a commodity. The
compensation is the cost. The value of inputs required in the production of a commodity
determines its cost of output. Cost of production refers to the total money expenses (Both
explicit and implicit) incurred by the producer in the process of transforming inputs into
outputs. In short, it refers total money expenses incurred to produce a particular quantity of
output by the producer.

Concept of costs

1. Marginal costs
Marginal cost refers to the cost incurred on the production of another or one more
additional unit. It implies additional cost incurred to produce an additional unit of output. It
has nothing to do with fixed cost and is always associated with variable cost.

2. Average costs
Average costs refers to the cost per unit of output. It refers to the cost divided by the number
of units of output.

3. Fixed costs
Fixed costs are those costs which do not vary with either expansion or contraction in output.
They remain constant irrespective of the level of output. They are positive even if there is no
production. These costs are incurred on fixed factors like land, buildings, equipments, plants,
superior type of labor, top management etc.

4. Variable costs
variable costs are those costs which directly and proportionately increase or decrease with
the level of output produced. These costs are incurred on raw materials, ordinary labor,
transport, power, fuel, water etc, which directly vary in the short run
Cost Curves in the Short Run
Meaning of Short Run
Short-run is a period of time in which only the variable factors can be varied while fixed
factors like plant, machinery etc. remains constant. Hence, the plant capacity is fixed in the
short run. The total number of firms in an industry will remain the same. Time is insufficient
either for the entry of new firms or exit of the old firms. If a firm wants to produce greater
quantities of output, it can do so only by employing more units of variable factors or by
having additional shifts, or by having over time work for the existing labor force or by
intensive utilization of existing stock of capital assets etc. Hence, short run is defined as a
period where adjustments to changed conditions are only partial.

The short run cost function relates to the short run production function. It implies two sets of
input components – (a) fixed inputs and (b) variable inputs. Fixed inputs are unalterable. They
remain unchanged over a period of time. Hence, the costs of the firm in the short run are
divided into fixed cost and variable costs.

Average
Average Total Cost
Output Total Total Total cost Average Variable or
(in Fixed cost Variable (TC = Fixed cost Cost Average Marginal
units) (TFC) cost (TVC) TFC+TVC) (AFC) (AVC) Cost (AC) Cost (MC)
0 100 0 100 - - - -
1 100 20 120 100 20 120 20
2 100 30 130 50 15 65 10
3 100 40 140 33.3 13.3 46.7 10
4 100 60 160 25 15 40 20
5 100 90 190 20 18 38 30

Total Fixed Costs (TFC)

TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools &
equipments in the short run. Total fixed cost corresponds to the fixed inputs in the short run
production function. TFC remains the same at all levels of output in the short run. It is the
same when output is nil.
Total variable cost (TVC)
TVC refers to total money expenses incurred on the variable factor inputs like raw materials,
power, fuel, water, transport and communication etc, in the short run. Total variable cost
corresponds to variable inputs in the short run production function. It is obtained by summing
up the production of quantities of variable inputs multiplied by their prices.

Total cost (TC)

The total cost refers to the aggregate money expenditure incurred by a firm to produce a given
quantity of output. TC = TFC +TVC.
TC varies in the same proportion as TVC. In other words, a variation in TC is the result of
variation in TVC since TFC is always constant in the short run.
Average fixed cost (AFC)
Average fixed cost is the fixed cost per unit of output. When TFC is divided by total units of
output AFC is obtained, Thus, AFC = TFC/Q

AFC and output have inverse relationship. It is higher at smaller level and lower at the higher
levels of output in a given plant. The reason is simple to understand. Since AFC = TFC/Q, it
is a pure mathematical result that the numerator remaining unchanged, the increasing
denominator causes diminishing cost. Hence, TFC spreads over each unit of output with the
increase in output. Consequently, AFC diminishes continuously.

Average variable cost (AVC)

The average variable cost is variable cost per unit of output. AVC can be computed by
dividing the TVC by total units of output. Thus, AVC = TVC/Q. The AVC will come down in
the beginning and then rise as more units of output are produced with a given plant. This is
because as we add more units of variable factors in a fixed plant, the efficiency of the inputs
first increases and then it decreases.
The AVC curve is a U-shaped cost curve. The main reason for this U-shaped curve is the
operation of the law of variable proportion. As output increases, law of increasing returns
operates in initial stages. At this stage, when a firm increases its output, it gets economies and
the result is decline in average cost. After the point of optimum combination, economies turn
into diseconomies and result is increase in output and average cost. This is the stage of law of
diminishing returns.

Average total cost (ATC) or Average cost (AC)

AC refers to cost per unit of output. AC is the sum of AFC and AVC. Average total cost or
average cost is obtained by dividing the total cost by total output produced. AC = TC/Q. Also
AC is the sum of AFC and AVC. In the short run AC curve also tends to be U-shaped. The
combined influence of AFC and AVC curves will shape the nature of AC curve.
Marginal Cost (MC)
Marginal Cost may be defined as the net addition to the total cost as one more unit of output is
produced. In other words, it implies additional cost incurred to produce an additional unit. For
example, if it costs Rs. 100 to produce 50 units of a commodity and Rs. 105 to produce 51
units, then MC would be Rs. 5. It is obtained by calculating the change in total costs as a
result of a change in the total output. Also MC is the rate at which total cost changes with
output.
MCn = TCn –TCn-1 (or)

∆ 𝑇𝐶
MC =
∆𝑄

MC is independent of TFC and it is directly related to TVC as we calculate the cost of

producing only one unit. In the short run, the MC curve also tends to be U-shaped. The shape
of the MC curve is determined by the laws of returns. If MC is falling, production will be
under the conditions of increasing returns and if MC is rising, production will be subject of
diminishing returns.
Cost curves in Short Run

Shut Down Point

It is a situation in which the price falls below average variable cost and thus the firm is
forced to stop production or shut down because the firm in this situation will not be able to
recover its entire average cost. The firm will continue to produce as long as the price of the
commodity covers its average variable cost. As such shut down point is a situation where
average revenue of the firm is equal to its average variable cost.
As long as the market price is above the AVC of the firm, inspite of making losses, the firm
will cover all its variable costs and will wait until and hope to cover the fixed costs in the long
run.

Cost Curves in the Long Run

Meaning of Long Run
Long run is defined as a period of time where adjustments to changed conditions are
complete. It is actually a period during which the quantities of all factors, variable as well as
fixed factors can be adjusted. Hence, there are no fixed costs in the long run.

The LAC curve

Long run average cost is the long run total cost divided by the level of output. In brief, it is the
per unit cost of production of different levels of output by changing the size of the plant or
scale of production.
The long run cost – output relationship is explained by drawing a long run cost curve through
short – run curves as the long period is made up of many short – periods as the day is made up
of 24 hours and a week is made out of 7 days. This curve explains how costs will change
when the scale of production is varied.
The long run-cost curves are influenced by the laws of return to scale as against the short run
cost curves which are subject to the working of law of variable proportions.
In the short run the firm is tied with a given plant and as such the scale of operation remains
constant. There will be only one AC curve to represent one fixed scale of output in the short
run. In the long run as it is possible to alter the scale of production, one can have as many AC
curves as there are changes in the scale of operations. In order to derive LAC curve, one has
to draw a number of SAC curves, each curve representing a particular scale of output. The
LAC curve will be tangential to the entire family of SAC cures. It means that it will touch
each SAC curve at its minimum point. The lowest point of the curve denotes the optimal
combination of inputs for a particular plant size or scale of operations.

Breakeven Analysis
There may be a change in the level of production due to many reasons, such as competition,
introduction of a new product, trade depression or boom, increased demand for the products,
scarce resources, change in the selling prices of products etc. In such cases management must
study the effect on profit on account of the changing levels of production. A number of
techniques can be used an aid to management in this respect. One such technique is break
even analysis.

The term break even analysis is concerned with finding out the breakeven point, ie level of
activity where the total cost equals the total selling price.

It is also a system of analysis which determines the probable profit at any level of production.
The break even analysis establishes the relationship of costs, volume and profit; so this
analysis is also known as “Cost Volume Profit Analysis”.

Assumptions of break even analysis

1. All costs can be separated into fixed and variable costs
2. Fixed costs will remain constant and will not change with the change in the level of
output.
3. There will be no change in the operating efficiency
4. Variable costs will fluctuate in the same production in which the volume of output
 5. Selling price remains constant even though there may be competition or change in
the volume of production
6. The number of units produced and sold will be the same as there is no opening stock
7. There is only one product or in the case of many products, product mix will remain
unchanged

Objectives of Break even analysis

1. This analysis helps to forecast profit fairly accurately as it is essential to know the
relationship between profits and costs on one hand and the volume on the other
2. The analysis is useful in setting up flexible budgets which indicate costs at various
levels of activity. Sales and variable costs tend to vary with the volume of output. It is
necessary to budget the volume first for establishing budgets for sales and variable
costs.
3. The analysis assists in evaluation of performance for the purpose of control. In order
to review profits achieved and costs incurred, it is necessary to evaluate the effects
on cost of changes in volume
4. The analysis also helps to formulate price policies by showing the effect of different
price structures on costs and profits. We are aware that pricing plays an important
part in stabilising and fixing up volumes especially in depression periods.
5. The analysis helps to know the amount of overhead costs to be charged to the
product cost at various levels of operation as we know that pre determined overhead
rates are related to a selected volume of production

Disadvantages of break even analysis

1. Assumes that all goods produced are sold
2. Fixed cost is assumed to remain constant. But it may change sometimes
3. Assumption of variable cost per unit is constant at all levels of output and constant price of
product may be unrealistic

Construction of Break even chart

1. Mark out the scales on the paper. The vertical axis will record costs and revenues. The
horizontal axis records the Units of output.
2. Draw fixed cost line
3. Draw variable cost line
4. Plot total costs
5. Plot total revenue
6. The level of output at which the firm just breaks even can now be shown by drawing a
vertical line down to the horizontal axis from when the total cost = total revenue
Break even chart

The break-even analysis can be shown graphically which is known as the break-even
chart. A break-even chart is the graphic approach to the study of the relationship of cost,
revenue and profit. Costs are fixed costs and variable costs. Fixed costs are the costs which
remain fixed for all practical purposes to a certain level of activity. Eg cost of plant and
machinery, salaries, rent etc. Variable costs vary in proportion to output. Cost of material,
wages etc are examples of variable costs.

The main objective of break-even analysis is to find the cut-off production volume from
where a firm will make profit. Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
S=s x Q

The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
= (v x Q) + FC

The intersection point of the total sales revenue line and the total cost line is called the
break-even point.
The corresponding volume of production on the X-axis is known as the break-even sales
quantity.
At the intersection point, the total cost is equal to the total revenue. This point is also called
the no-loss or no-gain situation. For any production quantity which is less than the break-
even quantity, the total cost is more than the total revenue. Hence, the firm will be making
loss.
For any production quantity which is more than the break-even quantity, the total revenue
will be more than the total cost. Hence, the firm will be making profit.
Profit = Sales – (Fixed cost + Variable costs)
= s x Q – (FC + v x Q)
Mathematical approach to cost volume profit analysis
In order to understand the relationship between Cost, volume and profit, it is necessary to
understand the following terms:
1. Contribution
2. Contribution/sales or Profit/volume ratio
3. Break even Point

1. Contribution
Contribution is the difference between the sales and the marginal cost of sales (variable
cost) and it contributes towards the fixed expenses and profit.
Contribution = Selling price – Marginal/variable cost
Or
Contribution = Fixed expenses + Profit
Or
Contribution – Fixed expenses = Profit

2. Contribution/Sales or Profit volume (P/V) ratio:

This ratio is calculated as under:
P/V ratio = Contribution
Sales
= Fixed expenses + Profit
Sales
= Sales – Variable costs
Sales
= Changes in profits or contributions
Changes in sales

Comparison of P/V ratios for different products can be made to find out which product is more
profitable. Higher the P/V ratio, more will be the profit and lower the P/V ratio, lesser will be the
profit. Hence, it should be the goal of every concern to increase or improve the P/V ratio. It can
be done by:
a) Increasing the selling price per unit
b) Reducing the direct and variable costs by effectively utilising men, machines and materials
c) Switching the production to more profitable products showing a higher P/V ratio

The P/V ratio is very useful and is used for the calculation of:
1. Break – even point = Fixed costs
P/V ratio
2. Value of sales to earn a desired amount of profit

= Fixed costs + Desired Profit

P/V Ratio
3. Margin of safety = Profit
P/V Ratio
Mathematical approach to Breakeven analysis

1. Break-even quantity (in units)

= Fixed cost__________
Selling price/unit -Variable cost/unit

𝐹
BEP (in units) =
𝑆−𝑉

2. Break-even sales (in Rs. ) =

Fixed cost__________ x Selling price per unit
Selling price/unit -Variable cost/unit

𝐹
BEP (in Rs.) = xs
𝑆−𝑉

3. Output to earn sales value (in units) =

Fixed costs + Desired Profit__________
Selling price per unit – variable cost per unit

𝐹+𝑃
=
𝑆−𝑉

4. Output to earn sales value (in rupees) =

Fixed costs + Desired Profit x selling price per unit
Selling price per unit – variable cost per unit

𝐹+𝑃
= xs
𝑆−𝑉

5. Margin of safety= Present sales – Breakeven sales

Example: From the following particulars calculate i) Break-even point in units and in rupees
ii) What will be the selling price per unit if the break-even point is brought down to 25,000
units?
Fixed expenses Rs 1,50,000
Variable cost per unit Rs 10
Selling price per unit Rs 15

Solution:
i) Break-even point in units = ____Fixed cost_____
Selling price- Variable cost
= 150000 = 30,000 units
5
ii) Break-even point in rupees = Fixed cost____ x Selling price per unit
Selling price- Variable cost
 = 30000 x 15 = Rs 4,50,000
v) Break-even point in units = Fixed cost_____
Selling price- Variable cost
25000 = 150000 __
S-10

Selling price = Rs 16

Example :
Consider the following data of a company for the year 2014:
Sales = Rs. 1,20,000
Fixed cost = Rs. 25,000
Variable cost = Rs. 45,000
Find Margin of Safety

Solution:
Break-even point in rupees = Fixed cost____ x Selling price per unit
Selling price- Variable cost
= Rs 40000

Margin of Safety = Present sales – Breakeven sales

= Rs 120000 -40000
= Rs 80000

Eg . Alpha Associates has the following details:

Fixed cost = Rs. 20,00,000
Variable cost per unit = Rs. 100
Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity, (b) The break-even sales
(c) If the actual production quantity is 60,000,
find (i) contribution; and (ii) margin of safety by all methods
Solution
One day you will wake up and there won’t be any
more time to do the things you’ve always wanted.
Do it NOW.”
 MARKETS

MEANING OF MARKET
The word ‘Market’ is generally understood to mean a particular place or locality where goods
are sold and purchased. However, in economics, the term ‘market’ do not mean any
particular place or locality where transactions take place. What is required for a market is
the existence of contract between sellers and buyers so that transactions take place at an
agreed price between them. The seller and buyer may be spread over a whole region,
sometimes in different countries, but they contact and communicate and sell and buy
commodities.

The essentials of a market are : 1. A commodity to deal with. 2. The existence of buyers and
sellers. 3. A place, it may be a particular place, a region or the whole country or the entire
world. 4. The facilities for free interaction between sellers and buyers.

Based on the territorial spread of the area, markets may be classified in to local market,
regional market, national market or international market.

On the basis of the degree of competition, i.e., on the basis of the number of sellers and buyers
and the various practices adopted in the market, markets are classified into:
1. Perfectly competitive markets. 2. Monopoly market 3. Monopolistically competitive
market, 4. Oligopoly markets.

I. Perfect Competition Market

Feature of a Perfectly Competitive Market
a. Large No of buyer and sellers. In a perfectly competitive market there should be a large
number of buyers and sellers in the market. The action of individual buyers or sellers do not
influence market price.
b. Homogenous Product- Perfectly competitive market condition assumes that the producers
produce identical products. Products of all producers are similar to one another.
c. Uniform market price. Because of the identical nature of the product and other unique
features, it is assured that a uniform market price prevail-All sellers sell their products at the
same price.
d. Freedom of entry and exit. Perfect competition assumes an open market without barriers
for the entry and exit of new firms.
e. Perfect Knowledge on the part of buyers about the product and seller about the market and
market conditions.
f. No Transport cost. It is assured that in a perfectly competition market, there is no transport
cost.
g. Free mobility of factors of production also is assumed in a perfectly competition market.
Price and Output determination under Perfect Competition

Under perfect competition, price of a commodity is determined by the interaction of

demand and supply not by any one seller or a firm.

In the figure shown above, the total demand curve DD1 intersects industry’s supply
curve SS1 at point E. thus point E is the equilibrium point and OP is the equilibrium price. The
second figure refers to firm’s demand curve. The firm will have to sell at its output at the
prevailing price OP. It may sell more units or fewer units, but will charge OP Price only. The
firm can neither increase nor decrease this price; because price is determined by the industry
and not by the firm.

II. Monopoly Market

‘Mono’ means one and ‘poly’ means seller. Monopoly is said to exist when one firm is the
sole producer or seller of a product which has no close substitutes.

The following are important features of monopoly.

1. There is a single producer or seller of the product. Entire supply of the product comes
from this single seller. There is no distinction between a firm and an industry in a monopoly.
The firm and industry are identical in monopoly.
2. There is no close substitute for the product. If there are some other firms which are
producing close substitutes for the product in question there will be competition between
them. In the presence of competition a firm cannot be said to have monopoly. Monopoly
implies absence of all competition.
3. There is no freedom of entry. The monopolist erects strong barriers to prevent the entry of
new firms. The barriers which prevent the firms to enter the industry may be economic or
institutional or artificial in nature. In the case of monopoly, the barriers are so strong that
prevent entry of all firms except the one which is already in the field.
4. The monopolist is a price maker. But in order to sell more a monopolist has to reduce the
price. He cannot sell more units at the existing price.
5. Price Discrimination - a monopoly firm might charge different prices to different groups
of buyers. This pricing technique is called price discrimination
6. The monopolist aims at maximisation of his profit

Source and Types of Monopoly

The following five types of entry barriers have historically been associated with the presence
of monopoly.
1) Control of inputs
Some firms acquire monopoly power from their overtime control over certain scarce inputs or
raw materials that are essential for the production of certain other goods, e.g. bauxite,
graphite, diamonds etc. such monopolies are often called raw material monopolies. The
monopolies of this kind may also emerge because of monopoly over certain specific technical
knowledge or technique of production.
2) Economies of scale
The technology of production for a product may be such that one large producer can supply
the entire market at a lower per-unit cost than can several firms sharing the same market.
3) Patents
Another source of monopoly power is the patent rights of the firm for a product or the
production process. The exclusive right to use the productive technique or to produce a certain
product granted by the government is called patents. Patents are granted to the inventor for a
technique or product, and they amount to the legal right to a temporary monopoly. Such
monopolies are called patent monopolies
4) Legal Restrictions
Some monopolies are created by law in public interests. Most of the state monopolies in the
public utility sector, including postal, telegraph, generation and distribution of electricity,
railways etc are public monopolies. The state may create monopolies in the private sector
through license or patents. Such monopolies are called franchise monopolies.
5) Entry Lags
The time needed to enter the market can act temporarily to shield an existing producer from
competition. Thus, the first firm to market some product will usually enjoy some monopoly
position. If the product turns out to profitable, entry is likely to occur as rapidly as
technological conditions permit.

Types of monopoly
1) Natural monopoly – This is the outcome of natural factors and not due to man made efforts.
Eg a company may be owning a well which supplies mineral water. Bengal has natural
monopoly of jute.
2) Legal monopoly – Sometimes the law of the country grants exclusive rights to an
individual or to a group of firms. All monopolies protected by the law of the country are
called legal monopolies.
3) Social monopolies – These are owned and managed by the government. Aim is not to make
maximum profits. Eg railways, posts etc
4) Voluntary monopolies – These are created voluntarily by the person concerned or by the
firms concerned. For eg. ACC cement is a voluntary monopoly created to eliminate
competition and to have greater profits by fixing a high price of the cement.
5) Discriminating monopoly – If monopoly firm charges different prices from different groups
of customers, it is called discriminating monopoly.

Difference between perfect competition and monopoly

Perfect competition Monopoly
1. Many sellers 1. Single seller
2. Individual seller has no control over the 2. Complete control over the market
market
3. Product is homogeneous 3. Product has no close substitute
4. Entry is free and easy 4. Entry is blocked
5. Competition is perfect 5. No competition
6. Uniform price 6. Different prices in discriminating
monopoly
Price and output determination under monopoly

The demand curve or average revenue curve is relative elastic and is downward
sloping from left to right. Further, in monopoly, since average revenue falls as more units of
output are sold, the marginal revenue is less than the average revenue. In other words, under
monopoly, the MR curve lies below the AR curve. The equilibrium level in monopoly is that
level of output in which Marginal Revenue equals Marginal Cost.

It can be seen from the diagram that till OQ output, MR is greater than MC, but
beyond OQ the MR is less than MC. Therefore, the monopolist will be in equilibrium at
output OQ where MR is equal to MC and the profits are the greatest.

III. Monopolistic competition

Competition and monopoly lie at opposite ends of the market spectrum. Perfect competition
and monopoly are rarely found in the real world and thus they do not represent the actual
market situation.

The Nature of Monopolistic Competition

As the name implies, monopolistic competition contains the element of both pure competition
and monopoly. The competitive element arises from the fact that there are many sellers of the
differentiated product, each of which is too small to affect other sellers. Firms can also enter
and leave the monopolistically competitive industry rather easily in the long run. The
monopolistic element arises from product differentiation. That is, since the product of each
seller is similar but not identical, each seller has a monopoly power over the specific product
it sales. Thus, monopolistic competition may be defined as a market structure where there are
many sellers who sell differentiated products which are close substitutes of one another. Each
producer under monopolistic competition enjoys some degree of monopoly and at the same
time faces competition.
The following are important features of monopolistic competition.
1. Large number of sellers
The market consists of relatively large number of sellers or firms each satisfying a small share
of the market demand for the commodity. Unlike perfect competition, these large numbers of
firms do not produce homogeneous products. Instead they produce and sell differentiated
products which are close substitutes of each other. Thus there is stiff competition between
them.
2. Product Differentiation
Product differentiation is a key feature of monopolistic competition. Product differentiation is
a situation in which firms use number of devices to distinguish their products from those of
other firms in the same industry. Products produced by the firms are close substitutes of each
other. Products are not identical but are slightly different from each other. In case of
monopoly, there is only one product and only one seller, and under perfect competition, a
large number of sellers sell homogeneous product. But under monopolistic competition, the
firms can differentiate their products from one another in respect of their shape, size, color,
design, packaging, etc.
3. Non price competition: Selling cost
Firms incur considerable expenditure on advertisement and other selling costs to promote the
sales of their products. Promoting sales of their products through advertisement is an
important example of non-price competition. Selling cost is the advertisement cost plus
expenditure on sales promotion schemes, salary and commission paid to sales personal,
allowance to retailers for displays and cost of after-sale-services.
4. Freedom of entry and exit
In a monopolistically competitive industry, it is easy for new firms to enter and the existing
firms to leave it. As in the case of perfect competition, there is no barrier on the entry of new
firms and exit of old ones from the industry. Firms will enter in to the industry attracted by
super normal profit of existing firms and existing firms will leave industry if they are making
losses
5. There is absence of perfect knowledge. That is buyers and sellers do not have perfect
knowledge about market conditions
6. There is no uniform price. Different producers charge different prices for their products
because products are differentiated in some way.

Price and output determination under monopolistic competition

Each firm fixes such price and output which maximizes its profit. The equilibrium
price and output is determined at a point where the short- run marginal cost equals marginal
revenue. In the figure, the short – run marginal cost curve cuts the marginal revenue curve at
E. this equilibrium point establishes the price QA and output OQ. As a result the firm earns
super normal profits represented by the area PABC.
IV. Oligopoly Market
Oligopoly is said to prevail when there are a few sellers or firms in the market producing or
selling either homogeneous or differentiated products. In other words, when there are two or
more than two, but not many, producers or sellers of a product, oligopoly is said to exist.
Oligopoly is often referred to as “competition among the few”.

Features of oligopoly market

1. Few firms – There are a few large firms. Each firm produces significant amount of total
output. There exists severe competition among different firms and each firm tries to
manipulate both prices and volume of production. Eg market for automobiles in India.
2. Interdependence – Action of one firm affects the action of others.
3. Selling costs – There exists large amount of selling costs. Firms incur considerable
expenditure on advertisement and other selling costs to promote the sales of their products
4. Homogeneous or differentiated products – Homogeneous products as in case of cement,
steel etc. Differentiated product as in case of automobiles, computers etc
5. Elements of monopoly – This is because there exists product differentiation.
6. Barriers to entry – This is because of the exclusive resource ownership, patents and
copyrights, government restrictions, high start up costs etc

Price output determination – Kinked demand curve model

The kinked demand curve model was developed by Paul M Sweezy in 1939. Kinked
demand curve explains price rigidity under oligopoly on the basis of following assumptions.

1. If a firm increases its price, others will not follow

2. If a firm decreases its price, others will also do the same.
The kinked demand curve theory is explained with the help of the above figure. According to
this theory, each firm faces a demand curve kinked at the prevailing market price. The
demand curve for an oligopolistic firm is represented by the AR curve. At price P1, the firm is
producing Q1 units of output. At point X the demand curve is kinked: there is a sharp change
in the slope of the curve.

The kink in the demand curve represents the assumed reaction of competing firms to a change
in the oligopolistic firm’s price. If the firm raises its price above the market price above the
market price P1, and other firms do not raise their prices, the firm will lose sales and much of
its market share. Thus, at prices above P1, the demand curve is very elastic. But if the firm
reduces its price and its competitors do not, the firm will increase its market share. Other
firms will reduce their prices. They will not want to lose their shares in the market. Thus the
firm cannot expect to increase its sales at the expense of the remaining firms in the oligopoly.
To the left of point X, demand curve is very elastic and to the right of point X, demand curve
is less elastic, indicating that if one firm reduces its price, all other firms in the industry will
reduce their prices and the sales of each firm will increase only slightly.

Comparing perfect competition, monopoly and monopolistic

competition
Sl Reference Perfect Monopoly Monopolistic
No Competition competition
1 No of Sellers & Large One seller, but Large
buyers large no of
buyers
2 Product Homogeneous Homogeneous or Product differentiation
differentiated
3 Price Uniform Not uniform Not uniform because
because of price of product
discrimination differentiation
4 Entry of firms Free entry Not possible No absolute freedom
5 Knowledge of Perfect knowledge Imperfect Imperfect knowledge
market conditions knowledge
6 Firms demand Perfectly elastic Relatively less Relatively more elastic
curve elastic
7 Slope of firms Horizontal straight Slopes downward Slopes downward with
demand curve line (AR=MR) with low high elasticity
elasticity (AR>MR)
(AR>MR)
8 Degree of price No control over Full control on Partial control over
control price price price

Cartel and Collusion

Collusion model recognizes that oligopoly firms depend on each other for their price-output
decision making. They enter into an agreement for the price and output levels. When this
agreement is formal and overt (open), the group of firms that operate under it for
determining their price and output levels form what is known as cartel. Some formal
agreements are however not possible in all countries. Cartels imply agreements among
competing oligopolistic with the aim of reducing the uncertainty arising from their mutual
interdependence. Where they are illegal, firms operate under a covert (hidden) and informal
agreement to decide their price-output levels. Such an informal agreement is called collusion.

The best example of a cartel today is the Organisation of Petroleum Exporting Countries
otherwise known as OPEC which comprises 14 oil-producing nations that supply 60% of all
oil traded internationally. Prices are maintained by restricting each country of the OPEC
Cartel.

A cartel or collusion is probably the best way to price products in an oligopoly. This is
because when firms are under an agreement for defining their price and output levels, they
almost act like monopolist entities. The firms can then extract the maximum from their
customers. In the process almost all firms will be benefitted and will be able to price their
products so as to maximize the total profits of the industry. Decision making under such an
arrangement, whether formal or informal, will be centralized. Firms will dissolve their
individual decisions into a joint decision that will be applicable to all firms. The combined
centralized authority, i.e. collusion or cartel will decide the price-output levels in the manner
that the total profits of the industry will be maximized.

“The secret of life is to fall seven times and to get

up eight times.”
 MODULE 4

CIRCULAR FLOW OF INCOME

Stock and Flow concept
Stock – Quantity measured at a point of time. Eg Bank balance on a particular date
Flow – Quantity measured over a period of time. Eg Income

Four sectors of the economy

1. Household sector – Includes consumers of goods and services. They are also the
owners of factors of production
2. Producer sector – includes all producing units (firms) in the economy. For production
of goods and services the firms purchase factors of production (land, labour, capital
and entrepreneurship) from households.
3. Government sector – Includes i) Government as welfare agency and ii) Government as
producer
4. External sector (Rest of the world/Foreign sector) – Includes all such activities related
to export and import of goods, and flow of capital between domestic economy and rest
of the world.
2 sector economy
Households and businesses are the two major entities in a simple economy. Business
organizations use various economic resources like land, labour and capital which are provided by
households to produce consumer goods and services which will be used by them. Business
organizations make payment of money to the households for receiving various resources. The
households in turn make payment of money to business organizations for receiving consumer
goods and services. This cycle shows the interdependence between the two major entities in a
simple economy.

3 sector economy

In a 3 sector economy there exists in addition to the businesses and the households, there is a third
sector namely the banking sector. The banks function to collect savings from the businesses and
households and to lend money to them.
4 sector economy

In a four sector economy, in addition to businesses, households and banks, there is a fourth sector
the Government sector. Flow to the Government from Households and businesses are in the form
of taxes. The flow from Government to Households is in the form of salaries, pensions etc. The
flow from Government to businesses is in the form of subsidies.

Multi sector economy

In a multi sector economy, in addition to businesses, households and banks, the Government
sector, there is a fifth sector, foreign sector. Flow to the foreign sector from Households and
businesses are in the form of payment for imports. The flow from foreign sector to Households is
in the form of payment for factor services. The flow from foreign sector to businesses is payment
for exports.
 NATIONAL INCOME CONCEPTS
Introduction
Economic growth of a country measured with the help of change in its national income. The
rate of growth of national income of an economy is indicative of the pace at which the
economy has been growing. The rate of growth of national income when compared with the
rate of growth of population indicates whether the economy is declining, stagnant or
developing.

Sources of Income
Following are the different sources of income
a) Income from work: People earn income mainly from work.
b) Income from property: Properties like land, building, factories, machinery etc. can be lent out
to others to earn income. The income so earned is called rental income.
c) Royalties:-Income earned by those who own mineral wealth like iron ore, coals, natural gases
etc. and by those who possess copy rights, patents etc. (intellectual property).
d) Dividends:-People can earn dividends by investing the surplus income in stocks and shares.
e) Interest:-The surplus income used for purchasing bonds or debentures or lending to banks or
other agencies may yield interest income .

CONCEPTS

1) Gross Domestic Product (GDP)

GDP is the money value of all final goods and services produced in the domestic territory of a
country during a year is called GDP.

Domestic territory of a country includes the following :

a. Political boundary including territorial waters

b. Ships and aircrafts operated by the residents of a country between two or more countries.
 c. Fishing vessels, oil and natural gas rigs operated by the residents of a country in the
international waters or where the country has exclusive rights to operate
d. Embassies, consulates and military establishments of the country located in other
countries
Normal residents of a country include all persons who ordinarily live in a country at least for
one year and whose economic interest belongs to that country are called the normal residents
of a country.

GDP includes the following components:

a) Value of goods and services used for ultimate consumption (C)
b) Value of capital goods used for investment purposes (I)
c) Government expenditure – refers to value of goods produced and services offered by
government (G)
d) Net receipts from abroad in terms of excess of value of exports (E) and imports (I) . Net
receipts (E-I)

GDP can be estimated both at market prices and at factor costs.

GDP at market price
GDP at market price is defined as the money value of all final goods and services produced in
the domestic territory of a country during an accounting year estimated at the prices prevailing
in the markets.
GDP at market price = C + I + G + (E-I)

GDP at factor cost

It is the estimation of GDP in terms of the earnings of factors of production. GDP at factor
cost is the sum total of the earnings received by the factors of production in terms of wages,
rent, interest and profit.
GDP at factor cost = (GDP at market price) – (Net Indirect Taxes)
Where , Net Indirect Taxes = Indirect Taxes – Subsidies

2) Gross National Product

GNP is defined as the money value of all goods and services produced by the nationals of a
country within the country and outside the country during a year.

GNP at market price = GDP at market price + Net Factor Income From Abroad (NFIA)

GNP includes the following components:

a) Value of goods and services used for ultimate consumption (C)
b) Value of capital goods used for investment purposes (I)
c) Government expenditure – refers to value of goods produced and services offered by
government (G)
d) Net receipts from abroad in terms of excess of value of exports (E) and imports (I) . Net
receipts (E-I)
e) Net income transfers from abroad- Payments received from other countries (R) minus
payments made to other countries (P) . Net income transfers is (R-P). It is also called as Net
Factor Income from abroad (NFIA). NFIA is the difference between the income received from
abroad by the residents of a country for rendering factor services and the income paid for the
factor services rendered by the non residents in the domestic territory of a country

Gross National Product at factor cost

GNP at factor cost = GNP at market price – NIT
3) Net Domestic Product (NDP)
Net Domestic Product is Gross Domestic Product minus depreciation or consumption of fixed
capital.
Depreciation or consumption of fixed capital refers to the loss of value of fixed capital due to
wear and tear in the process of production.

NDP at market price and factor cost

NDP at market prices is the market value of all final goods and services produced within the
domestic territory of a country less depreciation during a year.
NDP at market prices includes the contribution of foreigners residing the domestic territory of
a country. However, which excludes the contribution of the citizens of the country residing
abroad.

NDP at market price = GDP at market price – depreciation.

NDP at factor cost = NDP at market price – net indirect taxes

4) Net National Product (NNP) at market prices

It can be defined as the total value of final goods and services produced in an economy after
allowing depreciation
NNP at market price = GNP at market price – depreciation

5) Net National Product at factor cost or National Income

National income is the money value of all final goods and services produced in a country
during a financial year. National Income broadly means the income earned by the residents of a
country from work and property in an accounting or financial or fiscal year. In India, an
accounting year is from 1st April of a calendar year to 31st March of the next calendar year.

NNP at factor cost is defined as the volume of goods and services turned out in country during
an accounting year or it is the net value added at factor cost in country during a year. Or it is
the sum total of domestic factor incomes and net factor incomes from abroad. Thus,

NNP at factor cost or National Income = NNP at market prices - NIT

6) Personal Income
Personal income is the income received by the households and non corporate business in a
country during a year.
Personal income = National Income – corporate profits –corporate income taxes - social
security Contributions + transfers from Government to individuals

7) Disposable income
Disposable income is the income actually available to the households and to the non corporate
business after they have fulfilled their tax obligation to the government. That is, it is the
income actually available to the individuals for saving and consumption.
Disposable Personal Income = personal income – personal tax .

8) Per capita Income

It is the average per person national income.
Per capita Income = National income / Population
METHODS OF MEASURING NATIONAL INCOME
There are the three methods of calculating national income. The choice of a method depends
upon the availability of data. GDP is the measure of an economy’s total output. It is also used
as a measure of total income and total expenditure in that economy. Incomes received by
individuals is being spent to buy the output of goods and services produced. Hence the income
is equal to expenditure and expenditure is equal to the value of output produced in the
economy.

Income = Expenditure = Output

I. Product Method
This is also called the output method, the inventory method or the census method. It consists
of finding out the market value of all the goods and services produced during a year.
According to this method the economy is classified into different sectors. The various sectors
are Primary sector consisting of agriculture, fishing and mining; Secondary sector consisting
of industrial sectors and Tertiary sector consisting of service sector. In each sector we make
an inventory of goods produced and find out the end product making an addition to the value
of goods. The value added method can be followed in order to avoid double counting. The
value added of a firm is its output less whatever it purchases from other firms such as raw
materials, and other inputs

II. Income Method

It measures GDP as the sum of incomes earned by factors of production like land, labour,
capital and enterprise in the form of rent, wages, interest and profits. To arrive at the totality
of income of nation, the following procedure will be adopted:
a) Net rents include the rental value of owner occupied houses.
b) Wages, salaries and all such earnings of person employed, pensions are excluded.
c) Earnings by way of interest.
d) Income of joint stock companies.
e) Income from overseas investment.
This method gives national income at factor cost.

III. Expenditure Method

This method is also called the flow of product approach or the outlay method.
Here we take into account the expenditure on finished products-
 Expenditure by consumers on goods and services.
 Expenditure by producers on investment of goods.
 Expenditure by government on consumption as well as capital goods.
 Net exports ie exports minus imports

Difficulties in measurement of National Income

1. Non monetized sector – In India the bulk of goods and services produced do not come
to market for sale; these are either consumed by the producers themselves or
exchanged through barter system of exchange. So it becomes difficult to find out the
market value of production
2. Lack of distinct differentiation – In India large number of workers are engaged in
many activities simultaneously. Thus it becomes difficult to estimate the National
income in different economic activities.
3. Black money – A significant part of the economy operates through black money.
Economic activities are not reported or are under- reported. This is done in order to
evade taxes. So estimates of National income becomes wrong
 4. Non – availability of data about certain incomes – data about incomes of small
producers and household enterprises is not available. Hence estimates may go wrong
5. Fluctuation in price levels – Fluctuations make the measurement of national income
unstable.

INFLATION

Inflation
Inflation simply means a continuous increase in general price level. It can be described as a
decline in the real value of money or a loss of purchasing power in the medium of exchange.
When the general price level rises, each unit of currency buys fewer goods and services.
Inflation has been defined in several ways by different economists. Inflation is too much of
money chasing too few goods.

The rate of inflation is measured through Wholesale Price Index (WPI) or Consumer Price
Index (CPI) or GDP Deflator.

Features of inflation:
1. It is the situation of rising prices
2. It is the situation where supply of money is rising. Situation of more money chasing
less number of goods
3. Money buys less when price levels rises, Purchasing power decreases
4. The value of money decreases

Types of inflation
1. Demand pull inflation – When there is excess demand beyond the output capacity of
the economy to supply goods and services, it contributes to the rise in inflation. When
excess demand is responsible for inflation, it is called demand pull inflation. Excess
demand may result due to increase in money supply. This is also known as demand
pull inflation
2. Cost push inflation - When inputs such as wages, raw materials and overheads costs
more, the prices of finished products are also pushed up. When final prices rise as a
result of increase in input costs, it is called cost-push inflation
3. Creeping inflation – This is slow moving and a very mild inflation. When general
price level rises mildly say to 2% annually, it can be called creeping inflation.
4. Deficit induced inflation – When the Government adopts deficit budget, and when
deficit increases, this leads to inflation
5. Ratchet inflation – In some sectors, the demand for the goods is excessively high and
supply is lagging behind the excessive demand and as a result the prices of the
commodity shoots up.
6. Running inflation – The rate of increase in the general price level reached double
digit in the case of running inflation.
7. Galloping inflation – In the case of galloping inflation, the general price level reaches
double digits or even triple digits. The rate of increase in inflation may be 50%
8. Hyper inflation – Money becomes worthless and it is better to hold stocks of goods
and assets rather than money. Every minute, the value of money changes so much so
that people may have to carry bags of currency with them to purchase daily use goods.
Causes of inflation
I] Factors affecting demand
a) Increase in money supply – Inflation is caused by an increase in money supply which
leads to an increase in aggregate demand. The higher the growth rate of money supply,
the higher is the rate of inflation
b) Increase in disposable income – When the disposable income of people increases, it
raises their demand for goods
c) Increase in consumer spending – The demand for goods and services increases when
consumer expenditure increases when consumer expenditure increases. They may also
spend more when they are given credit facilities to buy goods on hire purchase and
installment basis
d) Cheap monetary policy – Cheap monetary policy leads to an increase in the money
supply which raises the demand for goods and services. It raises the money income of
the borrowers which in turn raises the demand. [ Cheap monetary policy refers to a
situation where interest rates on loans are decreased so that money is available to the
public at cheap rates.]
e) Black Money – People have a general tendency to spend unearned money
extravagantly. This leads to unnecessary demand for commodities. This leads to a rise
in price level
f) Increase in exports – When the demand for domestically produced goods increases in
foreign countries, this raises the earnings of industries producing export commodities
which in turn creates more demand for goods and services

II] Factors affecting supply

g) Shortage of factors of production – One of the important factors affecting the supply
of goods is the shortage of factors such as labour, raw materials, etc. They lead to
excess capacity and reduction in industrial production
h) Industrial dispute – In countries where trade unions are powerful, they can also restrict
production
i) Natural calamities – Natural calamities likes droughts, floods etc affects the supply of
agricultural products
j) Artificial scarcities – It is created by speculators who indulge in black marketing. They
reduce the supply and raise the prices
k) Increase in exports – When the country produces more goods for export than for
domestic consumption, this creates shortages of goods in domestic market. This leads
to inflation in the economy

Effects of inflation
a. Inflation reduces the standard of living of people who live on fixed income such as
pensioners and landlords
b. Interest rates rise due to two reasons. First lenders, require higher rewards, as there is a fall
in the value of money. Hence they charge a higher interest rate as a compensatory measure.
Second, the government may increase the bank rate through the central bank in order to
control inflation. As a result commercial banks are also compelled to increase their lending
rates.
c. People will not feel like saving as they expect further erosion in the value of money and
hence they feel like saving by postponing consumption.
d. They also feel it is safer to invest in goods rather than saving money
e. Social and political effects – Inflation disrupts social life by favouring rich and black
markets. People lose faith in democratic government due to inflation
Measures to control inflation
Measures are of three types:
a. Monetary Measures
b. Fiscal measures
c. Price control

A. Monetary measures
The best remedy for fighting inflation is to reduce the aggregate spending. Monetary policy
can help in reducing the pressure of demand. Monetary policy works by controlling the cost
and availability of credit. During inflation, the Central bank can raise the cost of borrowing
and reduce the credit-creating capacity of the commercial banks. This will make borrowing
more costly than before and thereby the demand for funds will be reduced. Similarly with a
reduction in their credit-creating capacity, the banks will be more cautious in their lending
policies. The result will be fall in the volume of spending.
The main methods of controlling the credit-creating capacity of banks are:
1. The Bank rate – The Central Bank of the country increases the bank rate in order to make
borrowing a costly affair so that there would be less incentive for borrowing and as
consequence, the supply of money and credit will decrease in the economy.
2. Open Market Operations – The Central bank will sell Government bonds and securities to
the public or to the banks in order to reduce the supply of money.
3. Higher reserve requirements – An increase in the CRR and SLR will reduce the ability of
the member banks to create credit and thus the step will result in decrease in supply of money
and credit.
4. Curbs on unproductive lending – The Central Bank may dissuade the member banks from
giving loans for unproductive purposes and impose restrictions on consumer loans.
5. Higher margin requirements - The Central Banks may ask member banks to have higher
margin requirements so that the borrower can obtain lower amount of loan and this will
reduce the supply of money.

B. Fiscal Measures
Fiscal policy is the use of Government revenue collection (taxation) and expenditure
(spending) to influence the economy, or else it involves the Government changing the levels
of taxation and Government spending in order o influence the aggregate demand and level of
economic activity.
The fiscal measures include:
1. Taxation – Government may increase the tax rates to curb excessive spending on goods and
services
2. Public borrowing – Government borrows from the public on voluntary basis or compulsory
basis through deposit schemes.
3. Deficit spending – The Government by reducing its deficit spending, can control inflation.
Deficit financing is the practice in which Government spends more money than it receives as
revenue, the difference being made up by borrowing or minting new funds .

C. Price Control
1. Increase in supply of goods – By increasing supply of goods. Government can arrest price
rise by encouraging investments
2. Price control and rationing – rationing of essential commodities and proper
implementation of public distribution system.
 Deflation
Deflation is a condition of falling prices. It is just the opposite of inflation. In deflation, the
value of money goes up and prices fall down. Deflation brings a depression phase of business
in the economy. Here output of goods and services increases more rapidly than the volume of
money income in the economy.

Causes of deflation
1. Decrease in the quantity of money – If the supply of money is less than the demand,
then the purchasing power of money will increase and consequently the price level
will decrease. Therefore deflationary situation will rise in the country
2. Increasing taxation – If the Government imposes high rate of taxes, the purchasing
power of the public will be adversely affected and it will give rise to a deflationary
situation
3. Open Market Operations – When RBI sells government securities in the open market,
public money goes in the hand of the RBI adversely affecting the deposits of
commercial banks. Thus to some extent credit creation powers of the commercial
banks are restricted which gives rise to deflation
4. Inflation ultimately leads to deflation – Inflation gives an incentive to production and
employment which raise income. High profits encourage investments, consequently
production goes up so much that effective demand for goods fall short of it and the
situation of deflation crops up
5. Increased productivity – Innovative solutions and new processes help increase
efficiency which ultimately leads to lower prices.

Effects of deflation
1. Effects on debtors and creditors – When prices fall, debtors lose and creditors gain.
The creditors gain because whatever the amount they receive as interest etc carries
now a higher purchasing power than before. The producers are worst hit by the falling
prices
2. Effects on consumers – During periods of falling prices consumers gain because of the
fall in price. The cost of the living falls rapidly. The consumers can purchase more
amounts of goods with falling prices
3. Effects on salaried classes and fixed income earners – They tend to gain when the
prices decrease. With increase in purchasing power of money, their standard of living
tends to increase
4. Effects on producers – producers tends to lose during the period of deflation. The
prices they pay for inputs are high and when they complete production, prices fall.
Profit margin decreases
5. Adverse effects on banking – During deflation, the number of borrowers goes down on
account of general recession in the economy

Measures to control deflation

The following measures will be taken up to control deflation:

1. Monetary measures –
a) Cheap money policy – Under this policy the rate of interest should be deliberately cut down
to encourage new business enterprises
b) Deficit financing – To check deflationary situations, the monetary authority should resort to
a policy of monetary expansion to push up the declining price.
c) Expansion of credit – Businessmen and industrialists should be encouraged to borrow funds
2. Fiscal measures –
a) Reduction in taxation – The Government should follow the reduced tax policy. If it is so,
the purchasing power of the people will increase and demand for commodities will go up
b) Repayment of public debt – The Government should repay the past debt taken from the
public. This will increase the purchasing power of the public
c) Increase in public expenditure – Government should increase the expenditure in different
development programmes. This will increase the volume of employment and also the
purchasing power of people
d) Grant subsidies - The Government should give subsidies to encourage setting up of new
industries which will increase the volume of employment in the economy

3. Other measures -
a) Policy of export promotion and import reduction – To control deflation, the Government
should adopt export promotion, this will solve the problem of over production. Further it may
be necessary to reduce imports
b) Control on production – To increase the price level, it may be necessary to regulate
production in the various industries

Trade Cycles
Trade cycles or business cycles are the periodic fluctuations in economic activities.
Economic activities are measured in terms of production, employment and income which
move in a cyclical manner over a period of time. This cyclical movement consists of periods
of economic growth and contraction.

Phases in trade cycles:

Business cycles are considered to have four distinct phases namely peak, contraction, trough
and expansion.

1. Boom or Peak
Peak is the highest point of growth, In this phase economic activities go on and factors of
production are put to optimum use. This phase is characterised by increase in income,
employment and consumption. At the same time price moves up, wage rates rise,
standard of living rises and there will be expansion in bank credit.
When the economy expands or grows too rapidly, inflation rates rise. A peak is often an
indicator of an upcoming economic contraction

2. Recession or Contraction
During this phase economic activities slow down. During this phase demand starts falling
and future investment plans are also given up. There is a steady decline in output, income,
employment, prices and profits. Businessmen lose their confidence. This reduces
investment. Credit also contracts. Orders are cancelled and people start losing their jobs. The
increase in unemployment causes a sharp decline in income. Recession generally lasts for
short period.
An economic contraction means the national economy is shrinking as a whole.

3. Depression or Trough
Depression is a recession that is major in scale and duration. The main feature of a
depression is a general fall in economic activity. Production, employment and income
declines. The prices fall and the main factor responsible for it is a fall in purchasing power.
As costs are rigid in nature, the margin of profit declines. Machines are not used to full
capacity as effective demand is much less. The aggregate economic activity is at the lowest
causing a decline in prices and profits until the economy reaches its trough (lowest point)

4. Recovery or Expansion
During the period of revival or recovery, there are expansions and rise in economic
activities. During this phase demand starts rising, production increases causing an
increase in investment. There is a steady rise in output, income, employment, prices and
profits. Businessmen gain confidence and become optimistic. The banks expand credit,
business expands. There is an increase in employment, production, income and aggregate
demand, prices and profits start rising and business expands. Revival emerges into prosperity
and the business cycle is repeated

MONEY
“Money can be defined as anything that is generally acceptable as a means of exchange and
that at the same time acts as a measure and a store of value”.

Functions of Money

1. Medium of exchange
Money solves all the difficulties of the barter system. There is no necessity for a double
coincidence of wants. The man with a cow who wants to purchase a horse need not hunt for
horse seller who wants a cow. He can sell his cow in the market for money and then purchase
a horse with the money obtained.

2. Store of value
It enables a person to keep a portion of his assets liquid. Liquid assets are those which can be
used for any purpose at anytime he likes. Eg. People keep currency notes in their pockets or at
home for this purpose

3. Standard measure of value

One inconvenience of barter was the lack of common measure of value in terms of which
other values could be expressed and added and accounts kept. Money removes this difficulty.
It makes transactions easy and also free
4. Standard for deferred payments
Money also serves as a standard of payments which are to be made after a lapse of time.
Lending and borrowing must take place in terms of a commodity which will reasonably
speaking keep its value stable over time. Most commodities deteriorate with the passage of
time. Eg a sack of rice cannot a kept for over long time of many number of years for exchange
at a future date.

5. Means of transferring value

This is another function which money performs. One can sell one’s movable immovable
belongings at one place and buy them elsewhere. Value will thus be transferred.

Quantity theory of money

The quantity theory of money seeks to explain the factors that determine the general price
level in an economy. The theory states that the price level is directly determined by demand
for and supply of money. There are two versions of the quantity theory of money namely
Transaction approach and Cash balance approach

Fisher’s equation - Transaction approach

The demand for money is the transaction motive. The value of money or price level is
determined at that point where demand for money is equal to supply of money. The
transaction approach to quantity theory of money may be explained with the help of following
equation of exchange:

MxV=PxT
Where,
M = The total supply of money
V = The velocity of circulation of money
P = the general price level
T = the total transactions in physical goods

This equation means that in an economy the total value of all goods sold during any period
(PxT) must be equal to the total quantity of money spent during the period (MxV)

Cambridge equation - Cash balance approach

The cash balance approach to the quantity theory of money may be expressed as follows:

P = kxR
M
Where
P = the purchasing power of money
k = Proportion of income that people like to hold in the form of money
R = The volume of real income
M = The stock of supply of money in the country at a given time

This equation shows that the purchasing power of money or the value of money (P) varies
directly with k or R and inversely with M.
 Velocity of circulation of money
A unit of money can be used several times over a given period of time. Thus that unit of
money serves the purpose of more than one unit. Suppose, in India one unit of money changes
hands seven times on the average during one year. It means that one unit of money serves the
purpose of seven units. It is called the transaction velocity of money, ie seven. Velocity of
money refers to the number of times a unit of money changes hands in the course of a year.
Velocity includes monetary expenditure on all transactions. Thus velocity of money means
the number of times one unit of money is used during a given period to buy goods and
services. Thus the supply of money can be estimated at a given period of time, by multiplying
the quantity of money by its velocity.

Supply of money = M x V

Where
M = the stock of supply of money in the country at a given time
V = Transaction velocity of money

The total money supply in an economy is affected to a large extent by the velocity of
circulation of money. An increase in the velocity of circulation of money will increase the
money supply and a decrease in it will decrease in money supply.

Factors affecting velocity of money

a) Quantity of money – Every country needs a minimum quantity of money. If the quantity of
money is less than this minimum, the velocity of money will be high because people will have
to use one unit of money several times
b) Cash transactions – If people in a country make use of more cash transactions, then the
velocity of money will be more. On the other hand if the transactions are paid through credit
then velocity will be less
c) Tendency to consume – Countries with high level f consumption have high velocity of
money. Where savings is more velocity of circulation will be less
d) Credit facilities – If credit facilities are available in plenty credit transactions will be more
and less money will be used. It would mean less velocity
e) Period of payment – if payments are made twice or thrice a year, the period of payment is
long and velocity is less.

THE INDIAN Banking SYSTEM

A bank is an institution in which those who have spare cash deposit it and those who need
funds borrow from it.

Types of banks
1. Commercial banks

These banks play the most important role in a modern economy. They receive deposit, give
loans and finance the trade of a country. They provide short term credit, ie lend money for
short periods. Eg SBT, SBI, PNB, IOB. RBI acts as the apex institution of commercial banks
These are joint stock banks regulated by Banking Regulation Act 1949.
 2. Development banks

They provide long term credit to industry for the purpose of business. Eg State Finance
Corporations (SFC), Industrial Finance Corporation of India (IFCI), Industrial Development
Bank of India (IDBI). IDBI acts as the apex institution of industrial banks.

3. Cooperative sector banks

It consists of State Cooperative Banks, Central Coopertaive Banks etc. They are registered
under the Cooperative Societies Act.. They are worked on cooperative principle. They provide
short term as well as long term credit.

4. Central banks

It is the highest banking & monetary institution in a country. It is the leader of all other banks.
Since it is occupying a central position, it’s known as Central Bank. It is controlled by the
government of the country. Reserve Bank of India (India), Bank of Canada (Canada), Federal
Reserve System (USA) etc are the examples of Central Banks.

RESERVE BANK OF INDIA

Central Banking ( Functions of Reserve Bank of India)
The Central bank is the most important institution in the banking system of a country. The
functions of a Central Bank are:
1. Bank of note issue – The Central Bank is the bank of note issue. It has the monopoly of
note issue. There are some regulations for the issue of notes by the Central banks. In India, the
minimum reserve system is used. Under this system, the Central Bank has to maintain
minimum reserves of gold and foreign securities and no maximum limit is placed on the
amount of note issue. The Central bank has the power to issue notes to any extent. Thus it can
regulate the volume of currency according to the needs of trade.

2. Bankers Bank – All commercial banks in the country have to keep, either by law or by
custom, a certain amount of their cash balance with the central bank. It helps commercial
banks in times of need by acting as the lender of last resort.

3. Banker to the Government – It acts as the banker and agent to government. Financial
operations of the Government are carried through Central Bank. It acts as financial agent of
the Government. Government loans are floated through Central Bank. It manages the public
debt of the country.

4. Lender of last resort – When commercial banks are in certain difficulties for funds, they
can approach the central bank and get credit at the shortest possible notice

5. Custodian of Nation’s reserve of International currency – This is necessary to meet the

foreign exchange needs of the country
6. Maintaining stability in the value of currency – It has to maintain the stability of foreign
exchange rates. Apart from this, it has to keep the internal price level stable by the regulation
of the volume of credit and currency.

7. Control of credit – It controls the volume of credit. This is necessary to control the volume
of money in order to have a stable price level. The Central bank controls credit by quantitative
credit control methods like bank rate policy, open market operations and variation of cash
ratios. It can also use Qualitative measures

Monetary Policy of RBI or Credit control Measure of RBI

The credit control measures of RBI are classified into quantitative and qualitative measures.
(a)Quantitative weapons

1. Bank rate policy:

Bank rate is the lending rate of central bank. It is the official minimum rate at which central
bank of a country rediscounts the eligible bills of exchange of the commercial banks and other
financial institutions or grants short term loans to them. By increasing bank rate, RBI can
make bank credit costlier. Bank rate is the minimum rate at which central bank of a country
will lend to other banks. If bank rate goes up, the rates charged by banks goes up. If interest
rates go up, businessmen will be discouraged to borrow more money.

2. Open Market Operations:

RBI Act authorizes the RBI to engage in the purchase of securities of central and State
Government and such other securities as specified by Central Govt. When there is an
excessive supply of money, RBI sells the securities in the open market. In that way RBI is
able to withdraw the excess money from circulation. But when there is shortage of money
supply in the market, it purchases securities from the open market and as a result, more money
is arrived at for circulation

3. Variable Cash reserve ratio:

Under the RBI Act of 1934, every scheduled and non- scheduled bank is required to maintain
a fixed percentage of total time and demand liabilities as cash reserve with RBI. It is called
statutory Cash Reserve Ratio (CRR). An increase in CRR reduces lending capacity of the
bank and a decrease in CRR increases the lending capacity. RBI can prescribe a CRR ranging
up to 15%.

4. Variable Statutory Liquidity Ratio

According to sec 24 of Banking Regulation Act 1949, every commercial bank is required to
maintain a certain percentage of its total deposits in liquid assets such as cash in hand, excess
reserve with RBI, balances with other banks, gold and approved Government and other
securities. This proportion of liquid assets to total deposits is called SLR. Banking Regulation
Act empowers RBI to fix the SLR up to 40%. The variation of the SLR is intended to reduce
the lendable funds in the hands of the commercial banks and to check the expansion of bank
credit. An increase in SLR will decrease the lendable funds in the hands of commercial banks
and vice versa.

5. Repo Rate and Reverse Repo Rate

Repo rate is the rate at which RBI lends to commercial banks generally against government
securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate
and increase in Repo rate discourages the commercial banks to get money as the rate increases
and becomes expensive. Reverse Repo rate is the rate at which RBI borrows money from the
commercial banks. The increase in the Repo rate will increase the cost of borrowing and
lending of the banks which will discourage the public to borrow money and will encourage
them to deposit.

b) Qualitative measures
1. Moral suasion – It implies friendly persuasion. Central Bank morally request the
commercial banks to please adjust their lending policies according to the present economic
conditions.
2. Publicity – It makes know the view of the central bank regarding monetary policy. It
regularly publishes statement of assets and liabilities of commercial banks for information to
the public. It publishes reports of general money, markets and banking trends
3. Direct action – It refers to all those directives and restrictive measures the Central Bank
may enforce on all commercial banks. It may reject loan facilities altogether. It may refuse to
sanction further accommodation to a bank. It may charge penal rate of interest on advances
made to offending banks.

Objectives of credit control or Monetary policy

The important objectives of the monetary policy are:
1. Price Stability – Fluctuations in prices create different problems of production,
distribution besides uncertainty and instability for the economy. Stability of price level
is the chief ain of Monetary policy. It will keep value of money stable, eliminate
cyclical fluctuations, bring economic stability, secures social justice and promotes
economic welfare.
2. Full employment- It is a situation in which those who are willing to work at the
prevailing wage rate are able to find jobs. The problem of full employment is one of
maintaining adequate effective demand. In a developing economy unemployment will
have to be removed. So monetary policy should be designed to increase investment.
Such a policy is the cheap money policy (low interest rate). Borrowing for investment
will increase and through operation of multiplier and accelerator, the level of
employment can be raised.
3. Balance of payments equilibrium – The achievement of this goal has been
necessitated by the tremendous growth in international trade. A deficit in BOP will
retard attainment of other objectives. This is because a deficit in BOP leads to sizeable
outflow of money.
4. Reduction in inequalities of income and wealth – Inflation causes a large scale
redistribution of income and wealth. The losers are people with fixed income. To
avoid inequality, monetary policy should be so designed to control changes in price
level.
5. Economic growth – It implies an increase in the real per capita income or output of a
country over a long period of time. Monetary policy helps in achieving continuous
economic growth by maintaining equilibrium between the total demand for money and
total output produced in the economy and creating favourable conditions for saving
and investment.

Emerging Bitcoin concept

Bitcoin is a form of digital currency created and held electronically. The concept was
developed by Satoshi Nakamoto. Bitcoin uses Peer to Peer Technology (P2P) to operate with
no central authority or banks; managing transactions and the issuing of bitcoins is carried out
collectively by the network. Bitcoin is opensource. Its design is public. Nobody owns or
controls bitcoins and everyone can take part.

Bitcoins can be kept in the digital wallet of a computer, mobile or website online. Bitcoin
transactions are sent from and to electronic bitcoin wallets, and are digitally signed for
security. Every transaction is recorded in a vast public ledger known as blockchain.

First step involved in transacting using a bitcoin is to install the bitcoin wallet in the mobile or
computer which will generate a bitcoin address for the user.

The algorithm created by Satoshi Nakamoto has set a finite limit on the number of bitcoin that
will ever exist which is 21 million. Currently more than 12 million are in circulation. A little
less than 9 million are waiting to be discovered. At the current rate the final bitcoin will be
mined by 2140. New bitcoins are generated by a competitive and decentralized process called
mining. There are 3 primary ways to obtain bitcoins: Buying on an exchange, accepting them
for goods and services and mining new ones.

In India Unocoin is one the leading bitcoin company for buying, selling and storing bitcoin
online.

Advantages of bitcoin
1. Decentralisation – The network is not controlled by a central authority. So no authority
can alter the monetary policy
2. Payment freedom – It is possible to send and receive bitcoins anywhere in the world at
any time and transactions can be made in minutes
3. Very low fees – There are no fees within bitcoin payments
4. Transparency – With block chain all finalized transactions are available for everone to
see, however personal information is hidden
5. Security and control – Users are in full control of transactions. It cannot be
manipulated by anyone as it is cryptographically secure
6. Fewer risks to merchants – Transactions are secure and irreversible.

Disadvantages
1. Degree of acceptance is less as people are not aware.
2. Volatility – The value of bitcoins in circulation and number of business using it is
small. Hence events affect the price
3. Ongoing development – software is still in developing stage
4. Untraceable – People can buy and sell illegal things without being tracked by
authorities
5. Uncertain future

“There is only one thing that makes a dream

impossible to achieve: the fear of failure.”
 MODULE 5

INVESTMENT ANALYSIS/ CAPITAL BUDGETING

Firms need to invest their capital or funds in assets or projects. These assets or projects
involve large sums of money and considerable risk. Usually for assets or projects many
alternatives are available. Such investments are known as capital budgeting.
Capital Budgeting / Project planning is the process of making investment decision in capital
expenditure. It involves the planning and control of capital expenditure. It is the process of
deciding whether or not to commit resources to particular long-term projects whose benefits
are to be realized over a period of time.

Features of Capital Budgeting

1. Exchange of funds for future benefits:
2. The future benefits are expected to be realized over a period of time.
3. The funds are invested vested in long-term activities.
4. They have a long term and significant effect on the profitability of the concern,
5. They involve huge funds.

Importance of Capital Budgeting

1. Large Investment: Capital budgeting decision involves large investment of funds. But the
funds available with the firm are always limited and the demand for funds far exceeds the
resources. Hence it is very important for a firm to plan and control its capital expenditure.
2. Long Term Commitment of Funds: capital expenditures involves not only large amount
of funds but also funds for long term or permanent basis. The long tern commitments of funds
increases, the financial risk involved in the investment decision. Greater the risk involved,
greater is need for careful planning of capital expenditure i.e. Capital Budgeting.
3. Irreversible Nature: The Capital expenditure decision is of irreversible nature. Once the
decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these
assets without incurring heavy losses.
4. Long term Effect on profitability: Capital budgeting decisions have a long term and
significant effect on the profitability of a concern. Not only the present earnings of the firm
are effected by the investments in capital asserts but also the future growth and profitability of
the firm depends upon the investment decision taken today. An unwise decision may prove
disastrous and fatal to the very existence of the concern.
5. Difficulties of investment Decisions: The long tern investment decision are difficult to be
taken because decision extends to a series of years beyond the current accounting period,
uncertainties of future, higher degree of risk.
6. National Importance: Investment decision though taken by individual concern is of
national importance because it determines employment, economic activities and growth.
 Investment evaluation techniques:

A. Traditional or non discounting techniques:

1. PAY BACK PERIOD

The payback method is the simplest way of looking at one or more major project ideas. It tells
you how long it will take to earn back the money you'll spend on the project.
The formula is:

In case of equal cash inflows:

Payback Period = Cost of project

Annual Cash Inflow

𝐶
P=
𝑅
P = payback period in years
C = original capital investment or cost of the project
R = net returns per annum or annual cash inflow

Example: A project requires an outlay of Rs 50,000 and yields an annual cash flow of
Rs 12,500 for 7 years. Calculate Payback period.

Solution: Payback period = Cost of project

Annual cash inflow

= 50000/12500 = 4 years

In case of unequal cash inflows:

𝐵
P=E+
𝐶

Where ,
E = Year preceding the last year of recover
B = Balance to be recovered
C = cash flow in the last year of recovery

Example: Calculate payback period for a project which requires a cash outlay of Rs
20,000 and generates cash inflows of Rs 8,000, Rs 7000, Rs 4000 and Rs 3000.

Solution.
Year Cash Flow Cumulative cash flow
1 8000 8000
2 7000 15000
3 4000 19000
4 3000 22000

𝐵
P=E+
𝐶
= 3 + 1000
3000
= 3 1/3 years

Example: The following details are available in respect of the cash flows of two projects
A & B:
Year Project A Project B
Cash flows Cash flows
0 (4,00,000) (5,00,000)
1 2,00,000 1,00,000
2 1,75,000 2,00,000
3 25,000 3,00,000
4 2,00,000 4,00,000
5 1,50,000 2,00,000

Compute payback period of A & B.

Solution:
Year Project A Cumulative Project B Cumulative
Cash flows Cash flows Cash flows Cash flows
1 2,00,000 200000 1,00000 100000
2 1,75,000 375000 2,00,000 300000
3 25,000 400000 3,00,000 600000
4 2,00,000 600000 4,00,000 1000000
5 1,50,000 750000 2,00,000 1200000

PBP of A = 3 years

PBP of B = 2+ 200000
300000
= 2.67 years
Project B is better.

Evaluation criteria
According to Payback criterion, the shorter the PBP, more desirable the project.
Advantages of PBP method
1. Simple to understand and easy to apply
2. Rough and ready method for dealing with risk.

Disadvantages
1. Ignores time vale of money
2. Ignores cash flows beyond pay back period.
3. Does not measure profitability of the project

2. AVERAGE RATE OF RETURN

This method take into account the earnings expected from the investment over their whole
life. It is known as accounting rate if Return method for the reasons that under this method,
the accounting Concept of profit is used rather than cash inflows. According to this method,
various projects are ranked in order of the rate of earnings or rate of return. The project with
the higher rate of return is selected as compared to the one with the lower rate of return. This
method can be used to make decisions as to accepting or rejecting a proposal. The expected
return is determined and the project with a higher rate of return than the minimum rate
specified by the firm called cut-off rate, is accepted and the one which gives a lower expected
rate of return than the minimum rate is rejected.

ARR = Average income x 100

Average investment

Average investment = Opening investment + Closing investment

2
Example. Find out ARR
Cost of project Rs 2,00,000
Estimated life in years 5
Returns Rs 60000, Rs 50000, Rs 40000, Rs 30000 and Rs 20000

Average income = 60000+50000+40000+30000+20000

5
= 40000
Average investment = 200000/2 =100000

ARR = 40000/100000 = 0.4 = 40%

Evaluation criteria:
Higher the ARR better the project

Advantages of Rate of Return Method

1. It is very simple to understand and easy to operate.
2. This method is based upon the accounting concept of profits; it can be readily calculated
from the financial data.
3. It uses the entire earnings of the projects in calculating rate of return.
Disadvantages of Rate of Return Method
1. It does not take into consideration the cash flows, which are more important than the
accounting profits.
2. It ignores the time value of money as the profits earned at different points of time are given
the equal weighs

B. Discounted cash flow techniques

The traditional methods of capital budgeting suffer from serious limitations that give the equal
weights to present and future flow of income. These do not take into accounts the time value
of money. Following are the discounted cash flow methods:

1. NET PRESENT VALUE

This method is the modern method of evaluating the investment proposals. This method takes
into consideration the time value of money and attempts to calculate the return in investments
by introducing the factor of time element. It recognizes the fact that a rupee earned today is
more valuable earned tomorrow. The net present value of all inflows and outflows of cash
occurring during the entire life of the project is determined separately for each year by
discounting these flows by the firm’s cost of capital.
Following are the necessary steps for adopting the net present value method of evaluating
investment proposals.
1. Determine appropriate rate of interest that should be selected as the minimum required rate
of return called discount rate.
2. Compute the present value of total investment outlay.
3. Compute the present value of total investment proceeds.
4. Calculate the net present value of each project by subtracting the present value of cash
inflows from the present value of cash outflows for each project.
5. If the net present value is positive or zero, the proposal may be accepted otherwise rejected.

NPV = Present value of inflows – Present value of outflows

𝑭𝑽
PV =
(𝟏+𝒊)𝒏

PV = Present value
FV = future value in each year
i = discount rate
n= number of year

Evaluation criteria
Reject the project if NPV is negative and accept if NPV is positive

Advantages of Net Present Value

1. It recognizes the time value of money and is suitable to be applied in situations with
uniform cash outflows and cash flows at different period of time.
2. It takes into account the earnings over the entire life of the projects and the true profitability
of the investment proposal can be evaluated.
3. It takes into consideration the objective of maximum profitability.

Disadvantages of Net Present Value

1. This method is more difficult to understand and operate.
2. It is not easy to determine an appropriate discount rate.
3. It may not give good results while comparing projects with unequal lives and investment of
funds.

Example
Consider a project which has the following cash flows:
Year Cash flows

0 (10,00,000)
1 2,00,000
2 2,00,000
3 3,00,000
4 3,00,000
5 3,50,000
Rate of interest is 10%. Calculate NPV.

Solution:
Year Cash flows NPV

0 (10,00,000) 1000000 10,00,000

( 1+ 0.10)0

1 2,00,000 200000 181818

( 1+ 0.10)1

2 2,00,000 200000 165289

( 1+ 0.10)2

3 3,00,000 300000 225394

( 1+ 0.10)3

4 3,00,000 300000 204904

( 1+ 0.10)4

5 3,50,000 350000 217322

( 1+ 0.10)5
__________________
Total of PV of inflows 994728

NPV = 994728 - 1000000 = -5273

NPV is negative so reject the project

 2. BENEFIT COST RATIO / PROFITABILITY INDEX

This is also known as Profitability Index. This is similar to NPV method. The major drawback
of NPV method that not does not give satisfactory results while evaluating the projects
requiring different initial investments. PI method provides solution to this.

BCR = Present value of inflows

Present value of outflows

Evaluation criteria:
BCR > 1 accept
BCR< 1 reject

Advantages of PI method
1. It considers Time value of money
2. It considers all cash flow during life time of project.
3. More reliable than NPV method when evaluating the projects requiring different initial
investments.

Disadvantages of PI method
1. This method is difficult to understand.
2. Calculations under this method arte complex

Example :
Consider the following investments and find out the BCR. Initial investment = Rs 1,00,000. Cost
of capital = 12%. Benefits are as follows:
Year Benefit
1 25,000
2 40,000
3 40,000
4 50,000

Solution:

Year Benefit PV of inflows

1 25,000 25000 22321

( 1+ 0.12)1

2 40,000 40000 31887

( 1+ 0.12)2

3 40,000 40000 28471

( 1+ 0.12)3

4 50,000 50000 31775

( 1+ 0.12)4
________
114456

BCR = 114456 = 1.144

100000
 3. INTERNAL RATE OF RETURN
It is a modern technique of capital budgeting that takes into account the time value of money.
It is also known as “time adjusted rate of return discounted cash flows” “yield method” “trial
and error yield method” Under this method, the cash flows of the project are discounted at a
suitable rate by hit and trial method, which equates the net present value so calculated to the
amount of the investment. Under this method, since the discount rate is determined internally,
this method is called as the internal rate of return method. It can be defined as the rate of
discount at which the present value of cash inflows is equal to the present value of cash
outflows.

Steps required for calculating the internal rate of return.

1. Determine the future net cash flows during the entire economic life of the project.
The cash inflows are estimated for future profits before depreciation and after taxes.
2. Determine the rate of discount at which the value of cash inflows is equal to the present
value of cash outflows.
3. Accept the proposal if the internal rate of return is higher than or equal to the minimum
required rate of return.
4. In case of alternative proposals select the proposals with the highest rate of return as long as
the rates are higher than the cost of capital.

The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which
the Net Present Value (NPV) of a project equals zero

Intrapolation formula:

IRR = LR + P1 - Q x (HR-LR)
P1 – P2

where,
LR = Lower discount rate
HR = Higher discount rate
P1 = Present value at lower rate
P2 = Present value at higher rate
Q = Initial investment

Advantages of Internal Rate of Return Method

1. It takes into account the time value of money and can be usefully applied in situations with
even as well as uneven cash flows at different periods of time.
2. It considers the profitability of the project for its entire economic life.
3. It provides for uniform ranking of various proposals due to the % rate of return.

Disadvantages of Internal Rate of Return Method

1. It is difficult to understand.
2. This method is based upon the assumption that the earnings are reinvested at the internal
rate of return for the remaining life of the project, which is not a justified assumption
particularly when the rate of return earned by the firm is not close to the internal rate of
return.
3. The result of NPV and IRR method may differ when the project under evaluation differ
their size.

Accept or reject criterion:

If the project’s IRR is greater than the firm’s cost of capital, accept the proposal. Otherwise
reject the proposal. A project with highest IRR is considered best.

Example.
Year Cash flow
0 (1,00,000)
1 30,000
2 30,000
3 40,000
4 45,000

Solution:
Assume i = 15%
PV of cash outflows = 30000 + 30000 + 40000 + 45000
( 1+ 0.15)1 ( 1+ 0.15)2 ( 1+ 0.15)3 ( 1+ 0.15)4

= RS 1,00,800.811

Assume i = 16%

PV of cash outflows = 30000 + 30000 + 40000 + 45000

( 1+ 0.16)1 ( 1+ 0.16)2 ( 1+ 0.16)3 ( 1+ 0.16)4

= RS 98,636.36

IRR = LR + P1 - Q x (HR-LR)
P1 – P2

= 15 + 100800 – 100000 x (16-15)

100800- 98636

= 15 + 800 x1
2164

= 15+0.37 = 15.37%

Capital Budgeting Process:

The capital budgeting process includes identifying and then evaluating capital projects for the
company. Company budgeting is a complex process which may be divided into the following
phases:

1. Identification of project – A project is an investment proposal. At a given point of time,

while the investible funds are limited, a firm may come across with mutually competing
projects and mutually exclusive projects as well.
2. Assembling of proposed investments – Investment proposals identified by the production
department and other departments are submitted in a standardized capital investment proposal
form.
3. Decision-making – Executives are vested with the power to approve investment proposals
keeping in mind the constraints.
4. Preparation of capital budget and appropriations – The decision to invest is followed by
financing alternatives. Before undertaking such projects, an appropriation order is usually
required. The purpose of this check is mainly to ensure the funds position of the firm is
satisfactory at the time of implementation
5. Implementation – In this stage an investment proposal is converted into a concrete project
which is complex, time consuming and risk involved task. Undue delays in implementation
may cause cost escalations.

BUSINESS DECISIONS

What is risk?

Risk refers to a decision making situation where there are different possible outcomes and
probabilities of these outcomes can be measured in some way. Risk involves choices with
multiple choices and multiple outcomes where the probability of each outcome is known or
can be estimated. A manager investing in a new product development, adoption of new
technology or new market entry faces various risks. There are various risks related to
investments in projects.

Types of risks
Risk can be classified into two groups namely, systematic risk and unsystematic risk.

Systematic risk arises due to macro economic factors of business such as social, political or
economic factors. Systematic risk includes market risk, inflation risk, interest risk etc. The
risk arising due to fluctuations in returns of a company’s security due to microeconomic
factors ie factors existing in the organization is known as unsystematic risk. The factors that
cause unsystematic risk relates to a particular industry such as labour problems. Unsystematic
risk includes business risk, credit risk and liquidity risk. Various types of risk are:

1. Market risk - Market risk is associated with consistent fluctuations seen in the
trading price of any particular shares or securities. That is, it arises due to rise or
fall in the trading price of listed shares or securities in the stock market.
2. Inflation risk – A general increase in price level will undermine the real economic
value of any legal agreement that involves a fixed promise to pay over an extended
period
3. Interest rate risk - Interest-rate risk arises due to variability in the interest rates
from time to time. It particularly affects debt securities as they carry the fixed rate of
interest.
4. Business risk – Business risk is the possibility that accompany will have lower than
anticipated profits or experience a loss rather than making a profit. It is classified
into internal business risk and external business risk. Internal business risk may be
represented by a firms limiting environment within which it conducts its business.
 External business risks are due to many factors like business cycles, demographic
factors, political policies, Monetary policy and economic environment of the
economy.
5. Credit risk – It arises when the other party fails to abide by the contractual
obligations
6. Liquidity risk – It is the difficulty of selling corporate assets and investments. Eg
selling real estate

Uncertainty
Uncertainty refers to a decision making situation where there are different possible
outcomes and the probabilities of these outcomes cannot be meaningfully measured,
sometimes because all possible outcomes cannot be foreseen or specified. There are two
sources of uncertainty. Uncertainty with complete ignorance refers to those situations in
which no assumptions can be made about the probabilities of alternative outcomes under
different states of matter. Uncertainty under partial ignorance refers to those situations in
which decision maker is able to assign subjective probabilities to possible outcomes. These
subjective probabilities may be based on personal knowledge, intuition or experience. The
process of decision making under conditions of partial ignorance is effectively the same as
decision making under risk

Decision making
Decision making signifies the actual selection of the course of action from among a number of
alternatives.

Decision making can be made under three conditions as given below:

I) Decision Making under Certainty

In this environment, the decision maker knows with certainty the consequences of
selecting every course of action or decision choice. In this type of decision problems the
decision maker presumes that only one state of nature is relevant for his purposes. He
identifies this state of nature, takes it for granted and presumes complete knowledge as to its
occurrence. For example, suppose a person has Rs 5,00,000 to invest for a one year period.
One alternate is to open a savings account paying 4% interest and another is to invest in a
government treasury paying 9% interest. If both investments are secure and guaranteed, then
there is a certainty that the treasury note will be the better investment.

The various techniques for solving problems under certainty are i) System of equations ii)
Linear programming iii) Inventory models iv) Break even analysis

One common technique for decision making under certainty is called linear programming. In
this method, a desired benefit (such as profit) can be expressed as a mathematical function
(the value model or objective function) of several variables. The solution is the set of values
for the independent variables (decision variables) that serves to maximize the benefit (or, in
many problems, to minimize the cost), subject to certain limits (constraints)
 II) Decision Making under Risk

The future conditions are not always made in advance. In real life most managerial decisions
are made under risk decisions, that is, some information is available but it is insufficient to
answer all the questions about the outcome. So a decision maker has to make probability
estimates of these outcomes. In decision making under risk one assumes that there exist a
number of possible future states of nature. Each has a known (or assumed) probability of
occurring, and there may not be one future state that results in the best outcome for all
alternatives

Examples of future states and their probabilities are as follows:

• Alternative weather (weather) will affect the profitability of alternative construction

schedules; here, the probabilities of rain and of good weather can be estimated from historical
data.

When making a decision under the condition of risk the manager does not know the outcome
of each alternative in advance, but can assign a probability to each outcome. For example one
action offers one percent of gain of Rs 10000 and other a fifty per cent of gain of Rs 400 the
rational decision maker will choose the second action because it has the higher Expected
Monetary Value (EMV).

Probability Outcome Expected Monetary Value

0.01 Rs 10000 Rs 100
0.50 Rs 400 Rs 200

The process for Decision making process with risk is as follows:

1. The problem is defined and all likely alternatives are identified
2. All possible outcomes for each likely alternative are identified
3. Outcomes are discussed based on monetary payoffs or net gain in reference to assets
or time
4. The uncertainties are allocated a probability of occurrence
5. The quality of the optimal strategy depends upon the quality of judgements made by
the decision maker in identifying the alternatives / outcomes and allocating
appropriate probabilities to the associated uncertainties.
6. The decision maker should undertake sensitivity analysis to check how sensitive the
answer is to the allocated probabilities.

Some of the important methods for taking investment decisions under risk are as follows:
1. Sensitivity analysis
In considering the nature and measurement of risk, a number of variables that
determine a project’s profitability are not known with certainty. In sensitivity analysis
we analyse the degree of responsiveness of the dependent variable for a change in any
of the dependent variables. The analysis consists of three steps:
a. Identifying all the variables that affect the NPV or IRR of the project
b. Establishing a mathematical relationship between the independent and dependent
variables
c. Studying and analysing the impact of the change in variables
 2. Decision tree analysis

Some decisions involve a series of steps, the second step depending on the outcome of the
first, the third depending on the outcome of the second and so on. Often uncertainty surrounds
each step, so the decision maker faces uncertainty piled on uncertainty. Decision trees are a
model for solving such a problem.

Decision tree is a graphical method for identifying alternate actions, estimating probabilities,
and indicating the resulting expected payoff. This graphical form visually helps the decision
maker view his alternatives and outcomes. Instead of compressing all the information
regarding a complex decision into a table, decision maker can draw a schematic representation
of the problem that displays the information in more easily understandable fashion.

Example of the problems which can be solved through decision tree may be when a new
product is to be introduced, whether to tool up for tool up for it in a major way as to assure
production at the lowest possible cost or to undertake cheaper temporary tooling involving a
higher manufacturing cost but lower capital losses if the product does not sell well as
estimated etc.

Here the second step of decision, that is, going for major or minor tooling, depends on the
outcome of the first decision, that is, whether to go for new product or not. Similarly within
the major tooling, there may be alternatives which can be considered in the light of decision
made of tooling.

Squares represent decisions you can make. The lines that come out of each square on its right
show all the available distinct options that can be selected at that decision analysis point.
Circles show various circumstances that have uncertain outcomes (For example, some types
of events that may affect you on a given path). The lines that come out of each circle denote
possible outcomes of that uncontrollable circumstance.

III) Decision Making under Uncertainty

At times a decision maker cannot assess the probability of occurrence for the various
states of nature. Uncertainty occurs when there exist several (i.e., more than one) future states
of nature but the probabilities of each of these states occurring are not known. In such
situations the decision maker can choose among several possible approaches for making the
decision. A different kind of logic is used here, based on attitudes toward risk. Such situations
arise when a new product is introduced in the market or a new plant is set up.
Following choices are available before the decision maker in situations of uncertainty
- Maximax, Minimax, Maximin, Laplace and Hurwicz Alpha criteria.

Maximax Decision Criterion

The term Maximax is the abbreviation of the phrase maximum of the maxima. It is alsocalled
the criterion of optimism. An adventurous and aggressive decision maker chooses that act that
would result in the maximum payoff possible . Suppose for each act there are three possible
payoffs,corresponding to three states of nature as given in the following decision matrix

Payoff Table

States of nature
Acts S1 S2 S3
A1 220 160 140
A2 180 190 170
A3 100 180 200
The maximum of these three maximums is 220 which relates to A1. Consequently, according
to the maximax criteria, the decision is to choose A1.

Minimax Decision Criterion

Minimax is just opposite to maximax. Application of the minimax criterion requires a table of
losses instead of gains The losses are the costs to be incurred or the damages to be suffered for
each of the alternative act and states of nature. The minimax rule minimizes the maximum
possible loss for a course of action. The term minimax is an abbreviation of the phrase
minimum of maxima loss. Under each of the various acts, there is a maximum loss and the act
that is associated with the minimum of the various maximum losses is the act to be undertaken
according to the minimax criterion. Suppose the loss table is
Opportunity loss table
States of nature
Acts S1 S2 S3
A1 0 3 18
A2 4 0 14
A3 10 6 0
Maximum losses incurred by the various decisions. And the minimum among these three
maximums is 10 which if offered by A3. According to Minimax criteria, the decision maker
should take A3.

Maximin decision criterion (criterion of Pessimism)

The maximin criterion of decision making stands for choice between alternative courses of
action assuming pessimistic view. Taking each act in turn, we note the worst possible results
in terms of pay off and select the act which maximizes the minimum pay off.
Suppose the pay off table is
Payoff table
States of nature
Acts S1 S2 S3 S4
A1 -80 -30 30 75
A2 -60 -10 15 80
A3 -20 -2 7 25
Minima under each decision A1 = -80, A2 = -60, A3 = -20. According to Maximin criterion,
A3 is to be chosen, which gives maximum pay off among minima.
Laplace criterion
As the decision maker has no information about the probability of occurrence of various
events, the decision maker makes a simple assumption that each probability is equally likely.
The expected Pay off is worked out on the basis of these probabilities. Then act having
maximum expected pay off is selected.

States of nature
Acts S1 S2 S3
A1 20 25 30
A2 12 15 20
A3 25 30 22
We associate equal probability for each event – 1/3 to each state of nature. So, as per Laplace
criterion, expected pay off are
A1 = 20 x 1/3 + 25 x 1/3 + 30 x 1/3 = 25
A2 = 12 x 1/3 + 15 x 1/3 + 20 x 1/3 = 15.67
A3 = 25 x 1/3 + 30 x 1/3 + 22 x 1/3 = 25.67
Since A3 has maximum expected pay off, as per Laplace criterion, A3 is the Act to be
selected.

Hurwicz Alpha criterion

This method is a combination of maximin criterion and minimax criterion. In this method, the
decision maker’s degree of optimism is represented by alpha -the coefficient of optimism.
Alpha varies between 0 and 1.When alpha is = 0, there is total pessimism and when alpha is
=1, there is total optimism. As per the criterion, Hurwicz value is calculated for each Act,
considering maximum pay off and minimum pay off as per an Act. Hurwicz value is the total
of products of maximum payoff and alpha, and minimum pay off and 1 – alpha.
Hurwicz value = Max pay off x alpha + mini pay off x 1- alpha for an Act.

Consider following pay off table. Hurwicz alpha value given is = .6

Payoff table
States of nature
Acts S1 S2 S3
A1 20 25 30
A2 12 15 20
A3 25 30 22
Hurwicz value for A1 = 30 x .6 +20 x .4 = 26
Hurwicz value for A2 = 20 x .6 + 12 x .4 = 16.8
Hurwicz value for A3 = 30 x .6 + 22 x .4 = 26.8
Since Hurwicz value is maximum for A3, it is the optimal Act. It is to be chosen.
 COST BENEFIT ANALYSIS
The benefit-cost analysis method is mainly used for economic evaluation of public projects
which are mostly funded by government organizations. In addition this method can also used
for economic evaluation of alternatives for private projects. The main objective of this method
is used to find out desirability of public projects as far as the expected benefits on the capital
investment are concerned. This method involves the calculation of ratio of benefits to the
costs involved in a project.

In benefit-cost analysis method, a project is considered to be desirable, when the net benefit
(total benefit less disbenefits) associated with it exceeds its cost. Thus it becomes imperative
to list out separately the costs, benefits and disbenefits associated with a public project. Costs
are the expenditures namely initial capital investment, annual operating cost, annual
maintenance cost etc. to be incurred by the owner of the project and salvage value if any is
subtracted from the costs. Benefits are the gains or advantages whereas disbenefits are the
losses, both of which are experienced by the owner in the project. In case of public projects
which are funded by the government organizations, owner is the government. However this
fund is generally taxpayers’ money i.e. tax collected by government from general public,
thereby the actual owners of public projects are the general public. Thus in case of public
projects, the cost is incurred by the government whereas the benefits and disbenefits are
mostly experienced by the general public.

In order to know the costs, benefits and disbenefits associated with a public project, consider
that a public sector organization is planning to set up a thermal power plant at a particular
location. The costs to be incurred by the public sector organization are cost of purchasing the
land required for the thermal power plant, cost of construction of various facilities, cost of
purchase and installation of various equipments, annual operating and maintenance cost, and
other recurring costs etc. The benefits associated with the project are generation of electric
power that will cater to the need of the public, generation of revenue by supplying the
electricity to the customers, job opportunity for local residents, development other
infrastructure in the nearby areas etc. The disbenefits associated with project are loss of land
of the local residents on which the thermal power plant will come up. If it is agricultural land,
then the framers will lose their valuable land along with the annual revenue generated from
farming, even though they get money for their land from the public sector organization at the
beginning. The other disbenefits to the local residents are greater likelihood of air pollution in
the region because of the thermal power plant, chances of contamination of water in the
nearby water-bodies etc.

In benefit-cost analysis method, the time value of money is taken in to account for calculating
the equivalent worth of the costs and benefits associated with a project. The benefit-cost ratio
of a project is calculated by taking the ratio of the equivalent worth of benefits to that of the
costs associated with that project. Either of present worth, annual worth or future worth
methods can be used to find out the equivalent worth of costs and benefits associated with the
project.
The benefit-cost ratio of projects is determined in different forms namely conventional
benefit-cost ratio and modified benefit-cost ratio. The benefit-cost ratio is generally
designated as B/C ratio.

The benefit-cost ratio of a project is calculated as follows:

Cost benefit ratio = Equivalent worth of benefits – Equivalent worth of disbenefits

Equivalent worth of total cost – Equivalent worth of salvage value

The disbenefits associated with the project are subtracted from the benefits in the numerator
of the ratio to obtain the net benefit associated with the project. Similarly the equivalent worth
of salvage value of the initial investment is subtracted from equivalent worth of cost in the
denominator of the ratio. The total cost mainly consists of initial cost (initial capital
investment) plus the operating and maintenance cost.

A project is considered to be acceptable when the benefit cost ratio is greater than or equal to
1.

“It’s the possibility of having a dream come true

that makes life interesting.”
 MODULE 6

BALANCE SHEET

 A Balance sheet indicates the financial condition of a business at a given point of time.
 As per Companies Act, the balance sheet of a company may be prepared in account or
report form.
 Balance sheet is a detailed expression of the following accounting equation:
Assets = Liabilities + Owners equity (capital)
 Balance sheet is a statement showing the assets and liabilities of a business on a
particular date. It shows how the assets of the firm and how the assets are financed by
different types of capital. The assets are displayed on one side and the sources of
assets or the liabilities are displayed on the other.
 A balance sheet measures a firm’s liquidity and profitability. It measures liquidity in
the sense that it shows whether the firm is able to pay of its debts in short run
circumstances. Similarly solvency means the firm’s ability to meet all its long term
and short term debt
 The assets and liabilities are displayed in a particular order, say, in the order of their
permanence

The items shown on the Assets side of the Balance sheet include:
Assets – Assets are economic resources owned by the business which will provide future
service benefits and can be measured in terms of money.
Assets are classified as:
1. Fixed Assets - Assets which are permanent in nature having long period of life and
cannot be converted into cash in a short period are termed as fixed assets . Fixed assets
are classified as
a. Tangible Assets: Assets which have some physical existence are known as
tangible assets. They can be seen, touched and felt, e.g. Plant and Machinery
b. Intangible Assets The assets which have no physical existence and cannot be
seen or felt. They help to generate revenue in future, e.g. goodwill, patents,
trademarks etc
2. Current assets - The current assets are assets which either in the form of cash or which
can be converted into cash within a year. They include:
a. Cash in hand and in bank
b. Bills receivable
c. Sundry debtors
d. Closing stock
e. Prepaid expenses (expenses paid in advance for services to be received in
future)
f. Accrued income ( Income which has been earned but not yet received)
3. Investments - They are securities held by business for investment purposes. The
intention is to hold those securities for the long run at least longer than a year.
The items shown on the Liability side of the Balance sheet include :
Liabilities - It represents what the business entity owes others.

The liabilities may be classified as follows:

1. Fixed liabilities – have to repaid only on termination of business eg capital
2. Long Term Liabilities- Liabilities which are repayable after a long period of time are
known as Long Term Liabilities. For example long term loans etc.
3. Current Liabilities- Current liabilities are those which are repayable within a year. For
example, creditors for goods purchased, short term loans etc.
4. Contingent liabilities - It is an anticipated liability which may or may not arise in
future. For example, liability arising for bills discounted. Contigent liabilities will not
appear in the balance sheet. But shown as foot note.
5. Net profit – It is the amount earned by the owner and is added to the capital
6. Drawings – The amount withdrawn by the proprietor is termed as drawings.

Marshalling of Assets and Liabilities

The term ‘Marshalling’ refers to the order in which the various assets and liabilities are shown
in the balance sheet. The assets and liabilities can be shown either in the order of liquidity or
in the order of permanence. a) In order of liquidity. Liquidity means convertibility into cash.
Assets will be said to be liquid if it can be converted into cash easily, they are placed at the
top of the balance sheet. Liabilities are arranged in the order of their urgency of payment. The
most urgent payment to be made is listed at the top of the balance sheet. b) In order of
permanence or performance. This order is exactly the reverse of the above. Assets and
liabilities are recorded in the order of their life in the business concern.
The total of the asset side of the balance sheet is equal to that of the liabilities side
Total assets = Total liabilities + Owner’s equity

Interpreting the Balance Sheet

The Balance Sheet along with the income and cash flow statements is an important tool for
investors to gain insight into a company and its operations. The Balance sheet is a snapshot at
a single point of time of the company’s accounts – covering its assets, liabilities and
shareholder’s equity. The purpose of the balance sheet is to give users an idea of the
company’s financial position along with displaying what the company owns and owes. It is
important that all investors know how to use, analyse and read the document. A balance sheet
gives the following information about the firm:

a. How liquid its assets are – how much is in the form of cash or can be easily converted
into cash, ie stocks and shares
b. How business is financed
c. How much capital is being used
Specimen of Balance Sheet is given below:
FORMAT IN ORDER OF LIQUIDITY
LIABILITIES Amount ASSETS Amount

Current liabilities: Current Assets:

Bank overdraft Cash in Hand
Bills payable Cash at Bank
Outstanding expenses Bills receivable
Sundry creditors Sundry Debtors
Income received in Prepaid expenses
advance Accrued Income
Closing stock
Fixed Liablities: Investments:
Long Term Loans Investments in Banks
Debentures Investments in shares
Fixed Assets:
Capital : Motor vehicles
Add: Net Profit/ Patents and trademarks
Less : Net Loss Furniture
Less: Drawings Plant and machinery
Land and Building
Goodwill

XXX XXX

FORMAT IN ORDER OF PERFORMANCE

LIABILITIES Amount ASSETS Amount
Capital : Fixed Assets:
Add: Net Profit/ Goodwill
Less : Net Loss Land and Building
Less: Drawings Plant and machinery
Reserves Furniture
Patents and trademarks
Fixed Liablities: Motor vehicles
Debentures Investments:
Long Term Loans Investments in shares
Investments in banks
Current liabilities: Current Assets:
Income received in Closing stock
advance Accrued Income
Sundry creditors Prepaid expenses
Outstanding Sundry Debtors
expenses Bills receivable
Bills Payable Cash at Bank
Bank overdraft Cash in Hand

XXX XXX
1. From the following information supplied by Mr. Roshan Lal, prepare a Balance
Sheet of Mr. Roshan Lal as on 31st March, 2016

Capital 50,000 Furniture 15,000 Debtors 25,000 Creditors 30,000

Plant and Machinery 58,000 Investments 5,000 Cash in hand 1,000 Cash at Bank 1,000
Stock at the end 10,000 Bank Overdraft 8,000 Bank Loan 20,000 Net Profit 10,000
Drawings 3,000

Solution:

Balance Sheet of Mr. Roshan Lal as on March 31, 2016

Liabilities Rs Assets Rs
Bank overdraft 8,000 Cash in hand 1,000
Creditors 30,000 Cash at Bank 1,000
Bank Loan 20,000 Debtors 25,000
Capital 50,000 Stock 10,000
Add: Net profit 10,000 Investments 5,000
60 ,000 Furniture 15,000
Less: Drawings -3,000 57,000 Plant & Machinery 58,000

115,000 115,000

2. From the following information supplied by Mr. Arun Kumar, prepare a Balance Sheet as on
31st March, 2016.

Creditors 30,000 Debtors 35,000 Cash in hand 24,500 Cash at Bank 27,500
Stock 22,500 Furniture 25,000 Loan 50,000 Plant & Machinery 32,500
Land & Building 52,000 Capital 1,37,000 Net Profit 12,000 Drawings 10,000

Solution:

Balance Sheet of Mr. Arun Kumar as on March 31, 2016

Liabilities Rs Assets Rs
Creditors 30,000 Cash in hand 24,500
Bank Loan 50,000 Cash at Bank 27,500
Capital 137,000 Debtors 35,000
Add: Net profit 12,000 Stock 22,500
149 ,000 Furniture 25,000
Less: Drawings -10,000 139,000 Plant & Machinery 32.500
Land & Building 52,000
219,000 219,000
Advantages of Balance Sheet

a. It throws light on the financial position of the business as characterised by its assets
and liabilities
b. It reflects the outcome of investing and financing decisions
c. It provides relevant information to explain the liquidity position of the business.
Liquidity, besides profitability, position is a very important yardstick to evaluate the
effectiveness and performance of the business
d. It portrays the claim of the owners and others in the business

Disadvantages of Balance Sheet

a. Because the balance sheet is a snapshot of financial position at a given point of time,
the figures can be misleading
b. Balance sheet figures alone can be less informative without benchmark data from
peer companies used for comparison
c. Balance sheet items, such as fixed assets are reported at their historical cost basis.
The amount an asset was purchased for which often has little to do with their market
value
d. Another potential disadvantage is that it does not tell us the accurate value of a
company. While it does provide us with a figure for shareholders equity, it does not
tell us how much the company is worth

Forecasting
A key to successful business operations, planning and strategy is the use of business forecasts.
Since business planning and strategy involve decisions or actions at the present time which
will have consequences in the future, useful forecasts about uncertain events are essential.
Business forecasts are an important source of information to management. The need for
business forecasting is found in all areas and at all levels of the business. Often it is the
demand forecast which plays a crucial role in production planning.

Forecasting can be defined as an estimate of future events, that can be obtained by

systematically combining past and present data in a predetermined way and arrive at the
future data.

Forecasting begins with demand forecast and is followed by production forecast and forecast
of costs, finance, purchase, profit or loss etc.

Why Forecast Demand ?

• Business environment is uncertain, volatile, dynamic and risky.

• Better business decisions can be taken if uncertainty can be eliminated or reduced
• Demand forecasting – predicting the future demand for firms product, is one of the ways to
reduce uncertainty
• Some of the business decision-making aided by a good demand forecast are:
– Determining the optimal level of output
– Planning and scheduling of production, distribution & transportation
– Acquiring inputs (raw material, labour, capital)
– Determining cost and pricing strategy
– Decisions on expansion and exit strategies for the product
– Meeting customer order dates and customer satisfaction.
• Demand forecasting is the starting point of fulfilling a customer order. Its accuracy is
paramount.
• Based on the forecasted demand, a firm commits its resources, capacities and capabilities for
a period of time to create goods and services that its customers value and are willing to pay
for
• A low forecast will result in lost sales opportunity and customer dissatisfaction
• A high forecast will lead to accumulation of inventory, resulting in higher costs and less
profits for the firm
• Thus forecast accuracy plays a crucial role in determining the effectiveness and efficiency of
a firm

Sources of forecasting data

1. Primary data – It is the data gathered specifically to provide information on the firm’s
own products, customers and markets. Data is collected by the use of questionnaires,
observation, experimentation and surveys and as a result is often expensive, but
relevant, accurate and up-to-date. Primary data presents the current scenario and is
therefore more effective in taking business decisions.
2. Secondary data- It is the information obtained from existing records of past collection
or from outside source. It is cheaper than primary data, but the data may be less
relevant as it is not collected for specific needs of the firm and may have already
become out of date. It may be collected from existing sources such as annual reports,
sales data, customer records and survey, client databases, payment records, reports of
marketing research companies, trade associations etc

Limitations of demand forecasting

1. Lack of efficient and experienced forecasters
2. Lack of demand history
3. Change in consumers’ needs, fashions and styles etc
4. Complex psychology of consumers

Essentials of good demand of forecasting system

1. Simplicity
2. Accuracy
3. Availability
4. Stability
5. Economy
Factors affecting demand forecasting
1. General business conditions
2. Conditions within the industry
3. Internal factors of the enterprise
4. Factors affecting export trade
5. Market behaviour

Steps in Demand forecasting

• Following are the typical steps for a systematic demand forecasting
– Understanding objective
– Determining the time perspective
– Understand and identify customer segments
– Identify major factors that influence demand forecast
– Determining the appropriate forecasting technique
– Estimation and interpretation of results

Demand forecasting methods

I. Qualitative methods or Opinion and judgemental methods

• Deals with
- What do people say
- What do they do. Useful in forecasting for new product or new market for which no
past data available

A. Consumer’s Opinion Survey

• Buyers are asked about their future buying intentions of products, their brand preferences
and quantity of purchase.
• Possible response to increase in price, probable change in product's feature and competitive
product.

B Sales force Opinion

• Salespersons are asked about their estimated sales target in their respective sales territories
in a given period of time.
• Sum total of such estimates form the basis of forecasted demand.

C. Jury of expert opinion

The views of experts from sales, production, finance, purchasing and administration are
averaged to generate a forecast about future sales as they are well informed about the
company’s market position, capabilities, competition and market trend
D. Delphi Technique
It is similar to jury of experts. In this a panel of experts is asked to respond to a series of
questionnaires. The responses are tabulated and opinions of the entire group are made known
to each other panel members so that they may revise their previous forecast response. The
process continues until some degree of consensus is achieved.

II. Time series forecasting or Quantitative forecasting methods

A trend of the company’s or industry’s demand is obtained with the help of historical data
relating to the demand which are collected, observed or recorded at successive intervals of
time. Such data is referred to as time series. The study may show that the demand sometimes
increases and sometimes decreases but a general trend in the long run will be either upward or
downward.

A time series refers to the past recorded values of the variables under consideration. The
values of the variables under consideration in a time-series are measured at specified intervals
of time. These intervals may be minutes, hours, days, weeks, months, etc. In the analysis of a
time series the following four time-related factors are important
1) Trends: These relate to the long-term persistent movements/tendencies/changes in data
like price increases, population growth, and decline in market shares.
2) Seasonal variations: There could be periodic, repetitive variations in time-series which
occur because of buying or consuming patterns and social habits, during different
times of a year. The demand for products like soft drinks, woolens and refrigerators,
also exhibits seasonal variations.
3) Cyclical variations: These refer to the variations in time series which arise out of the
phenomenon of business cycles. The business cycle refers to the periods of expansion
followed by periods of contraction. The period of a business cycle may vary from one
year to thirty years. The duration and the level of resulting demand variation due to
business cycles are quite difficult to predict
4) Random or irregular variations: These refer to the erratic fluctuations in the data which
cannot be attributed to the trend, seasonal or cyclical factors. In many cases, the root
cause of these variations can be isolated only after a detailed analysis of the data and
the accompanying explanations, if any. Such variations can be due to a wide variety of
factors like sudden weather changes, strike or a communal clash. Since these are truly
random in nature, their future occurrence and the resulting impact on demand are
difficult to predict.

Various Time series techniques are:

a) Simple moving average
i) Simple average technique
ii) N-period moving average technique
iii) Weighted n-period moving average technique
b) Exponential smoothing method
c) Regression analysis
d) Hand fitting
Simple Average technique
The simple arithmetic average of a set of observed values of demand for n-period is calculated
and it is used as the forecast for (n+1)th period in the immediate future. The forecasting
equation is :

Average demand for ‘n+1’ period, Fn+1 = D1 + D2 + D3 + …. + Dn

n

Advantages of simple average method

1. Simple to use

Disadvantages of simple average method

1. Gives equal importance to very old data

N-period moving average technique

The forecast for a particular period mostly depends on some near pas values. The old data did
not mostly predict the proper forecast.
For the ‘n+1’ period, forecast is calculated from the previous ‘n’ period average value. A
Moving average is obtained by summing and averaging the values from a given number of
periods repetitively, each time deleting the oldest value and adding a new value. Moving
averages can smooth out fluctuations in any data, while preserving the general pattern of the
data.
The number of period selected for moving average depends on what is forecasted and
characteristics of demand. The forecasting equation will be of form as below:

Fn+1 = D1 + D2 + D3 + …. + Dn
No. of period

Advantages of moving average method

1. Simpler without fitting the curve
Disadvantages of moving average method
1. Care is taken for data selection and period of moving average

Weighted moving average technique

In this method different weights are given to different periods as compared to simple moving
average where equal weights are given to all periods. The forecasting equation will be of the
form as follows:

Fn+1 = Weighted n-period moving average

Fn+1 = W1D1 + W2D2 + ……… + WnDn
A weighted moving average allows some values to be emphasized by varying the weights
assigned to each component of the average. This makes the techniques more responsive to
changes since more recent periods may be more heavily weighted.
Advantages
1. This method assigns a factor related to how recent they are. The more recent the
average, the more the weight
Disadvantages
1. False signals are likely to be generated than with simple moving averages

Problems

1. The monthly demand of scooters in an automobile shop are given below for one year.
Find the demand forecast for the next month using a) simple average method b) 3
months, 4 months and 5 months moving average c) Calculate weighted moving average
for the 13th month taking weightages as 0.1, 0.1, 0.2, 0.2, 0.3, 0.1 for the 7 th month to 12th
month respectively.

Month 1 2 3 4 5 6 7 8 9 10 11 12
Demand 12 18 24 28 36 30 21 42 15 8 20 10

Solution
a) Simple Average, Fn+1 = D1 + D2 + D3 + …. + Dn
n
F13 = 12+18+24+28+36+30+21+42+15+8+20+10
12
= 264 = 22
12

b) Moving average

Month Demand 3 Months MA 4 Months MA 5 Months MA

1 12 - - -
2 18 - - -
3 24 - - -
4 28 18 - -
5 36 23.33 20.50 -
6 30 29.33 26.50 23.60
7 21 31.33 29.50 27.20
8 42 29 28.75 27.80
9 15 31 32.25 31.40
10 8 26 27 28.80
11 20 21.67 21.50 23.20
12 10 14.33 21.25 21.20
13 12.67 13.25 19

c) Fn+1 = W1D1 + W2D2 + ……… + WnDn

= (0.1 x 21) +(0.1 x 42) +(0.2 x 15) +(0.2 x 8) +(0.3 x 20) +(0.1 x 10)
= 17.9
Exponential smoothing
This is a sophisticated weighted moving average method that calculates the average of a time
series by giving recent demands more weight than earlier demands. It is most frequently used
because of its simplicity and small amount of data needed to support it. Here only forecasted
and actual demand of current month is necessary to forecast the demand for the next period.
The forecast Fn+1 is made up of the last period forecast Fn plus a portion “α” multiplied by the
difference between the last periods actual demand An and the last period forecast Fn and is
given by the equation below:

Fn+1 = Fn + α (An – Fn)

Where,
Fn+1 = Forecasted demand for next time period
Fn = Forecasted demand for nth period
α = Weightage given ( smoothing constant)
An = Actual demand for the nth period
2
α =
𝑛+1
Advantages of smoothing methods:
1. Well suited for immediate prediction of larger number of items
2. They have short term accuracy, simplicity and low cost
3. Easier to implement and more efficient to compute
4. The effect of unusual data fades uniformly

Disadvantages
1. No good rule for determining the approximate values of weights
2. Does not account for any of the other variables that might influence the forecast
3. When improperly used they can smooth away important trends and distort predictions

Problems
1. A firm uses simple exponential smoothing with α = 0.1 to forecast demand. The
forecast for the first week of February was 500 units and whereas actual demand was
450 units. A) Forecast the demand for the next week B) Continue forecasting through
assuming that subsequent demands were 505, 516, 488, 467, 554 and 510 units
Solution
Fn+1 = Fn + α (An – Fn)

Given forecast for first week of Feb as 500 units and actual demand as 450 units. Forecast for
the next time are tabulated below:
Week Fn An Fn+1 = Fn + α (An – Fn)
2 500 450 F2 = 500 + 0.1 (450 – 500) = 495
3 495 505 F3 = 495 + 0.1 (505 – 495) = 496
4 496 516 F4 = 496 + 0.1 (516 – 496) = 498
5 498 488 F5 = 498 + 0.1 (488 – 498) = 497
6 497 467 F6 = 497 + 0.1 (467 – 497) = 494
7 494 554 F7 = 494 + 0.1 (554 – 494) = 500
8 500 510 F8 = 500 + 0.1 (510 – 500) = 501
Forecast for 8th week is 501 units
2. Given the weekly demand data, what are the exponential smoothing forecast for the
periods 2-10 using α = 0.1. Assume F1 = A 1

Week 1 2 3 4 5 6 7 8 9
Demand 820 775 680 655 750 802 798 689 775

Solution
Assume F1 = A 1 = 820
Week Fn An Fn+1 = Fn + α (An – Fn)
2 820 820 F2 = 820 + 0.1 (820 – 820) = 820
3 820 775 F3 = 820 + 0.1 (775 – 820) = 815.5
4 815.5 680 F4 = 815.5 + 0.1 (680 – 815.5) = 801.95
5 801.95 655 F5 = 801.95 + 0.1 (655 – 801.95) = 787.26
6 787.26 750 F6 = 787.26 + 0.1 (750 – 787.26) = 783.53
7 783.53 802 F7 = 783.53 + 0.1 (802 – 783.53) = 785.38
8 785.38 798 F8 = 785.38 + 0.1 (798 – 785.83) = 786.64
9 786.64 689 F9 = 786.64 + 0.1 (689 – 786.64) = 776.88
10 776.88 775 F10 = 776.88 + 0.1 (775 – 776.88) = 776.89

Forecast for 10th week is 776.89 units

Regression analysis

“Regression analysis is an attempt to establish the nature of the relationship between

variables-that is to study the functional relationship between the variables and thereby
provides a mechanism for prediction or forecasting”.
Regression Analysis is a statistical device with the help of which we are able to estimate the
unknown values of one variable from known values of another variable. The variable which is
used to predict the another variable is called independent variable (explanatory variable) and,
the variable we are trying to predict is called dependent variable (explained variable).

Types of Regression:-
There are two types of regression. They are linear regression and multiple regression.
Linear Regression:
It is a type of regression which uses one independent variable to explain and/or predict the
dependent variable.
Multiple Regression:
It is a type of regression which uses two or more independent variable to explain and/or
predict the dependent variable.

The methods of regression analysis are:

a. Least square method
b. Logarithmic straight line
c. Parabolic method
Least square method
This is one of the most popular methods of fitting a mathematical trend. The fitted trend is
termed as the best in the sense that the sum of squares of deviations of observations, from it, is
minimized. It gives the equation of the line for which the sum of squares of vertical distance
between the actual values and the line values are minimum.
The method of least square is an objective method of determining the best relationship
between the two variables constituting a bivariate data. To find out best relationship means to
determine the values of the constants involved in the functional relationship between the two
variables. This can be done by the principle of least squares:
The principle of least squares says that the sum of the squares of the deviations between the
observed values and estimated values should be the least. In other words, ∑(y-yc)2 will be the
minimum.

This line passes through the points in such a way that the sum of squares of deviations of the
actual points above and below the trend line is minimum. This line is called ‘ line of best fit’.
A straight line fitted in the least square method is given as follows:
Regression Equation of Y on X ( it means finding value of Y on the basis of X)
y = a + bx

where y is the dependent variable of demand

x is the independent variable in terms of unit of time as day, week,
month or year

The values of a and b are calculated by the equations:

a =∑Y/n
b =∑ XY /∑X2

(or)

When the sum of the deviations is not Zero

𝑦 − 𝑦̅ = 𝑏𝑦𝑥 (𝑥 − 𝑥̅ )

𝑛Ʃ𝑋𝑌−(Ʃ𝑋.Ʃ𝑌)
Where byx =
𝑛Ʃ𝑋 2 −(Ʃ𝑋)2

ƩX Ʃ𝑌
𝑥̅ = and 𝑦̅ =
n 𝑛
Advantages:
1. Gives most satisfactory results
2. Simple and economical

Disadvantages
1. Based on the assumption that all factors affecting demand will remain constant during
the period of forecasting. But this assumption is not valid as factors affecting demand
always keep changing
Problems

1. From the following time series data of sales, project the demand for the next three
years

Year x 2001 2002 2003 2004 2005 2006 2007

Sales (1000 units) y 80 90 92 83 94 99 92

Solution

Years Time deviation Demand (in 1000 Squares of Product of time

from 2004 units) time deviations and
demand
x y x2 xy
2001 -3 80 9 -240
2002 -2 90 4 -180
2003 -1 92 1 -92
2004 0 83 0 0
2005 1 94 1 94
2006 2 99 4 198
2007 3 92 9 276
N=7 ∑x = 0 ∑y = 630 ∑x = 28
2
∑xy = 56
Regression Equation of Y on X ( it means finding value of Y on the basis of X)
y = a + bx
The values of a and b are calculated by the equations:
a =∑Y/n
b =∑ XY /∑X2
a = 630/7 = 90
b = 56/28 = 2
Therefore projected trend values for next three years =
Y2008 = 90 + 2 (4) = 90 + 8 = 98
Y2009 = 90 + 2 (5) = 90 + 10 = 100
Y2010 = 90 + 2 (6) = 90 + 12 = 102

2. Find regression equations y on x from the following:-

X: 25 30 35 40 45 50 55
Y: 18 24 30 36 42 48 54
Solution
x y x2 xy
25 18 625 450
30 24 900 720
35 30 1225 1050
40 36 1600 1440
45 42 2025 1890
50 48 2500 2400
55 54 3025 2970

∑x = 280 ∑y = 252 ∑x2 = 11900 ∑xy = 10920

Regression equation Y on X is:
𝑦 − 𝑦̅ = 𝑏𝑦𝑥 (𝑥 − 𝑥̅ )

Where byx = n∑xy – (∑x * ∑y )

n∑x2 – (∑x)2
𝑦̅ = 252/7 = 36

𝑥̅ = 280/7 = 40

Solving byx = n∑xy – (∑x * ∑y )

n∑x2 – (∑x)2

= 7 * 10920 – ( 280 * 252 )

7 * 11900 – (280)2
= 1.2

Regression equation Y on X is:

𝑦 − 𝑦̅ = 𝑏𝑦𝑥 (𝑥 − 𝑥̅ )
y – 36 = 1.2 (x – 40)
therefore y = 1.2 x -12

3. An investigation into the demand for colour tv sets in 5 towns has resulted in the
following data:

Population of the town (in lakhs) X 5 7 8 11 14

No of TV sets demanded (in thousands) Y 9 13 11 15 19

Fit a linear regression of y on x and estimate the demand for CTV sets for two towns
with a population of 10 lakhs and 20 lakhs

Solution
Population Demand of CTV (in
thousands)
x y xy x2
5 9 45 25
7 13 91 49
8 11 88 64
11 15 165 121
14 19 266 196
∑x = 45 ∑y = 67 ∑xy = 655 ∑x2 = 455

Regression equation Y on X is:

𝑦 − 𝑦̅ = 𝑏𝑦𝑥 (𝑥 − 𝑥̅ )
Where byx = n∑xy – (∑x * ∑y )
n∑x2 – (∑x)2
 𝑦̅ = 67/5 = 13.4

𝑥̅ = 45/5 = 9

Solving byx = n∑xy – (∑x * ∑y )

n∑x2 – (∑x)2

= 5 * 655 – ( 45 * 67 )
5 * 455 – (45)2
= 1.04

Regression equation Y on X is:

𝑦 − 𝑦̅ = 𝑏𝑦𝑥 (𝑥 − 𝑥̅ )
y – 13.4 = 1.04 (x – 9)
therefore y = 1.04 x + 4.04

When x (population) = 10
Substituting y = 1.04 x + 4.04
Therefore y = 14.44

When x (population) = 20
Substituting y = 1.04 x + 4.04
Therefore y = 24.84

Freehand method / Hand fitting

In this method the given time series data are plotted on graph paper by taking time on the x-
axis and the other variable on the y-axis. The points are joined by straight lines. The graph
obtained will be irregular. Now drawing a freehand curve passing through all this points will
represent trend line. However it is very difficult to draw a freehand smooth curve and
different persons are likely to draw different curves from the same data. This method is hence
inaccurate.
 Business financing

Finance is essential for a business’s operation, development and expansion. Funds can be
procured from different sources and therefore procurement is always considered as a complex
problem by business concerns. Funds procured from different sources have different
characteristics in terms of cost, risk and control. It is crucial for business to choose the most
appropriate source of finance.

Methods of Raising Finance

1. Public Issue of Shares:
A share can be defined as “A fraction part of the capital of the company which forms the basis
of ownership and interest of a subscriber in the company”. When the owned capital is divided
into a number of equal parts, then, each part is called as a share. A person who contributes for
a share is called as a share- holder. The company can raise a substantial amount of fixed
capital by issue of shares- equity and preference.
2. Issue of Debentures:
When borrowed capital is divided into equal parts, then, each part is called as a debenture.
Debenture represents debt. For such debts, company pays interest at regular intervals. It
represents borrowed capital and a debenture holder is the creditor of the company. Debenture
holder provides loan to the company and he has nothing to do with the management of the
company.
3. Long Term Loans:
The company may also obtain long term loans from banks and financial institutions like
I.D.B.I., I.C.I.C.I., and so on.
4. Retained Earnings (Reserves):
The Company often resorts to ploughing back of profits that, is, retaining a part of profits
instead of distributing the entire amount to shareholders by way of dividend. Such
accumulated earnings are very useful at the time of replacements, or, purchases of additional
fixed assets.
5. Public Deposits:
Often companies find it easy and convenient to raise short- term funds by inviting
shareholders, employees and the general public to deposit their savings with the company. It
is a simple method of raising funds from public for which the company has only to advertise
and inform the public that it is authorised by the Companies Act 1956, to accept public
deposits.
Public deposits can be invited by offering a higher rate of interest than the interest allowed on
bank deposits.
6. Trade Credit:
Just as the companies sell goods on credit, they also buy raw materials, components and other
goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e.,
trade creditors for credit purchases are regarded as sources of finance. Generally, suppliers
grant credit to their clients for a period of 3 to 6 months.
7. Discounting Bills of Exchange:
When goods are sold on credit, bills of exchange are generally drawn for acceptance by the
buyers of goods. A bill of exchange is defined as an instrument in writing containing an
unconditional order, signed by the maker, directing a certain person to pay a certain sum of
money only to, or to the order of a certain person or to the bearer of the instrument.
8. Bank Overdraft
Overdraft is a facility extended by the banks to their current account holders for a short-period
generally a week. A current account holder is allowed to withdraw from its current deposit
account upto a certain limit over the balance with the bank. The interest is charged only on the
amount actually overdrawn. The overdraft facility is also granted against securities.

Types of shares: Shares can be broadly divided into equity shares and preference shares

Equity Shares: Shares which enjoy dividend and right to participate in the management of Joint
Stock Company are called equity shares, or, ordinary shares. They are the owners and real risk
bearers of the company. Equity shareholders are the real owners of the company and,
therefore, they are eligible to share the profits of the company. The share given to equity
shareholders in profits is called “Dividend”. At the time of winding of company, the capital is
paid back last to them after all other claims have been paid in full.
Preference Shares: Shares which enjoy preference as regards dividend payment and capital
repayment are called “Preference Shares”. They get dividend before equity holders. They get
back their capital before equity holders in the event of winding up of the company. The
owners of these shares have a preference for dividend and a first claim for return of capital;
when the company is closed down. But, their dividend rate is fixed.

Difference between preference shares and equity shares

Basis of difference Preference shares Equity shares
Right of dividend They are paid dividend before They are paid dividend out of
equity shares the balance profit available after
payment to pref shareholders
Rate of dividend Fixed Decided by Board of Directors
year to year depending on
profits.
Convertibility They can be converted into They cannot be converted
equity shares if the issue
provides so
Participation in management No right to participate They have the right
Voting right No voting right They have voting right

Differences between Shares and Debentures

Basis of difference Shares Debentures
Ownership The share of a company Debenture-holders are
provides ownership to the creditors of a company who
shareholders provide loan to the company
Identity Person holding share is known person holding debenture is
as shareholder. known as debenture-holder
Certainty Of Return No certainty of return in case of
Debenture-holder receives the
loss for the shareholder. interest even if there is no
profit
Convertibility Shares cannot be converted Debentures can be converted
into debentures. into shares
Control Shareholders have the right to Debenture holders do not
participate and vote in possess any voting right and
company's meeting. cannot participate in meeting.
Financial Market
Financial market is the market that facilitates transfer of funds between investors/ lenders and
borrowers/ users. Financial market may be defined as ‘a transmission mechanism between
investors (or lenders) and the borrowers (or users) through which transfer of funds is
facilitated’. It consists of individual investors, financial institutions and other intermediaries
who are linked by a formal trading rules and communication network for trading the various
financial assets and credit instruments. It deals in financial instruments (like bills of exchange,
shares, debentures, bonds, etc).

Financial Market Classification

A. Money Market.
B. Capital Market.

Money Market
The money market in that part of a financial market which deals in the borrowing and lending
of short term loans generally for a period of less than or equal to one year. Money market
instruments have the characteristic of liquidity (quick conversion into money), minimum
transaction cost and low loss in value. The money market is one of the primary mechanisms
through which the RBI influences liquidity and the general level of interest rates in an
economy. Mostly government, banks and financial institutions dominate this market. Some of
the instruments used in this market are certificate of deposits, bills of exchange, promissory
notes, commercial paper, treasury bills etc.

Functions of money market

The major functions of money market are given below:

1. To maintain monetary equilibrium. It means to keep a balance between the demand for and
supply of money for short term monetary transactions.
2. To promote economic growth. Money market can do this by making funds available to
various units in the economy such as agriculture, small scale industries, etc.
3. To provide help to Trade and Industry. Money market provides adequate finance to trade
and industry. Similarly it also provides facility of discounting bills of exchange for trade and
industry.
4. To help in implementing Monetary Policy. It provides a mechanism for an effective
implementation of the monetary policy.
5. To help in Capital Formation. Money market makes available investment avenues for short
term period. It helps in generating savings and investments in the economy.
6. Money market provides non-inflationary sources of finance to government. It is possible by
issuing treasury bills in order to raise short loans. However this dose not leads to increases in
the prices.

Capital Market
Capital Market is an institutional arrangement for borrowing medium and long-term funds and
which provides facilities for marketing and trading of securities. So it constitutes all long-term
borrowings from banks and financial institutions, borrowings from foreign markets and
raising of capital by issue various securities such as shares, debentures, bonds, etc.
Classification of Capital market
Capital market can be classified into i) Industrial securities market ii) Government securities
market iii) Long term Loans market

1. Industrial Securities market

It is the market for industrial securities. Industrial securities dealt in this market are equity shares,
preference shares and debentures or bonds. It is a market where industrial organizations raise their
funds by issuing these securities. It is classified into primary and secondary market.
The primary market consists of arrangements for procurement of long-term funds by
companies by fresh issue of shares and debentures.
The secondary market or stock exchange provides a ready market for existing long term
securities. Stock exchange is the secondary market, which provides a place for regular sale
and purchase of different types of securities like shares, debentures, bonds & government
securities

2. Government securities market

It is also known as gilt edged securities. The Government securities consists dated securities
issued by the Government of India and state governments. The date of maturity is mentioned on
the securities. Therefore it is known as dated securities.
The government borrows funds through the issue of long term-dated securities, lowest risk
category instruments in the economy. The investors in these securities are mainly banks, foreign
investors, insurance companies, provident funds and trusts. These investors are required to hold
certain part of their investments in government securities.

3. Long term Loans market

These include long term loans supplied to corporate customers by banks and financial
institutions.

Functions of capital market

1. Allocation function – Capital market allows for the channelization of the savings of
innumerable investors into various productive avenues of investments. Accordingly the
current savings for a period are allocated among the various users and uses. The market
attracts new investors who are willing to make new funds available to business.
2. Liquidity function – Capital market provides a means whereby buyers and sellers can
exchange securities at mutually agreed prices. This allows for liquidity.
3. Other functions
a. Indicative function – it acts as a barometer showing not only the progress of a
company but also of the economy through share price movements
b. Savings and investment function – It is a means of quickly converting long term
investment into liquid funds thereby generating confidence among investors and speeding up
the process of savings and investment.
c. Transfer function – It facilitates transfer of existing – tangible and intangible assets
among individual economic groups.
d. Merger function – It encourages voluntary or coercive takeover mechanism to put
the management of inefficient companies into more competent hands

International Financing (FDI, FII, FPI)

Foreign direct Investment
FDI is the investment made by a foreign individual or company in productive capacity of
another country. It is the movement of capital across national frontiers in a manner that grants
the investor control over the acquired asset. FDI refers to the long term participation by one
country in another country. It involves participation in management, joint venture, transfer of
technology and expertise.
FDI flows are related with economic condition of a country. If economic condition of a
country is healthy then FDI flow will be more. FDI is normally defined as a form of
investment made in order to gain solid and long lasting interest in enterprises that are operated
outside of the economy of the shareholder or depositor. In FDI there is a parent enterprise and
a foreign associate which unites to form a multinational corporation (MNC). In order to be
deemed as FDI the investment must give the parent enterprise power and control over its
foreign affiliate.
It can be defined as an investor based on one country (home country), acquires an asset in
another country (host country), with the intention to manage it.
The returns of FDI are generally in form of profit that is retained earnings, profits, dividends,
royalty payments, management fees etc.

Benefits of FDI
Potential benefits of FDI to the host countries include the following:
1. Access to superior technology.
Foreign firms bring superior technology to the host countries while investing. The extent of
benefits depends upon the technology spill over to other firms based in the host country.
2. Increased competition.
The investing foreign firm increasing industry output resulting in overall reduction in
domestic prices, improved product or service quality, and more availability of products. This
intensifies competition in host economies resulting in the improvement in consumer welfare.
3. Increase in domestic investment.
It is found that capital flows in the form of FDI increase domestic investment so as to survive
and effectively respond to the increasing competition.
4. Bridging host country’s foreign exchange gap.
In most developing countries, the levels of domestic savings are often insufficient to support
capital accumulation and to achieve growth targets. Besides, the level of foreign exchange
may be insufficient to purchase imported inputs. Under such situations, the FDI helps in
making available foreign exchange for imports.
Negative impacts of FDI
1. Market monopoly.
MNCs are far more advanced than domestic enterprises, owing to their large size and
financial power. In some sectors, this is leading to MNE monopolies, thus impeding the entry
of domestic enterprises in marketing, and advertising and R&D activities
2. Crowding out and unemployment effects.
FDI tends to discourage entry and stimulates exit of domestic enterprises often termed as the
crowding out effect. As FDI enterprises are less labour intensive, their entry results in higher
unemployment and increased social instability.
3. Technology dependence.
MNCs often function in a way that doesn’t result in technology transfer or technology
sharing, thereby making local firms technologically dependent or technologically less self-
reliant.
4. Profit outflow
Foreign investors import their inputs and use the host country as a processing base, with little
value added earnings in the host country. A large proportion of their profits may be
repatriated.
5. Corruption
Many foreign investors often bribe government officials, to get their desires satisfied.
The Determinants of FDI Location
1. Market demand.
The flows of FDI are positively influenced by the size of a country’s market demand as
measured by GDP per capita.
2. Growth rate.
FDI flows to where fast economic growth has been recorded.
3. Political stability.
Political riots or armed conflicts may exert a negative influence on foreign companies’
investment decisions. Indeed, frequent changes of governments and the resultant policy
changes can reduce an investor’s assets to zero overnight.
4. Macroeconomic stability.
A country’s overall macroeconomic performance, such as low inflation rate and balanced
fiscal account, is a consistently significant factor in shaping the decision making of foreign
investors when assessing investment locations.
5. Infrastructure.
With regards to FDI, infrastructure encompasses both physical (e.g. roads and power) and
social (e.g. health and education) concepts. It has been repeatedly shown around the world
that a well developed infrastructure network and a well-trained labor force are major elements
of attractiveness to foreign investors.

Foreign Institutional Investment

FII means the institution established or incorporated outside India which propose to make
investment in securities in India. FII’s are regulated by Securities and Exchange Board of
India (SEBI). FII can invest in shares, debentures, mutual funds and government securities.
Now FII does not exist as a category. New class called Foreign Portfolio Investment was
created.

Foreign Portfolio Investment

Investment by individuals, firms or public bodies in financial instruments, such as foreign
stocks, government bonds etc is known as Foreign Portfolio Investment. Foreign portfolio
investment does not render any management control to the investor. Thus FPI can be viewed
only as a passive holding of foreign assets, without having any voice in the management of
the invested firm.FPI is favourably affected by factors like risk minimization through
diversification, and high rate of return. Thus it can be inferred that FPI is passive whereas FDI
is active. The returns in the case of FPI are generally in the form of non-voting dividends or
interest payments
Particulars FDI FPI
Management and control Investor obtains rights of No such rights are available
management and control in under FPI
the firm.

Mode of investment Active holding Passive holding

Disposal of investment Difficult to dispose Easy disposal

Nature of interest Long term Short term

Requirement of capital Very high Comparatively less

 TAXATION

Tax may be defined as a compulsory contribution collected from people for the general
services by the state. Whatever type of Government, it has to perform certain functions. To
carry out these functions it needs funds.

Objectives of taxation
1. Raise More Revenue
The government requires carrying out various development and welfare activities in the
country. For this, it needs a huge amount of funds. The government collects funds by
imposing taxes.

2. Prevent Concentration Of Wealth In A Few Hands

Tax is imposed on persons according to their income level. High earners are imposed on high
tax through progressive tax system. This prevents wealth being concentrated in a few hands of
the rich.

3. Redistribute Wealth For Common Good

Tax collected by the government is expended for carrying out various welfare activities. In
this way, the wealth of the rich is redistributed to the whole community.

4. Boost Up The Economy

Tax serves as an instrument for promoting economic growth, stability and efficiency. The
government controls or expands the economic activities of the country by providing various
concessions, rebates and other facilities.

5. Reduce Unemployment
The government can reduce the unemployment problem in the country by promoting various
employment generating activities.

6. Remove Regional Disparities

The government provides tax exemptions or concessions for industries established or
activities carried out in backward areas. This will help increase economic activities in those

Canons of taxation
(1) Canon of Equity. It implies that tax should be levied on citizens on the basis of
equality. The sacrifice of all citizens must be equal. In other words, this canon of
taxation maintains that every person should pay to the State as tax according to ability
to pay. It implies taxing the people on the rate of taxation.
(2) Canon of Certainty: This canon of taxation suggests that the tax which an individual
has to pay, should be certain and not arbitrary. It should be certain to the tax payer
how much tax he has to pay, to whom and by what time the tax is to be paid.
The place and other procedural information should also be clear. It would protect the
tax payer from the exploitation of tax authorities in any way. It will enable the tax
payer to manage his income and expenditure. The Government will also be benefited
by this principle.
(3) Canon of Convenience or Ease: According to this canon of taxation, every tax
should be levied in such a manner and at such a time that it affords to the maximum of
convenience to the tax payer. The reason is that the tax payer forgoes his purchasing
power and makes a sacrifice at the time of payment of tax hence the Government
should see that the tax payer suffers no inconvenience.
 For example, in an agricultural country, tax should be collected only after the
harvesting has been done.
(4) Canon of Economy. This principle suggests that the cost of collecting tax should
be the minimum so that a major part of collections may bring to the
Government treasury. If the administration expenses in the collection of taxes
consume a major portion of tax revenue collected; it cannot be said to be a good tax
system.
(5) Canon of productivity: The canon of productivity indicates that a tax when levied
should produce sufficient revenue to the government. If a few taxes imposed yield a
sufficient fund for the state, then they should be preferred over a large number of small
taxes which produce less revenue and are expensive in collection.
(6) Canon of elasticity: Canon of elasticity states that the tax system should be fairly
elastic so that if at any time the government is in need of more funds, it should
increase its financial resources without incurring any additional cost of collection.
Income tax, railway fares, postal rates, etc., are very good examples of elastic tax. The
government by raising these rates a little can easily meet its rising demand for
revenue.
(7) Canon of simplicity: Canon of simplicity implies that the tax system should be fairly
simple, plain and intelligible to the tax payer. If it is complicated and difficult to
understand, then it will lead to corruption.
(8) Canon of diversity: Canon of diversity says that the system of taxation should
include a large number of taxes which are economical. The government should
collect revenue from its citizens by levying direct and indirect taxes. Variety in
taxation in desirable from the point of view of equity, yield and stability.

Classification of taxes
Taxes may be i) proportional ii) progressive iii) regressive iv) degressive
1. Proportional tax - A proportional tax is one which takes out of the pocket of every person
exactly the same percentage of income. For eg. A tax on all incomes, big or small, at a flat
rate of 5% would be proportional tax.

2. Progressive tax - A progressive tax tries to distribute the sacrifice in a more just manner.
Higher incomes are charged at higher rates. Since marginal utility of money falls with its
increase, richer people have a greater capacity to pay taxes.

3. Regressive tax - A regressive tax is one which is charged from the poor at a higher rate
than from the rich.

4. Specific and ad valorem taxes – On the basis of assessment taxes on commodities may be
classified into two categories – specific tax and ad valorem tax

Taxes which are levied on certain qualities or attributes such as weight, size, volume etc are
called specific taxes. For example is imposed on sugar according to its weight.

Tax which is imposed according to the value of the commodity are known as ad valorem taxes
(Latin word for according to value) For eg import duty in many cases is levied on the value of
goods imported like 20% of the value of goods imported. Value Added Tax (VAT) and sales
tax are Ad valorem taxes.

A sales tax is the tax charged at the point of purchase for goods and services. The tax is
usually set as a percentage by the government. VAT has been introduced to replace sales tax.
The problem with India’s sales tax structure was that of double taxation – Inputs are first
taxed before a commodity is produced and then after the commodity is produced with input
tax, the output is again taxed.

Value Added Tax (VAT) was introduced as an indirect tax into the Indian Taxation system
from 1 April 2005. VAT is imposed on goods or services at various stages of its production or
distribution. VAT is imposed on the value that a business firm adds to the value of goods and
services purchased from other firms. For instance if a dealer purchases goods for Rs 100 from
another dealer and a tax of Rs 10 (ie 10%) has been charged in the bill. He sells the goods for
Rs 120 (Rs 20 being profit to him) on which the dealer will charge a tax of Rs 12 at 10%. The
tax payable by the dealer will be only Rs 2 being the difference between tax collected of Rs
12 and tax already paid on purchases of Rs 10.

The difference between the tax paid on purchase and the tax payable on sale is the VAT. VAT
is not a tax on the total value of the commodity being sold but on the value added to it by the
last trader. VAT mainly falls on the final consumer of goods and services. However all those
involved in the chain of transactions from the manufacturer to the retailer are charged VAT
and then it passes on to the next person in the chain.

5. Direct and indirect taxes

Direct tax is one that is collected directly from the people. In this case the person who pays
the tax is also intended to bear the burden of it, ie impact and incidence are on the same
person. A direct tax is one which is really paid by the person on whom it is legally imposed.

When we buy a TV from the market, we have to pay sales tax to the shopkeeper in addition to
the price of the TV. In this way the government collects tax from the shopkeeper and the
shopkeeper collects it from the customer. Thus the customer pays tax indirectly to the
government, through the shopkeeper. Such taxes are called indirect taxes. An indirect tax is
imposed on one person but is partly paid or wholly paid by another. Taxes on income are
direct and those on goods are indirect.

Indirect taxes – Sales tax, VAT

Direct tax – Income tax, Corporation tax

Goods and Services Tax (GST)

In India GST came into force from 1st July 2017. “ One Nation One Tax”.

GST is a consumption based tax levied on sale, manufacture and consumption on goods and
services at a national level. This tax is asubstitute for all indirect taxes levied by state and
central governments. Exports and direct tax like – income tax, corporate tax and capital gain
tax will not be affected by GST. GST would apply to all goods other than crude petroleum,
motor spirit, diesel, aviation turbine fuel and natural gas.

Eg. Let us assume that a dealer in Gujarat had sold the goods to a dealer in Punjab worth
Rs.50,000. The GST rate is 18% comprising only 18%. In such case the dealer has to charge
Rs. 9000 as IGST. This IGST revenue will go to central government.
The same dealer sells goods to a consumer in Gujarat worth Rs. 50,000. The GST rste on the
good is 12%. This rate comprises of CGST and SGST ie. 6% each. The dealer has to collect
Rs. 6000 as GST and Rs. 3000 will go to central government and Rs. 3000 will go to state
government as the sale is within the state.

Advantages

1. To abolish cascading effect on tax

2. To create a common market across states
3. Price reduction
4. Make more transparent
5. Simplified and cost saving system

Disadvantages

1. It is considered as a single taxation but in reality it’s a dual tax in which centre and
state collects separate tax on a single transaction of sale and service
2. In many areas, tax is considered as high
3. Majority of the dealers are not aware of the system.

What is GST? Why was there a need for this bill?

GST (Goods and Services Tax) is a tax levied when a consumer buys a good or service.
The previous tax regime consisted of many indirect taxes which the GST aims to subsume
with a single comprehensive tax, bringing it all under a single umbrella. The bill aims to
eliminate the cascading effect of taxes on production and distribution prices on goods
and services.

Impact and incidence of Taxation

Impact of a tax is on person from whom government collects money in first instance. While
incidence of a tax is on person who finally bears burden of a tax. For example if we buy a
music system from a shopkeeper we pay sales tax to the shopkeeper. The shopkeeper will pay
it to the government. This means that the incidence of sales tax will be on the customer and its
impact on the shopkeeper.

Shifting of tax
Shifting is process of transferring money burden of tax to someone else. Shifting finally ends
in incidence. When a person on whom tax is levied tries to shift tax on to the other, he may
succeed in shifting tax completely, partly, or may not succeed at all.

Shifting of tax can take place in two directions, forward and backward. If tax is shifted, from
seller to consumer, it is a case of forwarding shifting.

Backward shifting takes place when consumers do not purchase commodities at increased
prices. Sellers are then forced to cut down prices and bear burden of tax themselves.
Backward shifting is thus performed by buyers.
Tax evasion
Tax evasion is the illegal evasion of taxes by individuals, corporations, and trusts. Tax
evasion often entails taxpayers deliberately misrepresenting the true state of their affairs to the
tax authorities to reduce their tax liability and includes dishonest tax reporting, such as
declaring less income, profits or gains than the amounts actually earned, or overstating
deductions.

Common Methods of Tax Evasion:

1. Failing to pay the due:
People may decide not to pay taxes to the government, not even when the dues are called for.
2. Smuggling:
When certain goods move from one location to another, across international or state borders, a
tax or charge may be payable in order to move the goods. However, some individuals may
move these goods in unaccounted ways in order to avoid paying those taxes
3. Submitting false tax returns:
In some cases, when an individual files taxes, they may submit false or incorrect information
in order to either lessen the tax that they are supposed to pay or not pay it at all.
4. Inaccurate financial statements:
The taxes that are payable by an individual or an organisation may be decided on the financial
dealing that have taken place during the assessment year. If false financial statements are
submitted, ones that show incomes less than what was actually earned, the tax may come
down.
5. Using fake documents to claim exemption:
The government may have provided certain exemptions and privileges to certain members of
society in order to ensure they have a bit more financial freedom to progress. In some cases,
members who actually don't qualify for such privileges will get documents created to support
their claim of being a part of that group thus claiming exemptions where they are not suited.

“A child can always teach an adult three things:

to be happy for no reason, to always be busy with
something, and to know how to demand with all
his might that which he desires.”
 QUESTION BANK

HS 200 – BUSINESS ECONOMICS

MODULE 1
1. What is meant by Business Economics?
2. Differentiate Business economics and Managerial Economics?
3. Explain the nature of Business Economics?
4. What is the scope of Business Economics?
5. What are the fundamental economic problems?
6. Explain the following terms:
a. Scarcity, choice and resource allocation
b. Trade-off
c. Opportunity cost
d. Marginal analysis
e. Theory of diminishing marginal utility
f. Production Possibility curve

MODULE 2
1. What is meant by the terms demand and supply?
2. State the law of demand, the factors affecting demand and the exceptions to the law of
demand?
3. State the law of supply and the factors affecting supply?
4. Explain the concept of elasticity of demand. What are the types of elasticity of demand?
5. What are the degrees of price elasticity of demand?
6. Explain the concept of elasticity of supply.
7. Elaborate the concept of market equilibrium
8. Explain the concept of Production function
9. What is meant by the terms average product and marginal product?
10. Explain the law of variable proportions
11. Explain the law of returns to scale
12. Explain the Cobb-Douglas production function.

MODULE 3
1. Explain the following terms with suitable diagrams:
a. Marginal cost
b. Average cost
c. Fixed cost
d. Variable cost
2. Elaborate the nature of cost curves in the short run as well as in long run.
3. Explain the concept of shut down point with a diagram
4. Explain the concept of Break even analysis with a diagram
5. Explain the features of the following markets:
a. Perfect competition
b. Monopoly
c. Monopolistic competition
 d. Oligopoly
e. Collusion and cartel

MODULE 4
1. Explain with a suitable diagram the circular flow of income in a two sector and multi sector
model of economy
2. Explain the various concepts of National income
3. Elaborate the various methods of measuring National Income
4. Explain the term inflation, causes, effects and remedial measures.
5. Explain the term deflation, causes, effects and remedial measures
6. Explain the various phases of a trade cycle with a suitable diagram
7. What are the functions of money?
8. Briefly explain the concept of velocity of circulation of money.
9. Explain the functions of the central bank
10. Explain the credit control measures of the RBI

MODULE 5
1. Explain the process of Capital budgeting
2. Explain the concepts, advantages and limitations of the following methods:
a. Pay back period
b. Average Rate of Return
c. Net present Value
d. Profitability Index
e. Internal Rate of Return
3. Explain the concept of decision making under:
a. Certainty
b. Risk
c. Uncertainty
4. Explain the concept of Cost Benefit Analysis

MODULE 6
1. Explain the concept of Balance sheet and its significance
2. What are the items shown on assets side of Balance Sheet?
3. What are the items shown on liabilities side of Balance Sheet?
4. What is meant by Marshalling of Assets and Liabilities?
5. Explain the various techniques of Forecasting?
6. Explain the various qualitative techniques of forecasting.
7. What are the sources of Finance for business?
8. Explain briefly the following term:
a. Capital markets
b. Money markets
c. FDI
d. FPI
e. FII
f. Direct tax , Indirect tax
g. GST
 APJ Abdul Kalam Technological University
Third/Fourth Semester B.Tech Degree Examination
2016-17
Model Question Paper
HS200 BUSINESS ECONOMICS

Time: 3 Hours Max. Marks: 100

Part A
(Answer any 3 Questions out of 4 Questions. Each carries 10 Marks)

1. a. Discuss the scope of Business Economics.

b. Is usefulness same as Utility? Justify your answer with examples.
2. a. With the help of a suitable diagram explain Production Possibility Curve.
b. What do you understand by i. Veblen Effect ii. Griffen’s Paradox
3. a. If you are the Finance Minister, for which item, eg. Perfectly Elastic or
Perfectly Inelastic item will you increase tax to ensure additional revenue.
Why?
b. Discuss Variable Proportion Production. How is it different from Fixed
Proportion Production?
4. Suppose the production function is
1/4 3/4
Y = 2K L

and K = L = 1. How much output is produced? If we reduced L by 10%, how

much would K need to be increased to produce the same output?

Part B
(Answer any 3 Questions out of 4 Questions. Each carries 10 Marks)

5. The owner of Old-fashioned Berry Pies is thinking of adding a new line of pies
which require leasing new equipment for a monthly payment of $6000. Variable
costs would be $2 per pie and retail price per pie is $7.
a. How many pies must be sold in order to break even?
b. What would be the profit (or loss) if 1000 pies are made and sold
out in a month?
c. How many pies must be sold to realize a profit of $4000?
d. If 2000 can be sold and a profit target is $5000, what price should
be charged per pie?

6. Discuss the following:

a. Features of Monopolistic Competition.
b. Oligopoly
7. Explain how RBI controls inflation.
8. With the help of a diagram, explain two sector model for circular flow of
money.
 Part C
(Answer any 4 Questions out of 6 Questions. Each carries 10 Marks)

9. Discuss the classification of investment analysis techniques and popular

methods under each.
10. Initial outlay for each of the following projects is Rs. 15,000 & standard
payback is 3 years. Evaluate the projects and rank them based on payback
period.
Year Project Project Project Project D
A B C
1 5000 3500 2500 8000
2 5000 4000 2500 6000
3 5000 4500 2500 6000
4 5000 6000 2500 5000
5 5000 6000 2500 5000

11. Discuss the advantages and disadvantages of IRR over NPV.

12. a. State the Accounting Equation and explain its terms
b. Explain the usefulness of Balance Sheet.

13. Explain the terms

a. Associative Forecasting
b. Delphi Technique
14. Develop a trend equation for the following data and predict the sales in the
7th Week.

T y
Week Sales
1 150
2 157
3 162
4 166
5 177
 Solution for Model Question Paper- HS200 Business Economics

Time: 3 Hours Max. Marks: 100

Part A
(Answer any 3 Questions out of 4 Questions. Each carries 10 Marks)
1. a. Discuss the scope of Business Economics.
Solution :

The scope of business economics is so wide that it consists of almost all the problems and areas of
the manager and the firm. The following aspects are said to generally fall under business economics.
a) Demand analysis and forecasting – A business firm is an economic organization which transform
productive resources into goods to be sold in the market. A major part of business decision
making depends on accurate estimates of demand. A demand forecast can serve as a guide
to management for maintaining and strengthening market position and enlarging profits.
Demands analysis helps identify the various factors influencing the product demand and thus
provides guidelines for manipulating demand. Demand analysis and forecasting provides the
essential basis for business planning and occupies a strategic place in managerial economic.
b) Cost and production analysis – A study of economic costs, combined with the data drawn from the
firm’s accounting records, can yield significant cost estimates which are useful for management
decisions. An element of cost uncertainty exists because all the factors determining costs are not
known and controllable. Discovering economic costs and the ability to measure them are the
necessary steps for more effective profit planning, cost control and sound pricing practices.
Production analysis frequently proceeds in physical terms while cost analysis proceeds in
monetary terms. The main topics covered under cost and production analysis are cost
concepts and classification, cost-output relationships, economics and diseconomies of scale,
production function and cost control.
c) Pricing decisions, policies and practices – Pricing is an important area of business economic.
In fact, price is the genesis of a firms revenue and as such its success largely depends on
how correctly the pricing decisions are taken. The important aspects dealt with under
pricing include price determination in various market forms, pricing method, etc.
d) Profit management – Business firms are generally organized for purpose of making profits
and in the long run profits earned are taken as an important measure of the firm’s
success. If knowledge about the future were perfect, profit analysis would have been a
very easy task. However, in a world of uncertainty, expectations are not always realized
so that profit planning and measurement constitute a difficult area of business economic.
The important aspects covered under this area are nature and measurement of profit,
profit policies and technique of profit planning like break-even analysis.
e) Capital management – Among the various types business problems, the most complex and
troublesome for the business manager are those relating to a firm’s capital investments. Relatively
large sums are involved and the problems are so complex that their solution requires considerable
time and labour. Often the decision involving capital management is taken by the top management.
Briefly capital management implies planning and control of capital expenditure. The main topics
dealt with are cost of capital rate of return and selection of projects.

b. Is usefulness same as Utility? Justify your answer with examples.

Solution:

Utility should not be equated with usefulness. The capability of a product to satisfy human
want is referred as utility. Usefulness is associated with those goods and services which are
useful and are related to the betterment of the human beings. The concept of utility is related
to all those products which provide utility, irrespective of whether they are useful or harmful.
 The product’s usefulness is related to its ability to create wellbeing for the humans. The
products which do not create such well being may not create usefulness. All those products
which provide satisfaction to the consumer are considered to have utility. These may include
even those products which are not useful but harmful. The examples in this situation may be
the addictions like cigarette and alcohol. Products like groceries, medicines and so on could
be said to have usefulness. It simply means that usefulness is rooted in the well being.

2. a. With the help of a suitable diagram explain Production Possibility Curve.

Solution :
Production possibility schedule is that schedule which shows alternative production possibilities of two sets of
goods with the given resources and technique of production. Production possibility curve is a graphic
presentation of production possibility schedule, showing alternative production possibilities of two sets of goods
with the given resources and technique of production. Let us suppose that an economy can produce two
commodities, wheat and cloth. We suppose that the productive resources are being fully utilized and
there is no change in technology. If all the resources of production are used for the production of wheat
alone, then 100 lakh tonnes of wheat can be produced. On the contrary, if all the factors of production
are used for the production of cloth alone, then 4000 bales (bundles) of cloth can be produced. If the
economy produces both the goods, then within these limits, various combinations of two goods can be
produced. The following table gives production possibility schedule.
Production possibilities
Goods
A B C D E
Wheat (lakh tones ) 100 90 70 40 0
Cloth (1000 bales) 0 1 2 3 4
The above schedule shows that besides the extreme
Y Inefficient
limits ‘A’ and ‘E’, there are many alternative possibilities of Unattainable

Wheat
combination
production of wheat and cloth. For instance, under 'B' 100 A combination
combination, it is 90 lakh tonnes of wheat and 1000 bales of B
90 F
cloth; under 'C’ combination it is 70 lakh tonnes of wheat
70 C Production
and 2000 bales of cloth and so on. Representing these
possibility curve
various production possibilities on a graph, we get G
production possibilities curve as shown in the figure. Point 40 D
‘F’ represents unattainable combination and point ‘G’ inside Attainable
combinations
the curve represents inefficient use of resources. A
E
production possibility curve illustrates three concepts.
1 2 3 4 X
a) Scarcity – Scarcity is illustrated by point ‘F’ which lies Cloth
Production possibility curve
outside the production possibility curve. To reach point ‘F’,
an increase in resources and/or an increase in efficiency of production are needed.
b) Choice – It is implied by the need to choose among the attainable points on the curve. For instance, we
need to choose whether we are going to produce combination ‘C’ or combination ‘D’.
c) Opportunity cost – Opportunity cost is the value of the next-best alternative that is given up or it is the
cost of a missed opportunity. Opportunity cost is illustrated by the negative slope of the curve which
indicates that more of one good can only be obtained by sacrificing the other good. In terms of the
production possibility curve, the opportunity cost of increasing the production of cloth from 1000 to
2000 leads to the decrease in the production of wheat from 90 lakh tonnes to 70 lakh tonnes.

b. What do you understand by i. Veblen Effect ii. Griffen’s Paradox

The goods of status are named after Thorstein Veblen as Veblen goods. Veblen goods are
prestigious goods. They promote social prestige of the holder. Diamonds and other precious
stones are all status goods. Higher the price, more the demand for them.
Giffen good is necessarily an inferior good consumed mostly by poor consumers as essential
commodities. Cheaper varieties of goods like low priced rice, low priced bread, potatoes,
etc., are some examples of giffen goods.
 th
Sir Robert Giffen of England observed that in the 19 century low-paid British workers were
purchasing more bread when its price was rising. When the price of bread was falling, instead of
buying more bread they were buying less. He was puzzled by this contradiction of buying more at
rising prices and buying less when prices were falling. Bread and meat was the staple food (food
that is eaten routinely) of low wage earners. When the price of bread increased, after purchasing
bread they did not have surpluses money to buy meat. So the rise in price of bread compelled
people to buy more bread and thus raised the demand for bread. When the price was falling,
instead of buying more they tried to buy less of bread and use the savings for the purchase of
meat. This behaviour is now called Giffen's paradox and such goods are termed inferior or Giffen
goods. So, Giffen’s good is a special type of inferior goods where the increase in the price results
into the increase in the quantity demanded. This happens because these goods are consumed by
poor people who would like to buy more if the price increases. For example, in the case of a poor
person who buys inferior quality vegetables, if the price of such vegetables increases then they
prefers to buy more because they think that it would be of a better quality. Thus, in case of Giffen
goods, there is direct relationship between price and quantity demanded.

3. a. If you are the Finance Minister, for which item, eg. Perfectly Elastic or Perfectly Inelastic item
will you increase tax to ensure additional revenue. Why?
Solution :
If the demand for a product is perfectly elastic, the rise in price level causes quantity demanded
fall to zero. So the imposition of tax to elastic goods would lead to reduction in quantity demanded
and hence reduction in the tax revenue. If demand is perfectly inelastic, consumers would buy the
same quantity even after the imposition of the more tax. We have seen that the rise in taxes is
usually for items such as alcohol, tobacco and petrol, all of which are relatively price inelastic.
1/4 3/4
4. Suppose the production function is Y = 2K L and K = L = 1. How much output is produced? If
we reduced L by 10%, how much would K need to be increased to produce the same output?
Solution :
1/4 3/4
Given that, Y = 2K L and K = L = 1
1 3 1 3
4 4 4 4
i.e., Y 2K L 21 1 2
90
10% reduction in value of L = 1 0.9
100
To produce the same output of 2, change to be made on K is calculated as follows.
1 3
4 4
i.e., 2 2 K 0.9
K 1.3717
Part B
(Answer any 3 Questions out of 4 Questions. Each carries 10 Marks)
5. The owner of Old-fashioned Berry Pies is thinking of adding a new line of pies which require
leasing new equipment for a monthly payment of $6000. Variable costs would be $2 per pie and
retail price per pie is $7.
a. How many pies must be sold in order to break even?
b. What would be the profit (or loss) if 1000 pies are made and sold out in a month?
c. How many pies must be sold to realize a profit of $4000?
d. If 2000 can be sold and a profit target is $5000, what price should be charged per pie?
Solution :
Given, v = $2.0, s = $7, F = 6000
 F 6000
a) Break Even Point in units , Q 1200 pies
(s v) (7 2)
b) No. of units sold s F + v No.of units sold =Profit/Loss i.e.,

Profit/Loss 1000 7 6000+ 2 1000

= –$1000 [i.e., loss]

c) No. of units sold s F + v No.of units sold =Profit/Loss i.e., No.

of units sold 7 6000+ 2 No.of units sold =4000

No. of units to be sold to get a profit of $4000 is 2000

pies. d) No. of units sold s F + v No.of units sold =Profit/Loss
i.e., 2000 s 6000+ 2 2000 = 5000

The selling price of a pie to get a profit of $5000 by selling 2000 pies is $7.5.

b. Discuss Variable Proportion Production. How is it different from Fixed Proportion Production?
Solution :
Production function is of two different forms viz., fixed proportion production function and
variable proportion production function. These are explained as follows.
a) Fixed proportion production function - A fixed proportion production function is one in which the
technology requires a fixed combination of inputs, say capital and labour, to produce a given level
of output. There is only one way in which the factors may be combined to produce a given level of
output efficiently, in this type of production, there is no possibility of substitution between the
factors of production. Ihe fixed proportion production function is characterized by constant returns
to scale, i.e., a proportionate increase in inputs leads to a proportionate increase in outputs.
b) Variable proportions production function- The variable proportion production function is the
most familiar production function. In this case, a given level of output can be produced by
several alternative combinations of factors of production, say capital and labour. It is
assumed that the factors can be combined in infinite number of ways , thus, one factor
can be substituted for the other. For example, certain amount of wheat may be produced
using more labour and less capital in India and more capital and less labour in USA.

6. Discuss the following:

a. Features of Monopolistic Competition.
b. Oligopoly
Solution :
Monopolistic competition is a market structure characterized by the following.
a) Large number of buyers and sellers – In a monopolistic competition, there will be large
number of firms but not as large as under perfect competition. This means each firm can
control its price-output policy to some extent.
b) Product differentiation – The distinct feature of monopolistic competition is product differentiation.
Though the number of firms is large but their products differ from one another, in colour, shape,
brand, quality, durability, etc., these products are close substitutes. Product differentiation has
many examples i.e. in case of soaps, we have several brands as Lux, Pears,
Palmolive, etc., and in case of tea, Lipton, Brooke Bond, Taj Mahal, etc. Because of product
differentiation, each firm can decide its price policy independently. So that each firm has a
partial control over price of its product.
c) Freedom of entry and exit of firms – Firms are free to enter into, or exit from the industry.
But new firms have no absolute freedom of entry into industry.
 They may have to face several difficulties. Products of some firms may be legally patented.
No rival firm can produce and sell a patented item like Woodland shoes.
d) Pricing decision – A firm under monopolistic competition is neither a price- taker nor a price-
maker. However, by producing a unique product or establishing a particular reputation, each
firm has partial control over the price.
e) More can be sold only at lower price – Under monopolistic competition, a firm can sell more of
the product only by lowering the price. Accordingly, firm's demand curve is more elastic and
the curve slopes downwards.
f) Lack of perfect knowledge – The buyers and sellers do not have perfect knowledge of the
market. There are innumerable products each being a close substitute of the other. The
buyers do not know about all these products, their qualities and prices.
The main features of an oligopoly market situation are as follows.
1. There are a large number of buyers.
2. There are only a few sellers.
3. There are entry and exit barriers.
4. The product may be homogeneous or heterogeneous, i.e., similar or differentiated.
5. The price-output decisions of one firm are highly dependent on those of others.

7. Explain how RBI controls inflation.

Solution :
RBI controls inflation by the following methods.
a) Bank rate policy – To control inflation the central bank increases the bank rate. With this the cost of
borrowing of commercial banks from RBI will increase so the commercial banks will charge higher rate
of interest on loans. This discourages borrowings and thereby helps to reduce the money in circulation.
b) Open market operation – Open market operations consist of buying and selling of govt. securities by the
RBI. During the period of inflation, RBI issues govt. securities to the commercial banks for which they
have to pay to RBI resulting in limitation of funds and they cannot lend further.
c) Variable Reserve Ratio – The commercial banks have to keep certain percentage of their deposits with
RBI in the form of cash reserve. During inflation, the central bank increases this cash reserve ratio
reducing the lending capacity of the banks.

8. With the help of a diagram, explain two sector model for circular flow of money.

Solution :
In a two sector economy, only two sectors are considered viz., households and firms. There is no government
sector and no foreign sector. There exists a flow of services from the households to the firms and a corresponding
of factor incomes from the firms to the households. Firm produces goods and services with the help of factor
services from households and pay rewards to household sectors for their factor services in the form of rent, wage,
interest, etc. After this first round, firms have goods and services and household sectors have income which they
want to spend for satisfying their wants.
Factor payments

Factor services

Households Firms

Flow of goods and services

Consumption expenditure

Circular flow of income for two sector model

 Household sector spends its earned money to buy goods and services from firm and thus, firm, in
return gets money in this exchange. This two-way circulation (one clockwise and the other anti-
clockwise) goes on moving and re-cycling of economic activities in both the sectors takes place.
Briefly, circular flow model shows that production during the year is converted into factor
income (implying income of the owners of factors of production in terms of rent, interest, profit
and wages) during the year, and factor income during the year is converted into expenditure
(on goods and services) during the year. Thus, factor payments = income of households =
consumption expenditure of households.
Part C
(Answer any 4 Questions out of 6 Questions. Each carries 10 Marks)

9. Discuss the classification of investment analysis techniques and popular methods under each.
Solution :
The investment analysis techniques include Payback period, Average Rate of Return ARR, Net
Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index.
ARR (Average Rate of Return) method is also called the Return on Investment (ROI) since,
the return is measured in accounting terms and concepts. It is a mere expression of the
expected return as a percentage to investment. The average return on investment is defined
as the ratio of the net average annual income from the project to the initial investment. The net
income is defined as the different between the net cash inflows generated by the project and
the cash outflows resulting from the initial investment. The net average annual income is
defined as the income divided by the life of the project measured in years.
Average income
ARR =
Average investment
The average profits after tax are determined by adding up the after-tax profits expected for
each year of the project's life and dividing the result by the number of years. The average
investment is determined by dividing the net investment by 2.
Payback period method determines the period of time required for the return on an
investment to ‘repay’ the sum of the original investment. When all other things being equal, the
better investment is the one with the shorter pay-back period. There can be two situations, one,
when the net annual cash inflow is the same every year, and two, when it is uneven. For even cash
flows, the expression for calculating payback (P) is as below.
C
Then, P = R
; where,
P = Payback period in years,
C = Original capital investment and
R = Net returns per annum.

10. Initial outlay for each of the following projects is Rs. 15,000 & standard payback is 3 years.
Evaluate the projects and rank them based on payback period.

Year Project A Project B Project C Project D

1 5000 3500 2500 8000
2 5000 4000 2500 6000
3 5000 4500 2500 6000
4 5000 6000 2500 5000
5 5000 6000 2500 5000

Cumulative cost for each project is computed and tabulated in the table below.
 Project A Project B Project C Project D
Year Cost Cum. cost Cost Cum. cost Cost Cum. cost Cost Cum. cost
l 5000 5000 3500 3500 2500 2500 8000 8000
2 5000 10000 4000 4000 2500 5000 6000 6000
3 5000 15000 4500 4500 2500 7500 6000 6000
4 5000 20000 6000 6000 2500 10000 5000 5000
5 5000 25000 6000 6000 2500 12500 5000 5000
For Project A,
The above table shows that for the Project A having constant cash flow, the payback period is,
15000/5000 = 3 years.
For Project B,
The above table shows that for the Project B having uneven cash flow, the payback period will
emerge in the 4th year. The number of number of years immediately preceding the year of
payback period, E = 3. By the end of 3rd year, Rs.12000 has been recovered. Hence, balance
to be recovered, B Rs. 15000 Rs.12000 Rs.3000. Also, cash flow during the year 4 is, C =
Rs.60000. Substituting the above values in the expression below, we get,
PBP = E + B
C
3 . 5 years.
For Project C,
The above table shows that for the Project C, the payback period is more than 5 years
and hence it is not accepted.

For Project D,
The Project D with uneven cash flow, the payback period will emerge in the 3rd year. The
number of number of years immediately preceding the year of payback period, E = 2. By
the end of 2nd year, Rs.14000 has been recovered. Hence, balance to be recovered, B Rs.
15000 Rs.14000 Rs.1000. Also, cash flow during the year 3 is, C = Rs.60000.
Substituting the above values in the expression below, we get,
PBP = E + B
C
2 . 166 years.

So, based on the Payback period, the projects are ranked as follows.
1. Project D with Payback period of 2.166 years.
2. Project A with Payback period of 3 years,
3. Project B with Payback period of 3.5 years and
4. Project C. with Payback period of more than 5 years.

11. Discuss the advantages and disadvantages of IRR over NPV.

Solution :
Though both NPV and IRR are methods of discounted cash flow, yet they are different
from each other due to the following points.
1. The net present value method takes the interest rate as a known factor while internal rate
of return method takes it as an unknown factor.

2. The net present value method seeks to find out the amount that can be invested in a given project so that
its anticipated earnings will exactly suffice to repay this amount with interest at the market rate. On the
other hand, internal rate of return method seeks to find the maximum rate of interest at which the funds
invested in the project could be repaid out the cash inflows arising out of that project.
 3. Both the net present value method and internal rate of return method proceed on this
presumption that cash inflows can be reinvested at the discounting rate in the new
projects. However, reinvestment of funds at the cut-off rate is more possible than at the
internal rate of return. Hence, net present value method is more reliable than the internal
rate of return method for ranking two or more capital investment projects.
12. a. State the Accounting Equation and explain its terms
Solution :
Accounting equation is expressed as below.

Assets = Liabilities + Owners equity (capital)

This means that assets, or the means used to operate the company, are balanced by a
company's financial obligations, along with the equity investment brought into the company
and its retained earnings.
Assets denote the resources acquired by the business from the funds available either by owners of
the business or others. It includes all rights or properties which a business owns. Cash,
investments, bills receivable, debtors, stock of raw materials, work in progress and finished
goods, land, building, machinery, trademarks, patent rights, etc., are some examples of assets.
Liabilities denote claims against the assets of a firm whether those of owners of the business or of
the creditors that are to be satisfied by the disbursement or utilization of corporate resources.
b. Explain the usefulness of Balance Sheet.
Solution :
The preparation of balance sheet provides following advantages.

1. It throws light on the financial position of the business as characterized by its assets
and liabilities.
2. It reflects the outcome of investing and financing decisions.
3. It provides relevant information to explain the liquidity position of the business. Liquidity,
besides profitability, position, is a very important yardstick to evaluate the effectiveness
and performance of the business.
4. It portrays the claim of owner(s) and others in the business.

13. Explain the terms

a. Associative Forecasting
b. Delphi Technique
Solution :
Associative forecasting models (causal models) assume that the variable being forecasted
(the dependent variable) is related to other variables (independent variables) in the
environment. This approach tries to project demand based upon those associations. In its
simplest form, linear regression is used to fit a line to the data. That line is then used to
forecast the dependent variable for some selected value of the independent variable.
In Delphi Technique method, a panel of experts is asked to respond to a series of questionnaires. The
responses are tabulated and opinions of the entire group are made known to each of the other panel
members so that they may revise their previous forecast response. The process continues until some
degree of consensus is achieved. Forecast can be made quickly and economically using this method

14. Develop a trend equation for the following data and predict the sales in the 7 th Week.

Week Demand
1 150
2 157
3 162
4 166
5 177
Solution :

Week X Y X2 XY
1 -2 150 4 -300
2 -1 157 1 -157
3 0 162 0 0
4 1 166 1 166
5 2 177 4 354
0 812 10 63

Σx = 0 Σy = 812 Σx2 = 10 Σxy = 63

a= y 812 162.4 and b xy 63 6.3

N 5 x2 10
Hence regression equation takes the form, y = 162.4 + 6.3x. With the help of this equation
we can project the trend values for the 6th and 7th week.
y6 = 162.4 + 6.3(3) = 181 units.

y7 = 162.4 + 6.3(4) = 187.6 units.

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